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Kodak's implications for director primacy theory

In an article entitled Unocal at 20, I built upon my "director primacy model of corporate governance and law" to argue that "Unocal strikes an appropriate balance between two competing but equally legitimate goals of corporate law: on the one hand, because the power to review differs only in degree and not in kind from the power to decide, the discretionary authority of the board of directors must be insulated from shareholder and judicial oversight in order to promote efficient corporate decision making; on the other hand, because directors are obligated to maximize shareholder wealth, there must be mechanisms to ensure director accountability. The Unocal framework provides courts with a mechanism for filtering out cases in which directors have abused their authority from those in which directors have not."

As I read today's WSJ, however, I was prompted to wonder whether my analysis left enough room for the market for corporate control to do its part in the process of creative destruction that makes capitalism work.

In a 1999 University of Cincinnati Law review article, my friend Bill Carney explained how my friend Henry Manne made the breakthrough argument about the critical role the market for corporate control plays in a capitalist economy:

[Manne’s article] Mergers and the Market for Corporate Control [73 J. Pol. Econ. 110 (1965)] was the natural culmination of Manne's writing and thinking on the role markets played in constraining managers. … Manne noted that shareholders were primarily interested in having managers maximize profits, and that stock prices reflected the success of their efforts.

In 1962 Manne’s article] The Higher Criticism introduced the notion that weak management that caused profits to decline would also cause share prices to decline, which would in turn attract outsiders as buyers because of the votes attached to the shares. These buyers would in turn use the votes they had purchased with their shares to seek better management and the rewards of higher earnings and stock appreciation. In this first article, Manne had made the critical linkage between share voting and share transferability, which he would develop more fully in 1964 and 1965.

In 1964 [Manne’s article] Some Theoretical Aspects of Share Voting first developed the notion that there were positive returns to acquiring voting control of firms, and that these returns come from improved management. Manne described shares as consisting of a bundle of rights--one being the investment and the other being the right to vote. He noted that the value of the share vote rose as the value of the share itself declined from poor management, and that the difference represented the control premium that outside management teams would be willing to pay for control. … It was this 1964 article that first introduced the phrase, “the market for corporate control.”

But it was Mergers and the Market for Corporate Control that gained the most attention in this remarkable series. … The returns from acquiring control, Manne argued, were from improving management. Improving management would, in turn, increase cash flows that would be capitalized by the market. …

In the context of mergers, Manne recognized the value of the veto power held by managers over this form of takeover, and the likelihood that this veto would encourage side payments to management to persuade it to allow shareholders to accept a premium for their shares. This observation has obvious implications, of which we all became acutely aware later on. First, if managers can extract a part of the economic rents available to shareholders in a target corporation, returns to target shareholders in mergers should be smaller than in tender offers. Later evidence has borne this out. Second, if changes of control are efficient and are furthered by management acquiescence, how much power should target-management possess in order to extract part of the gains? The struggles of the Delaware courts in attempting to delineate how much corruption is too much in this setting have occupied corporate lawyers for the past fifteen years. But the outline of the problem has been present for the last 34 years.

The … most important contribution of this article was its description of the market for corporate control as a serious constraint on management misbehavior. As Manne wrote:

Only the take-over scheme provides some assurance of competitive efficiency among corporate managers and thereby affords strong protection to the interests of vast numbers of small, non-controlling shareholders. Compared to this mechanism, the efforts of the SEC and the courts to protect shareholders through the development of a fiduciary duty concept . . . seem small indeed.

What prompted me to ruminate on all this was the Journal's coverage of Kodak's rumored bankruptcy filing. Kodak long was a great success story. But all things--including corporations--have a life cycle. Kodak got old. It became a mature cash cow. Managers of mature cash cows all too often succumb to a mid-life crisis. The firm must be revitalized. It needs the corporate equivalent of botox. Just as Hollywood types with too much money to spend on plastic surgery all too often end up with duck lips and chipmunk cheeks, corporate managers with too much free cash flow often end up with bloated, dysfunctional conglomerates.

Kodak's sad story is a classic example of the phenomenon:

The company ... invented the digital camera—in 1975—but never managed to capitalize on the new technology.

Casting about for alternatives to its lucrative but shrinking film business, Kodak toyed with chemicals, bathroom cleaners and medical-testing devices in the 1980s and 1990s, before deciding to focus on consumer and commercial printers in the past half-decade under Chief Executive Antonio Perez.

None of the new pursuits generated the cash needed to fund the change in course and cover the company's big obligations to its retirees. A Chapter 11 filing could help Kodak shed some of those obligations, but the viability of the company's printer strategy has yet to be demonstrated, raising questions about the fate of the company's 19,000 employees.

A viable market for corporate control might well have prevented Kodak from spending the last few decades flailing from one failed strategy to another. Back in the 1980s, before Martin Lipton invented the poison pill, bankers like Michael Milken and buyout boutiques like KKR put Manne's theories to the test by taking on the economic dinosaurs of that day--i.e., conglomerates. Managers of that era thought good managers could manage anything. They also thought intrafirm diversification was superior to diversification at the shareholder level. Looser antitrust rules on horizontal acquisitions than on vertical acquisitions further encouraged the building of huge conglomerate empires by imperially-minded CEOs. The result was bloated businesses that did everything from -- as the Kodak case exemplifies -- film to "chemicals, bathroom cleaners and medical-testing devices" to  "consumer and commercial printers." Those managers were wrong. Just as Kodak's managers have been wrong in more recent times.

The conglomerates suffered from a form of reverse synergy. They worth more broken up into pieces with the various lines of business sold off as individual firms. And that's precisely what happened because the market for corporate control worked.

Sometimes the process of breaking up conglomerates included the sad but necessary task of killing off lines of business that had outlived their expiration date. If it were not for the creative destruction process, after all, buggy whip companies would still be in business because we'd all still be driving buggies.

Kodak has outlived its expiration date. The cash cow of film has died. The cupboard is empty. If we had a functioning market for corporate control, somebody would buy the shell, sell off whatever assets remain of value, and kill the rest.

I feel badly for the people who work at Kodak. Ideally, public policy would provide mechanisms for retraining and transitioning of employees adversely affected by corporate takeovers. After all, if corporate takeovers really are Kaldor-Hicks efficient, there should be some money available for the state to redistribute to those who suffer from the externalities of that market. But Kodak still should die.

All of which leaves me with a coupe of basic questions to ponder: Did Unocal at 20 properly strike the balance between protecting director primacy and preserving an functional market for corporate control? And does current delaware law do likewise?

Ponder. Not blog. Not yet.

Glen Alden Coal and Farris v. Glen Alden Corp.

I've recently started collecting stock certificates and the like of companies that were involved with sufficiently famous corporate law cases to make it into the casebook that I co-edit with Bill Klein and Mark Ramseyer. Here, for example, is a stock certificate for Glen Alden Coal, the predecessor to the Glen Alden Corporation that featured in Farris v. Glen Alden Corp.

By 1958, although Glen Alden was still "engaged principally in the mining of anthracite coal," it had expanded into the "manufacture of air conditioning units and fire-fighting equipment." In the transaction challenged in the case, Glen Alden combined with "List, a Delaware holding company owning interests in motion picture theaters, textile companies and real estate, and to a lesser extent, in oil and gas operations, warehouses and aluminum piston manufacturing." As a result, the Pennsyvania court explained, "Instead of continuing primarily as a coal mining company, Glen Alden would be transformed ... into a diversified holding company whose interests would range from motion picture theaters to textile companies."

The legal issue in the case is whether the combination of List and Glen Alden--structured as a puchase by Glen Alden of List's assets--was a so-called de facto merger.

I also use the case, however, as an opportunity to talk about the craze in the post-WW II period for conglomerates. I've never understood the logic of combining "motion picture theaters, textile companies and real estate, and ... oil and gas operations, warehouses and aluminum piston manufacturing," not to mention coal mining, under one corporate roof. Ultimately, of course, setting aside GE, the conglomerate mania proved to be a disastrous economic failure. Much of the so-called "merger mania" of the 1980s in fact consisted of bust-up takeovers breaking up these conglomerate dinosaurs.

Leo Strine on the covenant of good faith and fair dealing in merger and acquisition earnout clauses

According to BNA, Delaware Chancellor Leo Strine pithly dismissed a claim airing under the covenant of good faith and fair dealing by observing that:

“The implied covenant of good faith and fair dealing is not a license for a court to make stuff up, which is what [the plaintiff] seeks"

The timing of the opinion is quite opportune as I was working on the earnout section of the forthcoming third edition of my Mergers and Acquisitons text last week. As a taste of what's to come, here's the updated section as further revised to include this latest Strine opinion:

Using Earnout Clauses to Adjust the Price Ex Post: Because valuation is such an inexact science, the parties may not be able to agree on a definitive price. In such cases, the deal may still be able to go forward if the parties include ex post price adjustments in the merger agreement. In LaPoint v. AmerisourceBergen Corp.,[1] for example, the merger agreement between acquirer AmerisourceBergen Corporation (“ABC”) and target Bridge Medical, Inc. (“Bridge”) included an earnout clause pursuant to which the former bridge shareholders would receive additional compensation in the event that Bridge met certain financial targets during the first two years after the merger closed. Specifically, the agreement contemplated “sliding scale of earnout payments depending upon the Adjusted EBITA achieved by Bridge in 2003 and 2004. EBITA was to be calculated according to GAAP and adjusted according to the provisions of the merger agreement. In 2003, former Bridge shareholders would receive no earnout payments if Adjusted EBITA fell below $2.31 million, and would receive a maximum earnout of $21 million if Adjusted EBITA exceeded $4.29 million. In 2004, former Bridge shareholders were to receive no earnout if Adjusted EBITA did not reach $5.46 million, and would receive a maximum of $34 million if Adjusted EBITA exceeded $11.83 million.”[2]

 The trouble with these sort of ex post price adjustments, of course, is that they create an incentive for the acquirer to hold down earnings during the earnout period and only take full advantage of its newly acquired business once the earnout period ends. Typically, the agreement will contain certain provisions designed to prevent the acquirer from doing so. In LaPoint, for example, the agreement obliged ABC to “exclusively and actively promote [Bridge's] current line of products and services” and to refrain from “any products, services or companies that compete either directly or indirectly with [Bridge's] current line of products and services.” In addition, ABC agreed to “act in good faith during the Earnout Period and” to “not undertake any actions during the Earnout Period any purpose of which is to impede the ability of the [Bridge] Stockholders to earn the Earnout Payments.” When ABC allegedly violated those agreements, former bridge shareholders successfully brought suit seeking damages.

The disadvantage of earnout clauses should be obvious; how do the target’s former shareholders monitor the acquirer’s compliance with its obligations? Earnout clauses are most effective in sales of closely held businesses in which the target’s former shareholders remain affiliated with the company as officers, board members, or some other capacity. The resulting access to inside information is invaluable in monitoring the acquirer’s efforts.

The acquisition of closely held Advanced Bionics Corp. (“Bionics”) by publicly held Boston Scientific Corp. provides a good example of the kinds of provisions that can be used to make an earnout clause more effective. 

Under the merger agreement, Bionics shareholders received $742 million in cash at closing and the right to receive additional compensation through earnout payments contingent upon Bionics's sales growth. Approximately 800 former Bionics shareholders and option holders had a right to receive earnout payments with a projected value of $3.2 billion.

The merger agreement contained provisions outlining a system of joint control of Bionics designed to protect the interests of the earnout recipients. The officers of Bionics would be responsible to a six-person executive board comprised of three representatives appointed by Boston Scientific and three representatives appointed by the earnout recipients. A multi-step dispute resolution process was provided to deal with deadlock. The disputed matter would first be referred to Mann and the chief executive officer of Boston Scientific (or their successors). If they were unable to resolve the dispute jointly, the chief executive officer of Boston Scientific was entitled to resolve it unilaterally, provided that if Mann or his successor disagreed with Boston Scientific's decision, Mann could refer the matter to a committee of three independent business people jointly selected by Mann and the Boston Scientific chief executive officer to propose a nonbinding resolution.  Ultimately, if the Boston Scientific chief executive officer made a decision over the objection of Mann and the executive board, the Bionics stockholders' representative, acting on behalf of the earnout recipients, was entitled to challenge the decision in a court proceeding.

 The merger agreement also specifically provided that: “for the benefit of the Earn Out Recipients, without the approval of the Executive Board,” Boston Scientific was prohibited from replacing Mann or Jeffrey Grenier (“Grenier”), the co-chief executive officers of Bionics, and that if either ceased to be a co-chief executive officer, Mann and the Boston Scientific chief executive officer were required to agree jointly on the appointment of a successor.[3]

In effect, the merger agreement turned Mann and the earnout recipients’ representatives on the executive board into monitors of Boston Scientific’s compliance with the earnout clause. The case thus “illustrates the importance of addressing in detail in an acquisition agreement what corporate governance and other business restrictions will be imposed on the operation of the target company during the earnout period.”[4]

Winshall v. Viacom International Inc. further illustrates the importance of contractual specificity in drafting earnout clauses.[5] Vicaom effected a triangular merger with a company called Harmonix Music Systems, Inc., which manufactured two highly popular music video games, “Rock Band” and “Guitar Hero.” As a result of the merger, Harmonix became a wholly owned Viacom subsidiary and the former Harmonix shareholders got a total of $175 million in cash and an earnout clause granting them contingent rights to additional payouts based on Harmonix’s performance in 2007 and 2008. Prior the merger Harmonix had entered into a distribution agreement with Electronic Arts Inc. After the merger, EA asked to renegotiate the distribution contract so as to get broader distribution rights to Rock Band and its sequels. In return for granting EA the broader rights, Harmonix could have bargained for an immediate reduction in the distribution fees it paid EA, which would have increased the earnout payments to the former shareholders. Instead, at Viacom’s direction, Harmonix negotiated a reduction in those fees for future years, after the earnout period ended.

 The selling Harmonix shareholders knew about the deal with EA and could have protected themselves contractually against the possibility that that deal might be improved during the earnout period. But the contract failed to do so.

The former Harmonix shareholders nevertheless sued, claiming a breach and the covenant of good faith and fair dealing. Delaware Chancellor Leo Strine dismissed, pithily opining that the “implied covenant of good faith and fair dealing is not a license for a court to make stuff up.” Chancellor Strine elaborated that the covenant does not give the court “a license to rewrite contractual language just because the plaintiff failed to negotiate for protections that, in hindsight, would have made the contract a better deal. Rather, a party may only invoke the protections of the covenant when it is clear from the underlying contract that “the contracting parties would have agreed to proscribe the act later complained of . . . had they thought to negotiate with respect to that matter.”

All the implied covenant of good faith and fair dealing requires in the context of an earnout clause thus is that the buyer refrain from arbitrary or unreasonable conduct that deprives the former target shareholders of the fruits of its bargain. The buyer has no duty to give the former target shareholders the benefit of a better deal than the one for which they bargained. The take home lesson once again is for target shareholders to devote considerable attention to drafting an earnout clause that takes into account foreseeable future changes in this business that could affect the target’s profitability.

 Update: There's more analysis at Francis Pileggi's blog.

Another update. There's a very interesting new paper by Brian J.M. Quinn, Putting Your Money Where Your Mouth Is: The Performance of Earnouts in Corporate Acquisitions (November 12, 2011), which argues that:

Recently available data suggests that actual target company performance post-closing often falls short of the expectations of both buyers and sellers – even when those expectations have been discounted for risk. The consistent failure of sellers to meet earnout targets of all types and the declining values of contingent earnout payment suggests that the earnout provision may not be an adequate response to the dual problems of adverse selection and moral hazard. Rather than be an effective contractual tool to overcome information asymmetries, earnouts may be more modestly credited with the distribution of the costs of uncertain adverse outcomes between the parties, thereby insuring buyers against the risk of overpayment without necessarily the benefit of the revelation of private information. Consequently, the earnout mechanism may not have the level of utility ascribed to it by academics studying transactional law. These conclusions with respect to the utility of earnouts have implications for the larger normative project for transactional lawyering, which seeks to provide a conceptual framework to guide the study and teaching of transactional law.

I'll be working some of his key points into the draft.

I'm adjudged to be "useful"

Delaware Chancellor Strine, in GRT, Inc. v. Marathon GTF Technology, Ltd., 2011 WL 2682898, at *12 n.64 (Del.Ch. 2011):

Examples of useful works that are helpful to M & A practitioners but that spend comparatively little time on contractual issues include: ... STEPHEN M. BAINBRIDGE, MERGERS AND ACQUISITIONS 72–73 (2d ed.2009) (considering only the general nature and purpose of representations and warranties in a typical merger agreement) ....

In my defense, Strine overlooked the discussion at pp. 76-85 of the contract law aspects of exclusivity provisions such as no shop and best efforts clauses.

Having said that, I'll take under advisement for the upcoming third edition Strine's suggestion that our books need to provide "learned consideration of the important contract issues that are often even more central to the parties to such transactions" and "delve into the admittedly obscure differences between covenants, representations, warranties, and conditions, and how they work together in an acquisition agreement."

Revlon-Land in the Classroom

Over at the Conspiracy, Professor Kenneth Anderson notes that:

I have taken the plunge and assigned Professor Bainbridge’s new self-published Amazon e-book, Directors as Auctioneers: A Concise Guide to Revlon-land, to my Business Associations class.  I’ve read it and it’s outstanding, but I had some trepidation about assigning a mandatory e-book to a class of 70.  However, I polled the class and asked how many people had no access to make an Amazon purchase via Kindle, I-Pad, I-phone, or computer, and the answer was zero.  Everyone seemed to have an actual Amazon account, amazingly — I asked why, and they said, to buy textbooks.

I have assigned a small chunk now, early in the course, in connection with the initial discussion of agency law, and agent-principal problems.  This is the part (if you’re familiar with the book) on the conflict between the agent’s authority and the agent’s accountability.  One reason it is a useful discussion is that it is not merely about changes of corporate control, or even about corporate governance — it is a useful description of the basic problem of agency, in a particular way, as well as about governance.

I will keep you posted on how it goes using an e-book as a required law text.  The book is awfully good; I use Allen, Kraakman, and Subramanian as my main Business Associations textbook, and I think this helps give both a fuller and alternative explanation for Revlon-land.

I'm delighted, grateful, and honored. I've yet to see the surge in sales reflected in my royalty statements, but I assume that'll come when he starts really relying on it in class.

In any case, I'm delighted to claim this adoption as initial validation of my hopes for self-publishing as an alternative vehicle for scholarship.

Social networking and 13D groups

james McRitchie has a very interesting post on the ability of activist shareholders to use social networking to communicate without forming Section 13(d) groups obliged to file Schedule 13Ds with respect to their ownership stakes in the issuers about whom they communicate.

How goes the experiment?

I read somewhere or another that the average law review article has just 6 readers. If so, in less than a week I've tripled that score. We've sold a whopping 18 copies of Directors As Auctioneers: A Concise Guide to Revlon-Land, which means it is ranked:

• Amazon Bestsellers Rank: #25,476 Paid in Kindle Store (See Top 100 Paid in Kindle Store)
  • #2 in Kindle Store > Kindle eBooks > Nonfiction > Business & Investing > Management & Leadership > Consolidation & Merger
  • #8 in Books > Business & Investing > Management & Leadership > Consolidation & Merger

Not exactly JK Rowling territory, to be sure, but it's a start. Further updates as events warrant. In the meanwhile, tell your friends and neighbors!

Directors as Auctioneers: An Experiment in Self-Publishing Legal Scholarship

I've just published Directors as Auctioneers: A Concise Guide to Revlon-Land as an eBook available at Amazon's Kindle store.

What's the book about? In Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986), the Delaware Supreme Court explained that when a target board of directors enters Revlon-land, the board’s role changes from that of “defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.”

Unfortunately, the Court’s colorful metaphor obfuscated some serious doctrinal problems. What standards of judicial review applied to director conduct outside the borders of Revlon-land? What standard applied to director conduct falling inside Revlon-land’s borders? And when did one enter that mysterious country?

By the mid-1990s, the Delaware Supreme Court had worked out a credible set of answers to those questions. The seemingly settled rules made doctrinal sense and were sound from a policy perspective.

Indeed, my thesis herein is that Revlon and its progeny should be praised for having grappled—mostly successfully—with the core problem of corporation law: the tension between authority and accountability. A fully specified account of corporate law must incorporate both values. On the one hand, corporate law must implement the value of authority in developing a set of rules and procedures providing efficient decision making. U.S. corporate law does so by adopting a system of director primacy. See generally Stephen M. Bainbridge, The New Corporate Governance in Theory and Practice (2008).
In the director primacy (a.k.a. board-centric) form of corporate governance, control is vested not in the hands of the firm’s so-called owners, the shareholders, who exercise virtually no control over either day-to-day operations or long-term policy, but in the hands of the board of directors and their subordinate professional managers. On the other hand, the separation of ownership and control in modern public corporations obviously implicates important accountability concerns, which corporate law must also address.

Academic critics of Delaware’s jurisprudence typically err because they are preoccupied with accountability at the expense of authority. In contrast, or so I will argue, Delaware’s takeover jurisprudence correctly recognizes that both authority and accountability have value.
Achieving the proper mix between these competing values is a daunting—but necessary—task. Ultimately, authority and accountability cannot be reconciled.

At some point, greater accountability necessarily makes the decision-making process less efficient. Making corporate law therefore requires a careful balancing of these competing values. Striking such a balance is the peculiar genius of Unocal and its progeny.

In recent years, however, the Delaware Chancery Court has gotten lost in Revlon-land. A number of Chancery decisions have drifted away from the doctrinal parameters laid down by the Supreme Court. In this monograph, I argue that they have done so because the Chancellors have misidentified the policy basis on which Revlon rests. Accordingly, I argue that Chancery should adopt a conflict of interest-based approach to invoking Revlon, which focuses on where control of the resulting corporate entity rests when the transaction is complete.

Now to explain the format: A while back I wrote a blog post on self-publishing legal scholarship. In it, I argued that:

I can see several reasons that self-publishing would be a good idea:

1.  I get all proceeds instead of royalties of 15% of book sales.
2.  Law reviews don't pay for articles. An article self-published would generate income.
3.  I get to control marketing. I was really disappointed by the (lack of a) marketing campaign for one of my more recent books. If I self-published, I'd control the marketing campaign.
4.  I control the price. If I want to maximize the number of readers, I set the price low. If I want to maximize revenue, I can set the price somewhat higher.

The problems? Publishers of legal scholarship tend to act as gatekeepers with respect to quality. Oxford is routinely ranked as the #1 academic press. Having two books published by Oxford (ahem) thus is a signal to one's employer and other relevant observers that one is doing good work. The signal is objective and unbiased, which gives it very useful credibility.

The same is true of law reviews, I suppose, although it's less clear why. Unlike professional academic presses, which have multiple levels of grown-up editors that must be persuaded and make use of peer reviews, law reviews mostly are staffed by twenty-something second-and third-year law students whose knowledge of the law, legal profession, business, and so on is typically modest at best. If the Harvard Law Review turns down an article that Chapman's law review accepts, all it really tells you is that kids who on average scored higher on the LSAT liked your article less than did kids who on average scored lower. Why their choices send signals worth paying attention to is unclear, at least to me, which is not to say that I'd turn down any offer of publication the Harvard Law Review would care to make. I may think that the market is absurd, but I'm still an economically rational actor.

The signaling effect doubtless matters for junior scholars of whom no one has ever heard. It's particularly important when tenure rolls around. In my years in the academy, I've seen very few tenure discussions in which book and article placement did not serve as a proxy for quality. It's not the only quality measure, of course, but it is a factor.

For a more established scholar, however, the signaling effect may not matter all that much. Indeed, I suspect that "Professor Bainbridge" is a more potent brand name than, say, the UCLA Law Review.

Suppose I had taken that last law review article and self-published it as an e-book entitled "Professor Bainbridge on Insider Trading Inside the Beltway" and priced it at, say, $4.99. Could I have sold a couple of hundred copies? How about a whole "Professor Bainbridge on ____" short e-books?

Having said all that, why should the State of California pay me to write self-published books? Isn't part of the deal I make as an academic that I will do scholarship that is publicly accessible to all? Advance mankind's knowledge and all that? This actually strikes me as the biggest and most valid objection to self-publishing scholarship. OTOH, however, if it were a fatal objection the university ought not let me do any writing that produces royalties or, at least, ought to force me to turn my royalties over to the university. As things stand, however, I'm free to decide how to allocate my time between writing law review articles for free, academic press books for modest royalties, and case books for ... well, that's between me and my Mercedes dealer.

But I'm equivocating. It's not obvious to me that self-publishing legal scholarship is intrinsically silly or an idea waiting to happen.

But I am tempted to turn my next 30,000 word law review article draft into a 50,000 word ebook and try selling that baby through Amazon and so on. And when I retire, maybe I will try my hand at a whole series of "Professor Bainbridge on ____" books.

A while back, the Chancery Court issued the series of Revlon decisions mentioned above. As I thought about those decisions, it occurred to me that this was an ideal project to try self-publishing. I could update, expand, and augment older work on Revlon and offer up a new and improved analysis in a different package. I could reach a different audience than law review readers and make a few bucks at the same time.

Hence, this experiment.

I'll be interested to get reactions to this new possibility for getting one's ideas out into the market.

In the meanwhile, you can buy the book here.

The proverbial bird in the hand

I'm working on a project entitled A Concise Guide to Revlon-Land—With Side Trips through Other Mysteries of Delaware Corporate Takeover Law, which as I have often threatened will be published as an eBook on Kindle rather than in a law review.Look for it by the end of the summer.

In it, I'm discussing the Delaware Supreme Court's decision in  Ryan v. Lyondell, and I observe that:

The Chancery Court conceded that Lyondell’s board “was active, sophisticated and generally aware of the value of the Company and the conditions of the markets in which the Company operated.” Lyondell, 2008 WL 2923427 at *13. The board long had been kept up to date on the company’s financial outlook and plans. The board had been kept fully abreast of the negotiations with Access and another potential bidder. The board had been briefed on Access’ proposal by Lyondell’s financial advisor.

Despite all this, however, the Chancery Court found the board’s conduct deficient in a number of respects: (1) “The entire deal was negotiated, considered, and agreed to in less than seven days.” Id. at *14. This gave the court “pause as to how hard the Board really thought about this transaction and how carefully it sifted through the available market evidence.” Id. This concern is consistent with an earlier Supreme Court caution that : “History has demonstrated boards ‘that have failed to exercise due care are frequently boards that have been rushed.’” McMullin v. Beran, 765 A.2d 910, 922 (Del. 2000). Having said that, however, boards often must act quickly. If courts insist that boards beat the bushes in search of the proverbial two birds, they force boards to risk losing the equally proverbial bird in the hand.

I rather like that last turn of phrase. But what do you think? Good? Forced? Over the top?

BTW, you'll notice that citations are in the text. I hate how Kindle handles footnotes. So I'm not using them. Instead, I'm putting citations in the text. What do you think? Good idea? bad idea?

Update: Here's my new eBook for Kindle: Directors as Auctioneers: A Concise Guide to Revlon-Land

Lost in Revlon-land: An acquisition by a public corporation should not trigger Revlon

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.[1] 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."[2] 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."[3] 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.

Update: I cover this and related Revlon issues in my new eBook for Kindle: Directors as Auctioneers: A Concise Guide to Revlon-Land

Unocal and takeover defenses in hard to value firms

Can takeover defenses create value? Mark Humphrey-Jenner's paper Anti-Takeover Provisions as a Source of Innovation and Value Creation argues for an affirmative answer in some cases:

Managers are risk averse. Excessive risk-aversion can destroy shareholder wealth. A key source of risk is the threat of an opportunistic takeover designed to take advantage of depressed market prices. This is especially the case in innovative or hard-to-value ('HtV') companies whose price may be depressed due to valuation difficulties rather than managerial under-performance. For these HtV firms, the threat of an opportunistic takeover can destroy value by inducing agency conflicts of managerial risk aversion. managers and regulators argue that ATPs can ameliorate this problem. This article presents a theoretical model and empirical results that show that for HtV firms, ATPs encourage managers to make value-creating takeovers and increase innovation and do not induce agency conflicts of managerial entrenchment. This implies that for innovative or hard-to-value firms, ATPs can ameliorate managerial risk aversion and encourage value-creation.

Assuming that's true (models and empirical data together, yikes!), how would one incorporate his conclusions into Delaware's Unocal framework for judicial review of takeover defenses? I am reminded of Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 278 (Del.Ch. 1989).

Shamrock made a hostile takeover bid for Polaroid. The target responded by issuing convertible preferred stock to friendly investors and initiating a substantial stock buyback program. Polaroid also had a poison pill "containing 'flip-in' and 'flip-over' provisions. In addition, although the company does not have a staggered board of directors, several provisions limit a dissident stockholder's ability to gain control of the company. Polaroid's charter prohibits stockholder action by written consent. Pursuant to the bylaws, stockholders may not call special meetings and must give written notice of their intention to nominate directors for election ninety days prior to the annual meeting." Shamrock sued, claiming the defensive tactics violated the Unocal standard.

The court held that:

Polaroid directors [satisfied the first Unocal prong because they] acted in good faith and reasonably investigated Shamrock's offer. The board met on at least six occasions over a four month period to review Shamrock's original and amended offer and to discuss appropriate responses with management as well as its financial and legal advisers. Only two of Polaroid's thirteen board members are present or former officers of the company and there is no evidence from which the Court could make a preliminary finding that the outside directors were seeking to entrench themselves.

The second prong of Unocal is the proportionality test under which Polaroid's response must be balanced against the Shamrock threat. ...

Here is where the case becomes relevant to Humphrey-Jenner's paper. In assessing whether the Shamrock bid posed a threat to Polaroid, the court took into consideration that fact that Polaroid was ... you will have guessed it ... hard to value. Polaroid has recently won the liability phase of a major patent lawsuit against Kodak. Critically, however, the damages phase of the suit remained unresolved. Nobody knew exactly what the damages were likely to be, but it seemed fair to assume that the damage claim represented a very significant chunk of Polaroid's value. Hence, as the court explained, Polaroid argued that:

Shamrock's offer is also considered a threat because, in the board's view, it does not offer full value for the Kodak judgment. That judgment is, by far, Polaroid's most valuable asset. The directors fear that Shamrock will either exploit or impair that asset: "(a) ... Shamrock may undervalue the award because of its uncertainty and Shamrock's lesser knowledge of the full merits of Polaroid's claim; (b) ... because of Shamrock's need to pay down its acquisition debt promptly, Shamrock may be willing to quickly settle the litigation for less than full value; and (c) ... the court in the Kodak action may be inclined to award less damages to a takeover acquiror than to the original victim."

The Court agreed:

In sum, Polaroid is anticipating a monetary recovery that may exceed $5 billion as the result of a complicated patent infringement claim that spans more than a decade. In the foreseeable future, the amount of the damage award will be quantified if not paid. Until that time, it seems appropriate to consider a non-coercive but inadequate tender offer to be a threat. Although the stock market has “valued” the Kodak judgment and analysts have made estimates, Polaroid's stockholders really have very little way of assessing the present worth of this extremely valuable asset. Under these circumstances, there is a real possibility that the Polaroid stockholders will undervalue the Kodak judgment and it does not appear that the mere dissemination of information will cure this problem. Thus, I am satisfied that the Polaroid directors were entitled to treat the Shamrock tender offer as a threat. There is evidence that the offered price is inadequate (and the board so found) and there is a valid basis for concern that the Polaroid stockholders will be unable to reach an accurate judgment as to intrinsic value of their stock in light of the current status of the Kodak litigation.

The issue then becomes whether the Management Transactions constitute a reasonable response to the threat presented by this arguably inadequate bid. The purported purpose of the self-tender and buyback is to offer some immediate value to those stockholders interested in cash while increasing the equity interest held by the remaining stockholders. The Preferred Stock issuance is said to be an advantageous form of financing for the repurchase program. ...

In sum, although I am not entirely satisfied that the issuance of the Preferred Stock was simply a financing device, I am unable to conclude preliminarily that either the Corporate Partners transaction alone or the Management Transactions as a whole are unreasonable either because they are disproportionate to the Shamrock threat or because they were improperly motivated.

Humphrey-Jenner's paper suggests that the court in Shamrock holdings got it exactly right. Where targets are hard to value, even more deference than usual may be appropriate in applying the Unocal standard.

Yours truly quoted re Mentor Graphics v Carl Icahn

The Oregionian on the Mentor Graphics-Carl Icahn fight:

In theory, one vote for one share sounds like corporate democracy. But Stephen Bainbridge, a corporate law professor at the University of California at Los Angeles and prominent blogger on legal and financial issues, says it's more complicated than that.

"Think about a very large organization, like a nation-state," Bainbridge said. "We don't run the United States the way we run New England town meetings."

That's not to say that Bainbridge opposes shareholder activism. But he worries that pension funds, unions and some hedge funds are pushing special interests that benefit one class of shareholders at the expense of others.

Corporations aren't helpless in the fight. They have a variety of tactics at their disposal to beat back hostile takeovers, and Bainbridge said there's sometimes good reason to repel an activist with narrow aims or lowball buyout offers.

But companies deploy these defenses at their peril, exposing themselves to lawsuits and allegations that they're passing up lucrative offers. Icahn has often turned to the courts to advance his cause and sometimes had suits turned against him.

"Litigation is just part of the deal-making process," Bainbridge said. "I think everybody knows that."

David Zarig tags me in on the Schedule 13D ten day window

David Zarig reports that:

Hedge funds and other investors have been acquiring large stakes in a very small number of companies within the ten day window before they have to report the stake to the SEC. Wachtell wants the SEC to change that to a one day reporting requirement and then a two day standstill in the acquisition of further shares.  The SEC sounds like it is inclined to address the problem. 

He then tags me in:

I wonder what Professor Bainbridge, the corporate-law-should-protect-boards theorist, thinks about it.

First, some background. As I relate in Mergers and Acquisitions:

For the would be acquirer, keeping its interest in the target and takeover plans secret for as long as possible is crucial. As soon as a possible bid is disclosed, the target’s stock price jumps. Target management may begin erecting defenses against the bid or seeking alternative transactions. Other potential acquirers may begin looking at the target with the idea of making a competing bid, such that the initial bidder’s disclosures may simply serve to identify the target and publicize its vulnerability. Prior to adoption of the federal Williams Act in 1968, it was common for a prospective acquirer to quietly buy up substantial amounts of target stock before initiating its public offer. In some cases, bidders managed to acquire de facto control before going public. Today, however, Securities Exchange Act § 13(d) and the SEC rules thereunder form an early warning system effectively mandating early disclosure of impending control contests.

Securities Exchange Act § 13(d) requires that any person who acquires beneficial ownership of more than 5% of the outstanding shares of any class of voting equity securities registered under Securities Exchange Act § 12 must file a Schedule 13D disclosure statement within 10 days of such acquisition with the SEC, the issuer, and the exchanges on which the stock is traded.

The 10 day window begins to run on the day the acquiring person makes an acquisition which puts his holdings over the five percent threshold. Where a group is formed, the 10 day window begins to run on the day they enter into the requisite agreement to act in concert, provided their aggregate holdings exceed 5% on that date.

The statutory framework had a predictable timing effect. A bidder who intends or expects to make a hostile takeover will buy up to 4.9% as quietly as possible. It will not cross the 5% threshold until all its preparations are completed. Once it crosses that threshold, it will begin actively buying stock, attempting to acquire as many shares as possible without alerting the target during the 10 day window. Pre-filing acquisitions of 10% of the issuer’s stock are common and there are anecdotal accounts of pre-filing acquisitions of as much as 25% or more of the stock.

The 10 day window has never been changed in the 4 decades-plus that the rule has been in place. This despite the fact that most other reporting obligations have had time shaved off them ias modern technology has made it possible to prepare and file documents much faster. Insiders now have only two business days to file a Form 4 reporting transactions in their comany's shares. Issuers now have only 4 business days in which to file a Form 8-K reporting certain specified events. The 10 day filing window for Schedule 13D thus looks antiquated.

So I favor a narrowing of the window. Sunlight being the best disinfectnt and all that, after all. If an issuer can file an 8-K within 4 business days, why shouldn't an acquirer be able to file a Schedule 13D within at least that period.

The proposed one day filing period seems a bit too short. Maybe give acquirers the same 2 day window we give insiders?

Having said that, however, I agree with Zarig that the proposed 2 day standstill is unwarranted:

Why on earth should there be a two day stand-still?  It's bad enough that companies can resist the market for corporate control by creating anti-takeover defenses.  But their investors can sell.  This would be a market wide rule - the only way to sell is to leave and go to Europe.

Interestingly, the original Williams Act as proposed in 1965 would have included a 20-day standstill. It provided that a bidder could not acquire more than 5% of a target company's stock “until the expiration of twenty days after such person has" filed a disclosure document with the SEC and sent a copy to the issuer.

As I explain in Mergers and Acquisitions, such a provision would have been fatal to the nascent market for corporate control:

The first prospective bidder to identify a prospective target incurs significant search costs, which become part of the bidder’s overall profit calculation. By announcing its offer, however, the first bidder identifies the prospective target to all other potential bidders. Subsequent bidders thus need not incur the high search costs carried by the first bidder, perhaps allowing them to pay a higher price than is possible for the first bidder. If target resistance delays closing of the offer, subsequent bidders have a greater opportunity to enter the fray. At the very least, target resistance may force the initial bidder to raise its offer, reducing the gains to search.

A 20 day standstill would have given target management more than enough time to seek out white knights, erect poison pills and other defenses, and otherwise bollix up the bidder's plans.

The reasonable solution, it seems to me, is to reduce the 10 day day filing to, say, two days but with no standstill requirement. The modest number of shares a bidder is likely to pick up during the two day pre-fling period simply doesn't pose serious risks of abuse in most cases.

Brady on Airgas

Delaware lawyer Kevin Brady has a lengthy, detailed, and very useful analysis of the recent Delaware Chancery Court's decision in Airgas on poison pills.

Lipton on Airgas

Dean of takeover lawyers Martin Lipton weighs in on the recent Airgas poison pill decision:

The Chancellor could not have been clearer that “the power to defeat an inadequate hostile tender offer ultimately lies with the board of directors.”  And it is up to directors, not raiders or short-term speculators, to decide whether a company should be sold:  “a board cannot be forced into Revlon mode any time a hostile bidder makes a tender offer that is at a premium to market value.”  The Chancellor concluded:  “in order to have any effectiveness, pills do not—and can not—have a set expiration date.”  The poison pill lives.