Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc.

MOORE, Justice:

In this battle for corporate control of Revlon, Inc. (Revlon), the Court of Chancery enjoined certain transactions designed to thwart the efforts of Pantry Pride, Inc. (Pantry Pride) to acquire Revlon. The defendants are Revlon, its board of directors, and Forstmann Little & Co. and the latter's affiliated limited partnership (collectively, Forstmann). The injunction barred consummation of an option granted Forstmann to purchase certain Revlon assets (the lock-up option), a promise by Revlon to deal exclusively with Forstmann in the face of a takeover (the no-shop provision), and the payment of a $25 million cancellation fee to Forstmann if the transaction was aborted. The Court of Chancery found that the Revlon directors had breached their duty of care by entering into the foregoing transactions and effectively ending an active auction for the company. The trial court ruled that such arrangements are not illegal per se under Delaware law, but that their use under the circumstances here was impermissible. We agree.

Thus, we granted this expedited interlocutory appeal to consider for the first time the validity of such defensive measures in the face of an active bidding contest for corporate control. Additionally, we address for the first time the extent to which a corporation may consider the impact of a takeover threat on constituencies other than shareholders. . . .

In our view, lock-ups and related agreements are permitted under Delaware law where their adoption is untainted by director interest or other breaches of fiduciary duty. The actions taken by the Revlon directors, however, did not meet this standard. Moreover, while concern for various corporate constituencies is proper when addressing a takeover threat, that principle is limited by the requirement that there be some rationally related benefit accruing to the
stockholders. We find no such benefit here.

Thus, under all the circumstances we must agree with the Court of Chancery that the enjoined Revlon defensive measures were inconsistent with the directors' duties to the stockholders. Accordingly, we affirm.

The somewhat complex maneuvers of the parties necessitate a rather detailed examination of the facts. The prelude to this controversy began in June 1985, when Ronald O. Perelman, chairman of the board and chief executive officer of Pantry Pride, met with his counterpart at Revlon, Michel C. Bergerac, to discuss a friendly acquisition of Revlon by Pantry Pride. Perelman suggested a price in the range of $40-50 per share, but the meeting ended with Bergerac
dismissing those figures as considerably below Revlon's intrinsic value.

There were 14 directors on the Revlon board. Six of them held senior management positions with the company, and two others held significant blocks of its stock. Four of the remaining six directors were associated at some point with entities that had various business relationships with Revlon. On the basis of this limited record, however, we cannot conclude that this board is entitled to certain presumptions that generally attach to the decisions of a board whose majority consists of truly outside independent directors.

Thus, on August 14, Pantry Pride's board authorized Perelman to acquire Revlon, either through negotiation in the $42-$43 per share range, or by making a hostile tender offer at $45. Perelman then met with Bergerac and outlined Pantry Pride's alternate approaches. Bergerac remained adamantly opposed to such schemes and conditioned any further discussions of the matter on Pantry Pride executing a standstill agreement prohibiting it from acquiring Revlon without the latter's prior approval.

On August 19, the Revlon board met specially to consider the impending threat of a hostile bid by Pantry Pride. At the meeting, Lazard Freres, Revlon's investment banker, advised the directors that $45 per share was a grossly inadequate price for the company. Felix Rohatyn and William Loomis of Lazard Freres explained to the board that Pantry Pride's financial strategy for acquiring Revlon would be through "junk bond" financing followed by a break-up of Revlon and the disposition of its assets. With proper timing, according to the experts, such transactions could produce a return to Pantry Pride of $60 to $70 per share, while a sale of the company as a whole would be in the "mid 50" dollar range.

[The Revlon board adopted a number of anti-takeover defenses. After Pantry Pride announced its official offer ($47.50 per share), the Revlon adopted additional defenses that included issuing to shareholders, in exchange for 10 million shares, $47.50 worth of Revlon Notes (i.e., debt) bearing 11.75% interest. The new Notes contained covenants which limited Revlon's ability to incur additional debt, sell assets, or pay dividends unless otherwise approved by the
"independent" (non-management) members of the board. [The covenants thus acted as a further defense against a hostile takeover.] The Revlon board held [another] meeting on September 24. The directors rejected the latest Pantry Pride offer and authorized management to negotiate with other parties interested in acquiring Revlon. Pantry Pride remained determined in its efforts and continued to make cash bids for the company, offering $50 per share on September 27, and
raising its bid to $53 on October 1, and then to $56.25 on October 7.

In the meantime, Revlon's negotiations with [alternative parties] Forstmann and the investment group Adler & Shaykin had produced results. The Revlon directors met on October 3 to consider Pantry Pride's $53 bid and to examine possible alternatives to the offer. Both Forstmann and Adler & Shaykin made certain proposals to the board. As a result, the directors unanimously agreed to a leveraged buyout by Forstmann. The terms of this accord were as follows: each stockholder would get $56 cash per share; management would purchase stock in Forstmann's $57.25 offer ostensibly is worth $1 more than Pantry Pride's $56.25 bid. However, the Pantry Pride offer was immediate, while the Forstmann proposal must be discounted for the time value of money because of the delay in approving the merger and consummating the transaction. The exact difference between the two bids was an unsettled point of contention even at oral argument. Actually, at this time about $400 million of Forstmann's funding was still subject to two investment banks using their "best efforts" to organize a syndicate to provide the balance. Pantry Pride's entire financing was not firmly committed at this point either, although Pantry Pride represented in an October 11 letter to Lazard Freres that its investment banker, Drexel Burnham Lambert, was highly confident of its ability to raise the balance of $350 million. Drexel Burnham had a firm commitment for this sum by October 18.

the new company by the exercise of their Revlon "golden parachutes"; Forstmann would assume Revlon's $475 million debt incurred by the issuance of the Notes; and Revlon would [remove its antitakeover defenses] and waive the Notes covenants for Forstmann or in connection with any other offer superior to Forstmann's. Part of Forstmann's plan was to sell Revlon's Norcliff Thayer and Reheis divisions to American Home Products for $335 million. Before the merger,
Revlon was to sell its cosmetics and fragrance division to Adler & Shaykin for $905 million. These transactions would facilitate the purchase by Forstmann or any other acquiror of Revlon. When the merger, and thus the waiver of the Notes covenants, was announced, the market value of [the Notes] began to fall. The Notes, which originally traded around $100, dropped to $87.50 by October 8. One director later reported (at the October 12 meeting) a "deluge" of telephone calls from irate noteholders, and on October 10 the Wall Street Journal reported threats of litigation by these creditors.

Pantry Pride countered with a new proposal on October 7, raising its $53 offer to $56.25, subject to [removal of Revlon's antitakeover defenses], a waiver of the Notes covenants, and the election of three Pantry Pride directors to the Revlon board. On October 9, representatives of Pantry Pride, Forstmann and Revlon conferred in an attempt to negotiate the fate of Revlon, but could not reach agreement. At this meeting Pantry Pride announced that it would engage in fractional bidding and top any Forstmann offer by a slightly higher one. It is also significant that Forstmann, to Pantry Pride's exclusion, had been made privy to certain Revlon financial data. Thus, the parties were not negotiating on equal terms. Again privately armed with Revlon data, Forstmann met on October 11 with Revlon's special counsel and investment banker. On October 12, Forstmann made a new $57.25 per share offer, based on several conditions. [The conditions amounted to Revlon's granting Forstmann 6 terms, including a "lock-up", that would make it very difficult, if not impossible, for anyone else (such as Pantry Pride) to acquire Revlon.] In return, Forstmann agreed to support the value of the Notes, which had faltered in the market, by an exchange of new notes. Forstmann also
demanded immediate acceptance of its offer, or it would be withdrawn. The board unanimously approved Forstmann's proposal because: (1) it was for a higher price than the Pantry Pride bid, (2) it protected the noteholders, and (3) Forstmann's financing was firmly in place.

[O]n October 22, Pantry Pride again raised its bid, with a cash offer of $58 per share conditioned upon [removal of Revlon's antitakeover defenses], waiver of the covenants, and an injunction of the Forstmann lock-up. On October 15, the Court of Chancery prohibited the further transfer of assets, and eight days later enjoined the lock-up [and other antitakeover provisions of the contract with Forstmann]. The trial court concluded that the Revlon directors had breached their duty of loyalty by making concessions to Forstmann, out of concern for their liability to the noteholders, rather than maximizing the sale price of the company for the stockholders' benefit. We turn first to Pantry Pride's probability of success on the merits. The ultimate responsibility for managing the business and affairs of a corporation falls on its board of directors. . . . In discharging this function the directors owe fiduciary duties of care and loyalty to the corporation and its shareholders. . . . These principles apply with equal force when a
board approves a corporate merger pursuant to 8 Del.C. Sec. 251(b); . . . and of course they are the bedrock of our law regarding corporate takeover issues. . . . While the business judgment rule may be applicable to the actions of corporate directors responding to takeover threats, the principles upon which it is founded--care, loyalty and independence--must first be satisfied.

If the business judgment rule applies, there is a "presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." . . . However, when a board implements anti-takeover measures there arises "the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders ..." Unocal Corp. v. Mesa Petroleum Co.,. . .

This potential for conflict places upon the directors the burden of proving that they had reasonable grounds for believing there was a danger to corporate policy and effectiveness, a burden satisfied by a showing of good faith and reasonable investigation. . . . In addition,the directors must analyze the nature of the takeover and its effect on the corporation in order to ensure balance--that the responsive action taken is reasonable in relation to the threat posed. [The court concluded that the initial antitakeover measures Revlon took passed the Unocal standard in light of Pantry Pride's grossly inadequate $45 per share offer.] However, when Pantry Pride increased its offer to $50 per share, and then to $53, it became apparent to all that the break-up of the company was inevitable. The Revlon board's authorization permitting management to negotiate a merger or buyout with a third party was a recognition that the company was for sale. The duty of the board had thus changed from the preservation of Revlon as a corporate entity to the maximization of the company's value at a sale for the stockholders' benefit. This significantly altered the board's responsibilities under the Unocal standards. It no longer faced threats to corporate policy and effectiveness, or to the
stockholders' interests, from a grossly inadequate bid. The whole question of defensive measures became moot. The directors' role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.

This brings us to the lock-up with Forstmann and its emphasis on shoring up the sagging market value of the Notes in the face of threatened litigation by their holders. Such a focus was inconsistent with the changed concept of the directors' responsibilities at this stage of the developments. The impending waiver of the Notes covenants had caused the value of the Notes to fall, and the board was aware of the noteholders' ire as well as their subsequent threats of suit.

The directors thus made support of the Notes an integral part of the company's dealings with Forstmann, even though their primary responsibility at this stage was to the equity owners. The original threat posed by Pantry Pride--the break-up of the company--had become a reality which even the directors embraced. Selective dealing to fend off a hostile but determined bidder was no longer a proper objective. Instead, obtaining the highest price for the benefit of the stockholders should have been the central theme guiding director action. Thus, the Revlon board could not make the requisite showing of good faith by preferring the noteholders and ignoring its duty of loyalty to the shareholders. The rights of the former already were fixed by contract. The noteholders required no further protection, and when the Revlon board entered into an auction-ending lock-up agreement with Forstmann on the basis of impermissible considerations at the expense of the shareholders, the directors breached their primary duty of loyalty.

The Revlon board argued that it acted in good faith in protecting the noteholders because Unocal permits consideration of other corporate constituencies. Although such considerations may be permissible, there are fundamental limitations upon that prerogative. A board may have regard for various constituencies in discharging its responsibilities, provided there are rationally related benefits accruing to the stockholders. . . . However, such concern for non-stockholder interests is inappropriate when an auction among active bidders is in progress, and the object no longer is to protect or maintain the corporate enterprise but to sell it to the highest bidder.

The Forstmann option had a destructive effect on the auction process. Forstmann had already been drawn into the contest on a preferred basis, so the result of the lock-up was not to foster bidding, but to destroy it. The board's stated reasons for approving the transactions were: (1) better financing, (2) noteholder protection, and (3) higher price. As the Court of Chancery found, and we agree, any distinctions between the rival bidders' methods of financing the proposal were nominal at best, and such a consideration has little or no significance in a cash offer for any and all shares. The principal object, contrary to the board's duty of care, appears to have been protection of the noteholders over the shareholders' interests.

While Forstmann's $57.25 offer was objectively higher than Pantry Pride's $56.25 bid, the margin of superiority is less when the Forstmann price is adjusted for the time value of money. In reality, the Revlon board ended the auction in return for very little actual improvement in the final bid. The principal benefit went to the directors, who avoided personal liability to a class of creditors to whom the board owed no further duty under the circumstances. Thus, when a board ends an intense bidding contest on an insubstantial basis, and where a significant by-product of that action is to protect the directors against a perceived threat of personal liability for consequences stemming from the adoption of previous defensive measures, the action cannot withstand the enhanced scrutiny which Unocal requires of director conduct.

In conclusion, the Revlon board was confronted with a situation not uncommon in the current wave of corporate takeovers. A hostile and determined bidder sought the company at a price the board was convinced was inadequate. The initial defensive tactics worked to the benefit of the shareholders, and thus the board was able to sustain its Unocal burdens in justifying those measures. However, in granting [a] lock-up to Forstmann, we must conclude that under all the circumstances the directors allowed considerations other than the maximization of shareholder profit to affect their judgment, and followed a course that ended the auction for Revlon, absent court intervention, to the ultimate detriment of its shareholders. No such defensive measure can be sustained when it represents a breach of the directors' fundamental duty of care. . . . In that context the board's action is not entitled to the deference accorded it by the business judgment rule. The measures were properly enjoined. The decision of the Court of Chancery, therefore, is affirmed.