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E-MailFernán 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.
In a 2000 article, one of us (along with co-author John Coates) recommended that the Delaware courts should provide guidance to practitioners on the permissible boundaries of deal protection (Coates and Subramanian, 2000). Beginning around the same time—while not actually invalidating any deal protections—the courts began to signal that 4-5% was at the very high end of what would be tolerated. We present empirical evidence in this article indicating that this guidance has had the desired effect: termination fees for Delaware targets (including any additive expense reimbursement) have capped out at just below this level, thus ending “termination fee creep.” We present further evidence that average termination fees are higher in non-Delaware jurisdictions, presumably due to the lack of judicial guidance in these jurisdictions as to the permissible limits on deal protection.
But consistent with thirty years of deal protection experience, and reflecting the fact that deal protections are for the most part fungible, deal protections have migrated away from continued increases in termination fees to other areas where the Delaware courts have signaled tolerance or have not yet provided guidance. We document three such areas in current transactional practice. First, match rights, which were unheard of in the 1990s, have become ubiquitous by the 2010s. While practitioners claim that match rights should have no effect on M&A deals and (perhaps based on these claims) the Delaware courts have signaled tolerance of match rights, we use basic game theory to document why match rights have a significant deterrent effect on prospective third-party bidders. Second, asset lockups, which disappeared from the landscape after the Delaware Supreme Court’s seminal Revlon decision in 1986, have re-emerged. Unlike the hard-asset lockups of the 1980s, the new generation of asset lockups tends to involve intangible assets such as licensing agreements or service agreements. Third, and perhaps most interestingly, practitioners have begun implementing side agreements to the deal that have a commercial purpose along with a deal protection effect.
We offer three recommendations for how the Delaware courts should approach this new look to the deal protection landscape. First, Delaware courts should clarify that deal protection must survive Unocal/Unitrin “preclusive” or “coercive” analysis in addition to Revlon “reasonableness” review. Second, Delaware courts should apply basic game theory to identify the deterrent effect of match rights and “new economy” asset lockups. And third, Delaware courts should take a functional approach to deal protection (“if it walks like a duck, it is a duck”), meaning that collateral provisions that have a deal protection effect should be scrutinized under deal protection doctrine, even if these agreements have some colorable business purpose as well.
Our article proceeds as follows. Part II provides general background on deal protection, including the business motivations for such devices and the prior literature. Part III identifies the “new look” of deal protection, relying in part on a new database of M&A transactions from 2003-2015. Part IV provides our recommendations on how Delaware courts should refine existing deal protection doctrine to accommodate the new deal protection landscape. Part V concludes.
The full article is available here.
