The golden ratio of corporate deal-making.

• Author: Sautter, Christina M.

2015 and 2016 mark the 30th anniversaries of the Delaware Supreme Court's landmark decisions in Unocal and Revlon, respectively. Those cases and their progeny called for enhanced scrutiny standards to be applied in change of control transactions as well as to deal protection devices--contractual provisions which deter third parties from overbidding between signing and closing. Since those decisions, the courts have struggled with the application of these enhanced scrutiny standards. This Article uses auction theory principles and the related concept of information costs to correlate deal protection devices to the pre-signing sale process in change of control transactions. More specifically, this Article argues that the more extensive the pre-signing sale process, the more information that both the selling company, or target, and buyer have gathered. Specifically, the target board (who has a duty to maximize stockholder value in change of control transactions) achieves greater certainty regarding maximum value from engaging in a more extensive pre-signing sale process. Similarly, the buyer has greater certainty regarding the target's value. At the same time, information costs incurred on both sides is higher--as the parties expend more to learn about the value of the company, there is a lower likelihood that a third party will overbid. In this case, the courts should be more tolerant of more restrictive deal protection devices because of this information certainty.

Conversely, when the target has engaged in only a single bidder negotiation, information costs are lower as is certainty that maximum shareholder value has been achieved. In that case, because of this lack of certainty regarding the achievable maximum value of the target, the courts should be less tolerant of restrictive deal protection devices. In other words there should be a direct proportional relationship between the information gathering process (i.e., the pre-signing sale process) and the resulting deal protection devices. This proportion--the Golden Ratio of Corporate Deal-Making--is supported by auction theory principles as well as Delaware Court of Chancery rhetoric. Despite, however, rhetoric that more extensive sale processes should lead to more restrictive deal protection devices, the Court of Chancery has not differentiated deal protection devices contained in single bidder transactions from those in deals resulting from a more extensive pre-signing sale process. The Golden Ratio of Corporate Deal-Making seeks to provide a template from which the courts can engage in a more nuanced analysis. If applied, in reviewing deal protection devices, the courts would be making distinctions based off of the pre-signing sale process rather than what they deem standard terms.

1. INTRODUCTION II. THE IDEAL M&A SALE PROCESS A. Unocal: Announcing a Standard of Review for Defensive Measures B. Revlon and the Maximization of Value in a Sale of Control III. THE EXTENSIVE PRE-SIGNING SALE PROCESS AND WHY IT MATTERS A. Economic Incentives--Information Costs and Auction Theory B. The Delaware Courts' Rhetoric 1. Favoring a More Extensive Sale Process for Information Gathering 2. The Possible Restrictiveness of Deal Protection Devices IV. CURRENT COURT PRACTICE AND WHY IT IS NOT WORKING A. In re Plains Exploration & Production Co. Shareholder Litigation B. In re Pennaco Energy, Inc. V. THE GOLDEN RATIO OF CORPORATE DEAL-MAKING A. What is the Golden Ratio of Corporate Deal-Making? B. Implications of the Golden Ratio VI. CONCLUSION APPENDIX A: DELAWARE SUPREME COURT AND COURT OF CHANCERY RULINGS ON DEAL PROTECTION DEVICES FROM APRIL 4, 2003 TO DECEMBER 31, 2014 APPENDIX B: ADDITIONAL FACTS REGARDING THE SALE PROCESSES FOR THE CASES INCLUDED IN APPENDIX A I. INTRODUCTION

   Measure what is measurable, and make measurable what is not so.

   --Galileo Galilei (1564-1642) (1)

   For centuries, mathematicians like Galileo, architects, builders, biologists, musicians, and artists, among others, have examined and applied the Golden Ratio in their work. (2) The Golden Ratio is a mathematical proportion said to "describe a harmonious relationship between different parts." (3) Mergers and acquisitions (M&A) transactions involving sales of corporate control can also be boiled down to a Golden Ratio-like equation. More specifically, the contract terms used in a sale of control should bear a harmonious relationship to the process leading up to the sale. Balancing contract terms with the sale process helps to make measurable what is not generally easy to measure.

   Striking this balance is a question of information flow. The flow of information drives price but information itself is not free. The selling company--commonly known as a target company, or target--incurs costs, both tangible and intangible, in finding a buyer, including running a sale process, in valuing the company, and in negotiating the definitive acquisition agreement. (4) At the same time, bidders incur costs of their own by participating in the sale process, engaging in due diligence on the target, and ultimately negotiating an agreement. Because of the information costs incurred on both sides of a transaction, both the target company and bidders must determine how much in the way of information costs they are willing to incur before the resulting deal is no longer worth their while. This Article concentrates on the target's information costs, including how the target gathers information and how the target's information gathering should impact the ultimate deal terms.

   In the bedrock case of Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., (5) the Delaware Supreme Court held that, in a sale of corporate control, the target's board of directors has a duty to maximize stockholder value. (6) The courts also have held that various sale methods may be used in satisfying this obligation. (7) One available sale method is a full blown auction (8) process; however, that would typically be the most costly option. (9) Due to the competitive nature of the auction it would likely provide the target with the most security that the price being paid correlates to maximum stockholder value. (10) Another sale method is single bidder negotiations. This method is typically cheaper than a full-blown auction process but, in many cases, it provides the target with less security that the price being paid maximizes stockholder value. (11) Between these two alternatives lies the market canvass. During a market canvass, the target will contact a select group of potential buyers to gauge their interest in the target. (12) For many targets, the market canvass provides a good middle ground, which allows the target to minimize its information costs while at the same time providing the target with a sense of the value it can ultimately obtain.

   In evaluating the target's fiduciary duties, one must not lose sight of the potential buyer's perspective. Potential buyers may not be eager to incur the costs necessary to participate in a competitive auction process when there is a chance they may not win the auction. Moreover, the ultimate auction winner will typically seek security that the deal is not going to be disrupted by a third party. This security comes in the form of deal protection devices--contractual provisions in negotiated M&A agreements intended to deter third party bidders between the signing and closing of a transaction. A continuing issue for M&A practitioners is how restrictive these deal protection devices can be. The Delaware Supreme Court has held that deal protection devices are subject to the enhanced security standard first announced in Unocal Corp. v. Mesa Petroleum Co. (13) and that such provisions cannot make a transaction a "fait accompli." (14)

   This Article contends that the relationship between the deal protection devices and sale process is derived from information flow and information costs. In a nutshell, the more extensive the pre-signing sale process, the more information costs the respective parties are made to bear. Consequently, a more accurate assessment of the target's value is achieved. When this is the case, the deal protection devices can be more restrictive. Conversely, single bidder negotiations can become a gamble in that each party has less information and subsequently lowered costs. On the downside, these information cost savings may not "pin the tail on the donkey" regarding the maximization of shareholder value. Accordingly, the deal protection devices should be less restrictive so as not to overly dissuade third parties from bidding. In other words, the sale process and the deal protection devices should bear a proportional relationship. This proportion is what I dub the "Golden Ratio of Corporate Deal-Making."

   The Golden Ratio of Corporate Deal-Making is consistent with auction theory principles that tend to favor competition as a way of extracting the most value for the target. (15) Moreover, the Delaware courts themselves have implicitly recognized this ratio as the ideal. (16) Despite this implicit recognition, however, the courts, in many cases, have failed to abide by the ratio by authorizing the same level of deal protection devices in a single bidder transaction as have occurred in a transaction resulting from a full auction. (17) This is problematic, as it has led to the erosion of the Unocal enhanced scrutiny standard for deal protection devices. (18)

   A few caveats regarding the scope of this Article are in order at this point. First, this Article assumes the applicability of Revlon and does not address the ongoing debate regarding which transactions trigger Revloris value maximization requirement. (19) Second, this Article assumes the application of the Unocal standard of review to deal protection devices and does not address the propriety of applying the Unocal enhanced standard to such devices. (20) Finally, and perhaps most importantly, this Article does not advocate that a...