It’s been ten years since MFW and Corwin opened a process pathway to business judgment review of cashout mergers, subject to Weinberger, and arm’s length mergers, subject to Revlon. At the time the cases came down, I anticipated smooth sailing for the cases’ two-track cleansing regime, under which the defendant needs independent director approval followed by ratification by a fully informed and uncoerced majority of disinterested shareholders. I figured that we had enough law in place on each of the tracks to make their application a straightforward matter. The components of the board approval leg, director independence and a special committee process, were focal point matters in late twentieth-century corporate governance, and there were plenty of Delaware cases providing guidance. The shareholder approval leg had a sketchier background. We had a well-developed law, mostly federal, on the full information requirement, and we knew coercion when we saw it. We had much less on the table to help us with precise questions respecting majority disinterested shareholder approval, because shareholder ratification had not theretofore been the usual practice recourse respecting conflicted transactions. But how hard could it be to fill in the details?
It turned out to be a lot harder than I thought. MFW and Corwin came down before everybody’s attention turned to the Big Three institutional investors and their growing block of voting shares and the closely related question of portfolio investor incentives, in particular the incentives of “common owners.” Common owner conflicts first popped up on the screen in 2004 with the empty voting allegations triggered by the Mylan-King merger agreement. The problem has been looming larger ever since, implicating not just corporate governance but antitrust.
Corporate law models shareholders as single firm owners whose fortunes rise and fall in lockstep with the fortunes of the corporate stock issuer. The incentives of portfolio investors can differ sharply, as a simple example will show. Target (T) has 1,000,000 shares outstanding and is merging into Acquirer (A), which has 5,000,000 shares outstanding. The merger price is $50 per T share. Unfortunately, the merger process has been impaired by self-dealing at T. It plausibly can be shown that T could have been sold for $60 per share. In fact, Bidder (B) is ready to make such an offer. A sole owner of T shares, knowing all of this, will vote against the merger, looking to improve its yield by $10 per share in a B merger. Compare institutional investor Delta (D), which owns one percent of T (10,000 shares) and five percent of A (250,000 shares). D has every incentive to vote its T shares in favor of the merger, because the $10 per share bargain is worth $10,000,000 to A and hence $500,000 to D, while the $10 per share opportunity cost at T implicates a loss of only $100,000 to D in its position as a one percent owner. D’s economic interest is clearly opposed to that of a sole owner of T stock. But does this incentive skew make D an “interested” voter for Corwin purposes?
Marcel Kahan and Edward B. Rock offer an exhaustive analysis of this problem. Everything is beautifully set up. The base issue is whether we should go into these incentive questions at all, because “interested” can be defined narrowly or broadly. Under the narrow definition (majority of unaffiliated or MOU), only those directly involved in the transaction and their affiliates are disqualified. Under the broad definition (majority of economically disinterested or MOD), a shareholder’s economic incentives are subject to question when set against the sole owner yardstick, making common owner votes vulnerable to challenge. Kahan and Rock, having thus stated the issue, provide us with a neat set of real-world transactional examples to serve as focal points for law-to-fact analysis. Then they summarize Delaware law, which turns out to be even sketchier than I thought, as it vacillates between MOU and MOD.
The big question concerns the specifications of an MOD regime: Which common ownership positions implicate a cognizable incentive skew and which do not? Kahn and Rock really go to town here. They show that the conflict’s severity is a function of (1) the joint gains yielded by the transaction; (2) the amount of the joint gains as a percentage of the value of T; and (3) a variable they call the ownership stake multiplier, which is a function of the common owner’s stakes in T and A.
It’s all algebra at this point, so it’s a good thing Kahan and Rock have four sample transactions ready to be run through their analysis. We get a disturbing result at the end of the line: Except where joint gains are negative and the common owner has a higher stake in T than in A, it is entirely possible that a common owner will vote in favor of a transaction yielding less than the pre-transaction value of T. Here is a shocking example from the paper. A’s pre-merger value is $2 billion, T’s pre-merger value is $1 billion, and a merger of the two will yield a combined company worth $3.1 billion. D owns six percent of T and five percent of A. The merger price is $510 million, which, of course, is $490 million less than the value of T. Yet D will vote in favor of the deal! Here’s why: “The value of the common owner’s combined stake would be $160.1 million if the merger is approved (5% of the $2.59 billion value of Acquirer ($129.5 million) plus 6% of the $510 price paid for Target ($30.6 million)) compared to $160 million if the merger is not approved (5% stake in Acquirer worth $2 billion plus 6% stake in Target worth $1 billion).” (P. 17.)
Kahan and Rock go on to give us a hard-nosed and well-informed discussion of the institutional implications of their findings. They want nothing to do with MOU. They also reject an approach suggested by Lawrence Hamermesh and Henry Hu (in a paper available here) under which unaffiliated voters would be presumed to be disinterested, with the plaintiff bearing the burden of proof to show otherwise. Kahan and Rock make an old school objection to this, insisting that the burden to qualify the transaction stay firmly on the conflicted fiduciary. That said, Kahan and Rock admit that an MOD regime would create much uncertainty in the market for mergers and acquisitions. Nor, as it turns out, is Kahan and Rock’s incentive test easy of real-world application: institutional holdings are not transparent, and there’s no verifiable joint gains number with which to anchor the test. Kahan and Rock close with a rule proposal that looks for tractability even as it would cut back on MFW and Corwin—they recommend that there be no cleansing effect accorded to a vote in the event of a “material” level of negative votes and “widespread” common ownership.
A companion piece, Explicit and Implicit Bundling in Shareholder Voting on Cleansing Acts, available here, is also recommended.
