Against the background of a growing merger and acquisition market, a swelling number of bidders seek protection for their deals.

Part one of this series explored the interplay between the counterparties once a business combination has been agreed upon and provided an overview of deal protection mechanisms available to both target and bidding companies.

Part two of this series explores how to craft a deal protection package that delivers the right tension of protection, while adhering to the various regulatory and legal constraints to a business combination.

There is no definitive catalogue of deal protection mechanisms, because the term describes a class of mechanisms that are both fluid and flexible. Several devices, such as no-shop, confidentiality and break fees have emerged as standard in business combination transactions, whereas other, more exotic deal protection mechanisms have been deployed with varying degrees of success.

No-shop provisions (commonly used in Bermuda) principally seek to prevent a target company from soliciting or encouraging third-party proposals. These provisions vary from a less restrictive clause that permits the target company to provide information to unsolicited bidders, to the much more restrictive “no-talk” covenants that prohibit the target company from responding to any third-party advances.

Overly restrictive no-shop/exclusivity provisions could be challenged on the basis that the target board breached its fiduciary duty to act in the best interests of the company (including the shareholders) where it fails to enter into a transaction that recognises the true value of the company and allows shareholders to realise the same. Consequently, even though the directors may negotiate deal protection mechanisms, they should be able to accept a superior proposal for the shareholders. Any contract provision that seeks to abrogate the board’s ability to do so is contrary to their duties. Accordingly, target boards typically require a fiduciary out as an exception to the no-shop that gives them certain rights to review alternate proposals or respond to intervening events.

Another central deal protection device is the “confidentiality” provision. This allows the parties to negotiate the material terms of the business combination without alerting potential competitive bidders. From the outset, parties should enter into a non-disclosure agreement to prevent disclosure of the proposed transaction and sensitive information that is shared between them. When combined with other deal protection devices — for example, no-shop provisions — the obligations of confidentiality facilitate the exchange of sensitive information to allow each party to effectively evaluate the proposed business combination, protect the transaction during its infancy from interference by third parties and minimise the potential of share value fluctuations due to market speculation.

In business combinations, it is also common for the bidder to request that the target company pay a “break fee” to the bidder in certain circumstances, including compensating a failed bidder for transaction expenses and loss of opportunity. Prospective bidders often attempt to negotiate the largest break fee possible as a deterrent to deal cancellation.

Conversely, an interesting development has been the emergence of the reverse break fee — a fee paid by the bidder if it breaches the merger/acquisition agreement or is unable to consummate the transaction (eg due to lack of financing or failure to obtain necessary regulatory approvals) and the target terminates the agreement. If an agreement provides for a reverse break fee, the amount (which tends to be higher than a break fee) and the conditions under which it is payable should be set out in the termination provisions of the merger/acquisition agreement.

One of the more exotic deal protection mechanisms, is the “crown jewel” provision. This is a device by which the target company agrees to grant the proposed acquirer an option to purchase, or otherwise obtain the benefit of, certain of the target’s valuable assets if the proposed transaction does not close, including because of a topping bid.

This type of protection gives the acquirer assurance that even outside of a successful acquisition or merger, it will nevertheless acquire key pieces of the target’s business. This device also deters competing bidders, as a superior bidder will at best acquire the target without the “crown jewels”.

While there may be room for creative variations on crown jewels, they are not a staple of transactions in Bermuda and one would expect boards of targets to be generally unwilling to agree to such a provision as it could make the target less attractive, reduce the chances of subsequent bids and weaken the target if the merger does not proceed, making the target company a mere shadow of its former self.

When agreeing to deal protection terms, the goal should be to achieve a reasonable outcome that weighs the economic interests of both parties while ensuring that directors remain focused on their contextually specific fiduciary duties.

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