Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

The DVD releases of future Disney films featuring Marvel superheroes undoubtedly will contain bonus items for the cinephile. If a single viewing of a movie doesn’t sate your appetite, you’ll probably be able to watch it again accompanied by the director’s audio commentary. The Walt Disney Company’s S-4 registration statement regarding its proposed merger with Marvel Entertainment, Inc. contains a director’s commentary of a different stripe. The SEC filing includes a six-page section titled the “Background to the Merger” that describes the terms of Disney’s first proposal to Marvel, subsequent negotiations among their legal counsel, and explanations for why Marvel eventually agreed to the deal. We’ll break down this behind-the-scenes look at the talks. Keeping in mind that Disney and Marvel are both Delaware corporations, it’s difficult not to read this section – with its emphasis on the transaction’s deal protection terms – as a preemptive apologia of the Marvel directors’ actions in light of their Revlon duties to maximize shareholder value in the sale.

Disney-Marvel Negotiations: The Director’s Cut

Negotiations between Disney and Marvel focused on two transaction documents: the merger agreement and a voting agreement with Marvel’s CEO Isaac Perlmutter, who owns about 37% of Marvel’s shares through various affiliates. On August 11, Disney’s lawyers emailed their initial drafts of the merger agreement and voting agreement to Marvel’s legal counsel. According to the S-4, Marvel objected to several deal protection mechanisms contained in Disney’s proposal:

• a “force the vote” provision requiring Marvel to put the Disney deal before Marvel’s shareholders, even if Marvel’s board of directors received a superior bid for Marvel by a third party;
• a break-up fee equal to 4% of the transaction value if Marvel ended the deal;
• a  soft lock-up provision that would proscribe Marvel’s board from dropping its recommendation of Disney’s offer unless a third party made a superior offer to Marvel; and
• a demand that Mr. Perlmutter agree (i) to vote his Marvel common shares in favor of the Disney transaction and (ii) to veto any other transaction with another prospective buyer for a period of 18 months after the termination of the merger agreement.  

After two weeks of intense negotiations, a number of substantive terms remained outstanding. Disney continued to insist on a “force the vote” provision in the merger agreement and refused to concede on any of the deal protection measures contained in its first draft of the Perlmutter voting agreement. On August 27, Marvel’s special transaction committee informed the company’s financial and legal advisers that it would not recommend a transaction to Marvel’s board that included a “force the vote” provision or an 18-month tail on Mr. Perlmutter’s voting agreement because they considered these terms to be improper restrictions on the Marvel board’s ability to consider or enter into transactions with other potential buyers prior to the consummation of the Disney deal.   

During the ensuing days, Marvel told Disney that it would be willing to agree to a break-up fee equal to 2.9% of the transaction value in return for concessions by Disney on the other requested deal protection measures. 

In response to Marvel’s counteroffer, Disney agreed:

• to remove the “force the vote” provision;
• to let Marvel terminate the merger agreement in favor of a superior proposal if the board decided that “failing to do so might reasonably be expected to be a breach of its fiduciary duties;”
• to reduce the break-up fee from 4% to 3.5% of the transaction value;
• to allow Marvel’s board to change its recommendation of the Disney transaction to Marvel’s shareholders if it concluded that it had a fiduciary duty to do so; and
• to eliminate the 18-month tale on Mr. Perlmutter’s voting agreement (so that a termination of the merger agreement would constitute a termination of the voting agreement as well). 

Marvel’s Board of Directors Meeting

Marvel’s board of directors convened a meeting on August 30 to consider Disney’s revised proposal with its financial and legal advisers. During the course of the meeting, Marvel’s outside legal counsel advised the board on the agreements’ deal protection measures and the board’s fiduciary duties under Delaware’s general corporation law in the event that it received a possible superior proposal from a third party after the signing of the Disney merger agreement. Marvel’s lawyers also analyzed the procedure for considering alternative bids for the company under the merger agreement, the situations in which the board could terminate the merger, and the conditions under which the break-up fee would be payable to Disney. In the end, Marvel’s attorneys concluded that Disney’s deal protection measures “provided the Marvel board of directors with sufficient flexibility to entertain bona fide alternative proposals, were consistent with the Marvel board of directors’ fiduciary duties and were not coercive to Marvel stockholders.”

The following day Disney and Marvel signed the merger agreement and Mr. Perlmutter and Marvel entered into the voting agreement with Disney.

Critic’s Corner

Of course, the “Background to the Merger” section only summarizes discussions between Disney and Marvel. The disclosure contained in Disney’s S-4 stresses the companies’ haggling over the deal protection terms, but negotiations over the purchase price and the proportion of cash and stock that made up the purchase price were probably not mere subplots to the main action. Nevertheless, the narration of Disney’s and Marvel’s back-and-forth over the deal protection terms at times resembles Kabuki theater more than the Hollywood blockbusters the marriage of the two companies is likely to spawn. While it’s well known that a board’s fiduciary duties under Delaware law to maximize the sale price of a company does not impose any “legally prescribed steps that directors must follow to satisfy their Revlon duties,” Delaware courts have done a fairly decent job of coloring in the outlines of directors’ obligations to shareholders in the sale of a company since the 1986 landmark ruling. The story told by Disney’s S-4 raises questions about what purpose the inclusion of terms likely proscribed by Revlon in the first draft of a merger agreement serves. For example, how useful are such terms as bargaining chips when making an initial offer to a potential seller’s board of directors? When a buyer agrees to eliminate these types of deal protection measures in subsequent negotiations, has it really conceded anything of value? 

The Sequel

Nowadays, it seems that almost every profitable movie has a sequel in the works before it has even finished its run in the cinemas. We see no good reason why this blog post shouldn’t follow suit:

Much of the discussion in the S-4 regarding merger negotiations between Disney and Marvel addresses what actions the Marvel board would be permitted to take if it were to receive a “superior proposal” from a third party. But without an explanation of what constitutes a superior proposal under the merger agreement, any discussion of the proposed merger signifies very little. When we revisit the Disney-Marvel merger in a later post, we’ll take a closer look at the merger agreement’s definition of a Superior Proposal.

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In our third and final post today on noteworthy deal protection provisions in the KKR-Sum Total merger agreement, we review Sum Total’s remedies for a breach or termination of the agreement by KKR. (Our first post covered the agreement’s “go shop” and “no shop” provisions and KKR’s break-up fee; our second post discussed the absence of a “financing out” for KKR.)

No Reverse Break-Up Fee

Sum Total is not entitled to a reverse break-up fee if KKR breaches or terminates the agreement under any circumstances.     

Specific Performance

The merger agreement pointedly provides that specific performance constitutes Sun Total’s “sole and exclusive remedy” for breaches of the merger agreement by the KKR merger vehicle or of the guarantee by Accel-KKR Fund III, L.P. Sum Total’s only recourse, in other words, is to get a court order compelling KKR to complete the merger. Sum Total has even agreed that if a court declines to enforce the specific performance remedy and awards monetary damages instead, the company may only collect its court ordered award if KKR is no longer willing to go ahead with the merger. 

The remedies section of the merger agreement appears to have been drafted in the shadow of the Delaware Chancery Court’s ruling in United Rentals v. Ram Holdings. In that case, the target company United Rentals moved for summary judgment on its claim that it was entitled to specific performance from a Cerberus-led private equity fund consortium under the terms of their merger agreement. The court, however, found that the priority of the two remedies provided to United Rentals under the merger agreement -  a reverse break-up fee and a right to specific performance - was ambiguous. Determining that neither United Rentals nor Cerberus was able to demonstrate that its proposed interpretation of the merger agreement was the only one that would be reasonable as a matter of law, the court resorted to extrinsic evidence by applying the forthright negotiator principle to divine the parties’ intent at the time of contract. The remedies section of the KKR-Sum Total merger agreement appears to be closely drafted to memorialize the parties’ intent that Sum Total’s only remedy is specific performance and that KKR’s right to specific performance does not preclude it from seeking its break-up fees.     

NB: The merger agreement also gives Sum Total the right to force the shell holding company serving as KKR's merger vehicle to compel Accel-KKR Fund III, L.P. to finance the purchase price of the merger.

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Following our post earlier today in which we reviewed KKR's break-up fees and the "go shop" and "no shop" provisions in the KKR-Sum Total merger agreement, we now examine the absence of a “financing out” in the agreement.

No Financing Out

In private equity buyouts, the acquisition vehicle tends to be a shell holding company with no assets. At the closing of highly leveraged cash-for-stock mergers, the holding company is funded by an equity investment from the funds participating in the merger and by senior and mezzanine, or “bridge,” loans from a syndicate of banks. Upon receipt, the holding company immediately transfers these funds to the target company for distribution to the target’s shareholders to complete the merger.   (The movement of these funds as they’re wired from entity to entity is mapped out in painstaking detail beforehand by the accounting firms in a chart dubbed the “funds flow.”) 

Although private equity firms usually have obtained signed letters from the banks committing their funds to the transaction before they enter into a merger agreement, firms always face the danger that, at some point between signing the merger agreement and closing, their lenders renege on their financing commitments or increase the costs of borrowing. To protect themselves against the possible loss of debt financing on acceptable terms, private equity funds in years past have negotiated a “financing out” in merger agreements by setting the continued availability of financing from their bank syndicates as a condition to closing the deal. 

The merger agreement does not have a “financing out” for KKR because the firm is financing the Sum Total merger solely with an equity investment from Accel-KKR Fund III, L.P., a fund dedicated to investing in mid-market technology companies. With no fear of a third-party’s failure to make good on its loan promises, KKR faces very little risk that it will not be able to come up with the cash to complete the transaction. 

Guarantee from KKR Fund

In fact, it is Sum Total who bears some risk that the KKR fund may fail to contribute cash to the shell holding company serving as KKR’s merger vehicle. The merger agreement gives Sum Total additional comfort by having the right to force the merger vehicle to compel the KKR fund to finance the purchase price. Sum Total also has a direct guarantee from Accel-KKR Fund III, L.P. for the holding company’s (and its subsidiary’s) obligations under the merger agreement. In effect, Sum Total’s contractual right to force the KKR fund to finance the transaction serves as an alternative, extra-judicial means of enforcing its right to specific performance under the agreement.

Sum Total’s right to specific performance will be the subject of our third and final post on the deal protection terms in the KKR-Sum Total merger agreement.

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A signed merger agreement with Accel-KKR in hand, Sum Total’s board has a month to go to the market to find a better deal. On Friday, Sum Total Systems, Inc. announced that Accel-KKR had offered its shareholders $3.80 per share in a definitive merger agreement filed with the SEC. For this deal at least, the private equity fund has foregone the LBO model, financing the entire $124 million price tag with an equity investment from a KKR fund focused on mid-market technology companies. By the time the markets closed on Friday, Sum Total stood at $3.83 a share, a 22% jump from the previous day’s closing price of $3.13. Trading volume for Sum Total’s shares skyrocketed to 5,759,368 on the day, compared to an average daily trading volume of 330,000 shares. 

Investors seem eager to become beneficiaries of an anticipated bidding war. While Sum Total’s board of directors has recommended the KKR merger, the company’s shareholders have yet to vote on the deal. According to the website Mergers Unleashed, a JPM Securities’ analyst report affirmed its $5 per share target value for Sum Total’s stock after Accel-KKR announced the merger deal. KKR has laid its cash and deal terms on the table, now it’s time to see whether anyone else will sit down and ante up.  

Over the course of the day, we’ll take a look at some of the noteworthy deal protection measures in the KKR-Sum Total merger agreement: 

“Go Shop” Period and "No Shop" Provisions

The Sum Total board of directors has a one-month “go shop” period (ending just after midnight on May 24) to solicit competing offers for the company’s shares. From May 24 until the company’s shareholders approve the merger, Sum Total’s board may not engage in any discussions with other parties regarding the sale of the company. This “no shop” provision has a customary fiduciary exception that allows the company’s board to entertain unsolicited written acquisition proposals so that Sum Total’s directors can fulfill their Revlon duties under Delaware corporate law to bargain for the highest price obtainable for the company’s shareholders. Though the Revlon court observed that “no shop” provisions are a legal deal protection measure under Delaware law, the court held that an absolute “no shop” prohibition on a company’s board of directors “when a board’s duty becomes that of an auctioneer for selling the company to the highest bidder” is impermissible.     

Even if it receives a better offer, Sum Total can’t terminate the agreement without first going back to KKR. If the board considers approving a merger agreement with another buyer, Sum Total must give KKR detailed information about the proposal, negotiate a potential counteroffer with KKR, and permit KKR to present a revised merger agreement to the board of directors for their consideration. KKR has found some relief, it seems, from the Revlon restrictions placed on their ability to lock-up the deal by negotiating a right of first refusal if a competing bidder proposes a higher price.    

Break-Up Fee

If the merger agreement is terminated because the Sum Total stockholders don’t approve the deal, the company breaches certain of its covenants (including the no shop restrictions), or the board changes its recommendation without entering into a merger agreement with another buyer, Sum Total must pay KKR a $4.95 million break-up fee. If the company terminates the agreement because the board has authorized the company to execute a merger agreement with another buyer offering the company’s shareholders a better deal, then KKR’s break-up fee is reduced to $3.1 million.  

Update:  Other aspects of the deal protection measures in the KKR-Sum Total merger agreement are discussed in:

No "Financing Out" Required: KKR's Equity Financing of the Sum Total Merger

Sum-Total's Remedies Under the KKR Merger Agreement

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