Enhanced Scrutiny on the Buy-side

• Publication year: 2019

Enhanced Scrutiny on the Buy-Side

Afra Afsharipour
University of California, Davis School of Law

J. T. Laster
Delaware Court of Chancery

ENHANCED SCRUTINY ON THE BUY-SIDE

Afra Afsharipour^* and J. Travis Laster^**

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Empirical studies of acquisitions consistently find that public company bidders often overpay for targets, imposing significant losses on bidder shareholders. Numerous studies have connected bidder overpayment with managerial agency costs and behavioral biases that reflect management self-interest. For purposes of corporate law, these concerns implicate the behavior of fiduciaries—the officers and directors of the acquiring entity—and raise questions about whether those fiduciaries are fulfilling their duty of loyalty. To address comparable sell-side concerns, the Delaware courts developed an intermediate standard of review known as enhanced scrutiny. There has been little exploration, however, of whether the rationales for applying enhanced scrutiny to the actions of sell-side fiduciaries extend to comparable fiduciaries on the buy-side.
This Article addresses this long-neglected question. Drawing upon the history of Delaware jurisprudence on enhanced scrutiny, it argues that enhanced scrutiny should extend to the decisions of buy-side fiduciaries. The Article also recognizes that, although doctrinally coherent, applying enhanced scrutiny to buy-side decisions would open the door to well-documented stockholder litigation pathologies that have undermined the effectiveness of enhanced scrutiny for sell-side decisions. To address these pathologies, the Delaware

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courts have recently encouraged the use of fully informed stockholder votes on the sell-side to lessen litigation risk. This Article reasons that a primary argument in favor of extending enhanced scrutiny to buy-side decisions rests not on the ability of the litigation itself to generate superior outcomes, but rather as an inducement to more frequent buy-side votes. This argument builds on recent empirical literature which finds that stockholder voting can provide an important counterbalance against the self-interest and biases that lead to bidder overpayment.

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Table of Contents

I. Introduction..........................................................................446

II. Bidder Overpayment and Its Causes................................449

A. BIDDER OVERPAYMENT.................................................450
B. THE CAUSES OF OVERPAYMENT....................................453

III. Enhanced Scrutiny As A Possible Response.................458

A. ENHANCED SCRUTINY AS AN INTERMEDIATE STANDARD OF REVIEW..................................................458
B. ENHANCED SCRUTINY FOR SELL-SIDE M&A TRANSACTIONS.............................................................470

IV. The Fit Between Enhanced Scrutiny and Buy-Side M&A Decisions................................................................479

A. SUPPORTIVE CONSIDERATIONS.....................................479
B. COUNTERVAILING CONSIDERATIONS.............................482

V. A Path To Buy-Side Stockholder Voting.........................488

VI. Conclusion..........................................................................493

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I. Introduction

Empirical studies of acquisitions consistently find that public company bidders often overpay for targets, imposing significant losses on bidder shareholders.¹ Research also indicates that the losses represent true wealth destruction in the aggregate and not simply a wealth transfer from bidder shareholders to target shareholders.² Numerous studies have connected bidder overpayment with managerial agency costs³ and behavioral biases that reflect management self-interest.⁴ For purposes of corporate law, these concerns implicate the behavior of fiduciaries—the officers and directors of the acquiring entity—and raise questions about whether those fiduciaries are fulfilling their duty of loyalty.

Beginning in the 1980s, to address circumstances that present a high risk of self-interest, the Delaware courts began to develop an

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intermediate standard of review known as enhanced scrutiny.⁵ The situations evaluated in these cases did not encompass the flagrant self-dealing often observed in traditional duty of loyalty cases, but instead involved the potential risk of soft conflicts and fiduciary self-interest.⁶ Much of Delaware's enhanced scrutiny jurisprudence was developed through scrutiny of decisions by sell-side fiduciaries.⁷ We argue that the enhanced scrutiny framework has become a means of screening for improperly motivated actions "when the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors."⁸

Because the core conflict-derived rationale that supports applying enhanced scrutiny to actions by sell-side fiduciaries applies equally on the buy-side, we propose extending enhanced scrutiny to the decisions of buy-side fiduciaries.⁹ The decision to undertake a significant acquisition differs from other routine business judgments taken by directors and officers. As in the sell-side scenario, acquisitions are often large transactions that are plagued by subtle personal interests that affect the decision-making process.¹⁰ Empirical evidence suggests that in acquisitions, particularly significant acquisitions, the business judgment of boards is contaminated by the interests of managers and advisors

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on whom boards of directors rely.¹¹ The board's judgment is even more contaminated in public company acquisitions where the potential for realization of the value of the transaction is uncertain, but the prestige and compensation connected with purchasing another public company is high.¹²

Although doctrinally coherent, applying enhanced scrutiny to buy-side decisions would open the door to well-documented stockholder litigation pathologies that have undermined the effectiveness of the sell-side regime.¹³ In recent years, the Delaware courts have strived to lessen the impact of these pathologies. One powerful intervention has been to lower the standard of review from enhanced scrutiny to the business judgment rule if the transaction receives fully informed stockholder approval.¹⁴ Logically, this innovation also would apply to bidder fiduciaries.

It seems likely, therefore, that a principal consequence of applying enhanced scrutiny to bidder decisions would be to induce more buy-side stockholder votes.¹⁵ There are substantial reasons to believe that buy-side stockholder votes would be an effective tool to limit the bidder overpayment phenomenon.¹⁶ On balance, extending enhanced scrutiny to decisions by buy-side fiduciaries should lead to a superior regime in which stockholders can provide a meaningful check on bidder overpayment.¹⁷

This Article proceeds as follows. Part II summarizes the bidder overpayment problem and the empirical explanations for overpayment: agency costs and behavioral biases. The explanations for overpayment highlight soft conflicts of interests and implicate

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the role of fiduciaries. Delaware law has developed a nuanced framework—enhanced scrutiny—for reviewing the decisions of sell-side fiduciaries. In Part III we examine the development of enhanced scrutiny in order to determine whether enhanced scrutiny may be used to address bidder overpayment.

Part IV argues that the Delaware courts' rationales for applying enhanced scrutiny to the decisions of target boards in third-party M&A transactions equally hold in the context of bidder boards. This part then assesses both supporting and countervailing considerations for using litigation as the solution to the fiduciary conflicts that lead to problems on the bidder side. Over the past several years the Delaware courts have encouraged the use of a fully informed stockholder vote on the sell-side to lessen litigation risk in third-party M&A transactions.

In Part V, we reason that the primary argument for extending enhanced scrutiny to buy-side decisions is not that the litigation itself will generate superior outcomes, but rather that buy-side companies will have a greater incentive to undertake shareholder votes on a proposed transaction. This argument builds on recent empirical literature which finds that voting by stockholders can provide an important counterbalance to guard against the self-interest and biases that lead to bidder overpayment.

II. Bidder Overpayment and Its Causes

Hewlett-Packard (HP), a Silicon Valley icon, agreed to acquire UK software firm Autonomy for approximately $11 billion in August 2011.¹⁸ The deal was a boon for Autonomy shareholders, who received a premium of almost 64 percent to Autonomy's share price at the time of announcement.¹⁹ By November 2012, HP announced a write-down of $8.8 billion related to the Autonomy acquisition, including a write down of $5 billion related to accounting problems

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at Autonomy.²⁰ The disastrous deal destroyed billions of dollars in value for HP shareholders, and resulted in large securities class-action suits against HP.²¹ While the extent of the loss suffered by HP was a surprise, analysts had warned at the outset that the Autonomy deal was "wildly overpriced."²² According to reports, HP's zealous courtship of Autonomy was spearheaded by Léo Apotheker, HP's then-new chief executive officer, who was eager to use the Autonomy acquisition to make his mark at the company.²³ The failed Autonomy deal was only one in a string of poorly performing acquisitions—all of which were touted by a series of successive HP CEOs as acquisitions that would "transform" the company.²⁴

A. BIDDER OVERPAYMENT

HP's acquisition of Autonomy illustrates a striking pattern in public company acquisitions. A vast body of empirical literature has shown "that a large percentage of transactions involve negative returns for acquirer shareholders . . . and that the losses from the worst performing deals are very...