The recent Delaware Chancery Court decisions in Ryan v. Lyondell and In re Lear raise many important questions. I'm told that the Delaware Supreme Court has decided to accept an interlocutory appeal in Lyondell, although I can't find an on-line link in support of that report. If true, we may get some answers. In this post, I want address one issue that may come up; namely, the geography of Revlon-land. (See also my later post
Does Every Sale of the Corporation Put us in Revlon-Land?)
In Revlon v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del.1985), the Delaware supreme court developed a modified version of the Unocal standard to deal with a particular problem; namely, the use of takeover defenses to ensure that a white knight would prevail in a control auction with the hostile bidder. In response to an unsolicited tender offer by Pantry Pride, Revlon's board undertook a variety of defensive measures, culminating in the board's authorization of negotiations with other prospective bidders. Thereafter the board entered into a merger agreement with a white knight, which included a lock up arrangement, as well as other measures designed to prevent Pantry Pride's bid from prevailing. Revlon's initial defensive tactics were reviewed (and upheld) under standard Unocal analysis. In turning to the lock up arrangement, however, the Court struck out in a new direction:
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.
Because the lock up ended the auction in return for minimal improvement in the final offer, it was invalidated.
Revlon posed (and, I guess still poses) some critical questions. For example, did it establish special duties to govern control auctions or were the so called "Revlon duties" really just the general Unocal rules applied to a special fact situation? The courts have waffled on this issue, although the latter interpretation seems to have ultimately prevailed. In 1987, for example, the Delaware supreme court drew a rather sharp distinction between the Unocal standard and what it then called "the Revlon obligation to conduct a sale of the corporation." Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1338 (Del.1987). Two years later, however, the court indicated that Revlon is "merely one of an unbroken line of cases that seek to prevent the conflicts of interest that arise in the field of mergers and acquisitions by demanding that directors act with scrupulous concern for fairness to shareholders." Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1286 (Del.1989).
In the pivotal QVC case, the Delaware supreme court indicated that both under Unocal and Revlon courts were to apply an enhanced scrutiny test. In practice, enhanced scrutiny is basically a reasonableness inquiry to be applied on a case by case basis: "The key features of an enhanced scrutiny test are: (a) a judicial determination regarding the adequacy of the decisionmaking process employed by the directors, including the information on which the directors based their decision; and (b) a judicial examination of the reasonableness of the directors' action in light of the circumstances then existing." The burden of proof is on the directors with respect to both issues. They need not prove that they made the right decision, but merely that their decision fell within the range of reasonableness. See Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34 (Del.1994).
The doctrinal differences between Unocal and Revlon still loom quite large at times or, at least, in some eyes. We still see references in the literature to such things as ?Revlon duties? or ?Revlon-land.? Given the conflation of the Unocal and Revlon standards, however, these references seem anomalous, at best.
Second, whatever precise content of the Revlon standard, when do directors stop being "defenders of the corporate bastion" and become "auctioneers"? Prior to the Paramount decisions, it seemed well settled that the auctioneering duty is triggered when (but apparently only when) a proposed transaction would result in a change of control of the target corporation. For example, if a defensive recapitalization, which most of these cases involved, transferred effective voting control to target management, or some other identifiable control block, the courts treated the transaction as a "change in control" of the corporation requiring adherence to Revlon's auction rule. Mills Acquisition Co. v. Macmillan, Inc., 559 A.2d 1261, 1285 (Del.1989) (holding that the requisite "sale" could take "the form of an active auction, a management buyout or a 'restructuring' "); see also Robert M. Bass Group, Inc. v. Evans, 552 A.2d 1227, 1243 (Del.Ch.1988); cf. Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334, 1345 (Del.1987) (Revlon not triggered where management ally had less than 50% voting control after defensive recapitalization); accord Black & Decker Corp. v. American Standard, Inc., 682 F.Supp. 772, 781 (D.Del.1988) (reading Delaware law to require directors of a company to maximize the amount received by shareholders once it is clear to them that the "corporation is to be subject to a change of control"). If no identifiable control block formed (or changed hands), however, defensive measures were subject solely to standard Unocal review. Paramount Communications, Inc. v. Time Inc., [1989 Transfer Binder] Fed.Sec.L.Rep. (CCH) ? 94,514 at 93,279?80, 1989 WL 79880 (Del.Ch.), aff'd on other grounds, 571 A.2d 1140 (Del.1989).
It's important to recognize that, like Unocal, Revlon was not really addressed at what course of conduct a board of directors must follow in conducting a takeover. Instead, both are properly understood as being concerned with conflicts of interest and director motives. I discuss this point at length in
Mergers and Acquisitions at 366-73.
In its takeover jurisprudence, Delaware typically has balanced the competing claims of authority and accountability by varying the standard of review according to the likelihood that the actions of the board or managers will be tainted by conflicted interests in a particular transactional setting and the likelihood that nonlegal forces can effectively constrain those conflicted interests in that setting. In other words, the Delaware cases suggest that motive is the key issue. As former Delaware Chancellor Allen explained in the closely related context of management buyout transactions: "The court's own implicit evaluation of the integrity of the ... process marks that process as deserving respect or condemns it to be ignored." Assuming that a special committee of independent directors would be appointed to consider the proposed transaction, Allen went on to explain: "When a special committee's process is perceived as reflecting a good faith, informed attempt to approximate aggressive, arms length bargaining, it will be accorded substantial importance by the court. When, on the other hand, it appears as artifice, ruse or charade, or when the board unduly limits the committee or when the committee fails to correctly perceive its mission--then one can expect that its decision will be accorded no respect." William T. Allen, Independent Directors in MBO Transactions: Are They Fact or Fantasy?, 45 Bus. Law. 2055, 2060 (1990); see generally Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 517n24 (1992) (discussing the significance of board motives in Delaware's takeover jurisprudence).
Revlon itself can be seen as a case in which the board's actions strongly suggest self interest.
Why else would an honest auctioneer approve a transaction other than the highest bid if not for improper motives, at least assuming the competing proposals are identical in all respects other than price? While the court did not find that the board acted out of self interest, the inherently conflicted position of a target board coupled with the suggestive conduct of the board at hand sufficed to taint their course of action. In fact, it appears that Revlon's directors were mainly concerned with protecting themselves from litigation by the company's debtholders.
Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 521 (1992).
We see this same concern in the Delaware supreme court?s decision in QVC. If Viacom's offer succeeded, Sumner Redstone would have controlled the combined Paramount/Viacom entity. The presence of a controlling shareholder substantially changes the conflict of interest mix.
In theory, so long as acquisitions of publicly held corporations are conducted by other publicly held corporations, diversified shareholders will be indifferent as to the allocations of gains between the parties. Assume that the typical acquisition generates gains equal to 50 percent of the target's pre mid market price. A fully diversified investor is just as likely to own acquiring company shares as target shares. Indeed, he may own both. Allocation of the available gain between targets and acquirers is thus irrelevant to the diversified shareholder. Increasing the target's share of the gains by increasing the premium the acquirer pays to obtain control necessarily reduces the acquirer's share, which from the shareholder's perspective is simply robbing Peter to pay Paul. Worse yet, to the extent that gain allocation rules increase transaction costs, they leave a fully diversified shareholder worse off. In practice, of course, this argument is undermined by the implicit assumption that gains to the acquirer flow through to its shareholders.
Whatever one makes of the theory, however, situations like QVC unquestionably raise serious gain allocation concerns for target shareholders. If the acquiring entity is privately held, even a fully diversified shareholder by definition cannot be on both sides of the transaction. If the acquiring entity is publicly held, but is controlled by a single very large shareholder, a fully diversified shareholder may not be able to fully share in the gains to be reaped by the acquiring company because the large shareholder's control enables it to reap a non pro rata share of any such gains. In the QVC situation, shareholders therefore would not be indifferent to gain allocation. Instead, they would prefer to see gains allocated to the target.
For this reason, QVC raised special accountability concerns. There is good reason to fear that the controlling shareholder's positional and informational advantages will affect the allocation of gains. In particular, the controlling shareholder's ability to reap a disproportionate share of post transaction gains gives it an unusually high incentive to cause the acquiring entity to offer side payments to target directors in order to obtain their cooperation. In turn, the controlling shareholder's ability to reject acquisition proposals insulates the combined entity from the constraining influence of the market for corporate control. As a result, the normal conflict of interest to be found in any acquisition is substantially magnified in the QVC situation.
In QVC, the Delaware supreme court demonstrated its sensitivity to this concern. Indeed, The QVC court not only recognized the enhanced conflict of interest present in this situation, but also seemingly recognized the doctrinal limitations the earlier decision in Time imposed on efforts to deal with this conflict. (I discuss Time in
Mergers and Acquisitions at 373-80.)
Granted, the court did not overrule Time, but it did limit Time to its unique facts. It did so by rejecting Paramount's reading of Time. Recall the relevant passage from Time: "Under Delaware law there are, generally speaking and without excluding other possibilities, two circumstances which may implicate Revlon duties," which are initiation of an active bidding process and approval of a break up of the company. Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140, 1150 (Del.1989). In QVC, the court emphasized the phrase "without excluding other possibilities." In this case, the court opined, one of the other possibilities was present; namely, a change of control. Accordingly, Revlon was triggered. Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34, 46n48 (Del.1994).
By thus rehabilitating Chancellor Allen's Time opinion, which the QVC court went out of its way to describe as "well reasoned," and by resurrecting the change of control test, QVC specifically addressed the potential for conflicted interests on the part of directors in transactions like the one at hand. Indeed, the court laid great stress on the fact that a transaction in which control changes hands to an identifiable owner leaves the target's shareholders vulnerable to both ex ante and ex post misconduct by the incumbent directors and the new owner.
Once we understand that Revlon is really about dealing with conflicts of interest and director motives, we can begin to define the borders of Revlon-land.
Where the target board of directors uses deal protection devices to end or prevent competitive bidding, that action raises serious questions. Why would a faithful agent take actions that preclude it from making more money for the principal. Hence, the use of deal protective devices appropriately is subject to review under Unocal and/or Revlon.
Now suppose, however, that the target?s board of directors is approached by a bidder who makes what the target perceives to be as a fair offer. The target board makes no effort to seek out competing bids. On the other hand, the target board does not use deal protection devices to prevent competing bidders from starting an auction for the company. No competing bidders emerge, however.
A target shareholder sues the board, claiming that the board could have gotten a higher price for the company if they had proactively sought competing bids. The shareholder claims that the board?s failure to do so constituted a breach of the board?s ?Revlon duties.? In addition, the shareholder claims that the board consciously disregarded those duties and therefore acted in bad faith. Accordingly, plaintiff claims that the board?s actions are not exculpable under the corporation?s ? 102(b)(7) clause.
I worry that both Ryan and Lear both can be read to suggest that such a transaction raises "Revlon duties." To be sure, Strine wrote in Lear that:
Another risk warrants mention, which arises if courts fail to recognize that not all situations governed by Revlon have the strong sniff of disloyalty that was present in the original case. Whena Revlon case simply involves the question of whether a board took enough time to market test a third-party, premium-generating deal, and there is no allegation of a self-interested bias against other bidders, a plaintiff seeking damages after the deal has closed cannot rest on quibbles about due care. And, in that sort of scenario, the absence of an illicit directorial motive and the presence of a strong rationale for the decision taken (to secure the premium for stockholders) makes it difficult for a plaintiff to state a loyalty claim. For example, if a board unintentionally fails, as a result of gross negligence and not of bad faith or self-interest, to follow up on a materially higher bid and an exculpatory charter provision is in place, then the plaintiff will be barred from recovery, regardless of whether the board was in Revlon-land.
With deference, however, I think Strine doesn't go far enough here. I strongly believe that this transaction should lie outside the borders of Revlon-land. Instead, the business judgment rule should preclude judicial review of this transaction. As such, Strine should not inquire into whether there "a strong rationale for the decision." Likewise, whether the board?s conduct amounts to gross negligence is a duty of care question. As long as the board made an informed decision, however, the business judgment rule ought to preclude Strine from even reaching that issue. See generally my article The Business Judgment Rule as Abstention Doctrine, 57 Vanderbilt Law Review 83 (2004), explaining that the rule acts as "a prophylactic barrier by which courts pre-commit to resisting the temptation to review the merits of the board?s decision." Interestingly, by the way, Strine in fact cited that article favorably elsewhere in the decision. The article goes on to explain that under the rule:
The court [should begin] with a presumption against review. It then reviews the facts to determine not the quality of the decision, but rather whether the decisionmaking process was tainted by self-dealing and the like. The requisite questions to be asked are more objective and straightforward: Did the board commit fraud? Did the board commit an illegal act? Did the board self-deal? Whether or not the board exercised reasonable care is irrelevant, as well it should be.
Likewise, whether the board had a "strong rationale" for what it did is irrelevant. So too is whether the board acted grossly negligently.
One of my key concerns about these cases, especially Lyondell, thus is that the emerging post-Stone v. Ritter jurisprudence on questions of good versus bad faith tend to undermine the barrier to judicial review created by the business judgment rule. This post is already too long to address the question of whether VC Noble's latest opinion in Lyondell, which denied certification of the case for interlocutory appeal, is correct in suggesting that his good faith analysis does not gut the business judgment rule. Suffice it say that I believe there is a very serious risk that the post-Stone good faith jurisprudence does in fact pose that very risk. The business judgment rule is designed to prevent courts from asking "did the directors act with reasonable care?" But good faith apparently allows courts to ask "did the directors consciously disregard their duty to act with reasonable care." There is a difference between the two inquiries, to be sure, but we're starting to slice the baloney pretty thinly. It would have better if the Delaware supreme court had just drawn discreet veil around the whole question of good faith so that people could go on ignoring it, as they had done for decades. Pernicious may be too strong a word for Stone and its progeny, but I still think that the Delaware courts are going to have do to do some serious repair work to ensure that the business judgment rule remains intact. See generally my article The Convergence of Good Faith and Oversight, 55 UCLA Law Review 559 (2008).
Why do I believe, as a policy matter, that the business judgment rule ought to control here?
Modern corporation statutes give primary responsibility for negotiating a merger agreement to the target?s board of directors. The target?s board possesses broad authority to determine whether to merge the firm and to select a merger partner. The initial decision to enter into a negotiated merger transaction is thus reserved to the board?s collective business judgment, shareholders having no statutory power to initiate merger negotiations. Smith v. Van Gorkom, 488 A.2d 858, 873 (Del. 1985). The board also has sole power to negotiate the terms on which the merger will take place and to arrive at a definitive merger agreement embodying its decisions as to these matters. DGCL ? 251(b).
Allocating the principal decision-making role to the board of directors reflects the general deference corporation law gives board decisions. See my book
The New Corporate Governance in Theory and Practice. It also makes good sense from a governance perspective. The board knows much more than its shareholders about the company's business goals and opportunities. The board also knows more about the extent to which a proposed merger would promote accomplishment of those goals. The board is also a more manageable body. The familiar array of collective action problems that plague shareholder participation in corporate decision making obviously preclude any meaningful role for shareholders in negotiating a merger agreement.
As with any conferral of plenary authority, of course, the board?s power to make decisions about negotiated acquisitions gives rise to the potential for abuse. I discuss the potential conflicts of interest in
Mergers and Acquisitions at 163-64.
Despite the potential for conflicts of interest, in a plain vanilla arms-length merger, the board's potential conflict of interest is policed by a variety of non-legal constraints. Independent directors and shareholders must be persuaded to approve the transaction. The reputational consequences of self-dealing may cause bother the directors and managers problems in the internal and external job markets. Ill-advised acquisitions are likely to cause the acquiring firm problems in the capital markets, which may constrain its willingness to divert gains from target shareholders to the target?s board and managers.
In addition to those monitoring mechanisms, negotiated acquisitions are subject to the constraining influences of the market for corporate control. Where side payments persuade management to accept a low initial offer, a second bidder may--and often does--succeed by offering shareholders a higher-priced alternative. Indeed, to the extent side payments affect the initial bidder's ability to raise its offer in response to a competing bid, the threat of competing bids becomes particularly important. In such cases, the second bidder is almost certain to prevail. True, the competing bidder's transaction can not be structured as a merger or asset sale if it is unable to persuade target management to change sides. But the intervenor has a formidable alternative: the tender offer, which eliminates the need for target management's cooperation by permitting the bidder to bypass the target's board and to buy a controlling share block directly from the stockholders.
Do these various monitoring systems perfectly constrain the board?s potential conflicted interests? Almost certainly not. Agency cost theory predicts that neither monitoring by the principal nor bonding by the agent can entirely eliminate shirking by the agent. There are always some residual losses. Why should Delaware tolerate such losses in this context by permitting the business judgment rule to shield the board's decisions from judicial review absent clear evidence of self-dealing? In my view, the perfect must not become the enemy of the good. As always, a balance must be struck between authority and accountability, which necessarily entails less than perfect accountability.
Absent deal protection devices, accordingly, the business judgment rule should be the standard by which the board's decision to merge is reviewed. The strong conflicts of interest inherent in cases falling within Revlon-land simply are not present in the case I've described.
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