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April 10, 2019

Enhanced Scrutiny on the Buy-Side

[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.


November 5, 2010

The Bigger They Come...

(cross-post from TheConglomerate forum: Legislative Agenda for the 112th Congress)

Agenda for the 112th: The Bigger They Come

Too Big to Fail.

Bailouts of megabanks preserved our financial system-for better and for worse. Next time around, Dodd-Frank allows winding down of big firms that cause systemic threats.  But as I far as I can tell, the Act doesn’t require any liquidations—it’s up to the Treasury Secretary to decide whether to appoint the FDIC as receiver, (and up to the FDIC to pass the actual rules ).  So it’s not clear whether there will be political courage to use this power in a future crisis; likely there will be bailouts again. 

The obvious solution to the too-big-to-fail problem is to start breaking up the too-big ones that almost failed last time, and to prevent any more from getting that big.  Then we can see a little creative destruction now and again.  [How to do it?  Luckily, I don’t have to bother with that part, since this forum is about the next two years and this is so not going to happen any time soon (if ever).]

Monetary policy: [Yes, I know this is mostly Fed policy, not legislative]

 One has to wonder: the economy almost self-destructed because of easy credit, and the solution is…to ease up on credit? 

I understand, and generally sympathize with, demand-side economics, and it may be the only way to mitigate the current pain of job losses.  And I find it hard to believe there’s currently a real danger of inflation in the near term (those who claim to be worried about these days are probably most concerned about bond prices).  But in the longer term, economic growth based entirely on expanding domestic demand seems like a snake eating its own tail.  Is it prudish--or radical--to suggest there’s something wrong with our culture of consumption?   If it needs fixing, punishing savings with low/negative interest rates ain’t the way to start.  I don’t profess to have a palatable alternative.  Maybe that’s the point—it’s time to take the nasty medicine….But I have tenure, so it’s too easy for me to say that. 

 Do nothing:

Looks like I'm not the only wishing I'd written Dave Hoffman’s post, but since he got there first, let me polish the apple a bit: Instead of passing new laws, how about actually enforcing the laws already on the books?    Oh, yeah, enforcement is the job of the executive branch.  Then how about Congress just refrains from obstructing the enforcement of the ones it just passed?  [Edit: Underbelly has more juicy stuff on this.] Just a thought.

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.