Fernán Restrepo is John. M. Olin Fellow and Gregory Terrill Cox Fellow in Law and Economics at Stanford Law School. Guhan Subramanian is Joseph H. Flom Professor of Law and Business at Harvard Law School and H. Douglas Weaver Professor of Business Law at Harvard Business School. This post is based on a recent article by Mr. Restrepo and Professor Subramanian and is part of the Delaware law series; links to other posts in the series are available here.
It is well-known in transactional practice that the magnitude of termination fees has gone up over the past thirty years. What used to be 1-2% of deal value in the 1980s increased to 2-3% by the 1990s and 3-4% by the 2000s. This trend cannot be readily explained by changes in M&A fundamentals: as a percent of deal value, it is not obvious why compensation for search costs, out-of-pocket costs, reputational costs, and opportunity costs should be higher today than they were in the 1980s. The more plausible explanation lies in the nature of transactional practice. Nearly two decades ago, Dick Beattie, then Managing Partner at Simpson Thacher & Bartlett in New York City, explained this trajectory to one of us as follows:
“The percentage that is okay has slowly risen. A year ago, two years ago, people were talking about two percent, two-and-a-half percent. Now, you hear them talking about three, three-and-a-half percent. Some are even saying four percent. You sit there and ask, ‘On what basis are you doing that? Where did you get that number?’ There hasn’t been a specific challenge, so everybody pushes the envelope.”
There are important policy reasons for the Delaware courts to set limits on deal protection. Sellers can gain leverage from judicial rules that require some degree of market canvass as a matter of fiduciary duty. The purpose of these limits is to provide sell-side shareholders with full value and a meaningful shareholder vote. Giving boards legal protection against preclusive deal protections prevents bidders from demanding such deal protections in the first place. The result is greater allocational efficiency in the M&A marketplace, which improves overall social welfare.
