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Anabtawi on "The Twilight of Enhanced Scrutiny in Delaware M&A Jurisprudence"

My friend and colleague Iman Anabtawi has posted a new article:

Merger and Acquisition (M&A) transactions create the potential for self-interested behavior by the boards of directors of acquired, or target, corporations because target boards may have self-interested reasons for preferring one acquirer over any other. The preferred acquirer may, for example, be more likely to retain the services of certain board members or to employ them in some other capacity after the completion of the transaction. In recognition of these potential conflicts of interest, the courts have recognized that target boards of directors may not always be incentivized to exercise their business judgment in M&A transactions in the best interests of shareholders and have therefore held them to the heightened standard of review of enhanced scrutiny. Enhanced scrutiny contemplates substantive judicial review of the reasonableness of the target board’s conduct in the sale of the company. Until recently, enhanced scrutiny review was not susceptible to being adjusted downward to business judgment-level review through procedural safeguards, such as the constitution of a special committee of the board or shareholder ratification. A special committee was not considered to be an effective means of cleansing an inherent conflict, and shareholder approval of the transaction was deemed to approve only the board’s decision to sell, as opposed to the board’s conduct of the sale process. The Delaware Supreme Court revisited the issue, holding that the shareholder ratification doctrine applies to a shareholder approval of an M&A transaction on the rationale that shareholders, particularly institutions, are at least as well-positioned as judges to evaluate the merits of a sale. As a result, approval of an M&A deal by target shareholders displaces enhanced scrutiny of the board of directors’ conduct in managing the sale in favor of the business judgment rule, effectively making the target board’s decision unreviewable. This Article argues that recent Delaware jurisprudence on shareholder ratification constitutes a fundamental shift in M&A jurisprudence, predicts that, while it will reduce deal litigation, it will have unnecessary detrimental effects on deal process, and proposes a procedural mechanism for mitigating those effects in the form of a bifurcated shareholder vote on each of the deal process and the sale transaction.

Anabtawi, Iman, The Twilight of Enhanced Scrutiny in Delaware M&A Jurisprudence. 43 Delaware Journal of Corporate Law (January 2019, Forthcoming); UCLA School of Law, Law-Econ Research Paper No. 18-11. Available at SSRN: https://ssrn.com/abstract=3248474

Delaware clears up some Kahn v. M&F Worldwide questions

Ann Lipton has a great summary:

This week, the Delaware Supreme Court decided Flood v. Synutra, and began to clear up some of the questions left open after its earlier decision in Kahn v. M&F Worldwide Corp., 88 A.3d 635 (Del. 2014) (“MFW”).  ...

In MFW, the Delaware Supreme Court held that if a controlling shareholder employs both protections, and makes clear from the outset that any deal will be conditioned on their satisfaction, and there is no reason to think the protections were circumvented (i.e., the committee acted with care, was fully empowered, and so forth), the resulting deal will get business judgment review.  But a lot was still left open.

For one thing, MFW had this odd footnote that suggested that an independent committee’s lack of care/bargaining power might be demonstrated, for pleading purposes, by a showing that the deal price was insufficient.  The footnote was odd because normally a lack of care is not pled by challenging a substantive outcome; allowing it in this instance suggested the Court was not entirely confident that MFW’s dual protections truly substituted for an arm’s-length deal.  And for another thing, MFW did not specify how early in the process the controller would have to disable itself to be entitled to business judgment protection.

So in Flood, per Chief Justice Strine, the Court began to close the holes.

First, it basically did away with MFW’s baffling footnote, which to be honest is more housekeeping than anything else.

And second, the Court held that “so long as the controller conditions its offer on the key protections at the germination stage of the Special Committee process, when it is selecting its advisors, establishing its method of proceeding, beginning its due diligence, and has not commenced substantive economic negotiations with the controller, the purpose of the pre-condition requirement of MFW is satisfied.”

In other words, a controlling shareholder may still take advantage of the MFW framework if it proposes the deal without the protections, and adds them later, so long as no “substantive economic negotiations” (and possibly other steps) have taken place in between.

Francis Pileggi also offers a very helpful analysis of the case.

Contrary to rumor, the material adverse change clause does have teeth

Speaking as a casebook author, however, what am I supposed to do with a 246 opinion?!?

Anabtawi on "The Twilight of Enhanced Scrutiny in Delaware M&A Jurisprudence"

My friend and colleague Iman Anabtawi has just published an interesting new article on an important trend in Delaware M&A law:

Merger and Acquisition (M&A) transactions create the potential for self-interested behavior by the boards of directors of acquired, or target, corporations because target boards may have self-interested reasons for preferring one acquirer over any other. The preferred acquirer may, for example, be more likely to retain the services of certain board members or to employ them in some other capacity after the completion of the transaction. In recognition of these potential conflicts of interest, the courts have recognized that target boards of directors may not always be incentivized to exercise their business judgment in M&A transactions in the best interests of shareholders and have therefore held them to the heightened standard of review of enhanced scrutiny. Enhanced scrutiny contemplates substantive judicial review of the reasonableness of the target board’s conduct in the sale of the company. Until recently, enhanced scrutiny review was not susceptible to being adjusted downward to business judgment-level review through procedural safeguards, such as the constitution of a special committee of the board or shareholder ratification. A special committee was not considered to be an effective means of cleansing an inherent conflict, and shareholder approval of the transaction was deemed to approve only the board’s decision to sell, as opposed to the board’s conduct of the sale process. The Delaware Supreme Court revisited the issue, holding that the shareholder ratification doctrine applies to a shareholder approval of an M&A transaction on the rationale that shareholders, particularly institutions, are at least as well-positioned as judges to evaluate the merits of a sale. As a result, approval of an M&A deal by target shareholders displaces enhanced scrutiny of the board of directors’ conduct in managing the sale in favor of the business judgment rule, effectively making the target board’s decision unreviewable. This Article argues that recent Delaware jurisprudence on shareholder ratification constitutes a fundamental shift in M&A jurisprudence, predicts that, while it will reduce deal litigation, it will have unnecessary detrimental effects on deal process, and proposes a procedural mechanism for mitigating those effects in the form of a bifurcated shareholder vote on each of the deal process and the sale transaction.

Anabtawi, Iman, The Twilight of Enhanced Scrutiny in Delaware M&A Jurisprudence. 43 Delaware Journal of Corporate Law (January 2019, Forthcoming); UCLA School of Law, Law-Econ Research Paper No. 18-11. Available at SSRN: https://ssrn.com/abstract=3248474

Your Mergers & Acquisitions Homework: Draft a Weinstein Clause

Bloomberg reports:

On Wall Street, it's known as “the Weinstein clause.”

Advisers are adding guarantees to certain merger agreements in light of the sexual misconduct scandals that have enveloped the producer Harvey Weinstein and other high-profile businessmen -- ones that legally vouch for the behavior of a company's leadership.

So. Would you draft it as a representation, warranty, or covenant? Would you make it a condition? How would you treat it for purposes of an indemnification provision? Would you subject it to a knowledge scrape?

Appraisal arbitrage takes another big hit

Ann Lipton:

... in Dell and DFC Glob. Corp. v. Muirfield Value P’rs, L.P., 172 A.3d 346 (Del. 2017), the Delaware Supreme Court threw some cold water on the practice of appraisal arbitrage.  The two decisions suggest that in an appraisal action, courts should not try to conduct their own valuation of a company except in unusual circumstances; instead, where the deal was negotiated appropriately, the deal price itself represents the best evidence of fair value.

That alone would be enough to discourage would-be appraisers, absent evidence of significant dysfunction in the process by which the deal price was reached, but the decisions went further: both contained extensive endorsements of the efficient markets hypothesis and the accuracy of market pricing.  ...

In Verition Partners Master Fund, Ltd., et al. v. Aruba Networks, Inc., C.A. No. 11448-VCL, memo. op. (Del. Ch. Feb. 15, 2018), VC Laster concluded that after Dell, he had no choice but to accept the market price as the best evidence of the target's fair value - even in the face of evidence that the acquirer made an employment offer to the target's CEO while negotiations were continuing (in violation of a prior agreement with the target, and without the Board's knowledge), and in the face of evidence that the target's financial advisors were trying to curry favor with the acquirer.  As a result, he awarded the dissenters the pre-deal market price of $17.13 per share, a figure significantly below the merger price of $24.67 per share.

Delaware Supreme Court reverses Dell appraisal decision

Big news. From Richards, Layton & Finger:

The Supreme Court identified and rejected three premises on which the trial court had relied in deciding to assign no weight to the transaction price:

First, the trial court had concluded that there had been a "valuation gap" between the trading price of Dell's stock and the intrinsic value, leading the trial court to believe that the bidding during the sale process had been anchored at an artificially low value. The Supreme Court rejected this premise, emphasizing that Dell's stock was widely traded in a liquid and efficient market and that the Company had been transparent about its long-term plans.

Second, the trial court had focused on the absence of strategic (as opposed to financial) bidders during the pre-signing market check. Following its ruling in DFC Global Corp. v. Muirfield Value Partners, __ A.3d __, 2017 WL 3261190 (Del. Aug. 1, 2017), the Supreme Court wrote that it saw "'no rational connection' between a buyer's status as a financial sponsor and the question of whether the deal price is a fair price." The Supreme Court emphasized that "Dell's sale process bore many of the same objective indicia of reliability that we found persuasive enough to diminish the resonance of any private equity carve out or similar such theory in DFC."

Third, the trial court had credited expert testimony to the effect that management-led buyouts tend to suffer from structural problems, such as the "winner's curse" and the perceived value of management to the company, that undercut the reliability of the deal price as evidence of fair value. The Supreme Court held that "none of these theoretical characteristics detracts from the reliability of the deal price on the facts presented here." With regard specifically to the "winner's curse," the Supreme Court wrote: "If a deal price is at a level where the next upward move by a topping bidder has a material risk of being a self-destructive curse, that suggests the price is already at a level that is fair. The issue in an appraisal is not whether a negotiator has extracted the highest possible bid. Rather, the key inquiry is whether the dissenters got fair value and were not exploited."

Anthony Rickey on "Chronic 'Merger Tax' Class-Action Litigation"

He argues there is little relief in sight.

If Delaware had listened to me, of course, it would have validated fee shifting bylaws and we'd have gotten some relief from this wave of often meritless litigation.

Teacher's manual for Bainbridge & Anabtawi Mergers and Acquisitions coming

My friend, UCLAW colleague, and now coauthor Iman Anabtawi and I have submitted to Foundation Press the teacher's manual to accompany our new casebook Mergers and Acquisitions: A Transactional Perspective. The manual is a whopping 232 pages (which compares quite favorably to the text's 766 pages) and provides answers to every question, problem, and exercise in the text, detailed descriptions of the facts and holdings of all principle cases, and many suggestions for how to cover the material in class. I think it is fair to say that it is the most detailed teacher's manual in this subject matter area. I am confident it will make life for adopters, especially new teachers, much easier.

Law professors considering using the casebook should contact their Foundation Press rep to request complimentary copies.

On top of which, I am pounding away at a comprehensive set of PowerPoint slides with speaker's notes to accompany the text. I hope to have them available for Spring 2018 adoption, at the very latest.

Hurt on American Airline's NOL Pill

Interesting analysis

A plug for my new mergers and acquisitions casebook

Bainbridge and Anabtawi's Mergers and Acquisitions now available for law school course adoption. https://t.co/mSICOAodWt pic.twitter.com/jNN8WX4d3M

— Professor Bainbridge (@ProfBainbridge) April 19, 2017

Why would a candy maker want to buy a chain of animal hospitals? The misbegotten Mars-VCA deal

The LA Times reports that:

VCA Inc. has spent the last three decades consolidating chunks of the pet health industry into a leading chain of animal hospitals and diagnostic labs. 

Now the Los Angeles company has agreed to be bought for $7.7 billion by Mars Inc., which is best known for its candy but also owns a significant pet-care business. ...

Mars? Yep.

Mars, which is based in McLean, Va., and has $35 billion in annual sales, is the privately held maker of brands such as M&M’s, Snickers, Milky Way, Skittles, Dove chocolate and Wrigley’s gum.

The century-old company also has a major pet-care unit whose pet food brands include Pedigree, Whiskas and Sheba. It owns Banfield Pet Hospitals, many of which are in PetSmart Inc. retail locations.

What's the logic of bringing pet food and animal hospitals under one roof, especially when that roof is owned by a candy maker?

Bloomberg "explains":

The deeper push into the pet business by Mars comes as large packaged-food companies are struggling with flagging sales. Changing consumer tastes, particularly a desire for less processed foods, has made it difficult for the companies that have dominated grocery-store shelves. Efforts to reduce sugar intake have struck an additional blow to candy makers such as Mars. That’s added pressure to diversify their portfolios.

But if that's Mars' reasoning, it's a lousy business idea. We have been here before, after all.

Once upon a time, companies often made strategic acquisitions for the sake of diversification. But why would a company choose to diversify its business when shareholders can very cheaply diversify?

For example, back in the 1960s ITT made telephones and other communication equipment. They also ran some phone companies. Then they decided to become a conglomerate: a holding company that owned lots of different businesses. They bought: Hilton Hotels, Wonder Bread, a steamship line, and a host of other companies. None of which had anything to do with telephones or each other.

Why would they do this? The theory was that a recession-sensitive industrial company (like ITT) could buy a non-recession sensitive company (like Wonder Bread), making it stronger by enabling it to always have some division that was doing well.

But this made no sense as a business strategy. Diversification necessarily reduces the maximum gains a conglomerate can produce. When one segment is doing well, it is being pulled down by a segment that is doing less well.

Moreover, the theory only worked if good telephone company managers also make good bakery managers. But it simply wasn’t true that management expertise could be transferred from one industry to the other. 

True, the company lowered its exposure to unsystematic risk by diversifying. But so what?

Investors could diversify away unsystematic risk in their own portfolios. Indeed, they can do it more cheaply, because they need not pay a control premium. Shareholders thus are not better off because of diversification. Management may be better off, because their employer is subject to less risk, but making themselves better off is not management’s job.

Economists generally now agree that the conglomerate mergers were very bad for the economy. Most are negative NPV transactions. Indeed, many of the hostile takeovers were de-conglomerations in which somebody bought up conglomerates cheaply (due to their depressed prices) and sold off the pieces at a profit.

 Granted, Mars is a private company. But it's owners are now in the fourth generation and the company now has non-family managers. To the extent its shareholders are now mostly passive investors their situation is not all that different from public shareholders of an exchange listed conglomerate.

Richard Booth on Appraisal Arbitrage

Interesting post

Winter has come for shareholder plaintiff lawyers in Delaware

Alison Frankel reports:

... according to three top-notch plaintiffs’ lawyers who talked to me on background, a series of recent decisions from the Delaware Supreme Court and Chancery Court has made it much tougher for investors to police corporate boards and advisers, to block shareholder votes on deals involving a single bidder and to recover damages for disclosure violations if shareholders have voted in favor of a merger. The net effect of this recent precedent, they said, is to encourage shareholders to file M&A class actions in federal court, alleging violations of federal disclosure laws, rather than bringing fiduciary duty suits in Delaware.

These lawyers weren’t even talking about Chancery Court’s celebrated 2015 crackdown on “deal tax” settlements. You probably remember that Delaware judges acted in concert to squelch M&A class action settlements in which corporations received broad releases from shareholder claims in exchange for additional, often immaterial, proxy disclosures.

Chancery Court’s refusal to sign off on six- or seven-figure fees for plaintiffs’ lawyers who negotiated disclosure-only settlements has already sharply reduced the number of M&A challenges filed in Delaware. According to a Cornerstone Research study published this summer, nearly two-thirds of all deals valued at more than $100 million still provoked shareholder litigation, but that’s way down from the 2013 peak of 94 percent – and shareholder lawyers are much more likely to file investor suits outside of Delaware. (Thus explaining Time Warner’s new forum selection clause.)

For all of the attention paid to the clampdown on disclosure-only settlements (including by me!), the Delaware Supreme Court’s 2015 opinion in Corwin v. KKR may turn out to have been a more important disincentive for shareholder lawyers to sue in Chancery Court. In the Corwin decision, written by Chief Justice Leo Strine, the state supreme court held that if a deal is approved by “fully informed, uncoerced” shareholders, the board’s actions during the sale process should be reviewed under the extremely forgiving business judgment standard. Effectively, the Corwin ruling spelled the end of post-closing damages claims in deals shareholders voted to approve.

...

The answer, they say, may be to stop litigating M&A challenges as fiduciary duty cases in Delaware and instead start asserting violations of federal securities law, which, after all, prohibits corporations from making false or misleading proxy filings.

I assume that exclusive forum bylaws that tried to keep such cases out of federal courts would run afoul of the securities law provisions giving federal courts exclusive jurisdiction over federal securities law claims. In which case, the onus will be on federal courts to make use of the tools given them by the PSLRA to prevent a new generation of deal tax litigation.

Dell and the myth of "intrinsic value"

I've been thinking so moe about the May 31 Delaware Chancery decision in the Dell appraisal proceeding. As Paul Weiss summarizes the case:

Vice Chancellor Laster of the Delaware Court of Chancery held that, for purposes of Delaware’s appraisal statute, the fair value of the common stock of Dell Inc. at the time of its sale to a group including the Company’s founder Michael Dell was $17.62 per share, almost a third higher than the $13.75 deal price. The decision has received a good deal of attention from the press and commentators, largely because the Court rejected the use of the transaction price as compelling evidence of fair value, despite several recent Delaware appraisal decisions that have relied heavily or exclusively on the transaction price.

VC Laster cited a number of factors in support of his decision, but, as Paul Weiss observes, one of the major take home lessons seems to be that "target boards may wish to make a record of their focus on the company’s intrinsic value, as opposed to the premium to market represented by the transaction price."

The focus on intrinsic value, of course, is a longstanding principle of Delaware law as the VC pointed out:

“The concept of fair value under Delaware law is not equivalent to the economic concept of fair market value. Rather, the concept of fair value for purposes of Delaware's appraisal statute is a largely judge-made creation, freighted with policy considerations.” Finkelstein v. Liberty Digital, Inc., 2005 WL 1074364, at *12 (Del. Ch. Apr. 25, 2005) (Strine, V.C.). In Tri–Continental Corp. v. Battye, 74 A.2d 71 (Del.1950), the Delaware Supreme Court explained in detail the concept of value that the appraisal statute employs:

The basic concept of value under the appraisal statute is that the stockholder is entitled to be paid for that which has been taken from him, viz., his proportionate interest in a going concern. By value of the stockholder's proportionate interest in the corporate enterprise is meant the true or intrinsic value of his stock which has been taken by the merger. In determining what figure represents the true or intrinsic value, ... the courts must take into consideration all factors and elements which reasonably might enter into the fixing of value. Thus, market value, asset value, dividends, earning prospects, the nature of the enterprise and any other facts which were known or which could be ascertained as of the date of the merger and which throw any light on future prospects of the merged corporation are not only pertinent to an inquiry as to the value of the dissenting stockholder's interest, but must be considered....

Subsequent Delaware Supreme Court decisions have adhered consistently to this definition of value.

In re Appraisal of Dell Inc., No. CV 9322-VCL, 2016 WL 3186538, at *21 (Del. Ch. May 31, 2016), reargument denied, (Del. Ch. June 16, 2016).

The difficulty, of course, is that there is no such thing as "intrinsic value." As with any other asset, a company is worth only what somebody is willing to pay for it.

Given that the meaning of "fair value" is a product of common law adjudication rather than statutory interpretation, Delaware courts can and should rethink their approach. Instead of focusing on the purported intrinsic value, the court should focus on the fact that while the company's only value is its market value, an asset can have different values in different markets. (Otherwise, arbitrage would never be profitable.) Two distinct markets are implicated in this setting. On the one hand, there is the ordinary stock market in which the company's shares trade. On the other, however, there is the market for corporate control. Prices in the latter market typically exceed those in the former. Hence, we speak of a "control premium" that is paid when someone buys all of the shares of a company's stock.

The relevant inquiry thus is not what is the company's "intrinsic value" but did the board of directors do an adequate job of figuring out the reservation price of the highest realistically credible bidder. In cases where the board's motives are unquestioned, courts should defer to the board's decision in that regard.

In cases like Dell, however, there are good reasons to question the board's motives. As Paul Weiss explained, VC Laster correctly pointed to such factors as:

• The transaction was a management buyout. “Because of management’s additional and conflicting role as buyer, MBOs present different concerns than true arms’ length transactions.”

• There was limited pre-signing competition for the Company, and the effectiveness of the post-signing go-shop period was limited by the size and complexity of the Company.

Those are far more relevant inquiries than "intrinsic value." As a White & Case briefing remarked:

Limited pre-signing competition can be an impediment to achieving fair value even if a robust post-signing market check is undertaken during a "go-shop" period given numerous disincentives facing would-be topping go-shop bidders, according to the Court. In particular, the ability for the incumbent buyer to make at least one matching bid in the event of a superior proposal from a third party – a common feature of a go-shop – may have a chilling effect on go-shop bids, especially when the target company is large and complex and therefore requires significant and costly due diligence by the go-shop bidder. The chilling effect may be accentuated in the context of a management-led buyout, in which the incumbent buyer presumably has the best knowledge about the company's prospects and therefore presumably has priced the company properly; moreover, a go-shop bidder in this context must overcome the lack of support from management, which support may be an asset impacting valuation in and of itself. Indeed, in the Dell case, evidence showed that only three financial sponsors and no strategic bidders were involved in the pre-signing sale process, and even though 60 potential buyers were contacted during the go-shop phase, the Court still found that the lack of pre-signing competition rendered the merger consideration unreliable.