Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  In addition, MidAmerican negotiated a force-the-vote provision that required the Constellation board to hold a shareholder vote even if a third party made a superior bid. Once the vote was held and the merger approved, Constellation could not terminate the agreement to accept a higher bid. If the Constellation shareholders voted no, Constellation was required to pay a $175 million termination fee to MidAmerican.

  The MidAmerican acquisition agreement also had a reverse termination fee, and the maximum liability of MidAmerican under the acquisition agreement was capped at $1 billion. Finally, in case of a successful competing bid, MidAmerican was entitled to approximately 20 million shares of Constellation Energy common stock, representing 9.99 percent of outstanding shares, and approximately $418 million in cash.22 If paid, MidAmerican would receive well over a billion dollars in cash and securities. MidAmerican had used Constellation’s desperation to negotiate a very tough bargain. The end result in the Constellation bid was actually favorable to Constellation.Three months after MidAmerican’s liquidity infusion, EDF Group proposed a superior offer, a joint venture, and Buffett’s MidAmerican yielded, but took its billion-dollar payday with it.23

  The Constellation deal showed how far a bidder would and could go in securing a distressed deal.24 Other distressed deals began to pattern themselves on the Constellation deal, as buyers sought and received due diligence conditions, reverse termination fees, force-the-vote provisions, and higher break fees than normal. For example, Bank of America negotiated a force-the-vote provision in its agreement to acquire Merrill. Bank of America also negotiated a provision that Merrill’s board could change its recommendation on the transaction only if a third party made a superior bid. This provision was a constriction of the board’s fiduciary duties. It was also probably invalid under Delaware law as unduly restrictive on the board’s decision making. In the Merrill deal, the termination fee implemented through a stock option agreement could also rise to 4 percent of the deal value, or $2 billion, a higher sum than normal.25

  In more extreme cases, when the buyer did not want any taint of the target’s bad investment decisions, there were asset purchases. Asset purchases allow the buyer to purchase only selected assets and liabilities. The buyer can therefore choose to leave with the target the liabilities the buyer does not want to assume. An asset purchase is thus a time-honored way to acquire troubled companies. For example, JPMorgan Chase & Co., chose to purchase Washington Mutual Inc.’s assets and selected liabilities, but not the company itself. This allowed JPMorgan to avoid taking on liabilities it would prefer not to assume, namely, mortgage-backed securities and loans related to real estate.26 Left with little,WaMu itself filed for bankruptcy.

  Toxic convert rights were often also negotiated by buyers purchasing equity stakes in distressed companies, but who did not purchase the entire company. Toxic convert rights typically involved an automatic resetting of the per-share price to be paid if there was a decline in the target company’s stock after the purchase. Because of the huge potential for diluting out other shareholders, these types of investments are accepted only by the most desperate sellers. In this environment, though, buyers were forcing through these provisions in unexpected circumstances.

  TPG’s illfated investment in Washington Mutual was one example. Much earlier in 2008, when things looked a bit more stable for WaMu, TPG negotiated a right that allowed it to reset its investment value to any lower per-share price at which WaMu issued new equity. Ultimately, this protected TPG at the expense of WaMu, inhibiting it from raising additional capital until TPG waived the right. TPG eventually did waive this right, but that action came too late to save TPG’s assets from being seized by federal regulators and sold to Bank of America. TPG’s right had worked against it, and TPG lost $1.3 billion on its investment in WaMu.27

  Finally, in two prominent deals, the target had so little leverage that the buyer negotiated a force-the-transaction provision. The Bear Stearns deal discussed in Chapter 6 is one deal. Another was in Wells Fargo & Co.’s $15.1 billion purchase of Wachovia. In that takeover, Wells Fargo negotiated a share issuance of 39.9 percent of Wachovia’s voting stock to Wells Fargo. The shares were issued to Wells Fargo before the Wachovia shareholder vote on the transaction, providing Wells Fargo with the ability to push the transaction through despite shareholder objections.28 Dealmakers were pushing the edge of the law on permissible deal-protection devices, justifying these maneuvers on account of the distressed nature of their targets.

  Do Takeovers Pay?

  The more disciplined takeover approach in the sixth wave belied a more fundamental question that many were asking in the wake of the fifth wave. Do takeovers even pay? The conventional wisdom is that they do not. Targets gain from takeover transactions but buyers lose, and on the whole, they result in a net destruction of value. In support of this proposition, classic deals from hell such as Time Warner’s merger with AOL or Chrysler’s merger with Daimler-Benz AG are cited. In addition, there are equally classic studies that are often wheeled out to support this proposition. One study by KPMG analyzed a sample of 700 mergers and found that only 17 percent created “real value.”29 An infamous McKinsey & Co. study found that “less than a quarter [of mergers] generated excess returns on investment.”30

  The thesis that takeovers do not pay for buyers supports the ego theory of dealmaking. It justifies the conception that deals are creatures of personality. After all, why would takeovers still occur if they were value-destructive for buyers? The personality-driven model of dealmaking persists even after these studies, but the skeptical light thrown on acquisitions has, at least anecdotally, driven CEOs in the sixth wave toward more careful, planned acquisitions.

  But the evidence on takeover returns is more complex and supports a different viewpoint than the conventional wisdom.This alternative view is informed by over 135 studies, and 5 surveys on the matter. A review of this evidence finds that takeovers do indeed create value for both targets and buyers. More specifically, targets obviously win in takeovers; their shareholders receive a share premium. For buyers, the statistics are less certain. Two-thirds of studies find that takeovers create or conserve value for buyers, and one-third find the opposite. Based on this much more substantial evidence, Professor Robert F. Bruner finds that the disputes over whether takeovers pay mainly arise from defining how value is measured for buyers in takeovers. He notes that most studies conclude that the majority of buyers earn their cost of capital on acquisitions. However, the returns are widely distributed, and some buyers lose or gain substantially. A deal from hell and personality factors can not only adversely affect the poor buyer but also bias the study of takeover gains.31

  Based on all the evidence, it appears that takeovers do pay but that the synergies, cost savings, and value creation necessary for successful deals can be hard to realize. In other words, takeovers are hard work. They need to be entered into with a firm plan for postacquisition integration that accounts for the culture of the acquired company.

  Haphazard takeovers based on empire building or other notions of conquest are unlikely to have the necessary discipline.32 Here, we have a good example from industry: private equity. Although the jury is still out on whether private equity in the aggregate pays, and certainly the vintage 2004-2007 acquisitions are troubled, very disciplined firms like Kohlberg Kravis Roberts and the Blackstone Group have earned extraordinary returns over extended periods. KKR had an annual average return of 20.2 percent net of fees on its first 10 private equity funds, and Blackstone has earned an annual return of 30.8 percent on its investments gross of fees since the firm began in 1987.33

  The sustained takeover activity even in these turbulent economic times points to the value of takeovers. The forces toward disciplined takeovers and the rise of the distressed deal may also result in more value being produced in takeovers. Against these forces, the egos of corporate executives and the deal machine will continue to encourage uneconomical takeovers. This is a battle that will be never-en
ding and continue to shape strategic transactions in the coming years.

  Delaware Law and Strategic Transactions

  Like hostile transactions, strategic takeovers are also guided by the standards Delaware law imposes. The key question is again whether Revlon duties—the duty of a target board to obtain the highest price reasonably available—apply. In the 1989 case of Paramount Communications, Inc. v. Time Inc.34 and the 1994 case of Paramount Communications, Inc. v. QVC Network Inc.,35 the Delaware Supreme Court restricted application of Revlon review to a board’s decision making upon the inevitable breakup or change of control of a target. These two decisions effectively eliminated stock-for-stock acquisition transactions from review under Revlon. The reason given by the Delaware court is that in such transactions, both buyer and target stockholders share ownership of the merged entities and therefore control is almost always indeterminate. Revlon duties are accordingly inapplicable, and the board’s conduct is subject to review under Unocal or Blasius. These decisions heavily influenced the structure of fifth wave transactions and spurred the widespread use of stock consideration. Participants could now characterize their stock-for-stock transactions as mergers of equals and avoid application of Revlon.

  The widespread use of the stock-for-stock merger structure in the fifth wave was accompanied by an increase in the use of lockups. Lockups are deal-protection devices negotiated by a target and buyer to ensure that their transaction is not interfered with by a third-party bidder. Examples of lockups include stock options, break fees, asset options including crown jewel lockups, force-the-vote provisions, no-talks, and no-solicits.

  EXAMPLES OF SIGNIFICANT TRANSACTION DEFENSES (LOCKUPS)

  Break Fee/Termination Fee—Fee paid by a target to an acquirer to terminate their agreement. Typically, this fee is payable if the agreement is terminated by the target to accept a third-party offer or the shareholders of the target reject the acquisition and subsequently accept within a specified period of time thereafter a third-party offer.

  Stock Option—An option granted by a target to a buyer to purchase shares of the target. Typically, this option is for 19.9 percent of the target’s shares and is triggered upon the termination of the agreement in similar circumstances where a break fee would be payable.

  Asset Option (Crown Jewel Lockup)—An option granted by a target to a buyer to purchase a key asset of the target. This option is also triggered in similar circumstances as a break fee or stock option. The price for this option can be discounted, but the purpose is to ward off a subsequent bid because the first bidder will be assured of receiving the target’s crown jewel asset.

  Shareholder Support Agreement—An agreement with a target’s significant shareholders to support the acquisition through a voting agreement to vote in favor of the merger or a tender agreement to tender into a tender offer.

  No-Talk—A provision in an acquisition agreement that neither a target nor its representatives will speak to other third-party bidders. In its most common form, a target is allowed to talk to other potential bidders only if the target predetermines that the dialogue is, or is reasonably likely to lead to, a superior offer.

  No-Solicit—A provision in an acquisition agreement that neither a target nor its representatives will solicit third-party offers.

  Force-the-Vote Provision—A provision in an acquisition agreement that a target is required to hold a shareholder vote on the acquisition, even if a higher competing bid emerges.

  In their study of lockups from takeovers from 1988 through August 31, 1999, Professors John C. Coates IV and Guhan Subramanian found: “In friendly U.S. mergers greater than $50 million in value, lockups appeared in 80% of deals in 1998, compared to 40% of deals a decade ago.”36 They also determined that in their sample “all-stock deals are much more likely to have stock lockups than cash deals (39% vs. 12%) or deals involving mixed consideration (18%), but are not more likely to have breakup fees than cash deals (46% vs. 47%) or mixed deals (55%).”37 The aggregate result was that “lock-up incidence is significantly higher in all stock deals (governed by Unocal) than in all-cash deals (governed by Revlon).”38 The difference was probably attributable to the applicable standard of review. Lockups in cash deals are reviewed under Revlon because they involve a change of control. In contrast, lockups in stock deals are subject under Delaware law to lower standards of review. Targets were aware of the distinction and so used their perceived latitude to negotiate more lockups in stock deals. This provided targets greater latitude to ensure that their company was acquired by their chosen buyer.

  This trend was buoyed by the Delaware courts in 1997 in Brazen v. Bell Atlantic.39 In Brazen, the Delaware Supreme Court upheld the validity of a $550 million termination fee agreed in the negotiated stock-for-stock merger-of-equals transaction between Bell Atlantic and NYNEX. However, the Supreme Court’s holding was arguably at odds with the decision in Time, which had held that “structural safety devices” in non-Revlon transactions were to be reviewed under Unocal’s proportional standard. Nonetheless, the court refused even to scrutinize under fiduciary duty principles the board decision to agree to the fee, instead applying a liquidated damages contractual analysis to uphold the fee under reasonableness grounds. Henceforth, buyers agreeing to transactions without the specter of another bid would arguably be able to avoid even Unocal review.

  These targets would thus have wide latitude to agree to potentially preclusive lockups. For example, in In re IXC Communications Inc. Shareholders Litig., Vice Chancellor Steele, then sitting in the Chancery Court, reviewed a number of lockups and found them valid, stating that:

  enhanced judicial scrutiny does not apply…[as] [n]either the termination fee, the stock-option agreements, nor the no-solicitation provisions are defensive mechanisms instituted to respond to a perceived threat [by] a potential buyer.40

  In other words, absent a competing bid, it appeared that Delaware courts would not even find a threat necessary to review the devices under the Unocal standard and would instead subject these lockups to deferential review under the business judgment standard.41 In Omnicare, the court rejected IXC’s proposed standard and instead held that lockups should be reviewed under the Unocal standards.42 This may not make a difference, though, as Vice Chancellor Strine, at least, has implied that review under the business judgment rule contemplated by IXC would not be in a materially different spirit than Unocal review.43

  Brazen also firmly places termination fees, the main form of lockup utilized these days, under a different standard of review as liquidated damages. The net effect of all of this is to make intervening bids more difficult and costly. This also provides a head start to a target board’s choice of buyer. Here, Professor Coates and Subramanian have argued that in the strategic context when another “buyer is present, a lock-up more than doubles the likelihood of completion for the first buyer.”44 On this basis, they conclude that “foreclosing lockups do exist, and, more generally, that lockups do influence bid outcomes.”45

  Targets could thus agree to transactions and negotiate protections that ensured that their chosen buyer completed their deal. In the wake of these liberalizing rulings in the 1980s and 1990s, the use of termination fees, in particular, began to become the norm. According to one study, termination fees were rare in 1989. At that time, they accounted for only 2 percent of all takeovers. However, by 1998 these provisions were in more than 60 percent of all takeovers.46 In the wake of Brazen, these fees became even more commonplace as targets attempted to affect the course of their acquisition. They also became the lockup de jure as targets and buyers less frequently utilized stock and asset lockups.

  Then in Omnicare v. NCS Healthcare, Inc.47 the Delaware courts limited the ability of a majority stockholder to agree to a stock lockup when the target had agreed to a force-the-vote provision. In the end, though, the Delaware courts never addressed the fundamental question of lockups per se, and their use post-Omnicare remains widespread, albeit subject to the restrictions set forth in
Omnicare, the oversight of the Delaware courts, and the arguments of some academics that these provisions deter subsequent bids. Moreover, the Chancery Court strictly construed the scope of Omnicare in Orman v. Cullman, sharply reducing its impact.48

  In another 2008 opinion referred to in Chapter 6,Vice Chancellor Stephen P. Lamb even further restricted Omnicare to almost meaninglessness. “Omnicare is of questionable continued vitality,” stated Vice Chancellor Lamb of Delaware’s Court of Chancery in Optima International of Miami v. WCI Steel, Inc.49 In WCI Steel,Vice Chancellor Lamb declined to halt the acquisition of WCI via a merger by Severstal. The dispute centered over the mechanics of the approval of the deal. WCI’s directors had approved the acquisition, and the acquisition agreement had been signed. The merger was then approved by the stockholders of WCI by written consent that very same day. In fact, the acquisition agreement permitted Severstal to terminate the transaction if this did not occur. Optima, a competing bidder who had bid $14 million more than Severstal, sued. Optima argued that this immediate shareholder vote was a lockup that violated Omnicare. More specifically, by approving and agreeing to the merger and arranging for shareholder approval that day, the WCI board breached Omnicare’s requirement that there be a meaningful fiduciary out and no fully locked-up deal.

  Vice Chancellor Lamb rejected this argument. First, he made the comment just quoted about Omnicare’s continued validity, though he also noted that he was not in a position to overturn it. He then stated: “Nothing in the [Delaware General Corporation Law] requires any particular period of time between a board’s authorization of an acquisition agreement and the necessary stockholder vote.”50