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Pondering how the material adverse effect clause of the LVMH-Tiffany merger agreement would have played out absent the settlement

Predictably, the LVMH-Tiffany takeover battle has reached a negotiated settlement. After COVID-19 broke out, LVMH tried to wriggle out of a $135 per share deal to acquire Tiffany, claiming that the pandemic was a material adverse change. Like most M&A deals, the LVMH-Tiffany deal included a closing condition that there have been no material adverse change since the deal was signed.

As I discuss in my Mergers and Acquisitions Concepts and Insights text, material adverse change (MAC)--a.k.a., material adverse effect (MAE)--clauses are pervasive in M&A agreements. Many agreements include a representation, for example, that there has been no material adverse change as of some specified date (usually closing). The absence of a MAC is a common closing condition. In addition, many materiality qualifiers in representations and warranties or in covenants can be raised to the MAC level.

The clause defining a MAC is one of the most heavily—and expensively—negotiated terms on M&A agreements.

MAC clauses generally include carveouts for some market-wide changes. These are events or changes that the parties have agreed in advance will not constitute a MAC. In the MAC closing condition, the effect of a carveout is to shift the risks associated with the carved out events from the target to the acquirer, because an adverse impact from such an event will not excuse the acquirer’s performance.

Carveouts for economic conditions and war or terrorism are nearly universal (98% and 97%, respectively, in 2018-19). Carveouts for acts of God or natural disasters are also quite common. When the COVID-19 pandemic first broke out, relatively few MACs included a carveout for pandemics. (Carveouts for epidemics and pandemics are now common.)

As I told my Mergers and Acquisitions class in the fall, I thought LVMH had a very weak case for becoming the second case to find a MAC.

If the case had reached the merits at trial or during motions practice, the first issue presented by the dispute would have been whether the coronavirus constituted a MAC as defined in the agreement.

The MAC clause in the LVMH-Tiffany agreement was fairly standard:

“Material Adverse Effect” means any Effect that, individually or in the aggregate with all other Effects, (a) has had or would be reasonably expected to have a material adverse effect on the business, condition (financial or otherwise), properties, assets, liabilities (contingent or otherwise), business operations or operations of the Company and its Subsidiaries, taken as a whole or (b) would or would reasonably be expected to prevent, materially delay or materially impair the ability of the Company to consummate the Merger or to perform any of its obligations under this Agreement by the Outside Date; provided, however, in the case of clause (a) no Effect arising out of or resulting from any of the following shall be deemed either alone or in combination to constitute a Material Adverse Effect: (i) changes or conditions generally affecting the industries in which the Company and any of its Subsidiaries operate, (ii) general economic or political conditions (including U.S.-China relations), commodity pricing or securities, credit, financial or other capital markets conditions, in each case in the United States or any foreign jurisdiction in which the Company or any of its Subsidiaries operate, (iii) any failure, in and of itself, by the Company to meet any internal or published projections, forecasts, estimates or predictions in respect of revenues, earnings or other financial or operating metrics for any period (it being understood that the facts or occurrences giving rise to or contributing to such failure may be deemed to constitute, or be taken into account in determining whether there has been, or is reasonably expected to be, a Material Adverse Effect, to the extent permitted by this definition), (iv) consequences resulting from the execution and delivery of this Agreement or the public announcement or pendency of the transactions contemplated hereby, including the impact thereof on the relationships, contractual or otherwise, of the Company or any of its Subsidiaries with employees, labor unions, customers, suppliers, designers, landlords or partners, (v) any change, in and of itself, in the market price or trading volume of the Company’s securities or in its credit ratings (it being understood that the facts or occurrences giving rise to or contributing to such change may be deemed to constitute, or be taken into account in determining whether there has been, or is reasonably expected to be, a Material Adverse Effect, to the extent permitted by this definition), (vi) any change in Law applicable to the Company’s business or GAAP (or authoritative interpretation thereof), (vii) geopolitical conditions, the outbreak or escalation of hostilities (including the Hong Kong protests and the “Yellow Vest” movement), any acts of war (whether or not declared), sabotage (including cyberattacks) or terrorism, or any escalation or worsening of any such acts of hostilities, war, sabotage or terrorism threatened or underway as of the date of this Agreement, (viii) any hurricane, tornado, flood, earthquake or other natural disaster or (ix) any actions required to be taken or not taken by the Company or any of its Subsidiaries (other than the Company’s obligations under the first sentence of Section 7.1(a)) pursuant to this Agreement or, with Parent’s prior written consent, except, in the case of clauses (i), (ii), (vi), (vii) and (viii) to the extent such Effect has a materially disproportionate adverse effect on the Company and its Subsidiaries, taken as a whole, relative to others in the industries and geographical regions in which affected businesses of the Company and its Subsidiaries operate in respect of the business conducted in such industries and applicable geographical regions.

MAC claims typically face significant hurdles. In Hexion Specialty Chemicals, Inc. v. Huntsman Corp.,[1] the Delaware Chancery Court emphasized that an acquirer has a “heavy burden” to establish the existence of a material adverse change. The court operationalized that burden by setting forth a number of principles for interpreting MAC clauses:

• The party asserting an MAC (usually the Acquirer) bears the burden of proof.
• Carve-outs are only relevant if the initial MAC definition is met.
• An alleged MAC is not measured by performance versus projections.
• An alleged MAC will be determined by reference to pertinent representations and disclaimers.
• Absent a clear contractual provision, an effect must be “durationally significant” to constitute a MAC.
• The parties should define their own test of what constitutes a MAC; otherwise, EBITDA is the appropriate benchmark.

The burden imposed by those factors is so heavy that, as of the time Hexion was decided, Delaware courts had “never found a material adverse effect to have occurred in the context of a merger agreement.”[2] Subsequently, in Akorn, Inc. v. Fresenius Kabi AG,^[3] the Delaware Chancery Court found that a MAC clause was triggered and excused the acquirer’s performance. It took the Chancery Court 246 pages to justify that result. As of this writing, there has been no subsequent case finding that a MAC had occurred.

Applying those factors, would one conclude that the pandemic was “reasonably expected to have a material adverse effect on [Tiffany’s]  business, condition (financial or otherwise), properties, assets, liabilities (contingent or otherwise), business operations or operations of [Tiffany] and its Subsidiaries, taken as a whole”?

Critically, it quickly became clear that the effect of the pandemic was not likely to have a durationally significant impact and that EBITDA had not taken a major long-term hit. As the WSJ observed:

On Oct. 15, Tiffany released preliminary results for August and September 2020 that showed its business had begun to stabilize. World-wide sales had decreased slightly but operating earnings had jumped 25% from a year earlier. The company also reported strong e-commerce sales and growth in China.

Although not directly pertinent, LVMH’s shenanigans in trying to get the French government to intervene—conduct Tiffany said gave LVMH “unclean hands,” to which LVMH’s boss apparently took particular offense (I guess luxury brands and dirty hands don’t mesh)—hurt them badly in the media war that had broken out between the two.

As such, I think Tiffany had a strong argument that there had been no MAC. As a cautionary matter, however, I note that in AB Stable VIII LLC v. Maps Hotels and Resorts One LLC,[4] the Delaware Chancery Court (per VC Travis Laster) assumed that the Seller had “suffered an effect due to the COVID-19 pandemic that was sufficiently material and adverse to satisfy the requirements of Delaware case law. Based on that assumption, the burden rested with Seller to prove that the effect fell within at least one [carveout] exception.”[5]

As was typical of merger agreements entered into before (or in the early days of) the pandemic, the LVMH-Tiffany deal lacked an express carveout for pandemics. As was often the case with disputes over MACs in the wake of the pandemic’s outbreak, Tiffany would have pointed to carveout number viii’s exception for adverse changes arising out of “natural disasters.”

In AB Stable VIII LLC, the MAC contained an exception for adverse changes arising out of “natural disasters or calamities.”[6] VC Laster had little difficulty concluding that the pandemic was a calamity.

The COVID-19 pandemic fits within the plain meaning of the term “calamity.” Millions have endured economic disruptions, become sick, or died from the pandemic. COVID-19 has caused human suffering and loss on a global scale, in the hospitality industry, and for [Seller’s] business. The COVID-19 outbreak has caused lasting suffering and loss throughout the world.[7]

The court further concluded that the pandemic “arguably” fell within the definition of a natural disaster.[8]

A vernacular definition is a “a sudden and terrible event in nature (such as a hurricane, tornado, or flood) that usually results in serious damage and many deaths.”  

The COVID-19 pandemic . . . is a terrible event that emerged naturally in December 2019, grew exponentially, and resulted in serious economic damage and many deaths.[9]

VC Laster went on to explain that:

In addition to the dictionary meaning of “calamities,” the structure and content of the MAE Definition point in favor of a plain-language interpretation that encompasses the COVID-19 pandemic. From a structural standpoint, MAE definitions allocate risk through exceptions and exclusions from exceptions. The typical MAE clause allocates general market or industry risk to the buyer and company-specific risk to the seller. The standard MAE provision achieves this result by placing the general risk of an MAE on the seller, and then using exceptions to reallocate specific categories of risk to the buyer. Exclusions from the exceptions return risks to the seller. As noted previously, one standard exclusion applies when a particular event has a disproportionate effect on the seller's business. Both MAE exceptions and disproportionality exclusions have become increasingly prevalent.

For purposes of finer-grained analysis, the risks that parties address through exceptions can be divided into four categories: systematic risks, indicator risks, agreement risks, and business risks.

• Systematic risks are “beyond the control of all parties (even though one or both parties may be able to take steps to cushion the effects of such risks) and ... will generally affect firms beyond the parties to the transaction.”
• Indicator risks signal that an MAE may have occurred. For example, a drop in the seller's stock price, a credit rating downgrade, or a failure to meet a financial projection would not be considered adverse changes, but would evidence such a change.
• “Agreement risks include all risks arising from the public announcement of the merger agreement and the taking of actions contemplated thereunder by the parties,” such as potential employee departures.
• Business risks are those “arising from the ordinary operations of the party's business (other than systematic risks), and over such risks the party itself usually has significant control.” “The most obvious” business risks are those “associated with the ordinary business operations of the party—the kinds of negative events that, in the ordinary course of operating the business, can be expected to occur from time to time, including those that, although known, are remote.”

Generally speaking, the seller retains the business risk. The buyer assumes the other risks.

. . . The risk from a global pandemic is a systematic risk, so it makes sense to read the term “calamity” as shifting that risk to Buyer. The structural risk allocation in the definition thus points in the same direction as the plain-language interpretation.[10]

Hence, I believe that in the unlikely event that the pandemic would have been regarded as a material adverse change in Tiffany’s business, it would have fallen within the exemption for natural disasters.

The take home lesson, however, may be that sellers should be even more expansive in identifying systematic risks that they wish to have excluded from the definition of a MAC. Consistent with that observation, the post-COVID MACs I’ve seen have tended to be a lot longer than pre-COVID MACs.

Although claims that there has been a MAC not infrequently result in litigation, in the real world they serve mainly as a tool for reopening negotiations over price. LVMH initially offered to go forward with the deal if Tiffany accepted a cut to $120 per share. Tiffany laughed that one off. After Tiffany announced its August and September results, as a result of which everybody knew the MAC claim likely would be a non-starter, LVMH came back with an offer of $130 per share. More negotiations resulted in a price of $131.50 per share, in addition to which Tiffany was allowed to pay its shareholders $141 million in dividends prior to the deal closing (which reduced Tiffany’s value).

At the end of the day, LVMH managed to save about $300 million on the deal price. Minus, one assumes, many millions in legal and financial advisor fees.

I thank University of Colorado Law School Professor Andrew Schwartz for his very helpful comments and critique of an earlier draft of this post. His article, A ‘Standard Clause Analysis' of the Frustration Doctrine and the Material Adverse Change Clause, 57 UCLA L. Rev. 789 (2010), has been cited and followed by VC Laster.

Iowa Law Professor Robert T Miller gets a nice shout out from Delaware VC Laster

I think Iowa Law Professor Robert T. Miller is doing some of the most interesting work in corporate law. It appears I am not alone.

In his recent opinion in AB Stable VIII LLC v. Maps Hotels and Resorts One LLC, CV 2020-0310-JTL, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020), which I discussed in the preceding post, Delaware VC Travis Laster wrote:

Professor Robert Miller has provided a helpful set of terminology for analyzing MAE definitions. See Robert T. Miller, Material Adverse Effect Clauses and the COVID-19 Pandemic 30–31 (Univ. Iowa Coll. L. Legal Stud. Rsch. Paper, No. 2020-21, 2020) [hereinafter Miller, COVID-19].

Id. at *54 n.200. (You can down Miller's paper here.)

Subsequently in the opinion, VC Laster relied on Miller's article to explain that:

For purposes of finer-grained analysis, the risks that parties address through exceptions can be divided into four categories: systematic risks, indicator risks, agreement risks, and business risks. See generally Miller, Deal Risk, supra, at 2071–91.

• Systematic risks are “beyond the control of all parties (even though one or both parties may be able to take steps to cushion the effects of such risks) and ... will generally affect firms beyond the parties to the transaction.”
• Indicator risks signal that an MAE may have occurred. For example, a drop in the seller's stock price, a credit rating downgrade, or a failure to meet a financial projection would not be considered adverse changes, but would evidence such a change.
• “Agreement risks include all risks arising from the public announcement of the merger agreement and the taking of actions contemplated thereunder by the parties,” such as potential employee departures.
• Business risks are those “arising from the ordinary operations of the party's business (other than systematic risks), and over such risks the party itself usually has significant control.” “The most obvious” business risks are those “associated with the ordinary business operations of the party—the kinds of negative events that, in the ordinary course of operating the business, can be expected to occur from time to time, including those that, although known, are remote.”

Generally speaking, the seller retains the business risk. The buyer assumes the other risks.

Id. at *60. Personally, I plan to add that quote to the forthcoming new edition of my Mergers & Acquisitions treatise.

Delaware and Ontario agree that COVID-19 was not a material adverse change, as defined: Comments and drafting notes

The Chancery Daily calls our attention to AB Stable VIII LLC v. MAPS Hotel and Resorts One LLC, 2020 WL 7024929 (Del. Ch. Nov. 30, 2020), memorandum opinion by Delaware Vice Chancellor Travis Laster. AB Stable VIII LLC (Seller) owned all the membership interests in Strategic Hotels and Resorts LLC. Seller agreed to sell all of those membership interests to MAPS Hotel and Resort One (Buyer). The sales agreement included a bring down condition that excused Buyer's obligation to close if "Seller’s representations were inaccurate and the degree of the inaccuracy was sufficient to result in a contractually defined Material Adverse Effect." One of Seller's representations was that "there had not been any changes, events, states of facts, or developments, whether or not in the ordinary course of business that, individually or in the aggregate, have had or would reasonably be expected to have a Material Adverse Effect."

In turn, the MAC definition stated:

“Material Adverse Effect” means any event, change, occurrence, fact or effect that would have a material adverse effect on the business, financial condition, or results of operations of the Company and its Subsidiaries, taken as a whole, other than any event, change, occurrence or effect arising out of, attributable to or resulting from

(i) general changes or developments in any of the industries in which the Company or its Subsidiaries operate,

(ii) changes in regional, national or international political conditions (including any outbreak or escalation of hostilities, any acts of war or terrorism or any other national or international calamity, crisis or emergency) or in general economic, business, regulatory, political or market conditions or in national or international financial markets,

(iii) natural disasters or calamities,

(iv) any actions required under this Agreement to obtain any approval or authorization under applicable antitrust or competition Laws for the consummation of the transactions contemplated hereby,

(v) changes in any applicable Laws or applicable accounting regulations or principles or interpretations thereof,

(vi) the announcement or pendency of this Agreement and the consummation of the transactions contemplated hereby, including the initiation of litigation by any Person with respect to this Agreement or the transactions contemplated hereby, and including any termination of, reduction in or similar negative impact on relationships, contractual or otherwise, with any customers, suppliers, distributors, partners or employees of the Company and its Subsidiaries due to the announcement and performance of this Agreement or the identity of the parties to this Agreement, or the performance of this Agreement and the transactions contemplated hereby, including compliance with the covenants set forth herein,

(vii) any action taken by the Company, or which the company causes to be taken by any of its Subsidiaries, in each case which is required or permitted by or resulting from or arising in connection with this Agreement,

(viii) any actions taken (or omitted to be taken) by or at the request of the Buyer, or

(ix) any existing event, occurrence or circumstance of which the Buyer has knowledge as of the date hereof.

For the avoidance of doubt, a Material Adverse Effect shall be measured only against past performance of the Company and its Subsidiaries, and not against any forward-looking statements, financial projections or forecasts of the Company and its Subsidiaries.

Id. at *53-54. As an initial drafting note, the court observed that this definiton "adheres to the general practice of defining a 'Material Adverse Effect' self-referentially as 'a material adverse effect.'" I do not understand that practice. I believe it was in second grade that I learned you don't use the word being defined in the definition.

The Court explained that:

Buyer asserts that Strategic suffered a Material Adverse Effect due to the consequences of the COVID-19 pandemic. The parties debated at length whether the effect was material and adverse. To that end, both sides amassed factual evidence, expert analyses, and arguments in favor of their positions. They also debated at length whether the effect fell within an exception.

Ordinarily, this court would determine first whether Strategic suffered an effect that was sufficiently material and adverse to meet the strictures of Delaware case law. At times, however, it is more straightforward to determine whether the effect was attributable to a cause that fell within one of the exceptions. This is one of those cases. This decision assumes for purposes of analysis that Strategic suffered an effect due to the COVID-19 pandemic that was sufficiently material and adverse to satisfy the requirements of Delaware case law. Based on that assumption, the burden rested with Seller to prove that the effect fell within at least one exception.

Id. at *55 (citations omitted). Seller relied on the first three and the fifth exceptions. Ultimately, however, the Court focused on the third exception. The plain meaning of "calamity," the court opined, "encompasses the COVID-19 pandemic and its effects." Id. at *58. 

In other words, the pandemic was a material adverse event, but it was attributable to a natural calamity. Accordingly, the pandemic did not constitute a MAC as defined.

The court pointed to a number of seller friendly provisions of the MAC that will be important drafting notes in the future:

• The MAC definition "broadly shifts systematic risk to Buyer." The pandemic was just such a risk and, accordingly, should be allocated to Buyer. Id. at *60.
• The MAC definition provided an exception (ix) that eliminated "any effect from 'any existing event, occurrence or circumstance of which the Buyer has knowledge as of the date hereof.'” Id. This is an "expansive carve-out," id., which Seller doubtless had Wtoworkhard to get.
• None the exemptions contained an exclusion for events that have a disproportionate effect on Seller. "A disproportionate-effect exclusion favors the seller by shifting risk back to the buyer. The overwhelming majority of contemporary deals include disproportionality exclusions, so the omission of a disproportionality exclusion signals a seller-friendly MAE clause." Id. at 61.

The Court concluded:

Consistent with the allocation of systematic risk to Buyer, the generally seller-friendly nature of the MAE Definition supports interpreting the exception for “calamities” as including pandemic risk. To interpret the term narrowly would cut against the flow of the definition. Buyer has not offered any explanation why the parties would have excluded pandemic risk from their overarching risk allocation despite assigning all similar risks to Buyer. Absent a persuasive (or at least rational) explanation, there is no reason to think that the term “calamities” should be construed narrowly to achieve that result.

Id. at *63. 

The Court went on to hold that Seller's responses to the pandemic--although reasonable--violated the ordinary course covenant. One does not read the boilerplate ordinary course covenant "to permit management to do whatever hotel companies ordinarily would do when facing a global pandemic. Instead, [one compares] the company's actions with how the company has routinely operated and hold that a company breaches an ordinary course covenant by departing significantly from that routine." Id. at *70. The ordinary course covenant thus allocates systematic risks like pandemics to Seller, which seems incongruous given the considerable extent to which the MAC clause allocated those risks to Buyer. As such, "when faced with an extraordinary event," Seller's management may not "take extraordinary actions and claim that they are ordinary under the circumstances." Id.

The Court acknowledged that seeming incongruity, but suggested the parties could have avoided that problem by including a MAC qualifier in the ordinary course covenant. 

The Chancery Daily also points us to:

Fairstone Financial Holdings, Inc., et al. v. Duo Bank of Canada, No. 20-641857-00CL, opinion (Ont. Sup. Ct. J. Dec. 2, 2020, [in which the] Ontario Court ... found that the effects of the pandemic did not constitute a Material Adverse Change / Event / Effect, but differed from the Court of Chancery's decision in finding that the target's response to the pandemic did not breach obligations to conduct business in the ordinary course -- and, where the Court of Chancery found that the buyer was entitled to terminate the transaction as a result of the seller's breach of the breach of the Ordinary Course Covenant, the Ontario Court orders specific performance requiring the buyer to close on the merger. ...  Fortunately, sage counsel at Davies Ward Phillips & Vineberg provided a helpful discussion of the ruling -- Buyer Beware: In Canada's First COVID-19 "Busted Deal" Decision, Court Finds That Duo Bank Cannot Terminate Its Acquisition of Fairstone Financial -- which TCD found informative; interested subscribers might agree.

Update: I direct your attention to Cooley Discusses Delaware Chancery Case on MACs and Business Covenants During COVID, which provides a very detailed analysis of the opinion.

Update 2: I also direct your attention to a very detailed Fried, Frank analysis of the First COVID-19 M&A Decision. 

Are management buyouts subject to Corwin or MFW?

I've been grappling with the titular question in writing the fourth edition of my Mergers and Acquisitions treatise. Here's what I've come up with so far:

MBOs are a related party transaction writ very large. As agents and officers of the corporation, the top management team are fiduciaries of the entity and the shareholders. In that capacity, they are obliged to protect the shareholders’ interests and to help ensure that the shareholders get the best possible deal. At the same time, however, they are acting as buyers and have a selfish interest in paying the lowest possible price.[1] Unfortunately, in contrast to the extensive Delaware caselaw on most conflict-of-interest transactions, “the case law on MBOs is remarkably thin. Because there is no case squarely articulating the standard of review for MBOs, commentators generally reason by analogy from non-MBO cases that involve conflicts of interest.”[2]

One potentially applicable body of law comes from DGCL § 144, which governs contracts and transactions “between a corporation and 1 or more of its directors or officers, or between a corporation and any other corporation, partnership, association, or other organization in which 1 or more of its directors or officers, are directors or officers, or have a financial interest . . ..” The acquisition agreement between the corporation and the acquisition special purpose entity created by the management buyout group is just such a contract. Delaware caselaw provides that such transactions will be reviewed under the business judgment rule rather than entire fairness provided it has been approved by either a majority of the disinterested directors or a majority of the disinterested shareholders, provided there has been full disclosure of the material facts relating both to the transaction and to the management group’s conflict of interest.[3]

An alternative body of case law on which one might draw by way of analogy is provided by Revlon and its progeny. An MBO of a public corporation typically will constitute a sale of control. The firm goes from being owned by a large and diffuse collection of shareholders to being a privately held company owned by the management group and their private equity ally. As such, MBOs commonly should be subject to review under Revlon.[4] Accordingly, one might expect that the transaction should be subject to business judgment review if the target’s board complies with Corwin.[5] A widely used M&A treatise, however, claims that Corwin does not apply to MBOs because such transactions involve a controller on both sides of the transaction.[6] One might nevertheless argue that Corwin should apply to MBO for at least two reasons. First, the conflict of interest inherent in an MBO arguably is not as severe as is the case in controlling shareholder transactions. Unlike the case in which there is a controlling shareholder, the directors do not owe their election and positions to the management group. Second, Corwin’s rule that the business judgment rule applies when the transaction is approved by a fully informed vote of a majority of the disinterested shareholders parallels the analysis of shareholder approval under § 144.[7]

Having said that, however, there are some situations in which the entire fairness standard of Weinberger and its progeny applies to MBOs. In In re Cysive, Inc. Shareholders Litig.,[8] for example, a management buyout by the target’s CEO was subject to entire fairness review because the CEO was also the target’s controlling shareholder. In the older Mills Acq. Co. v. Macmillan, Inc.,[9] an MBO was subjected to entire fairness review where the board allowed the management group to control the decision-making process. In such cases, the standard of review should shift to the business judgment rule if the board complies with MFW.[10]

The bizarre lack of specificity regarding the timing of Schedule 13D: Calendar or business days?

Under § 13(d), the acquirer has 10 days before it must file a Schedule 13D disclosure statement. The 10–day window begins to run on the day the acquiring person makes an acquisition that puts his holdings over the five percent threshold. Where a group is formed, the 10–day window begins to run on the day they enter into the requisite agreement to act in concert, provided their aggregate holdings exceed 5% on that date.

Curiously, neither § 13(d) nor the rules thereunder specify whether the days in question are calendar or business days. The courts that have addressed the issue held that filers have ten business days within which to file.[1] Commentators are divided, with some stating that filers have ten calendar days to file[2] and others claiming that it is business days that are relevant.[3] Bizarrely, the SEC has used both in litigation releases.[4] In one of the few efforts to resolve the issue, a Wachtell Lipton associate cogently argued that calendar days is the correct interpretation.[5]

He reviewed the text of the SEC’s rules and its governing statute, the statutory history of the Williams Act, and the prudential concerns which underlie the disclosure requirements more generally, and concluded that all of these factors favor the calendar-day approach.

Across regulation 13d-G, the SEC rule that governs investors’ disclosure obligations, the term “day” is preceded by the term “business” on three occasions, but is not preceded by the term “calendar” at all. Using the line of interpretive logic laid out above, the SEC’s semantic choices are telling: when the agency wants to describe a “business day,” it utilizes those words specifically. Thus, even though the agency is on record as adopting both the business-day and calendar-day approaches, the text of its own rules makes clear that only the latter interpretation is correct. ...

Even if one were to find the text of the governing law too terse, the legislative history of the Williams Act makes clear that the Act contemplates prompt disclosure. This again suggests that the ambiguous term “days” should be read in its shorter varietal—i.e., calendar, not business. ...

Finally, as has been catalogued in a long-running debate elsewhere, there are significant prudential reasons to favor the calendar-day approach. ...

First, a calendar-day approach forces investors to disclose their positions sooner, rather than later. ...

Second, changes in technology have rendered even the 10-day timeline outdated.

It's bizarre that so few observers have commented on the lack of clarity in the statute and rules. It's especially bizarre that the SEC itself seemingly cannot make up its mind.

Can a Corporation Contract Out of (or Around) Appraisal? Updated

A friend (who uses my casebook, which gets him extra points) sent along this email:

I assume it is possible for a corporation to contract around appraisal in some meaningful way, but I'm having trouble finding a supporting citation.  Any suggestions?

For those joining us late, I explain in my book Mergers and Acquisitions

Mergers and sales of all or substantially all corporate assets can be likened to a form of private eminent domain. If the requisite statutory number of shares approves the transaction, dissenting shareholders have no statutory basis for preventing the merger. Granted, some of the minority shareholders may believe that the merger that is being forced upon them is unfair. They may want to retain their investment in the target or they may believe that the price is unfair.

Corporate statutes give hold-out shareholders no remedy where they simply want to keep their target shares—the statutes permit majority shareholders to effect a freeze-out merger to eliminate the minority. All the statute gives disgruntled shareholders is a right to complain about the fairness of the price being paid for their shares; namely, the appraisal remedy.

In theory, appraisal rights are quite straightforward. Briefly, they give shareholders who dissent from a merger the right to have the fair value of their shares determined and paid to them in cash, provided the shareholders comply with the convoluted statutory procedures.

Obviously, appraisal crops up in purchase agreements. Practical Law tells us that buyers sometimes "demand appraisal-rights closing conditions in their merger agreements. An appraisal-rights closing condition places a maximum limit on the percentage of common stock that can demand appraisal before the buyer can refuse to close." In addition, sellers sometimes offer a representation that appraisal rights are not available in connection with the transaction.

Also, of course, appraisal statutes commonly provide a "market" out that eliminates appraisal rights in certain transactions. Again, we turn to Practical Law:

Delaware, along with several other states (such as California, New Jersey, Texas, and Pennsylvania), maintains an exception to a stockholders' right to an appraisal. This exception, commonly known as the "market-out" exception, is based on whether a stockholder owns shares of a public company or stock that is held by a significant number of stockholders.

The market-out exception presumes that stockholders do not need appraisal rights when they are not being cashed out in the merger and there is a public and liquid market for their stock. If they disagree with a transaction, stockholders can sell their stock in the open market for the fair market value rather than involve the courts.

In Delaware, the market-out exception is only available if stockholders hold stock that is either:

• Listed on a national securities exchange.
• Held of record by more than 2,000 holders. (8 Del. C. § 262(b)(1).)

As of August 1, 2018, the market-out exception applies equally to two-step mergers conducted as front-end tender offers under Section 251(h) of the DGCL. ...

In Delaware, a stockholder owning public company shares listed on a national securities exchange regains the right to a statutory appraisal if the stockholder has to accept anything in the transaction other than:

• Stock of the surviving corporation.
• Stock of any other corporation that is or will be listed on a national securities exchange or held by more than 2,000 stockholders.
• Cash in lieu of fractional shares.
• Any combination of the above. (8 Del. C. § 262(b)(2)(a)-(d).)

None of this, however, speaks to the query. The question was whether you can get out of appraisal by contract. Before we can answer that query, however, we need to further refine it. Could the corporation include a provision in the articles of incorporation eliminating or limiting appraisal rights? Could the shareholders enter into a shareholder agreement that limited or eliminated appraisal rights? Does it matter whether we are talking about a public or a closely held corporation?

I start by looking at DGCL § 262, the appraisal statute. I don't see anything therein that provides a contractual out.

I then turned to the Model Business Corporation Act, which devotes an entire chapter (13) to what it calls dissenter rights. Section 13.02(c) provides a limited option to limit or eliminate appraisal rights:

... the articles of incorporation as originally filed or any amendment to the articles of incorporation may limit or eliminate appraisal rights for any class or series of preferred shares, except that (i) no such limitation or elimination shall be effective if the class or series does not have the right to vote separately as a voting group (alone or as part of a group) on the action or if the action is a conversion under section 9.30, or a merger having a similar effect as a conversion in which the converted entity is an eligible entity, and (ii) any such limitation or elimination contained in an amendment to the articles of incorporation that limits or eliminates appraisal rights for any of such shares that are outstanding immediately before the effective date of such amendment or that the corporation is or may be required to issue or sell thereafter pursuant to any conversion, exchange or other right existing immediately before the effective date of such amendment shall not apply to any corporate action that becomes effective within one year after the effective date of such amendment if such action would otherwise afford appraisal rights.

If you think of the articles as a contract (as I do), we have here a limited contract out. But it's very limited. In particular, it doesn't apply to common stock.

So I then turned to MBCA § 7.32, which governs shareholder agreements. It effectively only applies to close corporations, since it requires unanimity among the shareholders.

Nothing in § 7.32 expressly authorizes contracting out of appraisal, but there is a fairly broad catchall:

(a) An agreement among the shareholders of a corporation that complies with this section is effective among the shareholders and the corporation even though it is inconsistent with one or more other provisions of this Act in that it: ...

(8) otherwise governs the exercise of the corporate powers or the management of the business and affairs of the corporation or the relationship among the shareholders, the directors and the corporation, or among any of them, and is not contrary to public policy.

The commentary explains that:

Although the limits of section 7.32(a)(8) are left uncertain, there are provisions of the Act that may not be overridden if they reflect core principles of public policy with respect to corporate affairs. For example, a provision of a shareholder agreement that purports to eliminate all of the standards of conduct established under section 8.30 might be viewed as contrary to public policy and thus not validated under section 7.32(a)(8). Similarly, a provision that exculpates directors from liability more broadly than permitted by section 2.02(b)(4), or indemnifies them more broadly than permitted by section 2.02(b)(5), might not be validated under section 7.32 because of strong public policy reasons for the statutory limitations on the right to exculpate directors from liability and to indemnify them. The validity of some provisions may depend upon the circumstances. For example, a provision of a shareholder agreement that limited inspection rights under section 16.02 or the right to financial statements under section 16.20 might, as a general matter, be valid, but that provision might not be given effect if it prevented shareholders from obtaining information necessary to determine whether directors of the corporation have satisfied the standards of conduct under section 8.30. The foregoing are examples and are not intended to be exclusive.

Do dissenter rights "reflect core principles of public policy with respect to corporate affairs," such that they would fall within the non-exclusive list of provisions that may not be modified by contract? I was unable to find anything in the MBCA text or commentary that spoke to that issue.

Interestingly, however, Florida's version of § 7.32 formerly provided that:

For purposes of this paragraph, agreements contrary to public policy include, but are not limited to, agreements that reduce the duties of care and loyalty to the corporation as required by ss. 607.0830 and 607.0832, exculpate directors from liability that may be imposed under § 607.0831, adversely affect shareholders' rights to bring derivative actions under s. 607.07401, or abrogate dissenters' rights under §§ 607.1301-607.1320.30

Since Florida is an MBCA state, that sent me back to the history of § 7.32. The statutory comparison included in the MBCA Annotated says that Florida's version of § 7.32(a)(8) was unique.

A Westlaw search for the phrase "public policy" /s "dissent! right!" turned up noting pertinent except for a few references to the Florida statute. A search for the phrase "public policy" /s "appraisal! right!" kicked up one case claiming that courts have "have found a de facto merger or a continuation of the enterprise [where they] have involved public policy considerations which favor compensating tort victims or appraisal rights to minority shareholders." Atlas Tool Co., Inc. v. C. I. R., 614 F.2d 860, 871 (3d Cir. 1980). But the court cited only one case, Knapp v. N. Am. Rockwell Corp., 506 F.2d 361, 367 (3d Cir. 1974), which was a tort case not an appraisal case. A few courts have quoted Atlas, but without useful elaboration. 

A Westlaw search for (contract! /5 (around out)) /s "appraisal! right!" found only two results. The first was an article by Ian Ayres from 1991, in which he asserted that:

In the corporate context, for example, most states allow shareholders to contract around the default of preemption rights in the corporation's articles of incorporation, but minority appraisal rights are an immutable part of any corporate form of business. See Black, Is Corporate Law Trivial?: A Political and Economic Analysis, 84 NW. U.L. Rev. 542 (1990); see generally Bebchuk, The Debate on Contractual Freedom in Corporate Law, 89 Colum. L. Rev. 1395 (1989) (discussing mandatory and enabling aspects of corporate law).

Ian Ayres, Back to Basics: Regulating How Corporations Speak to the Market, 77 Va. L. Rev. 945, 999 (1991). As far as I could find, however, neither the Black nor the Bebchuk article speaks to contracting out of appraisal.

The other reference was a 1999 article by John Coates, in which he wrote that:

Some commentators have noted an alternative method for corporations in many jurisdictions to effectively avoid appraisal rights through the choice of transaction structure. See, e.g., Roberta Romano, Answering the Wrong Question: The Tenuous Case for Mandatory Corporate Laws, 89 Colum. L. Rev. 1599, 1600 (1989) (noting that the ability to choose transaction structure makes the rule that shareholders must vote on mergers “completely optional”). For example, the sale of substantially all of a Delaware corporation's assets does not trigger appraisal rights, while a merger does. Compared to “fair price” charter provisions, buy/sell agreements, and redeemable common stock (“discount contracts”), transaction choice is a blunt weapon. Discount contracts vary from traditional corporate structures only by specifying how the “fair value” will be determined. In addition, transaction choice only permits contracting around appraisal rights.

John C. Coates IV, "Fair Value" As an Avoidable Rule of Corporate Law: Minority Discounts in Conflict Transactions, 147 U. Pa. L. Rev. 1251, 1353 n.130 (1999). But this is not the sort of contracting out with which we are concerned. Instead, it's a transactional engineering out by opting for a transaction structure for which the law does not grant appraisal rights.

Turning back to Delaware law, it turns out that there are cases holding that preferred stockholders can waive appraisal rights. In Matter of Appraisal of Ford Holdings, Inc. Preferred Stock, 698 A.2d 973, 977 (Del. Ch. 1997), the certificate of designation governing the rights of the preferred stock in question purportedly limited appraisal rights by contractually specifying the price to be paid the preferred in the event a cash-out merger. Famed Delaware Chancellor William Allen began his analysis by noting that "preferred stock is a very special case." He went on to explain that:

All of the characteristics of the preferred are open for negotiation; that is the nature of the security. There is no utility in defining as forbidden any term thought advantageous to informed parties, unless that term violates substantive law. ...

It is my judgment ... that the terms of the Designations of the Cumulative Preferred clearly describe an agreement between the shareholders and the company regarding the consideration to be received by the shareholders in the event of a cash-out merger. There is no ambiguity ... regarding the value to be paid to shareholders if they are forced to give up their shares in a cash-out merger. The shareholders can not now come to this court seeking additional consideration in the merger through the appraisal process. Their security had a stated value in a merger which they have received.

See also In re Appraisal of Metromedia Intern. Group, Inc., 971 A.2d 893, 900 (Del. Ch. 2009) ("Given the contractual nature of preferred stock, a clear contractual provision that establishes the value of preferred stock in the event of a cash-out merger is not inconsistent with the language or the policy of § 262.").

But what about common shareholders?

At this point, I heard from a couple of friends who are experienced M&A practitioners. One pointed me to Manti Holdings, LLC v. Authentix Acq. Co., Inc., CV 2017-0887-SG, 2019 WL 3814453 (Del. Ch. Aug. 14, 2019). The shareholders of Authentix, Inc., a Delaware corporation, negotiated a merger with The Carlyle Group (a private equity fund manager). Under the terms of the deal, the former Authentix shareholders would remain shareholders of the post-merger entity, but with Carlyle now as a majority shareholder. The former Authentic shareholders, with the advice of counsel, unanimously entered into a shareholder agreement (SA) that waived any appraisal rights the shareholders might have in connection with the merger. In an unpublished opinion, Vice Chancellor Glasscock explained that:

The SA was not a contract of adhesion. As provided in the supplemental Joint Stipulation of Fact, the Petitioners—who were, I find, sophisticated parties—were represented by counsel, who exchanged drafts of the proposed SA before agreeing to a final contract. In other words, the sole owners of Authentix, Inc., with the help of counsel, negotiated the terms of the SA, as part of the 2008 merger with the Carlyle entity, Authentix, which merger was, I presume, valuable to the Petitioners. One of the provisions in that negotiated contract was, as I have found, a waiver of appraisal rights at issue here. The SA also rigorously limits the Petitioners' rights to sell their shares: the Carlyle majority must approve any sale, and the buyer must consent in writing to be bound by the SA's terms, including the waiver of appraisal rights. Presumably, the Petitioners have enjoyed the benefit of their bargain, through the time of the sale of Authentix.

The Vice Chancellor went on to hold that:

The SA is a clear, unambiguous contract, created as part of a merger, that was entered into by sophisticated parties, including the Petitioners here, who owned the entire interest in the entity to be merged. Modification of a statutory right to appraisal “must be express or at least very clearly implied.” This reasoning—that waiver of a party's rights is permitted, but must be clear—is found elsewhere in our law.

Here, Authentix Inc. was a private company (as is Authentix), and the Petitioners were its sole stockholders. There is no record evidence that the Petitioners were not fully informed; to the contrary, there is evidence that the Petitioners are sophisticated investors who were fully informed and represented by counsel when they signed the SA, under which they obtained some rights and relinquished others, and then accepted the benefits of that contract for seven years. The SA clearly and unambiguously waives appraisal rights; therefore, it should be enforced. I need not decide whether a waiver of appraisal would be upheld in other circumstances.

Notice the emphasis on four points: (1) this was a privately held company; (2) there was unanimity among the shareholders; (3) the parties were sophisticated investors represented by counsel; and (4) the terms are clear. To the extent Manti stands for the proposition that you can contract out of appraisal, it provides a very limited contractual out. 

My other friend sent along this detailed note:

... venture capital investors routinely waive appraisal rights. The standard National Venture Capital Association form of Voting Agreement provides, in pertinent part, that the investor agrees "to refrain from (i) exercising any dissenters’ rights or rights of appraisal under applicable law at any time with respect to such Sale of the Company, (ii) asserting any claim or commencing any suit (x) challenging the Sale of the Company or this Agreement, or alleging a breach of any fiduciary duty of the Requisite Parties or any affiliate or associate thereof (including, without limitation, aiding and abetting breach of fiduciary duty) in connection with the evaluation, negotiation or entry into the Sale of the Company, or the consummation of the transactions contemplated thereby...."

So it looks like you can ex ante waive appraisal via a unanimous shareholder agreement in a closely held corporation (possibly excepting Florida corporations), and at least limit appraisal rights of preferred stock in the certificate of designation. As for common shareholders of public corporations, however, it seems doubtful.

In closing, I feel constrained to ask: What other casebook author gives you this sort of service?

Update: A friend sent along a link to an article by Jill Fisch:

A judicial determination of fair value in a private company can be a difficult and imprecise process. This difficulty coupled with variations in way mergers are negotiated and structured and the potential for conflicts of interest lend uncertainty to appraisal proceedings. As a result, corporate participants have powerful reasons to seek to limit the uncertainty associated with an appraisal proceeding ex ante. The response has been the growing use of shareholder agreements that limit appraisal rights.

Appraisal waivers also offer a potentially attractive solution to a somewhat different concern, the growth of appraisal litigation in publicly traded companies. As with private companies, public companies face the problem that appraisal proceedings involve substantial cost and uncertainty. Although courts and commentators have grappled with how best to calculate fair value and the impact of that methodology on the incentives of participants in the merger process, they have failed to reach consensus. Appraisal waivers provide an alternative approach - a market-based mechanism to determine the efficient level of merger litigation.

Public companies have not followed the lead of private companies, however, in using appraisal waivers. As this Article explains, the likely reason is the impracticality of using shareholder agreements in public companies and a concern that appraisal waivers in a charter or bylaw would be invalid.

This Article considers both the normative and legal case for appraisal waivers. It argues that, with appropriate procedural protections – specifically the requirement that such waivers take the form of charter provisions -- appraisal waivers are normatively desirable. It then questions whether distinguishing between the use of appraisal waivers in private and public companies is appropriate and argues that it is not. The source of this distinction is a potential difference in the scope of private ordering available through shareholder agreements as opposed to the charter or bylaws, a difference that this Article critiques.

The Article concludes that, under current law, the legal status of appraisal waivers is unclear. Given the potential value that such waivers provide, and the particular value that market discipline would bring to the scope and structure of such waivers, the Article argues for legislation validating a corporation’s authority to limit or eliminate appraisal rights in its charter.

Fisch, Jill E., Appraisal Waivers (August 2, 2020). U of Penn, Inst for Law & Econ Research Paper No. 20-47, European Corporate Governance Institute - Law Working Paper No. 537/2020, Available at SSRN: https://ssrn.com/abstract=3667058 or http://dx.doi.org/10.2139/ssrn.3667058

Professor Lipton asks "What about Blasius?" Well, what about it?

In the preceding post, I commended to your attention Professor Ann Lipton's thoughtful post on VC Laster's recent decision in United Food & Commercial Workers Union v. Zuckerberg. (As she kindly notes, I also blogged about that case recently.)

After the extended and useful discussion of how the case exemplifies some of the key "pathologies associated with the common law," Ann turns to the merits of the case:

... when it comes to the underlying substantive dispute in Zuckerberg, I’m not sure I agree with Laster’s analysis.

The lawsuit arose out of Mark Zuckerberg’s ill-fated proposal to amend Facebook’s charter to create a class of no-vote shares, essentially to allow him to transfer much of his financial interest in the company while maintaining his hold on the high-vote B shares that give him control.  As many will recall, the Board recommended the charter amendment and the shareholders – dominated by Zuckerberg’s high vote shares – voted in favor, but in a subsequent lawsuit, stockholder-plaintiffs uncovered multiple irregularities that had occurred in the course of negotiating the proposal.  Zuckerberg dropped the plan, and that was that, until new plaintiffs brought a derivative lawsuit alleging that even though the plan was abandoned, all of the expenditures associated with it damaged the company.  Thus, the question before Laster was whether the Facebook Board was sufficiently disinterested and independent to decide whether to bring a lawsuit over the Board’s earlier approval of the charter amendments, namely, whether to sue many of its own members.  And that question turned, in part, on whether Reed Hastings and Peter Thiel, two of Facebook’s Board members, faced a substantial risk of liability for having voted in favor of the charter amendment in the first place.

So really, part of the underlying legal question here was whether Hastings and Thiel breached their duties of loyalty by recommending the charter amendment.  The plaintiffs argued, in part, that they did so because they were “biased” in favor of founder control – namely, they believed that corporate founders should be able to run their companies free from the meddling influence of public shareholders.

Laster held that even if this was their reasoning, it did not constitute a lack of loyalty:

A director could believe in good faith that it is generally optimal for companies to be controlled by their founders and that this governance structure is value-maximizing for the corporation and its stockholders over the long-term. Others might differ. As long as an otherwise independent and disinterested director has a rational basis for her belief, that director is entitled (indeed obligated) to make decisions in good faith based on what she subjectively believes will maximize the long-term value of the corporation for the ultimate benefit of its residual claimants.  If a director believes that it will be better for the corporation to have the founder remain in control, then the director may make decisions to achieve that goal. As long as a director acts in good faith, exercises due care, and does not otherwise have any compromising interests, a director will not face liability for making a decision that she believes will maximize the long-term value of the corporation for the ultimate benefit of its residual claimants,…

The belief that founder control benefits corporations and their stockholders over the long run is debatable, but it is not irrational.

To which I respond – what about Blasius?

In Blasius Industries v. Atlas, an incumbent board maneuvered to neuter the effects of shareholder consents that would otherwise have replaced it with a dissident slate. Chancellor Allen held that even if the Board sincerely and in good faith believed the dissident slate would harm the company and its own plans were better for shareholders, the incumbents would violate their fiduciary duties by taking the choice out of the shareholders’ hands. 

To which I respond, well, what about Blasius? I have huge respect for Chancellor Allen. But even mighty Homer nodded. Allen's record has more than a few glitches. Caremark was wrong when decided and gave birth to an increasingly awful body of law. Credit Lyonnais was a disaster waiting to happen, although the Delaware Supreme Court managed to nip that one in the bud. And Blasius may be the worst of the bunch.

By the way, I discuss Blasius in my new Advanced Corporation Law text (and it as much a text as it is a casebook, so practicing lawyers will want a copy too).

Ever since Allen invented Blasius, the Delaware courts have struggled to figure out what to do with it.As Former Delaware Chief Justice Leo Strine aptly observed in an opinion written while he was still on the Chancery Court, Blasius is not "a genuine standard of review that is useful for the determination of cases," but rather "an after-the-fact label placed on a result." Mercier v. Inter-Tel (Delaware), Inc., 929 A.2d 786, 788 (Del. Ch. 2007). 

Indeed, as Strine also observed, post-Blasius cases are commonly “threshold exertions in reasoning as to why director action influencing the ability of stockholders to act did not amount to disenfranchisement, thus obviating the need to apply Blasius at all.” Id. at 806. Personally, I think they're embarrassed by it and the failure to overturn it is one of those pathologies about which Professor Lipton was writing.

One of the first things the Delaware courts did to limit Blasius was to effectively subsume Blasius into the Unocal standard "where the board 'adopts any defensive measure taken in response to some threat to corporate policy and effectiveness which touches upon issues of control.'” Stroud v. Grace, 606 A.2d 75, 92 n.3 (Del. 1992)

Shortly thereafter they limited Blasius to cases of unilateral board action. See, e.g., Williams v. Geier, 671 A.2d 1368, 1376 (Del. 1996) ("Blasius is appropriate only where the primary purpose of the board's action [is] to interfere with or impede exercise of the shareholder franchise, and the stockholders are not given a full and fair opportunity to vote"; internal quotation marks deleted).

Strine built on that foundation when he was a Vice Chancellor Portnoy v. Cryo-Cell Int’l, Inc.,940 A.2d 43 (Del. Ch. 2008). He declined to apply Blasius to vote buying. To be sure, Strine’s opinion in Portnoy can be seen as part of a larger trend in Delaware corporate law towards judicial deference to informed, non-coerced shareholder votes. But if Blasius doesn't reach vote buying, what's left of it?

In another case, Strne declined to apply Blasius where the board of directors timed a shareholder vote to be held before a dual class capital structure expired even though the board knew that after that structure expired a favorable vote would be much harder to obtain.  In re Gaylord Container Corp. S'holders Litig., 753 A.2d 462, 469, 486-87 (Del. Ch. 2000) (Strine, VC). 

In light of such decisions, a New York court has suggested that Blasius is now limited to proxy contests involving director elections:

Blasius a... application 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."

In re Bear Stearns Litig., 870 N.Y.S.2d 709, 733 (N.Y. Sup. 2008) (citations and footnote omitted).

So what about Blasius? "Blasius is simply 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.” Mary Siegel, The Problems and Promise of "Enhanced Business Judgment", 17 U. Pa. J. Bus. L. 47, 81 (2014).

It is also an unnecessary standard. In Schnell v. Chris-Craft Indus., Inc., 285 A.2d 437, 439 (Del.1971), the Delaware Supreme Court held that “inequitable action does not become permissible simply because it is legally possible."

The Schnell decision has been routinely used to strike down board of director action that improperly infringed on shareholder voting. Consider, for example, the unjustly overlooked case of Alpha Sunde Smaby and her almost successful campaign to be elected to the board of Northern States Power Company. The company used cumulative voting to elect directors. Smaby was put forward with support from environmental and consumer groups. Under the prevailing articles and bylaws, Smaby needed about 7% of the votes to be elected. She was thought likely to get the votes of about 9%. The board amended the bylaws to reduce the number of directors from 14 to 12 and to adopt a classified board. Under the new bylaws, with three classes of four directors each and only one class up for election in the current year, Smaby needed 20% of the votes to win. In reliance on Schnell, the court struck down the bylaw changes: 

In the instant case, the actions of the insiders, if not unfair, were certainly questionable in light of their fiduciary obligation to the plaintiff shareholders. Not only did the defendants change the rules in the middle of the game, but they refused to disclose the existence of the changes when approached by the plaintiffs. Both of these actions served to frustrate the plaintiff shareholders’ legitimate efforts to run for the Board of Directors and may well be a breach of fiduciary duty. ...

Coalition to Advocate Public Utility Responsibility, Inc. v. Engels, 364 F. Supp. 1202 (D. Minn. 1973). (It's in my Advanced Corporation Law book.) What more do you need?

Finally, and I will not expound on this point at any length, Blasius is fundamentally flawed because it rests on a deeply erroneous premise. It rests on Allen's belief that corporate law assumes corporate democracy. Disproving that claim, of course, has been my principal contribution to corporate law and my principal claim to fame. For a concise treatment, I refer you to my book The New Corporate Governance in Theory and Practice.

Material Adverse Change Clauses under UK Law

Interesting post from Narine Lalafaryan on the uncertain state of MAC clauses under UK law.

Delaware Chancery Court Provides Guidance on Breach of Efforts Covenants in M&A Agreements

The failed merger between Anthem and Cigna led to a ton of litigation in both federal and Delaware courts. As the saga winds towards its conclusion, there remained a suit in which both sides are suing the other for breaching covenants requiring each "to take all reasonable steps to consummate the Merger (the “Reasonable Best Efforts Covenant”) and to take “any and all actions” necessary to avoid impediments to the Merger from government entities (the “Regulatory Efforts Covenant”)."

The Delaware Business Litigation Report has a lengthy post on the case, describing the complex background and the issues involved. They key finding is that:

Cigna breached the Efforts Covenants, the Court held that the burden then shifted to Cigna to prove that, even if Cigna had met its obligations under the Efforts Covenants, a condition to closing – the No Injunction Condition—still would have failed. The Court ruled that Cigna had proved, in part based on the opinions of two of its experts, that the District Court would have concluded, and the Circuit Court would have affirmed, that the effect of the Merger on the market for the sale of commercial insurance to national accounts violated the anti-trust laws regardless of Cigna’s breaches and thus would have enjoined the Merger. The Court held, therefore, that Cigna had proved that it was more likely than not, that Cigna’s breaches of the Efforts Covenants would not have affected those courts acting to enjoin the Merger. For that reason, the Court held that, notwithstanding Anthem’s proof of Cigna’s violations of the Efforts Covenants, Anthem was entitled to no damages.

I plan to put this case aside for discussion in the next edition of my M&A casebook and treatise.

Does Van Gorkom's requirement of an informed decision survive Corwin? I'm stumped.

Assume the following:

1. The board of directors is approached by a private equity fund-backed management buyout group.
2. The board approves the transaction but, in doing so, was grossly negligent in failing to inform themselves of all information reasonably available to them.
3. The board then puts the proposal to a vote of the shareholders. The shareholder vote is uncoerced. The proposal is approved by a substantial majority of the disinterested shareholders.
   1. But the proxy statement did not disclose that the directors had been grossly negligent in failing to inform themselves of all information reasonably available to them.
4. Has the shareholder vote satisfied Corwin?
   1. See Stroud v. Grace, 606 A.2d 75, 84 n.1 (Del. 1992) ("We recognize the long-standing principle that to comport with its fiduciary duty to disclose all relevant material facts, a board is not required to engage in “self-flagellation” and draw legal conclusions implicating itself in a breach of fiduciary duty from surrounding facts and circumstances prior to a formal adjudication of the matter. Nonetheless, when a board allegedly breaches its fiduciary duties, we will not uphold shareholder ratification unless the board discloses all material facts relevant to the issue at hand.").

Assuming Corwin applies, is there any room left for rebutting the business judgment rule by showing that the directors failed to satisfy the informed decision requirement laid out by Van Gorkom? Or is that requirement a dead letter?

On the basis of Leo Strine's decision in Singh v. Attenborough, 137 A.3d 151 (Del. 2016), I think the answer to the former is no:

We affirm the judgment of the Court of Chancery solely on the basis of its decision on reargument of October 29, 2015, finding that a fully informed, uncoerced vote of the disinterested stockholders invoked the business judgment rule standard of review. But, we note that the reargument opinion's decision to consider post-closing whether the plaintiffs stated a claim for the breach of the duty of care after invoking the business judgment rule was erroneous. Absent a stockholder vote and absent an exculpatory charter provision, the damages liability standard for an independent director or other disinterested fiduciary for breach of the duty of care is gross negligence, even if the transaction was a change-of-control transaction.Therefore, employing this same standard after an informed, uncoerced vote of the disinterested stockholders would give no standard-of-review-shifting effect to the vote. When the business judgment rule standard of review is invoked because of a vote, dismissal is typically the result. That is because the vestigial waste exception has long had little real-world relevance, because it has been understood that stockholders would be unlikely to approve a transaction that is wasteful.

On the other hand, I take it that Robert Miller disagrees:

Even after Corwin, in the absence of a Section 102(b)(7) provision in the corporate charter, a plaintiff-stockholder may argue post-closing that the stockholder vote was not fully informed, and if the plaintiff succeeds on this score, the directors would be liable in monetary damages for any breaches of their duty of care, including under Revlon. In the presence of a Section 102(b)(7) provision, the plaintiff-stockholder has to argue that any material misstatement or omission in the disclosure resulted from a breach of the board's duty of loyalty--a claim that, in a third-party transaction in which the directors were not otherwise interested--is very unlikely to succeed. See Larkin v. Shah, C.A. No. 10918-VCS, 2016 WL 4485447, at *20 (Del. Ch. Aug. 25, 2016). The upshot is that, even after Corwin, Section 102(b)(7) remains very important in insulating directors from post-closing actions for damages in merger cases.

Robert T. Miller, Smith v. Van Gorkom and the Kobayashi Maru: The Place of the Trans Union Case in the Development of Delaware Corporate Law, 9 Wm. & Mary Bus. L. Rev. 65, 219 n.676 (2017). But note that his article pre-dated Singh.

I welcome comments, but prefer not to get speculation. Cites preferred.

Update: We got a great response from Robert Miller. Here.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 4

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.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 3

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 this Part, I discuss 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.

The conflicted interest argument

Put in my director primacy terminology, the conflicted interest argument is that accountability concerns are so severe in this context that they must trump authority values. Unsolicited tender offers implicate accountability concerns in at least two ways, which might be referred to respectively as transactional and systemic. The former relates to the effect of a hostile takeover on the target in question, while the latter relates to the effect resistance to hostile takeovers can have on public corporations as a whole. Neither justifies wholly barring authority values from playing a part in developing the governing legal rules.

Transactional accountability. As with business judgment rule scholarship generally, a failing of the academic literature on takeovers is the almost universal tendency to conflate the roles of corporate officers and directors. The legal literature speaks of “management resistance” and “management defensive tactics,” rarely recognizing any separate institutional role for the board. Most commentators simply assume that even independent directors are in thrall to senior managers and will ignore shareholder interests if necessary to preserve their patrons’ jobs.[2]

In contrast, the Delaware courts take the board’s distinct role quite seriously, especially with respect to its independent members. As a doctrinal matter, the board’s burden of proof is more easily carried if the key decisions are made by independent directors.[3] As a practical matter, the court’s assessment of the outside directors’ role often is outcome-determinative.[4]

Why have the Delaware courts insisted on drawing such sharp distinctions between the board’s role and that of management? Because while the conflict of interest unsolicited tender offers pose for the target company’s managers is inescapable, the independent director’s conflict of interest is merely a potential problem. For the independent directors, the conflicts posed by unsolicited tender offers are no different than those posed by freezeout mergers, manage­ment buyouts, interested director transactions, or a host of similar situations. Corporate law neither prohibits these transactions, nor requires complete board passivity in connection with them, simply because they potentially involve conflicts of interest. Instead, it regulates them in ways designed to constrain self-interested behavior. Unless one makes a living on the buy-side of corporate takeovers, it is not clear why hostile takeovers should be treated differently.

Consider, for example, the somewhat analogous case of management-sponsored leveraged buyouts. Like unsolicited tender offers, these transactions inherently involve a strong risk of management self-dealing. While management is acting as the sellers’ agents and, in that capacity, is obliged to get the best price it can for the shareholders, it is also acting as a purchaser and, in that capacity, has a strong self-interest to pay the lowest possible price. Like unsolicited tender offers, management buyouts also create conflicts of interest for the independent directors. Just as an independent director may resist an unsolicited tender offer to avoid being fired by the hostile bidder, he may go along with a management buyout in order to avoid being fired by the incumbent managers. Alternatively, if an independent director is inclined to resist a hostile takeover because of his friendship with the insiders, why should he not go along with a management-sponsored buyout for the same reason? Strikingly, however, the empirical evidence indicates that shareholder premiums are essentially identical in management-sponsored leveraged buyouts and arms-length leveraged buyouts.[5] This evidence suggests that the potentially conflicted interests of independent directors are not affecting their ability to successfully constrain management misconduct. Accordingly, while judicial review of management buyouts tends to be rather intensive, courts have not prohibited such transactions, but have addressed the problem of conflicted interests by encouraging an active role for the firm’s independent directors in approving a management buyout proposal.[6] Why should the same not be true of the board’s response to unsolicited tender offers?

In sum, the conflict of interest present when the board responds to an unsolicited tender offers thus differs only in degree, not kind, from any other corporate conflict. Although skepticism about their motives is thus appropriate, their conflict of interest does not necessarily equate to blameworthiness. Rather, it is simply a state of affairs inherently created by the necessity of conferring authority in the board of directors to act on behalf of the shareholders. To be sure, proponents of the no resistance rule will respond that such a state of affairs could be avoided by declining to confer such authority on the board in this context. Yet, if the legal system deprives the board of authority here, it will be hard-pressed to decline to do so with respect to other conflict transactions. As has been the case with other situations of potential conflict, we therefore would expect the courts to develop standards of review for takeover defenses that are designed to detect, punish, and deter self-interested behavior. Because the risk may be greater in this context, stricter than normal policing mechanisms may be required, but this does not mean that we must set aside authority values by divesting the board of decisionmaking authority.

Systemic accountability. Because the incumbent directors and management’s transactional conflict of interest is neither so severe nor unusual as to justify a wholly new governance system for tender offers, opponents of target resistance to tender offers must find some other basis for depriving the board of its normal decisionmaking authority. For most critics of takeover defenses, such a basis is to be found in the systemic agency cost effects of management resistance. Sharfman and Moore, for example, make this point at pp. 22-23.

In agency cost theory, disciplinary actions against employees and mid-level managers are expected to take the form of dismissals, demotions, or salary adjustments imposed by senior management. Where it is senior management that requires discipline, however, alternative mechanisms become necessary. According to the standard academic account, hostile takeover bidders provide just such a mechanism. Making the standard efficient capital market assumption that poor corporate performance will be reflected in the corporation’s stock price, opponents of target resistance claim that a declining market price sends a signal to prospective bidders that there are gains to be had by acquiring the corporation and displacing the incumbent directors and managers. Of course, the signal will not always be correct. Sometimes the firm’s market price may be declining despite the best efforts of competent management, as where some exogenous shock—such as technological change or new government regulation—has permanently altered the corporation’s fundamentals. If close examination by a prospective bidder reveals that the declining market price is in fact attributable to shirking by senior management, however, a disciplinary takeover could produce real gains for division between the target’s shareholders and the successful acquirer. This prospect creates positive incentives for potential bidders to investigate when the market signals a firm is in distress. Conversely, because keeping the stock price up is the best defense managers have against being displaced by an outside searcher, the market for corporate control—more specifically, the unsolicited tender offer—is an important mechanism for prevent­ing manage­ment slacking. Indeed, some would argue, the market for control is the ultimate monitor that makes the modern business corpora­tion feasible.

By making possible target resistance to unsolicited takeover bids, so the theory goes, takeover defenses thus undermine the very foundations of corporate governance. The first prospective bidder to identify a prospective target incurs significant search costs, which become part of the bidder’s overall profit calculation. By announcing its offer, however, the first bidder identifies the prospective target to all other potential bidders. Subsequent bidders thus need not incur the high search costs carried by the first bidder, perhaps allowing them to pay a higher price than is possible for the first bidder. If target resistance delays closing of the offer, subsequent bidders have a greater opportunity to enter the fray. At the very least, target resistance may force the initial bidder to raise its offer, reducing the gains to search. Target resistance therefore reduces bidders’ incentives to search out takeover targets. Reductions in bidders’ search incentives results in fewer opportuni­ties for shareholders to profit from takeover premia. More important, a reduction in search incentives also reduces the effectiveness of interfirm monitor­ing by outsiders. In turn, that reduces the market for corporate control’s disciplinary effect. A rule prohibiting target resistance is therefore likely to decrease agency costs, and increase stock prices, benefiting shareholders of all firms, even those whose companies are never targeted for a takeover bid.[7]

All well and good, but who died and left the unsolicited tender offer in charge? A no resistance rule in effect creates a kind of private eminent domain: bidders can effectively “condemn” target shares by offering even a slight premium over the current market price.[8] Awarding the lion’s share of the gains to be had from a change of control to the bidder, however, only makes sense if all gains from takeovers are created by bidders through the elimination of inept or corrupt target managers and none are attributable to the hard work of efficient target managers. Unfortunately for proponents of the no resistance rule, the evidence is that takeovers produce gains for a variety of reasons that are likely to differ from case to case.[9]

In order for a no resistance rule to make sense, the unsolicited tender offer also must be the critical mechanism by which incumbents are disciplined. In fact, however, unsolicited tender offers are so rare and sporadic that a director or manager who shirks his responsibilities by playing golf when he should be working is undoubtedly more likely to be struck by lightening while on the course than to be fired after a hostile takeover. As a result, the disciplinary effect of takeovers has been grossly overstated by proponents of the no resistance rule. Instead, as our analysis of Delaware’s takeover jurisprudence will suggest, the critical disciplinary mechanism is the board of directors, especially the independent directors. In turn, the tenure and reputation of outside board members are determined by the performance of the inside managers, which gives indepen­dent directors incentives to be vigilant in overseeing management’s conduct.

If independent directors were the sole bulwark against managerial shirking, concerns about structural and actual bias might be troubling, but they do not stand alone. Although monitoring by institutional investors is weak, and problematic given our theory of the firm, it likely has some effects on the margins. Whatever one makes of institutional investor activism as a monitoring device, important accountability mechanisms continue to be supplied by the product market in which the firm operates and the internal and external job markets for the firm’s managers.[10] Corporate directors and managers do not get ahead by being associated with sub-par performance in the product markets. Indeed, as between shareholders and managers, it is the latter who have the greatest incentives to ensure the firm’s success. Shareholders can and should hold diversified portfolios, so that the failure of an individual firm will not greatly decrease their total wealth, while managers cannot diversify their firm-specific human capital (or their general human capital, for that matter). If the firm fails on their watch, it is the incumbent directors and managers who suffer the principal losses.

It is for this reason that the capital markets also have a disciplinary function. Incompetent or even unlucky management eventually shows up in the firm’s performance. These signs are identified by potential debt or equity investors, who (if they are willing to invest at all) will demand a higher rate of return to compensate them for the risks of continued suboptimal performance. In turn, this makes the firm more likely to flounder—taking the incumbent managers down with it.

Our point is not that the tender offer has no disciplinary effect, but merely that the tender offer is only one of many mechanisms by which management’s behavior is constrained. Once we view corporate governance as a system in which many forces constrain management behavior, the theory of the second best becomes relevant. In a complex, interdependent system, it holds that inefficiencies in one part of the system should be tolerated if “fixing” them would create even greater inefficiencies elsewhere in the system as a whole.[11]Even if we concede the claim that a no resistance rule would reduce agency costs, such a rule would still be inappropriate if it imposes costs in other parts of the corporate governance system. By restricting the board’s authority with respect to tender offers, the various academic proposals impose just such costs by also restricting the board’s authority with respect to the everyday decisions upon which shareholder wealth principally depends. Accordingly, it is not surprising that Delaware has rejected the academic approach to the unsolicited tender offer. This half of Delaware’s takeover jurisprudence, like that regulating negotiated acquisitions, is best explained as implicitly concluding that the benefits of preserving authority outweighs the costs of doing so.

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.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 2

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.

A long time ago, in my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] 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.

Given the Delaware courts’ normal sensitivity to conflicts of interests, the clear evidence that management resistance to unsolicited tender offers is at best a risky proposition for shareholders and at worst economically disastrous (note that I do not quibble with the empirical evidence Sharfman and Moore rehearse at 38-55, I'm just not persuaded it overcomes the arguments herein), and the undeniable fact that the no resistance rule does a more thorough job of removing management’s conflicted interests from the tender offer process than does Unocal, is it not surprising that Delaware courts adopted a standard that permits target resistance? The Delaware courts’ consistent rejection of the no resistance rule suggests that the courts have perceived some dimension to the puzzle that has escaped the attention of academics.

Analysis should begin with the proposition that all doctrinal responses to corporate conflict of interest transactions have two features in common. First, so long as the board of directors is disinterested and independent, it retains full decision-making authority with respect to the transaction.[2] Second, the board’s indepen­dence and decision-making process is subject to judicial scrutiny. Here, as ever, we see the competing influences of authority and accountability.

In a sense, Delaware’s takeover cases do no more than to simply bring this traditional corporate governance system to bear on target resistance to tender offers.[3] Admittedly, the form of review is unique, but so too is the context. Just as has been the case with all other corporate conflicts of interest, Delaware decisions in the unsolicited tender offer context strive to find an appropriate balance between authority and accountability. We see the courts’ concern for accountability in, for example, Unocal’s explicit recognition of the conflict of interest that target directors and officers face in an unsolicited takeover bid. Of course, it is one thing to recognize this conflict of interest and quite another to do something about it. As a doctrinal matter, the Delaware supreme court concretely demonstrated its sensitivity to management’s conflicted interests by placing the preliminary burden of proof on the board. This action demonstrated considerable judicial sensitivity to the board’s conflicted interests, because outside of areas traditionally covered by the duty of loyalty, putting the initial burden of proof on the board of directors is a very unusual—indeed, essentially unprecedented—step.

At the same time, however, we see the value of authority reflected in, for example, Unocal’s express rejection of the passivity model. Even plainer evidence of the Delaware courts’ concern for authority came when Chancellor Allen wrote that unless Unocal was carefully applied “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.”[4] Is it not striking how precisely Allen echoes our argument that one cannot make an actor more accountable without simultaneously transferring some aliquot of his decision-making authority to the entity empowered to hold him to account?

In contrast, virtually all of the policy prescriptions to emerge from the academic accounts of the tender offer’s corporate governance role would create an entirely corporate governance system, in which the board is stripped of some or all of its normal decision-making authority. Recast in our terminology, the academic proposals reflect an overriding concern with accountability. There is no room in the academic account for the value of authority. Indeed, the academic proposals reject the very notion that authority has any legitimate role to play in developing takeover doctrine. Deciding whether the judiciary or the ivory tower has the better argument is the task to which the remainder of this section is devoted.

We approach the problem by asking whether the unsolicited tender offer differs in kind, not just degree, from any other conflicted interest transaction. If so, perhaps a special governance scheme applicable only to unsolicited tender offers can be justified. If not, however, we would expect the law to treat unsolicited tender offers just as it treats other conflicted interest transactions. In other words, the law can be expected to develop mechanisms for policing incumbent conflict of interests, but cannot be expected to deny incumbents a role in the process.

The question of comparative advantage

According to most critics of Delaware’s takeover jurisprudence, corporate law gives the board decision-making authority because in most situations the directors have a competitive advantage vis-a-vis the shareholders in choosing between competing alternatives. They then argue that directors have no such competi­tive advantage when it comes to making tender offer decisions and, accordingly, reject granting the board decision-making authority in the tender offer context. Certainly, it is true that even the most apathetic investor is presumably capable of choosing between an all-cash bid at $74 per share and an all-cash bid at $76. This analysis, however, obscures two important rationales for granting the board decision-making authority in the tender offer context.

At the outset, it is important to recognize that unsolicited tender offers and negotiated acquisitions have a good deal in common. From a practical perspective, it is often increasingly difficult to tell the two apart. In today’s market place most takeovers follow a fairly convoluted path. They start out quasi-hostile, but end up as quasi-friendly, or vice-versa. They start out as a merger proposal, which is restructured as a tender offer for tax or other business reasons, or vice-versa. The problem is usefully illustrated by Chancellor Allen’s opinion in TW Services v. SWT Acquisition.[5] SWT’s unsolicited partial tender offer for TW Services was subject to a number of conditions, including a requirement that the transaction be approved by TW Services’ board of directors. The TW Services’ board saw the tender offer as a ruse designed to extort greenmail or to put the company into play. Accordingly, the board declined to redeem the company’s outstanding poison pill. SWT filed a lawsuit seeking invalidation of the pill. Because SWT conditioned its offer on the TW Service board’s support, the case presented a problem of characterization that the legal literature largely ignores. If the transaction is characterized as a merger, then most commentators would permit the board an active decision-making role. Conversely, if the transaction is characterized as a tender offer, they would preclude the board from exercising decision-making authority. Categorizing this transaction, however, is a non-trivial task.[6] Attempting to define the scope of the board’s authority by the nature of the transaction at hand thus quickly proves an unsatisfactory resolution.

Even if one were wholly confident of one’s ability to appropriately characterize transactions, however, the comparative advantage argument still would not justify precluding the board from exercising decision-making authority in tender offers. Consider transactions like the defensive restructuring at issue in City Capital Associates v. Interco. In the face of an all-cash hostile bid at $74 per share, Interco’s board of directors proposed to sell certain assets and to borrow a substantial amount of money. The joint proceeds of those transactions would then be paid out to Interco’s shareholders as dividends. The dividends would be paid in three forms: cash, bonds, and preferred stock. The dividends’ total value was said to be $66 per share. Interco’s investment banker opined that, after this series of transactions, Interco’s stock would trade at no less than $10 per share. The proposed defensive measures thus purportedly would give Interco’s shareholders a total value of $76—$2 more than the hostile bid. In rebuttal, the bidder’s investment bankers valued the defensive plan at $68-$70 per share.[7] It is precisely because passive, widely dispersed shareholders have neither the inclination nor the information necessary to decide between these sort of alternatives that the corporate law in other contexts allocates the decision to the board.[8] Only compelling accountability concerns can justify treating tender offers differently. The comparative advantage argument thus collapses into a variant of the agency cost arguments discussed below.

The bypass argument

An alternative justification for treating the tender offer differently than negotiated acquisitions rests on the former’s elimination of the need for target management’s cooperation. As we saw above, the target board’s gatekeeper role in negotiated acquisitions creates a conflict of interest, which is constrained principally by the ability the tender offer gives a bidder to bypass the target’s board by purchasing a controlling share block directly from the stockhold­ers. According to some academics, authority values thus are only appropriate in the negotiated acquisition context if the board is denied the ability to resist tender offers.[9]

This argument looks good on paper, but ultimately is unpersuasive. In the first place, it too ignores the problem of characterization alluded to in the preceding section. In addition, tender offers are not the only vehicle by which outsiders can appeal directly to the shareholders. Proxy contests similarly permit a would-be acquirer to end-run management. How a shareholder votes in director elections seems just as an individual decision as that of whether to tender to a hostile bidder. Yet, nobody expects a board to be passive in the face of a proxy contest. To the contrary, the incumbent board’s role is very active indeed. Why? Because the incumbent board members remain in office and therefore also continue to be legally responsible for the conduct of the business until they are displaced. Complete passivity in the face of a proxy contest thus would be inconsistent with the directors’ obligation to determine and advance the best interests of the corporation and its shareholders.[10]

The same is true of a tender offer. While the analogy between tender offers and proxy contests is unconvincing for most purposes, the courts may have correctly sensed a fit at this most basic level. The directors will remain in office unless the offer succeeds and they thereafter resign or are removed by the new owner. As a doctrinal matter, the board of directors has a “fundamental duty” to protect shareholders from harm, which can include an unsolicited tender offer that the directors truly believe is not in the shareholders’ best interests. As Unocal recognized, complete passivity in the face of such an offer would be inconsistent with their fiduciary duties.[11] To the contrary, their on-going fiduciary duty obliges them to seek out alternatives. At the bare minimum, it thus would be appropriate for the board to use takeover defenses to delay an inadequate bid from going forward while the board seeks out an alternative higher-valued offer, because until the board has time to arrange a more attractive alternative there is a risk that the shareholders will “choose an inadequate tender offer only because the superior offer has not yet been presented.”[12]

The structural argument (a.k.a. shareholder choice)

A more substantial argument against authority values in the unsolicited tender offer context contrasts the board’s considerable control in negotiated acquisitions with the board’s lack of control over secondary market transactions in the firm’s shares. Corporate law generally provides for free alienability of shares on the secondary trading markets. Mergers and related transfers of control, however, are treated quite differently. As we saw above, corporate law gives considerable responsibil­ity and latitude to target directors in negotiating a merger agreement. The question then is whether unsolicited tender offers are more like secondary market trading or mergers.

The so-called structural argument—also known as the shareholder choice argument—asserts that the tender offer is much more closely analogous to the former. According to its proponents, an individual shareholder’s decision to tender his shares to the bidder no more concerns the institutional responsibilities or prerogatives of the board than does the shareholder’s decision to sell his shares on the open market or, for that matter, to sell his house.[13] Both stock and a home are treated as species of private property that are freely alienable by their owners.

The shareholder choice argument actually cuts against one of Sharfman and Moore’s arguments. They suggest (at 23-24) that some hostile bids are motivated by private information asymmetrically held by the bidder. I doubt that happened very often even in the hostile takeover’s heyday, but if true would not allowing a bidder to act on that information be inconsistent with shareholder choice? After all, we no longer live in a world of caveat emptor. Major purchases these days come with masses of disclosure (I vividly recall the mountain of information I reviewed at my house closing). Assume the law requires the bidder to disclose its private information. Would the passivity thesis preclude management from undertaking changes in response to learning that information?

In any case, none of the normative bases for the structural argument prove persuasive. That shareholders have the right to make the final decision about an unsolicited tender offer does not necessarily follow, for example, from the mere fact that shareholder have voting rights. While notions of shareholder democracy permit powerful rhetoric, corporations are not New England town meetings. Put another way, we need not value corporate democracy simply because we value political democracy.[14]

Indeed, we need not value shareholder democracy very much at all. In its purest form, our authority-based model of corporate decision making calls for all decisions to be made by a single, central decision-making body—i.e., the board of directors. If authority were corporate law’s sole value, shareholders thus would have no voice in corporate decision making. Shareholder voting rights thus are properly seen not as part of the firm’s decisionmaking system, but as simply one of many accountability tools—and not a very important one at that.

Nor is shareholder choice a necessary corollary of the shareholders’ ownership of the corporation. The most widely accepted theory of the corporation, the nexus of contracts model, visualizes the firm not as an entity but as a legal fiction representing a complex set of contractual relation­ships. Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept under this model. Each input is owned by someone, but no one input owns the totali­ty. A shareholder’s ability to dispose of his stock thus is not defined by notions of private property, but rather by the terms of the corporate contract, which in turn are provided by the firm’s organic documents and the state of incorporation’s corporate statute and common law. The notion of shareholder ownership is thus irrelevant to the scope of the board’s authority. As Vice Chancellor Walsh observed, “shareholders do not possess a contractual right to receive takeover bids. The shareholders’ ability to gain premiums through takeover activity is subject to the good faith business judgment of the board of directors in structuring defensive tactics.”[15]

Finally, and most importantly, the structural argument also ignores the risk that restricting the board’s authority in the tender offer context will undermine the board’s authority in other contexts. Even the most casual examination of corporate legal rules will find plenty of evidence that courts value preservation of the board’s decision-making authority. The structural argument, however, ignores the authority values reflected in these rules. To the contrary, if accepted, the structural argument would necessarily undermine the board’s unquestioned authority in a variety of areas. Consider, for example, the board’s authority to negotiate mergers. If the bidder can easily by-pass the board by making a tender offer, hard bargaining by the target board becomes counter-productive. It will simply lead to the bidder making a low-ball tender offer to the shareholders, which will probably be accepted due to the collective action problems that preclude meaningful shareholder resistance. Restricting the board’s authority to resist tender offers thus indirectly restricts its authority with respect to negotiated acquisitions.[16]

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

To take but one more example, it is quite clear that managers can make themselves less vulnerable to takeover by eliminating marginal operations or increasing the dividend paid to shareholders and thus enhancing the value of the outstanding shares. A corporate restructuring thus can be seen as a preemptive response to the threat of takeovers. It is hard to imagine valid objections to incumbents securing their position through transactions that benefit shareholders.[17] Why then should it matter if the restructuring occurs after a specific takeover proposal materializes? The structural argument not only says that it does matter, but taken to its logical extreme would require close judicial scrutiny of all corporate restructurings.

Were Easterbrook and Fischel right that target company boards should remain passive in the face of a hostile takeover bid? A comment on Sharfman and Moore. Part 1

In 1965, my friend and mentor the late Henry Manne published the seminal article on the market for corporate control, Mergers and the Market for Corporate Control.[1] As my friend Bill Carney explains, Manne “rejected the received wisdom: ‘Take-overs of corporations are too expensive generally to make the ‘purchase’ of management compensation an attractive proposition.’”[2] “The returns from acquiring control, Manne argued, were from improving management. Improving management would, in turn, increase cash flows that would be capitalized by the market.”[3]

As a result, Manne argued, a market for corporate control exists because outsiders can profit by buying control of a poorly managed company, firing the incompetent or venal incumbent managers, and replacing them with competent managers who would focus on shareholder wealth maximization:

The market for corporate control is really to be understood in consumer-protection terms, with “consumers” in that market being shareholders. In the pre-Manne era, the prevailing academic paradigm treated shareholders--that is, consumer-purchasers of corporate shares--as chumps. They were routinely, and so predictably, bamboozled by managers supposedly advancing shareholder welfare but really maximizing their own welfare. Management operated seemingly without constraints in bilking shareholders.

But, Manne noted, the corporate control needed to undertake such machinations is subject to market forces. And if markets ordinarily operate reasonably competitively, would not shareholder sovereignty emerge in this market, just as consumer sovereignty emerges in competitive markets generally? So, Manne wrote, mergers “are of considerable importance for the protection of individual non-controlling shareholders . . . .” Thus, … for the first time the famous Berle-Means concern about the separation of ownership and control was seen for what it truly is: an undeniable fact but one that invites, and has elicited, a market solution because it offers manager-entrepreneurs individual gains while protecting other shareholders as well.[4]

The chief difficulty with Henry’s thesis was that the principal acquisition technique of the time—the merger—is ill-suited to play a role in hostile takeovers, because approval of a proposed merger by the target’s board of directors is an essential prerequisite to the accomplishment of a merger.

The solution was coming down the tracks of history at high speed, however. One piece of the puzzle was the emergence of the tender offer. Tender offers were possible in 1965—the first hostile tender offer reportedly took place in 1956[5]—but two barriers had to be overcome before they could become commonplace.

First, as Carney explains, new sources of financing were necessary:

Remarkably, the article predicted leveraged buyouts, noting that any gains from efficient management could be leveraged through borrowed funds, “although American commercial banks are generally forbidden to lend money for this purpose.” It took development of other sources of funds--notably junk bond markets and non-bank institutional lenders--for this leveraging to flower two decades later.[6]

Second, as I have explained elsewhere, there needed to be a major cultural shift on Wall Street:

Given the tender offeror's comparative advantages, it is somewhat surprising that they were relatively rare before the 1960s. Although there are various explanations for that phenomenon, I suspect that the social mores of the business, financial, and legal communities played a major role. Before the 1960s, hostile tender offers were regarded as bad form by most of the key players. See David Halberstam, The Reckoning 674-75 (1986).[7]

Once those pieces were in place, sometime in the mid-1970s,[8] the short-lived era of the hostile takeover began.

In response to the emergence of the hostile takeover, incumbent managers hired talented lawyers to develop an array of defenses—such as the shark repellent, the poison pill, and the Pac-man defense—that allowed the target board to assert a gatekeeping function in the tender offer comparable to the one it long played in the merger.[9]

That development led to one of the most famous of all corporate law review articles; namely, Easterbrook and Fischel’s The Proper Role of a Target's Management in Responding to a Tender Offer.[10] As John Coffee summarizes their argument:

Viewed through the lens supplied by the “market for corporate control” thesis, the role of the tender offer is to replace inefficient management. The bidder, it is argued, pays a premium over the market price because it believes that the target's assets have not been optimally utilized and that under superior management they would earn a higher return, thereby justifying the tender offer premium. In this light, the higher the premium, the greater the degree of mismanagement that the bidder must perceive. So viewed, the hostile tender offer appears a benign and socially desirable phenomenon, which benefits both the bidder and the target's stockholders, who simply divide among themselves the value that the incumbent management's inefficiency denied them.

The Disciplinary Hypothesis places special weight on the target management's resistance to the takeover to demonstrate that the anticipated gain that motivated the acquisition was probably predicated upon the displacement of an inefficient target management. … [According to Easterbrook and Fischel, managerial] resistance is comprehensible only if the interests of the target's management deviated from those of its shareholders. Such a conflict would arise either because the management of the target expected to be replaced by the bidding firm, or because it saw an opportunity to demand a side payment for its acquiescence. The significance of this perspective then lies in its clear implication that “hostile” acquisitions are disproportionately motivated by the bidder's desire to realize enhanced value through replacing an inferior management while “friendly” acquisitions are typically motivated by other business considerations that pose less of a threat to the incumbent management. This logic also leads to the conclusion that hostile bids have a unique role in corporate governance as a policing mechanism.[11]

In turn, those insights led Easterbrook and Fischel to advance what became known as the passivity thesis:

They propose that the management of a corporation subject to a tender offer, the target, should be prohibited from resisting the offer in any fashion. The authors view hostile takeovers as a significant means of displacing poor managers and argue that facilitating tender offers increases the incentive of all managers to perform in the best interests of their shareholders. The passivity thesis has found a sympathetic audience. Many legal scholars have accepted the basic claim that most defensive tactics are undesirable, although some authors would preserve management's right to engage in some limited responses.[12]

Despite their success in the academic arena, Easterbrook and Fischel lost where it matters; namely, in the real world. The passivity thesis developed no traction in the courts. In particular, the one court system that really matters in corporate law—that of Delaware—summarily dismissed the passivity thesis:

It has been suggested that a board's response to a takeover threat should be a passive one. Easterbrook & Fischel, supra, 36 Bus.Law. at 1750. However, that clearly is not the law of Delaware, and as the proponents of this rule of passivity readily concede, it has not been adopted either by courts or state legislatures. Easterbrook & Fischel, supra, 94 Harv.L.Rev. at 1194.[13]

Now, however, come Bernard Sharfman and Marc Moore—two respected and thoughtful corporate law commentators with whom I have frequently corresponded to my benefit—to argue for a restoration of the passivity thesis:

Unfortunately, while a vibrant hostile takeover market did exist in the United States during the 1960s, 70s, and 80s, this has not been the case for many years. By contrast, the United Kingdom, despite having a broadly similar capital market environment and corporate governance system to the U.S., has gone down the path of allowing its hostile takeover market to flourish. Thus, the U.K. has been able to successfully retain the hostile takeover as a corrective mechanism in corporate governance.

We find the current domestic state of affairs unacceptable. Without a vibrant hostile takeover market, a significant corrective mechanism has been lost. Therefore, with a view to correcting this inefficiency, we use as our primary authority the core principles identified in the U.K.’s regulatory legal framework, and especially its longstanding board passivity (or “non-frustration”) rule. More than any other element of the British framework, the board passivity rule has allowed for the creation of an enduring and successful hostile takeover market in the U.K. Accordingly, this Article recommends that domestic state corporate law statutes be amended to include a safe harbor for a hostile bidder when making an all-cash, all-shares tender offer that includes a guarantee of the same or higher price if a back-end or squeeze-out merger occurs.

The use of the above safe harbor would effectively disallow a board’s use of the poison pill as a takeover defense unless a specific takeover defense, such as a poison pill, is provided for in the corporate charter. In this way, private ordering can always be used to trump the statutory safe harbor.[14]

I strongly encourage you to read their article. It is an excellent, yet concise, history of the evolution of the market for corporate control, the academic theorizing about that market, and the development of the law. It also provides a very useful and insightful comparative law treatment of the problem by contrasting US and UK law. In addition, they offer a very helpful review of the empirical literature on the costs and benefits of hostile takeovers. They also make a unique contribution by tying the Delaware courts’ resistance to the passivity thesis to the Delaware courts’ resistance to private ordering in the corporate context, which leads them to proffer a private ordering solution, as noted above.

In Part II, however, I will explain why I don't buy the passivity thesis.

Ann Lipton finds the purity of the interpretative questions posed in two recent M&A case aesthetically pleasing

She explains here.