As the percentage of tender offers in friendly transactions has risen in recent years, so too has use of so-called "top-up options." Yet, despite their prevalence, the validity of top-up options has not been addressed squarely by the Delaware courts and continues to be challenged by the plaintiffs' bar. However, two separate rulings from the Delaware Court of Chancery this week suggest that the use of top-up options is likely to present little litigation risk.
A top-up option gives the acquiror the right, upon successful completion of a tender offer at or above the minimum condition level (usually 50 percent), to purchase newly issued shares of the target so as to increase its ownership in the target to greater than 90 percent. Under Delaware law, once an acquiror crosses the 90 percent ownership threshold, it may complete the back-end squeeze out through a simple short-form merger. The purpose of the top-up option is to expedite the closing of the merger (and thus the receipt of the consideration by the target's stockholders) once a majority (but less than 90 percent) of the target's stockholders have endorsed the transaction by tendering their shares.
In In re Cogent, Inc. S'holders Litig. (Consol. C.A. No. 5780-VCP), Vice Chancellor Parsons denied a motion to preliminarily enjoin the proposed friendly two-step acquisition of Cogent by 3M. Certain Cogent stockholders challenged, among other things, the companies' inclusion of a top-up option in the 3M/Cogent merger agreement. In denying the motion for preliminary injunction, Vice Chancellor Parsons found that the plaintiffs did not establish a likelihood of success on their challenge to the top-up option:
Theoretical Disenfranchisement of Minority Stockholders Too Speculative
Plaintiffs argued that because 3M, with the consent of the Cogent, could waive the minimum tender condition, 3M was theoretically able to exercise the option even if a majority of shares were not tendered. Vice Chancellor Parsons concluded that although "it technically might be possible for 3M to acquire the Company through the Top-Up Option without acquiring a majority of the shares in the tender offer, this argument depends on the occurrence of more than one highly unlikely event [i.e., that 3M would waive the minimum tender] and is far too speculative to warrant injunctive relief."
Top-Up Option is Not a "Sham" Transaction or Illusory Promise
Vice Chancellor Parsons likewise found that plaintiffs were not likely to succeed in their contention that, because the top-up option allowed 3M to pay for the top-up shares with a promissory note payable in a year (by which time it presumably would own Cogent), it was an illusory promise to pay itself. Noting that DGCL section 157 leaves the judgment as to the sufficiency of consideration received for stock to the conclusive judgment of the directors absent fraud, Vice Chancellor Parsons reasoned that the Board had received due consideration for entering into the merger agreement and that the promissory note, at the time issued, would be a legally enforceable obligation owed by 3M to Cogent.
Parties May Provide For Exclusion of Top-Up Option from Consideration in Fair Value Appraisal
Plaintiffs argued that the value of existing Cogent shares would be reduced as a result of (1) the dilutive effect of a substantial increase in shares outstanding if the top-up option were exercised and (2) the "questionable value" of the promissory note given as consideration for them. They contended that the fair value of the appraisal shares in a subsequent appraisal proceeding following the execution of the top-up option would also be decreased. Cogent and 3M, anticipating this issue, had followed the increasingly common practice of providing in the merger agreement that "the fair value of the Appraisal Shares shall be determined in accordance with DGCL § 262 without regard to the Top-Up Option, the Top-Up Option Shares or any promissory note delivered by the Merger Sub." Noting that there is a strong argument in favor of permitting merger parties "to stipulate to certain conditions under which an appraisal will be conducted—certainly to the extent that it would benefit dissenting shareholders and not be inconsistent with the purpose of the statute," Vice Chancellor Parsons concluded that, in this case, the merger agreement provision was sufficient to overcome plaintiffs' professed concerns about the potential dilutive effects of the top-up option.
Similarly, in In re Protection One, Inc. S'holders Litig. (Consol. C.A. No. 5468-VCS), Vice Chancellor Strine entered an order approving a settlement of stockholder litigation which included, among other things, a stipulation by the parties that any top-up shares would not be included for purposes of adjudicating fair value in an appraisal action. Indeed, Vice Chancellor Strine seemed skeptical of any of the professed concerns about top-up options, declaring that he hadn't "caught the top-up wave." Emphasizing that the top-up option is "part and parcel of the transaction that gave rise to appraisal in the first instance," he questioned why there was even an issue as to whether top-up shares would be included as part of the going concern value of the company.
These recent rulings provide certain comfort to parties that seek to benefit from the flexibility of the top-up option feature. Despite the court's recent and justifiable skepticism as to the theoretical necessity of the provision excluding the top-up option from appraisal value consideration, we continue to believe in the advisability of such a provision to further reduce litigation risk relating to its purported dilutive effect.