Stacked deck: go-shops and auction theory.

• Author: Denton, J. Russel

INTRODUCTION I. AUCTION THEORY A. Comparison Between Auctions and Sequential Mechanisms B. Empirical Studies of the Benefits of Auctions II. GO-SHOP BACKGROUND A. An Analysis of a Typical Go-Shop B. Transactions Likely to Employ a Go-Shop III. APPLYING THE THEORY TO THE FACTS IV. RECOMMENDATIONS GOING FORWARD CONCLUSION APPENDIX: JUMPED DEALS "[W]e don't want to waste our time.... We don't participate in auctions."

--Warren Buffet (1)

INTRODUCTION

During the recent wave of private equity buyouts of public companies, boards of directors for selling companies have been increasingly turning to go-shop provisions as a means of fulfilling the board's Revlon duty to maximize shareholder value. (2) A go-shop provision operates as a post-signing market check by allowing a selling board to actively solicit offers from third parties after signing a merger agreement with an initial buyer. In the words of one publication for practicing lawyers, go-shops give the selling company the benefit of an open auction without any downside risk since they allow the selling company to lock in a price floor while retaining the ability to conduct further negotiations with other buyers for a higher price. (3) However, there is also speculation that a go-shop is a "disingenuous article that boards are including in deals to protect themselves from angry shareholders...." (4)

A selling board's decision to contest any merger provision is made in a situation in which the buyer can simply not sign a deal if it does not get the terms that it wants. This puts pressure on selling boards of directors and there is no single answer for how a board can maximize value in all situations. Boards have to do their best to maximize value for their shareholders while not pushing buyers so hard that they prefer not to sign a deal. Delaware courts have recognized that a buyer abandoning a deal is a real threat in a simulated dialogue between a selling company pressing for better terms and a buyer offering a take-it-or-leave-it set of deal terms. (5) The ability for buyers to simply not agree to a deal has led courts to recognize that target boards are allowed to grant lock-up provisions to the buyer as long as the provisions are within the range of reasonableness. (6)

Up until June 2007, there had not been any court cases dealing with the extent to which go-shop provisions could walk this line and satisfy Revlon duties. (7) However, two Delaware Chancery Court cases decided in June 2007 rejected plaintiffs' Revlon claims that go-shop provisions failed to maximize shareholder value.

In the first of these cases, In re Topps Company Shareholders Litigation, the plaintiffs challenged a private equity buyout of Topps where management had been given assurances of continued employment by the buyout firm. The merger agreement contained a go-shop provision, a termination fee and a matching right in favor of the buyer. Additionally, there was no pre-signing market check of any kind. Nevertheless, Vice Chancellor Strine wrote that "[he did] not believe the substantive terms of the Merger Agreement suggest[ed] an unreasonable approach to value maximization. As a result of the go-shop process, a second bidder, Upper Deck, made a bid for the company that was $1.00 (10.25%) higher than the initial offer, but the Topps board rejected it and recommended that shareholders vote for the initial merger with the private equity firm. (9)

The go-shop provision, in Strine's estimation, provided a reasonable post-signing market check, and "for 40 days the Topps board could shop like Pasis Hilton." (10) Despite approving the go-shop provision under Revlon, Strine enjoined the shareholder vote on the merger because Topps had failed to adequately disclose both the extent of management participation and the size of management's contracts with the private equity firm.

In In re Lear Corporation Shareholder Litigation, Vice Chancellor Strine dealt with buyout of a public company in which management had been promised jobs running the company after it was taken private. (11) In the negotiations to buy out Leas, Casi Icahn, the buyer, refused to allow Leas to conduct a full-blown auction, saying that he would pull his offer if it did so. (12) In a decision that closely followed the Topps decision, Strine enjoined a shareholder vote on the merger until Leas adequately disclosed management's participation in the buyout negotiations. (13) The Vice Chancellor rejected the shareholders Revlon claims despite saying that Leas's board's negotiation tactics were "less-than-ideal." (14) Strine additionally wrote that he "also perceive[d] no reason why a strategic or financial bidder would have believed that Icahn's relationship with Leas's management made a topping bid inadvisable." (15)

This Note will use formal auction theory to analyze the effects of go-shops on selling companies' premiums and will show that while Strine is correct in saying that the combinations of management involvement and go-shop provisions will not deter strategic bidders, they do deter additional financial bidders from pursuing a company. (16) This means that go-shops, as they are currently written, do not maximize value for the target company's shareholders. Aside from management participation, there are features of go-shop provisions that, based on auction theory, make it significantly less likely that a third-party financial bidder will emerge and make a jump bid, stacking the deck in favor of the initial bidder.

Part I of this Note will summarize the important aspects of auction theory as it relates to corporate takeovers. Part II will provide a background of go-shop provisions, discussing the kind of transaction in which go-shops are being used, and summarize how a typical go-shop provision works. Part III summarizes the impact of go-shop provisions on expected revenue, based on auction theory developed in Part I and the observations in Part II, and examines real-world mergers to determine whether or not auction theory correctly predicts the outcomes in go-shop transactions. Part IV offers a set of recommendations to make go-shops more effective at maximizing shareholder value.

1. AUCTION THEORY

   Under the Delaware Supreme Court's decision in Revlon v. McAndrews, once a board of directors makes a decision to sell a company for cash, the board has a duty to maximize the value that shareholders receive. (17) Auction theory can be used to determine how boards of directors for selling companies can best go about maximizing revenue when selling a company. As selling boards' principal focus is maximizing shareholder value, analysis in this Note will focus on the principles of auction theory relating to maximizing expected revenue for the seller, not on designing a process that will result in a socially efficient sale.

   There are four styles of auctions: ascending bid auctions (also called English auctions), first-price sealed bid auctions, second-price sealed bid auctions, and descending bid auctions (also called Dutch auctions). (18) In an ascending bid auction, the seller raises the price until a bidder is not willing to pay a higher price and the highest bidder wins the auction for that price. (19) In a first-price sealed bid auction, the bidders all submit a sealed bid and the bidder who bids the highest amount, wins the auction for the value of her bid. (20) In a second-price sealed bid auction, the process is just like a first-price sealed bid auction except the winning bidder pays the second-highest bid. (21) Finally, in a descending price auction, the seller starts with a high value and lowers the price until a bidder is willing to pay the price the seller is offering. (22) Depending on the circumstances of the auction, each of these forms of auction can result in different expected revenues for the seller, so it is necessary for a seller to be mindful of the effects on revenue when deciding which form of auction to use.

   Regardless of the potential impact on expected revenue, it is difficult, if not impossible, for a selling board to auction a company by any means other than a first-price ascending auction. Because of the selling company's duty to maximize shareholder value, any director who turns down a higher bid after an auction is "over" is going to be "vulnerable" to shareholder lawsuits. (23) A prominent example of an attempt for a selling board to run a sealed-bid auction was the sale of RJR Nabisco. However, after the end of the auction process, the RJR board allowed additional rounds of bidding. Essentially, the RJR board ended up having multiple rounds of "sealed bid" auctions and therefore the auction was essentially an open-outcry ascending auction. (24)

   The Delaware Supreme Court's decision in Omnicare created a bright-line rule against signing a merger agreement without an effective "fiduciary out." This forecloses the possibility of auctioning a company via a non-open-outcry ascending bid auction. (25) Any bid is going to have to be made public for the shareholder vote, and a board of directors has to consider any superior bids from a third-party in order to fulfill its fiduciary duties to its shareholders. Because of the board's fiduciary duty to consider higher bids, any auction held for a company will be an ascending price auction regardless of prior auction design; a board simply cannot credibly commit otherwise regardless of the ex ante effects on expected revenue from using another auction form. (26) Therefore, the rest of the analysis in this Part will focus on how to maximize revenue in an ascending price auction with public bids. One of the most important components of increasing revenue in an auction is to increase the number of participants in the auction. (27) The more bidders there are in an auction, the higher the expected valuation of the second-highest bidder. In an ascending price auction the winning bidder pays a price only slightly higher than what the second highest bidder...