When a board of directors resolves to sell the corporation, it must structure the sale so as to obtain the highest price reasonably available. In the landmark case Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., the Delaware Supreme Court held that when a sale of the corporation becomes inevitable, the “directors’ role change[s] from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders . . . .” Post-Revlon, auctions have become a pervasive feature of the modern takeover landscape. Indeed, a recent survey of four hundred large-scale takeovers with a total deal value of over $1 trillion found that over half of the sales involved a process of competitive bidding rather than private negotiations with selected buyers.
Yet, current Delaware corporate law leaves in doubt the legality of a tool useful to the value-maximizing auctioneer: the ability to pre-commit to the rules of the auction. In a series of recent cases, the Delaware courts have struggled with the fiduciary propriety of these precommitments and have reached ambiguous and sometimes contradictory decisions. Indeed, one Vice-Chancellor questioned, in dicta, whether such agreements are ever enforceable. Looming over these cases is the Delaware Supreme Court’s decision in Omnicare, Inc. v. NCS Healthcare, Inc., which forbids a target (i.e., selling) board from fully locking up a transaction with a particular counterparty. Instead, the board is legally obliged to include a “fiduciary out” clause in the acquisition agreement, which contractually preserves the target board’s right to cancel the agreement should it subsequently receive a better offer.
Such restrictions, which I term the fiduciary precommitment constraint, call into question the validity of First Price Sealed Bid (“FPSB”) auctions in which bidders agree to make their best and final offers, and the seller agrees that the highest bidder wins the auction at the price bid. Absent the seller’s ability to credibly commit to those rules, bidders will alter their strategy. Specifically, as the losing bidders can simply top the winning bidder after the initial auction ends, the bidders will treat the structured sales process as if it were a standard ascending price auction (also known as an “English” auction), in which bidders iteratively increase their offering price until only one bidder remains. Auction theory, the branch of applied economics that studies auction design, posits that English auctions are not necessarily optimal from the seller’s perspective. Thus, modern auction theory finds itself at odds with Delaware takeover jurisprudence.
This tension is particularly problematic because the Delaware courts derive both aspects of Delaware law, i.e., the value maximization mandate and the restrictions on precommitment, from principles of fiduciary obligation. Takeovers are one of the most important events in the life cycle of a corporation and are of particular financial significance to the corporation’s shareholders. The value-maximization norm acknowledges that a sale of the company represents shareholders’ last chance to receive a premium price for their equity. The restriction on precommitments is a prophylactic rule, which prevents potentially unfaithful directors from locking up transactions motivated by self-interest. Thus far, Delaware courts have struggled to balance these competing policy considerations, and have failed to provide a principled standard for reviewing directors’ decisions when conducting a corporate auction.
Resolving these issues is both timely and necessary in light of recent efforts by target boards to simulate FPSB auctions via intricate contractual agreements with potential bidders. Targets require bidders to sign a “standstill” agreement in order to gain access to the target’s confidential financial (or other) information prior to commencing the auction process. The standstill prohibits losing bidders from making subsequent bids. One particularly strong form of standstill, termed a “Don’t Ask, Don’t Waive” agreement, prevent bidders from even requesting that the target board waive the no-subsequent-bids condition. As noted above, the Delaware Chancery Court has wrestled with the interplay between these standstills and the boards’ fiduciary obligations, but has reached varying (and limited) conclusions as to the propriety of target boards’ conduct. The Delaware Supreme Court has not yet addressed the issue squarely, but its fiduciary precommitment constraint jurisprudence casts substantial—and, in my view, improper—doubt on the legality of these structures.
Auction theory, combined with a sensitivity to the need for judicial oversight of corporate fiduciary behavior in the high-stakes context of corporate mergers and acquisitions, provides a theoretically rigorous position on the use of ex ante precommitment devices to facilitate value-maximizing corporate sales. Briefly, Delaware corporate law should allow neutral ex ante commitment devices that facilitate a FPSB auction, as such mechanisms can maximize shareholder value and do not create the positional conflict that animates much of Delaware’s takeover jurisprudence. Courts should draw a principled distinction between ex ante precommitments characterized by ambivalence concerning the identity of the winning bidders and mid-stream or ex post lock-ups, in which the board favors a known buyer (which should be subjected to the more searching analysis governing takeover defenses and deal protection devices). Specifically, the former should be governed only by Revlon’s range of reasonableness review, and not the more rigid frameworks set out in Unocal/Unitrin (which bars deal protection devices that are either coercive or preclusive) or Omnicare (i.e., the fiduciary precommitment constraint described above).
The preceding post comes to us from Jay Kesten, Assistant Professor at The Florida State University College of Law. The post is based on his article “Adjudicating Corporate Auctions”, forthcoming in the Yale Journal on Regulation Vol. 32 and available here.