Book Review: Bainbridge’s Directors as Auctioneers–A Concise Guide toRevlon-Land
posted by Michael Sirkin
Stephen M. Bainbridge, Directors as Auctioneers—A Concise Guide to Revlon-Land (2011).
“Motive” is a legal concept no longer reserved for criminal lawyers. Motive matters in M&A litigation, too, according to UCLA law professor Stephen Bainbridge in his e-book, Directors as Auctioneers—A Concise Guide to Revlon-Land. This notion is not unique to Bainbridge, as Chancellor Leo E. Strine, Jr. of the Delaware Court of Chancery recently reaffirmed:
As Revlon itself made clear, the potential sale of a corporation has enormous implications for corporate managers and advisors, and a range of human motivations, including but by no means limited to greed, can inspire fiduciaries and their advisors to be less than faithful to their contextual duty to pursue the best value for the company’s stockholders.
Yet, despite this apparent agreement about Revlon’s core principles, Bainbridge contends that the Court of Chancery has been misapplying them. Bainbridge specifically criticizes the line of Court of Chancery decisions that turn on the form of merger consideration rather than on the directors’ motivations and potential conflicts of interest.
Bainbridge begins the book with a guided tour through “Revlon-Land,” including Revlon’s history and policy foundations in the “veritable flood of academic writing” from the 1980s about the proper role of a target board in the context of an unsolicited takeover bid. Bainbridge identifies and analyzes the emergence of two leading policy proposals.
First, Bainbridge focuses on Professors Ronald Gilson and Lucian Bebchuk, who argued that a target board should be permitted to use takeover defenses only to achieve a higher-priced offer, and that defenses deployed by the target board to fend off the bidder and remain independent should be illegal. This is contrary to Delaware law. Bainbridge dismisses this approach as unworkable because it would place the target board’s legal advisors in a quandary, paralyzed by the risk of trying to predict which takeover defenses would generate a topping bid and which would not. Consequently, rational companies desirous of the security that takeover defenses provide would erect them prophylactically on the proverbial clear day before receiving an unsolicited takeover bid, thereby choking the market for corporate control.
Second, Bainbridge discusses Judge Frank Easterbrook and Professor Daniel Fischel, who advocated a simpler policy: total passivity. According to Easterbrook and Fischel, all takeover defenses (and anti-takeover legislation) should be illegal because an unimpeded market for corporate control would better align the interests of stockholders and management: If the only effective defense against an unwanted takeover is a consistently high stock price, then management’s inevitable entrenchment motivations actually benefit stockholders. And, taking aim at Gilson and Bebchuk, Easterbrook and Fischel argue that the most pernicious takeover defenses are those that tend to encourage topping bids. As Bainbridge notes, if a defensive action increases the probability of a topping bid, then it correspondingly reduces the first bidder’s expected value, thereby diminishing the economic incentive for potential bidders to monitor potential targets.
The Delaware Supreme Court soundly rejected the Easterbrook and Fischel proposal in its Unocal decision. This result is unsurprising. Delaware corporate law is board-centric by statute, and the notion of passivity is antithetical to underlying tenets of Delaware law.
Bainbridge thus concludes instead that Delaware courts focus on the board’s motives. “In its takeover jurisprudence, Delaware has balanced the competing claims of authority and accountability by varying the standard of review according to the likelihood that the actions of the board or managers will be tainted by conflicted interests in a particular transactional setting and the likelihood that non-legal forces can effectively constrain those conflicted interests in that setting.”
“By the mid-1990s, the Delaware Supreme Court had worked out a credible set of answers . . . . The seemingly settled rules made doctrinal sense and were sound from a policy perspective.” The Supreme Court set forth three simple Revlon triggers: “(1) when a corporation initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company; (2) where, in response to a bidder’s offer, a target abandons its long-term strategy and seeks an alternative transaction involving the break-up of the company; or (3) when approval of a transaction results in a sale or change of control. In the latter situation, there is no sale or change in control when [c]ontrol of both [companies] remain[s] in a large, fluid, changeable and changing market.”
But, “[s]imple it’s not, I’m afraid you will find, for a mind-maker-upper to make up his mind.” Bainbridge contends that “a number of Chancery decisions have drifted away from the doctrinal parameters laid down by the Supreme Court.” To return to the Supreme Court’s policy foundations, Bainbridge argues that the Court of “Chancery should adopt a conflict of interest-based approach to invoking Revlon, which focuses on where control of the resulting corporate entity rests when the transaction is complete.”
Bainbridge’s chief criticism is the Court of Chancery’s application of Revlon to cash mergers between widely held, publicly traded companies. Revlon does not apply to the stock-for-stock merger-of-equals paradigm because control of the post-transaction entity will remain in the hands of dispersed shareholders in the “large, fluid, changeable and changing market.” By contrast, Revlon does apply if the acquisition currency is at least approximately 50% cash.
But why? Bainbridge astutely observes that this result is counterintuitive for two reasons. First, the form of consideration is irrelevant so long as the acquiror’s stock is liquid, allowing stockholders to convert from cash to stock (and vice versa) at their whim. And second, a rational, diversified stockholder is equally likely to own stock of an acquiror as of a target, and would therefore be indifferent to the division of merger gains between acquirors and targets in cash deals. Thus, according to Bainbridge, equitable division of a merger premium is a less compelling reason to apply Revlon than some Court of Chancery decisions may suggest.
Although Bainbridge’s criticisms are presented adroitly and are thought provoking, I believe the Court of Chancery has gotten Revlon right because of a concept that Vice Chancellor Laster has dubbed the “Last-Period Problem.” The Last-Period Problem concept recognizes that in the ordinary course of business, the faithful service of directors to stockholders is secured by legal and non-legal forces. The legal forces are obvious, and commonly enforced by the threat of litigation for breach of fiduciary duty. Less obvious, but perhaps equally important, are the non-legal forces that govern the directors’ conduct, including social or relational norms, moral obligations, and market forces. In a merger, though, the relationship between the target directors and stockholders is in its last period, and the non-legal constraints fall away. In the absence of these non-legal constraints, directors are more likely to deviate from the shareholder-maximization norm, even in innocent ways. Revlon scrutiny addresses this Last Period Problem, and Bainbridge himself recognizes as much, in the parlance of “operational” and “structural” decisions, with structural decisions posing the Last Period Problem:
[S]tructural decisions—such as corporate takeovers—present a final period problem entailing an especially severe conflict of interest. . . . Target boards are no longer subject to shareholder discipline because the acquirer will buy out the target’s shareholders. Target directors and managers are no longer subject to market discipline because the target by definition will no longer operate in the market as an independent agency. Accordingly, in the structural context there is sufficiently good reason to be skeptical of incumbent’s claims to be acting in the shareholders’ best interests to justify a more intrusive standard of review than the business judgment rule.
The Last-Period Problem also illuminates a key distinction between cash mergers and stock-for-stock deals. Bainbridge is indisputably correct that, regardless of the acquisition currency, the target directors will not be subject to shareholder or market discipline in a final-stage transaction. But what about the acquiror’s directors?
In a cash-out merger, the target stockholders and acquirer’s board are mere counterparties, and all of the principles of the Last-Period Problem apply. But, following a stock-for-stock merger, the acquiror’s board becomes answerable to the target stockholders; the merger is the “First Period” of their relationship. The acquiror’s board will therefore have a prospective interest in protecting the target stockholders and ensuring that the target stockholders are treated fairly. Target directors are less likely to shirk their duties because the acquiror’s directors will not allow it. Call it the “First-Period Solution” to the Last-Period Problem; this non-legal force is present in stock-for-stock deals and absent in cash mergers, and the First-Period Solution might obviate the need for Revlon scrutiny in stock-for-stock mergers.
Of course, the degree to which the proposed First Period Solution protects target stockholders is unknown. In price negotiations, for example, the interests of the target stockholders are directly adverse to the interests of the acquiror stockholders. And, while non-legal forces discussed here would tend to protect the interests of the target stockholders, those non-legal considerations might lose out to the legal ones, with their concomitant consequences, that require the acquiror’s board to bargain for the lowest achievable acquisition price. But, it remains true in a stock-for-stock deal that there are social, moral, and relational pressures on the acquiror’s board to protect target stockholders, who are stockholders-in-waiting of the acquiror. Quantifying those pressures poses an open empirical question that is difficult, if not impossible to answer. Perhaps the answer resides among the “Legislative Facts” that comprise the “Inescapably Empirical Foundation” of Delaware corporate law.
I’d be interested to hear Bainbridge’s response to this concept. If his blog and his prolific academic writing are any indication, he will no doubt have a well-reasoned, thorough, and principled response that may convince me that he’s right. Bainbridge writes in a distinct and singular voice, authoritative and firm in its convictions. The book is well researched and its positions skillfully argued. It reads like a cross between a traditional law review article and what could be a companion book for an M&A course text, conveying a fulsome understanding of where the law is and how it got there. All consumers of Delaware corporate law would do well to read it.
Mike Sirkin is an associate at Seitz Ross Aronstam & Moritz LLP.
 Professor Bainbridge was kind enough to provide me with an electronic review copy of his book. All quoted material not attributed to other sources is taken from his text.
 In re El Paso Corporation S’holder Litig., Consol. C.A. No. 6949-CS, Slip Op. at 11 (Del. Ch. Feb. 29, 2012).
 For a thorough discussion of the legality of using takeover defenses to preserve independence, see Air Products & Chemicals, Inc. v. Airgas, Inc., 16 A.3d 48, 100 (Del, Ch. 2011).
 Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 n.10 (Del. 1985).
 See 8 Del. C. § 141.
 Arnold v. Soc’y for Sav. Bancorp, Inc., 650 A.2d 1270, 1289-90 (Del. 1994) (citations,
footnotes, and internal quotation marks omitted)
 Dr. Seuss, Oh the Places You’ll Go! (1991).
 Arnold, 650 A.2d at 1289-90.
 See, e.g., In re Smurfit-Stone Container Corp., 2011 WL 2028076 (Del. Ch. May 24, 2011); Steinhardt v. Howard-Anderson, C.A. No. 5878-VCL (Del. Ch. Jan. 24, 2011) (TRANSCRIPT).
 Putting aside tax implications and transactions costs for present purposes.
 See, e.g., Steinhardt v. Howard-Anderson, C.A. No. 5878-VCL (Del. Ch. Jan. 24, 2011) (TRANSCRIPT).
 Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 458-59 (Del. Ch. 2011). This statement also strikes me as a sort of “legislative fact” that informs “The Inescapably Empirical Foundation of the Common Law of Corporations.” See generally Leo E. Strine, Jr., The Inescapably Empirical Foundation of the Common Law of Corporations, 27 Del. J. Corp. L. 499 (2002).
 These consequences can be immediate: in a stock-for-stock merger, the stockholders of the acquiror often must vote on whether or not to approve the deal. See, e.g., New York Stock Exchange Listed Company Manual § 312.03(c), available at http://www.nyse.com (requiring shareholder approval for a company to issue twenty percent or more of the voting power of a company’s stock).
 To test this effect empirically would require a study of merger premiums as a function of acquisition currency, but would have to control for many other variables, including competing bids, under- or overvaluation of the acquiror’s stock, and tax effects.
 See generally Leo E. Strine, Jr., The Inescapably Empirical Foundation of the Common Law of Corporations, 27 Del. J. Corp. L. 499 (2002).