Lock-up creep.

• Author: Davidoff, Steven M.
• Position: IV. The Causes of Lock-up Creep A. Omnicare and the Delaware Court of Chancery through VI. Conclusion, with footnotes, p. 705-731

"customary" is documented on the chart set forth in Appendix A. The chart summarizes each Chancery Court decision involving a challenge to lock-ups decided since Omnicare through May 21, 2013 and is available on Westlaw. It reveals that, despite the expert testimony in Toys "R" Us, the Delaware Court of Chancery has repeatedly upheld termination fees within a 2% to 4% range. (112) In fact, according to Factset Mergermetrics, the average termination fee during the period from 2008 and 2012 was 3.52% of transaction value and the median termination fee was 3.41% of transaction value. (113) Moreover, the Court of Chancery has repeatedly upheld matching rights periods of between two and five business days. (114)

The Chancery Court's deferential approach to lock-ups in the wake of Toys " R" Us was illustrated two years later in Louisiana Municipal Police Employees' Retirement System v. Crawford (115) Relying on Toys "R " Us in its discussion, the court explained that there was no bright line rule that dealmakers must follow in designing deal protection devices. (116) More specifically, the court enumerated factors it would consider when examining termination fees, including:

the overall size of the termination fee, as well as its percentage value; the benefit to shareholders, including a premium (if any) that directors seek to protect; the absolute size of the transaction, as well as the relative size of the partners to the merger; the degree to which a counterparty found such protections to be crucial to the deal, bearing in mind differences in bargaining power; and the preclusive or coercive power of all deal protections included in a transaction, taken as a whole. (117) once again, the court warned that dealmakers should not rely on a "3% rule," which, although it may be "convenient ... it is simply too blunt an instrument, too subject to abuse, for th[e] [c]ourt to bless as a blanket rule." (118) The court also cautioned that dealmakers could not "rely upon some naturally-occurring rate or combination of deal protection measures, the existence of which will invoke the judicial blue pencil." (119) Instead, plaintiffs challenging deal protections would need to show how those deal protections "operate in an unreasonable, preclusive, or coercive manner, under the standards of this Court's Unocal jurisprudence, to inequitably harm shareholders." (120)

But while this rhetoric opens up some avenue for shareholders to challenge lock ups, a review of the cases shows in reality that the Delaware Chancery Court has repeatedly signed off on merger agreement lock-ups without significant scrutiny. (121) Chancellor Strine's decision in Toys "R" Us arguably remains one of the only Court of Chancery opinions in which the deal protection provisions were not automatically approved as standard. In contrast to Toys " R" Us, the majority of the Chancery Court decisions tend not to engage in a detailed analysis of the deal facts or otherwise cite to expert testimony. Even when there is some modicum of scrutiny, it is not focused on the full panoply of lock-ups but rather on the most significant ones with a particular focus on the termination fee. (122) This lack of a detailed analysis may well be attributed to the context in which most lock-up challenges are brought. Namely, the overwhelming majority of these cases are brought on a motion for a preliminary injunction, and the standard applied to obtain a preliminary injunction places the burden of proof on the plaintiff at each step of the analysis. (123) Thus, it is the plaintiff who must submit expert testimony as to the preclusive or coercive nature of the lock-ups. With the dramatic increase in takeover litigation in recent years, expecting plaintiffs to produce expert testimony and evidence may be too much when most cases settle. This is particularly true in light of the Delaware court's inherent skepticism of expert witness testimony, which creates an obstacle against putting forth such testimony. (124)

The end-result is that most Chancery Court decisions generally note that lock-ups are standard merger agreement provisions and emphasize that these devices are not per se unreasonable to then find that the lock-ups in that instance are appropriate. (125) For example, in In re Atheros Communications, Inc., the court upheld an agreement that included a no shop, matching rights, and a termination fee that represented 3.3% of the transaction value, stating that "Delaware courts have repeatedly recognized 'that provisions such as these are standard merger terms, are not per se unreasonable, and do not alone constitute breaches of fiduciary duty.'" (126) Similarly, in In re 3Com Shareholders Litigation, the shareholders alleged that the 3Com directors breached their fiduciary duties by approving an agreement including a no shop, matching rights provision, and a termination fee that, along with the reimbursement fee, represented over 4% of the equity value of the merger. The 3Com directors also allegedly failed "to make an effort to solicit other buyers before entering the Merger agreement. " (127) The Chancery Court did not engage in a detailed analysis of the deal facts as they related to the deal protection provisions nor detailed analysis of all of the lock-ups, instead stating:

[T]his Court has repeatedly held that provisions such as these are standard merger terms, are not per se unreasonable, and do not alone constitute breaches of fiduciary duty. Plaintiffs here fail to explain how these provisions would prevent another bidder from making a competing offer in this case. Indeed, plaintiffs ignore the notable absence of any other interested bidders. (128) Despite the repeated recognition that lock-ups are not per se unreasonable, the courts have recognized that lock-ups are ever-evolving. (129) In a 2011 case, In re Orchid Cellmark Inc. Shareholder Litigation, the court warned:

Deal protection measures evolve. Not surprisingly, we do not have a bright line test to help us all understand when too much is recognized as too much. Moreover, it is not merely a matter of measuring one deal protection device; one must address the sum of all devices. Because of that, one of these days some judge is going to say "no more" and, when the drafting lawyer looks back, she will be challenged to figure out how or why the incremental enhancement mattered. It will be yet another instance of the straw and the poor camel's back. At some point, aggressive deal protection devices--amalgamated as they are--run the risk of being 0deemed so burdensome and costly as to render the "fiduciary out" illusory. (130) Notwithstanding that warning, the Orchid Cellmark court ultimately found that the line had not been crossed in that case. (131) Orchid Cellmark highlights the Delaware Chancery Court's deferential approach to lock-ups, which at the same time is evolving to continue this approach even with the advent of lock-up creep.

Our review of these cases thus leads us to conclude that by repeatedly stating that lock-ups are not per se unreasonable and continually upholding lock-ups so long as they are market terms, the Chancery Court has abandoned enhanced scrutiny analysis in favor of a reasonableness analysis. Of course, one can argue this is circular. If reasonableness is a market standard, then the market can change. And change it did as we have seen. In the period during and after these decisions, we have seen the expansion of market creep. This leads to the next question. We argue that changes in Delaware court doctrine allowed lock-up creep, but this begs the question of whether the response is based on market forces or due to other agency costs.

2. Market Forces Versus Agency Costs

The market story is an easy one. The relaxation of Delaware supervision allowed the market to function effectively. In this regard, targets are best able to judge their individual preferences. They can decide whether additional lock-ups will affect future bidding and adjust those based upon their prior contacts with other bidders, how the company has been shopped, and what lock-ups are appropriate. Bidders can negotiate based upon their own assessment. This will result in optimal market lock-ups.

There is evidence to support this theory. Again anecdotally, deals where there may be higher immediate bidding sometimes have more lock-ups (though sometimes they do not). (132) In addition, the rise of the go-shop and its spread to outside private equity transactions may be seen as a way to deal with lock-up creep, though if that is the case, it begs the question of why they are used principally in private equity and not strategic deals. (133) The existence of these lock-ups did produce higher prices in the bidding for 3Par and Diedrich's Coffee. (134) The counter-evidence to this explanation is that lock-up creep has been relentless and uniform in almost all transactions, whether or not the buyer is a private equity or strategic one, and whether or not a go-shop is present.

This market story also has a darker gloss. The opening up of space for enhanced

lock-ups may have led management to impose their own costs. Management may have pushed for these lock-ups in order to steer bids towards preferred bidders. In other words, sell-side agency costs are driving lock-up creep. In this case, anecdotal evidence is harder to find due to the uniformity of many types of lock-ups, but in examining transactions and in discussions with practitioners, there does not appear to be much evidence of this story. (135)

An alternative narrative involves agency costs on the buy-side. Freed of court restrictions, buy-side lawyers, wanting to show value to their clients, negotiated more intricate and novel lock-ups. Alternatively, it may be that lock-up creep is a function of attorneys acting to protect their own interests. As one takeover attorney put it to us:

[I]n my experience, lock-up creep sometimes happens when a buyer was burned...