M&A practitioners watched closely as Oracle Corp.'s recent hostile acquisition of PeopleSoft Inc. raised, but didn't fully answer, a fascinating tactical question. Did PeopleSoft's "customer assurance programs" - contracts that would pay customers significant amounts if an acquirer stopped supporting the PeopleSoft products - constitute appropriate business protections or impermissible takeover defenses?

In general, customer agreements (as well as supplier agreements and other contracts) are binding upon the successor to a merger. One of the first things a buyer and its lawyers will do in a deal is to analyze the target's contracts to assess whether they impose risks or costs that need to be factored into the economics or structure of the deal. Do the contracts contain change of control triggers that would impose costs or risks on the buyer? If so, these costs and risks are commonly dealt with in setting the purchase price, the deal structure or in establishing conditions to closing.

What was different in the Oracle-PeopleSoft deal was that, shortly after Oracle announced its intention to acquire PeopleSoft, PeopleSoft began including CAPs in its sales agreements, which would provide a refund of between 2 and 5 times the license fee if an acquirer failed to support the PeopleSoft products post-acquisition. The rationale was that the threatened takeover created significant uncertainty among PeopleSoft's customers about whether the products would be continued and that the CAPs were designed to compensate the customers for this risk.

Oracle, of course, viewed the CAPs as an impermissible type of poison pill, and in the course of the overall takeover battle sued to stop their use. Testimony at trial indicated that the potential cost of the CAP program was at least $800 million and rising. Oracle argued that the CAPs were ambiguous and would effectively preclude it from running the PeopleSoft side of the business in the event its takeover bid were successful; they would make it difficult, if not impossible, to complete an acquisition of PeopleSoft, and were therefore a violation of the fiduciary duties of PeopleSoft's board.

The case settled before the court ruled on this issue - but not before a number of lessons about the use of CAPs in M&A came to light. In future cases, the courts will almost certainly examine the tension between the business protection rationale and the takeover defense claim. In general, the board of directors will be protected by the business judgment rule, which says that in a decision where the directors are not conflicted, are well-informed, have acted in good faith and have considered the matter appropriately, and where the decision supports a rational corporate purpose, the courts will not interfere. Conversely, in the takeover context, where the board adopts defensive measures, the courts will look to whether the board had reasonable grounds for believing that a threat to corporate policy and effectiveness existed and whether the response to the threat was reasonable (the "Unocal" rule, named after the case establishing this standard of review).

If Unocal is deemed to apply, the courts will examine whether a CAP is reasonable and balanced. Factors that will come into play include the proportionality of the potential cost imposed by a CAP as compared to the threat imposed, whether the costs can be reasonably determined by a potential buyer and whether the CAP poses an unreasonable burden on the successful buyer.

Two of the most critical features of a CAP would be the amount of refund to be provided to the customer and how long the CAP is intended to last. Companies should document that their CAP addresses legitimate customer concerns, is carefully worded and balanced to address those concerns, is unambiguous and is carefully considered at the board level before implementation.

While there are no currently definitive guidelines, CAPs can be expected to come under scrutiny the next time a takeover battle involving them is fought in Delaware. A careful practitioner will prepare for a Unocal analysis. - Adam Salassi

Adam Salassi is a partner in the Northern Virginia office of law firm Cooley Godward LLP. His practice focuses on mergers and acquisitions and private equity investments.

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