Let me start by excerpting some background from my book Mergers and Acquisitions (Concepts and Insights):
In Revlon v. MacAndrews & Forbes Holdings, 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 proved surprisingly troublesome. 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." 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." The doctrinal differences between Unocal and Revlon still loom quite large at times or, at least, in some eyes.
Whether the Revlon duties were distinct or just a sub‑set of Unocal, what exactly were directors supposed to do once their role changes from "defenders of the corporate bastion to auctioneers"?
It's the latter issue that was at stake in Delaware Vice Chancellor Parson's recent opinion in In re Smurfit-Stone Container Corp. Litig. (No. 6164-VCP May 24, 2011). [BTW, when I first saw the caption, I misread the firm name and concluded that Smurfs were building containers!]
The pertinent facts are simple: We are dealing with a triangular merger in which publicly held target Smurfit is to merge into a wholly owned subsisdiary of a publicly held corporation named Rock-Tenn Co. In the merger, the shareholders of Smurfit will get $35 per share, with 50% of the consideration paid in cash and 50% paid in Rock-Tenn stock. Accordingly, as VC Parson observed:
... this case provides cause for the Court to address a question that has not yet been squarely addressed in Delaware law; namely, whether and in what circumstancesRevlon applies when merger consideration is split roughly evenly between cash and stock.
Unfortunately, VC Parsons came up with the wrong answer.
Because the shareholders will get cash for a portion of their shares, VC Parsons concluded that the transaction was subjected to the heightened Revlon standard of review rather than the business judgment rule:
... while no Smurfit-Stone stockholder will be cashed out 100%, 100% of its stockholders who elect to participate in the merger will see approximately 50% of their Smurfit-Stone investment cashed out. As such, ... the concern here is that there is no "tomorrow" for approximately 50% of each stockholder's investment in Smurfit-Stone. That each stockholder may retain a portion of her investment after the merger [does not preclude the Court from invoking Revlon where] a transaction ... constitutes an end-game for all or a substantial part of a stockholder's investment in a Delaware corporation.
This was so, VC Parson argues, even though "control of Rock-Tenn after closing will remain in a
large, fluid, changing, and changeable market" and the "Smurfit-Stone stockholders will retain the right to obtain a control premium in the future."
I completely disagree with VC Parsons on this issue. Parsonis is wrong on the law. Revlon duties are triggered "(1) when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company; (2) where, in response to a bidder's offer, a target abandons its long term strategy and seeks an alternative transaction involving a break-up of the company, or (3) when approval of a transaction results in a sale or change of control." Arnold v. Society for Sav. Bancorp, Inc., 650 A.2d 1270 (Del. 1994). Only the third prong is relevant here and on these facts there is no change of control.
That conclusion follows because Revlon is not triggered where control of the combined entity remains in the hands not of an identifiable control person or group but rather "in a large, fluid, changeable and changing market." Paramount Communications Inc. v. Time Inc., 1989 WL 79880 (Del. Ch. 1989), aff'd on other grounds, Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140 (Del. 1989). Where one public corporation is acquired by another public corporation, that condition is satisfied. Arnold v. Soc. For Savings Bancorp., Inc., 650 A.2d 1270, 1290 & n. 45 (Del. 1994).
On these facts, both companies are publicly held. Neither company has a controlling shareholder. The same will be true of the combined post-acquisition corporate group. There is no change of control.
As to policy, Parsons follows some Chancery Court opinions that focus on whether there will be a tomorrow for the target shareholders. The logic of these opinions is that shareholders who get cash have no opportunity to participate in the potential post-acquisition gains that may acrue to shareholders of the combined company. But that's just wrong. First, shareholder who get cash could simply turn around and buy stock in the post-acquisition company. Only if there has been a change of control is that option foreclosed.
Second, the relevant policy concern is not whether there is a tomorrow. The relevant concerns are gain division and conflicted intersts. 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‑bid 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.The argument that Revlon must be invoked so as to increase the size of the premium paid target shareholders in such a case is thus misplaced.
In contrast, 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 either situation, shareholders therefore would not be indifferent to gain allocation. Instead, they would prefer to see gains allocated to the target. It is in these situations that Revlon should come into play.
There is so because there is special 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 latter situations.
The Chancery Court continues to get lost in Revlon-land. Hopefully, the Supreme Court will eventually choose to provide them with a map. Preferably, of course, my map.