Avoid Unenforceable Termination Fee Provisions in Mergers and Acquisitions Agreements-Delaware Case Provides More Detailed Scrutiny - Mergers and Acquisitions
April 1, 1998 Advisory
In May 1997, the Delaware Supreme Court issued a decision in Brazen v. Bell Atlantic that will require more careful consideration of the purpose and scope of termination fee (or so-called "break-up fee") provisions in merger agreements to ensure that such provisions will be enforced. A termination fee provision is designed to protect a party to a merger agreement in the event that the merger is not consummated for reasons such as the acceptance of a competitive offer or the failure to obtain shareholder approval. The fee is expected to reasonably reflect an estimate of the costs that the aggrieved party would realize upon termination, such as out-of-pocket expenses and lost opportunity costs incurred during the merger negotiations.
In deciding whether to enforce termination fee provisions, courts apply varying standards of review, ranging from the deferential business judgment rule to the more detailed liquidated damages analysis, depending upon the facts of each case. If the provision does not meet the required standard, the court will view it as a penalty and render the provision unenforceable. Though it is often difficult to predict what level of scrutiny a particular court will apply, the Bell Atlantic decision is noteworthy because it was rendered recently by an influential court in the area of corporate law. After this decision, it is likely that termination provisions will have to meet the more restrictive liquidated damages standard to be upheld. Although this standard is not difficult to meet, parties to a merger should ask their counsel to draft the provision with the Bell Atlantic decision in mind.
In Bell Atlantic, the merger agreement between Bell Atlantic and NYNEX contained a termination provision calling for a fee of $550 million. The provision was structured in two parts. The first part called for a $200 million fee in the event of a competing offer and either (a) failure to obtain shareholder approval or (b) termination of the agreement. The second part called for a $350 million fee if a competing transaction was consummated within eighteen months of the termination date. Language in the provision stated that the termination fee constituted liquidated damages and not a penalty. A class of Bell Atlantic stockholders sued Bell Atlantic, challenging the termination fee as not being an accurate estimate of actual expenses incurred in preparation of the merger. The suit claimed that the fee constituted an unconscionably high "lockup fee" designed to coerce Bell Atlantic's board of directors and shareholders to approve the merger. The court, relying in large part on the express language of the provision, found the termination fee to be a liquidated damages provision.
Applying liquidated damages analysis, the court found the termination fee provision to be valid and not a penalty. The court held that the provision satisfied a two-prong standard: (1) the damages were uncertain and (2) the amount agreed upon was reasonable. The court found the fee to be reasonable because Bell Atlantic and Nynex, in arriving at the fee amount, considered: (a) the lost opportunity costs associated with a contract to deal exclusively with each other; (b) the expenses incurred in negotiating the transaction; (c) the likelihood of a higher bid for the acquisition of either party; and (d) the size of the termination fees in other transactions. The court was also persuaded by the fact that the $550 million fee was only 2% of Bell Atlantic's $28 billion market capitalization.
As long as a termination fee amount takes into consideration factors similar to those set forth in Bell Atlantic and the merger negotiations are made at arms length, a court is more likely to enforce such a termination fee revision. It is appropriate, therefore, to structure such provisions in a way which will likely survive judicial scrutiny under the standard recently set forth in Bell Atlantic.