Every pundit and commentator has by now analyzed the ongoing battle between Elon Musk and Twitter over Musk’s attempt to walk away from their deal. Almost all of these evaluations have rated Twitter as having a considerably stronger case, because (among other reasons) Musk did no due diligence, was well aware of the “bot” (or fake user) problem, negotiated no contractual protections directly addressed to these risks, and generally behaved inequitably, disparaging Twitter and toying with the SEC’s rules. Okay, but that raises an interesting puzzle: If the facts favor Twitter, and if Musk’s offer was for $54.20 a share (and Twitter’s stock price was languishing at below $35 per share at the time Twitter’s suit was filed), what explains this wide price disparity? Normally, the arbs buy the target stock until its price approaches the merger price (minus some allowance for risk). Most recently, Twitter’s stock price rose to around $39 after the Delaware chancellor granted the company an expedited trial. Even if the movement is in the right direction, there is still a wide gap.
Why? True believers in the efficient market may conclude that the arb community doubts that the Delaware Chancery Court will grant Twitter specific performance, the remedy that it is seeking. They may expect that Musk will escape Delaware with a liability no higher than the $1 billion ceiling that is specified in the parties’ merger agreement. Although this ceiling does not bar an award of specific performance, the arbs may expect that the maximum damages will not exceed $1 billion. If so, they would only price up Twitter’s stock a modest amount. Alternatively, those who are more inclined towards behavioral economics may believe that some kinds of qualitative and judgmental information are not easily priced by the market, and so price movement may be slower. Possibly that could explain a slower market response, but much of the information here is publicly available to anyone who looks. Finally, there may be some that doubt that any large liability can be enforced against Musk, even if Delaware imposes it (perhaps he will escape to Mars).
So what best explains the failure of the arbs to buy in quantity and boost the price of Twitter when they think it will win? At first glance, the most plausible answer involves the uncertain availability of specific performance. If Musk escapes with only a $1 billion liability, he is the real winner, and the stock price of Twitter can be expected to sink well below its current level. In short, the difference between Twitter’s value if it is not acquired by Musk and the deal price of $54.20 per share may be as much as $20 billion (or more).
Still, new information has recently become available, which should move the market, but has not yet done so significantly. We now know the identity of the judge who will decide the judgment. She is Chancellor Kathaleen McCormick. She is universally agreed to be likeable, pleasant, intelligent, and reasonable. But two facts about her should worry Musk’s team. First, she wanted this case. The chancellor assigns the judge who hears the case in Delaware’s Chancery Court, and she picked herself. Second and far more important, she awarded the remedy of specific performance in a basically similar merger case in 2021.
In that case, Snow Phipps Grp. LLC v. KCAKE Acquisition, Inc.,[1] the original bidder (KCAKE Acquisition, an affiliate of Kohlberg) agreed to acquire DecoPac Holdings, Inc., which specialized in cake decorations and associated technology. This purchase occurred in March2020, at the outset of the pandemic (but with it clearly in view). KCAKE’s interest in DecoPac quickly cooled when it became obvious that the pandemic implied fewer parties with elaborately decorated cakes. Accordingly, KCAKE declared that a “material adverse effect” had occurred. “Chalking up a victory for deal certainty” (in her own words),[2] Chancellor McCormick rejected all of the buyers’ theories and “ordered the buyers to close on the purchase agreement.”[3] Her analysis of why the buyers could not break their contract was consistent with the vast majority of Delaware decisions. For present purposes, we only need focus on how she handled the issue of specific performance. Citing the Delaware Supreme Court’s decision in Osborn v. Kemp,[4]she ruled that a party seeking specific performance must establish that: (1) a valid contract exists; (2) the party seeking specific performance is ready, willing, and able to perform; and (3) “a balance of equities tips in favor of the party seeking specific performance.”[5]
This is not new law. A series of Delaware decisions have awarded specific performance in merger cases reciting this same formula.[6] These cases basically trace back to Delaware’s emphatic rejection of “buyers’ remorse” in In re IBP, Inc. Shareholders Litigation.[7] There, then Chancellor Strine rebuffed Tyson Foods’ attempt to escape its overpriced acquisition of IBP (the second largest beef producer in the U.S.), emphasizing both that Tyson had rushed into the deal, ignoring red flags, and that an arguably short-term decline in IBP’s earnings and prospects was insufficient to justify Tyson’s efforts to cancel a strategic marriage. Having served as an expert witness for Tyson and Skadden in that case, I am painfully mindful that Musk’s current position bears a strong resemblance to that of Tyson in that case.[8]
The most important common denominator in these Delaware cases is that they have endorsed giving the Chancery Court a very discretionary power – one that maximizes the court’s power to balance the equities. So far, Chancellor McCormick seems to be headed on such a course and viewing the balance of equities as tipping towards Twitter. For example, in giving Twitter an expedited trial date, she emphasized the losses that Twitter would suffer if the trial were delayed to Musk’s proposed date in 2023. Given that her views seem to align with Twitter’s view of the case, why then are the arbs not investing in Twitter’s stock? Perhaps, the answer is that they will shortly. Or perhaps, they doubt that the rules applicable to ordinary mergers will apply in a mega-sized case. Or, they may fear a further problem: Can an injunction against Musk actually be enforced? Although most public corporations, after exhausting their appeals, will comply with a court’s order, Musk may be different. Like The Donald, The Elon is not inherently law compliant. Still, Tesla is also incorporated in Delaware, and Delaware courts could find a way to attach Musk’s shares in Tesla.
Thus, we reach this dual assessment: The outlook for Twitter in Delaware seems encouraging, but, if the chancellor does not order Musk to close, Twitter’s stock price will plummet precipitously. All this suggests that both sides should seriously consider settlement before their October trial date.
How much of a discount can Musk’s team negotiate for him? If we look to the LVMH negotiation with Tiffany’s (which followed LVMH’s attempt to back away from its $16 billion acquisition of Tiffany’s), my rough calculation suggests that the parties negotiated only a modest 2 percent discount off the deal price. Possibly, The Elon should get more, based on his reputation for relentless and even extra-legal resistance. But there is a problem here. Even if Musk agrees to settle, how does Twitter know that he will not default on his settlement agreement? Like the Donald, The Elon may be incapable of admitting that he lost. One answer may be to postpone the trial (and not cancel it) until he makes full payment. But some delay in payment seems necessary, as Musk will need to unload a substantial number of Tesla shares in order to pay Twitter’s shareholders. Here, at last then, is a rational strategy for the risk-neutral arbitrageur: As it becomes clearer that Twitter is likely to win specific performance, buy Twitter and sell Tesla short.
ENDNOTES
[1] 2021 Del. Ch. LEXIS 84 (April 30, 2021).
[2] Id. at * 3.
[3] Id.
[4] 991 A.2d 1153, 1158 (Del. 2010). This is not a corporate decision, but one involving a house sale.
[5] 2021 Del. Ch. LEXIS 84, at * 108.
[6] See, e.g., Channel Medsystems, Inc. v. Boston Sci. Corp., 2019 WL 7293896 (Del. Ch. Dec. 26, 2019); Hexion Specialty Chems. Inc. v. Huntsman Corp., 965 A. 2d 715,738 (Del. Ch. 2008). As Chancellor McCormick also notes, the case law shows that presence of a specific performance condition in the agreement eliminates any need to show “that a legal remedy would be inadequate” and that “Delaware courts do not lightly trump freedom to contract.” See Gildor v. Optical Sols., Inc., 2006 Del. Ch. LEXIS 110 (Del. Ct. 2006).
[7] In re IBP Inc. Shareholders Litigation, 789 A.2d 14 (Del. Ch. 2001).
[8] In his defense, the author would point out that he was a mere child at the time of this 2001 litigation (probably still in high school).
This post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.