For those readers new to US
Corporate Law, it should be understood that the majority of U.S.
corporations are registered in Delaware because of the long tradition of
Delaware's legal precedent in corporate law. As such, Delaware Law
in the United States is followed by many other states, which in many
instances, creates a de facto national body of case law. Thus,
what happens in Delaware is watched across the U.S. and globally.
Introduction
Delaware law should be refined
to improve the allocation of financial resources between bidders of corporations
and target shareholders. Since the 1980’s sufficient evidence has emerged
which shows that when a target board of directors successfully defeat an
unsolicited bid by increasing its corporate debt, long term value to
shareholders suffer. While the business judgment rule should continue to be the
standard of review in non-takeover transactions, the business judgment rule
standard should be refined in a takeover context to ensure that shareholder
choice, not director fiduciary duties per se, be identified as the proxy by
which resources are allocated efficiently. Shareholder choice should focus on
the right to vote on a tender offer, in particular, when a target board is about
to embark on increasing the corporation’s debt burden to fight off an
unsolicited takeover bid.
The traditional business judgment
standard focused on providing directors of corporations with wide discretion to
manage the affairs of a corporation; however, the Supreme Court’s intermediate
standard of review as outlined in to Unocal Corp. v. Mesa Petroleum Co.,
Del. Supr., 493 A.2d. 946 (1985) and Unitrin, Inc. v. American General
Corp., Del. Supr., 651 A.2d 1361 (1995), for example, tried to manage a
board’s response given the potential for a conflict of interest in a hostile
or unsolicited takeover transaction. Rather than try and outline new fiduciary
duties for boards, Delaware law should acknowledge that shareholder choice, and
any board responses that promote choice, should be the defining duties of a
board in a takeover context.
Under Delaware law a board of
directors is given broad authority to manage the affairs of a corporation.1
Prior to Unocal Delaware law gave a board of director’s discretion
under the business judgment rule to manage the financial affairs of a
corporation. The business judgment rule is a "presumption that in making a
business decision the directors of a corporation acted on an informed basis, in
good faith and in the honest belief that the action taken was in the best
interests of the company."2 As such, the "…judgment of
directors of corporation in making business decision will be respected by the
courts absent an abuse of discretion…"3 In spite of the
business judgment rule, a board of directors "…stand in a fiduciary
relation to the corporation and its stockholders"4
During the 1980’s corporate
boards were faced with a wave of unsolicited or hostile takeovers. In response
to these takeover threats, corporate boards felt compelled to formulate
defensive measures to thwart off hostile takeovers. For example, defensive
measures such as the poison pill, White Knights, PAC man, charter amendments and
other assorted tools were deployed either to thwart off a hostile bid, or to
make a bid more expensive. Unocal 5 was the first case to
depart from the traditional business judgment rule presumption because the
Supreme Court outlined a new threshold test that a board of directors had to
satisfy prior to receiving the protection of the business judgment rule.
Because of the omnipresent
specter that a board may be acting primarily in its own interest’s, 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.
6
The Delaware Supreme Court in Unocal
developed an enhanced scrutiny test because it saw that a potential conflict
of interest by the board of director’s was real in the context of a takeover
bid; namely, a board of directors may attempt to thwart a takeover bid to
protect or entrench themselves rather that respond objectively to a bid on its
merits. "The directors are of necessity confronted with a conflict of
interest, and an objective decision is difficult." 7
In Unocal, the Supreme
Court then outlined a two step test that a board of directors had to satisfy in
order to receive the protection of the business judgment rule. The Unocal
two-tier test essentially requires a board of directors to show: a) the board
"…had reasonable grounds for believing that a danger to corporate policy
and effectiveness existed because of another persons stock ownership,"8
and b) that any defensive measure is "reasonable in relation to the threat
posed."9 The court did, however, outline a broad limitation to
the proportionality of a board’s defensive response. "But such powers are
not absolute. A corporation does not have unbridled discretion to defeat any
perceived threat by any draconian means available."10
If the court is satisfied that a
board of directors had met their burden under Unocal, then it will apply
the business judgment rule presumption protecting a board of director’s
decisions with respect to the financial affairs of the corporation.
To the extent that a board of
directors responds disproportionately to the threat posed, then the Supreme
Court’s decision in Unitrin defined the scope of a board’s
fiduciary duty more precisely relative to Unocal by describing any
disproportionate defensive measure as creating a "preclusive or
coercive," effect upon shareholders. "In the modern takeover lexicon,
it is now clear that since Unocal, this Court has consistently recognized that
defensive measures which are either preclusive or coercive are included within
the common law definition of draconian."11 If a board’s
defensive measure is not draconian, Unitrin stipulates that the Unocal
standard require that defensive measures fall within a "range of
reasonableness."12
Unocal’s focus
on ensuring that a board’s response is both "reasonable" and
"proportionate" measured together with Unitrin’s "range
of reasonableness" develops a paradigm for a board to receive the
protection of the business judgment rule. However, it is submitted that the
Supreme Court is focusing too much on the nature of the response to the
perceived threat while assuming that as long a board’s response is
"reasonable" and "proportionate" that the defensive measure
is necessarily in the best interests of the company’s shareholders. As Unocal
shareholders discovered after their board’s successful defense against Mesa
Petroleum’s hostile takeover bid, not only must a board’s response be
reasonable and proportionate to a threat, but such defensive measures should
also demonstrate that they will not undermine the financial ability of a
corporation to sustain its long term strategic plans.
Defensive measures which rely
heavily on debt, or consume substantial corporate funds to repurchase shares,
while permitting a corporation to successfully win a takeover battle, my run the
risk of leaving that corporation vulnerable to either a adverse market
conditions or subsequent takeover bids at prices below the original unsolicited
takeover price - all resulting in even lower shareholder value.
In fighting Pickens’
takeover raid in April 1985 Hartley saddled his Los Angeles-based oil company
with $ 4.4 billion of added debt, pushing its debt ratio from 18% to over 75%
of total capital, now roughly double the industry average. Some people say
that to survive, Unocal must sell oil and gas reserves to pay down this debt. 13
Not only did Unocal saddle its
shareholders with a increased debt, but the long term cost can also be measured
in terms of the inability to make low cost investment - investments that would
have made Unocal more competitive and in a position to reap the benefits of
lower oil prices.
What bothers Hartley most
about Unocal’s straitened circumstances is its restraint on growth. Unocal
once had the flexibility to invest for the long term because of its strong
equity base. If he didn’t have all that debt, Hartley, and Richard
Stegemeier, his chief operating officer since the start of the year, could be
picking up reserves at fire-sale prices. 14
Frank H. Easterbrook and Gregg
A. Jarrell, in their study prior to Unocal, introduced evidence that
showed that defensive measures – under a wide spectrum of empirical
methodologies – hurt shareholder values after a successful target defense.
It does not matter how one
looks at defeated tender offers. Any method that takes into account the
movement of the stock market shows that managers who resist tender offers to
the point of defeating them do a grave disservice to their investors. The size
of the loss is 52% of value by some methods…. 15
As such, the formulation of
Delaware law given Unocal and Unitrin appear to promote a less
than optimal allocation of financial resources resulting in threats to long term
corporate share values.
The Unocal experience was
dramatically exemplified in Paramount Communications, Inc. v. Time
Inc. Del. Supr., 571 A.2d 1140 (1989). In Paramount, the Supreme
Court ruled that Time’s defensive responses to Paramount’s unsolicited bid
for $200 per share neither triggered Revlon16 duties nor was
unreasonable in relation to the threat.
…we premise our rejection of
plaintiffs’ Revlon claim on different grounds, namely, the absence of any
substantial evidence to conclude that Time’s board, in negotiating with
Warner, made the dissolution or break-up of the corporate entity inevitable,
as was the case in Revlon. 17
By not triggering any Revlon
duties, the Time board was relieved
from maximizing short term
shareholder value by opening up an
auction process at the expense
of the company’s long term strategic plans. While the Supreme Court held that
Time’s original plan to merge with Warner did not constitute a "change of
control," and thus implicate Revlon, it also held that Time’s
defensive response to Paramount’s bid was reasonable and proportionate
to the threat.
Here on the record facts, the
Chancellor found that Time’s responsive action to Paramount’s tender offer
was not aimed at "cramming down" on its shareholders a
management-sponsored alternative, but rather had as its goal the carrying
forward of a pre-existing transaction in an altered form. Thus, the response
was reasonably related to the threat. 18
While the Supreme Court deemed
Time’s defensive response reasonable, it appears that the Court glossed over
the "altered form" element of Time’s revised plan to merge with
Warner. The "altered form" forced Time to incur some 11 billion
dollars in debt to pay Warner shareholders, and to avoid a shareholder
vote. The court viewed this debt burden as not "…unreasonable so long as
the directors could reasonably perceive the debt load not to be so injurious to
the corporation as to jeopardize its well being."19 Under the
framework of maximizing shareholder choice in a takeover context, a shareholder
proxy vote would have addressed two clear choices for shareholders. Namely, $200
per share now versus moving forward with a merger with Warner plus 11 billion in
debt. History has shown the shareholders would have been better off and
resources allocated more efficiently had they voted for the Paramount offer.
When Paramount
Communications made a play for Time Inc. in the late 1980’s, Time refused
an offer of $200 a share –or $50 adjusted for a subsequent stock split.
Seven years have passed, and the price of Time Warner Inc., created in a
1989 merger of Time and Warner Communications, closed Friday at $39.50. 20
An efficient allocation of
resources would allow a company to use financial resources to maximize product
mix, reduce cost, or finance real investments. Yet, the Supreme Court’s focus
on the reasonable and proportional response of the Time board,
under the Unocal standard, while focusing on director fiduciary duty in a
takeover context, could not foresee the sub optimal context of this approach
when a target company incurs substantial debt to thwart a takeover. Rather than
permit a company’s directors under the business judgment rule to judge whether
a significant increase in debt will affect the well being of the company’s
long term strategic plans, in a takeover context, sufficient empirical evidence
shows that promoting shareholder choice should be the guiding fiduciary duty of
boards especially when an unsolicited bid offers a significant control premium
for shareholders. Avoiding this reality can result in the Time-Warner experience
where "…debt, not strategy…"21
guide a company’s post takeover defense.
Maximizing Shareholder Value: A
Black Box Theory
Delaware law seems to have
adopted a broad approach in its treatment of maximizing shareholder value
through the prism of director duties in a takeover context. This black box
approach focuses on ensuring that directors comply with their fiduciary duties
on one side, which in turn protects shareholder value on the other side. For
example, Unocal, Moran v. Household Intern., Inc., Del. Supr., 500
A.2d 1346 (1985) and Unitrin all examine the nature of a takeover threats
through the perspective of a board’s response. Unocal, for example,
examines the director’s "reasonable" investigation to assess whether
a threat to the corporation exists, and if the board perceives a threat, then
the court examines whether any board defensive responses are
"proportionate" to that threat. Similarly, in Unitrin, the
court examines the board’s defensive responses in so far as they are not
"draconian," and if not draconian, whether such defensive measures are
within a "range of reasonableness." Finally, in Moran, the
court examined whether the board’s decision to retain a repurchase plan
precluded future proxy contests. While the court in Moran did not agree
that a board’s adoption of a rights plan (i.e., poison pill) prior to an actual
takeover bid was preclusive in terms of shareholders waging a proxy contest, the
court illuminated it’s decision with a revealing view about how boards’ use
of debt to defend against an unsolicited bid can undermine the long term value
of a company. "Comparing the Rights Plan with other defensive mechanisms,
it does less harm to the value structure of the corporation than do the other
mechanisms. Other mechanisms result in increased debt of the corporation." 22
Essentially, Delaware courts seem
to have adopted an efficient standard of review that promotes substantive rather
then rhetorical standards of review which seeks to ensure that a boards’
response in a takeover environment is reasonable and proportionate prior to
receiving the protection of the business judgment rule.
Is the Supreme Court’s concern
with establishing whether a board should be afforded the protection of the
business judgment rule an efficient framework to ensure the optimal allocation
of resources such that shareholders values are maximized in a takeover context?
Steven Fink introduces an interesting thesis. 23
Fink argues, in part, that
"…the unique dynamics of tender offers make stockholders the best actors
to evaluate offer defenses."24 Fink focuses on a paradigm where
Delaware law should be used to scrutinize director defensive responses with
respect to their ability to "enhance target stockholders’ ability to
evaluate competing offers." 25 Fink’s approach suggests a
revealing point, that the courts ultimate focus with establishing an
intermediate threshold test to assess whether the business judgment rule
protection should be given to a board of directors is inherently inefficient
within the context of a takeover environment.
Unocal’s threshold
tests of "reasonability" and "proportionality" are built on
the courts express concern regarding the potential conflict of interest between
directors and a takeover transaction. 26 It seems interesting that
Delaware courts would devote so much effort to mitigate this inherent potential
for conflict, when ultimately, what the courts are trying to protect in large
measure are share values. Share values are maximized by informed and good faith
decision making – normally through the board of directors; however, as Fink
rightly points out, "[t]he business judgment rule makes sense in the
context of business decision in which directors are not confronted with a
conflict of interest." 27
The business judgment rule’s
effectiveness breaks down in a takeover context so that shareholder choice
becomes the best alternative to traditional director functions. The Delaware
Supreme Court decisions in Unocal, Moran and Unitrin
express a concern regarding the preclusive measures that board’s seem to have
the potential for. Even in a non-takeover environment, the Supreme Court
outlined a need for fairness (i.e., non-preclusive), so shareholders are
afforded the best deal possible. In Revlon for example, the court
emphatically stated that once directors move from a defensive posture to a
position whereby the corporation is up for sale, directors have duty to promote
a fair auction to afford shareholders the highest reasonably attainable price.
The Revlon board’s authorization permitting
management to negotiate a merger or buyout with a third party was a
recognition that the company was for sale. The duty of the board had thus
changed from the preservation of Revlon as a corporate entity to the
maximization of the company’s value at a sale for the stockholder’s
benefit. 28
The inefficiency of Delaware law does not stem
from it’s attempt to contain disproportionate defensive measures, especially
in reaction to unsolicited takeover attempts, but from it’s need to outline
what criteria should trigger shareholder choice. In a takeover context, the
Supreme Court should consider, inter alia, limiting director discretion
and increase the ability for a target shareholder constituency to vote on a
tender offer when the amount of the tender offer is significantly higher that
either the current or historical share price of the company stock. Secondly, if
the target board is proposing a rights plan to thwart a tender offer that is
going to be financed by increasing the corporation’s debt burden, then
shareholders, not directors, should decide whether to opt for short term gains,
or the board’s long term strategy. The Delaware Supreme Court’s desire to
establish an intermediate threshold prior to affording the presumption of the
business judgment rule to a board of directors misses a vital element that can
ensure the maximization of shareholder value, namely, shareholder choice.
"Courts should strive to create legal rules which maximize stockholder
choice in sales of control, thus, facilitating target assets’ movement to
their most highly valued use."29
Fink’s Proposal: An Assessment
for Reform
Fink proposes limiting director discretion so
that any defensive actions enhance shareholder choice.30 Under a
hostile takeover bid, for example, where the board of directors may believe that
shareholders may mistakenly tender their shares not realizing the intrinsic
value of the corporation or where shareholders tender their shares out of fear
of being left behind to face a back end offer where payment may be in junk
bonds, Fink proposes that directors should be limited to a narrow range of
defensive responses. Specifically, target boards would be restricted to the
following range of defenses: Target boards may offer to repurchase a
"controlling block of target shares" for a greater premium relative
the bidder.31 Target boards should be barred from paying greenmail to
the bidder.32 Target boards should be permitted to solicit competing
offers for the target company.33 Courts should not permit lock up
agreements between a target board and preferred bidders since this arrangement
restricts shareholder choice.34
Fink also advocates "…providing
stockholders an opportunity to vote whether or not they want an offer to succeed
independent of their choice to tender if it does succeed, and finally,
permitting only those defenses which encourage either management buyouts or
competing outside bids."35 The underlying assumption with Fink’s
proposal is that resources are best allocated when "…the ultimate
decision whether to accept a tender offer is in the hands of the actor best
positioned to evaluate the offer: the target stockholder."36
Fink’s premise represents a fundamental difference relative to the Delaware
Supreme Court’s where the latter implicitly directs resource allocation when
directors meet their fiduciary duties under Unocal/Unitrin. This
proposition can be examined by reference to the Supreme Court’s reasoning in Unitrin.
In Unitrin, despite American General’s
offer that it would "consider offering a higher price" subject to
Unitrin’s ability to "demonstrate additional value," the Unitrin
board responded by adopting defensive measures on the grounds that American
General’s offer was anti-competitive and financially inadequate.37
Unlike a coercive offer, American General’s offer was seeking to forge "a
consensual merger transaction."38
What is notable in Unitrin is the Supreme
Court’s focus on the Court of Chancery’s interpretation of Unocal.
Specifically the Supreme Court remanded the case back to the court of Chancery
on the grounds that the lower court’s findings with respect to "…the
Repurchase Program was a disproportionate defensive response, was based on
faulty factual predicates…"39 The Chancery Court ruled that
Unitrin’s repurchase plan was not necessary in light of the other defensives
it adopted. The Supreme Court overruled the Chancery Court on the grounds that
highlighting whether the repurchase plan was "necessary" was the wrong
issue, and the key issue was whether the repurchase plan was preclusive to the
extent that American General was barred form waging a proxy fight. Though very
difficult, the Supreme Court based its ratio on the fact that a proxy vote was
still possible, and thus, the Unitrin repurchase plan was not preclusive.
Using Fink’s proposal, the issue would instead
turn on whether Unitrin’s defensive repurchase program precluded shareholder
choice. While the Supreme Court examined the issue of whether the repurchase
program was disproportionate or "preclusive," in terms of preventing American
General from waging a proxy contest, it chose to remain silent on the more
obvious issue of why in the face of American General’s express willingness to
negotiate a higher price, the Untirin board chose not to negotiate but instead,
pursue a more costly defensive measure. Under the Fink proposal, Unitrin
may have been decided differently. Given the paramount objective of stockholder
choice, the Unitrin board’s repurchase program would not be deemed reasonable
in relation to the threat, but preclusive from the standpoint of preventing
shareholders from deciding whether the American General Offer should be
accepted. In Unitrin, quite plausibly, given American General’s
willingness to negotiate a higher price, shareholders did not have an
opportunity to maximize their share value. As a result, "…shareholders of
the insurance company Unitrin Inc. have been waiting two years for their stock
to trade significantly above the $50.375 a share offered by American
General." 40
The Delaware Supreme Court should refine its
review standard in a takeover context not with respect to measuring whether a
boards’ defensives should be afforded the protection of the business judgment
rule, but with a fundamental change that discounts the relevance of the business
judgment rule per se as a fiduciary issue, and instead adopt a review standard
that promotes board action that permits shareholders, not directors, to vote in
a takeover context.
Endnotes
1
Power of directors to govern – 8 Del.C. § 141(a).
2 Aronson v. Lewis, Del.
Supr., 473 A.2d. 805, 812 (1984).
3
Id. at 805.
4
Guth v. Loft, Inc., Del. Supr., 5 A.2d. 503, 510 (1939).
5
Unocal Corp. v. Mesa Petroleum Co., Del. Supr., 493 A.2d 946 (1985).
6
Id. at 954.
7
Id. at 954-955.
8
Id. at 955.
9
Id.
10
Id.
11
Unitrin, Inc. v. American General Corp., Del. Supr., 651 A.2d 1361, 1387 (1995).
12
Id. at 1388.
13
John Heins, It's Not As Much Fun, Forbes, November 17, 1986, at 106.
14
Heins, supra.
15
Frank H. Easterbrook and Gregg A. Jarrell, Do Targets Gain From Defeating
Tender Offers?, 59 N.Y.U. L. Rev., 277, May 1984.
16
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., Del. Supr., 506 A2d. 173
(1986).
17
Paramount Communications, Inc. v. Time, Inc., Del. Supr., 571 A.2d 1140. 1150
(1989).
18
Id. at 1154.
19
Id. at 1155.
20
Reed Abelson, Investing It; When Boards Say ‘No Deal’ to Holders,
N.Y. Times, Oct. 6, 1996, at § 3, at 1.
21
Time Warner; That's not all, folks, The Economist, November
2, 1991, at 64.
22
Moran v. Household Intern., Inc., Del. Supr., 500 A.2d. 1436, 1354 (1985).
23
Steven J. Fink, The Rebirth of the Tender Offer? Paramount Communications,
Inc. v. QVC Network, Inc., 20 DEL. J. CORP. L. 133, 136, (Winter 1993).
24
Fink, supra note 23 at 137.
25
Fink, supra note 23 at 136.
26
Unocal, 493 A.2d at 954.
27
Fink, supra note 23 at 136.
28
Revlon, 506 A2d. at 173.
29
Fink, supra note 23 at 140.
31
Fink, supra note 23 at 167.
32
Fink, supra.
33 Fink,
supra.
34
Fink, supra note 23 at 168.
35 Fink,
supra note 23 at 164.
36 Fink,
supra note 23 at 170.
37
Unitrin, 651 A.2d at 1368.
38
Id.
39
Id. at 1391.
40
Reed, supra note 20 at § 3 at 1.
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