ProfessorBainbridge.com

Back to the Future: Warner and Paramount Come Full Circle

Back in the 1980s, Time Inc. was principally a print publishing company. It's lineup included such stalwarts as Time, People, Sports Illustrated, and so on. Along the way, however, Time had picked up cable network HBO. Video entertainment was anticipated to play an increasing role in Time's future, which meant HBO and its other video enterprises need a constant flow of new content. 

Time management developed a strategic plan, which the board adopted, to grow the video side of the business by combining with a major motion picture studio. After searching for acquisitions that would advance that plan, Time’s board of directors eventually approved a merger with Warner Communications. The deal was billed as a merger of equals, although the former Warner shareholders would receive newly issued shares representing approximately 62 percent of the shares of the combined Time-Warner entity. 

By the way, the negotiations between Time and Warner were a claassic clash of massive Wall Street and Hollywood egos. Which company got its name first in the new title? Which firm's CEO could become CEO of the combined company? Who was the acquirer and who the target, a question that became even more fraught whenParamount entered the picture. All of which is chronicled by Connie Bruck in Master of the Game: Steve Ross and the Creation of Time Warner.

As I describe in my book, Mergers and Acquisitions:

Shortly before Time’ shareholders were to vote on the merger agreement,[1] Paramount made a cash tender offer for Time. Time’s board rejected the offer as inadequate, without entering into negotiations with Paramount. To forestall Paramount, the Time and Warner boards then agreed to a new structure for the transaction, under which Time would make a cash tender offer for a majority block of Warner shares to be followed by a merger in which remaining Warner shares would be acquired, thus obviating the need for shareholder approval. The new plan required Time to incur between 7 and 10 billion dollars in additional debt. Finally, and perhaps most damningly from the perspective of a Time shareholder, it foreclosed the possibility of a sale to Paramount. If the new plan succeeded, Time’s shareholders therefore would end up as minority shareholders in a company saddled with substantial debt and whose stock price almost certainly would be lower in the short run than the Paramount offer.

[1]      The plan of merger called for Warner to be merged into a Time subsidiary in exchange for Time common stock. Although Time was not formally a party to the merger and approval by its shareholders therefore was not required under Delaware law, New York Stock Exchange rules required a vote of Time shareholders because of the number of shares to be issued.

Paramount faced the obverse of Time's strategic problem. Time had a conduit for delivering video entertainment directly to consumers in their homes but insufficient content. Paramount had lots of content but no conduit for delivering it to consumer homes. So Paramount prized Time for HBO. But Paramount had no interest in Warner; indeed, Paramount would be unable to raise financing to buy the combined Time Warner entity even if it had wished to do so.  Paramount thus needed to stop the Time-Warner merger. On the other hand, as the Delaware Supreme Court later explained, Time’s revisions to the Warner deal was motivated by a desire to advance legitimate corporate interests. The revised plan had not been cobbled together simply to justify takeover defenses, but was only intended to carry forward “a preexisting transaction in an altered form.” As a result, Paramount was essentially asking the court to enjoin Time’s board from continuing to operate the corporation’s business and affairs during the pendency of the takeover bid. The Delaware courts were properly reluctant to do so, as a hostile bidder has no right to expect the incumbent board of directors to stop an ongoing business strategy in mid-stream. Accordingly, in a landmark decision I still teach in M&A 30+ years later, the Delaware Supreme Court allowed Time to go forward with the revised acquisition.

Time shareholders probably would have preferred the Paramount deal. Paramount ultimately offered $200 per share in cash. Time's board claimed that the Warner deal would eventually result in a combined entity whose stock would trade in "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." Paramount Commun. Inc. v. Time Inc., 1989 WL 79880, at *13 (Del. Ch. July 14, 1989), aff'd, 565 A.2d 281 (Del. 1989).

None of those predictions panned out. To the contrary, a 2003 WSJ article observed that:

[Time's] shareholders didn't fare so well, particularly with the double whammy of the AOL combination. If you were a shareholder of Time back in 1989 and held your shares through various splits over the years, they would now be worth $113.76 each, about where they were trading more than 14 years ago and far below the Paramount offer. Meanwhile, if you'd just bought the stocks in the S&P 500 index, you would have almost tripled your money.

In 2021, I calculated that if you had taken the Paramount deal in 1989 and invested the $200 per share in the S&P 500, you'd have had $5,182.69 in 2021.

Of course, as that WSJ article reminds us, Time-Warner later went on to be acquired by AOL in a disastrous deal chronicled by Alec Klein in Stealing Time: Steve Case, Jerry Levin, and the Collapse of AOL Time Warner. At the time, AOL's stock price was hugely inflated by the doc-com bubble. The then-management and board of Time Warner thus agreed to a stock for stock deal, which went through mere months before the dot-com bubble burst. AOL Time Warner stock fell by pover two-thirds in the wake of the burst bubble. Over the next decade, trying to repair the damage required management to divest "the Time Warner Book Group, Warner Music Group, Time Warner Cable, and AOL." 

The WSJ provided a simplified map of the complex series of deals that created today's Warner-Discovery entity:

All of which brings us up to this week. Despite decades of unwise deals, Warner is back in the news because it's thinking about coming full circle:

The Wall Street Journal and other media outlets reported late Wednesday that Warner Chief Executive David Zaslav met with Paramount CEO Bob Bakish earlier this week to discuss a possible deal. 

Would this deal turn out any better than the ones that preceded it? The WSJ suggests caution:

Combining the owners of the Max and Paramount Plus streaming services also makes a certain amount of sense in a world where every streamer not named Netflix is losing money or owned by a tech giant (Amazon and Apple) that can stomach the losses. Warner and Paramount combined have about 158 million subscribers, which exceeds those of Disney’s core streaming services and would come second only to the 247 million subscribers Netflix currently boasts. 

But such a combination would bring together two companies under a mountain of debt—$61 billion combined as of the end of the third quarter. Meanwhile, the benefits from combining the scale and reach of two media titans would also likely draw the ire of regulators. 

One wonders whether an alternative deal structure, such as a joint venture between Warner's Max and Paramount's Paramount+ streaming services would not make more sense. 

In any case, this is a fitting Hollywood twist to a long running story, as Warner is now trying to woo the suitor it spurned 3 decades ago.

What is the "Impact of the Duty to Maximize Short-Term Value in Mergers and Acquisitions"?

My friend and UCLAW colleague Fernan Restrepo has a new paper asking and answering the titular question:

For nearly four decades, Revlon v. MacAndrews and Forbes has required the boards of target companies in change-of-control transactions to maximize immediate shareholder value – that is, to expose the firm to a market canvass before closing any transaction and refrain from favoring one bidder over another for reasons unrelated to short-term value. Although Revlon is certainly one of the most famous and controversial decisions in the history of corporate law, it remains unclear whether the case had any effect on shareholder welfare. This paper examines that question. The results show that, in fact, the returns of the target shareholders in Revlon deals increased significantly after Revlon – not only in absolute terms, but also in relation to transactions not subject to the decision. From a policy perspective, this finding suggests that if courts continue to limit the scope of the Revlon doctrine (as they have in recent cases), there might be a point after which that trend will harm the welfare of the target shareholders.

Restrepo, Fernan, The Impact of the Duty to Maximize Short-Term Value in Mergers and Acquisitions: An Analysis of Revlon (November 8, 2023). Available at SSRN: https://ssrn.com/abstract=4626391 or http://dx.doi.org/10.2139/ssrn.4626391

Recommended reading.

As Delaware contemplates the Match.com case, the court should acknowledge that not all controlling shareholder transactions should require cleansing.

Bloomberg reports:

Delaware’s top court is weighing a potentially groundbreaking ruling that could streamline corporate dealmaking while scaling back protections for minority investors in many transactions that favor insiders.

A case involving dating site Match.com is giving the leading US forum for M&A disputes a chance to reaffirm or rein in enhanced scrutiny of deals involving a potential conflict of interest between a company and its controlling stockholder. ...

The legal framework getting a hard look from the Delaware’s high court is known as the “MFW” doctrine. Named after the court’s seminal 2014 ruling in Kahn v. M&F Worldwide Corp. , it was developed for “squeeze-out” or “freeze-out” transactions that forcibly cash out investors at a price unilaterally set by a controlling stockholder.

But judges on Delaware’s Chancery Court are now applying the standard to a wider range of deals. 

Bloomberg further explains that:

The legal standard facing an unexpected challenge requires corporate leaders to defend a transaction as “entirely fair” unless the board sets up an independent special committee and seeks “majority of the minority” approval from unaffiliated investors, onerous steps that can derail a deal.

IAC is asking the state high court to reject that “belt and suspenders” approach and instead require only one or the other. 

But IAC didn't go far enough. Independent board committees and votes of the disinterested shareholders are what we call cleansing devices. They supposedly "cleanse" the conflicting shareholders' conflict of interest in transactions with the company.

My own view is that not all controlling shareholder transactions need cleansing. I start with the Delaware Supreme Court's decision in Sinclair Oil. v. Levien, 280 A.2d (Del. 1971). Under Sinclair Oil, as I explain in my book Corporate Law (Concepts and Insights):

The Delaware supreme court identified two standards potentially applicable in such situations: the business judgment rule and the intrinsic fairness rule. Under the business judgment rule, the directors of Sinven get the benefit of a rebuttable presumption of good faith. Under the intrinsic fairness test, the burden of proof is on the directors to show, subject to close scrutiny, that the transactions were objectively fair to Sinven. In this case, as in most, it mattered quite a lot which standard applied. As is often the case, the party bearing the burden of proof on a given dispute lost.

Under Sinclair Oil, a court will apply the intrinsic fairness standard, as opposed to the business judgment rule, when the parent has received a benefit “to the exclusion and at the expense of the subsidiary.” In other words, the fiduciary obligations owed by a parent corporation are limited to self-dealing. The more exacting intrinsic fairness standard comes into play only when the parent is on both sides of the transaction and, moreover, used its position to extract non-pro rata benefits from a transaction to the minority shareholders’ detriment. (Page 210)

Accordingly, the initial question is whether the controlling shareholder “has received a benefit to the exclusion and at the expense of the subsidiary.” Only if that is the case does thee transaction require cleansing. Controlling shareholder transactions that do not involve such a benefit are reviewed under the business judgment rule without the need for cleansing by an independent board committee of disinterested shareholder vote.   (To be sure, Sinclair Oil involved a parent-subsidiary relationship, but the parent by definition is a controlling shareholder and the principles are the same.)

The fact that the controlling shareholder is a party to the transaction is not enough to trigger ckeansing. The controlling shareholder must have gotten a benefit that is both at the expense of and to the exclusion of the minority shareholders.

This is made clear by the court’s treatment of the minority’s objection to the subsidiary’s dividend policy. Sinven (the subsidiary) had adopted at Sinclair Oil’s behest a policy of paying out the maximum lawful dividend. This benefited Sinclair Oil but did not constitute self-dealing by Sinclair Oil because Sinclair received nothing from Sinven to the exclusion of its minority stockholders.” Id. at 772.

Moreover, the need for cleansing is not triggered even if the controlling shareholder get a benefit or even if that the benefit is not shared. The controlling shareholder must get a benefit not only that excludes the minority but comes at their expense. This is made clear by the court’s treatment of the minority’s complaint that Sinclair Oil had denied Sinven opportunities to develop oil properties outside of Venezuela. “From 1960 to 1966 Sinclair purchased or developed oil fields in Alaska, Canada, Paraguay, and other places around the world. The plaintiff contends that these were all opportunities which could have been taken by Sinven.” Id. But the court rejected that claim: “Sinclair usurped no business opportunity belonging to Sinven. Since Sinclair received nothing from Sinven to the exclusion of and detriment to Sinven's minority stockholders, there was no self-dealing.” Id. Again, you must have both exclusion AND detriment.

I will grant you that some recent Chancery Court cases appear to assume that any “interested” transaction involving a controller is subject to intrinsic fairness analysis (unless cleansed as per below). But that is not the law, at least in Delaware. Under Sinclair Oil, there are two standards of review. If the plaintiff can carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then entire fairness is the standard. But if the plaintiff cannot, the business judgment rule is the standard of review. The requirement that the controller receive a benefit “to the exclusion and at the expense of the" minority is essential because it ensures that courts will only get involved where there is a real conflict in the sense of a detriment to the minority, not just a benefit to the controller.

The rule thus is not: Controlling shareholder > was controlling shareholder connected to transaction > fairness unless cleansing.

The rule is: Controlling shareholder > did controlling shareholder benefited at the expense of and to the exclusion of minority shareholders > if yes, fairness unless cleansed; if no, business judgment rule.

In other words, If the plaintiff can't carry the burden of proof of showing that the controlling shareholder benefited itself at the expense and exclusion of the minority, then no cleansing--whether ordinary Kahn v. Lynch or MFW--is required.

As been ably said by a court otherwise quite protective of minority shareholder rights, “The majority . . . have certain rights to what has been termed ‘selfish ownership’ in the corporation which should be balanced against the concept of their fiduciary obligation to the minority.” Wilkes v. Springside Nursing Home, Inc., 353 N.E.2d 657, 663 (Mass. 1976). This seems to be the principle animating Sinclair Oil, which allows some controlling shareholder transactions the protection of the business judgment rule even without the sort of cleansing envisioned by either Kahn v. Lynch or MFW.

In Corporate Law (Concepts and Insights) I go on to explain that you can understand many controlling shareholder doctrines through the Sinclair Oil lens. I argue for example, that sale of control cases like Perlman v. Feldmann can be understood as an application of Sinclair Oil:

Perlman does not stand for the proposition that a controlling shareholder must give all other shareholders an equal opportunity to sell their stock on a pro rata basis. Instead, it simply stands for the proposition that a controlling shareholder may not usurp an opportunity that should be available to all shareholders. One could have reached the very same result under a Sinclair Oil-style analysis. The controlling shareholder received a benefit “to the exclusion and at the expense” of the minority. Not only were the minority excluded from the opportunity to sell at a premium, they were left worse off as a result.

Beyond Perlman’s unique facts, where are corporate opportunity issues most likely to arise? Probably in connection with structuring of acquisitions. Suppose Lorraine Looter approaches Susan Stockholder with an offer to buy Stockholder’s control block at a premium. Should there be liability? Not if we adopt the Sinclair Oil analogy. The majority shareholder can do whatever she wants as long as she does not deprive the minority shareholders of something to which they are entitled. On these facts, there is no corporate opportunity to be usurped. (Pages 218-19)

To be sure, the Sinclair Oil approach does not explain the law in freeze-out mergers. As a policy matter, I think that it makes sense to go immediately into an entire fairness review--and thus to require cleansing--in this context. tThe potential conflict of interest is especially pronounced in this context. After all, “a merger in which it is bought out is the most important event that can occur in a small corporation's life, to wit, its death . . ..” SEC v. Geon Industries, Inc., 531 F.2d 39, 47 (1976). In a freeze out merger, the transaction takes on even greater significance than in the ordinary case because the controlling shareholder is buying the company and thus has a strong incentive to minimize the price at the expense of the minority. Freeze out mergers thus have long been the subject of especially close review.

Complying with M&A ordinary course of business covenants in times of global disasters

As I explain in my guide, Mergers & Acquisitions, merger agreements usually include an ordinary course of business covenant:

Covenants are a series of promises about how the parties will behave during the interim (usually two to four months) between the time the agreement is signed and the closing. A key covenant is that governing the target’s conduct of the business during the pendency of the merger agreement. Usually, the target is prohibited from doing anything other than engaging in ordinary course transactions that are consistent with past practice. Typically, certain major acts will be expressly forbidden, such as changes to the articles or by-laws, dividends, stock repurchases, and the like. Conversely, a target friendly version will allow various deviations from past practice, such as those that are immaterial or would not constitute a MAC.

As I also explain:

The COVID-19 pandemic strained ordinary course covenants to their limits. In AB Stable VIII LLC v. MAPS Hotels and Resorts One LLC, for example, the Chancery Court reportedly observed that:

The real question is whether an ordinary course covenant means ordinary course on a clear day or ordinary course based on the hand you’re dealt. In other words, if you have flooding, is it the ordinary course of what you do consistent with past practice when you are in a flood, or is it ordinary course on a clear day when there hasn’t been any rain? Here, we obviously have a colossal and viral-based rainstorm.

The court opted the clear day rule, holding that “when faced with an extraordinary event,” the target’s management may not “take extraordinary actions and claim that they are ordinary under the circumstances.” Not surprisingly, in the immediate aftermath, ordinary course covenants increasingly included a pandemic exception allowing the target to take such actions as are reasonably necessary in response to such an event.

All of which leads me to Kevin Bishop's post Nevada Supreme Court Holds That Temporary Closing During Pandemic Did Not Violate This "Ordinary Course" Covenant:

When Lucky Lucy D, LLC agreed to sell its hotel and casino to LGS Casino LLC in 2019, the parties included a covenant pursuant to which Lucky Lucy agreed to maintain the property and conduct related business "in a manner generally consistent with the manner in which [Lucky Lucy] has operated and maintained the [p]roperty and [a]ssets prior to the date hereof."    COVID-19 arrived before the sale was consummated and Lucky Lucy temporarily closed the casino and laid off employees in response to gubernatorial directive ordering the closure of non-essential businesses.   The buyer then sent a notice of breach, which Lucky Lucy was unable to cure in light of the Governor's emergency directive.  Needless to say, litigation ensued.

... The Nevada Supreme Court ... held that "[i]n closing the casino and hotel pursuant to the emergency directive, the seller was merely following the law so as to maintain its gaming licenses and thus did not materially breach the agreement".  Lucky Lucy D LLC v. LGS Casino LLC, 139 Nev. Adv. 26 (2023).

Oddly, as Bishop explains, the court thought the result might have been different if the provision had not included the word "generally." It's another valuable lesson in the point that words do work and the transaction planner must carefully consider the meaning of every word, even those that seem generally mundane.

How does one apply the medium form merger rule under DGCL 252(h) when there are multiple classes of stock

I got an email from a student that posed an interesting question: 

According to the DGCL 251(h): no vote of stockholders of a constituent corporation that has a class or series of stock that is listed on a national securities exchange or held of record by more than 2,000 holders immediately prior to the execution of the agreement of merger by such constituent corporation shall be necessary to authorize a merger if: ... (3)  Immediately following the consummation of the offer referred to in paragraph (h)(2) of this section, the stock irrevocably accepted for purchase or exchange pursuant to such offer and received by the depository prior to expiration of such offer, together with the stock otherwise owned by the consummating corporation or its affiliates and any rollover stock, equals at least such percentage of the shares of stock of such constituent corporation, and of each class or series thereof, that, absent this subsection, would be required to adopt the agreement of merger by this chapter and by the certificate of incorporation of such constituent corporation;

My question is if there is Class A, B, C voting stock, would this mean that the buyer would have to acquire the outstanding % of all three classes of voting stock? I would presume that the same rule would apply to a company that had common stock and preferred stock. Am I interpreting this part of the statute correctly?

Two points:  Section 251(h) applies to a target corporation with any class or series of stock that is listed on a national securities exchange or held of record by more than 2,000 stockholders.  In other words, not all classes or series of stock of the target corporation need to be listed on such exchange. 

Subsection (3) of Section 251(h) requires that subsequent to the close of the tender or exchange offer, the acquirer must own enough target stock as would be necessary to adopt the merger agreement, both under the terms of the Delaware General Corporation Law and the target’s certificate of incorporation, such that the acquirer could complete the merger, even if Section 251(h) was inapplicable.

The first question thus is what classes are eligible to vote. The articles of incorporation will tell you what voting rights each class of stock has. See Mariner LDC v. Stone Container Corp., 729 A.2d 267 (Del. Ch. 1998) (charter amendment giving non-voting preferred stock voting rights subsequent to merger did not confer right to vote on merger or right to vote on the non-adverse charter amendment itself).

The second question is whether the shareholders will vote as a single class or whether each class will vote separately. The default rule is that all shares of all classes vote as a single group unless the articles of incorporation provide to the contrary. This is implicitly confirmed by Section 251(c), which states that a merger must be approved by “a majority of the outstanding stock of the corporation entitled to vote thereon.”

So let’s say there is Class A common with 1 million shares outstanding and Class B common with 100,000 shares outstanding. Assuming both have 1 vote per share, you’d need to get a total of 550,001 shares in the first step tender offer. Any combination of A and B should work.

But what if the Class B has 10 votes per share. DGCL 212(a) provides that “If the certificate of incorporation provides for more or less than 1 vote for any share, on any matter, every reference in this chapter to a majority or other proportion of stock, voting stock or shares shall refer to such majority or other proportion of the votes of such stock, voting stock or shares.” Accordingly, the outstanding shares would have 2 million votes and you’d need some number of Class A and Class B shares totalling 1,000,001 votes.

In some cases, however, DGCL 242 may kick into play. It provides a for a class vote when an amendment to the articles would adversely affect the rights of that class. Compare Elliott Associates, L.P. v. Avatex Corp., 715 A.2d 843 (Del. 1998) (merger operated to repeal rights of preferred granted in the articles; vote by preferred required) with Warner Communications Inc. v. Chris-Craft Industries, Inc., 583 A.2d 962 (Del. Ch. 1989), order aff'd, 567 A.2d 419 (Del. 1989) (no class vote of preferred required in connection with merger where preferred was merely converted into common).

Delaware Merges Blasius and Unocal: Commentary on Coster v. UIP Cos., Inc.

In Coster v. UOP Cos., Inc., the Delaware Supreme Court finally addressed the longstanding debate over the validity of the Blasius doctrine. (The following is based in part on the discussion of Blasius and Unocal in my books Mergers and Acquisitions (Concepts and Insights) and Corporate Law (Concepts and Insights).)

In Unocal v. Mesa Petroleum,[1] the Delaware Supreme Court laid out what has been called an “intermediate” or “enhanced business judgment” standard of judicial review, but is perhaps best described as a “conditional business judgment rule,”[2] to govern target board of director actions taken in. response to an unsolicited takeover offer. In Unocal, the Delaware Supreme Court reaffirmed the target’s board general decision-making primacy, which includes an obligation to determine whether the offer is in the best interests of the shareholders. In light of the board’s potential conflict of interest vis-à-vis the shareholders, however, judicial review was to be somewhat more intrusive than under the traditional business judgment rule: “Because of the omnipresent specter that a board may be acting primarily in its own interests, rather than those of the corporation and its shareholders, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred.”

The initial burden of proof is on the directors, who must first show that they had reasonable grounds for believing that a danger to corporate policy or effectiveness existed. The directors satisfy this burden by showing good faith and reasonable investigation. The good faith element requires a showing that the directors acted in response to a perceived threat to the corporation and not for the purpose of entrenching themselves in office. The reasonable investigation element requires a demonstration that the board was adequately informed, with the relevant standard being one of gross negligence.[3] Assuming the directors carry their initial burden, they next must prove that the defense was reasonable in relationship to the threat posed by the hostile bid.

Because unsolicited takeover bids often end up involving a shareholder vote, such as when the acquirer conducts a proxy contest to elect a new board of directors for the target in hopes that the new board will remove any takeover defenses that may be impeding the offer, there long was a question about how Unocal applied when the target board’s actions allegedly disenfranchised target shareholders.

The problem was that in that context Unocal bumped up into another line of cases arising out of Blasius Industries, Inc. v. Atlas Corp.[4] In Blasius, the Delaware Chancery Court held that where the board of directors takes actions for the “primary purpose” of interfering with the free exercise of the shareholder franchise, the board must demonstrate that it had a “compelling justification” for doing so. Taken by itself, Blasius proved to be “an unworkable standard of review, as once a court triggers Blasius, it would seem impossible for the directors to provide a compelling justification for disenfranchising their shareholders.”[5]

When a board action affecting the shareholder franchise takes place in other contexts, such as a simultaneous tender offer and proxy contest, Unocal provide the basic standard of review for the board’s actions. In applying Unocal’s proportionality prong, however, the courts treated board action that purposefully disenfranchises the shareholders as “strongly suspect.”[6] Attempting to merge the two created an even more untenable standard.

I have never been a fan of Blasius.[7] (See my post Professor Lipton asks "What about Blasius?" Well, what about it?) So I pleased to learn that the Delaware Supreme Court has finally more or less killed off Blasius by essentially merging it into Unocal. See Coster v. UIP Cos. Inc.

I’m going to skip over the facts and the case’s convoluted procedural history, as Ann Lipton has a great post on the Chancery Court opinion and an excellent post on the Supreme Court decision.

The key passage is at 31-32:

First, the court should review whether the board faced a threat “to an important corporate interest or to the achievement of a significant corporate benefit.” The threat must be real and not pretextual, and the board’s motivations must be proper and not selfish or disloyal. As Chancellor Allen stated long ago, the threat cannot be justified on the grounds that the board knows what is in the best interests of the stockholders.

Second, the court should review whether the board’s response to the threat was reasonable in relation to the threat posed and was not preclusive or coercive to the stockholder franchise. To guard against unwarranted interference with corporate elections or stockholder votes in contests for corporate control, a board that is properly motivated and has identified a legitimate threat must tailor its response to only what is necessary to counter the threat. The board’s response to the threat cannot deprive the stockholders of a vote or coerce the stockholders to vote a particular way.

Critics of Unocal have long complained that it is an essentially toothless standard.[8] Assuming arguendo that they are correct, does this mean that judicial review of shareholder disenfranchisement will now be reviewed with a lenient eye?

There are suggestions in the opinion that Unocal is to be applied contextually. See Coster at 31 (stating that “the court’s review is situationally specific and is independent of other standards of review”). There are also suggestions that, as applied to shareholder disenfranchisement, the standard may not be Unocal but rather what might be called Unocal+. See Coster at 31 (“Unocal can also be applied with the sensitivity Blasius review brings to protect the fundamental interests at stake – the free exercise of the stockholder vote as an essential element of corporate democracy.”); id. at 33 (“Applying Unocal review in this case with sensitivity to the stockholder franchise is no stretch for our law.”). In other words, it is at least possible that Unocal will be applied in this context with a more skeptical eye than it is in other situations.[9]

There are also suggestions that the new Unocal/Blasius standard and the sensitivity it supposedly demands will be more limited in scope than early Blasius decisions suggested. Some 15 years ago, a New York court suggested that Blasius is now limited to proxy contests involving director elections:

Blasius has been largely limited to disputes over the election of directors. Accordingly, “courts will apply the exacting Blasius standard sparingly, and only in circumstances in which self-interested or faithless fiduciaries act to deprive stockholders of a full and fair opportunity to participate in the matter.” Of particular significance here, “the reasoning of Blasius is far less powerful when the matter up for consideration has little or no bearing on whether the directors will continue in office.”[10]

There are a few passages in the Supreme Court decision suggesting that the new standard is in fact limited to proxy contests over the election of directors and similar situations:

• Describing the standard as calling for “enhanced judicial scrutiny of board action that interferes with a corporate election or a stockholder’s voting rights in contests for control.” Coster at 30.
• “When a stockholder challenges board action that interferes with the election of directors or a stockholder vote in a contest for corporate control, the board bears the burden of proof.” at 31.
• Noting the need “[t]o guard against unwarranted interference with corporate elections or stockholder votes in contests for corporate control . . ..” at 32.

The key question here is whether by “corporate elections” the court meant all proxy contests or only proxy contests involving election of directors. If Unocal/Blasius is in fact now so limited, it will have important implications for cases like the current litigation involving the AMC APES shares, in which the AMC board allegedly interfered with the shareholder vote but not in the context of a proxy contest for electing directors. If so, is the standard of review now applicable to such matters the business judgment rule?

Finally, on a personal note, let me vigorously object to the Supreme Court’s claim that there are “fundamental interests at stake”; i.e., “the free exercise of the stockholder vote as an essential element of corporate democracy.” As regular readers know, much of my scholarly output over the last several decades has been devoted to the proposition that corporations are not democracies.[11] And I am not alone in saying that corporations are not democracies.[12]

Foundation announces the second edition of Bainbridge & Anabtawi's Mergers & Acquisitions casebook

Here is the book's homepage.

Twitter Pushed Stakeholders Under the Bus: Just as my new book would have predicted

Lucian Bebchuk et al.:

We just posted on SSRN a new discussion paper, How Twitter Pushed Stakeholders under the Bus.(An earlier post noting our work on this project and our take on the subject is available here.)

This paper provides a case study of the acquisition of Twitter by Elon Musk. Our analysis indicates that when negotiating the sale of their company to Musk, Twitter’s leaders chose to disregard the interests of the company’s stakeholders and to focus exclusively on the interests of shareholders and the corporate leaders themselves. In particular, Twitter’s corporate leaders elected to push under the bus the interests of company employees, as well as the mission statements and core values to which Twitter had pledged allegiance for years.

Our analysis supports the view that the stakeholder rhetoric of corporate leaders, including in corporate mission and purpose statements, is mostly for show and is not matched by their actual decisions and conduct (Bebchuk and Tallarita (2020)). Our findings also suggest that corporate leaders selling their company should not be relied upon to safeguard the interests of stakeholders, contrary to the predictions of the implicit promises and team production theories of Coffee (1986), Shleifer-Summers(1988) and Blair-Stout (1999).

A basic point of my new book is that ESG is a means to an end and not an end in and of itself. Twitter is just the latest example.

;

Insider Trading and Corporate Takeovers: A ProfessorBainbridge.com Video

Insider trading is often said to be the most common violation of the federal securities laws. Insider trading based on information relating to corporate mergers, tender offers, and other acquisitions is a common and potentially very lucrative variant. This video reviews the basic theories of insider trading liability under Rules 10b-5 and 14e-3 as applied to takeovers.

Management Buyouts: A ProfessorBainbridge.com Video

A management buyout (MBO) occurs when a public company's management team purchases the company from its shareholders. The substance of the transaction typically is a leveraged buyout. The form can be either a merger between the company and an acquisition corporate shell set up by the management group or a two-step acquisition in which management first makes a tender offer and then freezes out any remaining shareholders with a merger. Management often will seek a private equity fund to serve as a financial partner.

The transaction can produce significant gains, but it also poses a serious conflict of interest. Managers are simultaneously acting as agents of the shareholders and as buyers. In effect, they are on both sides of the deal. In addition, because management typically will have private information, some regard MBOs as simply a very large insider trading transaction.

This video explains how MBOs work and provides an overview of judicial review.

"The Rise of Anti-Activist Poison Pills"

Very interesting new paper:

We create a novel dataset of the terms of poison pill plans to examine their prevalence over time. Consistent with the hypothesis that poison pills have responded to the increase in hedge fund activism, recent adoptions have characteristics and provisions that appear to target hedge funds, such as low trigger thresholds. Moreover, using unique data on activist hedge fund views of SEC filings as a proxy for the mere threat of an activist intervention, we show that hedge fund interest strongly predicts pill adoption. Finally, the likelihood of a 13D filing declines after firms adopt “antiactivist” pills. Our analysis has implications for understanding the modern dynamics of market discipline of managers in public corporations, and evaluating policies that regulate defensive tactics.

Eldar, Ofer and Kirmse, Tanja and Wittry, Michael D., The Rise of Anti-Activist Poison Pills (August 22, 2022). Fisher College of Business Working Paper No. 2022-03-007, Charles A. Dice Center Working Paper No. 2022-07, Available at SSRN: https://ssrn.com/abstract=4198367 or http://dx.doi.org/10.2139/ssrn.4198367

Purchase versus pooling accounting

A student in my Mergers and Acquisitions class asked a question that took me back two decades:

I had a question about how pre 2001 consolidation was preferred due to accounting rules allowing pooling rather than purchase. I was taught last year and working this past summer that the form of an M&A deal was heavily influenced by tax considerations. I intuitively assumed purchase was the far superior option; doesn’t purchase accounting create an massive taxation benefit by allowing the surviving corporation deductions for goodwill even though I am ignorant as to the marked up value of assets on other considerations such as basis? I get that there are appearances to consider, but is that the only reason pooling was the preferable method of accounting?

Let's start with basics.

Acme Co., Inc., buys Omega, Inc., with Acme as the surviving entity. If pooling accounting was used, Acme's financial statements would be combined—“pooled”—with those of Omega, so that both companies’ assets and liabilities would be included on Acme’s balance sheet at their existing book value.[1]

If the deal is structured so as to use purchase accounting, however, the transaction is treated for accounting purposes as a purchase by Acme of Omega. In that case, Omega's assets would be marked up or down, as the case might be, to their fair market value on Acme's post-acquisition financial statements.

In addition, in purchase accounting, any control premium—defined for this purpose as the difference between the fair market value of Omega's assets and the price Acme paid to acquire Omega—would be included on Acme’s balance sheet as “goodwill.” In pooling accounting, there is no goodwill, because both companies' items are simply combined—the control premium is ignored.

Goodwill is amortized over time, which during the amortization period generates an annual expense on the company’s income statement. This reduces the company’s earnings and, as such, earnings per share.

Because the amortization period does not depend on the amount of goodwill in question, the more goodwill created in the acquisition, the greater the amount the company will recognize each year as an expense and, hence, the greater the reduction in the company’s annual earnings. Purchase accounting thus typically resulted in lower reported earnings.

Why would a company care? After all, we’re talking about a technical accounting treatment. The company’s actual cash flows are not affected. Yet, because reported earnings get so much attention from analysts and investors, falling accounting earnings are generally disfavored.

In addition, as we’ll see below, the purchase method makes it easier to assess the total purchase price paid to acquire the target, which in turn allows for more meaningful evaluation of the subsequent performance of that investment than is the case with the pooling method. Managers who would prefer that their shareholders not be able to accurately assess their performance might opt for pooling.

Given the option between purchase and pooling, companies thus would often pick pooling because management believed it made their earnings look better.

The SEC and the FASB thus worried that companies would choose between pooling and purchase based purely on how they wanted their accounting earnings to look rather than their actual financial condition.

Did the choice between purchase and pooling actually affect the stock price of the surviving entity? The answer appears to be no. Empirical studies found no statistically significant abnormal returns from one choice versus the other. Analysts and investors appear to have focused on cash earnings rather than accounting earnings. Perhaps as a result, the corporate preference for pooling was marginal. Most years, the split between purchase and pooling leaned only slightly to the latter. Still, there was a perception that companies wasted a lot of money trying to structure deals so that their preferred accounting treatment could be available and that some deals didn’t happen simply because they couldn’t get the preferred treatment.

Turning to the tax consequences, it is true that purchase accounting generates significant tax benefits. The goodwill accrued generates amortization tax deductions. The stepped-up basis means that if the surviving company sells some of the acquired assets, the company will recognize less gain and, accordingly, pay less tax.

In 2001, the FASB ruled that all acquisitions should be taxed as purchases:

The single-method approach … reflects the conclusion that virtually all business combinations are acquisitions and, thus, all business combinations should be accounted for in the same way that other asset acquisitions are accounted for-based on the values exchanged.

The FASB argued that the change would aid investors by ensuring that financial statements would:

Better reflect the investment made in an acquired entity—the purchase method records a business combination based on the values exchanged, thus users are provided information about the total purchase price paid to acquire another entity, which allows for more meaningful evaluation of the subsequent performance of that investment. Similar information is not provided when the pooling method is used.

Improve the comparability of reported financial information—all business combinations are accounted for using a single method, thus, users are able to compare the financial results of entities that engage in business combinations on an apples-to-apples basis. That is because the assets acquired and liabilities assumed in all business combinations are recognized and measured in the same way regardless of the nature of the consideration exchanged for them.

Provide more complete financial information—the explicit criteria for recognition of intangible assets apart from goodwill and the expanded disclosure requirements of this Statement provide more information about the assets acquired and liabilities assumed in business combinations. That additional information should, among other things, provide users with a better understanding of the resources acquired and improve their ability to assess future profitability and cash flows.

In addition, the FASB argued it would lower transaction costs:

Requiring one method of accounting reduces the costs of accounting for business combinations. For example, it eliminates the costs incurred by entities in positioning themselves to meet the criteria for using the pooling method, such as the monetary and nonmonetary costs of taking actions they might not otherwise have taken or refraining from actions they might otherwise have taken.

In sum, both forms had perceived advantages—but only if you assumed analysts and investors focused solely on headline earnings rather than digging into the income statement and balance sheet.

JB Heaton and Todd Henderson Respond: They Think Twitter's Lawsuit is a Loser

I offered JB Heaton and Todd Henderson an opportunity to do a guest post responding to my post, Does Twitter's Lawsuit Against Elon Musk Really Look "Like a Loser"?, which had commented on their WSJ oped on the lawsuit:

J.B. Heaton and Todd Henderson

July 18, 2022

Thank you to the inestimable Steve Bainbridge for allowing us the opportunity to discuss the Twitter v. Musk lawsuit here. In our discussions with investors betting on the outcome, we heard that they all read Steve’s blog, confirming it as the essential place for corporate law commentary. This is a close case, and we are grateful for and fascinated by the ongoing debate.

Our Wall Street Journal commentary has provoked considerable discussion. Some of it serious and excellent (such as Steve Bainbridge on this blog and Yair Listokin Jonathon Zytnick in the New York Times); some of it the equivalent of the ranting of a hypoglycemic child. Some of it agrees with us; some of it does not. Of course, that’s why we have such opinion pieces: to state an opinion, usually on one side of an issue that might be seen differently by different people. Our original piece rose out of our own discussions on the Twitter v. Musk lawsuit, and primarily in response to what we saw as a chorus of agreement that Elon Musk was almost certain to be forced to close the deal he and his holding corporations made with Twitter, Inc. Clinical professors of marking, professional pundits, news anchors, and even constitutional law professors were suddenly experts on corporate law and M&A, and they all thought it was obvious that Musk would be forced to buy Twitter, even though it is far from clear this is something anyone (other than merger arbs invested in Twitter stock) wants to happen. If the Delaware courts are going to get this right, we thought it important to offer the other side of the case.

Our point is that specific performance is by no means the sure thing many pundits claim. The proof of the reasonableness of our view is in the pudding of Twitter, Inc.’s stock price. That stock price closed on Friday, July 15, 2022 at $37.74. The deal price that so many believe Musk will be ordered to pay is $54.20. As a back of the envelope calculation, if the average of all of the possibilities for the stock price without specific performance is, say $30.00, then the current stock price reflects about a 32% chance of specific performance. Maybe the case will settle for an amount less than $54.20, but if it were clear specific performance was an obvious option for Twitter, that settlement would be about $54.20 minus the cost of litigation, or about $54.20.  There are many ways to think about the possible outcomes of course, but there is no question that people with real money on the line are not viewing specific performance as even more likely than not, and definitely not as the slam dunk many commentators claim.

Could the Delaware Chancery Court order specific performance and could that ruling be affirmed on appeal? Of course. We don’t think otherwise. Has the same court ordered specific performance in the past? Of course. Enough times so that “rarely” is the wrong word? Perhaps. Remember, we had editors at the Wall Street Journal and they love to punch up their pieces. If we’d been mealy mouthed and hedged like lawyers do, we are doubtful the debate today would be as joined and as valuable as it is.

The question is whether specific performance is likely here. This case is not the same as the prior cases. For one thing, Musk’s lawyers at Quinn Emanuel will leave no stone unturned on the remedy of specific performance. This will not be IBP v. Tyson Foods, the 2001 case where then-Vice Chancellor Leo Strine observed that “[a]lthough Tyson’s voluminous post-trial briefs argue the merits fully, its briefs fail to argue that a remedy of specific performance is unwarranted in the event that its position on the merits is rejected” and where VC Strine observed that “[t] his gap in the briefing is troubling.” Quinn Emanuel won’t make that mistake. This case will be as much about the remedy as Musk’s defenses on the merits.

It should also be noted that the Tyson case was under New York law, not Delaware as in the Twitter case, that the court took into consideration the impact on all of the various corporate stakeholders, not just shareholders, and, most importantly, in asking whether the opportunity was truly “unique,” the court asked the same question we did in our oped, and noted that the decision to require specific performance was not one the court was confident about. In other words, in a highly contextualized analysis, the court found the case to be about a coin-flip.

In the Twitter case, Quinn Emanuel is likely to home in on the serious legal problem in Twitter, Inc.’s case with respect to specific performance: Twitter, Inc. is not obviously even harmed by the breach.

Corporations, as all readers of this blog know, are legally separate and distinct from their shareholders. Suppose a corporation enters into an agreement to merge with another entity, and under that agreement the corporation will cancel its existing shares, giving its then-former shareholders the right to receive money from the acquirer, although that money never enters the corporation itself. If the acquirer breaches its agreement and refuses to close, the shareholders will not receive the money promised to them by the agreement but the corporation itself will receive $1 billion (in the form of a termination fee) that it did not have before and would not have received if the merger proceeded. What rights do the shareholders have under Delaware law if the merger agreement disavows them as third-party beneficiaries for purposes of enforcing the agreement? Can the corporation itself ignore the benefit it receives from breach (the $1 billion termination fee) to ask a court to specifically enforce the merger agreement and, if it does, would it be lawful for the Delaware courts to award specific performance?

We think this is the situation presented by the case of Twitter v. Musk. There is an agreement and plan of merger among Twitter, Inc., a Delaware corporation, and X Holdings I, Inc. and X Holdings II, Inc. In the merger agreement, X Holdings I, Inc. is known as the Parent and X Holdings II, Inc. is known as the Acquisition Sub. The merger agreement reflects a plan for a so-called reverse triangular merger under which Acquisition Sub merges into Twitter, Inc. with Twitter, Inc. surviving to become a wholly-owned subsidiary of the Parent. Under the merger agreement, Twitter, Inc. cancels its existing shares and replaces them with certificates that then-former Twitter, Inc. shareholders can take to a bank acting as paying agent, receiving $54.20 for every former share of Twitter, Inc. stock held as reflected in the certificates.

Twitter, Inc.’s shareholders before the merger becomes effective are not parties to the merger agreement, and the merger agreement disavows those shareholders as third-party beneficiaries except as to a provision limiting Twitter, Inc.’s money remedies to a $1 billion termination fee, the purpose of which is to bind Twitter, Inc.’s shareholders to that part of the agreement without giving them wider rights. The merger agreement also entitles Twitter, Inc. to that $1 billion termination fee as one of three possible and mutually exclusive remedies, the other two being, first, a damages remedy capped by the amount of the termination fee ($1 billion) and so no better than and possibly worse than the termination fee and, second, the right to ask for specific performance.

On July 8, 2022, Musk (who is also a party to portions of the merger agreement), Parent, and Acquisition Sub purported to terminate the agreement. Twitter, Inc. sued Musk, Parent, and Acquisition Sub in Delaware Chancery Court alleging that the termination was wrongful and that the court should order Musk, Parent, and Acquisition Sub to close under an equitable remedy of specific performance.

Suppose that the Musk termination was wrongful. Should the court grant specific performance? To both lay persons and lawyers who spend little time on the legal distinction between a corporation and its shareholders, the appealing answer is, Yes. After all, Musk, Parent, and Acquisition Sub made a deal with Twitter, Inc. and under that deal the Twitter, Inc. shareholders would receive $54.20 per share, a huge premium over the Twitter, Inc. share price before Musk’s interest in acquiring Twitter, Inc. became public. Specific performance is worth as much as $30 per share at this point, assuming that a loss on specific performance might see the Twitter stock fall to $24.20 or so. By contrast, a $1 billion termination fee paid to Twitter, Inc. (not to its shareholders) is worth only about $1.30 per share, approximately 9% of which will accrue to Musk’s benefit as owner of about that percentage of Twitter, Inc. stock. Specific performance surely is the only remedy that can compensate Twitter, Inc.’s shareholders for the lost deal premium.

But not so fast. The readers of this blog can see that the problem for the court is this: Twitter, Inc. is not obviously harmed by the breach. Form matters in these things. Twitter, Inc. is the surviving corporation in the reverse triangular merger reflected in the merger agreement. Twitter, Inc.’s assets and profits are exactly the same in the instant after the merger becomes effective as they were in the instant before the merger became effective. In fact, if Twitter, Inc. collects the $1 billion termination fee as its remedy (and we assumed it can; debate on that point is small potatoes), then Twitter, Inc. is $1 billion better off than it would have been had the merger closed.

That is, Twitter, Inc., the corporation, suffers no harm and, even if it did suffer some, there’s no indication that the $1 billion termination fee would leave Twitter, Inc. anything other than financially better off than it would have been with the merger, even if some of the $1 billion does compensate Twitter, Inc. for de minimis harm from, say, legal and consulting fees in pursuing the termination fee in court.

Twitter’s shareholders are obviously injured by the loss of the deal to have their stock cancelled and replaced with certificates that then would be presented to a paying agent funded by Parent. But shareholders have no damages remedy in the merger agreement for injuries that are separate and distinct from any injury to the corporation. Twitter, Inc. might have negotiated for that right but it did not, except that it asserted that it could seek damages for shareholder losses as well, but only up to $1 billion. Twitter, Inc.’s shareholders have no right of their own to pursue specific performance under the merger agreement.

This leaves the Delaware courts in a predicament. To order specific performance of the deal is to order contract parties to perform so that non-parties to the contract (the Twitter, Inc. shareholders) who were expressly disavowed as third-party beneficiaries for remedy purposes can receive payment for cancelled shares, even though an award of the termination fee would leave the legally distinct and actual party to the contract, Twitter, Inc., better off by $1 billion than would specific performance, which will leave Twitter, Inc. exactly as it was except for a new board of directors and new bylaws taken from the Acquisition Sub and the replacement of its pre-merger shareholders with a single shareholder, Parent. 

In substance under the merger agreement, Twitter, Inc. is acting as a commission-free broker of a deal where current Twitter, Inc. shareholders agree to have their shares cancelled in return for a payment and Musk’s parent holding company agrees to make that payment in return for  ownership of Twitter’s (one) new share. But rather than make a contract among shareholders and Musk and his holding companies, as a broker would do, Twitter, Inc. made itself the counter party to Musk and his entities. But as a commission-free broker, Twitter, Inc. loses nothing when the deal collapses. In fact, having negotiated a termination fee of $1 billion, Twitter, Inc. is actually better off with breach and that remedy than with either its limited (to $1 billion) damages remedy or specific performance. And shareholders, being nonparties disavowed as third-party beneficiaries, have no separate cause of action. Only by ignoring the legal distinction between Twitter, Inc., the corporation, and Twitter, Inc.’s pre-merger shareholders could specific performance make sense.

Of course, there is virtue in deal certainty. Parties may want to bind themselves, as Odysseus did to the mast. But Delaware courts scrutinize such acts of pre-commitment routinely, forbidding some kinds, as under the Unocal doctrine. One of our many points is that specific performance is, from a law and economics perspective, a bad deal device in all but a few kinds of cases. It would be better for the parties to contract in other ways, such as by including shareholders as third-party beneficiaries (and thus making the damages from a broken deal easily available). Deal structure matters. For instance, given the nature of the parties, it might have made much more sense for the Twitter board to let Musk deal directly with shareholders (as he wanted) than to force him to deal with the board. The poison pill may have been the original sin, since courts and the bluntness of specific performance would not have been needed had Musk been allowed to tender for Twitter shares.

Judges have ways of working around the law, and specific performance may well be awarded by a court that is loath to allow Musk, Parent, and Acquisition Sub to walk away from a $44 billion deal for a measly $1 billion.  To do so here, however, the Delaware court will have to ignore the most fundamental fact of corporate law, namely, that the corporation is not its shareholders. Wouldn’t that be a strange outcome in Delaware, of all places. Could it happen? Sure. It is more likely than not? We think no, and the stock market, so far, agrees with us.

Zohar Goshen on Twitter versus Elon Musk

Jeff Gordon on Elon Musk and Twitter

My friend Columbia University Law Professor Jeff Gordon sent along some thoughts on the Elon Musk's fight with Twitter and gave me permission to post them as a guest post:

I've been thinking about settlement possibilities.  It's now a kind of baseball arbitration, with choices between $1 BB and $44 BB.  As to settlement: I think the problem is going to be whether the Board can get out of what might be called the Revlon "box."  The $$ payout necessary to make Twitter whole in a financial sense is very large, $20 billion?  I haven't done the math.  It's this odd circumstance where the Board could have refused to sell to Musk on the grounds of some "public" value to Twitter ex Musk (perhaps with some dubious claim about maximizing long term value) but Revlon narrowly applied seems to say they (ie, board in fulfilling its fiduciary duty) can't do a "nevermind" to unwind a friendly sale to restore status quo ante.  

 

[$54/sh - standalone value (less than $37/sh which includes chance that deal goes through at a price higher than $37] x # shares outstanding.]  

 

I see that Ch McCormick is the judge.  Bad news for Musk, I think, since she is unlikely to go off on some doctrinal fancy.  The straight down the middle analysis favors Twitter.

 

A further thought:  I think the key to  specific performance will in the end be the financing conditions.  If I were a merger arb I will be looking very closely at those agreements.  If the banks have a legit basis to walk, then I think we are in the realm of Alliance Data Systems Corp v. Blackstone Capital Partners, in which parties are held to the terms of their deal structure.