Negotiated Transactions

Originally published in Bloomberg Law Reports, August 1, 2011

A pair of recent Delaware court decisions has shined a spotlight on the role of financial advisors in public M&A. This article summarizes these developments and provides some helpful insight on the impact these cases could have regarding investment banking engagements, proxy statement disclosures, and changes to merger agreements themselves.

Disclosure of Success Fee Arrangements

There is a tension in financial advisor compensation in any M&A advisory engagement. From the company's perspective, there is a strong possibility that the extraordinary transaction being considered will never come to fruition and it certainly does not want to be saddled with large expenses in that case. The company, however, wants to make sure that it has the best advice it can obtain, from an expert who is motivated to be there during this potential "bet the company" moment. In other words, the company wants the full attention of its financial advisor for several weeks or months, yet does not want to pay a substantial fee to the financial advisor if a deal doesn't happen. From the financial advisor's standpoint, consideration of these deals takes a significant amount of time and effort and, as importantly, has the significant opportunity costs of making the financial advisor unavailable for other transactions.

The success fee is a creative solution for both companies and their financial advisors. By paying a substantial portion of the fee only if the deal happens, the company reduces its expenses in a failed sale or auction. In addition, because, at least in the context of a target's financial advisor, the advisor's fee increases as the price to the stockholders increases, the advisor is incentivized to push for the highest price. On the flip side, because success fees are typically between 0.2 percent and 1.0 percent of the equity value (depending on the size of the deal), the fees a financial advisor can earn on one successful M&A transaction can more than pay for the foregone advisory fees for several busted deals. A 0.4 percent fee on a $5 billion deal earns the financial advisor a healthy $20 million fee.

While the success fee arrangement is mutually beneficial to both the company and its financial advisor, there is an inherent conflict when the advisor is also asked to opine as to the fairness of the transaction, knowing that receipt of an opinion that the transaction is fair is either explicitly or implicitly a condition for the transaction. Since Smith v. Van Gorkom,1 it has been standard operating procedure in public M&A transactions for a company's board to insist on a fairness opinion prior to the board recommending the transaction to the stockholders.2 Often a fairness opinion will also be required from the buyer's financial advisor, particularly where stock consideration is involved. In such a circumstance, the financial advisor will only earn its success fee if it opines that the transaction is fair. Given the obvious financial incentive of the opinion-giver to find the transaction to be "fair," and the potential questions surrounding a financial advisor's objectivity and self-interest, Delaware law has long held that proxy statements for transactions in which a fairness opinion is rendered must disclose the compensation arrangement between the company and its financial advisor.3

— In re Atheros Communications

The extent of the required disclosure of success fee arrangements to the stockholders was partially addressed in the Delaware Chancery Court's recent decision involving Qualcomm, Inc.'s proposed cash buyout of Atheros Communications, Inc.4 Atheros stockholders sought to enjoin the merger alleging that the Atheros board failed to satisfy its fiduciary duties under Revlon5 and that the proxy contained incomplete disclosure concerning, among other things, the fee arrangement between Atheros and Qatalyst Partners LP, Atheros' financial advisor. The court refused to enjoin the merger on process grounds, but did temporarily enjoin the stockholder meeting until additional disclosure was made concerning, among other things, the contingent success fee arrangement with Qatalyst.

Atheros and Qatalyst negotiated the engagement arrangement from early September until December 28, 2010. During this period of time, despite the lack of a formal engagement agreement, Qatalyst was active on behalf of Atheros in...