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November 11, 2017

How U.S. and UK Deal Structures Protect Minority Shareholders

By Afra Afsharipour

[Cross-posted from The CLS Blue Sky Blog]

Takeover transactions are often the most significant activity affecting corporations and their shareholders. Accordingly, there are intense debates about the value and impact of takeovers and the extent to which law should regulate such transactions. One area of focus for takeover regulation has been the potential impact of takeovers on minority shareholders. The focus on minority shareholders is not surprising as research suggests that laws which protect minority shareholders are associated with stronger financial markets.


In a recent book chapter, I focus on how deal structures affect the protection of minority shareholders in two common law jurisdictions, the U.S. and the UK. I discuss the three most-commonly used methods of effecting a takeover in these jurisdictions—tender offers, schemes of arrangement, and triangular mergers—and assesses both the theoretical and empirical literature on their impact on minority shareholders. In each jurisdiction, lawmakers, regulators and courts have attempted to design rules to address harm to minority shareholders under various deal structures. These rules often result in different rights for shareholders of bidders and targets, and vary among transaction structures, even when economically similar transactions are undertaken. While the UK takeover regime focuses on ex ante regulation, the U.S. system uses some ex ante regulation but places significant emphasis on ex post policing through the courts.


First focusing on the U.S., I address the two most commonly-used deal structures for takeovers of U.S. public companies—a one-step triangular merger and a two-step transaction involving a tender offer followed by a merger. Target shareholders are provided with a say under both structures, either through a vote or through the decision to sell their shares. In addition, several aspects of the securities laws and tender offer rules, for example the best price rule or extensive disclosure rules for tender offers, were specifically designed to lessen the likelihood of abuse of minority target shareholders.


In the U.S., the courts also play an important policing role in regulating the parties’ behavior in takeovers. Target minority shareholders regularly seek redress for any harm through the courts, either through ex post fiduciary duty litigation or appraisal litigation. U.S. law, however, does little to address harm to bidder shareholders. Management can structure takeovers to exclude bidder shareholders from any decision-making role in acquisitions. Moreover, bidder shareholders cannot meaningfully seek any redress through the courts.


An acquisition of a UK public company takes place through the acquisition of shares in the target by the bidder either through an offer (similar to a U.S. tender offer) or through the nearest UK analogue to a U.S.-style merger, a “scheme of arrangement.” While the economic substance of these transactions is similar in the U.S. and UK, the steps that must be followed and the methods of minority shareholder protection are quite different. Unlike the U.S., where hostile takeover activity is difficult, the UK is much more non-protectionist and holds shareholder primacy as a core value. Several of the rules implementing the principles of the UK takeover regime, including the mandatory bid rule and the sell-out rule, are designed to protect minority shareholders.


Over the past decade, schemes of arrangement have become a commonly used acquisition structure in friendly transactions in the UK. UK law treats schemes quite differently from takeover bids. In a scheme, a significant majority of the shareholders of each class can bind the minority, including any dissident shareholders, so long as the scheme is subsequently sanctioned by the court. Some have argued that minority protection in the scheme context should be greater than that in the traditional bid/takeover context since in a scheme even dissenting shareholders are forced to sell once the scheme has been approved. Nevertheless, there is a strong argument that protection for minority shareholders is built into the structure of the scheme itself – namely the 75 percent majority requirement for shareholder approval, the court’s sanction, and the opportunity for full exit rights.


Two other major differences exist among deal structures prevalent in the U.S. and the UK. The UK listing rules expressly contemplate a vote for bidder shareholders in substantial acquisitions. Furthermore, unlike the U.S., where courts play an important role in protecting minority shareholders, courts in the UK do not play a decisive role in most transactions, even in schemes which they formally must approve. The appraisal remedy is not available in the UK, and there is little chance of corporate directors being sued in connection with a takeover.


The chapter then surveys the empirical literature on takeovers to assess whether differences in legal rules governing different deal structures translate into a quantifiable impact on minority shareholders. The answers to this question are somewhat unclear and need further empirical enquiry to determine which of the tools used in the U.S. and UK regimes better protect minority shareholders. Nevertheless, a few insights are suggested by the empirical research. First, despite the differences in each jurisdiction’s regime, target shareholders gain in takeover transactions in both jurisdictions, and in the U.S. these gains are higher in tender offers than in mergers. Second, research suggests that the UK’s takeover rules better protect bidder shareholders in large transactions than does U.S. regulation, which largely deprives bidder shareholders of a role in acquisition transactions. Finally, the research on U.S. transactions suggests that different legal treatment of economically similar acquisition structures may make a difference to minority shareholders.


The comparisons and literature review raise several research questions. The empirical inquiry into UK takeover transactions is quite sparse. For example, no studies empirically explore whether minority shareholders in the UK gain more or less from schemes of arrangement than from takeover bids. Also, do bidder shareholders in the UK gain or lose more in schemes or takeover bids? The empirical inquiry exploring the differences in regulatory approaches in the U.S. and UK is also sparse. For example, it may be useful to further examine which of the tools used in the U.S. and UK regimes better protect minority shareholders. There is also a need for more literature on costs of the regulatory framework imposed by both jurisdictions and whether such regulations can be translated to other countries, as well as a need for further exploration into the institutions needed to implement these regulatory structures. Further inquiry into these issues can help lawmakers determine what features of takeover regulation could be best used by other jurisdictions contemplating takeover regulations.


This post is based on my most recent book chapter, “Deal Structure and Minority Shareholders,” available here.

April 28, 2010

Fixing the Rating Agencies

Credit rating agencies are back in the public eye as the Senate Permanent Subcommittee on Investigations releases another trove of embarrassing agency e-mails and the financial reform bill nears enactment.  In this context, a proposal by two professors at NYU's Stern School of Management, Lawrence White and Matthew Richardson, to improve credit rating agency performance by having the SEC decide which agencies will rate each instrument has attracted favorable attention from commentators such as Paul Krugman.  Although the proposal is refreshing in its boldness and offers a potentially useful way to address one of the many problems besetting the agencies, it should not be understood as a complete solution.  The complementary issue of rating-agency accountability for poor quality should also be addressed.

By now, the background story is familiar: Rating agencies - Moody's, Standard & Poor's, and similar firms whose business it is to assess the likelihood that debt obligations will be paid as agreed - gave their stamp of approval to innovative financial products that were in fact incomprehensible and/or based on the premise of an unending real-estate boom.  Panic set in when everyone realized that the ratings were wrong or unsupported.  The details and even the basic correctness of this narrative are disputed, but the major rating agencies have all more or less conceded that there was a problem of some kind:  their ratings on novel financial products didn't do  as well as they could have.

What exactly are the problems with the rating agency market?  There are several candidates:

(1) Lack of competition.   The SEC says that the three largest agencies have over 97% of the market, as measured by number of ratings outstanding.

(2) Absence of transparency.  Market participants complain that it is hard for users to know what the agencies do and how well their ratings perform.

 (3) Financial regulators' reliance on credit ratings in their rules.  If the rules say that regulated firms like banks and insurance companies have to own financial instruments with credit ratings, then there will be a demand for credit ratings, even if the agencies have no idea what they are doing. 

(4) The "issuer pays" business model.  The firms selling the financial products usually are the ones who pay for the ratings.  "Issuer pays" poses an obvious conflict of interest, as rating agencies have an incentive to please their customers, who are the people selling the products, not those buying them.

 (5) Absence of accountability.  There is no clear way to hold rating agencies liable for poor performance unless it rises to the level of fraud.

Congress' and the SEC's actions to date have focused mainly on the first two issues, competition and transparency:  Legislation passed in 2006 and rules adopted since then have focused on trying to get more rating agencies into the market and on increasing disclosure about what the agencies are doing, what data they're using, and how they're performing.  There has been fitful action on the third issue.  Starting in 2008, the SEC and other regulators have considered reducing their use of credit ratings in their rules, but they have not eliminated their reliance on credit ratings and do not seem to be on track to do so, although deliberations are ongoing.  The problem here is that financial regulators need a measure of credit risk, and it is not clear what would take the place of credit rating agencies, an issue I took up in this article last year. 

The White and Richardson proposal focuses on the fourth issue.  The idea is to remove issuers' ability to shop for high ratings from agreeable rating agencies by using the SEC to assign the agency that will rate each debt instrument.  Under the proposal, the issuers still pay for the rating, but they pay the agency that the SEC selects to do the rating.  The SEC will make its selection based on its assessment of which agency  is likely to do the best job, thus eliminating the conflict of interest that arises from the issuer-pays business model.  This is an innovative idea, and its boldness is refreshing given the limited scope of the reforms that have even been considered to date.  White and Richardson would fundamentally restructure the rating market - indeed, they apparently would eliminate the rating "market" and substitute SEC assignment. 

Of course, those who think that government can't do anything right will oppose this idea, arguing that the regulators are corruptible, capturable, and/or unskilled at evaluating the performance of rating agencies.   Those who think the SEC in particular is the wrong choice - pointing perhaps to the Madoff affair, to the SEC's oversight of the Wall Street investment banks leading up to the financial crisis, or to allegations that the SEC has been biased toward the large incumbent rating agencies - will oppose the choice of this particular regulator.  Those who think that government approval of rating agencies led to excessive reliance on them will observe that the proposal could exacerbate that problem.  I'll note all three sets of objections and set them to the side for the moment.   

I have two different concerns about this proposal.  First, it seems overbroad to prohibit agencies from expressing their opinions unless authorized to do so by the SEC.  If the SEC selects Moody's to rate a bond, should S&P really be barred from opening its mouth about that bond?  Even setting to one side the agencies' more extravagant First Amendment claims, this seems problematic.  The overbreadth concern could be addressed without changing the essence of the proposal by saying either that the SEC-selected agency is the only one whose ratings "count" for regulatory purposes or that only the SEC-selected can be paid by an issuer, leaving other agencies free to express their opinions in other contexts.

Second, the White and Richardson proposal doesn't address what I see as a central problem:  When confronted with a large and growing market for a set of novel products, agencies that are paid by the rating (or otherwise based on the volume of their business) have a financial incentive to issue ratings on those products even if they don't know what they are doing.  After all, the more ratings, the more revenue - even if the technical complexity or novelty of the product means that the agency can't do a good job.  Indeed, White & Richardson acknowledge this issue, stating that "it's surprising that rating agencies would even attempt to rate" certain types of novel products because of the technical difficulty of doing so.  But under their proposal, agencies apparently still are paid by the rating even though they are selected by the SEC:  The more ratings, the more revenue.  That enticement to poor quality still exists even though the issuer-pays problem may be eliminated.

This problem can be addressed by taking on the fifth issue, rating agency accountability.  Eventually, poor-quality ratings will be discovered and if the agencies know they will have to give up their profits from the poor-quality ratings in that event, that reduces their incentive to issue ratings when they don't know what they are doing.  An article I wrote two years ago addressing this point can be found here

The Dodd bill takes steps in the direction of accountability by clarifying that a rating agency can commit fraud by failing to conduct a reasonable investigation of facts upon which it relies and by empowering the SEC to decertify rating agencies that consistently produce poor-quality ratings.  Neither of these provisions really addresses agencies' temptation to issue ratings when they don't know what they're doing.  Decertification is a weak remedy, as credit rating agencies can operate without being certified, and the requirement to conduct a factual investigation doesn't go to the fundamental question, which is whether the agency knows what to do with the facts that it has. 

The Dodd bill does provide for further study of agencies' incentives to produce high-quality ratings, so even if neither the White and Richardson proposal nor a stronger rating-agency accountability provision makes it into the financial reform bill that seems likely to be passed soon, there is some chance that the complementary issues of issuer-pays and accountability will be addressed.


April 27, 2010

Reading Notes on the Meltdown

One of the melancholy consolations of the late economic meltdown is that it has produced some pretty good second-draft journalism: here in a moment, gone in a moment, but helpful and instructive while they last. Over the past year or so I’ve found myself obscurely compelled to try to keep up on this stuff. Of course I can’t really; there aren’t enough hours in the day. But I may have done some successful cherry-picking. Here are some offerings:

If I had to recommend just one book on how we got into this mess, I suppose it would be Barry Ritholz’ Bailout Nation with the saucy subtitle of “How Greed and Easy Money Corrupted Wall Street and Shook the World Economy.” Given the snarky packaging (an enrgaged bull on the cover), you’d think it was a lightweight but Ritholtz is an extraordinarly shrewd student of the market, and he’s not overawed by power and wealth. As the title implies, Ritholtz assigns a lot of blame to the role of the government as guarantor against loss—he goes all back to the first Chrysler bailout a generation ago. He also develops an important structural point I hadn’t thought about until I read him—the shift in the great investment banks from”partnership” to “corporate” form, setting the stage for a heads-I-win, tails-you-lose investment strategy, where it may make sense for the trader to make absolutely bad deals if he gets to keep the gains while someone else suffer the losses.

A variant on the theme is Yves Smith’s ECONned, another book better than its title. Yves saw some of the madness from the inside so she can get gritty and granular than an outsider. She also has a distinctive advantage: she’s a woman, so she can see how much of the mess finds its roots in macho bravado.

Thirteen Bankers by Simon Johnson and James Kwak has received and deserves respectful attention, not least for the insights that Simon can bring from his past experience with the International Monetary Fund. Johnson fears we are beginning to look like a banana republic (“without the bananas,” someone has grumped), and he knows what they look like because he has seen them. It does have the drawback of coming a little late in the game, so it can seem repetitive.

A recent arrival that does not seem repetitive is Gary Gorton’s Slapped by the Invisible Hand. (can’t anybody write good titles any more?). Gorton comes to the table with long experience in the study of financial bubbles: he offers a challenging analysis of the late meltdown as a classic bank panic in modern dress, with the Wall Street repo market playing the role once inhabited by Jimmie Stewart in the Greek Revival edifice down in the center of Bedford Falls.

Remember the housing bust? It almost gets lost in the underbrush of Wall Street, but it was, after all, the triggering event—the shock that sent the larger system into a tailspin. For background on housing, I doubt that there is anything better than Alyssa Katz, Our Lot. She makes a persuasive case that the housing problem was not just one problem but half a dozen. She pulls some of her most interesting examples out of California.

A superb little book with a shelf-life perhaps even shorter than the others is Robert Pozen’s Too Big to Save? which I elsewhere described as CliffNotes for Finance Professors. It’s a marvel of exposition, a point-by-point account of the various (economic) problems that afflict us, with specific action plans for reform. Might be the best economics book I’ve read all year; unhappily, events are already overtaking it.

There’s a lot more. I’ve more or less deliberately sidestepped the memoirs (necessarily self-serving) of the Alan Greenspan, Hank Paulson, and their ilk: I figure they would only send my blood pressure up. I’ve mostly sidestepped the journalism of people such as Andrew Sorkin, figuring the chances are they’ve already said what they know in the papers. I’ve read only a few of the ticktocks of day-to-day life in the midst of calamity (though I did enjoy Willliam D. Cohan’s House of Cards about the fall of Bear Stearns).

Oh, I could go on and on. But let me end with one item, not strictly on point but related, and likely to outlive the current uproar. That would be Liaquat Ahmed’s Lords of Finance, subtitled “The Bankers who Broke the World,” about the calamities of misjudgment that went so far to aggravate the Stock Market Crash of 1929 into the Great Depression of the 1930s. Ahmed just won a Pulitzer Prize and no wonder: this is a book that will stand solidly on the shelf. It’s perhaps a consolation to know that our betters have not led us quite so deep into the swamps this time. Or at least, not yet.

March 31, 2010

Senator Dodd's Magnum Opus

I haven't yet made my way through the 1336 pages of Senator Dodd's massive (but, as recent events suggest, necessary) overhaul of financial regulation (full text here), but the basic elements (very helpfully summarized here) look promising. The Bill promises to bring some transparency to the shadow banking system through required disclosures to financial authorities. It increases the government's power to shut down failing financial enterprises (and even requires companies to submit their own "funeral plans" providing a road map of how they should be shut down). It requires some "skin in the game" for securitization (certainly a controversial requirement). It also modifies compensation arrangements to require banks to have the right to clawback executive compensation if it was based on inaccurate financial accounting statements (broader clawback rights might also be justified for such activity as excessive risk-taking, but these might also be effectively required by changes to the Basel capital adequacy guidelines--at least for the entities covered by Basel).

Much of the public focus--and political debate--will be on the proposed Consumer Financial Protection Agency, but the systemic risks addressed elsewhere in the proposal are likely more important in terms of avoiding a future systemic financial collapse. 

I have coauthored a paper with Randall Costa of Citadel Investment Group on the virtues of central counterparty clearing for credit default swaps, a key step in Senator Dodd's financial reform. The paper, Clearing Credit Default Swaps: A Case Study in Global Legal Convergence, has just been published in the Chicago Journal of International Law.