An Incentive-Compatible Alternative to “Don’t Ask Don’t Waive” Standstills

In a recent essay forthcoming in the Delaware Journal of Corporate Law (available on SSRN), we argue that the current controversy over “Don’t Ask, Don’t Waive” standstills in M&A practice highlights the need to apply mechanism design to change-of-control transactions.[1]  Mechanism design is a Nobel Prize-winning theory based on incentive compatibility, whereby algorithmic procedures render it in the parties’ interests to be forthcoming, or truthful about their “bottom lines,” rather than relying exclusively on ex-post enforcement.

A.  The Tension Between Deal Certainty and Value Maximization in M&A Transactions

In M&A auctions, the board’s duty to maximize the sale price generally compels it to consider any offer received prior to closing the transaction, even one made by a third party subsequent to the board’s agreement with the winning party.  While a true bidding war could lead to a higher sale price for the target firm, the ex-ante risk that a winning bidder might lose to a free-riding interloper will sometimes deter many potential bidders from participating if the probability of losing to an interloper is sufficiently high.

Accordingly, target companies utilize various mechanisms to achieve the twin goals of (i) robust participation in the auction and (ii) attainment of the highest possible price for the company.  One mechanism is the confidentiality agreement, particularly when combined with a standstill provision.  Another is granting the winning bidder a matching right in the purchase agreement, which confers upon the winning bidder of the formal auction the right to match any subsequent topping bid.

Even if deal-protection mechanisms are effective at deterring interlopers, their fundamental tension with maximizing the sale price remains.  It might be true that preventing topping bids, or restricting their number, benefits shareholders by encouraging participation in an auction, which leads to a higher price than one in which only a few bidders participate.  But denying a firm the opportunity to consider a concrete offer at a significantly higher price makes these mechanisms difficult to reconcile with a board of directors’ duty to maximize the sale price for shareholders.

A particularly aggressive form of protecting the winning bidder in a formal auction is a “Don’t Ask, Don’t Waive” (DADW) standstill, which not only prohibits a board from waiving any standstill but also bars bidders from even requesting a waiver.  In a November 2012 hearing in the case of In re Complete Genomics, Inc. Shareholder Litigation, Vice Chancellor Laster struck down a DADW standstill, holding that it “impermissibly limited [the board’s] ongoing statutory and fiduciary obligations to properly evaluate a competing offer, disclose material information, and make a meaningful merger recommendation to its stockholders.”[2]  But In re Ancestry.com Shareholders Litigation, Chancellor Strine held that he was “not prepared to rule out that they can’t be used for value-maximizing purposes.”[3]

These seemingly contradictory holdings illustrate the challenge with the current approach to protecting the bidding process.  The ad hoc use of blunt instruments such as DADW standstills renders the injury to shareholders very salient, whereas the benefits of increased auction participation appear hypothetical.  Shareholders must believe that the one-shot sealed-bid nature of the formal auction maximizes value.

However, auction theory suggests that this is not the case.  As in any negotiation under incomplete information, potential purchasers have an incentive to shade their bids to avoid the winner’s curse, so the auction may not elicit the maximum price that an acquiring party may be willing to pay.

B. A Solution: The Two-Stage Auction Mechanism

We propose a new M&A auction procedure that induces honest bidding among participants, rendering it unnecessary to rely exclusively on heavy-handed, ex-post enforcement such as DADW standstills.  By utilizing this procedure, firms can render it theoretically impossible for participants to do better than bidding their true reservation prices.

In stage 1, the interested buyers independently submit bids to the company.   The submission of bids in the first stage must be effectively simultaneous—prior to some deadline—and no party’s bid would be revealed to any other party until all bids were received.  Upon conclusion of the first stage, the bid amounts are disclosed to all parties (including the target company), although the identity of the bidders need not be—some bidders might prefer confidentiality about their identity.

With the bids now on the table, each bidder in stage 2 independently chooses either to affirm its existing bid or “usurp” another bidder.  Usurping means that, instead of repeating (i.e., affirming) its stage 1 bid, a bidder chooses the bid of another participant, which may be either higher or lower than its own bid.  If lower, a bidder may effectively “bail out,” i.e., withdraw from the auction at this stage, by usurping the very lowest bid.

At the conclusion of stage 2, the highest bidder wins the auction.  If two or more bidders affirm or usurp the highest bid, the highest bidder in stage 1 breaks the tie and wins the auction.  In our essay, we show that with two intuitive assumptions, this simple procedure induces honest bidding in stage 1, i.e., bids which reflect the parties’ reservation prices, thereby removing the incentive for suboptimal bidding.[4]  The intuition is simple: If a party is the highest bidder in stage 1, it can usurp any lower bid that it thinks might be a more reasonable estimate of the common value.  If it wins, it will only have to pay this bid.  By contrast, if a party is the lowest bidder, affirming its own bid ensures that it loses, no matter what the other parties do.

The two-stage auction procedure not only gives an incentive to bid honestly in stage 1, but it removes the winner’s curse in stage 2, yielding the results of a second-price Vickrey auction—but one which is relatively immune to collusion.  It also may lead to a higher settlement price than is possible with an ordinary first-price or second-price auction.

To see this, consider the possibility that a bidder, other than the highest bidder in stage 1, wishes to maximize its chance of winning the auction in stage 2.  Such a bidder should usurp the highest bid in stage 1.  While this is not the outcome our theorem predicts, its possibility generates uncertainty for the highest bidder in stage 1—unless it affirms its stage 1 bid.  So if the goal of a bidder is to win, whatever the cost, the price it pays may be the highest stage 1 bid.

A second advantage of the two-stage auction procedure is the benefits to society of increased information, transparency, and stability in bidding.  For example, the distribution of reservation prices, made known at the end of stage 1, could help policymakers in setting tax policy,  or determine whether purchase prices in the takeover market reflect an efficient allocation of social resources.  Similarly, coupled with who affirms or usurps in stage 2, it would give courts a better understanding of the environment of the transaction in subsequent litigation.

Finally, the two-stage mechanism is fair to all parties.  It allows the company to put in a reserve price and use it to back out, and for the bidders to back out by usurping the lowest first-stage bid in the second stage of the procedure.  It is also likely to mitigate agency costs by preventing management from arbitrarily favoring certain bidders instead of promoting shareholder value.  As we explain in our essay, we suggest that these benefits of utilizing the two-stage auction procedure—not only to firms and bidders but also to society more broadly—render it worthy of reduced judicial scrutiny.

In conclusion, we have shown that mechanism design can inform the development of a two-stage auction procedure for M&A transactions that reduces many of the inefficiencies inherent in current practice.  Mechanism design can enhance shareholder value and facilitate an open, transparent, and stable bidding process in M&A auctions by rendering honest participation to be in the bidders’ interests.

The full essay is available here.