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E-MailFernan Restrepo is Research Fellow at the Rock Center for Corporate Governance at Stanford Law School. This post is based on his recent paper, and is part of the Delaware law series; links to other posts in the series are available here.
Prior to 2013, merger freezeouts were invariably subject to entire fairness review, a demanding standard of judicial review that permits a judicial revision of the price paid to the target shareholders when the price is challenged. Even approval of the deal by a special committee of independent directors (“SC”) or by the majority-of-the-minority shareholders (“MOM”) would only serve to shift the burden of proof on entire fairness to the plaintiff.
This situation changed in 2013. In an attempt to incentivize the simultaneous use of independent director approval and MOM conditions, the Delaware Chancery Court held in In re MFW Shareholders Litigation, 67 A.3d 496 (Del. Ch. May 29, 2013) that when a merger freezeout is subject to those procedural protections, the transaction would be reviewed under the deferential business judgment rule and not under entire fairness. This paper examines the impact of MFW on transactional practice and deal outcomes.
The first part of the analysis focuses on the effect of MFW on the incidence of MOM conditions. SCs were already the norm before MFW because Weinberger v. UOP, 457 A.2d 701, 711 (Del. 1983) recommended their use to satisfy entire fairness (Subramanian, 2007, 3, 11; Restrepo, 2013, 344-43; Restrepo and Subramanian, 2015, 226-27). This means that if MFW actually had a significant effect on deal process design, then this effect should take the form of an increase in the implementation of MOM conditions. As further discussed in the paper, the results show that the Chancery Court was in fact successful in incentivizing this procedural protection and, as a result, MOM conditions have now become the norm in merger freezeouts.
The second part of the analysis explores the effect of MFW on the gains of the target shareholders, as measured by the premium over market prices, the cumulative abnormal returns around the announcement of the transaction, and the change from the buyer’s first offer to the final offer. This part of the analysis considers two hypotheses. The first hypothesis predicts that the gains of the target should be higher after MFW because shareholder voting acts as a check against negligent or captured boards, and even if boards discharged appropriately their fiduciary duties, the target shareholders can still use the threat of a veto to push acquirers to raise their offer (Subramanian, 2005, 15; Edelman and Thomas, 2015, 468; Jiang, Li, and Mei, 2016). As a result, the fact that MFW effectively incentivized MOM conditions should lead to an upward pressure on deal prices. The second hypothesis predicts, in contrast, that the target gains should remain similar after MFW because freezeouts were already subject to significant scrutiny before 2013, and judicial scrutiny appears to be an effective substitute for procedural protections (Subramanian, 2007; Restrepo, 2013; Restrepo and Subramanian, 2015). As discussed in the paper, the results generally support this hypothesis.
Finally, this work explores the impact of MFW on the likelihood of deal completion. This section examines the hypotheses that frustration rates might have increased after MFW due to the greater risk of shareholder holdup problems (the “holdup” hypothesis) or simply due to the greater ability that shareholders have post-MFW to block undesirable transactions (the “efficient voting” hypothesis). Higher frustration rates are a cause for concern particularly if they are due to shareholders holding up a desirable transaction (see, for example, Boone, Broughman, and Macias, 2016, 1). The results presented in the paper show, however, that frustration rates did not increase significantly after MFW, which rules out these hypotheses.
Taken together, these results not only provide an assessment of MFW in particular, but also contribute to the existing literature more generally on three dimensions. First, they add to the legal literature on the standard of judicial review that should govern freezeouts and on the responsiveness of transactional practice to changes in doctrine. One of the central assumptions of the hybrid standard of judicial review adopted by MFW is that the use of procedural protections in a deal is responsive to different levels of judicial deference. By showing that MOM conditions in fact increased significantly after MFW, the results presented here validate this assumption. Prior evidence has also suggested that transactional practice, including deal structure and procedural protections, are responsive to doctrinal changes in freezeout transactions (see, for example, Subramanian, 2007; Restrepo, 2013; Restrepo and Subramanian, 2015). The results presented here, however, show specifically that controlling shareholders are willing to accept the greater risk of qualified shareholder approval in exchange for greater judicial deference.
Second, the results provide new evidence on the effect of shareholder voting on deal outcomes in the particular context of freezeouts. Prior studies have examined the relationship between voting by the shareholders of the buyer and deal outcomes in third-party acquisitions (Burch, Morgan, and Wolf, 2004; Hsieh and Wang, 2008; Kamar, 2011; Becht, Polo, and Rossi, 2016; Li, Liu, and Wu, 2017; Mason, Stegemoller, and Utke, 2017). In a more related line of research, other studies have examined the relationship between qualified majority approval by the target shareholders and deal outcomes, and find in some cases an insignificant correlation (Cain and Davidoff, 2011) or a negative causal effect (Boone, Boughman, and Macias, 2016). These studies, however, have focused on management buyouts (MBOs) and third-party acquisitions, where the role of shareholder voting might be different. This work adds to this line of research by exploiting MFW as a source of variation in the incentives of controllers to adopt MOM conditions in the specific context of freezeouts—a particularly sensitive context due to the inherent conflict of interests that characterizes these transactions and also a unique context due to the set of legal protections that apply when the minority shareholders do not approve the deal.
Third, the results also add to the legal literature on the relationship between judicial scrutiny and deal outcomes in freezeout transactions. As mentioned, the results indicate that the increase in MOM conditions after MFW did not result in higher gains for the target shareholders, which can be interpreted as suggesting that enhanced judicial scrutiny was an effective protection of minorities in merger freezeouts prior to 2013. If this interpretation is correct, then the results confirm prior empirical works that also suggest, based on changes in the law of tender offer freezeouts, that entire fairness review exerts an upward pressure on the gains of the target shareholders (Subramanian, 2007; Restrepo, 2013; Restrepo and Subramanian, 2015).
It is worth emphasizing that the evidence presented here is necessarily preliminary due to data limitations. In particular, freezeouts are not very common transactions, which significantly constrains the size of the sample (especially for the post-MFW period). In addition, there is room for selection bias in the analysis of deal outcomes precisely because controlling shareholders can decide whether or not to implement SC and MOM conditions. Due to these and other limitations discussed in the paper, therefore, the questions examined here should continue to be studied in future research.
The complete paper is available for download here.
