Bulletproof: mandatory rules for deal protection.

• Author: Quinn, Brian J.M.

1. INTRODUCTION II. COMMON DEAL PROTECTION AND BULLETPROOFING A. Voting Protections B. Exclusivity Measures C. Compensatory Devices D. Bulletproofing E. Restrictions on Use of Deal Protection III. COMMENTATORS' ARGUMENTS IN FAVOR OF BULLETPROOFING: CERTAINTY INCREASES SALE PRICE IV. DOES BULLETPROOFING RESULT IN HIGHER SALE PRICES? V. COMPENSATORY DEVICES CAN GENERATE INITIAL BIDS VI. WHY DO SELLERS AGREE TO BULLETPROOFING? VII. THE VIRTUES OF A MANDATORY RULE AGAINST BULLETPROOFING VIII. CONCLUSION I. INTRODUCTION

   This Article provides an economic analysis of mechanisms that protect negotiated acquisitions of companies and explains the need for a mandatory rule limiting the use of such mechanisms. The Delaware courts have in fact imposed restrictions on various forms of deal protection without recognizing a consistent underlying economic logic to their decisions and without establishing a consistent principle governing different forms of deal protection. At the same time, practitioners continue to push the edge of the envelope seeking ways to create stronger deal protection. I argue that when viewed together from an economic perspective, the courts' somewhat ad hoc decisions relating to deal protection are consistent with the efficiency objective underlying corporate law and should be bolstered rather than undermined. Specifically, I argue that sellers should be prohibited from providing buyers in non-Revlon (1) transactions with "bulletproof" protection. (2) Instead, sellers should be permitted to provide limited protection only to the extent necessary to compensate bidders for the transaction and opportunity costs of making bids. A well-measured termination fee should be sufficient for this purpose.

   In negotiating non-Revlon transactions, buyers of corporations commonly ask sellers to undertake certain commitments that prevent them from accepting an alternative offer from a third party. (3) Such commitments--including no-shops/no-talks, voting agreements, large stock or asset lockups, and large termination fees--when used alone or in combination can make the contemplated sale "bulletproof," or immune to a third party bid. The increased certainty that these commitments provide is valuable to the buyer, who must incur transaction-specific costs as well as opportunity costs to consummate the deal. By bulletproofing an acquisition, a seller may be able to extract some of this value by negotiating a higher sale price. Hence, buyers are frequently able to convince sellers to provide them with a bulletproof deal. The seller's cost of bulletproofing is the lost opportunity to expose the transaction to market competition, which would tend to increase the sale price--either through a price from the initial buyer that is high enough to pre-empt third party bids, or through a sale to a third party that outbids the initial buyer, or through a sale to the initial buyer after a bidding contest.

   Through a series of cases during the 1990s, Delaware courts have taken up the question of bulletproofing on a number of occasions. Courts used a number of ad hoc approaches to place limits on the use of large termination fees, stock options, and no-talk provisions, among others. In Omnicare, Inc. v. NCS Healthcare, Inc., the court held, broadly, that selling boards violate their fiduciary duties when they agree to merger agreements without effective fiduciary outs. (4) By requiring merger agreements to include effective fiduciary outs, the court has laid down a mandatory rule that significantly curtails the ability of sellers to bulletproof transactions and, more generally, that provides guidance regarding the limits of the uses of most, but not all, deal protection in stock-for-stock transactions. Reaction to the Delaware Supreme Court's majority decision in Omnicare was negative and has led to an expectation that the court will reverse its decision at the first opportunity. (5)

   Commentators have argued that sellers should be permitted latitude in protecting a negotiated transaction and that a seller's decision to bulletproof such transactions should be subject to judicial review only under the business judgment rule. Decisions by the Delaware courts that subject bulletproofing to enhanced levels of scrutiny have been criticized as the wrong result, and the courts have been encouraged to reverse their position with regard to bulletproofing. The basis for these commentators' view is that limiting a seller's ability to bulletproof a sale will reduce the willingness of would-be acquirers to make bids, and to the extent that bids are made, bidders will offer lower prices than they would if a bulletproof deal was available. (6)

   This Article presents an auction theory analysis of deal protection to demonstrate that, for reasons not necessarily related to the reasoning in the opinions themselves, the line of cases in the Delaware courts are correctly decided, that a mandatory rule against bulletproofing is sound as a matter of policy, and that it should be extended. While seller may be able to negotiate a higher price from a particular buyer in exchange for bulletproofing a deal, auction theory models demonstrate that such a negotiated gain will, in expectation, be lower than the gains a seller can reap by exposing a deal to potential market competition. For reasons I will explain, without a mandatory rule sellers find difficult to resist these demands. The line of cases limiting bulletproofing allows sellers to resist strong pressures from buyers to bulletproof transactions and thereby share in the joint gains generated by the transaction. At the same time, because acquisition bids are costly, in terms of direct expenses and opportunity costs, the expected return to making bid must be sufficiently high to justify a bidder's up-front investment. Limited deal protection, and more importantly, termination fees covering bid costs, can accomplish this objective. Here, the courts are correct in permitting such limited protection for bidders. Limiting the ability of selling boards to grant bulletproofing will result in enhanced social welfare. Enhanced social welfare is the proper measure for legal rules. Consequently, the Delaware Supreme Court's mandatory rule regarding bulletproofing should be maintained and extended rather than reversed. (7)

   This Article proceeds in the following manner: Part II describes the variety of bulletproofing measures and techniques that are commonly used in non-Revlon transactions. This Part also provides a brief overview of the legal restrictions on deal protection measures. Part III describes the arguments put forward to defend the use of deal protection measures to bulletproof these negotiated transactions. These arguments focus on sellers' ability to negotiate higher prices by assuring buyers that a sale will consummated. Part IV relies on auction theory to demonstrate that while such assurances may allow sellers to extract some of the buyers' gains, a seller would obtain a higher price in expectation by making itself available to third party bids. Part V argues that while the only valid justification for deal protection may be to encourage bids from potential buyer, bulletproofing is not necessary for that purpose. A termination covering bid costs will be sufficient for that purpose. Sellers need not revert bulletproofing in order to generate initial bids. Part VI argues that there are structural biases in the bargaining process that make it difficult for sellers to resist bulletproof transactions in a bilateral negotiation. These biases make it necessary to have mandatory rule that prevent sellers from agreeing to bulletproof transactions. Part VII describes the welfare enhancing effects of taking bulletproofing off the table and leaving negotiated transactions open to competition. Without bulletproof transactions, sellers can expect higher sale prices for sellers--either from initial or third party bidders. Such result is socially beneficial because it encourages sellers to invest ex ante in maximizing their value in a sale transaction and ensures that sellers end up in the hands of the highest-valuing buyer. Part VIII briefly summarizes and concludes.

2. COMMON DEAL PROTECTION AND BULLETPROOFING

   Deal protection measures, to varying degrees, deter subsequent bids and in some cases compensate a would-be buyer if a third party ultimately acquires the seller. When used in combination, or in some circumstances alone, deal protection measures can render a transaction "bulletproof," or immune to a topping bid. This Article is concerned with using such measures to bulletproof transactions that have not been exposed to market through either an auction or a pre-signing market check. (8) Common deal protection measures fall into one of three general categories: voting protections, exclusivity measures, and compensatory devices. This Part describes each of measures that have been developed and tested in the courts and then describes limitations that the courts have imposed on them.

   1. Voting Protections

      Voting protections enable a seller to "bank" a high percentage of the shareholders' votes in favor of the agreed upon transaction prior to an actual shareholder vote. A seller can ensure the success of its preferred transaction by securing voting agreements from stockholders holding a majority of the shares or voting power. Where ownership of seller is closely-held, the transaction costs associated with assembling a majority bloc support of the transaction can be reasonably low since many of the major stockholders are often directly represented on the seller's board of directors and the universe of stockholders is limited in size. (9) Where voting agreements are used, the merger agreement is usually signed contingent upon or contemporaneous with their delivery. (10)

      In public company transactions, where there is typically not a controlling bloc of shares that can be easily assembled in favor of the sale...