Fixing freezeouts.

AuthorSubramanian, Guhan
PositionTender offers and mergers

INTRODUCTION I. BACKGROUND A. Historical Origins of Freezeouts B. Development of Procedural Protections 1. Weinberger v. UOP 2. Kahn v. Lynch Communication Systems 3. Rosenblatt v. Getty Oil C. Disruptive Technology: The Tender Offer Freezeout 1. Solomon v. Pathe Communications 2. In re Siliconix Inc. Shareholders Litigation 3. Glassman v. Unocal Exploration 4. In re Pure Resources 5. Synthesis D. Prior Literature 1. Advocating Entire Fairness Review for Tender Offer Freezeouts 2. Defending the Status Quo 3. Proposing Doctrinal Convergence Through Hybrid Approaches II. THE PROBLEM WITH EXISTING DOCTRINE A. Opportunistic Behavior in Tender Offer Freezeouts 1. The Determination of Price in Tender Offer Freezeouts 2. Categories of Opportunistic Behavior a. Freezeout Timing b. Influencing the Target's Value 3. Efficiency Implications a. Nonreversible Value Reductions b. Facilitating Some Inefficient Freezeouts c. Reduced Access to Minority Capital B. Deterring Efficient Freezeouts Through the Merger Mechanism 1. The Problem of Special Committee Resistance a. With Special Committee Veto Power b. Without Special Committee Veto Power 2. The Problem of Deterred Deals a. Through Allocation of Deal Synergies b. Through Litigation Costs C. The Absence of a Private Solution III. A PROPOSAL FOR REFORM A. First Principles of Corporate Law 1. The Arms-Length Approach to Fundamental Transactions 2. Application to Freezeout Doctrine a. Tender Offer Freezeouts b. Merger Freezeouts 3. Synthesis B. Reforming Tender-Offer-Freezeout Doctrine 1. Increasing Special Committee Bargaining Power a. Through Standards of Judicial Review b. Through Ability, To Deploy a Pill 2. Promoting Majority-of-the-Minority Conditions 3. The Influence of Sarbanes-Oxley and Stock Exchange Listing Requirements C. Reforming Merger-Freezeout Doctrine 1. Promoting Majority-of-the-Minority Conditions 2. Bolstering the Tender Offer Threat D. Synthesis E. Applications 1. Cox Communications (August 2004) 2. Fox Entertainment Group (January 2005) CONCLUSION INTRODUCTION

On August 2, 2004, Barbara Cox Anthony and Anne Cox Chambers, who together owned a 62% equity interest and a 73% voting interest in Cox Communications, announced that they would offer $32 cash per share in a "freezeout" (1) of the Cox minority shareholders. (2) The offer represented a 16% premium over the preannouncement trading price for Cox, or $7.9 billion in total value.(3) Cox formed a special committee (SC) of three independent directors to review the offer and negotiate with the Cox sisters' representatives. (4) Minority shareholders sued alleging that the offer price was unfair. (5) Over the following four months, the SC bargained hard: counter-offering at $38 per share, walking away from the table at several points, and finally agreeing to a deal at $34.75 per share, representing a 26% premium over the pre-offer price. (6) The deal closed on December 8, 2004. (7)

One month later, on January 10, 2005, News Corporation, controlled by publishing magnate Rupert Murdoch, announced a freezeout exchange offer for the 18% of Fox Entertainment Group that it did not already own. (8) The proposed ratio of 1.9 News shares for each Fox share represented a 7.4% premium over the preannouncement trading price for Fox, or $6.0 billion in total value. (9) As in the Cox freezeout, Fox formed an SC of independent directors to review the offer, (10) and plaintiffs' counsel filed suit alleging that the offer price was unfair to the minority. However, in contrast to the Cox freezeout, News stated that it might go forward with the transaction even if the Fox SC did not approve the offer. (11) On January 24, the Fox SC issued a statement taking no position on the News offer, explaining that it needed more time. (12) On March 4, News raised its offer to 2.04 News shares per Fox share, or a 17.6% premium over the preannouncement trading price for Fox. (13) On March 7, the SC approved the revised offer, (14) and the deal closed on March 22, 2005. (15)

As the Cox Communications and Fox Entertainment Group examples illustrate, freezeouts are back. Due at least in part to the stock market decline of 2000 and the additional costs imposed on public companies under the Sarbanes-Oxley Act of 2002, (16) freezeout activity in the United States has increased to more than twice its historical levels: 128 announced transactions in the four years between July 2001 and July 2005 (32 per year, on average), (17) compared to 154 freezeouts during the ten years between 1987 and 1996 (15 per year, on average). (18) At the same time that freezeout activity has been increasing, the Delaware courts have established different standards of judicial review for the two ways of freezing out minority shareholders. The traditional route, known as a statutory merger freezeout, mandates an SC with veto power over the deal, followed by stringent "entire fairness" review by the courts. The Cox sisters (or, more accurately, their legal advisors) chose this transactional form for the Cox Communications freezeout. The new route, known as a tender offer freezeout, does not give the SC veto power and, at least as of mid-2001, is subject only to deferential business judgment review by the courts. News Corporation chose this transactional form for the Fox Entertainment freezeout.

These procedural differences have substantive implications. Examining the outcomes of all freezeouts in the current doctrinal regime, I find that minority shareholders received less in tender offer freezeouts than in merger freezeouts, as measured by premiums over preannouncement stock prices. (19) This finding is illustrated dramatically by the Cox and Fox examples above: If the Fox minority shareholders had received the same 26.0% premium that the Cox minority shareholders received (rather than their actual 17.6%), they would have achieved an additional $504 million in total consideration from News Corporation.

Commentators have debated the wisdom of doctrinal contours that create procedural and substantive differences based on choice of transactional form, and several have advocated convergence toward a single judicial approach to freezeouts. (20) The need for change has nevertheless remained unclear because of the possibility for adjustments in ex ante pricing of a minority stake. This Article makes the case for change by identifying two social welfare costs of the current regime. First, the tender-offer-freezeout mechanism facilitates some inefficient (value-destroying) transactions by allowing the controller to exploit asymmetric information against the minority. Second, the merger-freezeout mechanism deters some efficient (value-increasing) transactions because of the SC's power to veto the deal. Tender-offer-freezeout doctrine goes too far, and merger-freezeout doctrine does not go far enough, in facilitating freezeouts. Put another way, some companies that should not "go private" do, while others that should do not. As a result, there is a suboptimal distribution of companies between public and private status.

After identifying this efficiency loss, this Article proposes specific doctrinal adjustments that would fix freezeouts. Rather than propose a patchwork solution, this Article advocates a return to first principles of corporate law in the freezeout context. The objective is to replicate the elements of an arms-length negotiation--namely, disinterested board approval and disinterested shareholder approval--in the freezeout context. Translating the arms-length standard to the freezeout arena requires, first, meaningful approval by an SC of independent directors; and second, approval by a majority of the minority shareholders. When both of these procedural protections are provided, this Article proposes that courts should apply deferential business judgment review to assess the transaction. If either or both of these protections are absent, this Article proposes that courts should step in to scrutinize the transaction under the entire fairness standard. The result of this re-grounding would be convergence in standards of judicial review for freezeouts and elimination of the efficiency loss inherent in the existing doctrine.

The remainder of this Article proceeds as follows. Part I provides a brief history of freezeout doctrine, beginning with the Delaware Supreme Court's landmark decision Weinberger v. UOP in 1983, and tracing the evolution of this doctrine through Kahn v. Lynch Communication Systems, Solomon v. Pathe Communications, and the combination of In re Siliconix Inc. Shareholders Litigation, Glassman v. Unocal Exploration Corp., and In re Pure Resources, Inc. Shareholders Litigation in 2001-2002. Part I also summarizes the literature to date examining this latest doctrinal contour and demonstrates that the case for change has remained unclear. Part II identifies an efficiency loss that arises in the current doctrinal regime. With the case for change thus clarified, Part III puts forward my proposal for reform.

  1. BACKGROUND

    1. Historical Origins of Freezeouts

      Until the 1920s, minority shareholders had a property interest in the corporation that allowed them to hold out against a controlling shareholder's efforts to freeze them out. (21) While Florida enacted the first cash-out merger statute in the mid-1920s,(22) freezeouts only became commonplace when Delaware in the 1950s, and the Model Business Corporation Act in the 1960s, adopted similar cash-out statutes. (23) These laws provided the statutory merger mechanism for freezing out minority shareholders, which remains the most common procedure today. (24) In a merger freezeout, the controlling shareholder establishes a wholly owned corporation; the target board (typically dominated by the controller) approves the merger; and the shareholders of the target (again, dominated by the controller) approve the transaction. (25) Under the terms of the merger, the minority shareholders receive either...

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