Beyond the Trilogy | Holger Spamann | November 04, 2013

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Beyond the Trilogy

The Delaware Takeover Trilogy: Unocal, Moran, and Revlon

Unocal established the principle that “the board ha[s] both the power and duty to oppose a bid it perceive[s] to be harmful to the corporate enterprise.” In recognition of the possibility of board entrenchment, however, the Delaware Supreme Court formulated an “intermediate scrutiny” standard of review for defensive actions:

“Because of the omnipresent specter that a board [defending against a takeover] may be acting primarily in its own interests [of keeping its job], rather than those of the corporation and its shareholders, there is an enhanced duty which calls for judicial examination at the threshold before the protections of the business judgment rule may be conferred.  . . . If a defensive measure is to come within the ambit of the business judgment rule, it must be reasonable in relation to the threat posed.” (emphasis added)

Unocal explicitly blessed discriminatory defensive measures — measures that treat the bidder differently from other shareholders. The SEC subsequently prohibited the particular defense used by Unocal Corp. against Mesa, a discriminatory self-tender (cf. SEC rule 13e-4(f)(8)(i)). But this prohibition turned out to be without consequence for hostile bids because Moran approved the one discriminatory defense that made all others unnecessary: the “rights plan,” a/k/a the “poison pill.”

Revlon announced the main limit to these defenses. If the board is set to sell, it must simply get the highest price for shareholders; it cannot use defenses to play favorites between bidders or to protect some non-shareholder constituency. In the words of the Court:

“[W]hen . . . it became apparent to all that the break-up of the company was inevitable [and] that the company was for sale . . . [t]he duty of the board . . . changed from the preservation of [the] corporate entity to the maximization of the company's value at a sale for the stockholders' benefit. This significantly altered the board's responsibilities under the Unocal standards. It no longer faced threats to corporate policy and effectiveness, or to the stockholders' interests, from a grossly inadequate bid. The whole question of defensive measures became moot. The directors' role changed from defenders of the corporate bastion to auctioneers charged with getting the best price for the stockholders at a sale of the company.” (emphasis added)

In particular, the Court explicitly held that the board breached its duty of loyalty to shareholders when it favored one bidder over another out of concern for certain non-shareholder constituents — the note-holders. “Instead, obtaining the highest price for the benefit of the stockholders should have been the central theme guiding director action.”

A Brief Critical Intermission

The Delaware trilogy is now firmly established law, and fundamental change is highly unlikely. Nevertheless, it is worth pausing for a brief moment to note some irony in the Delaware Supreme Court’s reasoning.

Both Unocal and Moran argue that defenses are necessary to protect shareholders from the coercive nature of front-loaded two-tiered bids. But the defenses that the Court endorses are themselves coercive. In Unocal, the Court approved a partial self-tender that any individual shareholder will rationally tender into (because the price offered is higher than the share value) even if that shareholder believes the self-tender is a bad idea for the shareholders collectively. Similarly, the poison pill approved in Moran relies on the fact that all shareholders will rationally exercise their rights once they become exercisable, regardless of the collective effect of such exercise. Additionally, the board adopts the pill unilaterally without approval from the shareholders.

Moreover, the Delaware Supreme Court could have easily shut down coercive two-tiered bids. All it had to do was remind shareholders and deal-makers that the demanding “entire fairness” standard also applied to the consideration offered in the second tier squeeze-out merger. Recall that “coercion” emanates from the lower consideration expected in the second tier squeeze-out: shareholders tender in the first tier because they fear they will otherwise only receive low value in the second tier squeeze-out. But the merger consideration in the squeeze-out is subject to fiduciary duty review. In fact, it is subject to the exacting “entire fairness” standard because the bidder will be a controlling stockholder at the time of the squeeze-out. It seems quite straightforward to argue that any second tier (merger) consideration less than the first tier (tender) consideration is presumptively unfair.

Finally, coercive two-tiered bids entirely disappeared after the 1980s. As we will see in the next section, however, the Court’s attitude towards defenses became, if anything, more permissive. As a result, Delaware boards are now allowed to deploy unilateral, coercive defenses against even non-coercive bids.

Rather than allowing coercive defenses against coercive bids, the Court could have attempted to suppress all coercive devices, no matter who deploys them. It could have attempted to facilitate uncoerced shareholder choice to decide the merits of a takeover bid. UK law (surveyed later in the course) employs such an approach. However, that is not Delaware law and presumably never will be.

Refinements of the Trilogy

Countless decisions have interpreted the Delaware trilogy, driven by deal-makers probing its limits.

The Power of the Pill

The poison pill is now all but ubiquitous and defines the playing field for any takeover contest. It is not necessary for a corporation to formally adopt a “rights plan” because such a plan can be adopted on very short notice in the face of a threat. Thus, all Delaware corporations have a “shadow pill,” and a bidder must plan accordingly.

While some technical details have changed over time, the basic design and idea of the pill has remained the same, and it is as deadly as ever. In the 30 years since Moran, only one bidder has dared to trigger the pill. Thus, practically speaking, the only way to take over a Delaware corporation is by replacing the board. The so-called “dead-hand pill” attempted to eliminate even this possibility. It provided that only the existing board could redeem the poison pill “rights.” That is, if a bidder succeeded in electing a new board, the “rights” would cease to be redeemable. In Quickturn Design Systems v. Mentor Graphics (1998), the Delaware Supreme Court ruled that this “scorched earth” strategy violated DGCL 141(a), as it deprived the new board of its power to “manage” the “business and affairs” of the corporation.

Unocal – Anything Left?

Unocal could have placed important limits on the use of the pill. But subsequent decisions interpreted both cognizable “threats” and “reasonable” defensive measures extremely broadly.

In Paramount v. Time (1989, a/k/a “Time-Warner”) and even more clearly in Unitrin v. American General (1995), the Delaware Supreme Court confirmed that inadequacy of price was a sufficient threat, at least in conjunction with the risk that “shareholders might elect to tender into [the] offer in ignorance or a mistaken belief” about the alternative. Such threats have been labeled “substantive coercion.”

As to the “reasonableness” of the defense, the Time-Warner decision blessed the restructuring of a deal for the sole purpose of avoiding a shareholder vote (remember Schnell?).

Cynics have argued that this has provided Delaware boards with the power to “just say no” to any takeover bid. In response, Delaware courts have pointed out that the board still has to lay out an argument for why it thinks the offer is inadequate. The excerpt from Airgas below references this debate.

Revlon Duties
"Revlon Land"

With Unocal review weak at best, the boundary to “Revlon land” assumes great importance. When does the board’s duty shift to maximization of the sale price?

Revlon duties are clearly triggered in a break-up or sale for cash. But what about “stock-for-stock deals,” i.e., deals in which the shareholders of both merging corporations become shareholders of the surviving corporation? In these situations, it may not even be obvious who is “the buyer” and who is “the seller.”

In the aforementioned Time-Warner (1989) and in Paramount v. QVC (1994), the Delaware Supreme Court ruled that a stock deal triggered Revlon duties only if there was a change of control. In particular, Time-Warner held that Revlon duties were not triggered if the corporation is not broken up and was widely held both before and after the merger. By contrast, the Court found a change of control in Paramount v. QVC because the other constituent corporation had a controlling stockholder who would also control the surviving corporation. Control of the corporation would thus pass from the “fluid aggregation of unaffiliated stockholders” to the controlling stockholder of the merger partner.

Deal protections

Even in “Revlon land,” however, some defensive measures are permissible. The reason is that some protections granted to certain buyers at certain times may actually increase price. Clearly, the target has to be able to commit to a deal at some point, or else buyers would never be willing to engage in the transaction in the first place. Perhaps most obviously, if the board runs a genuine auction, it must be able to promise the winner a deal without further “bid jumping” (based on later information, etc.). Otherwise, bidders would rationally not bid top dollar.

More generally, a board may need to give some “deal protections” to friendly bidders to entice them to come forward. For example, an early bidder may risk being a “stalking horse”— an initial bidder who attracts superior bids by others —only if it receives in exchange a promise of a termination fee if another bidder later tops the first bidder’s price. Consequently, courts and deal-makers have been engaging in a subtle balancing act of enticing (initial) bidders without stifling possible bidding competition (or, as far as deal-makers are concerned, drawing the ire of the courts). For example, there has been a debate about the maximum percentage of deal price that could be promised as a termination fee. Section 6.02 of the 3G / Burger King agreement is an example of deal-makers handling this issue. The details belong to a specialized M&A course.

Liability

Finally and importantly, Unocal and Revlon are not generally available to support a claim for monetary damages. Under Corwin v. KKR Financial Holdings LLC (Del. 2015), "when a transaction not subject to the entire fairness standard is approved by a fully informed, uncoerced vote of the disinterested stockholders, the business judgment rule applies." Chief Justice Strine's opinion nicely captures the attitude of the Delaware courts:

Unocal and Revlon are primarily designed to give stockholders and the Court of Chancery the tool of injunctive relief to address important M & A decisions in real time, before closing. They were not tools designed with post-closing money damages claims in mind, the standards they articulate do not match the gross negligence standard for director due care liability under Van Gorkom, and with the prevalence of exculpatory charter provisions, due care liability is rarely even available. … [W]hen a transaction is not subject to the entire fairness standard, the long-standing policy of our law has been to avoid the uncertainties and costs of judicial second-guessing when the disinterested stockholders have had the free and informed chance to decide on the economic merits of a transaction for themselves. There are sound reasons for this policy. When the real parties in interest — the disinterested equity owners — can easily protect themselves at the ballot box by simply voting no, the utility of a litigation-intrusive standard of review promises more costs to stockholders in the form of litigation rents and inhibitions on risk-taking than it promises in terms of benefits to them. The reason for that is tied to the core rationale of the business judgment rule, which is that judges are poorly positioned to evaluate the wisdom of business decisions and there is little utility to having them second-guess the determination of impartial decision-makers with more information (in the case of directors) or an actual economic stake in the outcome (in the case of informed, disinterested stockholders).

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