In re Toys "R" Us, Inc., S'holder Litig. - 877 A.2d 975 (Del. Del. Ch. 2005)

Rule:

Neither a termination fee nor a matching right is per se invalid. Each is a common contractual feature that, when assented to by a board fulfilling its fundamental duties of loyalty and care for the proper purpose of securing a high value bid for the stockholders, has legal legitimacy.

Facts:

The Board of Toys “R” Us, Inc. proposed a merger with an acquisition vehicle formed by a group led by Kohlberg Kravis Roberts & Co. (“the KKR Group”). The proposed merger resulted from a lengthy, publicly-announced search for strategic alternatives that began in January 2004, when the Company's shares were trading for only $ 12.00 per share. If the merger is approved, the Toys "R" Us stockholders will receive $ 26.75 per share for their shares. This per share merger consideration constitutes a 123% premium over that price. During the strategic process, the Toys "R" Us board of directors, nine of whose ten members are independent, had frequent meetings to explore the Company's strategic options. The board, with the support of its one inside member, the company's CEO, reviewed those options with an open mind, and with the advice of expert advisors. Eventually, the board settled on the sale of the Company's most valuable asset, its toy retailing business, and the retention of the Company's baby products retailing business, as its preferred option. It did so after considering a wide array of options, including a sale of the whole Company. The Company sought bids from a large number of the most logical buyers for the toy business, and it eventually elicited attractive expressions of interest from four competing bidders who emerged from the market canvass. When due diligence was completed, the board put the bidders through two rounds of supposedly "final bids" for the toys business. In the midst of this process, one of the bidders expressed a serious interest in buying the whole company for a price of $ 23.25 per share, and then $ 24.00. The board decided to stick by its original option until that bidder made an offer to pay $ 25.25 per share and signaled it might bid even a dollar more. When that happened, the board was presented with a bid that was attractive compared with its chosen strategy in light of the valuation evidence that its financial advisors had presented, and in light of the failure of any strategic or financial buyer to make any serious expression of interest in buying the whole Company -- even a non-binding one conditioned on full due diligence or a friendly merger -- despite the board's openly expressed examination of its strategic alternatives. Recognizing that the attractive bids it had received for the toys business could be lost if it extended the process much longer, the "Executive Committee" of the board, acting in conformity with direction given to it by the whole board, approved the solicitation of bids for the entire Company from the final bidders for the toys business, after a short period of due diligence. When those whole Company bids came in, the winning bid of $ 26.75 per share from the KKR Group topped the next most favorable bid by $ 1.50 per share. The bidder that offered $ 25.25 per share did not increase its bid. After a thorough examination of its alternatives and a final reexamination of the value of the Company, the board decided that the best way to maximize stockholder value was to accept the $ 26.75 bid. That was a reasonable decision given the wealth of evidence that the board possessed regarding the Company's value and the improbability of another bidder emerging. In its proposed merger agreement containing the $ 26.75 offer, the KKR Group asked for a termination fee of 4% of the implied equity value of the transaction to be paid if the Company terminated to accept another deal, as opposed to the 3% offered by the company in its proposed draft. Knowing that the only other bid for the company was $ 1.50 per share or $ 350 million less, the Company's negotiators nonetheless bargained the termination fee down to 3.75% the next day, and bargained down the amount of expenses the KKR Group sought in the event of a naked no vote.

Thus, the plaintiff stockholders filed the instant action and moved for a preliminary injunction to enjoin a stockholder vote to approve the merger. In their motion, the plaintiffs faulted the Toys "R" Us board, arguing that it failed to fulfill its duty to act reasonably in pursuit of the highest attainable value for the Company's stockholders. They complained that the board's decision to conduct a brief auction for the full Company from the final bidders for the toys business was unreasonable, and that the board should have taken the time to conduct a new, full-blown search for buyers. Relatedly, they complained that the board unreasonably locked up the $ 26.75 bid by agreeing to draconian deal termination measures that preclude any topping bid.

Issue:

Did the Board act unreasonably in agreeing to the deal protection measures proposed by KKR?

Answer:

No.

Conclusion:

The plaintiffs posited that the board should have refused to sign the merger agreement with the KKR Group until the termination fee was reduced to some less onerous level and the matching rights were removed. In fact, the board did negotiate the termination fee down to 3.75% from the 4.0% that KKR had proposed on March 15, putting the $ 350 million bid differential at some risk to do so. The plaintiffs, however, assumed that the board should have pressed harder and that the KKR Group would have yielded further, but still kept its bid at $ 26.75. But what if the KKR Group had said, "if you want to cut the termination fee to 3%, our offer is only $ 25.75 per share?" What was the board to do then? Even worse, suppose the KKR Group had asked, "what did the other groups bid?" What was First Boston supposed to say, knowing that the KKR Group had topped Cerberus by a full $ 1.50 per share or $ 350 million? In that dynamic, only the reckless would have been insensitive to the worry that the KKR Group's bid might drop if it were asked to give up the matching rights or to accept a termination fee of less than 3%. Faithful fiduciaries and their advisors, facing a dynamic of this kind, would reasonably fear that the KKR Group might somehow get wind that it made an overbid and be chary about losing the proverbial bird in hand. It was this tradeoff - between getting the highest price the board could from KKR Group right then and there, and the limited opportunity of receiving a higher bid from a well-canvassed market by reducing the termination fee and eliminating the match rights - which the board and its advisors had to address, and which the plaintiffs and their ivory tower-based experts refuse to realistically engage.

The KKR Group was no doubt aware of that reality and the Company was in no position to deny the KKR Group any deal protections. Furthermore, unlike the plaintiffs, it was not absurd that the Company was willing to offer the KKR Group deal protections as strong, on a percentage basis, for a whole Company bid as it had for a sale of Global Toys. In this regard, it was important to recall that the Company had sought a I% termination fee originally in the proposed Global Toys asset sales agreement and had, in the course of extracting two "final" and winning bids from the KKR Group, eventually assented to a 3% fee. The inducement of staying at 3% in its initial merger agreement draft might therefore have been thought reasonably necessary to induce an attractive whole-Company bid from a wearied bidder, by signaling that the Company was credibly committed to selling and, separately, reasonably recognizing the KKR Group's need for adequate compensation if it risked the opportunity costs of tying up nearly $ 7 billion of capital in pursuit of an acquisition of the Company that might not come to fruition. Contributing to this negotiating dynamic, no doubt, were prior judicial precedents, which suggested that it would not be unreasonable for the board to grant a substantial termination fee and matching rights to the KKR Group if that was necessary to successfully wring out a high-value bid. Given the Company's lengthy search for alternatives, the obvious opportunity that unsolicited bidders had been afforded to come forward over the past year, and the large gap between the Cerberus and the KKR Group bids, the board could legitimately give more weight to getting the highest value bid out of the KKR Group, and less weight to the fear that an unlikely higher-value bid would emerge later. After all, anyone interested had had multiple chances to present, however politely, a serious expression of interest - none had done so.

Nor was the level of deal protection sought by the KKR Group unprecedented [**124]  in magnitude. In this regard, the plaintiffs ignored the fact that many deals that were jumped in the late 1990s involved not only termination fees and matching rights but also stock option grants that destroyed pooling treatment, an additional effect that enhanced the effectiveness of the barrier to prevent a later-emerging bidder. In cases like McMillan v. Intercargo and Pennaco Energy, the court approved deal protection measures in the Revlon context that were nearly as substantial, taking all factors into account, as those here. In Pennaco Energy, the court upheld an informed board's decision to sign up a sales deal, after negotiating with a single bidder, that included a 3% termination fee and matching rights. The court did so because the board was well-informed, clearly desired the best price, and because any serious bidder who wanted to present a materially higher bid could still do so. In view of this jurisprudential reality, the board was not in a position to tell the KKR Group that they could not have any deal protection. The plaintiffs admitted this and therefore second-guess the board's decision not to insist on a smaller termination fee, more like 2.5% or 3%, and the abandonment of the matching right. But that was precisely the sort of quibble that does not suffice to prove a Revlon claim.