Tune in tomorrow for this DealLawyers.com webcast - "Alternative Fee Arrangements for Deals: Little Less Talk and Lot More Action?" - to hear Wilson Chu of K&L Gates; Scott Depta of Dell and Lance Jones of Trilogy talk about how the ways that deal fees are being restructured, a trend hastened by a down economy.

Podcast Series for M&A Practitioners

We recently came across a new resource for M&A practitioners - a series of podcasts by Booz & Company, the management consulting firm that split off last year from Booz Allen.

To date, Booz & Co has posted 24 podcasts on various M&A and restructurings topics - many of them related to books authored by staffers there - including: M&A in China, bank merger integration and mistakes to avoid in financial sector M&A. The latest podcast, called “Velocity and Impatience,” includes a discussion on whether the pace of business has become too fast, the reason deals are closing more quickly today and its implications for merger integration.

Below are some thoughts from William Newman of Sullivan & Worcester on the regulatory regimen in the US for inbound M&A deals - often a significant factor in determining whether a deal will be completed or not - that he recently posted on his firm’s blog:

A lawsuit that could have determined whether a filing made with CFIUS can be considered customary has ended. In May 2009, husband and wife Joseph and Judy Ehrenreich sued 3Com Corporation for damages they allegedly suffered from the loss in value of their 3Com shares. The case was brought under the provision of the federal securities laws that enables purchasers of stock to recover losses arising out of incorrect or incomplete statements made by the issuer of the shares. 3Com is a Massachusetts-based enterprise networking solutions provider.

The Ehrenreichs claimed that the cause of their loss was 3Com’s failure to specify that CFIUS review of its proposed merger with affiliates of Bain Capital was a significant risk. 3Com had published a press release announcing the proposed merger on September 28, 2007. The press release stated that the merger was subject to “customary regulatory approvals.” CFIUS review was not mentioned. The plaintiffs purchased 13,000 shares of 3Com stock after the announcement of the proposed merger.

The basis of the plaintiff’s case was that the proposed merger did truly raise serious national security concerns and that, as a result, CFIUS review was not customary. The plaintiffs interpreted “customary” to mean perfunctory or ministerial. The aspect of the merger that triggered CFIUS review was that, as part of the transaction, affiliates of China’s largest network equipment company, Huawei Technologies, were to acquire an interest in 3Com. Press reports associated Huawei with China’s military and possible links to Chinese cyber warfare efforts against the U.S. and the U.S. military.

Although 3Com disclosed on October 4, 2007 that it intended to make a CFIUS filing, the plaintiffs contended that 3Com’s announcement omitted the reasons for seeking the review and downplayed the risk that CFIUS could block the transaction. Five months later, 3Com withdrew its CFIUS filing. One month later, the parties terminated their merger. The announced reason was that CFIUS intended to prohibit the deal. The price of 3Com stock plummeted from its level at the time of the original announcement.

The complaint claims that the peculiar structure of FINSA – its voluntary and not mandatory filing requirement -- gives parties an incentive not to mention the possibility of CFIUS review. It suggests that parties might try to “fly under the radar screen” and not provoke public reaction to a deal.

We will not know from this case whether 3Com’s initial failure to specify CFIUS review and the basis on which CFIUS could review the transaction was an incorrect or incomplete statement. The plaintiffs voluntarily withdrew on June 30, dismissing their case with prejudice. A settlement may have occurred. Even if abandoned at this stage, the case stands as a warning to parties contemplating a CFIUS filing. When communicating to the markets, it’s best to say more about the likelihood of a CFIUS review rather than less. Parties now are on notice that CFIUS review may be more than perfunctory. It’s safer to make that clear if the review leads to an unexpected end to the deal.

Here's some analysis from Cliff Neimeth of Greenberg Traurig:

As widely anticipated, in an open session of the SEC's Commissioners last week, they approved (in a 3-2 split-vote) the elimination of NYSE Rule 452. This will end the long-standing practice of broker-dealer discretionary authority to vote "uninstructed client shares" in uncontested director elections.

Under Rule 452, uncontested director elections historically were classified as a "routine matter" enabling brokers to vote as they deemed appropriate in respect of shares for which they did not receive specific client voting instructions prior to the 10th day next preceding the stockholder meeting. Statistically, such shares overwhelmingly were voted "for" director candidates nominated by the issuer.

For many issuers who, in the past few years, have adopted "majority voting" bylaw standards for uncontested director elections (or, at a minimum, have adopted so-called "plurality plus" director resignation requirements), the elimination of Rule 452 adds significant fuel to "withhold authority" campaigns initiated by activist hedge funds and other dissident stockholders to advance agendas not necessarily in the best interests of all stockholders.

Moreover, in view of (i) new Sections 112 and 113 of the DGCL - effective August 1, 2009 - which enable the adoption of binding bylaw provisions permitting direct insurgent access to the issuer's proxy materials and, in certain circumstances, reimbursement of expenses incurred by dissidents in opposition election contests; (ii) proposed SEC Rule 14a-11 which, if adopted substantially as proposed in time for the 2010 proxy season, will mandate the inclusion in issuer proxy materials of insugent (short-slate) nominees, provided that certain minimum ownership and other procedural requisites are satisfied; (iii) recent Delaware decisions strictly construing the validity and use of certain organic takeover defenses; and (iv) the SEC's recently adopted "e-proxy" rules and exempt solicitation "stockholder forum" rules, dissident boardroom access is being made increasingly more available to activists and far less less costly.

In turn, unsuspecting (or unprepared) issuers are becoming increasingly vulnerable.

What to Do Now

As you've no doubt read on all of these subjects, it is very important to review with your clients their existing advance notice bylaws and other organic and structural takeover defenses (including rights plans, etc.). This is further compounded by the current macroeconomic environment which has been an impetus for operating and financial performance shortfalls across myriad industries, and the sharp decline in straight buyside and sellside deal activity, in each case further giving rise to alternative "liquidity event" agendas and other management displacement and corporate change-in-control campaigns.

Of course, shark repellents that only can be implemented by means of charter amendment (under applicable state law) would require both director approval and stockholder adoption - which may be impractical or untimely in many circumstances.

The need to assess client "targetability" tends to be more pronounced in the case of small cap issuers who tend to be disproportionately more vulnerable to unsolicited assault for a variety of economic, structural, and other reasons.

The SEC also announced yesterday that, in addition to pending Rule 14a-11, it intends to undertake a comprehensive review of all current proxy regulations with a view to "overhaul" them as may be necessary.

Kevin Miller of Alston & Bird notes: In this order on Friday, Delaware Chancellor Chandler granted plaintiff's motion for expedited proceedings to seek injunctive relief to address a board's alleged failure to fulfill its Revlon duties.

Highlighting the significance that the procedural posture of a case can have, the Court noted that the Delaware Supreme Court's recent decision in Lyondell Chemical v. Ryan may preclude an award of monetary damages for a breach of the duty of care where the target company's charter contains a 102(b)(7) exculpatory provision. But exculpation for monetary damages does not preclude injunctive relief -"[t]hus, in cases such as this one, the shareholders' only realistic remedy for certain breaches of fiduciary duty in connection with a sale of control transaction may be injunctive relief."

Background/Allegations (for purposes of motion, the court treats plaintiff's well plead allegations as true):

- In March 2009, Data Domain began discussions with NetApp regarding a potential business combination

- On May 11, the Data Domain board was informed that EMC was interested in meeting with Data Domain and a meeting was subsequently scheduled for May 27.

- On May 20, Data Domain and NetApp entered into a merger agreement pursuant to which Data Domain would become a wholly owned subsidiary of NetApp and Data Domain's shareholders would receive $25 in a combination of cash and Net App stock. The merger agreement allegedly contains a number of deal protection provisions including a no-shop clause, a matching right and a termination fee and certain officers and directors of Data Domain entered into an agreement to vote approximately 20% of Data Domains shares in favor of the merger with NetApp.

- On June 1, EMC launched an all cash tender offer for Data Domain at $30 per share.

- On June 3, NetApp increase the cash component of its offer by $5, raising the overall value of its offer to $30 per share. Data Domain agreed to NetApps revised offer and left all the deal protection measures in place.

Plaintiffs alleged that Data Domain's directors violated their fiduciary duties in the context of a sale of control of the company under Revlon v. MacAndrews & Forbes - i.e., that Data Domain's directors breached their fiduciary duties by failing to take steps to obtain the best price reasonably available, by granting/permitting preclusive deal protection provisions and by failing to inform themselves.

[Note: where the consideration is cash and stock, Delaware case law is unclear as to whether and when Revlon duties apply. Here it appears a majority of the consideration is cash.]

- by John Jenkins, Calfee Halter & Griswold

Sometimes you can’t blame deal lawyers for feeling like Bill Murray’s character in Groundhog Day - there are just some things that seem to happen over and over again in almost the same way on practically every deal. When it comes to public company deals, having to decide whether or not to disclose pending negotiations is defin itely one of those recurring events.

Assuming you’re not dealing with an auction or some other process where the seller has decided to hang a “for sale” sign on itself, nobody involved in the transaction wants the world to know that talks are going on until the parties are ready to announce a signed deal. Among other issues, premature disclosure may create problems for the buyer and the seller with key constituencies - like their employees, customers and in some cases, shareholders - that they would like to postpone until a later date when they have had time to map out a communications strategy.

The SEC cuts public companies some slack when it comes to disclosure of merger negotiations. In general, the Staff’s position is that even though MD&A’s “known trends” disclosure requirement might be read to require companies to address pending talks, if the company doesn’t otherwise have an obligation to disclose preliminary talks, then disclosure won’t be required in response to this line item in an Exchange Act report. (See, e.g., Securities Act Rel. No. 6835 (May 18, 1989)).

The SEC’s position is helpful, but this issue isn’t confined to Exchange Act reporting. Public companies have a duty to disclose material information under other circumstances as well, including situations involving leaks for which the corporation or insiders are responsible - and it’s these situations in which the disclosure issue usually arises.

Legally, there are two major issues to keep in mind in deciding whether you need to say something. The first is whether you’ve got a duty to disclose that you’re engaged in discussions. While there’s no general obligation to dispel rumors in the marketplace that you aren’t responsible for, the problem is that you’ll seldom be able to determine whether you’ve got responsibility for the leak or not - and there’s a pretty good chance that you might.

The second legal issue is whether information about the potential deal is “material.” That question, as everybody knows, is a function of its probability and its magnitude under the test announced by the Supreme Court in Basic v. Levinson. There are a lot of ways to look at Basic’s requirements, but it goes without saying that the further down the path you are, the more likely it is that information about your deal is going to be considered material.

While lawyers naturally tend to focus on the legal issues, business concerns frequently drive a decision to go public with negotiations. Companies may feel that their hands are forced by the media’s decision to run with a story on the rumored deal, or by inquiries from the Nasdaq or the NYSE about the reasons behind unusual market activity. Once information leaks, the need to manage the potential damage to key relationships may also make a compelling business case for disclosure. What’s more, there’s sometimes concern that speculation may cause the market to get carried away. That can lead to the unpleasant situation where the market price rises above the price levels that the parties are negotiating.

Once a decision to disclose pending talks is made, the next issue becomes, how much do you say? Often, people want to say as little as possible. The parties may decide not to identify the buyer, and sometimes, will avoid making any disclosure about the price as well. Sometimes, discussions about what you’re going to say can get pretty contentious, as the two sides may have conflicting views when it comes to the extent of disclosure that’s appropriate.

If you’ve got a relatively efficient market for your stock, and you don’t feel a need to reach out to other constituencies, a minimalist approach may work. Just bear in mind that the less you say, the less freely you can communicate with your key constituencies and the more you remain at risk for the consequences of market speculation. If you don’t say enough, you may find yourself needing to make a second announcement, which only further complicates everyone’s life.

When leaks happen, companies often find themselves in a completely reactive position, with very little time to think through all of the implications of their decisions about disclosure. That’s why I think the best advice is to address the possibility of leaks early on in the process, and chart out a course for managing the disclosure process if they do occur.

Advance planning won’t stop leaks from happening, but it will put everyone in a better position to respond to them if they do. Getting a jump on this issue may make it less painful when you hear the familiar sound of Sonny & Cher’s “I Got You Babe” coming through your clock radio, followed by a couple of morning DJ’s cheerily reminding you that “It’s Groundhog Day!”

Again.

Broc's note: A great version of "I Got You Babe" is the one by UB40 and the Pretender's Chrissie Hynde.

Reacting to this blog recently from John Jenkins, a member posed the question: why, given the virtually universal use of indemnification, does reliance matter? This member would characterize most claims as actions to enforce a covenant to indemnify for damages resulting from inaccuracies in representations and warranties, rather than claims for breaches of representations and warranties themselves - and he noted John's somewhat oblique reference to specific indemnities and wondered if he had given any thought to the issue.

The member stated there are three main fact patterns:

1. Traditional breach of representation or warranty claim that can be analyzed under the existing case law relating to the reliance element - Ziff Davis or Galli v. Metz, which are fact specific and can lead to different results

2. Specific/special indemnity - indemnification for any loss relating to a specific issue - e.g., environmental problem, cost overruns on budgeted severance

3. Traditional indemnity for breach or inaccuracy of representation

John Jenkins responsed to this question as follows:

I'm not sure I've got a good answer to your question, although I think there are two reasons that reliance still matters:

1. I think that because of the indemnity right's status as a remedy that is tied in some fashion to a "breach" (whether defined broadly to include inaccuracies or in more narrow terms) of a rep or warranty, courts that think reliance matters won't view the covenant to indemnify as being an independent obligation. The existence of a right to indemnity is predicated on the rep, and therefore reliance on the rep remains an issue when a claim for indemnity is made.

2. The more fundamental problem is that you get it right, and the courts that adopt a reliance requirement don't. You're applying contract law principles to contract law issues, while the courts that are requiring a showing of reliance in these cases aren't. They are importing the tort concept of reliance into contract claims, which doesn't make sense to begin with:

"Transplanting tort principles into contract law seems analytically unsound. If a party to a contract purchases a promise, he should not be denied damages for breach on the grounds that it was unwise or unreasonable for him to do so. Indeed, Judge Hand admonishes: 'To argue that the promisee is responsible for failing independently to confirm [the warranty], is utterly to misconceive its office.' Metropolitan Coal Co. v. Howard, 155 F.2d 780, 784 (2nd Cir.1946). Thus, a claim for relief in breach of warranty is complete upon proof of the warranty as part of a contract and proof of its breach." Ainger v. Michigan General Corp., 476 F.Supp. 1209, 1224-1225 (S.D.N.Y. 1979).

Once courts have crossed this particular Rubicon, it's probably not too surprising that they would go on to ignore other principles of contract law, like the one that prompted your concerns.

If you read Robert Quaintance's article (which is where the quote about specific indemnity rights came from), I think this is where some of his concerns are coming from. For example, he says that buyers that rely solely on express reservations of rights run the risk of running into a court that looks principally to Ziff-Davis, "where timing [of the buyer's knowledge] seemed to matter a lot - and reservation of rights seemed not to matter very much - and holds that that if the buyer knew before signing that the seller's representation was untrue, the buyer could not have been relying on that representation when it entered into the agreement." In other words, the risk is that a court might approach the contract issues from a tort law perspective that elevates the "reliance" concept above the ability of the parties to bargain their own appropriate allocation of risk.

Last week, the Delaware Supreme Court affirmed - in Alliance Data Systems v. Blackstone Capital Partners V - the Chancery Court's decision dismissing Alliance Data Systems suit against Blackstone acquisition entities for breach of their merger agreement.

As we have blogged, the Chancery Court had dismissed ADS's claims that the Blackstone shell entities that had signed the merger agreement to acquire ADS had breached their obligations under the merger agreement and were obligated to pay ADS a $170 million “business interruption fee.” The Chancery Court found that those Blackstone entities had fulfilled their obligations under the merger agreement and had not promised to cause the Blackstone entities that control them to agree to terms demanded by the Office of the Comptroller of the Currency in order to obtain a required regulatory approval.

The Chancery Court's decision was widely considered an affirmation of the typical private equity transaction structure in which PE managers/advisors seek to shield themselves and their investment funds from liability for breaches of the transaction agreement by forming shell acquisition vehicles to enter into the transaction agreement.

In the succinct ruling, the Delaware Supreme Court stated: “Upon consideration of the briefs of the parties and their contentions in the briefs and oral argument, it appears to the Court that the judgment of the Court of Chancery should be affirmed on the basis of and for the reasons set forth in its well-reasoned January 15, 2009 opinion.”

Recently, The Corporate Library and the IRRC Institute teamed up to study whether private equity buyout firms institute more shareholder-friendly corporate governance structures in their IPO companies than non PE-backed IPO companies. The study – “What Is the Impact of Private Equity Buyout Fund Ownership on IPO Companies’ Corporate Governance?” - examined the ownership, board characteristics, takeover defenses and compensation policies of 90 companies that went public during 2004-06 (48 were PE-backed; 42 were not). [By the way, we recently blogged on TheCorporateCounsel.net about governance trends for all types of IPOs.]

The study found that PE-backed IPOs do not have superior corporate governance procedures as compared to non PE-backed IPOs. On the contrary, the study found that the PE-backed IPOs exhibit - in a higher proportion than average - a number of features that have the potential to benefit executives at the expense of shareholders, including takeover defenses and boards whose independence may be compromised.

But before you decide to stop investing in PE-backed IPOs, consider that this study did not review any performance metrics of these companies and, as pointed out in this DealBook blog, PE firms are themselves large shareholders after the IPO and are therefore incentivized to ensure the long-term success of the company. For more on the study, see Larry Ribstein’s Ideoblog and The Corporate Library’s Blog.

We note that one of our DealLawyers.com board advisors, Frank Aquila of Sullivan & Cromwell, weighed in recently on the state of corporate governance in this BusinessWeek article.

Frank argues that the recent market environment and reform efforts may serve to diminish the power of CEOs. He notes: “If we are to move beyond the current financial crisis, we will need business leaders who are permitted to take actions that will have a positive impact beyond the next quarter or next fiscal year. But at a time when businesses need long-term, strategic decision-making the most, the new corporate order actually impedes decisive action.”

Recently, I announced a "cool deal cube contest" as part of our ongoing "Deal Cube Chronicles." John Newell of Goodwin Procter takes the prize with this cube. John notes:

Here is an old JPMorgan advertisement from the late '80s that explains this cube. In a nutshell, it is that the cube/tombstone from the "tombstone of the unknown deal." I made a joke to a senior guy at Bowne of Boston after a public deal cratered and he made a couple of these babies.

Recently, I also received this story from a member:

During a drafting session for a follow-on offering in which we were underwriters' counsel, we commented that the CFO was referred to in his bio as a certified pubic accountant. Company counsel expressed surprise because they had copied the language verbatim from the original IPO prospectus. There followed 1-1/2 seconds of uncomfortable silence, after which we flipped through a copy of the IPO prospectus and confirmed the worst.

There is some consolation in the fact that a search of the term "certified pubic" on EDGAR yields 142 hits (and counting).

As the proxy season gets underway in Japan – where the majority of companies hold their meetings during the last two weeks of June - defensive measures are the hot topic once again this year. This report is from the RiskMetrics Group:

The most controversial issue of the 2009 Japanese proxy season will continue to be the introduction and renewal of “poison pills” and other types of takeover defenses. In the wake of attempts to take over companies including Hokuetsu Paper, Bull-Dog Sauce, and Sapporo Holdings - as well as the successful proxy challenge at Aderans Holdings - many companies have introduced defensive measures because of fears of being acquired.

However, these fears may be overblown because the difficulties of successfully managing a company after a hostile acquisition will help to ensure that the number of such cases will be limited. Nevertheless, several hundred companies will introduce or renew a poison pill this year. More than one in seven Japanese issuers already have a pill in place as of May 1, according to RiskMetrics data.

Notwithstanding investors’ skepticism toward takeover defenses, companies that have put their pills to a vote usually have had no difficulties in winning approval, thanks to the support of cross-shareholders and other management-friendly parties. One exception is Works Applications, which was forced to withdraw a pill proposal after the company could not garner enough shareholder support.

According to RiskMetrics data, about 30 companies have removed poison pills to date. However, this includes companies where pills became unnecessary due to organizational changes such as becoming listed subsidiaries of larger companies; RiskMetrics data shows that only about 10 companies, including Shiseido, Nissen Holdings, and Rohm, removed pills because they came to believe that the defenses were not in the best interests of shareholders.

Most poison pills introduced in 2005 were so-called “trust-type” plans, where warrants are issued to a trust bank, to be transferred to all shareholders (other than a would-be acquirer) in the event the pill is triggered. These plans require a shareholder vote under Japanese law. Since 2006, the vast majority of poison pills have been so called “advance warning-type” or “advance notice-type” plans. In these cases, the board announces a set of disclosure requirements it expects any bidder to comply with, as well as a waiting period between the submission of this information and the launch of the bid. As long as the bidder complies with these rules, the company “in principle” will take no action to block the bid and allow shareholders to decide. The exceptions are where the bid is judged to be clearly detrimental to shareholders, such as in cases of greenmail, asset stripping, and coercive two-tier offers. Usually, such judgments are made by a “special committee” or “independent committee,” but the committee’s decision is usually subject to being overruled by the board. At some companies, the decisions are made by the board with no committee input at all.

Advance warning-type defenses do not require shareholder approval, although in most cases, companies are choosing to put them to a shareholder vote, as it is believed that doing so will put the company in a stronger position in the event of a lawsuit. However, the primary problem is not the terms of the poison pills themselves - these are often superior to those of U.S. companies due to relatively high trigger thresholds, clear sunset provisions, and an absence of “dead hand” provisions. Rather, the main problem is with Japanese companies’ insider-dominated boards and insufficient disclosure. The presence of a critical mass of independent directors is essential to ensure that a takeover defense is used not merely to entrench management, but contributes to the enhancement of shareholder value.

Notwithstanding management fears, some of the companies implementing pills are in fact not especially vulnerable, because founding families, business partners, or other insiders own more than a third of outstanding shares. This is enough to veto any special resolution, such as an article amendment or a merger, meaning that even if a hostile bidder is able to accumulate a sizable stake in such a company, that bidder will be unable to force any major restructuring moves opposed by the insiders. It is difficult to see what shareholders of such a company stand to gain from a poison pill.

Many of the poison pills introduced in the past few years will be up for renewal in 2009. In evaluating these renewals, investors should examine the company's share price performance, relative to its peers, since the pill was first put in place. Where the company has underperformed the market, it will be difficult to argue that shareholders have benefited from the pill.

Some companies, while not putting a poison pill on the ballot, will seek to pave the way for the eventual introduction of a pill through measures such as increasing authorized capital. Investors should expect to see other article amendments designed to ward off hostile takeovers, such as the elimination of vacant board seats that could be filled by shareholder nominees, and the tightening of procedures for removing a director.

During this podcast, Mary Beth Kissane of Walek Associates analyzes how companies should be monitoring shareholder activist activity, including:

- How do hedge funds have such a solid activism record?
- What should companies do to prepare for an activist attack?
- Who within the company owns the "monitoring activists" task?
- Who within the company should be dealing with the financial press?
- Who is the "financial press" these days? Bloggers included? Social media?

- by Scott Walker, Walker Corporate Law Group

I want to expand on John Jenkins' recent blog on first drafts to capture a broader - and perhaps more important - point: The initial draft of the acquisition agreement should reflect the ongoing substantive discussions among members of the acquiror’s transaction team regarding risk allocation, purchase price considerations and the overall negotiating strategy.

Perhaps the purchase price is so “good” and any significant risks deemed to be so remote (or containable) that a “seller-friendly” (or “middle-of-the road”) draft is appropriate; on the other hand, perhaps the target has certain significant, uncontainable risks and/or the acquiror perceives it is paying a full purchase price, that the agreement should be aggressively drafted, with broad representations and warranties and indemnification obligations (assuming it is a private deal).

In short, every deal is different, and the role the acquiror’s counsel plays is critical: he must ensure that his client is making an informed judgment with respect to price and terms.

- by John Jenkins, Calfee Halter & Griswold

Webster’s Dictionary defines the term “sandbagging” to mean “to conceal or misrepresent one's true position, potential, or intent especially in order to take advantage of...to hide the truth about oneself so as to gain an advantage over another.” In the world of M&A, the term sandbagging generally refers to the ability of the beneficiary of a representation and warranty to rely on that rep - and sue for its breach - notwithstanding the fact that the beneficiary knew that it was untrue when it was made.

Many buyers will assert that they ought to be able to rely on a representation despite knowing that it was incorrect when made. The justification for pro-sandbagging position is that representations and warranties serve a risk allocation function in M&A, and the parties have a right to bargain to allocate that risk as they see fit.

If that’s your argument, and your agreement is governed by Delaware law, then it looks like the law is on your side. In Cobalt Operating LLC v. James Crystal Enterprises LLC, No. Civ.A. 714-VCS (Del. Ch.; 7/20/07), Vice Chancellor Strine held that a breach of contract claim arising out of an acquisition agreement does not depend on the buyer establishing justifiable reliance:

Due diligence is expensive and parties to contracts in the mergers and acquisitions arena often negotiate for contractual representations that minimize a buyer's need to verify every minute aspect of a seller's business. In other words, representations like the ones made in the Asset Purchase Agreement serve an important risk allocation function. By obtaining the representations it did, Cobalt placed the risk that WRMF's financial statements were false and that WRMF was operating in an illegal manner on Crystal.

So sandbag away, right?

Not so fast. It isn’t entirely clear that Vice Chancellor Strine’s position in Cobalt Operating is the last word on this issue under Delaware law. The Delaware Supreme Court affirmed the Vice Chancellor’s decision last year, but it did so in summary fashion, and it didn’t address a long line of cases from Delaware and other jurisdictions holding that “according to sound Delaware law, a plaintiff must establish reliance as a prerequisite to a breach of warranty claim.” Kelly v. McKesson HBOC, Inc., C.A. No. 99C-09-265 WCC (Del Super.; 1/17/02).

Perhaps it’s fitting that the Delaware courts leave us scratching our heads a bit on this issue, because frankly, the case law in this area is a bit of a mess across the country. The trend seems to be toward the kind of position enunciated by Vice Chancellor Strine, and the leading case is probably the New York Court of Appeal’s decision in CBS, Inc. v. Ziff-Davis Publishing Co., 553 N.E.2d 997 (NY 1990). (Here is a survey of the state of the law on this issue in various jurisdictions, as of 2002.)

Still, courts are still pretty far from giving buyers a license to intentionally sandbag. First of all, not everybody is with the program - some states still have an express reliance requirement. For example, if your agreement is governed by Minnesota law, the Eighth Circuit has held that you’ll need to demonstrate justifiable reliance in order to proceed with a claim for a breach, and you won’t be able to do that if you knew of the inaccuracy when the representation was made. Hendricks v. Callahan, 972 F2d 190 (8th Cir. 1992).

What’s more, cases following the Ziff-Davis line make it clear that the facts count. For instance, it may matter whether the buyer knew of the misrepresentation before signing (see Galli v. Metz, 973 F.2d 145 (2d Cir. 1992)), or whether the information about the inaccuracy of the information came from the seller or from a third party (see Rogath v. Siebenman, 129 F.3d 261 (1997)).

Since the case law remains somewhat opaque, lawyers often recommend that buyers negotiate for language stating that the seller’s representations and indemnity obligations won’t be affected by the buyer’s due diligence or its knowledge or suspicion that a rep is false. That kind of language puts buyers in a much better position to argue that they bargained for the risk allocation that’s embodied in the agreement.

That’s good advice, and it’s advice that many buyers appear to be taking. The 2006 Deal Points Survey of private company transactions indicates that approximately 50% of private deals contained “pro-sandbag” language, while only 8% contained an “anti-sandbag” clause that would preclude a buyer from making a claim with respect to a rep it knew was false. Still, 41% of the deals surveyed were silent on this issue, and the case law suggests that there may be more risks to this approach than most buyers realize.

That brings up another point. Maybe the most important advice for a buyer is that intentionally sandbagging the other side is a very risky tactic. As one commentator who analyzed the Ziff-Davis line of cases put it: “sandbag at your peril - if you have knowledge of a breach before signing and do not seek a specific indemnity, you risk losing your rights, even if you have attempted to preserve them.” Robert Quaintance, Jr. “Can You Sandbag? When a Buyer Knows Seller’s Reps and Warranties Are Untrue,” 5 The M&A Lawyer 9 (March 2002).

Let’s face it, the optics of strategic sandbagging look pretty bad, and as the case law suggests, there are all sorts of ways for courts to distinguish situations involving what it thinks is unfair behavior from those more benign situations in which general right to allocate risk through representations and warranties has been upheld. So when it comes to strategic sandbagging, caveat emptor - let the buyer beware.

- by Professor J.W. Verret

The ghosts of securities law past, present, and future seem to haunt the headlines lately. But proxy access is heralded as the issue most likely to bring a tectonic shift in the balance of power between shareholders and boards - and the boundary between federal and state authority in corporate governance. Many are concerned that the SEC's access proposal will empower special interests to hijack corporate policy toward objectives threatening long-term wealth maximization. In this article, Marty Lipton outlines his concerns. I have an answer that significantly alters the dynamic.

I call it the Chinese Menu Ballot. I explore the idea briefly in an article entitled "Pandora's Ballot Box, or a Proxy with Moxie?" The SEC's proxy access proposal concerns shareholder nominations. It says nothing about procedures to determine the winner of those elections. My method minimizes the ability of a small minority of highly interested, special interest shareholders to influence corporate elections. This danger is caused by the current plurality standard (most votes wins, even if not a majority) for contested elections.

The problem with plurality voting is that as more nominees appear on the ballot, the likelihood increases that a director not supported by a majority of voting shareholders will be able to win. And the number of nominees could be quite high. The SEC proposal limits individual shareholders from nominating more than a quarter of the total board size, but the presence of multiple shareholders nominating candidates could widen the field.

The reason why we don't currently use majority voting for contested elections is that it may require a runoff, which would necessitate a second round of solicitations and double the expense. But my method alleviates the need for a runoff. A Chinese Menu Ballot would require a shareholder to rank the candidates in order of their preferences. The ballots would clearly state that any ballots that do not rank all candidates will be excluded. Then, any runoffs will be determined using the shareholders preferences to successively eliminate candidates in new vote tallies.

The result is very similar to what would happen if the company had a pure majority vote election with an actual runoff, and the result is significantly different from an election in which there are a large number of candidates and plurality voting is used. In each new round of a vote tally, the vote of a shareholder that voted for an eliminated candidate will be transferred to the next highest ranked candidate. And this transitive property of the Chinese Menu Ballot is the key to its ability to screen out special interest directors. The result is that candidates ranked high by a small number of shareholders, but not ranked within the top echelon by a majority of shareholders, are eliminated from the pool very quickly. Candidates ranked in the top echelon by a majority of shareholders will tend to emerge as winners.

There are a multitude of algorithms to use the shareholders' rankings to generate an outcome. The appropriate method will depend upon circumstances particular to a company, including whether the board is staggered. The appropriate method will also depend on the demographics of a company's shareholders, including the balance of institutional vs. retail investors and the type of institutional investors it has.

Consider a simple example: In the first round of vote tallying, each ballot's vote will count toward the first ranked choice. After the first round of the tally, any seats not filled by a candidate receiving a majority of the votes will be determined by subsequent rounds of tallying. Before starting the second round of the tally, the candidate with the fewest number of votes (the candidate ranked first by the fewest number of shareholders) will be eliminated.

Any ballots that ranked the eliminated candidate first will now be registered as votes for their second ranked choice. This process would continue until the number of candidates remaining equals the number of available seats. There are a wide variety of available implementation methods and further recommendation would require a company-specific analysis.

For a brief analysis of the legality of this method under Delaware Corporate Law, I first note that DGCL 216 provides the plurality method as a default from which companies are free to opt-out via bylaw or charter amendment. And presuming that a company has the authority to amend the bylaws in its charter, it would be able to install this method unilaterally. In the unlikely event, however, that a company had a shareholder-adopted bylaw specifying the method for contested elections it would need to seek shareholder approval to implement this method.

I also do not think Chinese Menu Ballots would be subject to scrutiny under Blasius. Indeed, this method does not limit votes, it actually permits shareholders who voted for an eliminated candidate in one round to continue to have their vote counted in each successive round of the election. An analysis of this method under the federal proxy rules also indicates its legality. The Chinese Menu Ballot will need to include a space that permits withhold votes in accordance with Rule 14a-4(b)(2), but otherwise the proxy rules do not prohibit this method. I also note that this method would be difficult to implement, though not impossible, for companies that permit cumulative voting.

For assistance with implementing a Chinese Menu Ballot or other proxy access related issues, I am available for consultation.