[Cross-posted from the Business Scholarship Podcast]

Senior Associate Dean for Academic Affairs Afra Afsharipour joins Andrew K. Jennings’ Business Scholarship Podcast to discuss her Wisconsin Law Review article "Bias, Identity and M&A." In the article, Afsharipour considers the non-value maximizing behavioral biases that can influence M&A activity, with a particular focus on senior management and a board’s ability to monitor senior management in the deal process. As part of this discussion, Afsharipour reviews recent empirical research on the relationship between management identity and M&A behavior.

Listen to the episode.

[Cross-posted from the Oxford Business Law Blog]

By Afra Afsharipour

Takeover transactions raise significant corporate governance questions about the allocation of decision-making power among firm participants, whether and to what extent participants are constrained in their exercise of decision-making power, and whether and to what extent participants can be held accountable for their decisions. Public company M&A deals, especially, involve complex steps and contracts, and are transactions that unfold over time. This timeline involves a variety of decisions for the board of each company, and the ultimate decisions made by the board can be subject to shareholder voting or acceptance. The rules designed to address corporate governance in takeovers often reflect the ownership structure prevalent in a particular jurisdiction, but they also reflect the political power of interest groups that influence the law. The result is thus a mishmash of rules that attempt to balance both concerns about ownership structure and the desires of powerful interest groups.

In a forthcoming book chapter, I consider how corporate governance concerns are reflected in the law’s approach to regulating friendly takeovers, ie acquisitions by third party bidders that are negotiated and supported by the management of the target company. Two countries with similar capital markets and institutional frameworks, the US and UK, approach these corporate governance concerns and the balance of power between the board of directors and shareholders in increasingly divergent ways. I argue that while the UK approach to friendly takeovers constrains director power, the US approach continues to maintain and reinforce the centrality of director decision-making.

The UK is characterized by ex-ante rules that constrain managerial power and favor shareholder voice, whether deals are done via a takeover or some other structure such as a scheme of arrangement. For both structures, UK rules provide a significant voice, through voting rights or otherwise, for target shareholders. In a departure from the US model, in acquisitions of a significant size shareholders of UK bidder firms also have voting rights that constrain bidder boards. Furthermore, while the US takes a board-centric approach to director power in erecting takeover barriers, the Takeover Code limits the ability of directors to diminish or ‘frustrate’ shareholder power through takeover defenses. Significantly for friendly deals, in 2011 the UK revised its takeover rules to also dramatically constrain the power of directors to negotiate deal protection mechanisms. A key principle in the UK’s approach to friendly takeovers is constraint on director power and negotiating leverage. The shareholder-centric approach of the UK in many ways reflects the power of institutional investors who have been central to the drafting and design of the Takeover Code.

In balancing corporate governance concerns in friendly takeovers, the US has historically emphasized the interplay between ex ante protections (ie disclosure and shareholder voice) and ex post policing (ie litigation) in ways that reflect a director-centric approach. Shareholder voice is more constrained than in the UK. Not only is the voting threshold lower for shareholder voting in M&A deals, but bidder shareholders are often deprived of voting rights even in significant transactions. While shareholders may have a voice, the transaction is controlled by management. Management controls the timing and negotiation of the deal, as well as the information upon which shareholders rely in deciding whether to approve the matter or to tender in their shares. The shareholders’ vote on a deal hinges on the structure of the deal as designed by directors, including the deal protection provisions of the transaction. Unlike in the UK, directors of US firms have wide latitude to design deal protection measures. In fact, over the past decade, deal protection mechanisms have become stronger in the US with a proliferation and expansion of a variety of mechanisms that provide management with tools to protect its preferred deal.

Cognizant of management control and their conflicting incentives in negotiating takeovers, Delaware law has historically provided target shareholders two avenues to hold directors accountable through the courts—fiduciary duty litigation and appraisal rights. Over the past decade both avenues have been eroded by new doctrine. Shareholders seeking to pursue a claim for breach of fiduciary duties in a friendly takeover can file a suit for a preliminary injunction seeking to bring forth additional disclosure or to modify the merger agreement, particularly deal protection measures. Since the mid-2010s, however, the Delaware courts have tightened the standard for preliminary injunctions in merger cases, thus limiting shareholders’ ability to pursue fiduciary-based claims. Through the Corwin case and its progeny, the Delaware courts have also limited ex-post judicial review of board decisions in third-party takeovers. These decisions were a systematic move by the Delaware Courts to place limits on the wave of merger-related litigation sweeping its courts.

Under Delaware law, in certain takeovers, stockholders are entitled to an appraisal right; that is to refuse to accept the consideration offered and instead turn to the courts to determine the fair value of their shares. Appraisal was long seen as a limited remedy, but in the last decade appraisal actions gained steam with sophisticated investors acting as dissenting shareholders. The increase in appraisal actions led to a trio of important decisions by the Delaware Supreme Court.  These decisions place great emphasis on the agreed-to deal price as the ‘fair value’, substantially weakening appraisal as a remedy. The courts’ deference to deal price is driven by many of the same considerations that have driven limitations on fiduciary duty litigation in friendly takeovers.

Overall, Delaware jurisprudence now emphasizes the value of ex ante methods—such as deal process or deal-requirements like shareholder voting—to address corporate governance concerns. The shifts in Delaware have been depicted as elevating governance and procedure over costly and uncertain litigation. Some commentators have even argued that these moves recognize increased shareholder power in the US and bring Delaware closer to the UK model where the primary role of the target board is ensuring a stockholder vote.

I argue, however, that once we take into account the authority that boards have in designing a deal and putting into place a wide variety of deal protection mechanisms, the move toward expanding the value of ex ante shareholder voice and devaluing ex-post litigation in reality maintains and reinforces management power in Delaware. This is not surprising. The Delaware approach to takeovers, with courts as the arbiter of corporate governance disputes, has long been concerned with maintaining the centrality of board decision-making. And when that centrality came under attack with the rise in fiduciary duty and appraisal litigation, the courts responded to the significant management backlash to these rising trends by reverting to the pro-manager approach of Delaware jurisprudence. Thus, Delaware maintains the deference given to board decisions and continues to insulate director decisions on deal protection from second-guessing by shareholders or courts. Similarly, the turn in appraisal jurisprudence reflects judicial faith in deal process as designed by boards and management. While the US litigation regime now appears to elevate the value of a shareholder vote in friendly deals, this vote is in the context of deals that have been designed through a plethora of deal protection mechanisms to tie the hands of shareholders and leave them stuck with the deal as presented by management.

The primacy of directors under the US regime becomes even more pronounced when one compares that regime with the UK’s, which places significant constraints on the board’s ability to negotiate deal protection devices. The question remains open, however, as to which system is better for the corporation and its shareholders.

Afra Afsharipour is Senior Associate Dean for Academic Affairs & Professor of Law at the UC Davis School of Law.

[Co-written with the Hon. J. Travis Laster and cross-posted from Harvard Law School Forum on Corporate Governance and Financial Regulation]

Editor’s Note: Afra Afsharipour is Senior Associate Dean for Academic Affairs and professor of law at UC Davis School of Law; The Honorable J. Travis Laster is vice chancellor of the Delaware Court of Chancery. This post is based on their recent article, published in the Georgia Law Review, and is part of the Delaware law series; links to other posts in the series are available here.

Empirical studies of acquisitions consistently find that public company bidders often overpay for targets, imposing significant losses on bidder shareholders. Research also indicates that the losses represent true wealth destruction in the aggregate and not simply a wealth transfer from bidder shareholders to target shareholders.

Numerous studies have connected bidder overpayment with managerial agency costs and behavioral biases that reflect management self-interest. Agency theorists in law, management, and finance argue that agency costs explain bidder overpayment—that is management pursues wealth-destroying acquisitions at the expense of shareholders. Numerous studies provide evidence that acquisitions offer significant benefits to bidder management—particularly bidder CEOs—in the form of increased compensation, power, and prestige. For example, studies have found that CEOs are financially rewarded for acquisitions in the form of large, new options and grants, but are not similarly rewarded for other types of major transactions. A second, complementary contributor to bidder overpayment is behavioral bias, such as overconfidence and ego gratification. Managers may overestimate their ability to price a target accurately or their ability to integrate its operations and generate synergies. They may also get caught up in the competitive dynamic of a bidding contest, leading to the winner’s curse. Studies have shown that social factors can undermine decision making and lead to poor acquisitions. These factors include the existence of extensive business or educational ties between the managers of the bidder and target firms, the presence of fewer independent directors on the bidder’s board, and the desire to keep up with peers.

For purposes of corporate law, these concerns implicate the behavior of fiduciaries—the officers and directors of the acquiring entity—and raise questions about whether those fiduciaries are fulfilling their fiduciary duties.

Beginning in the 1980s, to address circumstances that present a high risk of self-interest, the Delaware courts began to develop an intermediate standard of review known as enhanced scrutiny. The situations evaluated in these cases did not encompass the flagrant self-dealing often observed in traditional duty of loyalty cases, but instead involved the potential risk of soft conflicts and fiduciary self-interest. Much of Delaware’s enhanced scrutiny jurisprudence was developed through scrutiny of decisions by sell-side fiduciaries. We argue that the enhanced scrutiny framework has become a means of screening for improperly motivated actions “when the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors.” (Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 457 (Del. Ch. 2011)).

In the article, we expand on three primary reasons to extend enhanced scrutiny to decisions of buy-side fiduciaries. Most importantly, the core conflict-derived rationale that supports applying enhanced scrutiny to actions by sell-side fiduciaries applies equally on the buy-side M&A scenarios. The decision to undertake a significant acquisition differs from other routine business judgments taken by directors and officers. As in the sell-side scenario, acquisitions are often large transactions that are plagued by subtle personal interests that affect the decision-making process. Empirical evidence suggests that in acquisitions, particularly significant acquisitions, the business judgment of boards is contaminated by the interests of managers on whom boards of directors rely. The board’s judgment is even more contaminated in public company acquisitions where the potential for realization of the value of the transaction is uncertain, but the prestige and compensation connected with purchasing another public company is high.

In addition, the sell-side concern that contingently compensated advisors may magnify the confounding incentives faced by senior managers applies to the buy-side as well. Like potential sellers, potential acquirers regularly hire investment bankers under contingency fee arrangements, which gives the bankers powerful financial incentives to pursue and close deals. Unlike on the sell-side, where the acquisition of a client and the resulting disappearance of a source of business may mitigate the advisor’s eagerness to support a sale, similar relationships on the buy-side reinforce the financial incentive. A longstanding advisor’s personal relationship with management may give the advisor additional reason to support an acquisition that management favors, particularly if a successful acquisition may lead to a bigger company that will purchase more companies in the future.

The real-world decision-making context in which boards operate also supports extending enhanced scrutiny to buy-side decisions. At present, there is reason to suspect that without a jurisprudential prod like enhanced scrutiny, directors may not be sufficiently involved in the buy-side acquisition process—just as they were less involved in the sell-side acquisition process before the systemic shock of cases such as Van Gorkom and Revlon. Descriptive accounts indicate that boards are reluctant to become deeply involved in acquisitions, preferring to leave the process in the hands of management and their advisors, with the board restricting itself to advisory and oversight roles. Although the board theoretically retains ultimate approval authority, once management and its advisors begin to feel committed to a deal and have expended significant resources to move forward on a transaction, abandoning plans can be quite difficult.

Although doctrinally coherent, we caution that extending enhanced scrutiny to the buy-side presents several concerns. Most significantly, applying enhanced scrutiny to buy-side decisions would open the door to well-documented stockholder litigation pathologies that have undermined the effectiveness of the sell-side regime. In recent years, the Delaware courts have strived to lessen the impact of these pathologies. One powerful intervention has been to lower the standard of review from enhanced scrutiny to the business judgment rule if the transaction receives fully informed stockholder approval. Logically, this innovation also would apply to bidder fiduciaries.

It seems likely, therefore, that a principal consequence of applying enhanced scrutiny to bidder decisions would be to induce more buy-side stockholder votes. There are substantial reasons to believe that buy-side stockholder votes would be an effective tool to limit the bidder overpayment phenomenon. And recent empirical literature finds that voting by stockholders can provide an important counterbalance to guard against the self-interest and biases that lead to bidder overpayment.

On balance, extending enhanced scrutiny to decisions by buy-side fiduciaries should lead to a superior regime in which stockholders can provide a meaningful check on bidder overpayment.

The complete article is available for download here.

I had the honor of serving as a visiting scholar at National Chiao-Tung University, Taiwan during the week of January 8^th. My visit was coordinated by Professor Chien-Chung Lin, who has twice visited UC Davis School of Law to present papers at the American Society of Comparative Law (ASCL), Younger Comparativists Committee (YCC) Workshop on Comparative Business and Financial Law. Taiwanese corporate law scholars such as Professor Lin have been doing excellent work especially in the area of comparative corporate law, so I was very much looking forward to interacting with some of them.

I began my visit with a fabulous lunch organized by Professor Lin and our own UC Davis JD student, Oscar Yang (himself a 2016 graduate of our LLM program). Oscar and Professor Lin had graciously invited leading Taiwanese lawyers for the lunch, including Prosecutor Jawyang Huang, Taipei District Prosecutors Office. Mr. Huang has been a visiting scholar at Yale University School of Law and was Oscar's supervisor in the Office of Trade Negotiations, in charge of WTO dispute settlement cases. We were joined by two of Oscar's former colleagues who were both fabulous company, Ms. Jenny Van, Senior Legal Adviser in Office of Trade Negotiations and Mr. Jason Lai, Secretary to the Director-General of Bureau of Foreign Trade.  It was a terrific lunch at one of Taipei's most popular restaurants, Din Tai Fung. After the lunch Mr. Huang gave me a fascinating tour of the Taipei Judicial Building, where I was able to observe a few trials that were being conducted. The efficiency and order at the judicial building was quite impressive.

After the first day in Taipei, Professor Lin took me to Hsinchu, one of the educational centers of Taiwan. The city has several prestigious universities, including National Chiao Tung University and National Tsing Hua University. Hsinchu is also an economic and technology hub in Taiwan with an impressive science and technology industrial park. The science and technology park is home to hundreds of high technology companies including world-renowned firms in the semiconductor space such as TSMC and UMC. Professor Lin gave me a tour of the technology park and given my prior corporate practice experience in the semiconductor space I was quite excited to see the place!

In Hsnichu, I gave three lectures at the two law schools there.

1. Redefining Corporate Purpose: An International Perspective, at the Institute of Law for Science & Technology, College of Technology Management, National Tsing Hua University in Hsinchu, Taiwan.
2. Deal Structure and Minority Shareholders, at the School of Law at National Chiao-Tung University, Taiwan
3. Legal Transplants in the Law of the Deal: M&A Agreements in India at the School of Law at National Chiao-Tung University, Taiwan

Lecturing at NTHU

My visit to National Tsing Hua University was coordinated by Professor Robert Tsai, who is trained as an attorney in both Taiwan and the U.S. The lectures were well-attended, and the audience of professors and law students asked excellent questions.

I also had the opportunity to visit the Taiwan Stock Exchange to learn more about the significant corporate governance initiatives undertaken in Taiwan. I had an informative meeting at the Taiwan Stock Exchange with Mr. Joe Tsun Cheng (Senior Vice President, Corporate Governance Department) and Ms. Tracy Chen (Associate, Corporate Governance), as well as meeting Mr. Lih Chung Chien, Senior Executive Vice President of the Taiwan Stock Exchange. At the meeting we exchanged views on corporate governance initiatives undertaken in Asia, and I detailed some of my scholarly work on the trajectory and possible outcomes of the corporate governance reforms undertaken in India over the last decade. I really enjoyed the intellectual engagement with the professors, lawyers and law students I had the privilege to meet.

Professor Lin had also kindly arranged many opportunities for me to experience the beauty and culture of Taiwan, including visits traditional tea houses, temples and the CKS Memorial Hall and Liberty Square, an afternoon at beautiful hot springs outside of Taipei, a culinary adventure with law students at one of Taipei's fabulous night markets, a tour of the National Palace Museum, several informative walks around the different districts in Taipei, and more delicious meals than I can count.  I could easily have spent weeks enjoying all that Taiwan has to offer from its vibrant coffee culture to its elegant tea houses and lush country side, all topped off by the generous hospitality and friendliness of its people.

If it is not already clear, the trip to Taiwan was truly inspiring, and I look forward to future visits!