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Chancery gets its half right

Edward McNally notes an interesting new Delaware Chancery Court decision:

In re Plains Exploration & Production Company Stockholder Litigation, C.A. 8090-VCN (May 9, 2013)

As this decision points out again, when a board of directors is disinterested in the transaction, its decision to accept the first offer for its company does not run afoul of the Revlon doctrine just because there was no pre-agreement market check.  Instead, their decision is subject to the business judgment rule.

Francis Pileggi elaborates:

Brief Overview

This case addressed the claims that the duties of the directors in connection with the sale of the company, based on the seminal Delaware Supreme Court decision in Revlon, were breached. TheRevlon duties of a board, in essence, are fiduciary duties that require the directors to get the best price for the company when it is determined to be for sale, and the procedures employed by the board in connection with the sale or merger will be scrutinized to determine if they were consistent with the board’s obligations. This case recited the contours and parameters of those obligations, but reiterates that there is no formal script or procedures that the directors need to follow. Certain types of procedures and processes have been addressed over the many years that Revlon has been applied, however, and this opinion builds on that extensive jurisprudence.

Select Highlights of Legal Rulings

This decision provides additional guidance on two points in particular: Neither: (i) absence of a special committee, nor (ii) the absence of a pre-market check, will, per se, amount to a violation ofRevlon duties. Of course, this finding needs to be tethered to the facts of this case which include a board that: (i) was experienced in the oil and gas industry, (ii) was adequately involved in the negotiations, and (iii) had 7 out of 8 directors who were independent and disinterested.

This strikes me as half right. On the one hand,the holding that there is "no formal script or procedures that the directors need to follow" is clearly correct.

On the other hand, I am disappointed to once again see the Chancery Court apply Revlon simply because part of the consideration was paid in cash:

The Defendants do not dispute that Revlon applies to the Plaintiffs’ claim. See In re Smurfit- Stone Container Corp. S’holder Litig., 2011 WL 2028076, at *11-16 (Del. Ch. May 20, 2011) (applying the Revlon standard to a 50 percent stock and 50 percent cash merger). (p. 10 n.32)

As I explained at great length in The Geography of Revlon-Land, a transaction does not trigger Revlon simply because a substantial part of the consideration is in the form of cash:

The most directly relevant Delaware Supreme Court precedent is In re Santa Fe Pac. Corp. S’holders Litig.[1] Santa Fe and Burlington were both publicly held Delaware corporations.[2] After negotiations, they agreed to a complicated deal in which the two companies would make a joint tender offer for up to 33% of Santa Fe’s shares at $20 per share in cash.[3] If successful, the offer would give Burlington 16% of Santa Fe’s remaining outstanding shares.[4] If the offer succeeded, a freeze-out merger in which remaining Santa Fe shareholders would get Burlington shares in exchange for their Santa Fe stock would follow it.[5] All the while, Santa Fe’s board of directors was fending off an unsolicited takeover bid by Union Pacific.[6]

The Supreme Court rejected the plaintiffs’ argument that the deal triggered Revlon duties for Santa Fe’s directors, on grounds that plaintiffs “failed to allege that control of Burlington and Santa Fe after the merger would not remain ‘in a large, fluid, changeable and changing market.’”[7] The clear implication is that the form of consideration was not the relevant issue. Instead, the issue was whether the Burlington shareholders would remain dispersed “in a large, fluid, changeable and changing market.”

Yet, in NYMEX, the Chancery Court characterized Santa Fe as simply setting a floor—33% cash—below which one did not enter Revlon-land.[8] As for higher ratios, the Chancery Court relied on Lukens for the proposition that the Delaware “Supreme Court has not set out a black line rule explaining what percentage of the consideration can be cash without triggering Revlon.”[9]

This characterization of Santa Fe is hard to square with the Supreme Court’s analysis in the case, which makes no reference to floors or ceilings, but rather to the post-deal “stock ownership structure of Burlington.”[10] It is even more difficult to square with the three checkpoints established by Arnold v. Soc’y for Sav. Bancorp, Inc.[11]

The Smurfit court finessed Arnold in the first instance by selective quotation of the key passage setting out the three checkpoints. The Smurfit court quoted it as follows:

The[SB1]  Delaware Supreme Court has determined that a board might find itself faced with such a duty in at least three scenarios: “(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 the break-up of the company; or (3) when approval of a transaction results in a sale or change of control [.]”[12]

The observant reader will note that the Chancery Court thereby omitted the critical qualifier Arnold adds to checkpoint # 3. To emphasize the point, let us quote the pertinent part of Arnold again in full: “(3) when approval of a transaction results in a sale or change of control. In the latter situation, there is no sale or change in control when [c]ontrol of both [companies] remain[s] in a large, fluid, changeable and changing market.”[13]

Arnold’s clear implication is that an acquisition by a publicly held corporation with no controlling shareholder that results in the combined corporate entity being owned by dispersed shareholders in the proverbial “large, fluid, changeable and changing market” does not trigger Revlon whether the deal is structured as all stock, all cash, or somewhere in the middle. The form of consideration is simply irrelevant.

The Delaware Supreme Court’s more recent opinion in Lyondell confirms this reading of both Santa Fe and Arnold. In addition to the substantive errors made by the Chancery Court in Lyondell,[14] the Chancery Court also took too expansive an approach to when Revlon-duties are triggered by holding that the target board enters Revlon-land when it “undertakes a sale of the company for cash.”[15]

Checkpoint # 1 was inapplicable on Lyondell’s facts, because the target board had not initiated “an active bidding process,” let alone one that would involve a break up of the company. Checkpoint # 2 was inapplicable because the transaction did not involve a hostile offer or an abandonment of the target’s long-term strategy or a break up of the company.

Checkpoint # 3, however, was triggered once the target board decided to sell the company to Access, because Access was a privately held corporation. The transaction therefore would have involved a change of control from disperse public shareholders in “a large, fluid, changeable and changing market” to a single controlling shareholder. Although the Supreme Court did not quote that now proverbial standard, it did hold that  one does not enter Revlon-land simply because a prospective target company is “in play.”[16] Instead, one does so “ only when a company embarks on a transaction—on its own initiative or in response to an unsolicited offer—that will result in a change of control.”[17]

Fairly read, this confirms that in the phrase “sale or change of control,” as used in checkpoint # 3, control must be understood to modify both the words sale and change. Accordingly, Lyondell confirms that the interpretation of Arnold and Santa Fe set out above is the correct one rather than that offered by the Chancery Court.

The logic of the Chancery Court decisions rests on the policy that target shareholders who get cash have no opportunity to participate in the potential post-acquisition gains that may accrue to shareholders of the combined company:

Defendants[SB2]  emphasize that no Smurfit–Stone stockholder involuntarily or voluntarily can be cashed out completely and, after consummation of the Proposed Transaction, the stockholders will own slightly less than half of Rock–Tenn. … Defendants lose sight of the fact that 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, like Vice Chancellor Lamb’s concern that potentially there was no “tomorrow” for a substantial majority of Lukens stockholders, 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 is insufficient to distinguish the reasoning of Lukens, which concerns the need for the Court to scrutinize under Revlon a transaction that constitutes an end-game for all or a substantial part of a stockholder’s investment in a Delaware corporation.[18]

As we have seen, however, this concern makes no sense.[19] As long as the acquirer is publicly held, shareholders who get cash could simply turn around and buy stock in the post-acquisition company. They would then participate in any post-transaction gains, including any future takeover premium. Only if there has been a change of control is that option foreclosed.

In any event, as the discussion in Part III.C makes clear, the relevant policy concern is not whether there is a tomorrow. To be sure, QVC spoke of “an asset belonging to public shareholders”; i.e., “a control premium.”[20] As we saw above, although he did not cite QVC, Vice Chancellor Laster implicated this concern by holding that Revlon was triggered because the transaction at issue was the “only chance [the target shareholders would] have to have their fiduciaries bargain for a premium for their shares.”[21]

If QVC is properly understood, however, the Supreme Court was not showing concern for whether there will be a tomorrow for the shareholders. Instead, as discussed above, the court was concerned in QVC with the division of gains between target and acquirer shareholders because the post-transaction company would have a dominating controlling shareholder.[22]

As the analysis of QVC in Part III.C.2 explained, the relevant concern thus is the potential that conflicted interests will affect the target’s board of directors’ decisions.[23] Indeed, as we have seen, even Vice Chancellor Lamb’s opinion in Lukens recognized that the motivating concern underlying Revlon is “the omnipresent specter that a board may be acting primarily in its own interest, rather than those of the corporation and its shareholders.”[24] Curiously, however, Vice Chancellor Lamb brought that policy concern into play only with respect to whether the directors had satisfied their Revlon duties, while ignoring it when deciding whether those duties have triggered. But nothing in Revlon or QVC suggests that that policy is limited to the former issue rather than both inquiries.

Because the conflict of interest policy concern is the underlying driver of both aspects of Revlon, the Chancery Court in Lukens and its progeny should have considered whether the all- or partial-cash transactions necessarily implicate conflicts of interest akin to those at issue in Revlon and QVC. If the various Vice Chancellors had done so, they would have recognized that, 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.[25] In turn, those shareholders also will be indifferent as to the form of consideration.

In contrast, if the transaction results in a privately held entity, a diversified shareholder cannot be on both sides of the transaction. If the post-transaction entity remains publicly held, but will be dominated by a controlling shareholder, there is a substantial risk that the control shareholder will be able to extract non-pro rata benefits in the future and get a sweetheart deal from target directors in the initial acquisition. In either situation, the division of gain matters a lot. As such, investors would prefer to see gains in such transactions allocated to the target.[26] It is in these situations that Revlon therefore should come into play.

Defending Patagonia: Mergers & Acquisitions with Benefit Corporations

The growing legal acceptance of the benefit corporation concept, especially with the prospect of Delaware adopting a B Corp statute, makes this issue one of considerable import:

Abstract:     
Yvon Chouinard, founder of Patagonia, stated that "benefit corporation legislation creates the legal framework to enable mission-driven companies like Patagonia to stay mission-driven through succession, capital raises, and even changes in ownership." This article uses Patagonia, one of the most visible benefit corporations, in the article’s examination of Chouinard’s claim and in the article’s exploration of issues surrounding benefit corporations in the mergers and acquisitions context.

Of special interest are the seminal Delaware cases of Unocal and Revlon, and how, if at all, the tests created by those cases should be applied to benefit corporations. This article concludes that the Unocal test could be used to evaluate takeover defenses erected by benefit corporations, but argues that the test should be modified to more clearly allow directors to protect the mission of their benefit corporation, even if the mission "openly eschews shareholder wealth maximization." A more difficult issue arises when the break-up or sale of a benefit corporation becomes inevitable and the benefit corporation, incorporated in a state that follows Delaware law, enters "Revlon-mode." To provide a practical corporate governance framework, this article concludes that Revlon should remain relevant for benefit corporations that are incorporated in states following Delaware law, but proposes statutory amendments requiring a partial-asset lock and an annual charitable giving floor to ensure public benefit.

via papers.ssrn.com

Murray, J. Haskell , Defending Patagonia: Mergers & Acquisitions with Benefit Corporations (March 28, 2013). Hastings Business Law Journal, Forthcoming. Available at SSRN: http://ssrn.com/abstract=2240885

Delaware courts should allow Dell's board to fend off Carl Icahn's financial play

When I first heard that Carl Icahn was considering bidding for Dell, I was quite surprised. Icahn's not a private equity guy who buys and develops portfolio companies. Instead, he's a fast buck artist who specializes in pure financial plays. His few high profile efforts to actually manage a business have ended disastrously, as when he asset stripped TWA before driving it into the ground once and for all. See Time to Sell! World’s “worst stock picker” Carl Icahn buys into Brazilian mining company, for an overview of Icahn's ineptitude as an investor/manager. He can only make money as a raider, looter, and greenmailer.

Fortunately, we have Steven Davidoff to dig through these stories and come up with the goods:

Mr. Icahn has reportedly acquired 6 percent of Dell and is now proposing two alternatives to the buyout.

The first is that if the proposed acquisition is voted down, the computer maker’s board should immediately declare a dividend of $9 a share, taking on an additional $5.25 billion of debt to pay for it. According to Mr. Icahn, Dell stock is worth roughly $13.81 a share, so shareholders would have a total value of $22.81 a share.

If the board does not implement his proposed dividend recapitalization, Mr. Icahn then indicated that Dell should commit to hold its annual meeting at the same time shareholders vote on the deal. Mr. Icahn then generously promised to run his own slate of directors to replace the current board.

If his slate proved victorious, Mr. Icahn’s handpicked directors could then implement his first proposal. In that instance, Mr. Icahn also promised to provide this $5.25 billion loan from his own personal wealth and that of his own fund.

In other words, Icahn has no interest in running in Dell. Instead, he's looking for a quick payout that will leave Dell with huge debt and, in all probability, unable to compete in the turbulent PC market.

Unfortunately, Dell's board probably has little legal room to maneuver against Icahn. Because Dell and his buyout partners proposed taking the company private, there is a proposed change of control triggering Revlon duties. See my article The Geography of Revlon-Land (July 23, 2012). 81 Fordham Law Review, (Forthcoming 2013); available at SSRN: http://ssrn.com/abstract=2115769. As a result, Dell's board may only consider short term shareholder wealth maximization--they must get the highest possible price.

But does that make any sense? Should directors really be forced to sell into a financial play that maximizes short term payout at the cost of leaving the company swamped by debt and at risk of collapse?

One hope is that the Delaware courts decide that Revlon does not apply to Icahn's bid, since it seems to contemplate leaving a public stub of shareholders. As Davidoff notes:

... in either case, if Blackstone or Mr. Icahn gets to this final bid stage (and remember either may not make a final bid – what is happening right now is really a placeholder), this will not be an easy decision for the Dell board. It will not be simply considering who is the highest bidder for the entire company. Instead, it will probably have to weigh proposals that keep part of the company public, and this will mean weighing the value of a future Dell. This is not the easy determination of merely weighing cash bids – there you pick the highest. Instead, the board will have to assess the value of what may be a highly leveraged Dell without its current management and a declining business model. In this situation Silver Lake’s current bid may still be a superior one, despite the disapproval that such a determination would be met with by some of Dell’s shareholders.

If the Delaware courts allow the Dell board sufficient leeway, they could reject Icahn's bid on the perfectly reasonable grounds that it would leave Dell overly leveraged and thus put shareholders at risk of firm failure.

Alternatively, perhaps the Delaware courts will finally embrace my argument that Revlon is about conflicts of interest and entrenchment motives. If Dell's independent board members continue to embrace a best practice approach, demonstrating that they are not trying to entrench themselves--or, more important, Michael Dell--in office, there is no good reason for Delaware to apply Revlon in a formalistic way that requires Dell to sell to Icahn.

Holman Jenkins on the Dell MBO

Using the proposed management buyout of Dell, Holman Jenkins offers a muddled and largely uninformative take on MBOs:

Yes, private-equity investors sometimes pay a premium to take a public company private in order to change management or strategy. That's not the case here. Much "legacy" talk has circulated about Mr. Dell's motives. Oddly, this doesn't help his case either, implying that he has been sacrificing shareholder interests all along in a quest for redemption.

Whatever Mr. Dell intends, moreover, stockholders can clearly see a tax arbitrage at work. Dell is still a profitable company. They suspect Mr. Dell and Silver Lake of taking advantage of Dell's depressed share price and the tax deductibility of LBO debt to get rid of Dell's outside shareholders on the cheap and capture more of Dell's ample cash flow for themselves.

So what does Jenkins think we should do about these sort of transactions?

Some will tell you, in all seriousness, that management buyouts like Dell's are inherently corrupt and should be banned as a matter of law.

A counterview is that, with thousands of public companies to choose from, investors knew they were getting in bed with Mr. Dell. One reason Dell was cheap was because of its CEO-founder's legacy-itis.

Conflicts of interest are intrinsic to any modern business run by insiders for the benefit of outside shareholders. Conflicts of interest are not aberrations. Corporate governance is the market's answer to these conflicts, in which shareholders withhold their capital unless satisfied with the rights afforded them, and then they take their chances. ...

Dell shareholders may have to hold their noses and take Mr. Dell's offer—and perhaps think twice next time before investing in a troubled company whose founder is still on the premises.

My own take is somewhere in the middle between banning MBOs and simply saying caveat emptor. More precisely, I think Delaware corporate law gets it pretty much right. Steven Davidoff explains:

In the Siliconix and Pure Resources opinions, Delaware courts held that a majority shareholder could freeze out and acquire a minority shareholding and avoid “entire fairness” review if the acquisition occurred via a tender offer rather than a merger. The business judgment rule would apply and the court would not second-guess the sale price or process so long as certain requisites of process were followed, including consideration by a special committee of independent directors and the inclusion of a noncoercive majority of minority condition in the tender offer. ...

Delaware courts have continued to push procedural mechanisms as an appropriate remedy in transactions involving controlling shareholders. ...

In light of this law, certain practices have been developed to ensure that these rules are followed in M.B.O.’s and freeze-outs, including the formation of special committees of independent directors with independent advisers. To protect shareholders, go-shop provisions and majority-of-minority conditions are included in acquisition agreements. Moreover, boards have been negotiating deals with lower termination fees to encourage bidding in the case of M.B.O.’s.

Recent research by Matthew Cain and Steven Davidoff (36 Del. J. Corp. L. 849) confirms that these procedural protections provide investors with significant protections:

... we compiled a dataset of MBOs announced from 2003 through 2009. We then empirically studied the contract terms and processes associated with these transactions. In addition, we compiled from court records an extensive set of litigation rates and outcomes in order to measure the effect of litigation on MBO outcomes. We have thus measured the value of “process” through board procedures, contractual mechanisms, and litigation in conflicted interest transactions involving MBOs. ...

... Our results show that process indeed matters in MBOs, and that certain mechanisms which empower shareholders in the decision process appear to particularly matter. In addition, we find that MBO merger transactions with controlling shareholders, which are also subject to “entire fairness” review, do not result in higher offer premiums. Our results provide support for the Delaware courts' adoption of procedural protections in takeovers where management principal/shareholder agency conflict exists.

So Dell will need to provide its shareholders with significant procedural and process protections or run the risk of litigation setbacks and substtnial liability. But you wouldn't have learned that from Jenkins.

What lessons can we draw as Time-Warner ends with a whimper?

In 1989, Time Inc. wanted to acquire Warner Communications. Its plans were temporarily disrupted by a competing offer in which Paramount Communications tried to buy Time. Paramount ultimately lost in a groundbreaking opinion by the Delaware Supreme Court. Time and Warner merged. Time-Warner, of course, later was acquired by AOL.

When the dot-com bubble burst, Time-Warner demoted AOL and then spun it off.

Now come reports that Time-Warner may split off its publishing side and sell it to a private equity outfit.

Back in 1989, Time's strategy was aptly summarized by Delaware Chancellor Allen as:

Over the years, Time's business appears to have evolved from one completely dominated by its publishing activities to one in which to an increasingly important degree, video supplies the medium in which its products reach consumers. Simultaneously, the firm has tended to reinterpret its mission from one of supplying information to a relatively educated market segment to one in which entertainment of a mass audience plays an important role. Time was, of course, founded as a journalistic enterprise. That meant most importantly that its writers created the material that it offered for sale. Publishing continues to be vitally important to it.As Time has in this decade become importantly dependent upon video media for its income and growth, however, it has recognized a need to create for itself and thus own the video or film products that it delivers through its cable network (HBO) and cable franchises. To fail to develop this capacity would, it was apparently feared, leave the firm at the mercy of others (both as to quality and to price) with respect to the element most critical to success in the video entertainment business. Thus, for some time, management of the corporation has reviewed ways in which the firm might address this need. -- Paramount Communications Inc. v. Time Inc., 1989 WL 79880 (Del.Ch.,1989).

Time's investment bankers predicted that a merger with Warner would reap huge benefits:

In the longer term, Time's advisors have predicted trading ranges of $159-$247 for 1991, $230-$332 for 1992 and $208-$402 for 1993.  The latter being a range that a Texan might feel at home on.

They were wrong. Badly. As things turned out, Time's shareholders would have been better off if they had been able to accept Paramount's $200/share offer and simply stuck the proceeds in a money market fund.

Many scholars (and, yes, I'm looking at you know who) would argue that Tme thus stands as a case study of why we should leave the ultimate decision to shareholders rather than boards.

I explain why in excruciating detail in Unocal at 20: Director Primacy in Corporate Takeovers. Here's a short version:

According to critics of the Delaware courts, an individual shareholder’s decision to tender his shares to the bidder no more concerns the institutional responsibilities or prerogatives of the board than does the shareholder’s decision to sell his shares on the open market or, for that matter, to sell his house. Both stock and a home are treated as species of private property that are freely alienable by their owners.

The trouble is that none of the normative bases for the structural argument prove persuasive. The idea that shareholders have the right to make the final decision about an unsolicited tender offer does not necessarily follow, for example, from the mere fact that shareholders have voting rights. While notions of shareholder democracy permit powerful rhetoric, corporations are not New England town meetings. Put another way, we need not value corporate democracy simply because we value political democracy.

Indeed, we need not value shareholder democracy very much at all. As previously discussed, what is most striking about shareholder voting rights is the extensive set of limitations on those rights. These limitations reflect the presumption in favor of authority. They are designed to minimize the extent to which shareholders can interfere in the board of directors’ exercise of its discretionary powers. In fact, as noted in Part II.D of the article, if authority were corporate law’s sole value, shareholders would have no voice at all in corporate decision making. Instead, all decisions would be made by the board of directors or those managers to whom the board has delegated authority. Shareholder voting rights are properly seen as simply one of many accountability tools available, not as part of the firm’s decision-making system.

Nor is shareholder choice a necessary corollary of the shareholders’ ownership of the corporation. As described in Part II.B of the article, the nexus of contracts model visualizes the firm as a legal fiction representing a complex set of contractual relationships. Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept under this model. A shareholder’s ability to dispose of his stock is merely defined by the terms of the corporate contract, which in turn is provided by the firm’s organic documents and the state of incorporation’s corporate statute and common law. As Vice Chancellor Walsh observed, “[S]hareholders do not possess a contractual right to receive takeover bids. The shareholders’ ability to gain premiums through takeover activity is subject to the good faith business judgment of the board of directors in structuring defensive tactics.”

Walsh’s observation is given particular significance when considered in light of the nexus of contracts theory described in Part II.A of the article, which posits that the law generally should provide default rules for which the parties would bargain if they could do so costlessly. Walsh’s dictum, therefore, suggests shareholders would bargain for rules allowing a target’s board of directors to function as a gatekeeper even with respect to unsolicited tender offers.

The empirical evidence supports this hypothesis. It is well-established, for example, that the combination of a poison pill and a staggered board of directors is a particularly effective takeover defense. Yet, almost 60% of public corporations now have staggered boards. Even more striking, the incidence of staggered boards has increased dramatically among firms going public (from 34% in 1990 to over 70% in 2001). Finally, activist shareholders have made little headway in efforts to “de-stagger” the board. These findings are highly suggestive, as Easterbrook and Fischel observe:

Although agency costs are high, many managerial teams are scrupulously dedicated to investors’ interests. . . . By increasing the value of the firm, they would do themselves a favor (most managers’ compensation is linked to the stock market, and they own stock too). Nonexistence of securities said to be beneficial to investors is telling.

The existence of securities having certain features seems equally telling. Indeed, if what investors do matters more than what they say, one must conclude that IPO investors are voting for director primacy with their wallets.

Finally, and most importantly, the structural argument also ignores the risk that restricting the board’s authority in the tender offer context will undermine the board’s authority in other contexts. Even the most casual examination of corporate legal rules will find plenty of evidence that courts value preservation of the board’s decision-making authority. The structural argument, however, ignores the authority values reflected in these rules. To the contrary, if accepted, the structural argument would necessarily undermine the board’s unquestioned authority in a variety of areas. Consider, for example, the board’s authority to negotiate mergers. If the bidder can easily bypass the board by making a tender offer, hard bargaining by the target board becomes counter-productive. It will simply lead the bidder into making a low-ball tender offer to the shareholders. This offer, in turn, would probably be accepted due to the collective action problems that preclude meaningful shareholder resistance. Restricting the board’s authority to resist tender offers thus indirectly restricts its authority with respect to negotiated acquisitions.

Indeed, taken to its logical extreme, the structural argument requires direct restrictions on management’s authority in the negotiated acquisition context. Suppose management believes that its company is a logical target for a hostile takeover bid. One way to make itself less attractive is by expending resources in acquiring other companies. Alternatively, the board could effect a preemptive strike by agreeing to be acquired by a friendly bidder. In order to assure that such acquisitions will not deter unsolicited tender offers, the structural argument would require searching judicial review of the board’s motives in any negotiated acquisition.

To take but one more example, a potential target can make itself less vulnerable to a takeover by eliminating marginal operations or increasing the dividend paid to shareholders, either of which would enhance the value of the outstanding shares. Thus, a corporate restructuring can be seen as a preemptive response to the threat of takeovers. Although such transactions may aid incumbents in securing their positions, it is hard to imagine valid objections to incumbents doing so through transactions that benefit shareholders. Why should it matter if the restructuring occurs after a specific takeover proposal materializes? On the contrary, the structural argument not only says that it does matter, but taken to its logical extreme, it would require close judicial scrutiny of all corporate restructurings.

Lastly, restrictions on the board’s authority to function as a gatekeeper with respect to unsolicited tender offers might have a multiplicative effect on the board’s authority generally. Because “the efficiency of organization is affected by the degree to which individuals assent to orders, denying the authority of an organization communication is a threat to the interests of all individuals who derive a net advantage from their connection with the organization.” Hence, by calling into question the legitimacy of the central decision-making body’s authority in this critical decision-making arena, a passivity rule might reduce the incentive for subordinates to assent to that body’s decisions in other contexts as well, thereby undermining the efficient functioning of the entire firm.

"Going to Revlon-Land With a Conflicted Financial Advisor"

Very interesting article by Robert Miller in the latest issue of Engage:

This article examines two recent cases in the Delaware Court of Chancery addressing the Revlon duties of directors when the company’s financial advisor has a conflict of interest related to the proposed business combination transaction. ...

Related Links:

• In re Del Monte Foods Co. Shareholders Litigation, 25 A.3d 813 (Del. Ch. 2011):http://www.rlf.com/files/Del Monte.pdf

• Del Monte and Barclays Settle Investor Lawsuit for $89.4 million, N.Y. Times Dealbook, Oct. 6, 2011: http://dealbook.nytimes.com/2011/10/06/del-monte-and-barclays-settle-investor-lawsuit-for-89-4-million/

• John Coaes, et. al, Barclays Capital and the Sale of Del Monte Foods, Harvard Law School Case Study (from the perspective of the bankers and lawyers at Barclays) (July 27, 2012):http://casestudies.law.harvard.edu/barclays-capital-and-the-sale-of-del-monte-foods/

• Jeffrey McCracken, Barclays Leads LBO Financing Retreat After Del Monte Slap, Bloomberg, Sept.14, 2011: http://www.bloomberg.com/news/2011-09-14/barclays-leads-lbo-financing-retreat-after-del-monte-criticism.html

We spent a fair bit of time on this issue in my Mergers & Acquisitions class last fall. It's a really important issue and Miller does it justice in a very concise format. My only real complaint is that he failed to cite my article The Geography of Revlon-Land, which is, of course, the seminal tourist guide to the strange place we call Revlon-land. (Wink)

The merger drinking game

This would explain a lot of merger decisions.

Red flags and the H-P board of directors' liability exposure re the Autonomy acquisition

In connection with the growing controversy over Hewlett-Packard's acquisition of Autonomy, the WSJ is reporting that HP is accusing Autonomy of having "made 'outright misrepresentations' to inflate its financial results" prior to the acquisition:

Last week, the company wrote down the value of Autonomy by $8.8 billion, blaming more than half the charge on what it said was Autonomy's misleading accounting. ... Autonomy used aggressive accounting practices to make sure revenue from software licensing kept growing—thereby boosting the British company's valuation. The firm recognized revenue upfront that under U.S. accounting rules would have been deferred, and struck "round-trip transactions"—deals where Autonomy agreed to buy a client's products or services while at the same time the client purchased Autonomy software, according to these people. ...

A person familiar with H-P's investigation said the company is confident the deals are improper even under the international accounting standards Mr. Lynch cites. "We've looked at this very closely," this person said.

In a statement issued Saturday, H-P said its "ongoing investigation into the activities of certain former Autonomy employees has uncovered numerous transactions clearly designed to inflate the underlying financial metrics of the company before its acquisition" ....

As a corporate governance teacher/scholar, my immediate thought was to ask "where was HP's board" and then "what's their liability exposure."

I can imagine two claims on the facts as we know them. First. H-P shareholders might sue the H-P board of directors for having made an uninformed decision to approve the merger. The key precedent here is Smith v. Van Gorkom, about which I have written here. In brief, that case held that directors who make an uninformed decision are not entitled to the protections of the business judgment rule. Instead, they face liability for damages caused by their breach of the duty of care. Instructively, Van Gorkom also involved a merger (although it was the target board being sued rather than the acquirer, as would be the case here).

Second, the shareholders might sue the H-P directors for having failed to exercise adequate oversight of the merger process. The key precedent here would be in re Caremark, about which I have written here. The Caremark decision asserted that a board of directors has a duty to ensure that appropriate “information and reporting systems” are in place to provide the board and top management with “timely and accurate information.” The claim here would be that the H-P board failed to ensure that such systems were in place to supervise both the pre-merger negotiations and the post-merger integration process.

In either case, a key question will be whether the board ignored red flags that should have alerted it to problems with Autonomy's books. 

Because liability generally requires a sustained or systematic failure on the board’s part, rather than just a few instances of inattention, red flags need to be "numerous, serious, directly in front of the directors, and indicative of a corporate-wide problem." Regina F. Burch, Director Oversight and Monitoring: The Standard of Care and the Standard of Liability Post-Enron, 6 Wyo. L. Rev. 481, 498 (2006).

An instructive Delaware precedent on this issue is Chancellor Chandler’s opinion in Ash v. McCall,[1] in which plaintiff shareholders sued the board of directors of McKesson HBOC, Inc. for, inter alia, failure to exercise proper oversight of financial matters in connection with the merger that formed the corporation. Plaintiffs relied heavily on “red flags” supposedly thrown up by various news reports casting doubt on the quality of the target corporation’s financial statements. In contrast, the defendant relied on the “clean bill of health” given those financial statements by the acquiring corporation’s financial advisors. Chancellor Chandler concluded that the plaintiffs had failed to state a claim:

When plaintiffs’ “red flags” are juxtaposed with the clean bill of health given by DeLoitte and Bear Stearns after due diligence reviews, the complaint permits one conclusion: that the McKesson directors’ reliance on the views expressed by their advisors was in good faith. What would plaintiffs have the McKesson board do in the course of making an acquisition other than hire a national accounting firm and investment bank to examine the books and records of the target company?[2]

In addition, the fact that HBOC’s management had responded to some of the media reports constituting plaintiffs’ red flags was not deemed to give the board of directors either constructive or imputed knowledge of the alleged accounting irregularities.[3] Post-McCall decisions have further explained that alleged “red flags” must be “either waived in one’s face or displayed so that they are visible to the careful observer.”[4]

So did the H-P board have sufficient such red flags to have been put on alert? The WSJ story recounts a certain amount of aggressive and unpleasant behavior on the part of senior Autonomy management, but that's not the sort of red flag in question. Instead, the issue is whether there were red flags that should have led the board to inquire into Autonomy's accounting practices. 

Here the Journal's Heard on the Street column is suggestive:

Consider the multiple reports published about Autonomy by accounting research firm CFRA. Dating back to 2007, these raised questions about its lack of nonacquisition-driven revenue growth and unsustainable contributions to cash flow, among other issues. It would be surprising if no one at H-P doing due diligence on the Autonomy deal was aware of such concerns. And what of the back-office integration work once the deal closed? It isn't uncommon for small software companies to have funky revenue-recognition policies that need updating. Such issues are typically discovered immediately by acquiring companies. ...

Autonomy isn't the first problematic acquisition during [Chief Financial Officer Cathie Lesjak's] tenure as CFO. Others include H-P's purchases of EDS and Palm.

In light of Deloitte's giving the deal a clean bill of health, nothing in the Journal's reporting strikes this observer as rising to the level of serious and pervasive red flags that are required for liability, at least on sofar as the decision to merge with Autonomy. 

As for board oversight of the merger integration, the main story reports that:

The company began seeing potential problems with Autonomy's business shortly after the deal closed earlier this year, say people familiar with the matter. The company clawed back some of the commissions paid to salespeople using questionable accounting methods, they said.

Autonomy tried to continue certain accounting practices that the new parent wouldn't allow, say people familiar with the matter. H-P fired Mr. Lynch in May, and soon afterward a member of his inner circle still at H-P told the company's general counsel about possible accounting problems.

Those look like pretty serious red flags. Having said that, however, what could an attentive board have done to prevent the loss? It's not at all clear that the board could have done anything sooner to reduce the damage suffered.

Can Netflix Just Say No?

The WSJ Deal Journal is reporting that:

Netflix CEO Reed Hastings dismisses the idea that the company should sell itself, a position advocated by new investor Carl Icahn.

“The question is: Is that the right thing in the long term?” Hastings says in an interview with The Wall Street Journal.

He argues the company can make it on its own, has enough money to expand internationally and doesn’t need an owner with deeper pockets.

We discussed this issue in my Mergers and Acquisitions class yesterday. Netflix now has a poison pill to go along with its classified board of directors, which is about as potent a takeover defense you can have other than dual class stock. But would a Delaware court let Netflix's board "just say no," refuse to put itself up for sale and hide behind the pill/classified board defense?

In considering that question, the case that immediately springs to mind is former Chancellor Chandler's decision last year in 

Air Products & Chemicals, Inc. v. Airgas, Inc.[1] Airgas had adopted a classified board more than a decade before it adopted a poison pill in 2007. Only the latter decision was prompted by the prospect of a hostile takeover offer, moreover. Chancellor Chandler nevertheless concluded that they were inextricably related and therefore had to be considered as a unitary defensive tactic.

In holding that the defense passed muster under the applicable Delaware precedents, Chandler wrote that:

A board cannot “just say no” to a tender offer. Under Delaware law, it must first pass through two prongs of exacting judicial scrutiny by a judge who will evaluate the actions taken by, and the motives of, the board. Only a board of directors found to be acting in good faith, after reasonable investigation and reliance on the advice of outside advisors, which articulates and convinces the court that a hostile tender offer poses a legitimate threat to the corporate enterprise, may address that perceived threat by blocking the tender offer and forcing the bidder to elect a board majority that supports its bid.

So a board cannot “just say no.” Instead, the board must conduct a reasonable investigation. It must hire independent outside experts. It must then determine that at least the threat of inadequate value is present. Only then can the target board “say no.”

The difference between the “just say no” defense and Chandler’s approach of saying no after jumping through certain hoops, however, seems trivial. So long as the incumbent board is willing to rely on independent directors advised by independent advisors paid out of the corporate treasury, they will always be able to say no. As we know, takeover valuation is at best an art rather than a science. A target will always be able to find credible experts who put a higher value on the company than the hostile bidder’s offer.

If Airgas's board could validly hide behind their pill/classified board defense in the face of a tender offer, how much more so can Netflix's board hide behind their defenses when no offer is even on the table yet.

The fact that many shareholders might agree with Icahn's view that a sale is the best option for Netflix is legally irrelevant, of course. As Chandler explained:

The Delaware Supreme Court has also made clear that the “selection of a time frame for achievement of corporate goals ... may not be delegated to the stockholders.” Furthermore, in powerful dictum, the Supreme Court has stated that “[d]irectors are not obliged to abandon a deliberately conceived corporate plan for a short-term shareholder profit unless there is clearly no basis to sustain the corporate strategy.” 

On the facts so far, I see no basis for a Delaware court to order Netflix to abandon its current strategy, drop its poison pill, and seek a sale.

---

[1] 16 A.3d 48 (Del. Ch. 2011).

Plaintiffs' lawyers move nuisance M&A litigation from the pre-merger stage to the post-merger stage

Kevin LaCroix has details.

Ethics of Corporate Takeovers

Anatomy of a Corporate Takeover is a now somewhat dated program exploring the ethics of corporate takeovers. There's some great stuff here, especially from Boone Pickens and Sir James Goldsmith.

Boone Pickens on Takeovers

I'm teaching Unocal v. Mesa Petroleum in Mergers and Acquisitions today. As takeover afficianados know, that deal involved famed raider T. Boone Pickens. In doing some pre-class research, I found an older CSPAN interview in which Pickens discusses his approach to the takeover business:

Netflix adopts poison pill

In response to Carl Icahn's disclosure that he now owns just under 10% of Netflix common stock, Netflix yesterday announced that its board had aopted a poison pill. Here's the Form 8-K with the shareholder rights plan described and copy attached. And here's the press release announcing the plan.

It's a pretty standard flip in/flip over poison pill, but interestingly the trigger is set aggressively low at 10%. I take it that Netflix's board (a) doesn't want Icahn to acquire any more stock and (b) is assuming that Selectica, Inc. v. Versata Enterprises, Inc.'s validation of a pill with a 4.99% trigger has general application beyond the unique facts of that case in which the trigger was set so as to ensure compliance with tax code provisions dealing with preservation of NOLs. (For more on that case, see my post on it.)

The Netflix pill has particular teetch because Netflix's board of directors is classified (three classes). The combination of a poison pill and a classified (a.k.a. staggered) board has been a very nearly insurmountable takeover defense. 

As this fight goes forward, I will be watching with particular interest the behavior of Netflix's board of directors. As Steven Davidoff has noted:

Reed Hastings, the chief executive of Netflix, has previously stated that he believes a chief executive should run the company without board interference. That is at odds with the view of those who believe companies should be run, or at least heavily supervised, by boards.

As someone who believes firmly in director primacy, I find old-fashioned imperial CEOS like Hastings to be a fundamental perversion of corporate governance. Ultimately, the decision of what happens to Netflix should be made by its independent directors, rather than its CEO or, for that matter, Carl Icahn.

For more on director primacy in takeovers, see Unocal at 20: Director Primacy in Corporate Takeovers:

Abstract: In Unocal Corp. v. Mesa Petroleum Co., the Delaware Supreme Court made clear that the board of directors of a target corporation is not a passive instrumentality in the face of an unsolicited tender offer or other takeover bid. To the contrary, so long as the target board's actions are neither coercive nor preclusive, the target's board remains the defender of the metaphorical medieval corporate bastion and the protector of the corporation's shareholders. 

Unocal is almost universally condemned in the academic corporate law literature. Building on his director primacy model of corporate governance and law, however, Bainbridge offers a defense of Unocal in this article. Bainbridge argues 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.

"Lawyers Extract `Merger Tax' From Shareholders, Study Says"

Daniel Fisher:

The U.S. Chamber’s Institute for Legal Reform today released a study on merger-related litigation that concludes plaintiff lawyers take advantage of the court system to extract tens of millions of dollars a year in fees from companies at the expense of shareholders.

A loophole in the federal law designed to cut down on securities class-action abuses allows lawyers to file suits challenging mergers in multiple state and federal courts, the study found, making it impossible for companies to consolidate the litigation in one place and increasing the odds they’ll pay the lawyers a fee to go away. ...

The study calls the litigation a “merger tax” on corporate transactions, since lawyers now file fraud suits challenging 91% of all mergers of public companies valued at over $100 million. Either there’s been a vast increase in corporate fraud since 2005 — when only 39% of mergers drew lawsuits — or lawyers are filing more meritless suits.  ...

Lawyers file suits accusing companies of fraud sometimes within hours of a merger announcement, hard to square with good-faith efforts to find a client and fully investigate that client’s claims. ...

The New York Bar Association offers another common-sense approach: Let companies contract with their shareholders to restrict litigation to the state of incorporation. That would at least eliminate the tactic of gaming multiple state courts to extract a fee, which of course is paid by the shareholders. Instead most companies would face lawsuits, at most, in Delaware state and federal court. And Delaware judges are increasingly hostile toward hastily filed merger suits.

 

The Trial Lawyers' New Merger Tax

The US Chamber of Commerce has a new report on the growing problem of M&A litigation. With virtually every merger deal triggering a race to the courthouse, the need for reform has become glaringly apparent:

Securities class action lawsuits have long been plagued by abusive practices. But the trial lawyers’ latest litigation tactic—across-the-board unjustified legal attacks on mergers and acquisitions—reaches a new low.

Here’s how it works: Just about every merger or acquisition that involves a public company and is valued over $100 million—91% of all such transactions in 2010 and 2011—becomes the subject of multiple lawsuits within weeks of its announcement. Because the parties to the merger want to close their deal and begin to reap the economic benefits of the combination, the vast majority of these lawsuits settle quickly—within three months—and typically provide little or no benefit for shareholders. But the settlements do award large attorneys’ fees to the lawyers who filed the lawsuits.

This is extortion through litigation, plain and simple. Trial lawyers hold transactions hostage until they collect a “litigation tax,” draining a share of the merger’s economic benefit away from shareholders and into the lawyers’ own pockets. Because this litigation is filed in multiple courts throughout the country—state and federal—judges today cannot stop the abuse. Action by Congress and state legislatures is needed now to prevent trial lawyers from obstructing economically beneficial transactions and diverting hundreds of millions of dollars away from productive uses, injuring the very shareholders they claim to represent. This paper analyzes the remarkable M&A litigation explosion.