The Golden Ratio of Corporate Deal-Making

2015 and 2016 mark the 30th anniversaries of the Delaware Supreme Court’s landmark decisions in Unocal Corp. v. Mesa Petroleum Co.[1] and Revlon, Inc. v. Macandrews & Forbes Holdings, Inc.[2] Those cases and their progeny called for enhanced scrutiny standards to be applied to negotiated change of control transactions as well as to deal protection devices.[3] During the past three decades, however, it has not been smooth sailing in the courts’ application of these standards. In fact, I have previously argued that the Delaware courts have shifted away from both the Unocal and Revlon enhanced scrutiny standards.[4] My recently published paper, The Golden Ratio of Corporate Deal-Making,[5] further examines this shift. I use auction theory principles and the related concept of information costs to correlate deal protection devices to the pre-signing sale process in change of control transactions. More specifically, I argue that the contract terms used in a sale of control should bear a harmonious relationship to the pre-signing sale process conducted by the target company board of directors. I dub this harmonious relationship the Golden Ratio of Corporate Deal-Making.

The Golden Ratio of Corporate Deal-Making relies upon Unocal, Revlon, and their progeny as a foundation. In Unocal, the Delaware Supreme Court held that a target board’s defensive measures taken in response to a hostile takeover attempt are subject to enhanced scrutiny before the business judgment rule becomes applicable.[6] Subsequent cases extended this enhanced scrutiny standard to deal protection devices in the context of negotiated transactions. But in many cases the courts do not appear to be applying enhanced scrutiny as they often uphold devices simply reasoning that they are standard or market terms. In Revlon, the Delaware Supreme Court held that when a sale of control becomes inevitable, the target company board of directors has an obligation to maximize stockholder value.[7] Following Revlon, the courts have stressed that there is “no single blueprint” to maximizing stockholder value.[8] Along these lines, they have not only upheld transactions following full-blown auctions but also after negotiations with only a single bidder.

The courts are not the only ones to consider how to best maximize stockholder value; the issue also is a popular one for financial economists using auction theory to design optimal sale processes. In examining what type of sale process best maximizes value, financial economists inherently rely upon information costs and the role those costs play in the sale process. Targets and bidders both incur tangible and intangible information costs in any type of sale process. For example, a target’s tangible costs include the assembly and dissemination of due diligence materials and the hiring of legal and financial advisors. A target’s intangible costs can take various forms, including the possibility of losing one’s competitive advantage by releasing information to competitors, suppliers, or customers. Tangible and intangible costs will vary from deal-to-deal and may depend on the type and size of the target. That being said, the more extensive the sale process, the higher the information costs are likely to be as the advisors take on more expansive roles and more bidders participate.

Like the target, a bidder also incurs tangible information costs such as hiring legal and financial advisors and completing the due diligence process. Moreover, a bidder also has intangible costs. One important consideration from the perspective of a bidder is the number of other bidders taking part in the process. The more participants in the sale process, the higher the probability that a bidder may not “win.” Financial economists point to this intangible cost of competition, or the potential for it, as a way of incentivizing a bidder to reveal its reservation value for a target.

The pre-signing sale process is the optimal time for both the target and bidders to obtain information. During this time, a target is gathering information regarding how much bidders may be willing to pay for it while bidders are attempting to value a target through the due diligence process. The Golden Ratio Theory provides for a direct proportional relationship between the information gathering process (i.e., the pre-signing sale process) and the resulting deal protection devices in the definitive agreement. As the parties incur more information costs they essentially “buy” the right to more restrictive deal protection devices. In other words, the more extensive the pre-signing sale process (e.g., the greater the number of potential bidders involved), the more tolerant courts should be of more restrictive deal protection devices. Conversely, the lower the information costs incurred, or the less extensive the pre-signing sale process, the less tolerant the courts should be of restrictive deal protection devices.

A couple of caveats are in order here. First, the Golden Ratio does not call for a magic number of bidders. Instead this inquiry should be context specific, considering the size and type of the target. Moreover, courts should still consider a board’s special knowledge, such as industry conditions, a target’s recent previous unsuccessful sale processes, or its particular financial condition. I only contend that a board’s special knowledge should not supplant the sale process but rather be considered along with the extensiveness of the process.

Along these lines another way to think of the pre-signing sale process and the board’s special knowledge is as a proxy for the shareholders’ trust of the board. As the courts and scholars have repeatedly acknowledged, the possibility for conflicts of interest are inherent in change of control transactions. Although conflicts can never be fully eliminated, by conducting a more extensive sale process before agreeing to restrictive deal protection devices, shareholders are more likely to trust that a board is not acting out of its own interests.

Ultimately the Golden Ratio of Corporate Deal-Making seeks a more thorough analysis of the sale process, considering all elements of the process in determining the impact of the deal protection devices on the transaction. In addition, in upholding or striking deal protection devices the courts should consider cases with similar factual backgrounds as opposed reasoning that certain devices are standard practice. The application of a more thorough analysis under the Golden Ratio Theory returns the courts to the enhanced scrutiny standards first set forth in Unocal and Revlon.

ENDNOTES

[1] 493 A.2d 946 (Del. 1985).

[2] 506 A.2d. 173 (Del. 1986).

[3] My article assumes the applicability of Revlon to change of control transactions and the applicability of Unocal to deal protection devices. It does not explore the propriety of applying these standards as other scholars are exploring that issue.

[4] See, e.g., Steven M. Davidoff & Christina M. Sautter, Lock-Up Creep, 38 J. Corp. L. 681, 708 (2013); Christina M. Sautter, Shopping During Extended Store Hours: From No Shops to Go-Shops-The Development, Effectiveness, and Implications of Go-Shop Provisions in Change of Control Transactions, 73 Brook. L. Rev. 525, 575 (2008).

[5] 41 J. Corp. L. 817 (2016).

[6] Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 954-55 (Del. 1985).

[7] Revlon, Inc. v. Macandrews & Forbes Holdings, Inc., 506 A.2d. 173 (Del. 1986).

[8] Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1286 (Del. 1989).

This post comes to us from Christina M. Sautter, Professor of Law at Louisiana State University’s Paul M. Hebert Law Center.  The post is based on her recently published paper, which is entitled “The Golden Ratio of Corporate Deal-making” (41 J. Corp. L. 817 (2016)) and is available here.