In Monty v. Leis (March 30, 2011), the California Court of Appeals held that the board of directors of a California target did not breach its fiduciary duty by failing to include a fiduciary out in an agreement where the target sold a substantial majority of its equity. In doing so, the Court explicitly rejected Omnicare, Inc. v. NCS Healthcare, Inc.‚1 which is the Delaware Supreme Court opinion requiring a fiduciary out in Delaware sale of the company transactions.
Pacific Capital Bancorp (PCB) is a California corporation. Because PCB suffered substantial losses, federal regulators imposed a deadline by which PCB had to significantly improve its capital position or face seizure and liquidation. PCB called a special meeting and obtained shareholder approval for proposals that would allow PCB to strengthen its capital base, including an amendment to its articles of incorporation that increased PCB’s authorized common stock from 100 million to 500 million shares. Seven months after the special meeting, PCB entered into an investment agreement pursuant to which it sold to an investor common stock and convertible preferred stock equivalent to 80 to 91 percent of the equity of PCB. Facing the looming deadline imposed by the regulators, PCB obtained an exemption from the NASDAQ shareholder approval requirement that ordinarily would have applied to the transaction.
Because of the amendment to its articles of incorporation approved at the special meeting, PCB had a sufficient number of authorized shares to issue the common stock and the convertible preferred stock under the investment agreement. However, PCB did not have a sufficient number of authorized shares of common stock to allow for the exercise of the conversion feature of the preferred stock. Accordingly, after the transaction closed, PCB amended the articles to increase the common stock share authorization, obtaining shareholder approval by written consent from the investor, who by virtue of the transaction closing controlled a majority of the shares.
Shareholders challenged the transaction alleging the investment agreement contained an improper defensive mechanism because there was no fiduciary out and various statutory breaches of the California Corporations Code.
The California Appeals Court concluded that the PCB board had not breached its fiduciary duty by failing to include a fiduciary out in the investment agreement. The Court specifically declined to adopt the Delaware Supreme Court’s reasoning in Omnicare. The Court noted that Omnicare has been criticized even by Delaware courts and instead adopted the reasoning of Jewel Companies, Inc. v. Pay Less Drug Stores Northwest, Inc.,2 a case that predated Omnicare. In Jewel, a federal appeals court applying California law found that a merger agreement granting exclusivity to a buyer pending submission of the agreement for shareholder approval was permissible.
The Court also found that the investment agreement did not violate California Corporations Code Section 405(a), which governs conversion rights, or Section 1001(a), which governs a sale of substantially all of a corporation’s assets. The Court found that after the transaction closing, the investor held a majority of the voting shares and thus alone had the power to approve the amendment to PCB’s articles to increase the number of authorized shares and, without conceding that Section 1001(a) of the California Corporations Code would apply, approve the transaction for purposes of that section.
Monty stands for the proposition that a fiduciary out is not required to be included in sale of the company transactions governed by California law, which will allow a target to grant iron-clad exclusivity to a buyer. Quoting Jewel, the Court said “an exclusive merger agreement may be necessary to secure the best offer for the shareholders of a firm,” acknowledging that “shareholders may suffer a lost opportunity” of a higher offer. Accordingly, once a board has exercised its fiduciary duty and executed an acquisition agreement that reflects the best offer the board was able to obtain for its shareholders, directors do not have a continuing obligation to obtain a better deal.
Monty could also be read more broadly for the proposition that locked-up deals may be permissible under California law. The PCB transaction turned out to be a locked-up deal — once the investment agreement was signed, shareholder approval was guaranteed. Moreover, the Court declined to follow, and alluded to judicial criticism of, Omnicare, which is generally interpreted as prohibiting lock-ups of a majority of the shareholder vote.
However, because of the lack of detailed legal analysis on the fiduciary out issue, the unique factual circumstances and the fact that a majority lock-up was not at issue in Monty, it is difficult to predict the extent to which California courts would countenance a locked-up deal. Accordingly, the use of any deal protection measures in California will still need to be carefully analyzed in light of the facts and circumstances.
In short, California has joined the chorus of courts signaling that Omnicare may be of “questionable continued vitality.”3
For additional information concerning this alert, please contact your regular Bingham contact or the following lawyers:Stephen D. Alexander, Partner
This article was originally published by Bingham McCutchen LLP.