[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.
