Developments in Disclosure of Financial Advisor Fees in M&A Transactions

Recent developments, including the U.S. Securities and Exchange Commission settlement with CVR Energy and related SEC Staff guidance, reinforce a trend towards more extensive disclosure of financial advisor fees in M&A transactions, including the circumstances in which fees are payable. 

Highlights

• The tender offer rules require the target of a tender offer to disclose a summary of all material terms of its engagement letters with investment banks that are advising on the transaction. 
• CVR Energy allegedly violated the tender offer rules by failing to properly disclose all material terms of its arrangements with investment banks advising CVR in connection with a hostile tender offer. Potential conflicts of interest that arose from the fee structure were not disclosed to CVR shareholders, including that the financial advisors could receive sizable “success” fees even if the hostile bidder prevailed despite the rejection of the offer by the CVR board.¹ 
• This enforcement action follows recent guidance by the SEC Staff that general disclosure that financial advisors are entitled to “customary fees” is usually insufficient and that disclosure should typically include a discussion of the fee structure, including the types of fees and circumstances that will trigger payment of the fees. 
• These developments are consistent with a general trend in Delaware case law to require more specific disclosure of financial advisor fees, conflicts and other arrangements in M&A transactions. 
• This is another example of the SEC’s recent enforcement actions related to disclosure obligations in connection with M&A transactions and fights for corporate control. See our other recent articles on these topics: SEC and Activist Investors Reach Settlement over Disclosure Violations and SEC and Drugmaker Allergan Reach Settlement over M&A Disclosure Violations. 

Background 

In January of 2012, Carl Icahn disclosed in a Schedule 13D filing that he had acquired beneficial ownership of approximately 14.5% of the outstanding shares of CVR Energy Inc., a NYSE-listed company that is engaged in the petroleum refining and nitrogen fertilizer manufacturing industries. In response, CVR immediately adopted a “poison pill” to “ensure that all stockholders receive fair and equal treatment and maintain the ability to realize the long-term value of their investment in the company.” CVR also engaged lawyers and investment banks to advise on the situation. The engagement letters with the investment banks provided that the banks were not engaged for work related to a tender offer, but that the banks would be offered that work for “customary” fees if a tender offer was launched. 

In February of 2012, Icahn launched a tender offer to acquire CVR. In response and as required by the SEC tender offer rules, CVR filed a Schedule 14D-9 in which CVR’s board of directors recommended that CVR shareholders reject Icahn’s offer. At the time of the filing, CVR had not yet agreed to the terms of the investment banks’ work on the tender offer. However, the Schedule 14D-9 noted that CVR had engaged the investment banks as its financial advisors in connection with, among other things, CVR’s analysis of Icahn’s offer and that CVR had agreed to pay “customary” fees to the banks for their services. 

A few weeks after CVR’s initial Schedule 14D-9 filing, CVR executed additional engagement letters with the investment banks related to, among other things, the banks’ advice in connection with Icahn’s offer. The potential fees payable to the banks included (a) US$9 million if CVR remained an independent company, (b) a potential US$4 million bonus payment at the discretion of CVR’s board, (c) a US$6 million fee if a transaction was announced and (d) a “success” fee equal to 0.525% of the value of a completed transaction. Importantly, the plain meaning of the terms of the engagement letters appeared to entitle the investment banks to the “success” fees even if the transaction involved Icahn, whether or not the banks’ work resulted in Icahn raising his initial offer price. At the time the letters were executed this may have been contrary to CVR’s intention, as certain members of CVR management had understood that the banks’ services would be part of a “raid defense” package. An email between lawyers at CVR’s outside counsel later expressed surprise that the banks would be entitled to “success” fees if Icahn prevailed, noting that this created a perverse incentive for the banks. 

In the weeks that followed, CVR filed several amendments to its Schedule 14D-9 in which CVR’s board continued to recommend that CVR shareholders reject Icahn’s offer, but none of those amendments updated the disclosure regarding the potential fees payable to the investment banks and the circumstances in which those fees might be payable, including that the banks could do nothing to encourage competing bids and still earn significant fees if Icahn prevailed. 

In April of 2013, it was apparent that Icahn’s offer would prevail and CVR and Icahn negotiated an agreement pursuant to which Icahn could complete the tender offer, including removal of CVR’s poison pill, in exchange for certain protections for minority shareholders of CVR. Although the CVR board continued to believe that the offer was inadequate, it agreed to remove the poison pill because many CVR shareholders had expressed support for Icahn’s offer and the CVR board had decided to permit CVR shareholders to make their own choice about Icahn’s offer. On the same day, CVR filed an additional amendment to its Schedule 14D-9, which continued to disclose that the investment banks advising CVR would be entitled to “customary” fees. 

Notwithstanding the fact that the CVR board continued to recommend that CVR shareholders reject Icahn’s offer, a majority of CVR shares were tendered in the offer, resulting in Icahn owning approximately 80% of CVR’s outstanding shares. Pursuant to the terms of the applicable engagement letters, the transaction triggered a claim by the investment banks for approximately US$36 million in “success” fees, despite the fact that Icahn prevailed at his initial price, the CVR board believed that price undervalued the company, and the banks were unable to find any competing bidders. 

Applicable SEC Rules 

Under applicable SEC rules, a public company that is the target of a tender offer is required to express a position on the tender offer by filing a solicitation or recommendation statement on Schedule 14D-9 with the SEC. In addition, Item 5 of Schedule 14D-9 (which incorporates Item 1009(a) of Regulation M-A) requires the target of the tender offer to “[i]dentify all persons and classes of persons that are directly or indirectly employed, retained, or to be compensated to make solicitations or recommendations in connection with the transaction” and “[p]rovide a summary of all material terms of employment, retainer or other arrangement for compensation.” After a Schedule 14D-9 is filed, Rule 14d-9(c) obligates the target company to promptly amend the Schedule 14D-9 to disclose any material changes that have occurred. 

SEC Order 

In anticipation of the institution of cease-and-desist proceedings, CVR consented to the issuance of an administrative cease-and-desist order by the SEC, in final settlement of the SEC’s investigation into CVR’s alleged disclosure violations relating to the terms of its agreements with the investment banks. Although CVR did not admit the findings in the SEC order, the order included the following key findings: 

• CVR violated the Schedule 14D-9 rules by failing to properly disclose all material terms of its arrangements with the investment banks for their work in advising CVR on Icahn’s offer. 
• In light of the fact that the investment banks would be entitled to a “success” fee in a broad range of circumstances, the specific financial terms of the engagement letters should have been disclosed, particularly given that the banks’ fees were not “customary” as CVR had described them. 
• The potential conflicts of interest that arose from the banks’ fee structure were not disclosed to CVR shareholders. The fee structure was material to investors because the sizable “success” fees could be earned even if the CVR board rejected the offer and the banks were unable to negotiate a higher price, whether from Icahn or a third party. This was not a customary fee structure and did not align the banks’ incentives with those of CVR’s shareholders. In similar situations, “success” fees are more often payable to investment banks if the target of the hostile offer is able to remain independent or the shareholders are able to receive an appropriate value for their shares. 

In addition, the SEC press release announcing the order noted: “Full, fair, and accurate disclosures from all parties in a battle for corporate influence or control are critically important to investors particularly when they are called upon to make decisions about their investments. Investors in [CVR] were deprived of key facts needed to make informed investment decisions.”² 

Pursuant to the SEC order, CVR agreed to refrain from engaging in future violations of certain reporting provisions of the federal securities laws. However, the SEC did not impose a civil money penalty, noting that CVR had cooperated with the investigation and promptly taken remedial actions. 

Recent SEC Staff Guidance

In November of 2016 (well after the underlying events described in the CVR order, but before the issuance of the order), the Staff of the Division of Corporation Finance released guidance on the disclosure of investment bank fees in tender offer transactions.³ The Staff stated that general disclosure that investment banks are entitled to “customary fees” is typically insufficient. The Staff noted that, disclosure should be based on the specific facts and circumstances, but that relying on boilerplate disclosure would not provide shareholders with sufficient specificity to determine the merits of the banks’ recommendation and the banks’ impartiality in analyzing a transaction. The Staff was careful to note that quantifying the banker fees might not be universally required, but that the disclosure should generally include the following: 

• the types of fees, such as “success” fees, periodic fees, fees payable at the discretion of the company or its board and fees payable if the company remained independent;
• if multiple types of fees are potentially payable and the fees are not quantitatively disclosed, then adequate qualitative disclosure of the fees so that shareholders can identify any conflicts of interests or incentives that might motivate the investment banks; 
• any triggers for the payment of fees, such as the completion of a transaction; and 
• any other information about the financial terms that would be material to a shareholder’s assessment of the bank’s analysis or conclusion. 

Delaware Law 

Under Delaware law, the duty of disclosure requires a board of directors to disclose to shareholders all material facts in the board’s possession when requesting shareholder action in connection with a corporate transaction. This information includes disclosure of a financial advisor’s fees, including whether the fees are customary and whether the fees are contingent or guaranteed. Delaware courts have noted that, given the important role of financial advisors, full disclosure of fees and potential conflicts of interest is required. In one case from 2011, for example, the Delaware Court of Chancery concluded that general disclosure that a financial advisor would receive a customary fee, and a substantial portion of it would be paid upon completion of the transaction, was inadequate, given that 98% of the fee was contingent upon the completion of the transaction.⁴ The court noted that “an approximately 50:1 contingency ratio requires disclosure to generate an informed judgment by the shareholders as they determine whether to rely upon the fairness opinion in making their decision to vote for or against the Transaction.” More recent Delaware cases have focused on the importance of disclosing conflicts of interest that investment banks may confront, including when advising on a sale transaction and simultaneously vying for the financing associated with the transaction, which can often result in even more lucrative fees. 

The duty of disclosure has become increasingly important in recent years as Delaware courts have continued to craft holdings that discourage meritless litigation of M&A transactions. For example, in a recent line of cases, Delaware courts held that when a transaction that does not involve a controlling shareholder standing on both sides of the transaction is approved by a fully informed, uncoerced vote of disinterested shareholders, the business judgment rule will irrebuttably apply in a post-closing damages lawsuit even if some higher standard of review, such as Revlon or Unocal, would otherwise apply. Delaware courts also extended this rule to two-step tender offers under Section 251 of the DGCL where disinterested shareholders who are fully informed and uncoerced tender a majority of their shares.⁵ These recent cases highlight the importance of a fully informed shareholder vote, which requires disclosure of all material information related to the transaction, including information regarding financial advisor fees, conflicts and other arrangements. Accordingly, companies and their counsel should pay close attention to the board’s disclosure obligations regarding these matters given the potentially significant benefits in post-closing litigation. 

Conclusion 

Targets of M&A transactions should carefully consider disclosure requirements relating to the fees payable to their financial advisors. Although the specific facts and circumstances will dictate the nature and specificity of disclosure, the SEC and Delaware courts have continued to focus on the disclosure of fee arrangements and how they align with the interests of shareholders. In particular, disclosure of potential conflicts of interests should be carefully considered, as such information may be material to a shareholder’s evaluation of the financial advisor’s analysis and conclusion. 

Footnotes 

_{1) See the SEC order.
2) See the SEC press release.
3) See the Staff guidance.
4) See the Delaware Court of Chancery case In re Atheros Communications.
5) See the Delaware Court of Chancery case In re Volcano Corp.}