In Part I of this essay, I discussed a new article by Bernard Sharfman and Marc Moore, in which they propose reviving the passivity thesis, which argued that target boards faced with a hostile takeover offer should be passive.
In Part II of this essay, I discussed my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] in which I explained why I disagree with the passivity thesis. My analysis grew directly out of my director primacy model of corporate governance. Because I still think a board-centric approach to corporate governance is appropriate, even in the context of a hostile takeover bid, let me summarize my argument here. I encourage you to go read the whole thing, however.
In Part III, I discussed the final and perhaps most important argument for treating negotiated and hostile acquisitions differently with respect to the scope of the target board’s authority, which rests on the conflicted interests inherent in corporate takeovers.
In this Part, I defend Delaware's approach to takeovers against one aspect of Sharfman & Moore's passivity thesis.
In their discussion of the UK system, which adopts a variant of the passivity thesis, and which they support, Sharfman and Moore point out that (at 32):
Notably, the board passivity rule is an effect- rather than intention-based doctrine, which enables the United Kingdom’s non-judicial Takeover Panel to enforce the rule against target directors and other relevant parties in an administratively straightforward manner, unencumbered by the vexing questions of factual inference and fiduciary duty conformance that typically confront U.S. trial and chancery courts.
In contrast, I think Delaware’s motive-based analysis gets it exactly right.
In its takeover jurisprudence, Delaware has balanced the competing claims of authority and accountability by varying the standard of review according to the likelihood that the actions of the board or managers will be tainted by conflicted interests in a particular transactional setting and the likelihood that nonlegal forces can effectively constrain those conflicted interests in that setting. In other words, the Delaware cases suggest that motive is the key issue. As former Delaware Chancellor Allen explained in the closely related context of management buyout transactions: “The court’s own implicit evaluation of the integrity of the . . . process marks that process as deserving respect or condemns it to be ignored.” Assuming that a special committee of independent directors would be appointed to consider the proposed transaction, Allen went on to explain: “When a special committee’s process is perceived as reflecting a good faith, informed attempt to approximate aggressive, arms-length bargaining, it will be accorded substantial importance by the court. When, on the other hand, it appears as artifice, ruse or charade, or when the board unduly limits the committee or when the committee fails to correctly perceive its mission—then one can expect that its decision will be accorded no respect.”[1] Our claim is the same is true with respect to board resistance to unsolicited tender offers. If the conflict of interest inherent in such resistance has matured into actual self-dealing, the court will invalidate the defensive tactics. If the board acted from proper motives, even if mistakenly, however, the court will leave the defenses in place.
Former Delaware supreme court Justice Moore argued, for example, that his court’s “decisions represent a case-by-case analysis of some difficult and compelling problems.”[2] He later elaborated:
We did not approach [takeover] cases with the question of whether to allow the corporation to continue in its present form or to permit someone else to acquire the company. . . . [T]he question before the Court was whether the directors acted properly in accepting or rejecting the competing offers. . . . As long as the directors adhered to their fiduciary duties, it would have been most inappropriate for any court to intrude upon a board’s business decision. No court has a role in disciplining directors for the proper exercise of business judgment, even if it turns out to be wrong.[3]
Former Delaware Chancellor Allen made much the same point in RJR Nabisco, where he indicated that the basic question is whether the board acted with due care and in good faith:
Surely the board may not use its power to exercise judgment in [an auction of control] as a sham or pretext to prefer one bidder for inappropriate reasons. . . . But the board of directors continues, in the auction setting as in others, to bear the burden imposed and exercise the power conferred by Section 141(a). Assuming it does exercise a business judgment, in good faith and advisedly, concerning the management of the auction process, it has, in my opinion, satisfied its duty.[4]
A federal court similarly described the Unocal standard as asking “whether a fully informed, wholly disinterested, reasonably courageous director would dissent from the board’s act in any material part.”[5]Motive is the consistent theme throughout these summations of Delaware law.
In light of Sharfman and Moore’s description of Delaware law as not being administratively straightforward and being encumbered by vexing questions, they presumably would agree with those who argue that the difficulty of distinguishing between proper and improper motives is so great in this context that courts should simply eschew a motive-based analysis.
Granted, motive analysis is always difficult, but in every other conflicted interest context the board’s authority to act depends upon the validity of the directors’ motives.[6] Unless we are to accept the passivity model and strip the board of decision-making authority in the takeover context, a motive-based inquiry is inescapable.[7]
The Delaware Supreme Court’s leading decision in Paramount Communications Inc. v. QVC Network Inc.,[8]explained that the enhanced scrutiny test Delaware courts use to review takeover defenses is basically a reasonableness inquiry to be applied on a case-by-case basis: “The key features of an enhanced scrutiny test are: (a) a judicial determination regarding the adequacy of the decision-making process employed by the directors, including the information on which the directors based their decision; and (b) a judicial examination of the reasonableness of the directors’ action in light of the circumstances then existing.” The burden of proof is on the directors with respect to both issues. They need not prove that they made the right decision, but merely that their decision fell within the range of reasonableness.
The new reasonableness standard is a logical culmination of our argument that motive is what counts. While a cynic might argue that it is merely a way of justifying a particular result, the reasonableness test in fact is well-calibrated to preventing improper motives from skewing the competition for control. Notice that the reasonableness test parallels the definition of fairness used in the former Revised Model Business Corporation Act provisions governing interested director transactions, namely, whether the transaction in question falls “within the range that might have been entered into an arms-length by disinterested persons.”[9] Both standards seem designed to ferret out board actions motivated by conflicted interests by contrasting the decision at hand to some objective standard. The implicit assumption is that a reasonable decision is unlikely to be motivated by conflicted interest or, at least, that improper motives are irrelevant so long as the resulting decision falls within a range of reasonable outcomes. The operating norm seems to be “no harm, no foul,” which seems sensible enough.
QVC, moreover, strongly indicated that a court should not second-guess a board decision that falls within the range of reasonableness, “even though it might have decided otherwise or subsequent events may have cast doubt on the board’s determination.” In Interco, Chancellor Allen had warned that “Delaware courts have employed the Unocal precedent cautiously. . . . The danger that it poses is, of course, that courts—in exercising some element of substantive judgment—will too readily seek to assert the primacy of their own view on a question upon which reasonable, completely disinterested minds might differ.”[10] QVC made clear that, so long as the board’s conduct falls within the bounds of reasonableness, Delaware courts will not second-guess the board’s decisions.
If that point was insufficiently clear after QVC, it was driven home in unmistakable terms by the Delaware supreme court’s subsequent decision in Unitrin v. American General Corp., in which the court approved an everything but the kitchen sink array of defensive tactics.[11] Unitrin’s board adopted a poison pill, amended the bylaws to add some shark repellent features, and initiated a defensive stock repurchase. The chancery court found the latter “unnecessary” in light of the poison pill. The supreme court reversed. The court deemed “draconian” defenses—those which are “coercive or preclusive”—to be invalid. (Note the parallel to our discussion of the post-Time status of the just say no defense.) Defenses that are not preclusive or coercive are to be reviewed under QVC’s “range of reasonableness” standard. On the facts before it, the court concluded that the shareholders were not foreclosed from receiving a control premium in the future and that a change of control was still possible. Accordingly, the defensive tactics were neither coercive nor preclusive. More important, the supreme court held that the chancery court had “erred by substituting its judgment” for that of the board. The court explained:
The ratio decidendi for the “range of reasonableness” standard is a need of the board of directors for latitude in discharging its fiduciary duties to the corporation and its shareholders when defending against perceived threats. The concomitant requirement is for judicial restraint. Consequently, if the board of directors’ defensive response is not draconian (preclusive or coercive) and is within a “range of reasonableness,” a court must not substitute its judgment for the board’s.
Note, once again, how the balance tips towards authority values even in a context charged with conflicts of interest. Given the significant conflicts of interest posed by takeovers, courts recognize the need for some review. But the Delaware courts also seemingly recognize that their power of review easily could become the power to decide. To avoid that unhappy result, they are exercising appropriate caution in applying the range of reasonableness standard.
In sum, the search for conflicted interests reflects the Delaware courts’ solution to the irreconcilable tension between authority and accountability. Concern for accountability drives the courts’ expectation that the board will function as a separate institution independent from and superior to the firm’s managers. The court will inquire closely into the role actually played by the board, especially the outside directors, the extent to which they were supplied with all relevant information and independent advisors, and the extent to which they were insulated from management influence. Only if the directors had the ultimate decisionmaking authority, rather than incumbent management, will the board’s conduct pass muster. But if it does, respect for authority values will require the court to defer to the board’s substantive decisions. The board has legitimate authority in the takeover context, just as it has in proxy contests and a host of other decisions that nominally appear to belong to the shareholders. Nor can the board’s authority be restricted in this context without impinging on the board’s authority elsewhere. Authority thus cannot be avoided anymore than can accountability; the task is to come up with a reasonable balance. Properly interpreted, that is precisely what the Delaware cases have done.
Reminder: If you want much more detail, be sure to check out my article Unocal at 20: Director Primacy in Corporate Takeovers, 31 DEL. J. CORP. L. 769 (2006), on which the posts have drawn.
[1] William T. Allen, Independent Directors in MBO Transactions: Are They Fact or Fantasy?, 45 Bus. Law. 2055, 2060 (1990); see generally Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 517-24 (1992) (discussing the significance of board motives in Delaware’s takeover jurisprudence).
[2] Andrew G.T. Moore, II, State Competition: Panel Response, 8 Cardozo L. Rev. 779, 782 (1987).
[3] Andrew G.T. Moore, II, The 1980s—Did We Save the Stockholders While the Corporation Burned?, 70 Wash. U.L.Q. 277, 287-89 (1992).
[4] In re RJR Nabisco, Inc. Shareholders Litigation, [1988-89 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 94,194 at 91,715 (Del. Ch. 1989).
[5] Southdown, Inc. v. Moore McCormack Resources, Inc., 686 F. Supp. 595, 602 (S.D. Tex. 1988).
[6] Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 518 (1992).
[7] In multiple bidder settings, moreover, the board’s conduct in overseeing the competition between the management-sponsored alternative and the hostile bid provides more-or-less objective insights into the board’s motives. As the Eleventh Circuit has noted:
All auctions must end sometime, and lock-ups by definition must discourage other bidders. The question therefore is not whether the asset lock-up granted to [the favored bidder] effectively ended the bidding process. The question is whether [the target] conducted a fair auction, and whether [the favored bidder] made the best of-fer.
Cottle v. Storer Communication, Inc., 849 F.2d 570, 576 (11th Cir. 1988) (citations omitted). If those questions can be answered in the affirmative, we have more or less objective evidence that the board acted from proper motives even though their actions effectively precluded anyone other than the favored bidder from acquiring the company. The use of a lock-up or other defensive tactics to foreclose shareholder choice in such situations thus no longer raises a presumption of self-interest. The superiority of the prevailing proposal will have been demonstrated by the competitive process.
[8] 637 A.2d 34, 46-48 (Del. 1994).
[9] Rev. Model Bus. Corp. Act § 8.31 cmt. 4 (1984).
[10] City Capital Assoc. L.P. v. Interco, Inc., 551 A.2d 787, 796 (Del. Ch. 1988).
[11] Unitrin, Inc. v. American General Corp., 651 A.2d 1361 (Del.1995).
