The Allergan Aftermath

The following post comes to us from Philip Richter, partner and co-head of the Mergers and Acquisitions Practice at Fried, Frank, Harris, Shriver & Jacobson LLP, and is based on a Fried Frank publication by Mr. Richter, John E. Sorkin, David N. Shine, and Gail Weinstein.

Valeant’s failed acquisition bid for Allergan has underscored longstanding M&A principles—even as the involvement of shareholder activists in the M&A arena has introduced new technologies, opportunities, and challenges. In the aftermath of the Allergan saga, it is clear that Pershing Square was richly rewarded for having crafted a novel bidder-activist collaboration model. The outcome for Valeant, however, notwithstanding the creative collaboration, is that its bid ultimately failed, and in the most conventional of ways (losing to a superior offer from an alternative bidder).

The Allergan outcome highlights the benefits of the Valeant-Pershing Square collaboration model to the activist partner, while underscoring the disadvantages of the model for bidders. We expect that the Valeant-Pershing Square model will be followed only under limited circumstances, but that bidder-activist collaborations will continue and evolve, and that other new technologies for bidders, activists, and target companies will emerge.

In this post, we discuss: (i) the broad lessons learned from the Allergan situation; (ii) the circumstances under which we expect that the Valeant-Pershing Square model may be followed by others; (iii) restructuring of the model that may be considered by future bidders and activists; (iv) specific lessons learned for bidders and target companies (the activist appears to need no lesson!); and (v) some new ideas to be considered by bidders, activists, and target companies in their respective quests to deliver shareholder value.

In our view, the broad lessons learned from the Allergan situation are:

  • Activists, bidders, and target companies will continue to develop creative M&A technologies as part of their respective efforts to deliver value to shareholders.
  • Bidder-activist collaborations, as they continue to evolve, are likely to create profit opportunities for activists and bidders and also to lead to shareholder value.
  • Target companies, focused on shareholder value and not on entrenchment, are likely to develop ways to establish a timeframe needed to create shareholder value and mechanisms to ensure that all shareholders participate in the value creation.
  • The best result for shareholders—and optimal functioning of our capital market system—requires both that activists have avenues to advance ideas that will deliver value for all stockholders (while protecting shareholders against those that deliver value for the activist at the expense of the other shareholders) and that companies have a reasonable period of time to respond to unsolicited bids (while protecting shareholders against entrenchment of boards and management teams).

Circumstances under which the Valeant-Pershing Square collaboration model may be followed.

Pershing Square’s inspired crafting of the collaboration model resulted in a gain to Pershing Square of well over $2 billion on its toehold stake in Allergan. While some saw a meaningful risk in the substantial investment Pershing Square made in Allergan without knowing whether Valeant’s (or any other) bid for Allergan would succeed, our view from the outset has been that there was almost a certainty that either the Valeant bid would succeed or that Allergan would deliver equivalent or greater value to the shareholders in some other way. There is every reason to believe that activists would want to follow what appears to be a high reward-low risk model.

There are significant disadvantages of the model to bidders, however. As we have discussed in previous memoranda, these include: the high economic cost to the bidder (most importantly, the bidder’s forgoing the opportunity to capture all or most of the gain on the toehold stake for itself); the inherent distraction to the deal from the activist’s involvement (reducing the critical focus on and “selling” of the deal and the bidder’s equity); and the conflicts of interest between the activist and the bidder (primarily that the activist is advantaged by an alternative superior transaction that thwarts its bidder-partner)—all of which occurred in the Allergan situation and played a part in Valeant’s ultimate failure. To these issues, serious legal uncertainty for the model was added when a California federal district court judge recently found that the model raised “serious questions” about whether the activist’s buying of the toehold stake constituted insider trading, as it was based on the activist’s knowledge of the bidder’s nonpublic intention to make a bid for the company and the activist, in the court’s view, probably was not a “true” co-bidder.

While the insider trading issues may be resolved by future judicial or SEC action, and while we believe in any event that they are not insurmountable (as discussed below), in our view, it is unlikely that the model will be followed by a bidder who has the financial ability and overall credibility to proceed on its own—unless the model is restructured and the bidder is more economically advantaged. The model may, however, on balance be beneficial to a bidder that has cash constraints and weak credit, or who has other reasons to seek assistance with the funding of the pre-announcement toehold stake in a target company (and/or an upfront commitment for assistance with funding the acquisition of the company). Thus, we expect that the model, as currently structured, may be followed in the following circumstances:

The bidder requires assistance with funding the toehold stake (and/or the acquisition of the company). While the primary benefit of a toehold stake in a target company is the economic benefit of the gain on the investment once the announcement of the bid is made—and while that benefit is largely transferred from the bidder to the activist in the Valeant-Pershing Square model—acquisition of the toehold stake should increase the bidder’s leverage with the target board and shareholders. Thus, the advantages of the model to a bidder may outweigh the disadvantages if the bidder cannot fund the acquisition of the toehold stake (and/or the acquisition of the target company) on better economic terms. As discussed in our previous memoranda, for most bidders, we would expect that the significant costs of the model would make more conventional financing a preferred choice.

The market for the target’s stock and/or options is highly liquid. The significant and aggressive pre-announcement purchase of stock and/or options by the activist (which is the linchpin of the model) is practical only if the market for the target’s stock and/or options is highly liquid, so that the buying does not dramatically move the market price and give notice of a bidder/activist’s interest.

There is reasonable certainty that a target shareholders meeting, at which the toehold shares can be voted in support of the bid, will be held without significant delay. Assuming that neither the activist nor any of its portfolio companies is a competitor of the target company, the activist generally can obtain Hart-Scott-Rodino clearance (which is needed before the shares can be voted) in a shorter timeframe than the bidder can, assuming the bidder is a competitor of the target. Thus, the purchase of the toehold stake by the activist instead of the bidder can provide the bidder with a significant advantage by making the toehold shares available quickly to be voted in support of the bid. The advantage of early Hart-Scott-Rodino clearance for the voting of the shares would not be meaningful, however, if it is not reasonably certain that a shareholder meeting at which the bidder could obtain control of a majority of the board would be held promptly. Thus, the timing advantage of the model is largely eliminated if either a) the target has a classified board, or b) the bid cannot be made shortly before the target’s annual meeting (although the target will have some ability to delay that meeting) and the target’s charter and bylaws do not provide reasonable certainty that the bidder can call a special meeting that would have to be held promptly.

The potential for insider trading liability for the activist partner is eliminated or significantly reduced. Neither activists nor bidders are likely to follow the model unless greater clarity on the insider trading issues is provided by the courts or the SEC, or the model is restructured (as discussed below) to eliminate or significantly reduce the potential liability (and distraction for the bid).

How the bidder-activist collaboration model could be re-structured.

No tender or exchange offer. Absent further clarity on the insider trading issues by judicial or SEC action, the risk of insider trading liability could be substantially reduced by restructuring the bid as an acquisition offer and proxy contest only—with the record supporting that no tender or exchange offer was commenced or contemplated in the early stages. Rule 13e-3 provides for insider trading liability for a person who purchases shares of a target company at a time he knows that another person has plans to seek to acquire the company and has taken “a substantial step toward” commencing a tender or exchange offer. While a tender or exchange offer can create added momentum for a bid and pressure on a target, a “fully” priced offer and proxy contest by a credible buyer—without a tender or exchange offer initially—can be almost as compelling, since a bidder generally cannot buy shares in a tender or exchange offer in any event until it wins a proxy contest, replaces the board, and redeems the target’s shareholder rights plan.

Making the activist a “true” co-bidder. A person making a bid (alone or as a co-bidder) does not have liability for trading on its own information that it intends to make a bid. While Pershing Square and Valeant labeled Pershing Square as a “co-bidder”, the California court indicated that the underlying collaboration arrangements had no indicia of Pershing Square’s being a true co-bidder. We expect that it would be possible for a viable co-bidder model to be developed.

More beneficial economic terms for the bidder. Pershing Square appears to have benefitted from a strong “first-mover” advantage. As with any new technology, the cost to the user (and gain to the provider) can be expected to decrease once the technology is known and begins to be used more widely. We expect that the model will develop to reduce the outsized-return-with-limited-risk of the activist partner. The most critical change would be a different split of the profits from the toehold stake. In the Allergan situation, the Pershing Square-Valeant split was 85%-15%, costing Valeant $7-8 per share that could have been used to increase the price of its bid, and, in the context of its bid not having succeeded, resulting in a $300 million profit for Valeant as compared to well over $2 billion for Pershing Square. A possible alternative would be a tiered profit split where, for example, the bidder shares a lower percentage of the gains up to a certain amount, and then a higher percentage of gains above that amount. A bidder might also try to negotiate for more financing, a greater commitment with respect to the stock portion of the consideration to be received by the activist in the offer if the bidder succeeds, a longer commitment with respect to retention of stock received in the offer, a post-acquisition standstill agreement, and so on, depending on the bidder’s greatest areas of need or concern. Of course, each situation will require a review by the bidder and the activist of their respective options, risks , and potential rewards—including whether the collaboration terms could both meet the risk-reward ratio required by the activist and induce the bidder to enter into the arrangement.

“Minimum” and/or “preferred” return for the activist. Other alternatives would be a “minimum” or “preferred” return to the activist partner. For a minimum return, the activist would receive all the profits up to a specified amount, with the remaining profits being split with the bidder. For a preferred return, the activist would receive a stated percentage return, with the remaining profits allocated to the bidder.

Lessons learned for bidders.

Need for a singular and continuous focus on “selling” the deal. To the extent possible, the focus on the activist and the collaboration should be limited, as it distracts from the fundamentals of the transaction, the bidder, and the value of the bidder’s equity.

Consider a contingent value right. A critical aspect of success for a bid that includes the bidder’s equity as part of the deal consideration is the ability to convince the target board and shareholders of the value of that equity. Under appropriate circumstances, a bidder should evaluate the utility and risks of a contingent value right or other value assurance mechanism to backstop the equity portion of the offer price.

Benefits of the process being concluded as quickly as possible. A bidder is advantaged when the target has less time to develop strategic alternatives to a bid.

  • Commence and effect the proxy contest as early as possible in the process. In the Allergan situation, the activist’s early effort at an “informal” shareholder meeting to pressure the target board was unproductive, wasted time, and created a distracting focus on the collaboration. Moreover, it is unclear why Valeant waited for months after that to commence the proxy contest.
  • Consider whether to offer the best and final offer price early in the process. Offering the best price early in the process may a) deter white knights from emerging and b) may induce the target company to agree to the transaction before white knight possibilities have emerged.

Negotiate a better deal with the activist. As discussed above, it is possible that bidders may now be able to negotiate better terms with activists.

Consider collaboration after the bid is made rather than before.

  • Benefits to the bidder. A well-financed and credible bidder who does not need an activist to fund or execute the pre-announcement toehold stake but believes that collaboration with an activist would still be beneficial, would probably be advantaged by entering into a collaboration arrangement after making a bid rather than before. At that time, the bidder will have gained the full post-announcement profit on the toehold stake for its own account, and will have more information about the Hart-Scott-Rodino timing, the target’s reaction, the market reaction, the emergence (or not) of competing bidders, and so on, before deciding what arrangement, if any, would be most appropriate. In addition, the bidder will have avoided at the critical early stage the inherent distraction from the financial merits of the bid that the collaboration causes when in place at the outset, including, as in the Allergan situation, the attention the arrangement generated relating to the perception of unfairness in dealing with shareholders by selectively providing the activist partner with an opportunity to trade based on non-public information.
  • Benefits to the activist. Similarly, under some circumstances, an activist may be advantaged by collaborating only after it has bought shares in a potential target company. While adding some degree of risk for the activist (that a bid partner may not be found or that the partner that emerges will not be the optimal bidder), a credible and well-financed activist can on its own put a company into play by buying shares and filing a 13D, sending a public letter, or making a proposal. With this approach, the activist could obtain the full profit on the initial equity stake and would eliminate the insider trading risk.

Lessons learned for target companies.

Need to monitor trading in the company’s stock and options in order to have as much notice as possible of a possible threat.

Need to define a compelling “message” and to deliver it consistently. Allergan was advantaged in the process by a) quickly developing a coherent and compelling message that cast serious doubt on Valeant’s business and growth plans and b) delivering the message consistently and effectively throughout the process.

Target shareholder patience, providing the company with reasonable time to respond to a bid, can lead to the best result for the shareholders. In the face of an unsolicited bid, target companies must have the objective (and must persuade shareholders that it is their objective) to deliver value for shareholders and not to entrench the board or management. In the Allergan situation, eight months after the unsolicited bid was received, Allergan announced a white knight transaction that nominally provided shareholders with $66 billion rather than Valeant’s $54 billion final offer price.

Dismantling of defensive protections increases a company’s vulnerability to unsolicited bids. In response to shareholder pressure for “good governance”, many companies have voluntarily declassified boards, shortened or simplified advance notice provisions, and otherwise dismantled defensive protections. In the Allergan situation, the earlier declassification of the board made the company significantly more vulnerable to a third party unsolicited bid. Allergan’s bylaw provisions—which gave the board broad authority with respect to calling a shareholder meeting and imposed requirements with respect to advance notice of director nominations—provided the company with time to consider and respond to the bid, including finding and considering alternatives. Notably, if Allergan had not had its unusual bylaws that ultimately led to a shareholder meeting date that was nine months after the bid was launched, Allergan could have had as little as 30 days (the period of the advance notice bylaw) to respond to the bid. The longer timeframe did not lead to entrenchment but to a much better result for the shareholders. A shorter timeframe likely would have made it less likely that the company could have found and negotiated a superior offer at a significantly higher price or even have caused Valeant to significantly raise its offer price, thus enriching the bidder at the expense of the shareholders.

New ideas for activists and bidders to consider.

Acquiring more than a 10% toehold, in appropriate circumstances. If there is sufficient liquidity in the market for a target’s stock and/or options to avoid a dramatic rise in the price or notice of the buying (and if there is no required regulatory approval, or a target company shareholder rights plan, that would be triggered), an activist or bidder might want to consider buying through the Section 16(b) 10% limit—thereby further increasing the pressure on the target, having additional capacity to increase the bid price and, if not successful, increasing the profit from the toehold stake. In most cases there should be no issue of 16(b) recapture, given that the process generally will continue for more than six months and/or the shares will be converted in a merger.

Marketing collaboration plans to bidders. To the extent activists believe that collaboration will generate better returns or less risk for them than go-it-alone investments that may put a company in play, and to the extent that they wish to profit as Pershing Square has but are willing to realize lower profit, activists may market their availability for similar collaborations on terms less favorable to the activist. Activists may actively approach potential bidders having the appropriate characteristics on a general basis or with a particular target in mind. Even under these circumstances, potential bidders may prefer to go it alone with a bid or to wait for an activist to put a company into play and then be available as a white knight (where the likelihood of successfully acquiring a company is heightened).

Joining with other activists to spread risk. Smaller or less established activist investors may become more involved in bidder activist collaborations by joining together in order to diversify their bidder-collaboration activities and otherwise spread their risk in this area. These arrangements would be complicated, raising legal and business issues about how decisions will be made; whether the activists will be a group for purposes of Section 13(d) or Hart-Scott-Rodino; and the potential for the triggering of shareholder rights plans (especially those that contemplate protection against “wolf packs”).

New ideas for target companies to consider.

In the context of increasing involvement of activists in the M&A arena, a convergence of the focus of activists and companies on delivering shareholder value, a general dismantling of traditional corporate defenses (such as classified boards), and new M&A technologies being developed by activists and bidders, target companies also may seek to develop new ways of responding to unsolicited bids.

Shareholder-friendly, tailored rights plans. Currently, when a company receives, or perceives that there is an actual threat of, an unsolicited bid, the typical response is a) to adopt a shareholder rights plan to prevent bidders from acquiring more than a threshold ownership interest and b) unless there is a classified board, to seek ways to obtain time to consider and respond to the threat. Once adopted, a shareholder rights plan in effect prevents further purchases of target stock by a bidder (through the threat of severe economic dilution of the bidder’s shares once the rights are triggered), but can be redeemed by the bidder if the bidder obtains control of a majority of the board. Target companies may wish to consider alternative shareholder rights plans that would be more shareholder-friendly than current rights plans, while being more specifically tailored to address target company concerns.

  • Reasonable time response plan”: For a company that does not have a classified board, this plan would facilitate both a) stockholder decision-making, by putting acquisition bids and change-of-control proxy contests on a more predictable timetable, and b) value creation, by providing a company with a reasonable period of time for its response to an unsolicited bid. The plan would require that a target company that has received an unsolicited Qualified Proposal would have to take action to schedule and hold a meeting of shareholders to vote on the proposal within [12] months. A “Qualified Proposal” would be any bona fide acquisition proposal for all shares that the bidder’s bankers confirm is financeable or any bona fide proxy contest seeking a change in [25]% or more of the board. The plan would be redeemable at the typical nominal redemption price, except that it could be redeemed by Non-Plan Directors only at a redemption price of [200]% of the unaffected market price. “Non-Plan Directors” would be directors proposed by a person making an unsolicited acquisition proposal or conducting a proxy contest for more than [25]% of the board unless elected at the meeting contemplated by the rights plan. Possible modifications to these terms that could be considered would include: reducing the 12-month time period; limiting a proxy contest Qualified Proposal to only those proxy contests that are made in connection with an acquisition bid; and/or making the plan non-redeemable by Non-Plan Directors.
  • It should be noted that the legal validity of a rights plan of this type has not been tested. In addition, institutional shareholders and proxy advisory firms have not generally been supportive of shareholder rights plans and other actions that may deter activism and acquisitions. However, in the context of the current environment of an overall decrease in defensive protections, shareholders should favor this type of plan, which is more shareholder-friendly and tailored—particularly if experience proves that it does not deter bids or permit entrenchment and that it creates additional value for shareholders.
  • 13D disclosure plan”: This plan would be designed to recapture for target company shareholders the profits made by a purchaser of target shares after crossing the 5% ownership threshold without public disclosure of the ownership. Currently, the SEC’s Schedule 13D rules permit a person who has acquired 5% of a company’s shares to wait for up to 10 days before filing a 13D that discloses the ownership, during which time additional shares can be purchased. Pershing Square, for example, disclosed in its first 13D filing on Allergan that it had purchased a 5% stake over several months and then had almost doubled that, to a 9.7% stake, during the 10-day 13D filing window period. Thus, the Allergan shareholders and option holders who sold to Pershing Square during that 10-day period did not know that they were selling to someone who had already bought 5% and who was buying their equity to assist Valeant in acquiring the company. A window-closing rights plan—which would cause severe dilution of the shares of a bidder who did not file a 13D immediately after crossing the 5% ownership threshold—has been proposed in the past but has never been adopted. A target company may wish to consider the 13D disclosure rights plan—which would only seek to recapture for the target shareholders the purchaser’s profit on the shares purchased after the 5% threshold is crossed and before a 13D is filed (or, alternatively, could seek to recapture the purchaser’s profit on all of the shares purchased prior to the 13D filing). (One issue that would have to be addressed is how and when the profit would be measured, and whether, for timing and implementation purposes, the recapture would have to be of a “presumed profit”.) Importantly, since this type of rights plan would have to be in place before an activist started buying shares, a company should, before adopting this type of plan, consider the reaction of stockholders and proxy firms.

Other possible actions to protect shareholders. Depending on the circumstances, target companies may wish to consider other novel approaches, each of which generally would be reviewable based on whether the action taken represented a proportionate response to the threat faced by the target company. Each of the possible approaches noted below would present practical and legal issues, and the advantages and risks would have to be evaluated by a target company to determine in any given case whether any of them might be in the company’s best interests under the applicable circumstances.

Possible actions could include the following: (i) if the target is of roughly equal size or bigger than the bidder and the bid is highly leveraged, the target company could acquire the bidder’s shares in order to vote against the bidder’s issuance of equity and/or make financing of the bid more difficult; (ii) if there are concerns about the value of the bidder’s equity, the target could create a value assurance plan that would protect against underperformance of the bidder’s equity (which would focus attention on concerns regarding the bidder’s equity—even if the plan were redeemable, or the bidder responded by lowering its price or by conditioning its offer to purchase shares on the value assurance rights being attached); and (iii) if appraisal rights are not statutorily available (and particularly if the bid significantly undervalues the company), the target could provide a kind of “quasi-appraisal right” for an impartial arbitration to determine an appraised value (based on state law), with a claim against the company for the appraised value by any stockholder who did not vote in favor of the bidder’s transaction and agreed to forgo the merger consideration it would receive in the deal in exchange for the appraisal amount.

Conclusion

In our view, the Valeant-Pershing Square saga highlighted the value that can be delivered through activist involvement in M&A, while at the same time underscoring the risks to shareholders of companies not having protections that provide a reasonable amount of time for them to respond to unsolicited bids. As we have discussed in previous memoranda, we expect that the Valeant-Pershing Square model of bidder-activist collaboration will be followed only in limited circumstances (even if there is a final judicial determination or SEC action that removes the insider trading liability issues). Nonetheless, we expect that bidder-activist collaborations, and other new M&A technologies, will continue to evolve, with the arrangements in each case depending on the circumstances of the particular bidder, activist, and target company.

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