The Pershing Square-Valent hostile takeover campaign for global pharmaceutical company Allergan, maker of Botox, represents a new milestone in hedge fund investor activism. But the media and investment community are underestimating Allergan’s ability, under Delaware law, to fight off the takeover and choose alternative actions that would reward shareholders more richly.
Activist hedge fund investors typically follow a familiar script. First, the activist quietly builds a stake in the target company, either individually or by teaming up with other investors to form a wolf pack. The activist then applies public pressure to the target, which often takes the form of threats to agitate against the board’s preferred strategy and smear campaigns against management, whom they routinely label as incompetent, overpaid and wasteful. Finally, the activist takes action against the directors, demanding seats on the board for the activist or his proxies.
For the original board members, the activist agenda represents a classic tension between short-term and long-term strategy. The activist investor’s proposed solutions often rely on financial engineering and additional leverage rather than steady growth and long-term value creation.
The activist attack on Allergan diverges from this script. In a novel partnership, the Bill Ackman-run hedge fund Pershing Square has teamed up with Valeant, a pharmaceutical firm that eschews old-fashioned research and development in favor of an aggressive acquisition strategy. By combining forces, the two firms make for a potent team that, if successful in their takeover bid, will be primed to hop over regulatory hurdles and hit the ground running in their race to a quick and tidy profit.
Their partnership provides Pershing Square and Valeant with several regulatory advantages over Valeant pursuing the acquisition alone. Most importantly, because the hedge fund is not a competitor of Allergan’s, it can likely obtain the Hart-Scott-Rodino antitrust clearance needed to convert options into voting stock faster than Valeant can. In addition, if the takeover attempt triggers SEC Rule 14e-3, which prevents insider trading if a bidder has taken significant steps to commence a tender offer, Pershing Square can claim to be a co-bidder and therefore exempt from the restriction.
The value of the venture’s initial investment increased by approximately 25 percent on the day Valeant announced its takeover bid, resulting in a handsome $1 billion profit. Not bad for a day’s work. Bill Ackman’s vocal support for the deal, combined with the partnership’s 9.7 percent ownership stake and its threat to remove a majority of the Allergan board, has tightened the screws on Allergan to negotiate with Valeant. At first blush, the picture is rosy for both Valeant and Pershing Square. Their initial investment is paying off and they are in pole position to stock the board with their allies.
However, the outcome of the takeover contest becomes less certain when we consider the fundamental conflict between the activist hedge fund’s objective of turning a quick profit and the Allergan board’s fiduciary duty to stockholders, under Delaware law, to maximize long-term value.
Valeant’s business model relies on serial acquisitions and cost reductions, including slashing R&D spending to the bone. In contrast, Allergan invests heavily in R&D and consequently has a rich pipeline of new products that industry experts believe represent billions of dollars in potential revenue and profit. In light of Valeant’s emphasis on short-term gains, the Allergan directors’ fiduciary duty will require them to carefully consider whether alternative partnerships or remaining independent provide better long-term value to the shareholders. Allergan’s board tracked this logic when it announced its unanimous rejection of Valeant’s proposal: “[We are] confident that the Company will create significantly more value for stockholders than Valeant’s proposal.”
So while Wall Street seems to take for granted that Valeant and Pershing Square’s best-laid plans to replace the board will succeed, the road to takeover has several potholes. If the remaining Allergan directors and their historical investment bankers and lawyers refuse to go along with the deal, the actions of the new directors may not withstand the legal challenges that are sure to follow.
Delaware law requires that a Valeant-Allergan merger be approved by the Allergan board before being submitted to the stockholders for a vote. Because of the potential conflicts of interest that fiduciaries face when considering whether and on what terms to sell the corporation, Delaware courts apply “enhanced scrutiny” to takeover bids, including their assessments of whether directors are “independent.” In order to qualify as independent, a director must commit to making decisions based on the best interest of a corporation free from extraneous consideration or influence. Delaware courts may question whether the new directors are beholden to the Pershing Square interests to whom they owe their seats.
This is best demonstrated in the recent case of Rural Metro, when the Delaware Court of Chancery found that a board of directors, led by an activist investor who owned 12 percent of the company, breached its fiduciary duty to its shareholders by agreeing to sell the company for a price that was less than what the court determined the stand-alone value of the company to be. The bid for Rural Metro represented a premium to market price and a nice profit for the activist hedge fund, but less than the value which could be achieved for shareholders by remaining independent and implementing the business plan.
The Rural Metro case demonstrated that Delaware courts aren’t afraid to put the kibosh on transactions that they view as inimical to shareholder interests, and they’re particularly attuned to the inherent conflicts of interest faced by an activist director. That’s the sort of precedent that could stop Bill Ackman and other activist investors dead in their tracks.
Even if Bill Ackman and Valeant replace a majority of the Allergan board, the surviving original directors, advised by their historical lawyers and investment bankers, can just vote against the merger if they believe its not the best way to maximize long-term value for the Allergan shareholders. If that occurs, the Delaware court will probably make the final call about whether the Valeant deal is the best alternative for maximizing long-term value for Allergan shareholders.
Gardner Davis is a partner and corporate lawyer with Foley & Lardner LLP. He regularly counsels companies and their boards of directors in M&A transactions and corporate governance matters. Davis can be reached at email@example.com.