Table of Contents Introduction I. Background A. Motivation for Deal Protection B. Prior Literature II. Recent Trends in Deal Protection A. End of Termination Fee Creep 1. Data analysis 2. Discussion B. Proliferation of Match Rights C. Emergence of "New Economy" Asset Lockups D. Emergence of Financing Arrangements with a Deal Protection Effect III. A Proposed Approach to Deal Protections A. Resolving the Unocal/Revlon Ambiguity B. Applying Basic Game Theory 1. Match rights 2. Asset lockups C. Adopting a Functional Approach Conclusion Introduction
It is well known in transactional practice that the magnitude of termination fees has gone up over the past thirty years. What used to be 1-2% of deal value in the 1980s (1) increased to 2-3% by the 1990s (2) and 3-4% by the 2000s. (3) This trend cannot be readily explained by changes in mergers and acquisitions (M&A) fundamentals: as a percent of deal value, it is not obvious why compensation for search costs, out-of-pocket costs, reputational costs, and opportunity costs should be higher today than it was in the 1980s. The more plausible explanation lies in the nature of transactional practice. Nearly two decades ago, Richard Beattie, then the managing partner at Simpson Thacher & Bartlett LLP in New York City, explained this trajectory:
The percentage that is okay has slowly risen. A year ago, two years ago, people were talking about two percent, two-and-a-half percent. Now, you hear them talking about three, three-and-a-half percent. Some are even saying four percent. You sit there and ask, 'On what basis are you doing that? Where did you get that number?' There hasn't been a specific challenge, so everybody pushes the envelope. (4) There are important policy reasons for the Delaware courts to set limits on deal protection. Sellers can gain leverage from judicial rules that require their management to search for bidders or to canvass the market as a matter of fiduciary duty. The purpose of these limits is to provide sell-side shareholders with full value and a meaningful shareholder vote. Legally shielding boards from preclusive deal protections prevents bidders from demanding such deal protections in the first place, which increases the likelihood that the target company will be acquired by the highest-value bidder. The result is greater allocational efficiency in the M&A marketplace (that is, resources will be more likely to flow to their most valuable uses), which improves overall social welfare.
In a 2000 article, one of us (along with coauthor John Coates) recommended that the Delaware courts provide guidance to practitioners on the permissible boundaries of deal protection. (5) Around the same time--while not actually invalidating any deal protections--the courts began to signal that 4-5% was at the very high end of what would be tolerated. (6) We present empirical evidence in this Article indicating that this guidance has had the desired effect: termination fees for Delaware targets (including any additive expense reimbursement) have capped out at just below this level, thus ending "termination fee creep." (7) We present further evidence that average termination fees are higher in non-Delaware jurisdictions, presumably due to the lack of judicial guidance in these jurisdictions as to the permissible limits on deal protection.
But consistent with thirty years of deal protection experience (8) and reflecting the fact that deal protections are for the most part fungible, deal protections have migrated from continued increases in termination fees to other areas where Delaware courts have signaled tolerance or have not yet provided guidance. We document three such areas in current transactional practice. First, match rights, which were unheard of in the 1990s, became ubiquitous by the 2010s. While practitioners claim that match rights should have no effect on M&A deals and while the Delaware courts have (perhaps based on these claims) signaled tolerance of match rights, we use basic game theory to document why match rights have a significant deterrent effect on prospective third-party bidders. Second, asset lockups, which disappeared from the landscape after the Delaware Supreme Court's seminal Revlon decision in 1986, (9) have reemerged. Unlike the hard-asset lockups of the 1980s, the new generation of asset lockups tends to involve intangible assets, such as licensing or service agreements. Third, and perhaps most interestingly, practitioners have begun implementing side agreements to the deal that have both a commercial purpose and a deal protection effect.
We offer three recommendations for how the Delaware courts should approach this new deal protection landscape. First, Delaware courts should clarify that deal protection must survive Unocal (10) /Unitrin (11) "preclusive" or "coercive" analysis in addition to Revlon "reasonableness" review. Second, Delaware courts should apply basic game theory to identify the deterrent effect of match rights and "new economy" asset lockups. And third, Delaware courts should take a functional approach to deal protection, meaning that collateral provisions which have a deal protection effect should be scrutinized under deal protection doctrine even if these agreements have some colorable business purpose as well.
The remainder of this Article proceeds as follows: Part I provides general background on deal protection, including the business motivations for such devices and the prior literature on this topic. Part II identifies the "new look" of deal protection, relying in part on a new database of M&A transactions from 2003 to 2015. Part III provides our recommendations on how Delaware courts should refine existing deal protection doctrine to accommodate the new landscape of deal protection.
Motivation for Deal Protection
In any public company acquisition, the need for shareholder and regulatory approval creates a window between the date of the deal announcement and the date the acquirer can close the deal. This window--which, based on the database used in this Article, (12) is three months on average--introduces the possibility that a higher-value bid will emerge. Because the target board's fiduciary duty typically requires consideration of any such higher offer, the acquirer cannot eliminate this risk through contracting with the target.
Instead, the typical solution in public company M&A is "deal protection" (equivalently, a "lockup agreement"), which provides value to the first bidder in the event that the target board accepts a higher-value bid. As defined by Coates and Subramanian, a deal protection is "a term in an agreement related to an M&A transaction involving a public company target that provides value to the bidder in the event that the transaction is not consummated due to specified conditions." (13)
In the 1980s, three main types of deal protection emerged: termination fees (or equivalently, "breakup fees" or "break fees"), which gave the acquirer the right to receive a cash amount from the target in the event that the target accepted a superior offer; asset lockups, which gave the acquirer the right to buy certain assets at a specified price in the event of an overbid (typically, at a price lower than fair market value); and stock option lockups, which gave the acquirer the right to buy a specified number of the shares of the target company (typically, due to stock exchange constraints, 19.9% of the outstanding shares (14)) at a specified price (typically the deal price). (15)
Deal protection has two main effects in the M&A marketplace. First, it encourages a first bidder to bid by compensating that bidder for, among other things, opportunity costs, reputational costs, and out-of-pocket expenses. (16) Second, it discourages second bidders from bidding because it siphons value out of the target company for the first bidder's benefit in the event of an overbid. (17) These two effects have directionally opposite implications for overall social welfare. The ex ante inducement effect for first bidders promotes value- enhancing deals, but the ex post deterrent effect for second bidders discourages potential bids that could increase target shareholder returns. Allocational efficiency therefore requires a balance between giving first bidders some deal protection to incentivize them to bid and, at the same time, not giving them excessive protections, which hinders competing bids. As reflected in the Delaware Court of Chancery's reluctance to adopt bright-line rules (18) and as other commentators have noted, (19) however, it would be difficult to answer the question how much protection is too much with a specific threshold.
There is a large body of theoretical and empirical literature on deal protection. In the realm of theory, Schwartz proposes a ban on termination fees and other deal protections to encourage ex post competition. (20) In contrast, Ayres, as well as Fraidin and Hanson, present theoretical models showing that under certain assumptions, deal protection should not reduce allocational efficiency in the M&A marketplace. (21) As a result, they propose a more tolerant view of deal protections. (22)
According to Ayres's model, lockups in particular reduce the reservation price (that is, the maximum bid that a bidder is willing to make) for all potential bidders. (23) This is so for the first bidder because lockups create an opportunity cost associated with increasing the bid, namely the cost of forgoing the possibility of profiting from the lockup (because that profit only materializes if the bidder loses the bidding contest). (24) For subsequent bidders, the lockup reduces their reservation value because it dilutes the value of the target. (25) Despite these effects, Ayres argues, lockups can also persuade a bidder to hold his offer open for a longer period and thus give the target board more time to create an auction. (26) Ayres then concludes that although a...