Business Law Prof Blog

Delaware Chancery Court and Auctions

The most interesting part of the new trilogy of opinions by Vice Chancellor Strine on private equity buyouts are his discussions on what a target board must do to secure the highest price.  In Lear the board did not violate its Revlon duties in securing the highest price and in Topps and Netsmart Technologies it did (or was likely to have, they were preliminary injunction motions).  The error in Netsmart was in not exploring a deal with "strategic buyers" as well as the private equity fund buyers.  The Judge, although asked to do so by the plaintiffs, did not fault the Special Committee's  blow- by- blow negotiating strategy with the private equity buyers, however.  Similarly in Lear, although critical of the Special Committee's specific negotiations as "far from ideal," the Judge refused say they were a violation of the board's legal duties.  Finally, in Topps, the Judge found the negotiations leading up to a merger agreement were reasonable.  The mistake the board made was the "go shop" period;  the board refused a higher bid and then refused to waive a standstill agreement with the second buyer (so it could not mount a tender offer or make public comment).  Again the court focused on structural decisions, not individual bargaining strategy, although the line was closer in the Topps case than the earlier two.  Slowly, the court is elaborating a list of "don'ts" for those negotiating private equity buyouts. 

Buyouts and the Delaware Chancery Court

The Delaware Chancery Court has issued recently three opinions critical of private equity buyouts.  They involve the buyouts of Topps Co., Lear Corp. and Netsmart Technologies.  Vice Chancellor Leo Strine Jr. wrote all three opinions.  In the Topps and Lear opinions, Chancellor Strine faulted the target companies with not providing information to their shareholders, asked to ratify the transactions, that may shield light on the incentives and motives of the company managers in recommending the deals.  In Netsmart, the Chancellor questioned whether the target company had disclosed adequately its efforts (or lack of efforts) to assess the market for other potential purchasers.  Each decision deals with the management conflicts inherent in modern private equity buyouts under the guise of adequate disclosure.  At issue will be how strongly management must word an adequate disclosure to meet the legal standards.  I am hopeful the legal standard will requirement something akin to a statement, if management is in the buyout group (or collecting a huge golden parachute payment of some form contingent on the deal), that "The managers of your company are on the opposite side of the deal being recommended and have a direct financial reward in paying you too little for your stock."       

Taxing Hedge Funds

The hearings have begun on taxing hedge fund and private equity fund "carry" as ordinary income.  The attack is based on 1) they make money, 2) they are speculators, and 3) they are instruments of change.  The is another attack on the financial speculators (gamblers who do not "make shoes") by those who under-appreciate their role in a capitalist economy.  There are other partnerships that allocate profits disproportionately to capital contributions: venture capital funds, which have a positive public image, REITS (holding land), oil and gas partnerships, and others.  Either Congress must exempt these groups, proving that it is taxing "speculators" and risk the inevitable line-drawing problems, or it must include them in the interest of tax neutrality and absorb the social costs of regulating efficient forms of capital investment that do not tie a divison of return to proportional capital contributions.  This is going to get very, very messy.

SEC Proposal on Shareholder Voting

The SEC is circulating a proposal, not yet formally proposed, to enable shareholders holding 5% or more of a public corporation's stock to put nominees for the board of directors on the corporation's proxy card.  The proposal will attract tremendous opposition from both company managements, who support current practice, and from shareholders, who believe the 5% requirement is too high.  The opposition will probably cow the SEC into doing nothing. 

The SEC approach is a further erosion of its "disclosure only" theory of regulation and a logic step from Rule 14a-8, a rule that requires firms to put specified items requested by shareholders on their proxy cards.  The further the SEC steps away from its "disclosure" regulation role the more it displaces state corporate codes control over corporate structure.  Some steps at the federal level seem to inevitably turn into to larger steps. 

In any event, the way out the SEC's conundrum, is to feature choice not mandatory rule.  Publicly-traded corporations could be asked to themselves produce a shareholder voting system that shareholders would have to ratify every five (three??) years or so. Shareholders could submit their own amendments at the ratification vote.  Some corporations could opt for 5 year board elections, others for 1 year elections with liberal nominations.  Supermajority requirements should require a supermajority ratification vote.  A robust system of choice could include modifications of shareholder derivative litigation rules or the choice could be limited to voting procedures.  Choice would blunt the criticism of both management and shareholder groups to the current proposal and leave the rule to a shareholder vote.       

Midwest Air Group Takeover

The refusal of the board of Midwest Air Group to sell to AirTran Holdings for $400 million, despite the overwhelming support of Midwest shareholders, is a classic illustration of the power of constituency statutes.  Midwest is incorporated in Wisconsin, a state that by legislation empowers corporate boards to look after constituencies other that shareholders (read employees).  The Midwest board used the statute to justify the rejection of the bid.  Midwest shareholders are now voting the board out, one election at a time (it will take two years; the shareholders elect only one-third of the board a year).  The CEO of Midwest, with a healthy yearly salary, has only a modest golden parachute in place.  Look for a bigger payout (a "consulting contract") and a deal.  Constituency statutes do not help non-shareholder groups, other than senior excutives of course.

Milberg Weiss's Woes

David J. Bershad, a former partner with the nation's leading plaintiff securities firm for over twenty years (now split into two firms), has pleaded guilty to a 20 count indictment detailing illegal kickbacks to named plaintiffs in the firm's lawsuits.  He has also agreed to cooperate with federal prosecutors in providing information that may be used against other high profile partners (William S. Lerach and Melvyn I. Weiss may be probable targets).  This is bad stuff, despoiling the name of lawyers, which needs no further rotting.  Folks in industry (and their lawyers) often suspected that the named shareholders where paid puppets of the plaintiff's lawyers but they could not prove it.  The government has (using a deal with one of the paid named plaintiffs would had other criminal troubles and agreed to sing). [I cannot get over the hubris of using the same named plaintiff in 150 or so suits! Did the lawyers think no one would notice???]  This is the big break in the case -- the facts are now out and confirmed; the prosecutors will now play out the string on the remaining targets.

The case is largely historical due to a change made in 1995 by Congress that permits large shareholders to take over securities class action cases brought by smaller ones.  The new larger plaintiffs often bring their own lawyers.  There is still an incentive to find (bribe) a small shareholder to bring the case and stimulate larger shareholder to take the case, but the incentive to bribe a smaller shareholder to sue initially is diluted substantially.  A final salutary change would be a minimum shareholder stake requirement for private litigation that is small (.01% in stock or $25,000 in value, whichever is less) but large enough to discourage the practice of holding one share in 500 companies or so solely to be available to plaintiff's firms as a named plaintiff.         

Taxes and Takeovers

Before Congress charges into new taxes on hedge funds and private equity funds it ought to pause and consider its record on special taxes aimed at takeovers.  Beginning in 1969 with section 279 and continuing to 1989 with section 163, Congress has attempted to discourage takeovers with various tax provisions aimed at debt financing.  We also have special rules for golden parachutes and pension plan cash-outs and special rules for the carry-over (and carry-back) of tax attributes.  All the rules need careful re-examination; most of them are either easily avoided and/or have consequences in deal structuring that are counterproductive.  Now we have Congress ready to impose special rules on partnerships in which a managing partner (the hedge fund firm or private equity firm) earns a portion of the profits (the "carry") to attack another form of an equity acquisition or takeover.  Once again the results will be the same.  Deal structures will change to meet the new rules and the new structures will cost more to create, but deals will still happen and tax collections will increase only marginally once the clever planners take over.  More rules and new regulations will be needed to stop the new deal forms or, as is usually the case, we just resign ourselves to the new forms. 

The new proposals themselves confuse reporters (and the public).  One reads commonly in the press, for example, that one bill pending in Congress seeks to have publicly-traded master limited partnerships (now taxed at 15%) "taxed like corporations" (at 35%).  Publicly traded limited partnerships are now taxed as separate entities and are now taxed at 35% on ordinary income; like corporations, such partnerships are taxed at 15% on long term capital gains (the business of equity based investment funds).  If a hedge fund was a corporation it would pay 15% on investment gains.  And, by the way, most corporations have an effective tax rate, even on ordinary income, at closer to 18%.   In essence, some in Congress want special rules for managing partners in partnerships.  Congress wants managing partners to pay ordinary income taxes on their investment gains, now taxed at capital gains rates.  Corporate managers who receive at-the-money options in lieu in all corporate investments (the equivalent of a "carry") would be better off under such a rule.  Publicly traded hedge funds will incorporate on the IPO.  There is no substitute for scrapping the double tax system and designing a flow through tax system for all business entities.  It would stop all the games and enable Congress to level whatever rates it wants on business income at the individual level.                

Supreme Court and Business

It was inevitable -- the Supreme Court is under attack by the popular press.  The Court's decisions on social issues has upset the fair minded.  One of the attacks is interesting; separate the Court from its political base by labeling it pro-business and anti-shareholder.  Even conservatives are pro-shareholder.  The attack is transparent.  Shareholders as well as businesses are better off when frivolous litigation is harder to bring.  The balance between legitimate and illegitimate lawsuits is important to shareholder value.  The court, by adjusting the balance, if it is correct, is not anti-shareholder; it is pro-shareholder. There is no evidence that the Court is biased toward or corrupted by big business; such challenges after the public legitimacy of the court and should not be lightly made, especially to serve other social purposes.  We have come through an era when many have come to believe that the court, like a kindly grandfather, is the repository of whatever is fair.  Jurisdiction, separation and balance of powers, executive or legislative prerogative, federalism, and limited judicial factfinding are concepts for wimps; the court should declare what is just and fair and tell everybody else to stuff it.  If the Court does not do what you think is fair (long statutes of limitation for discrimination actions), scream about it and impugn the integrity of the justices who do not do what you want.  That's the ticket. 

The Roberts court has a better sense of what the Court is and should be; now we need the press to educate the public not to mislead them.

Bell Canada Buyout

The 51.7 billion (Canadian $$) buyout for Canada's largest company is another one that smells.  The primary buyout group includes the Ontario Teacher's Pension Plan.  First, their involvement meets the 47% cap on foreign ownership under Canadian law that limits other United States buyout groups from actively bidding.  In other words, they are getting it cheap and if the Canadian Parliament lifts the cap they can immediately resell for a profit.  Second, the what is a teacher's pension plan doing with so much money in one deal?  Using teachers pension money to speculate on a buyout makes sense only in very small amounts.  Third, the bidding process was very secretive and led to speculation about a broad that favored a bidder that would protect existing management.  The Teacher's Pension Plan managers have been publicly very complimentary of existing managers.  It does not take much in an action to favor one bidder over another, managers have advisers that know the tricks; a secretive auction makes the temptation overwhelming.  We need to get better control over the conflicted role of existing management in buyouts, Canadian and American. 

Bausch & Lomb: A Sorry Tale

Bausch & Lomb, a 154 year old company, is selling to a private equity firm, Warburg Pincus for $65 a share.  The company is struggling and its stock price is well down from highs of $80 a share two years ago.  The CEO responsible for the company's recent setbacks is Ronald L. Zarella.  Zarella will receive a golden parachute payout of $40 million and have an equity stake in the privatized company.  If the company turns around, he will rake it more millions.  There are three things seriously wrong with this story:  First, Zarella is profiting from his own weak managing record (there were accounting problems while he led the company).  Second, Zarella is conflicted in the buyout both by the overly generous golden parachute and by his participation in the purchaser. And third, the purchaser will undoubtedly do the cookie cutter "Peltz thing" to print money -- sell under-producing assets, sell undervalued assets, leverage and distribute money to shareholders (an extraordinary dividend or buyback).   This is not rocket science; it is pathetically simple. If this is a viable strategy for the private company it is surely a viable strategy for a public company; Zarella should have done the Peltz thing as CEO of the public company.  The entire deal smells.  At some point, we are going to have to come to grip with the fact them many of the private buyouts are a huge reward for those who should not be rewarded and this reward may itself be a primary reason for the buyout.  Buyout groups look for companies with poor managers and fat golden parachute agreements; convince the manager to sell, cash the agreement, and come abroad the buyout team which can use his knowledge and contacts (and inside information) and tell him how to behave. We need a decent judicial opinion on one of these deals that lays out more protections for shareholders.