Bermuda companies, like companies in other jurisdictions competing in the international business sphere, are under continued pressure to succeed and grow so as to succeed on a greater scale. Brian Schneider, senior director at Fitch Ratings, commented in its report titled "Bermuda 2016 Market Update" that "organic growth options are limited and scale and diversification are driving a rapid pace of mergers and acquisitions (M&A) activity for Bermuda insurers and Fitch expects industry consolidation to continue."
The high costs and reputational risks of failed business acquisitions or combinations (business combinations) have increased the need for bidders, target companies and their respective advisers to ensure that the deal is successful, or that they are adequately protected if they fail.
Upon deciding the appropriate type of business combination, care should to be taken to ensure that the interests of the company are adequately protected during any negotiation period and between signing and closing. The company should also acknowledge and address the concerns of any counterparty with respect to any costs associated with a failed transaction. Consequently, deal protection mechanisms are often pleaded and tend to be some of the most heavily negotiated provisions. In negotiating deal protection mechanisms, each director must give due consideration to his/her fiduciary duties and continue to do so during the process — the core duty being to act honestly and in good faith with a view to the best interests of the company.
Deal protection mechanisms are principally covenants or arrangements between a bidder and target company boards that are intended to discourage alternative and/or superior proposals with a view to protecting a bidder's transaction if such a proposal materializes. From a bidder's perspective, the need for deal protection provisions principally arises because, among other things, they do not want to be a stalking horse as it were and they wish to realize synergies and projected benefits from the business combination and minimize competition. Also, a considerable amount of time and cost is spent resulting from both negotiating business combinations and anticipated future opportunities. For these reasons, bidders are typically reluctant to enter into a business combination without protecting the deal to the best extent possible.
Conversely, target company boards often resist and seek to limit the scope of deal protection provisions as they perceive that it is in the best interests of their company if a superior proposal materializes and they wish to retain elasticity to evaluate subsequent competing proposals. However, there are reasons why target boards agree to the request of the bidder for such provisions — principally to increase deal certainty — as the target board does not want to be "put in play" and subsequently lose a preferred or viable bid.
There is no definitive catalogue of deal protection mechanisms that could be complied with, because the term describes a class of mechanisms that are fluid and flexible. Several devices, such as confidentiality, no shop, break fees and fiduciary outs have emerged as standard in business combination transactions, whereas other, more exotic, deal protection mechanisms have been deployed with varying degrees of success.
One central deal protection device is the use of confidentiality provisions that allow the parties to negotiate the material terms of the business combination without alerting potential competitive bidders. From the outset, both parties should enter into a nondisclosure agreement with a view to preventing the disclosure of the proposed transaction and confidential information that is shared between them. When combined with other deal protection devices, for example, no-shop provisions, the obligations of confidentiality contained in a nondisclosure agreement facilitate the exchange of confidential information related to the potential transaction in order to allow each party to effectively evaluate the proposed business combination, protect the transaction from interference by third parties in its infancy and minimize the potential of share value fluctuations due to market speculation.
Break fees first emerged in the U.S. in the mid-1980s as contractual arrangements between a target company and a potential bidder pursuant to which the target company is obliged to confer a financial benefit (typically a lump sum or a percentage of the value of the target company calculated by reference to the bid value) on the bidder if certain trigger events occur that prevent consummation of the deal, so called "liquidated damages."
In business combination transactions, it is common for the bidder to request and the target's board to agree that the target company will pay a break fee to the bidder in certain circumstances, including compensating a failed bidder for transaction expenses and loss of opportunity. A break fee may be triggered when an acquisition agreement is terminated in connection with a variety of events, typically when the target's board invokes a fiduciary out (as described below) to support a superior bid.While break fees are permitted in Bermuda, as alluded to earlier, on the basis that they are intended to compensate for losses incurred in negotiating a failed transaction, the reality is that prospective bidders attempt to negotiate the largest break fee possible as a deterrent to deal cancellation.
Break fees in Bermuda are typically in the range of 1 to 5 percent, although in practice a more usual range is between 2 and 4 percent — and where one goes above 4 percent, the position that is intended to compensate for loss and not constitute a penalty alone becomes less tenable. However, on the facts of each given transaction, a higher fee may be justifiable and so must not be dismissed out of hand.
Conversely, an interesting development has been the emergence of reverse break fees — a fee paid by the bidder if it breaches the merger/acquisition agreement or is unable to consummate the transaction (e.g. due to lack of financing and failure to obtain necessary regulatory approvals) and the target terminates the agreement in accordance with its terms. If an agreement provides for a reverse break fee, the amount of the reverse break fee (which tend to be higher than break fees) and the conditions under which it is payable are usually set out in the termination provisions of the merger/acquisition agreement.
One of the more prominent ingredients in the nondefinitive catalogue of deal protection mechanisms (yet also a central point of bargaining) is a no-shop provision/exclusivity clause. The term no-shop clause is not used uniformly and may cover a wide range of covenants. No-shop provisions principally seek to prevent a target company from soliciting or encouraging third-party proposals. These provisions vary from a less restrictive clause that permits the target company to provide information to unsolicited bidders, to the much more restrictive "no-talk" provision that prohibits the target company from responding to any third-party advances. Because of their potential for discouraging what may be superior competing offers, no-shop provisions are subject to increasing scrutiny.
The use of no-shop provisions are common in Bermuda business combination transactions. However, overly restrictive no-shop provisions could be subjected to scrutiny on the basis that the target board breached its fiduciary duty to act in the best interest of the company (including the shareholders as a whole) because it failed to enter into a transaction that recognized the true value of the company and allowed shareholders to realize the same. Any contract provision that seeks to abrogate the board's ability to do so is contrary to these duties. Consequently, even though the directors may negotiate several deal protection mechanisms (including a no-shop provision), they should seek to be able to accept a superior proposal for the shareholders without being fully locked up by the terms of the agreement. Accordingly, target boards typically require a fiduciary out (as described below) as an exception to the no shop that gives them certain rights to review alternate proposals or respond to intervening events.
As highlighted in part 2 of this series, directors of the target company have certain fiduciary duties with which they must comply — the core duty being to act honestly and in good faith with a view to the best interests of the company — which in the context of a proposed business combination may include maximizing shareholder value. Therefore, the fiduciary-out provision was created and is another heavily negotiated provision in business combination transactions. A fiduciary-out provision is not a deal protection mechanism as such, but must be highlighted as it is an important exception to the no-shop provision. The fiduciary-out allows the target's board to take certain actions, which includes terminating the transaction, if the failure to do so would be inconsistent with its fiduciary duties to the company.
The board of a target company may seek to include any of the following three common forms of fiduciary outs:
- Intervening Event — a right for the target board to change its recommendation to its shareholders and terminate the agreement because of an event that has caused the target company to become worth significantly more than its valued amount at closing — commonly referred to as "gold in the backyard."
- Superior Proposal — a right for the target board to consider and accept superior proposals. This is the most common form of fiduciary out.
- Directors Fiduciary Duties — a general right of the target board to withdraw or amend its recommendation if it concludes that consummating the proposed business combination would be in breach of their fiduciary duties.
Target boards should seek to insist on a fiduciary out in exclusivity undertakings, unless the applicable period is so short it presents no impediment to a competing bidder.
A bidder may, however, seek to negotiate and impose limitations on the target's fiduciary out by incorporating the following conditions:
- Intervening Event — the bidder has a right to match and/or exceed the superior proposal upon the bidder reviewing the terms and conditions of all superior proposals.
- Superior Proposals — method and amount of consideration (eg. cash vs. shares); ease and confidence of closing (eg. no financing required vs. financing required); regulatory issues (eg. closing subject to approval vs. no approval required).
- Directors Fiduciary Duties — the target's board shall make a determination in good faith upon receiving advice from external counsel, that failure to withdraw or amend its recommendation to its shareholders would result in a breach of fiduciary duties.
The exercise of a fiduciary out is typically coupled with payment of a termination fee to compensate the bidder for its time and expense, both in terms of actual out-of-pocket costs and lost opportunity.
While a bidder wants certainty that the transaction it is negotiating with the target will be consummated even if a superior proposal arises, the target's board should ensure that it observes its fiduciary duties.
One of the more "exotic deal protection mechanisms," as mentioned above, is the "crown jewel" provision. This is a device by which the target company agrees to grant the proposed acquirer an option to purchase, or otherwise obtain the benefit of, certain of the target's valuable assets in the event that the proposed transaction does not close, including as a result of a topping bid.
This type of protection gives the acquirer assurance that even outside of a successful acquisition or merger, it will nevertheless acquire key pieces of the target's business. This device also serves to deter competing bidders, as a superior bidder will at best acquire the target without the "crown jewels."
While there may be room for creative variations on crown jewels, they are not a staple of transactions in Bermuda and we would expect boards of targets to be generally unwilling to agree to such a provision as it could make the target less attractive, reduce the chances of subsequent bids, and weaken the target if the merger does not proceed, making the target company a mere shadow of its former self.
As noted, deal protection provisions can be the most heavily negotiated provisions in business combination transactions. Those in favor of such provisions point to the value of them from an economic exploration perspective; they are seen as value-enhancing and encourage superior proposals. Those opposed seek to demonstrate the negative effects on shareholder value and so they negotiate against onerous terms.
Crafting a deal protection package that delivers the right level of protection while adhering to the various regulatory and legal constraints (and minimizing the risk of any judicial challenge) is and will continue to be important. As such, their terms should reflect a reasonable balance of the competing interests of the two parties to the transaction within the context of the relevant market and deal-specific framework and should always be considered against the backdrop of fiduciary duties. The goals should be to achieve a reasonable outcome that weighs the economic interests of both parties while ensuring that directors remain focused on their contextually specific fiduciary duties when agreeing to deal protection terms.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.