It is well known that acquirers of publicly held corporations usually pay substantial premiums relative to the pre-acquisition market prices of the acquired corporations' shares. (1) Legal scholars have examined a variety of explanations for this phenomenon, ranging from merger gain sharing to inefficient behavioral motivations. (2) Largely absent from these explanations, however, is any effort to differentiate between premiums paid in transactions in which the "acquirer" purchases the shares of the "target" or "selling" (3) firm for cash, and transactions in which the "target's" shares are converted into shares of the "acquirer." (4) The two types of transactions actually are quite distinct. Elaboration upon the distinction raises concerns about the coherence of the Delaware case law which addresses the standards governing judicial review of the conduct of the target's directors. Consideration of such questions in Part I of this Article leads to my suggestion that the Delaware case law could be rationalized by abandoning the change of control litmus test for enhancing both director duties and judicial scrutiny of director conduct. Delaware law should focus instead on the extent to which unilateral director action in approving mergers impairs the ability of shareholders to approve or disapprove such transactions.
Part II of this Article briefly reviews some of the explanations for the payment of merger premiums and questions the cogency of some of those explanations in light of recent merger data. In particular, the merger gain-sharing explanation appears problematic in light of evidence that premiums in cash and stock-for-stock mergers are nearly identical in magnitude. On the other hand, the data indicate that the existence of acquirer shareholder voting fights significantly (and negatively) affects premium size, reinforcing judicial views about the importance of such rights.
Part III examines whether modification of Delaware doctrine concerning the fiduciary obligations of directors in connection with their approval of mergers is necessary so that it more closely matches the level of intensity of judicial review with both the magnitude of the threat to shareholder interests and the likelihood of unchecked director misbehavior. In particular, Part III suggests that (1) a change of control in a merger should at most be one of several factors, rather than wholly conclusive, in the court's decision whether to apply "enhanced scrutiny" (5) in reviewing a transaction; and (2) the actions of disinterested and independent directors in relation to mergers warrant enhanced judicial scrutiny only when they unilaterally and significantly impair shareholder voting fights. Finally, the Article suggests that the similarity between the positions of acquiring firm shareholders and target firm shareholders justifies more similar legislative and judicial treatment of both groups in mergers.
EVALUATING MERGER GAINS AND OTHER EXPLANATIONS OF PREMIUMS IN LIGHT OF RECENT MERGER DATA
Traditional Gain-Sharing Explanations of Merger Premiums and Their Application in Cash Versus Stock-for-Stock Acquisitions
Although there are competing views about which explanations most effectively account for the phenomenon of merger and acquisition premiums, traditional explanations posit that acquiring firms justify payment of such premiums based on gains attributable to the merger in the form of synergies or improved management. (6) In the case of an acquisition for cash, such traditional explanations offer the comforting appearance of fairness to both the target and acquiring firm's shareholders. Payment of a premium to the target corporation's shareholders is a vehicle for sharing merger gains with target shareholders, who, as a result of the cash-out merger, would have no further equity claim to such gains, and therefore would not otherwise share in them.
The case of a stock-for-stock merger, however, is starkly different. In such a transaction, shareholders of both constituent corporations remain shareholders in the continuing combined enterprise. Thus, both groups--acquirer shareholders and target shareholders--are able to participate pro rata in gains arising out of the merger. Therefore, a premium to the target's shareholders cannot be justified, as in a cash acquisition, on the premise that it is the only way to permit those shareholders to share in the gains arising from the merger. (7)
Indeed, from a mechanical standpoint, it is somewhat arbitrary to characterize either corporation in a stock-for-stock merger as an "acquirer" or a "target." From the shareholders' standpoint, such a merger could be structured to provide that either corporation's shares be issued in the transaction. While we ordinarily see stock-for-stock mergers choreographed so that the smaller firm (measured by income, revenue, or aggregate market capitalization) merges into the larger firm (or with its wholly-owned subsidiary), it is just as possible for the minnow to swallow the whale. On occasion, stock-for-stock mergers are structured just that way, where the larger firm merges into the smaller firm (or its subsidiary), and the smaller firm issues shares in the merger. (8) From the shareholders' standpoint, it should not matter who swallows whom in terms of formal corporate structure or which corporation's shares are issued in the merger; the sole issue of concern is their proportional ownership of the combined firm. (9)
In either case, it is not immediately apparent why either of the combining firms' shares should be issued in the merger at a ratio that confers upon either of their respective shareholders a premium (measured by the market value of the shares to be received relative to the market price of the shares to be converted in the merger). If both groups of shareholders end up with a proportionate share of the continuing enterprise that reflects the pre-transaction ratio of their corporation's market value, one could conclude that, on average, they would share fairly in the value of the combined entity and in the value of merger gains. Of course, it is not asserted that, in each individual case, the ratio of merging corporations' pre-announcement stock prices determines a "correct" economic evaluation of the corporations' relative contributions to the combined entity or to the gains resulting from the merger. One firm's shares, for example, may be traded less actively, may be affected by the presence of a controlling shareholder, or may trade at a discount relative to the other firm's shares for some other reason. Perhaps acquirers (corporations whose shares are issued in stock-for-stock mergers) consistently pay a premium because the share prices of target firms are consistently undervalued. While all these reasons might be plausible, however, there is no systematic reason why either merger constituent should pay such a premium solely to allow the other constituent's shareholders to participate in merger gains.
Thus, if merger gain sharing were a valid explanation for the payment of merger premiums, one would expect to find that premiums in cash acquisitions consistently, and significantly, exceed premiums paid in pure stock-for-stock transactions. Indeed, if gain sharing were the only explanation for merger premiums, on average one would expect to find premiums in cash acquisitions, but not at all in stock-for-stock deals.
Evaluating Gain Sharing and Alternative Explanations in Light of Merger Premium Evidence
The reality, however, is that premiums are paid, routinely, in stock-for-stock mergers by the corporation (almost always the one dubbed the "acquirer") that issues shares in connection with the merger. Data from stock-for-stock mergers in 1999, 2000, 2001, and 2002 reveal a mean premium of approximately 30%, as compared to a mean premium of approximately 36% paid in cash acquisitions. (10) The median premium observed in stock-for-stock transactions in these years (28.26%) was essentially identical to the median observed in all-cash acquisitions (28.07%). (11)
One must be modest about the significance of these data. They are preliminary and limited, both in sample size and in chronological coverage. Their reflection of a near identical premium size in both cash and stock acquisitions, however, must be at least unsettling to those who would explain premium payments on the basis of merger gain sharing.
If merger gain sharing is unconvincing as an explanation for the payment of premiums in stock-for-stock mergers, what alternative explanations are available? One frequently invoked alternative is the theory that acquiring firms' managers consistently cause their firms to overpay in acquisitions in order to satisfy personal interests, namely, greater compensation and more extensive managerial authority. (12) This acquirer empire-building theory suggests that factors having no apparent economic justification from the standpoint of the acquiring firm's shareholders contribute significantly to the existence and size of the premium. If supported by the data, this suggestion might explain and corroborate the analyses that question both the economic wisdom of mergers from the standpoint of the acquiring corporation's shareholders and the adequacy of legal checks on actions of the acquiring corporation's directors. (13) Even more encouraging, the theory could explain why premiums paid in mergers are virtually identical regardless of whether the acquisition currency is cash or stock--since there is no apparent reason why the extent and effect of rent seeking by acquirer managers should differ as between those two types of mergers.
A possible empirical test of this suggestion, however, did not support the idea. The potency of private managerial interests might be measured by the extent to which acquiring firm directors agree to share postmerger control with directors or officers of the target firm. It is at least plausible that...