Even where the business judgment rule does not apply in the first instance because its preconditions are not satisfied, Delaware corporate law allows the use of ex ante procedural protections to avoid ex post substantive judicial review. D. Gordon Smith makes this point in “The Modern Business Judgment Rule,” which is forthcoming in the Research Handbook on Mergers and Acquisitions. In my forthcoming article, “Predatory Management Buyouts,” I analyze the related question whether the procedural mechanisms that, under Delaware law, boards may implement in order to “sanitize” the conflict-of-interest taint present in management buyout (MBO) transactions are adequate to achieve parity between transactions in which the business judgment rule attaches in the first instance and MBOs that invoke a procedural route back to the business judgment rule. The article raises a broader issue that I plan to address in future work whether, when we round-trip from the business judgment rule and back again via procedural mechanisms, we always end up in the same place.
Under Delaware corporate law, MBOs are subject to the same standard of review as other conflict-of-interest transactions. A plaintiff may rebut the presumption of the business judgment rule by showing that a majority of a board’s directors were conflicted. The presumption of the business judgment rule can be reinstated, however, through the implementation of appropriate sanitizing measures. As in any other conflict-of-interest transaction, the key to upholding an interested transaction is the approval of a neutral decision-making body. Delaware courts have held that approval of a conflict-of-interest transaction by a disinterested majority of the board (or a special committee of independent directors) or by stockholders representing a majority of the disinterested shares outstanding so qualify. In order for these mechanisms to be effective, the body reviewing the transaction must be fully informed of the conflict of interest and all facts material to its consideration. The Delaware courts will then deem the taint of the conflict of interest in the transaction to have been sanitized and, consequently, review the transaction under ordinary business judgment rule principles. On the other hand, if no judicially approved ex ante procedural mechanism has been implemented in the transaction, the transaction will be subjected to substantive entire fairness review.
In “Predatory Management Buyouts,” I argue that the procedural protections, applicable to conflict-of-interest transactions are ill-suited to the problem of asymmetric information peculiar to MBO transactions and that enhanced procedural protections that equalize that disparity of information between management and non-management decision-makers are needed to produce the result of arm’s-length bargaining that is the touchstone of conflict-of-interest jurisprudence.
In MBO markets, asymmetric information exists with respect to (1) the hidden actions of management as stewards of the target and (2) the hidden characteristics of the target that are known only to management. Together, these informational asymmetries create conditions for predatory management buyouts. By “predatory management buyouts,” I mean MBOs in which management buys targets for less than their fair market value. This is possible in MBO markets because, unlike in acquisition markets in which arm’s-length bargaining conditions are present, management-buyers have incentives to usurp joint surplus and to depress sellers’ reservation prices. The panoply of techniques potentially available to management for temporarily depressing firm value is suggested by those used by David Murdock, Dole Food Company, Inc.’s Chairman and CEO, and his right-hand man Michael Carter, Dole’s President and COO, to reduce Dole’s public stock price in anticipation of a proposal by Murdock to take Dole private, including making “false disclosures about the savings Dole could realize after selling approximately half of its business,” “cancel[ing] a recently adopted stock repurchase plan,” and providing Dole’s special committee with “lowball management projections.” In re Dole Food Co., Inc. Stockholder Litigation (Del. Ch. August 27, 2015). In that case, management’s tactics were sufficiently egregious so as to rise to the level of actionable fraud. The case nevertheless highlights the opportunities available to management to manipulate the terms of an MBO to its advantage even in the presence of procedural protections.
MBOs thus implicate concerns over self-dealing that go beyond ordinary conflict-of-interest transactions. Specifically, in ordinary conflict-of-interest transactions, the conflicted party’s ability to behave opportunistically can be sanitized merely by designating one or more neutral decision-making bodies at the target. In the case of an MBO, however, the potential for managerial opportunism survives the designation of a neutral decision-maker at the target because the taint of self-interest in MBOs is not solely a consequence of the identity of the target’s decision-making body; it is also a consequence of the identity of the buyer. In other words, even after a neutral decision-making body is put in place on the sell-side, asymmetrically-informed management buyers can use their superior information about the target to acquire it below fair market value.
In short, I argue that the procedural measures used in ordinary conflict-of-interest transactions to reinstate the business judgment rule are insufficient to produce the equivalent of arm’s-length bargaining in MBOs. Rather, conditions of asymmetric information inherent in MBOs justify enhanced procedural safeguards on the buy-side in order to equalize the informational disparity that exists between management and non-management directors and shareholders. Accordingly, the procedural gate-keeping mechanisms that courts have constructed with the intention of restoring conditions of arm’s-length bargaining in conflict-of-interest transactions do not achieve their intended purposes in the MBO context. More broadly, my article suggests that the presumption in Delaware corporate law that procedural safeguards can sanitize tainted conditions in transactional contexts outside of MBOs deserves individualized scrutiny.
The preceding post comes to us from Iman Anabtawi, Professor of Law and a member of the Lowell Milken Institute for Business Law and Policy at the UCLA School of Law. It is based on her forthcoming article, “Predatory Management Buyouts,” 49 U.C. Davis L. Rev. (forthcoming 2016). A current draft of the article is available here.