Inter Se Promoter Exemption for Takeovers: Computation of Holding Period

A few days ago, SEBI made public its informal guidance issued to Weizmann Forex Ltd. on October 25, 2012. In this case, the target company became listed only in 2011 due to a corporate restructuring process. The question was whether certain shareholders can avail of the exemption for inter se promoter transfer by taking into account the promoter holdings in the previous company from which the business was restructured into the target. Qualifying for the exemption requires that both the transferor and transferee should have been disclosed as promoters of the target company for at least 3 years. SEBI adopted a purposive interpretation to answer in the affirmative thereby making the exemption available in that case even though the parties did not technically satisfy the condition.

Facts

The relevant facts can be gathered from the company’s requestto SEBI. Weizmann Forex Ltd., the target company was previously an unlisted company with the name Chanakya Holdings Ltd. As part of an overall restructuring of the Weizmann group, which involved many other legs that are not directly relevant for our present purposes, the forex business of Weizmann Ltd. (the demerged company), being a listed company, was demerged into Weizmann Forex Ltd. (the resulting company). As part of this restructuring process, Weizmann Forex’s shares were listed on the stock exchanges. The promoters of Weizmann Forex intend to transfer certain shares of Weizmann Forex among themselves and hence approached SEBI for informal guidance.

Under Reg. 10(1)(a)(ii) of the SEBI Takeover Regulations, there is an exemption from a mandatory open offer for transfer of shares inter se among qualifying persons being “persons named as promoters in the shareholding pattern filed by the target company in terms of the listing agreement or [the takeover] regulations for not less than three years prior to the proposed acquisition.”

In the present case, none of the proposed transferors of shares were able to satisfy the requirement of being named as promoters in Weizmann Forex as they acquired shares in that company only under the restructuring process. However, if their shareholding in the demerged company (Weizmann Limited) were taken into account for the purpose of computation of the 3-year period, they would satisfy the requirement. Similarly, the transferees too were unable to satisfy the 3-year period of being named as promoters in Weizmann Forex. While one of the transferees held shares for a 3-year period across the two companies (similar to the transferors), the other transferee did not satisfy the 3-year period across two companies (on a combined basis) either.

The issue for SEBI’s consideration was whether, given these facts, the proposed transfer of shares among promoter was exempt from the mandatory open offer requirements under Reg. 10(1)(a)(ii).

SEBI’s Informal Guidance

In interpreting the Takeover Regulations, SEBI considered the 3-year holding period of the transferors and transferees by looking at their holdings on a combined basis in Weizmann Ltd. and Weizmann Forex Ltd. even though they may not have satisfied the requirement strictly with reference to Weizmann Forex Ltd., which is the target company.

Moreover, as far as the transferees are concerned, SEBI’s guidance goes one step further. Even though one of the transferees has not satisfied the 3-year holding period requirement, the exemption has been made available to it. SEBI reasons as follows: “The condition of 3 years shareholding by the transferees prior to the proposed acquisition would be deemed to be fulfilled in case all the transferees collectively hold shares for a period of 3 years prior to the proposed acquisition provided the other conditions for availing the exemption are fulfilled.”

Analysis

In interpreting the Takeover Regulations, SEBI had adopted a purposive approach in making the exemption available to the parties, as opposed to a literal or technical approach that may have denied this facility to the parties. By taking into accounting the shareholding of the parties in the demerged company, necessary consideration has been placed on the demerger transaction, which is essentially a restructuring of businesses and shareholdings as opposed to a complete transfer or sell-out of the business. In other words, it is considered a purely internal group restructuring.

Such an approach is not unusual. For instance, the Income Tax Act, 1961 considers such demerger transactions (provided certain other conditions are satisfied) as a restructuring (rather than a pure sale) and confers certain benefits in terms of exemptions from capital gains tax. More specifically, for the purpose of computing the holding period, the period of shareholding by a shareholder in the demerged company will be considered at the time of sale of shares in the resulting company. The present interpretation of SEBI brings the holding period under the Takeover Regulations on par with such a regime, which is understandable in the context of restructuring transactions and the purpose of the holding period for purpose of exemption under the Takeover Regulations. The only difference is that the Income Tax Act expressly provides for such treatment, while under Takeover Regulations it is only by virtue of the interpretation adopted by SEBI in this case.

However, in the case of the transferee, to the extent that SEBI finds that all the transferees may collectively satisfy the holding period requirement, it is perhaps providing a fairly liberal reading. This seems to suggest that where there is a group of transferees, it might be sufficient if one or more of the transferees satisfy the holding period requirement, and it is not necessary for each one of them to satisfy it. This might provide greater options to structure transfers that may avail of the inter se promoter exemption. At the same time, it may be argued that this is too much of a stretch of the Regulations, and could be subject to potential misuse.

Mandatory Offers and Creeping Acquisitions

The Securities and Exchange Board of India (SEBI) passed an orderunder the SEBI Takeover Regulations of 1997 (that existed prior to October 2011) in relation to the shares of Khaitan Electricals Limited (the Target Company). In this order, the SEBI whole time member directed the promoters of the company to make an open offer to the other shareholders on account of certain acquisitions of shares by them in 2006-2007. Along with the open offer consideration, the promoters have been directed to pay interest at the rate of 10% per annum from June 16, 2007 to the date of payment of the consideration.

The key facts of the case are summarized in the gist of the show cause notices issued by SEBI to the relevant promoters of the Target Company:

... consequent to the acquisition of shares [by the promoters] on March 12, 2007, there was increase in their pre-acquisition shareholding (as on March 11, 2007) of -

(a) [Khaitan Lefin Limited (KLL), one of the promoters], individually, from 10,73,415 shares (10.52%) to 19,73,415 shares (17.16%) in the Target Company and KLL failed to make a public announcement to acquire shares in accordance with provisions of regulation 10 read with regulation 14(1) of the Takeover Regulations, 1997 within 4 working days from March 12, 2007;

(b) The promoter group, collectively, from 26,34,639 shares (25.83%) to 39,34,639 shares (34.21%) and the acquirers collectively failed to make a public announcement in accordance with the provisions of regulation 11(1) read with regulation 14(1) of the Takeover Regulations, 1997 within 4 working days from March 12, 2007.

Given these facts, two primary legal issues arose for consideration.

First, whether an acquisition by a single promoter of more than 15% shares will trigger an open offer requirement under Reg. 10 although the promoter group as a whole already held more than 15%. In other words, whether can be independent obligations under Reg. 10 (for individually crossing the 15% threshold) and under Reg. 11(1) (for collectively activating the creeping acquisition trigger of 5% additional shares) in respect of the same set of acquisitions.

Second, in the case of a creeping acquisition, what is the precise timing to be considered for the acquisition of 5% additional shares? Specifically, whether a dilution of shares during the period ought to be taken into account or netted off while considering the 5% limit.

The SEBI order holds against the promoters on both the issues, thereby mandating them to make an open offer.

On the first issue, the SEBI order reasons as follows:

11. Thus, the obligation to make public announcement under regulation 10 gets triggered when the acquisition of the acquirer, individually or collectively alongwith persons acting in concert with him, would cross the threshold limit of 15%. Thus, if individual acquisition of any person in a group (acting in concert) breaches the threshold limit of 15%, such acquirer is under obligation to make public announcement under regulation 10. In my view, there is no ambiguity in the language of regulation 10 with regard to the obligation of an acquirer whose acquisition increases his individual shareholding beyond threshold limit of 15% and no other interpretation can be given to it. …

…

14. … The intent and object behind the obligation with regard to public announcement under regulation 10, 11 and 12 is common. Regulation 10 does not exempt an acquirer from this obligation when he individually breaches the threshold of regulation 10 but his shareholding collectively with persons acting in concert with him is beyond the threshold prior to his individual acquisition as sought to be contended by the noticees. In my view, therefore, no interpretation can be taken in violation of the language of the regulations or to defeat the intent and object thereof.

On the second issue, the promoters argued that the amount of increase in the shareholding due to creeping acquisition must be computed as of the last date of the financial year, i.e. March 31, and that intermediate divestments and dilution must be netted off. This argument was not accepted by SEBI, which adopted the following reasoning:

21. … If the argument of the noticees is accepted, an acquirer may acquire any percentage of shares in a financial year and by the end of that financial year he may reduce it to 5% by sale of holding or otherwise. This is not the intention of the regulation which, since inception, had put a limit on percentage of creeping acquisition and did not allow netting of acquisition and disinvestment for determining the percentage of increase. …

22. I, therefore, am of the view that for the purpose of availing creeping benefit under regulation 11(1), the gross acquisition of the acquirer should not be more 5% in a financial year that starts on April 1st and ends on March 31st. Further, if at any point of time, in that financial year, the acquisition breaches the threshold of 5% creeping acquisition, the obligation to make public announcement is triggered at that time itself. Regulation 11(1) does not allow an acquirer to wait till end of the financial year after such breach.

…

24. In my view, from the definition of the word 'acquirer' under regulation 2(1)(b) and the provisions of regulation 11 of the Takeover Regulations, 1997 it is clear that the obligation to make public announcement is triggered on the date of agreement to acquire or acquisition of shares or voting rights, as the case may be. Thus, the shareholding shall be calculated and reckoned taking into account the shareholding of the acquirer immediately prior to the acquisition. I, therefore, hold that the shareholding of the acquirers as on the date of the acquisition of additional shares should be taken into account to determine whether the acquisition entitles the acquirer to exercise more than 5% voting rights in the Target Company in a financial year ending on March 31st. Further, the 5% increase in the financial year has to be calculated on gross basis without netting the dilution and/or divestment and acquisition. Accordingly, the arguments of the noticees in this regard also cannot hold good.

SEBI’s order is consistent with the text and intent of the 1997 Regulations. Although the facts of the present case gave rise to some issues that required a detailed consideration, the order merely buttresses the position adopted by the Regulations.

The legal difficulties emanating from the above discussion have been partially addressed in the 2011 version of the Takeover Regulations. The first issue regarding the mutual exclusivity of the initial trigger by individual acquirers (now standing at 25%) and the creeping acquisition trigger by the promoters collectively would continue to operate even under the 2011 Regulations, and to that extent SEBI’s order in the present case would continue to be relevant. As far as the second issue on computation of creeping acquisition limits is concerned, the position has been expressly clarified in the 2011 Regulations in Reg. 3(2) Explanation whereby the limit would be computed on a gross basis (without netting off dilutions). In that sense, SEBI’s order seems to suggest that the introduction of this explanation does not change the legal position, but rather clarifies something that was even previously the intention of the Takeover Regulations.

Should Government Companies Be Exempt From the Takeover Regulations?

Today’s Business Standard carries a reportindicating that SEBI is in the process of considering a general exemption to the Government from making a mandatory open offer under SEBI’s Takeover Regulations 2011. This comes in the wake of two specific exemptions granted by SEBI this year in the case of IDBI Bank and IFCIwhereby the Government was given special dispensation from making an open offer when it increased its stake in the companies due to conversion of securities into equity shares.

Currently, under the 2011 Regulations, SEBI has the power to grant exemptions on a case-by-case basis, which it has exercised in the two cases mentioned above. But, any grant of blanket exemptions to the Government would be a retrograde step. There is no compelling reason for the Government to be treated on a special footing compared to private acquirers because the Regulations are in the end analysis concerned with the protection of minority shareholders in a listed company. By creating such an exemption, SEBI would be discriminating against shareholders of government companies, as they would lack an exit opportunity through an open offer that is available to shareholders in non-government companies.

Moreover, the grant of such dispensation to the Government does not augur well in terms of ensuring compliance with securities regulation in the interest of investors. The Government ought to be setting an example by undertaking the obligations under securities regulation such as the Takeover Regulations and paving the way for ensuring compliance by private acquirers, thereby protecting the interests of minority shareholders in public listed companies. This method of carving out special provisions for government companies, that began with the lower minimum shareholding of 10% rather than the larger 25% limit for other companies, stands no reason when judged against the purpose of the Takeover Regulations, which is to provide an equal exit opportunity to minority shareholders when there is a change in control of the company.

Such moves could give rise to governance implications in a broader sense. For example, there is already a dispute over the governance matters in Coal India Limited between the Government, which is the controlling shareholder, and a minority shareholder, which has also resulted in litigation that is pending before the Indian courts. Such matters could also be significant in the context of the government disinvestment programme where the limitation of protection to minority shareholders in listed companies substantially owned by the Government could impact the success (or otherwise) of such programme.

It would therefore be preferable for SEBI to exercise the power of exemption on a case-by-case basis as per the current practice. That would not only provide the flexibility to deal with specific circumstances such as those that arose in the IFCI and IDBI Bank cases, but at the same time it would require SEBI to apply its mind to individual cases rather than to deal with them on an overall basis as proposed.

Scheme of Arrangement & Tax Authorities: The Vodafone Essar Case

Lately, the income tax authorities have been actively objecting to schemes of arrangement initiated under sections 391 to 394 of the Companies Act, 1956 on the ground that the schemes are intended to avoid applicable taxes. Such objections are usually raised when the scheme is presented for sanction of the High Court. This scenario has been played out last week in a decisionof the Gujarat High Court in Vodafone Essar Gujarat Limited v. Department of Income Tax.

The scheme involved the demerger of the passive infrastructure assets of several telecom companies into a single transferee company. Both the transferor companies and the transferee company were part of the same group, with all of them being wholly owned subsidiaries of one of them. Since the companies were located in several states, the scheme required the approval of different High Courts. While the High Courts of Bombay, Calcutta, Madras and Delhi approved the scheme, a single judge of the Gujarat High Court rejected the scheme on the ground that the transaction did not fall within the scope of “arrangement” within the provisions of the Companies Act as the transaction was considered to be a gift due to the lack of consideration. The court found the existence of a number of other grounds to reject the scheme, primarily because the transaction would result in a loss to the revenue.

Although similar arguments were placed by the income tax authorities before the Delhi High Court, the scheme was nevertheless sanctioned with powers reserved to the income tax authorities to determine tax liability on the scheme. We have previously discussed these contrasting approaches between the Gujarat and Delhi High Courts in a previous post.

Unsurprisingly, the company appealed against the decision of the single judge of the Gujarat High Court, which was reversed last week by a division bench. After carefully considering the law pertaining to the ability of the income tax department to successfully challenge a scheme of arrangement on the ground of tax avoidance, the court came to its own conclusion on the relevant issues.

First, on the threshold question whether the income tax authority has the locus standi to challenge a scheme before the court, there was no doubt about that because the income tax authority is in the nature of a creditor of the company, and is entitled to examine the scheme from the purview of any tax liability arising from that.

Second, the court’s role in approving a scheme of arrangement was considered, and that includes an examination of whether the provisions of the scheme were structured so as to be against public policy or contrary to the provisions of applicable law.

Third, the expression “arrangement” in sections 391 to 394 is of wide import, and cannot be interpreted narrowly. In that sense, it cannot be said that a scheme that is in the nature of a gift cannot amount to an “arrangement” for the purposes of these provisions.

Fourth, while examining the scheme, the court cannot conduct a close examination of its terms such as the nature and extent of the consideration involved in the transaction, which was among group companies. As far as the role of the court is concerned, it was observed:

In our view, while examining the Scheme each and every objection of a third party cannot be considered by carrying out microscopic examination. It is also required to be noted that it is not necessary that consideration is always a monetary consideration. In such type of cases wherein the reconstruction involves give and take and mutual/reciprocal promises and obligations, which can be said to be consideration for each other and it cannot be said that there is absolutely no consideration so far as Scheme of Arrangement is concerned. The Court is required to see whether the Scheme in question is for the benefit of shareholders and whether it is framed with the sole object of avoidance of the Scheme is avoidance of tax or it is against the public policy. Even otherwise, when various High Courts have sanctioned the identical Schemes, even on the principles of parity and judicial comity, in our view, consent is required to be given to the Scheme in question.

Fifth, the role of the tax authority to object to the scheme is fairly narrow and courts will generally be slow in rejecting a scheme on account of issues pertaining to tax. Here, it was observed:

... it is required to be noted that even if the ultimate effect of the Scheme may result into some tax benefit or even if it is framed with an object of saving tax or it may result into tax avoidance, it cannot be said that the only object of the Scheme is tax avoidance. Considering the various clauses of the Scheme it is not possible for us to come to a conclusion that the Scheme is floated with the sole object of tax avoidance. In its commercial wisdom if the Company has decided to have a particular arrangement by which there may be even benefit of saving income-tax or other taxes, that itself cannot be a ground for coming to the conclusion that the sole object of framing the Scheme is to defraud the Income Tax Department or other taxing authorities.

In sum, the division bench of the Gujarat High Court appears to have adopted a similar stance as the other courts that sanctioned the scheme, particularly the Delhi High Court which considered similar objections from the income tax department. The ultimate outcome seems to be that while the income tax department may have limited powers to prevent the implementation of the scheme itself, courts have generally recognised powers to the department to subsequently open the issue of taxability of the scheme and the consequences arising from that. Therefore, from a structuring and implementation standpoint, while companies may now be able to undertake and successfully proceed with various types of schemes of arrangement, the impact of taxation may be felt only subsequently when the department examine the taxation issues.

There seems to be a pattern emerging now on cases involving challenges of schemes by the tax authorities or others (on taxation grounds). A somewhat similar approach was adopted in two other cases recently, In re: AVM Capital Services (P.) Ltd. and In re Indo Rama Textile Ltd.

In the AVM Capital case, a scheme of amalgamation was challenged on the ground that it amounted to avoidance of capital gains tax, and hence that the scheme ought not to be sanctioned. However, the Bombay High Court, after extensively considering the case law on tax avoidance and schemes of arrangement, proceeded to sanction the scheme.

In the Indo Rama Textilecase, a scheme of demerger was sanctioned by the court although there was no allocation of common assets and liabilities among the different undertakings. This was on the ground that the transferred assets and liabilities themselves constituted an undertaking that is capable of carrying on business in an uninterrupted manner. In that case, the court clearly stated that a scheme of demerger may be sanctioned by the court under sections 391 to 394 of the Companies Act although the scheme may not satisfy the requirements of a qualifying demerger under section 2(19AA) of the Income Tax Act.

Interpreting the Takeover Regulations

With the current Takeover Regulations (that came into effect in October 2011) being fairly recent, they are being subjected to interpretation during the course of their functioning. SEBI this week issued two sets of informal guidance in the context of one takeover.

The firstpertains to whether an acquirer holding less than 25% can make a voluntary offer and then acquire shares in the market during the course of the offer so as to cross that limit. SEBI’s response is in the affirmative, as Reg. 22(1) (which prevents completion of acquisitions before completion of the public offer) applies only to acquisitions under an “agreement” and not through open-market purchases. While this approach is consistent with the scheme of the regulations, it could be subjected to abuse by acquirers in the manner detailed in the company’s letter to SEBI.

The secondrelates to the size of a competing offer, and whether that ought to have a minimum of 26% similar to an original offer. SEBI confirmed that this was not necessary in view of the specific provisions of Reg. 20(2).

Although the two sets of informal guidance deal with technical (and somewhat minor) details, they can make a significant difference in a takeover scenario, particularly one where there is an element of hostility between and acquirer and promoters, or between competing acquirers. The previous versions of the Takeover Regulations had built up a significant body of interpretation through orders of the court, the Securities Appellate Tribunal and SEBI. That looks set to continue under the new dispensation as well. Since litigation during the course of a takeover can result in considerable delays that may be disastrous to investors due to adverse price movements in the interim, speedy decision-making is of the essence.

Delaware Courts Allow Litigation to Move at the Speed of Business

[The following post comes to us from Andrea Tinianow, who is a vice president and assistant general counsel at Corporation Service Company. She is also a Delaware attorney.

This post relates to the Delaware Supreme Court’s decision upholding the Chancery Court in Martin Marietta Materials inc. v. Vulcan Materials, Inc. We had earlier discussed some of the substantive aspects of the Chancery Court’s opinion here]

In a case that began in December of 2011, was argued before the Delaware Chancery Court in April of 2012, and argued on appeal to the Delaware Supreme Court on May 31, 2012, the Delaware courts have addressed a complex piece of litigation in under six months in order to ensure that the parties could have finality before a critical June 1, 2012 shareholders’ meeting.

In confirming the Court of Chancery’s decision, the Delaware Supreme Court also reconfirmed that Delaware courts are not only “open for business” for companies who need the assistance of the courts in resolving their disputes, but also that Delaware courts are capable of making decisions at the speed of business.

In 2010, Martin Marietta Materials, Inc. and Vulcan Materials, Inc. – two of the world’s largest producers of sand, gravel and similar materials used in construction - began discussing a consensual merger.  That transaction was scuttled in June of 2011 as the stock prices of the two companies diverged and disputes arose over the location of the merged companies’ headquarters and who would occupy the executive suite in those offices.  However, during those consensual negotiations, the parties signed a confidentiality agreement – governed by Delaware law - limiting the use of information about each of the companies conveyed to the other during their negotiations.

On December 12, 2011, Martin Marietta commenced a $4.8 billion hostile takeover bid for Vulcan, premised on Martin Marietta obtaining 80% of the shares of Vulcan through a tender offer.  Martin Marietta also launched a proxy battle, attempting to have four individuals supportive of the hostile takeover appointed to Vulcan’s board at Vulcan’s June 1, 2012 shareholders’ meeting.

Vulcan’s board opposed the hostile takeover and asserted that Martin Marietta improperly used information obtained during the consensual negotiations to structure its hostile bid, in violation of the confidentiality agreement.  On the same day it launched its hostile bid for Vulcan, Martin Marietta commenced an action before the Delaware Chancery Court asking the court to find that Martin Marietta had not violated the confidentiality agreement.  Vulcan counterclaimed, arguing that Martin Marietta had violated the confidentiality agreement and should be enjoined from proceeding with the hostile takeover.

Clearly time was of the essence for both Martin Marietta and Vulcan.  Martin Marietta needed certainty that its hostile bid and proxy effort would not be overturned by a finding of breach of the confidentiality agreement after the fact.  Vulcan, on the other hand, required a finding that Martin Marietta had breached the confidentiality agreement prior to the June 1, 2012 meeting and an injunction lasting long enough to prevent Martin Marietta from misusing the confidential information to take control of Vulcan.

In an extraordinarily detailed and well-reasoned opinionissued on May 4, 2012, just three weeks after argument by the parties and a month before the critical Vulcan shareholders’ meeting, Chancellor Strine of the Delaware Chancery Court concluded that Martin Marietta had breached the confidentiality agreement and that it should be enjoined from pursuing its hostile tender or proxy efforts for four months – past the time for Vulcan’s shareholders’ meeting, effectively delaying Martin Marietta’s efforts until another shareholders’ meeting could be called. 

The Delaware Supreme Court heard oral argument on an expedited basis on May 31, 2012 and issued a preliminary opinionupholding Chancellor Strine that same day, providing Martin Marietta and Vulcan the certainty both needed ahead of Vulcan’s June 1, 2012 shareholders’ meeting. 

The Martin Marietta/Vulcan case is yet another example of why companies choose to litigate in Delaware, where the Court of Chancery quickly and ably responds to the needs of companies at the speed of business with careful and thorough opinions, and the Delaware Supreme Court is open to those parties and flexible enough to ensure that the court’s calendar does not harm their interests.  Once again, the importance of choosing Delaware for incorporation and the governing law for contracts has been illustrated by Delaware’s courts.  

- Andrea Tinianow

Confidentiality Agreements in M&A Transactions: Lessons from Delaware

Background

Amongst legal documents in an M&A transaction, the confidentiality agreement plays an important role, as it does in other types of investment transactions (such as private equity), especially when it involves a public listed company. There are two key aspects of interest in any confidentiality agreement, which are also often the bone of contention in negotiations: (i) the scope of information that must be kept confidential; and (ii) various exceptions which may be invoked by the party receiving information and hence placing it outside the application of confidentiality obligations.

While confidentiality agreements are essentially within the purview of contract law, there is limited specificity in India in terms of principles laid down either in statutory law or judicial decisions as to the applicability and enforcement of confidentiality obligations in M&A transactions. Hence, a recent (and perhaps significant) pronouncement of the Delaware Chancery Court in Martin Marietta Materials Inc. v. Vulcan Materials Company (Martin Marietta) could throw some light on the manner in which confidentiality agreements are to be drafted and negotiated by legal practitioners. This decision rules on both of the key aspects discussed above, i.e. (i) the definitional aspects of confidential information and (ii) the availability of one of the exceptions to confidentiality.

Facts

The transaction originated as a potential friendly (negotiated) merger between Martin Marietta and Vulcan, both of whom were in the same business. As part of the transaction, both companies negotiated two confidentiality agreements, one a general non-disclosure agreement (referred to as the “NDA”) and another, a common interest, joint defense and confidentiality agreement (referred to as the “JDA”), for sharing of information to facilitate an analysis of the antitrust implications of the merger. Although the confidentiality agreements contained standards clauses relevant to M&A agreements, they did not contain the customary standstill provision (which would prevent a party from making an unsolicited takeover offer on the other party).

After prolonged negotiations, the merger proposal fell through on account of resistance from Vulcan. By then, a substantial amount of information had been shared by Vulcan, which was in Marietta’s possession. Following the failure of merger talks, Marietta initiated a hostile takeover offer on Vulcan combined with a proxy contest. As part of the takeover offer documentation and filings made with the US Securities Commission (SEC), Marietta included information that was subject to confidentiality obligations owed to Vulcan. This included the fact of previous negotiations between the parties towards a possible merger, and also other corporate and financial information regarding Vulcan.

While Marietta approached the Chancery Court seeking a declaration that it can use the information received from Vulcan without a breach of confidentiality obligations, the application was opposed by Vulcan which sought to enjoin Marietta’s hostile takeover.

Issues and Decision

The key issues considered by the Delaware Chancery Court, and its decision, are summarized in the court’s own terms:

This case presents interesting questions regarding the meaning of confidentiality agreements entered into by two industry rivals at a time when both were intrigued by the possibility of a friendly merger and when neither wished to be the subject of an unsolicited offer by the other or a third-party industry rival.

May one of the parties – especially the one who evinced the most concern for confidentiality and who most feared having its willingness to enter into merger discussions become public – decide that evolving market circumstances make it comfortable enough to make a hostile bid for the other and then without consequence freely use and disclose publicly all the information that it had adamantly insisted be kept confidential?  In this decision, I conclude that the answer to that question is no and that, consistent with Delaware’s pro-contractarian public policy, the parties’ agreement that the victim of any breach of the confidentiality agreements should be entitled to specific performance and injunctive relief should be respected.

Here, I find that, although the confidentiality agreements did not include an express standstill, they did bar either party from:

• Using the broad class of “evaluation material” defined by the confidentiality agreements except for the consideration of a contractually negotiated business combination transaction between the parties, and not for a combination that was to be effected by hostile, unsolicited activity of one of the parties; 

• Disclosing either the fact that the parties had merger discussions or any evaluation material shared under the confidentiality agreements unless the party was legally required to disclose because: (i) it had received “oral questions, interrogatories, requests for information or documents in legal proceedings, subpoena, civil investigative demand or other similar process”; and (ii) its legal counsel had, after giving the other party notice and the chance for it to comment on the extent of disclosure required, limited disclosure to the minimum necessary to satisfy the requirements of law; or

• Disclosing information protected from disclosure by the confidentiality agreements through press releases, investor conference calls, and communications with journalists that were in no way required by law.

The breaching party engaged in each of these contractually impermissible courses of conduct.  Because the victim of the breach has sought a temporally reasonable injunction tailored to the minimum period of time that the breaching party was precluded by the confidentiality agreements from misusing the information it had received or making disclosures that were not legally required in the sense defined in the confidentiality agreements, I grant the non-breaching party’s request, which has the effect of putting off the breaching party’s proxy contest and exchange offer for a period of four months.

The first issue pertains to the scope of confidential information. The NDA provides that each party shall use another party’s confidential information (termed in it as “Evaluation Material”) “solely for the purpose of evaluating a Transaction”, and a Transaction is defined as “a possible business combination … between [Martin Marietta] and [Vulcan] or one of their respective subsidiaries”. The key issue was whether the expression Transaction was limited to a negotiated merger between the two companies or whether it can be extended to include a hostile takeover as well. A restrictive meaning of the expression would work in favour of Vulcan as the use of the information for a hostile takeover would be a breach, while an expansive meaning to include a hostile takeover would work in favour of Martin Marietta as the use of confidential information would then be for the purpose of the Transaction. The Chancery Court considered a textual interpretation of the relevant clause, including the argument of Vulcan that since the Transaction was defined to be “between” the two companies, it necessitates a voluntary contractual transaction between them (as opposed to a transaction that is against the will of one of the companies as usually occurs in a hostile takeover). But, the court appears to be persuaded rather by the extrinsic evidence, being the history and evolution of negotiations between Martin Marietta and Vulcan that led to the conclusion of the confidentiality agreements.

The second issue pertains to whether the use of confidential information by Martin Marietta as part of the takeover offer documentation was “as legally required” so as to fall within the exception under the confidentiality agreements.  This involves an interpretation as to the scope of the legal requirement exception in confidentiality agreements. While Martin Marietta argued that the disclosure of information in takeover documentation was required by the relevant disclosure rules of the SEC, Vulcan argued that it does not include any party “taking discretionary action to self-impose a disclosure requirement” as an acquirer is entitled to exercise discretion whether to proceed with an offer or not (without any form of imposition that requires disclosures). Even here, the court did not only consider the relevant language in the confidentiality agreements, but it also looked at the extrinsic evidence of negotiations between the parties so as to conclude that Vulcan’s position deserves support.

Analysis

The Martin Marietta decision is important as it instills life into otherwise mundane clauses of confidentiality agreements, which have acquired overtones of standardization characterized by the exceedingly generous use of templates. It necessitates precise drafting of clauses by transaction lawyers so as to obviate any ambiguity. For example, in the Martin Marietta case, some amount of ambiguity was caused by the lack of uniformity in the definition and scope of confidential information between the two confidentiality agreements, i.e., the NDA and the JDA, although both were between the same parties and pertained to the same transaction.

The Martin Marietta decision is also significant due to the emphasis it places on the history of the drafting and negotiation process as a matter of extrinsic evidence. The court placed weight on the manner in which the clauses were drafted and iterated by the parties during negotiations, and also the enthusiasm displayed by one of them (Martin Marietta) to ensure formidable confidentiality obligations that indeed went on to haunt it in the end when it found itself on the other side of the equation. The lesson: as confidentiality obligations are often reciprocal, what is good for one party will also be good for the other; one must be prepared to be bound by the same terms that it seeks to be benefited by.

Overall, despite the fact-specific nature of the decision, Martin Marietta offers some lessons for M&A practitioners in dealing with confidentiality agreements.

For a further analysis of the decision, please see the Harvard Corporate Governance Blog, the Deal Professor and the Race to the Bottom Blog.