Bermuda companies competing in the international business sphere are under continued pressure to grow and thereby succeed on a greater scale.

In recent years, there has been a great deal of merger and acquisition activity for Bermuda companies, arguably because, as Brian Schneider, senior director at Fitch Ratings, has commented, “organic growth options are limited and scale and diversification are driving a rapid pace of mergers and acquisitions”.

This two-part series explores the interplay between the counterparties once an acquisition or combination (business combination) has been agreed upon and provides an overview of deal protection mechanisms available to both target and bidding companies.

Once the form of business combination has been agreed upon by the respective boards, care should be taken to ensure that the interests of both the target and bidding company are adequately protected during the negotiation period and between signing and closing. Consequently, deal protection mechanisms tend to be some of the most heavily negotiated provisions.

Deal protection mechanisms are arrangements between the boards of directors of the bidder and target company that are intended to discourage alternative (even superior) proposals with a view to protecting the transaction if a competing bid emerges.

From a bidder’s perspective, the need for deal protection provisions principally arises because, they do not want to be a stalking horse and they wish to realise synergies and projected benefits from the business combination and discourage competitive bids and the resulting negative perception of the same. Also, a considerable amount of time and cost is incurred negotiating business combinations and ascertaining future opportunities. As such, bidders are typically reluctant to enter a business combination without protecting the deal to the best extent possible.

Target company boards often resist or seek to limit the scope of deal protection provisions as they perceive that it is in the best interests of their company to retain elasticity to evaluate subsequent proposals (especially if a superior proposal materialises).

There are, however, some circumstances in which target boards agree to the request of the bidder for such provisions — principally to increase deal certainty — as the target board does not want the target company to be “put in play” and subsequently lose a preferred or viable bid.

In negotiating deal protection mechanisms, each director (whether of the target or bidder company) must discharge his or her duties during the process. There is no single statutory prescription in Bermuda that sets out all a director’s duties; however, the fundamental principles are codified in section 97 of the Bermuda Companies Act 1981, as amended – the duty (i) to exercise the care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances and (ii) to act in honest and good faith in what the director bona fide considers to be in the best interests of the company. Added to this are directors’ fiduciary duties — the duty to exercise his or her powers for the proper purpose and avoid conflicts of interest unless the conflict has been adequately disclosed.

Therefore, the directors’ fiduciary-out provision (although not a deal protection mechanism as such) is a heavily negotiated provision and consideration in business combination transactions. Principally, the respective boards incorporate a general right to withdraw or amend their recommendation/offer if they conclude that consummating the proposed business combination would be in breach of their fiduciary duties.

Specifically, the board of a target company may also seek to include the following two common forms of fiduciary-outs:

Superior proposal: a right for the target board to consider and accept a superior proposal. A bidder may, however, seek to negotiate and impose limitations on the target’s fiduciary-out by incorporating the method and amount of consideration (eg cash versus shares); ease and confidence of closing (eg no financing required versus financing required); regulatory issues (e.g. closing subject to approval versus no approval required).

Intervening event: a right for the target board to change its recommendation to its shareholders and terminate the agreement because of an event that has caused the target company to become worth significantly more than its valued amount at closing — commonly referred to as “gold in the backyard”. A bidder may, however, seek to negotiate and impose limitations on the target’s fiduciary-out by incorporating a right to match and/or exceed the superior proposal upon the bidder reviewing the terms and conditions of all superior proposals.

Those in favour of deal protection provisions point to the value of them from an economic exploration perspective; they are value-enhancing and encourage superior proposals. Those opposed seek to demonstrate the negative effects on shareholder value and so they negotiate against onerous terms.

Several deal protection devices, such as confidentiality, no-shop/exclusivity and break fees have emerged as standard in business combination transactions, whereas other, more exotic, deal protection mechanisms (such as the crown jewel) have been deployed with varying degrees of success.

Part two: the second part of this series will explore how to craft a deal protection package that delivers the right level of protection while adhering to the various regulatory and legal constraints to which parties to a business combination are subject.

Attorney Seth Darrell is an Associate in the Corporate Department at Appleby. A copy of this column is available on the firm’s web site at www.applebyglobal.com. This column should not be used as a substitute for professional legal advice. Before proceeding with any matters discussed here, persons are advised to consult with a lawyer