The fact that break fees and other deal protection measures succeed in discouraging rival bids that are only slightly higher does not make them preclusive, says a highly respected U.S. judge. Boards are well within their rights to constrain tiny incremental offers, says Delaware Vice Chancellor Leo Strine, because they lead potential buyers to underbid, drag out sale processes and are unconstructive overall to a healthy M&A market.
In the 88-page In re Toys "R" Us decision, Vice Chancellor Strine writes, "It is not the concern of our law to set up a system that promotes endless incremental bidding. To do so risks creating an incentive for lower initial deal prices because initial buyers will have less closing certainty."
The suit grew out of an attempt by institutional shareholders to block the US$6.6-billion sale of Toys "R" Us earlier this year to a group of private equity firms led by Kohlberg Kravis Roberts. The shareholders argued that the 3.75 percent break fee, combined with a no-shop provision and matching right, were "draconian" deal-protection measures that kept new bidders on the sidelines.
Vice Chancellor Strine forcefully rejected their arguments, stating that where a well-informed board has done a thorough job, it is not up to the court to revisit "reasonable, but debatable tactical choices."
The decision provides important guidance on break fees and other deal protections. Break fees in particular have made headlines in Canada recently. For example, corporate governance critics took aim at the 3.5-percent, or US$350-million, termination fee in Inco's proposed friendly takeover of Falconbridge. Stephen Jarislowsky, a respected shareholders' rights advocate, called such fees a "bribe" and said boards who approve them are abdicating their responsibility to shareholders.
Some Canadian institutions have policies outlining the maximum level of break fee they will support. But Vice Chancellor Strine says a bright-line test makes no sense because it is simply impossible to state that a break fee under a fixed percentage, 3 percent, for example, will always be reasonable, because it depends entirely on the rigor of the board process. Also, it is reasonable for boards to see break fees as compensation to friendly partners for the cost of failed bids, and at the same time as compensation for bidders agreeing to tie up billions of dollars in opportunity capital while an auction plays out. Finally, half a percentage point or even a full point does not always make much difference: in Toys "R" Us, cutting the break fee from 3.75 percent to 2.5 percent would have made a difference of US 33 cents a share—an amount that would not seriously deter a bidder willing to pay substantially more than the US$26.75 that was on the table.
The decision should provide solace to public company boards wrestling with such issues, says Richard Willoughby. "There's clear recognition there's no blueprint for this kind of thing. As somebody said, 'this toy doesn't come with an instruction manual.' This decision signals that as long as certain things are being done to maximize shareholder value, there will be a lot of latitude given to the board."
Richard expects that the ruling will be widely read among Canadian judges. "These decisions coming out of Delaware are definitely persuasive in a Canadian context," he says. "I think the Canadian courts generally have been a little more deferential to boards' judgment than U.S. courts, and a U.S. case that shifts towards more deference is something Canadian courts will be interested in. I think it will be read and referred to—it's too helpful a recap, and further thought in an area that doesn't get a lot of case law in Canada."