Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  “Don’t you understand that we have a problem?” Mr. Dimon asked. Mr. Schwartz, who had been taking a beating over the low price, knew an opening when he saw one. “What do you mean, ‘we’ have a problem?”37

  The guarantee appeared to be defective. Moreover, the shareholders and employees of Bear Stearns were seething. They had no incentive to support this deal. JPMorgan needed these shareholders to approve the transaction and, importantly, needed to keep the Bear Stearns employees satisfied. Otherwise, it would significantly destroy the value JPMorgan had agreed to pay for. JPMorgan had another option. It still had the power to direct Bear Stearns’s operations in its reasonable discretion. It might attempt to use this power to prevent Bear Stearns from incurring new liabilities if the deal appeared on the verge of collapse. This would be questionable under Delaware law, but JPMorgan might still try it.

  Probably because of its need to assuage the Bear Stearns employees, JPMorgan decided not to go this route. Instead, the issue was resolved that weekend when JPMorgan agreed to raise its offer to $10 a share for Bear Stearns. JPMorgan used the opportunity to rework the arrangement and lock up Bear Stearns definitively. In doing so, JPMorgan and its attorneys at Wachtell stretched the bounds of Delaware law past any normal limitations. To understand why, though, it is first necessary to go through the changes implemented by these new agreements.

  The Share Exchange

  The most controversial and significant revision to the deal was the elimination of the 19.9 percent option and its replacement with a share exchange agreement. The agreement provided that JP Morgan would be issued a 39.5 percent interest in Bear Stearns without prior approval of Bear Stearns’s shareholders. In exchange for this interest, Bear Stearns received shares of JPMorgan. JPMorgan presumably issued shares instead of paying cash in order to avoid providing additional liquidity to Bear Stearns. Moreover, the shares issued to Bear Stearns by JPMorgan were unregistered and could not be sold in the market to otherwise raise cash.38

  New York Stock Exchange Rule 312, though, still applied, requiring that Bear Stearns’s shareholders approve the share issuance. There is an exception under Rule 312, however, if “the delay in securing stockholder approval would seriously jeopardize the financial viability of the enterprise.”39 Bear Stearns relied on this exception to issue these shares to JPMorgan. The NYSE didn’t argue with Bear Stearns’s request and granted the exemption.

  The 39.5 percent interest placed JP Morgan at a significant advantage to obtain stockholder approval. But JP Morgan was not taking any chances this time. On March 24, the day after the parties agreed to recut their deal, JPMorgan acquired 11.5 million Bear Stearns shares in the open market, all of them at $12.24 a share. This constituted an additional 8.91 percent of Bear Stearns. JPMorgan would subsequently acquire a prevote 49.43 percent interest in Bear Stearns.40 This would mean that the Bear Stearns shareholder vote would become a certainty. After all, only 0.57 percent of the shares needed to approve the transaction after the JPMorgan interest was counted.

  JPMorgan probably structured this share acquisition in two separate tranches in order to build a litigation position. In Omnicare v. NCS HealthCare, the Delaware Supreme Court by a 3-2 vote struck down a locked-up deal.41 There, the court reviewed the deal under the Unocal standard, which requires that deal-protection devices not be preclusive or coercive and be reasonable in proportion to the threat posed. The Delaware Supreme Court held that under the Unocal standard, the agreement of approximately 65 percent of the shareholders to vote for a transaction, together with a force-the-vote provision, a provision that required the company to hold a shareholder vote, was preclusive and coercive. The merger protections were both preclusive and coercive because “any stockholder vote would have been robbed of its effectiveness by … [the] predetermined outcome of the merger without regard to the merits of the…transaction at the time the vote was scheduled to be taken.”42 The court ordered this despite the full auction of NCS and its near insolvency at the time. The opinion was criticized by academics and practitioners because of the failure of the Delaware court to provide sufficient latitude to the board to agree to a transaction in such circumstances.

  Thereafter, in the Delaware Chancery Court case of Orman v. Cullman,43 the Chancery Court upheld an agreement for a controlling shareholder to vote in favor of the merger. However, the controlling shareholder also agreed that for 18 months after termination of the agreement, the shareholder would vote against any other transaction. Notably, the shareholder vote was conditioned on approval of a majority of the minority, and the judge relied on this fact, that it was not a fait accompli, to make this decision. Since Orman, takeover practitioners have generally advised that so long as a deal was theoretically possible, Omnicare wasn’t implicated. Delaware practitioners have subsequently settled on the “40 percent rule” to set a limit on the highest share threshold a lockup could be under Omnicare. This was a rule of thumb. Nowhere had Delaware law validated this measure.

  Nonetheless, Omnicare was viewed at the time as highly likely to be overturned. The composition of the Delaware Supreme Court had changed since that time. Justice Myron Steele, who dissented from Omnicare, was now the chief judge, and Justice Joseph Walsh, who voted to overturn these deal-protection devices in Omnicare, was now retired. Later in 2008, Vice Chancellor Stephen Lamb, a judge on the lower Delaware Chancery Court, would even go so far as to assert that “Omnicare is of questionable continued vitality.”44

  Nonetheless, it appears that the 39.5 percent figure for the share exchange was set with this 40 percent rule of thumb in mind. The separation of the two events into a share exchange and open market purchase thus preserved a litigation position. If a shareholder ever challenged JPMorgan’s actions, JPMorgan could argue that the 39.5 percent issuance was valid and only the market share purchases should be nullified or were otherwise inappropriate, and vice versa.

  Other Lockup Arrangements

  The revised acquisition agreement and guarantee contained four other significant new provisions designed to further lock up the transaction.

  • The $1.1 billion option on Bear Stearns’s office building was expanded. JPMorgan could now acquire the building if Bear Stearns’s stockholders did not approve the deal at the first shareholders’ meeting. This was a powerful incentive for Bear Stearns’s shareholders to vote yes for the deal. Otherwise, Bear Stearns would not have any offices to run its business from.

  • JPMorgan obtained significantly more control over the day-to-day operations of Bear Stearns, further stretching the Delaware law on this matter.

  • The force-the-vote provision was now qualified by new termination rights. JPMorgan and Bear Stearns could now terminate the transaction if the first shareholder approval was not obtained and 120 days elapsed. JPMorgan was also able to negotiate some additional insurance providing it the right to terminate this agreement after the 120 days if a court enjoined JPMorgan from receiving or voting the 39.5 percent in Bear Stearns’s interest.

  • Finally, the guarantee was amended in a manner that made clear that JPMorgan’s guarantee was probably flawed under its original terms. The guarantee now terminated 120 days following the failure of Bear Stearns to receive the approval of Bear Stearns’s stockholders for the transaction at any shareholder meeting. This was a significantly shorter period than the one year that Bear Stearns could keep the guarantee in effect.45

  The Fight for Bear Stearns

  Bear Stearns was now cornered. JPMorgan had almost a majority stake and a host of other deal-protection devices in place that made it almost certain that it would obtain the minuscule 0.53 percent yes vote they needed. There were many questions still to ask, though, of the Bear Stearns board’s conduct in negotiating this second deal. Did Bear Stearns’s board act in due deliberation approving this deal and agreeing to a number of features that made the sale all but a certainty, or did the board sell too hastily? The Bear Stearns board had obtained a higher price but in doing so had seemed to bargain a
way any chance of any other opportunity. Moreover, why $10? The price was clearly being dictated at this point by negotiating leverage over the contract and the wishes of the government rather than the actual value of Bear Stearns.

  This may have been a calculated and correct assessment of its chances without JPMorgan’s support. However, the day after the announcement of the revised transaction, the price of Bear Stearns’s stock traded above the $10 a share price. The market was predicting that the offer would be raised yet again. Former Bear Stearns CEO and then Bear Stearns Chairman James Cayne quickly took advantage of this fact, selling his remaining shares in the week the new agreement had been announced and pocketing $61 million. Paul A. Novelly, another Bear Stearns director, also disclosed on April 1 that he had sold all of his stock. The market may have been betting on a higher price, but some members of the Bear Stearns board clearly were not.46

  Given JPMorgan’s new agreement, the only out for Bear Stearns left was if a court enjoined the transaction by finding that JPMorgan had overreached in negotiating its deal-protection devices. Five actions were filed between March 17 and March 20 in New York state court. Meanwhile, on March 20 and 24, two more lawsuits were filed in Delaware against Bear Stearns, its directors, and JPMorgan Chase & Co. The race was now on to judicially halt this transaction before JPMorgan voted its shares to complete it.

  The first judicial events in these disputes occurred in Delaware.The plaintiffs filed for a preliminary injunction to prevent JPMorgan from voting its acquired shares at the meeting. The plaintiffs argued that the motion should be granted on three separate legal grounds.47

  Undue Infringement on the Shareholder Franchise

  The plaintiffs first argued that the JPMorgan share issuance was inequitable under the seminal case of Schnell v. Chris-Craft Industries Inc.48 In Schnell, the Delaware Supreme Court found that management had utilized the corporate machinery “for the purpose of obstructing the legitimate efforts of dissident stockholders in their rights to undertake a proxy contest against management.” The court there held that such an action was for an “inequitable purpose, contrary to established principles of corporate democracy.”49

  The primary question under the Schnell doctrine was whether Bear Stearns acted inequitably or was merely trying to prevent a bankruptcy and preserve the only deal available. But at what point should this be measured from? Clearly, Bear Stearns was about to go bankrupt before it entered into deal one. But the share issuance here was only in connection with the recut deal. Bear Stearns may have been in a better situation by then, though Bear Stearns would later claim it would have gone bankrupt without the renegotiated deal. It was also unclear whether the Schnell doctrine applied at all to a vote on a takeover. Schnell took place in the context of a battle to replace directors. The plaintiffs in the Delaware lawsuit were arguing to expand the doctrine to the takeover context.

  Lacking a Compelling Justification

  The plaintiffs next claimed that the share issuance violated the Delaware Supreme Court’s holding in Blasius Industries Inc. v. Atlas Corp.50 The Delaware Supreme Court in Blasius held that where an action is taken for the sole or primary purpose of impeding the effectiveness of the shareholder vote, it is deeply suspect and can be sustained only upon the showing of some compelling justification.51 In their motion, the plaintiffs relied primarily upon the case of Commonwealth Associates v. Providence Health Care, Inc.,52 which applied Blasius in the context of a contest for board control. There, then Chancellor William T. Allen had invalidated an issuance of a 20 percent voting interest in a corporation that, together with a 30 percent interest controlled by a friendly party, would have effectively prevented an insurgent from replacing the board of directors. The court found no compelling justification for this issuance.

  Bear Stearns and JPMorgan argued that the compelling justification was Bear Stearns’s imminent bankruptcy. Moreover, Providence was distinguishable by the fact that in Providence, a majority voting bloc was being put in place. In Bear Stearns, a no vote was still theoretically possible. A compelling justification may have existed when the first deal was struck on March 16, when Bear Stearns was on the verge of bankruptcy. In the renegotiated, second deal being challenged, Bear Stearns already had the benefit of a one-year guarantee from JPMorgan. If compelling justification was assessed on the change from deal number 1 to deal number 2, it was not so certain. JPMorgan countered this argument by arguing that Bear Stearns was about to go under a second time before deal number 2 was reached. In addition, it was unclear whether and how the Blasius doctrine, a species of the Schnell test, applied to a vote on a takeover transaction. In prior cases, the Delaware courts had come to different conclusions, a split that has yet to be resolved.53

  The Bear Stearns Stock Issuance as Preclusive or Coercive

  The most interesting thing about the plaintiffs’ arguments was that at no point did they even cite the controversial case of Omnicare around which this share issuance had no doubt been structured.This was smart lawyering. By ignoring Omnicare, the plaintiffs avoided the whole dispute of whether Omnicare was rightly decided. Instead, the plaintiffs resorted to the Unocal doctrine applicable to actions taken by the board to protect itself against a corporate threat. The plaintiffs cited the case of Paramount v. QVC to argue that the sale was preclusive and coercive under the Unocal doctrine discussed more fully in Chapter 8 and so invalid. The plaintiffs made this argument implicitly, not by citing the intermediate standard of Unocal but instead by using its language, which prohibits preclusive or coercive action by a board of directors in the face of a danger to the corporation. The plaintiffs were probably correct, however, that the issue was that the Unocal doctrine required a threat to be triggered. Here, there arguably was no other willing bidder and no threat. The plaintiffs attempted to get around this argument by asserting that the threat was that the stockholders would vote no.

  In Paramount Communications v. QVC Network, the court held that “when a corporation undertakes a transaction which will cause: … a change in corporate control; or … a breakup of the corporate entity, the directors’ obligation is to seek the best value reasonably available to stockholders.”54 These are called Revlon duties after the case of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. and are a form of Unocal duties that are generally considered to impose strict scrutiny on a board’s actions when applicable.55 Delaware courts have never applied Revlon duties to a stock-for-stock merger. The reason is that posttransaction control is generally considered fluid, and therefore no change of control occurs. However, if there ever was a case for this doctrine to apply, this was it. The JPMorgan acquisition was clearly a change of control. Unfortunately, the implications of such a finding would upset Delaware doctrine substantially by allowing for target shareholders in stock-for-stock mergers to litigate the issue in future cases.

  In normal times, the plaintiffs’ arguments would almost certainly have prevailed. The deal was coercive and possibly preclusive and also draconian, though the actual existent threat was uncertain. However, in its public filings, Bear Stearns asserted that it would have been forced to declare bankruptcy without the first JPMorgan deal. Moreover, Bear Stearns also asserted that without the firmness provided by the second JPMorgan deal, the company would have had to declare bankruptcy yet a second time, since other parties were still refusing to do business with it. Bear Stearns was arguing that the insolvency justified all of these provisions either within each doctrine or as a new, untested insolvency doctrine. Ultimately, there was validity to their arguments. Bear Stearns probably had no time to adhere to the niceties of Delaware law due to its insolvent or near-insolvent status.

  This was shaping up to be a fight between Delaware and the federal government.The federal government had orchestrated a deal that it wanted to go through on terms that punished the Bear Stearns shareholders. This posed a dilemma for the Delaware courts. If they found these measures invalid, they would be criticized for endangering the capital markets system and c
ome into direct conflict with the federal government. Alternatively, they could issue an opinion that upheld them but risked stretching the law of Delaware and providing bad precedent and doctrine for future cases.

  A hearing was held on March 31. It became clear at that hearing that the main issue was whether Delaware should abstain entirely from the case and defer to New York. Delaware typically defers to first-filed cases under the McWane principle, which states that a Delaware court, when considering staying a case in deference to a first-filed action in another jurisdiction, should rule:

  freely in favor of the stay … in a court capable of doing prompt and complete justice, involving the same parties and the same issues; that, as a general rule, litigation should be confined to the forum in which it is first commenced… .56

  Here, the cases were filed so close together as to be considered contemporaneous, providing judicial flexibility to the Delaware court to retain jurisdiction. Vice Chancellor Donald F. Parsons, Jr., the judge in this case, ultimately ruled that Delaware would abstain under this doctrine for the New York proceedings. In doing so, he cited the federal issues involved:

  Rather, I find the circumstances of this case to be sui generis. What is paramount is that this Court not contribute to a situation that might cause harm to a number of affected constituencies, including U.S. taxpayers and citizens, by creating the risk of greater uncertainty.57

  Delaware would not risk coming into conflict with the federal government. Vice Chancellor Parsons’s ruling also confined any harm that the case might inflict. If New York issued any bad law to uphold these deal-protection devices, it would not be binding on Delaware. The ruling went against Delaware’s penchant to attempt to grab jurisdiction in as many cases as possible, but here, as Professors Kahan and Rock have described it, it could be viewed as simply a strategic decision designed to prevent Delaware from harming itself.58 It was a clear lesson in a judging tendency to rule with regard to political reality. Parsons quite wisely was not about to be the one blamed for upsetting the entirety of the global capital market by challenging the federal government and allowing Bear Stearns’s possible failure.