Deal Protection Devices

Albert H. Choi is Professor of Law at the University of Michigan Law School. This post is based on his recent paper, forthcoming in the University of Chicago Law Review. Related research from the Program on Corporate Governance includes Allocating Risk Through Contract: Evidence from M&A and Policy Implications by John C. Coates, IV (discussed on the Forum here); and The New Look of Deal Protection (discussed on the Forum here) by Fernan Restrepo and Guhan Subramanian.

In mergers and acquisitions transactions, a buyer and a seller will often agree to contractual mechanisms, such as termination fees and match rights, to protect the deal. Judicial attitude towards various deal protection devices migrated from fairly strong hostility to a more permissive allowance over time. This is evidenced by the line of cases, starting from Revlon and Paramount v. QVC to In re Toys R Us, Lyondell Chemical, and C&J Energy Services. While the question of whether entering into certain deal protection devices can constitute a breach of target directors’ fiduciary duty has not been fully resolved, the recent controversy over appraisal has breathed new life into the questions over the desirability of deal protection devices. A prominent issue was whether the court could use the deal price itself as an indicator of “fair value.” In cases, such as DFC Global, Dell, and Aruba, the Delaware Supreme Court stated that when an acquisition is done at “arms’ length” and when there is sufficient competition for the target, either before or after the agreement has been signed, the deal price is a reliable indicator of “fair value” of the target’s shares. In determining whether a transaction satisfies such a standard (i.e., whether “Dell-compliant”), the presence or absence of deal protection devices has become one of the core issues.

The line of cases, from Revlon and Paramount v. QVC, through In re Toys R Us, Lyondell Chemical, and C&J Energy Services, and to the recent appraisal cases (DFC Global, Dell, Aruba, and their progeny) raises interesting and important questions about deal protection devices. To the extent that the parties are trying to “lock up” the deal, to what extent are deal protection measures successful in ensuring that a third party buyer will not try to “jump” the deal? How do they affect a third party’s incentive to compete? For instance, can the inside buyer’s unlimited match right deter a third party from competing against the buyer? Will an unlimited match right create a “winner’s curse” problem? What if the target has to pay a sizable termination fee? What about for the target shareholders: do the deal protection devices undercut their return? Finally, in the context of appraisal, does the presence of deal protection devices undermine the reliability of the deal price as an indicator of “fair value”? Should the presence of an unlimited match right, for instance, make the deal price inadmissible as evidence of “fair value”?

A recent paper, titled Deal Protection Devices, forthcoming in the University of Chicago Law Review, examines these issues with the help of auction theory. The paper focuses on match rights and termination fees, the two most commonly used deal protection devices. The paper foremost argues that, while certain deal protection devices can impede the target from being sold to a buyer with a higher valuation (i.e., they induce allocative inefficiency), they can also increase the joint profit of the target and the inside buyer. Termination fees and match rights function quite differently, however. First, both a sizable termination fee and an unlimited match right can increase the joint return of the target and the inside buyer, but a large termination fee is likely to generate allocative inefficiency while an unlimited match right actually does the opposite. Second, in order to boost the target’s stand-alone return, a large termination fee requires a price concession from the buyer (e.g., through a higher deal price) while an unlimited match right does not require such a price concession.

The basic insight can be explained as follows. With a termination fee, the target has to pay a fee in order to accept a more attractive offer from a third party. This not only forces a third party to pay more for the target than the inside buyer (which increases the total size of the pie for the target and the inside buyer), but a large chunk of that additional payment flows to the inside buyer as the promised termination fee. Hence, in order for the target to share that additional return, the target needs to receive a concession from the inside buyer through a higher deal price. The story is different with a match right. When a match right is limited, i.e., the inside buyer can match third party buyers’ offers only a few times, given that there are no corresponding limitations on third party buyers and, more importantly, the target is not obligated to accept the inside buyer’s matched offer, this puts the inside buyer at a competitive disadvantage. With this uneven competition, the target’s return will be lower. When the match right is unlimited, by contrast, there will be more even competition between the inside buyer and third party buyers. Furthermore, unlike a termination fee, the higher proceeds go directly to the target, thereby increasing the target’s stand-alone return.

Although the paper primarily utilizes the setting of a “private value” auction, in which each buyer knows its own valuation for the target, the paper also examines (albeit, less formally) the possibility of the “winner’s curse” problem in an interdependent valuation setting, where each buyer is not aware of its valuation for the target and only gets a signal about the valuation. An interdependent valuation setting does create the possibility of the “winner’s curse” problem, but this is likely to happen when either there is a sizable termination fee or with a limited match right. With a sizable termination fee, a third party buyer is forced to make a “jump” bid, a bid that is substantially higher than the deal price. Similarly, a limited match right forces the inside buyer to make a jump bid so as deter a third party’s follow-up bid. In other words, when there is no (or small) termination fee or when the match right is unlimited, even in an interdependent (including common) valuation setting, the “winner’s curse” problem is unlikely to arise. The paper also briefly examines the scenario where the inside buyer has an informational advantage vis-à-vis third party buyers.

Based on these findings, the paper argues that answering the questions of (1) whether the deal protection devices can maximize target shareholders’ return and (2) whether their presence undermines the reliance of deal price as an indicator of “fair value” in appraisal, ultimately depends on whether the target directors (and managers) are properly incentivized to maximize the target shareholders’ return. If they are, termination fees and match rights can be utilized to enhance the return for the target shareholders. Furthermore, with the proper incentive in place, compared to the case without any deal protection measures, the deal price would be higher for the target shareholders, which increases the confidence with which the court can use the deal price as evidence of “fair value.” At the opposite end of the spectrum, when the target directors (and managers) are pursuing their own private gains at the expense of the target shareholders or when they are “conflicted,” not only can such devices be used to harm target shareholders but also the court should no longer rely on the deal price to as an indicator of “fair value.”

The paper also examines the deal protection devices from the perspective of contract law. Foremost, given that the devices can undermine competition between the inside buyer and a third party, under contract law, the court can inquire into whether they should be struck down as being against public policy, for instance, for imposing “unreasonable” restraint on trade. This type of reasoning has been used to cut down onerous non-compete clauses and unreasonably large liquidated damages. The paper argues that such a public policy concern is higher with a large termination fee than with an unlimited match right. A large termination fee, especially when the target also has an obligation to reimburse the expenses of the inside buyer in case the target gets sold to a third party buyer, raises the specter of unduly undermining the competition between the inside buyer and a third party. An unlimited match right, by contrast, the paper argues, actually promotes more competition.

The complete paper is available here.

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