The Law and Economics of Mergers and Acquisitions
Summary and Keywords
Law and economics has proved a particularly fruitful scholarly approach in the field of mergers and acquisitions. A huge law and economics literature has developed, providing critical insights into merger activity in general and the proper role of corporate and securities law in regulating this activity.
Early economic research examined the motivations for merger activity and the antitrust implications of mergers. Later scholarship elucidated the important disciplining effects on management from merger activity and the market for corporate control. If management performs poorly, causing a firm to become undervalued relative to a well-managed firm, the firm becomes vulnerable to a takeover where management will be replaced. This prospect provides a powerful incentive for management to perform well.
More recent work has revealed the limitations of market discipline on management actions in the merger context, and the corresponding role of corporate law in protecting stockholders. Because a merger is generally the final interaction between management and the other stakeholders in a firm, the typical constraints and mechanisms of accountability that otherwise constrain managerial opportunism may be rendered ineffective. This work has played a central role in informing modern jurisprudence. It has shaped the application of enhanced judicial scrutiny of management actions in the merger context, as embodied in the landmark Delaware cases Unocal and Revlon. The law and economics literature has also made important contribution to more recent developments in stockholder appraisal. The law and economics tradition has also provided a useful framework for evaluating the dynamics of merger litigation, including stockholder appraisal, and the extent to which such litigation can be made to serve a useful role in corporate governance.
Foundational Principles and the Role of Corporate Law
The dominant contractarian approach to corporate law views the primary role of corporate law as facilitating voluntary, wealth-increasing bargaining among the key corporate constituents—most prominently between the stockholders who provide equity financing, and the managers who control the corporate assets (e.g., Bainbridge, 1997; Easterbrook & Fischel, 1989, 1991; Ulen, 1993).1 The usual way corporate law approaches this is by attempting to reduce the transaction costs associated with such bargaining (e.g., Butler, 1989, pp. 119–120). It does this in two ways. First, corporate codes provide a set of default rules that apply in the absence of contrary agreement, thus reducing the number of terms that must be individually negotiated (Easterbrook & Fischel, 1991).2 Second, courts have developed a set of fiduciary principles—in particular, managers’ duties of care and loyalty—that serve as a backstop for problems that are not clearly encompassed by unavoidably incomplete contracts. By providing an ex post mechanism for resolving disputes, fiduciary duty law dramatically reduces the number of potential situations that must be negotiated over ex ante (Easterbrook & Fischel, 1991).3 In both cases, corporate law can perform best by selecting rules that the parties themselves would have selected had they bargained over the issue (Posner, 1973; Easterbrook & Fischel, 1991).4 In most cases, this will be a rule that can be expected, ex ante, to maximize corporate wealth in the long term (Easterbrook & Fischel, 1991).5 Where the wealth-maximizing rule is difficult to determine or likely to be highly situation-dependent, the law may encourage parties to bargain to their own solution by imposing a so-called “penalty default” (Ayres & Gertner, 1989).6 Typically, this takes the form of a default rule that penalizes the better-informed party, which can then be altered by contrary agreement (Ayres & Gertner, 1989).7 In either case, the question thus becomes what economic insights can tell us about the rules stockholders and managers would choose as wealth-maximizing.
Early economic research into merger activity focused on the motivations for takeovers. Among the common reasons cited for one firm to merge with another are to take advantage of economies of scale and scope, to capture synergies, to diversify by forming conglomerates, and to expand into new geographic and product markets via acquisition rather than organic growth (Carney, 2011, pp. 9–18). In the first half of the 20th century, however, economic and legal scholars paid special attention to the potential anti-competitive effects of mergers, and the resulting antitrust implications. In particular, a company may be willing to pay a premium to acquire a strategic competitor in the expectation that the resulting reduction in competition and increased market share will allow it to profit by engaging in monopoly pricing. By 1965, economists’ hostility to these so-called “horizontal” mergers was so widespread and influential that Henry Manne could write that “the position has gained considerable legal currency that any merger between competing firms is at least suspect and perhaps per se illegal” under the Sherman Antitrust Act (Manne, 1965, p. 110).
The modern era of law and economics in the field of mergers began with three foundational contributions. The first came from Henry Manne, who argued that mergers perform a valuable corporate governance function. Under the classic conception of the firm formulated by Berle and Means (1932), the modern corporation is characterized by the separation of ownership and control. The shareholders own the firm, while the directors and officers actually control the firm.8 This separation gives rise to a pervasive agency problem, in that the directors and officers will naturally be tempted to use their control to benefit themselves at the expense of stockholders, both by slacking off and by diverting corporate resources to themselves. This difficulty gives rise to serious agency costs, as stockholders protect themselves via costly monitoring activities and contractual protections, while directors and officers engage in bonding activities in an attempt to reassure stockholders (Jensen & Meckling, 1976). The traditional corporate law response to the agency problem was to regulate it via fiduciary duties of care and loyalty. The hesitance of courts to second-guess business decisions, though—as embodied by the business judgment rule—placed limits on the utility of fiduciary duties for policing mismanagement.
Manne’s fundamental insight was that the possibility of a takeover places a powerful constraint on mismanagement. This insight sprang from the proposition that “the control of corporations may constitute a valuable asset . . . independent of any interest in either economies of scale or monopoly profits” and that mergers may be motivated by the ability to profit from a change of control (Manne, 1965, p. 112). If a firm is managed poorly—whether from sloth, incompetence, or actual managerial looting—its stock price, in even a marginally efficient market, will be lower than it would be if it were managed well. As a result, a would-be buyer could profit by taking over the company and replacing the incompetent or disloyal management with better managers. Consider, for example, a company that, if managed competently, would be worth $100 per share. Mismanagement, however, has reduced cash flows to stockholders such that the stock price has fallen to $75 per share. An outside bidder could afford to pay a premium to acquire control of the company, replace management, and profit from this $25 per share difference. Manne noted that “taking over control of badly run corporations is one of the most important ‘get-rich-quick’ opportunities in our economy today” (Manne, 1965, p. 113).
This dynamic—which Manne termed “the market for corporate control”—limits the extent to which incumbent managers can mismanage a firm. Management may wish to loot the firms they control, but if their doing so depresses the stock price by too much, they risk facing a takeover and being replaced. Managers who wish to keep their positions are thus given powerful incentives to manage their firms well enough to avoid the attention of takeover artists. The constant constraint the market for corporate control places on mismanagement is potentially more significant than the sporadic and inconsistent supervision by courts or the weak monitoring of dispersed stockholders (Jensen & Ruback, 1983). Manne’s insights transformed the dominant view of merger activity from something that should be viewed with suspicion on antitrust grounds and disfavored by the law, to being an important mechanism of corporate governance that ought to be protected, and perhaps facilitated, by corporate law. This is especially so given the omnipresent threat that incumbent management may use their control over the corporation to fight off value-creating takeovers that would threaten their jobs and perquisites.
The second foundational contribution to the modern law and economics of mergers grew out of the emergence of modern portfolio theory in finance. One of the central insights of modern portfolio theory is that investors can virtually eliminate their exposure to firm-specific risk by holding a diversified portfolio of securities issued by a large number of firms (Markowitz, 1952; see also Brealey, Myers, & Allen, 2010, pp. 185–204). In a well-developed market, most investors are thus best served by holding a diversified portfolio, rather than trying to pick and choose individual stocks. This insight is one of the factors behind the remarkable rise of index investing over the past several decades (Hunnicutt, 2017).
The rise of diversified investors had two immediate consequences for the law and economics of mergers. First, it called into question the economic rationale for the large conglomerates that had arisen in the 1960s (Ravenscraft & Scherer, 1987, pp. 54–55). Among the justifications for these conglomerates was that by diversifying across a number of business segments, a conglomerate could reduce the risks faced by stockholders. In a world where investors could easily and cheaply achieve the same risk reduction simply by holding a diversified portfolio, this justification lost its force. Investors would, in general, be better served by investing in a number of separate firms focused on a single business in which they had a comparative advantage, rather than a single jack-of-all-trades conglomerate. The result was the wave of “de-conglomeratization” activity in the 1970s and 1980s (Cheffins & Amour, 2008, pp. 25–27).
A second consequence of diversified stockholding is to render less pressing the question of the allocation of gains from a merger. In a world of undiversified stockholders, it matters a great deal to target stockholders that they get as large a piece of any gains from a merger as possible. Indeed, stockholders may want to empower directors to use defensive tactics such as the poison pill in order to extract as much of the gains as possible. They may also want courts to protect them by requiring acquirers to “share” any gains with target stockholders.9
In an argument advanced most forcefully by Frank Easterbrook and Daniel Fischel, diversified stockholders have less need for such protection. In some transactions, a diversified stockholder will be on the buying side, in others he/she will be on the selling side. In the long run, the diversified stockholder benefits most by maximizing the total amount of gains from mergers, and is largely indifferent as to how those gains are allocated among buyers and sellers (Easterbrook & Fischel, 1991, pp. 122–124). Any sharing rule or defensive tactics that may threaten to block a positive-value merger would be wealth-reducing. This argument is not, of course, absolute. In the first place, not all investors will be fully diversified.10 More fundamentally, however, an increasing number of mergers are public-to-private, where a public company is taken private by management or private equity funds. Even a diversified investor will be unable to participate in gains captured by managers and private equity funds, which are generally not open to outside investors.
A third foundational economic insight comes from game theory. In many respects, the relationship of managers and stockholders in a firm resembles the classic game theoretical construct of the Iterated Prisoners’ Dilemma (Griffith, 2003, pp. 1937–1947). In such a game, both parties typically have an incentive to cooperate because of the prospect of being punished for unfaithfulness in future iterations (Axelrod & Hamilton, 1981). As Ralph Winter pointed out in a seminal article, as much as management may wish to exploit and rob stockholders, their ability to do so is heavily constrained by extra-legal constraints, such as capital markets, product markets, labor markets, and annual director elections, among others (Winter, 1977). Managers who behave unfaithfully in one period face shaming and punishment in the next. A merger, however, is a “final period” transaction (Axelrod, 1984; Ledyard, 1998). While the underlying business may persist, a merger is typically the final interaction between the target firm’s management and stockholders (Bainbridge, 2013).11 This distinguishes a merger from other managerial decisions, which take place in the context of repeat interactions. In a final period decision, many former constraints on misbehavior disappear (Griffith, 2003).12 If management can successfully expropriate value in the context of a merger—by steering the firm to a favored bidder, by engaging in empire building, by trading stockholder value for side payments or employment deals, or otherwise—they face little prospect of extra-legal consequences in the future. As a result, legal constraints take on higher significance.
Taken together, these insights have a number of implications for the design of corporate law respecting mergers and acquisitions (M&A). In general, stockholders should prefer an active market for corporate control to serve as a bulwark against mismanagement.13 As a result, stockholders should prefer a legal regime that takes a dim view of defensive tactics such as poison pills that may tend to ward off value-adding takeovers and entrench incumbent management. Most famously, Easterbrook and Fischel have argued that a target board should properly remain passive in the face of an outside takeover defense (Easterbrook & Fischel, 1981). In general, stockholders should also disfavor strong measures to ensure sharing of gains created by a merger, in that such measures may inhibit the creation of those gains in the first place. In the context of a go-private deal, however, these conclusions may be less compelling, in that stockholders may want to empower management to use defensive tactics to extract a greater share of the gains—which they would otherwise not be able to obtain via diversification. More generally, stockholders should want some form of protection against management entering—perhaps due to conflicts of interest—into value-destroying mergers that leave stockholders worse off than if no merger took place (Easterbrook & Fischel, 1991).14 Finally, stockholders may want greater judicial supervision of potential duty-of-loyalty violations by management, which may otherwise go undeterred in the context of a final period transaction.
Fiduciary Duties and Takeover Defenses
This section discusses the law’s implementation of the principles introduced in the section “Foundational Principles and the Role of Corporate Law.” The general outlines are familiar. In the 1980s, courts in Delaware—the leading corporate law jurisdiction—decided a series of cases imposing a heightened standard of review of managerial actions in the context of a merger. While the Delaware courts refused to formulate any new fiduciary duties, they made clear that the duties of care and loyalty required decisions to fight off hostile takeovers via defensive measures to be subject to special scrutiny, and required managers to act to maximize stockholder value in the sale of the firm. Since the 1980s, however—at least partly in response to the dynamics of merger litigation discussed in the section “Merger Litigation and Statutory Appraisal”—the courts have gradually backed off from this heightened scrutiny in favor of a more deferential, business judgment rule-like approach to merger-related decisions, at least where procedural safeguards are present, such as negotiating committees of independent directors and informed stockholder votes.
Four 1980s cases set the basic ground rules. First, in Weinberger v. UOP, Inc. (1983), the Delaware Supreme Court declined to give a controlling stockholder squeeze-out business judgment rule deference, and instead required the buyer to demonstrate that the transaction was “entirely fair” to the minority stockholders. Second, in Smith v. Van Gorkom (1985), the Court applied what amounted to heightened scrutiny to alleged duty-of-care violations, requiring the board to avail itself of all information reasonably available to it in evaluating the value of the company in a takeover, and applying a gross negligence standard. Third, in Unocal v. Mesa Petroleum (1985), the Court held that, due to the “omnipresent specter” of managerial self-interest, the use of takeover defenses would be subject to heightened scrutiny. Finally, in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (1986), the Court held that the directors’ fiduciary obligations required them to obtain the highest price reasonably available once a decision was made to sell control of the company, thus requiring them to not unduly favor any particular bidder. Beyond this case law stood statutory appraisal, which entitled minority stockholders to dissent from a cash-out merger and receive a judicial determination of the fair value of their shares, defined as the stockholder’s proportional share of the value of the firm on a standalone basis (8 Del. C. § 262).15
Almost immediately, the Delaware courts began a long process of weakening these standards. The Delaware legislature took the first step, following Van Gorkum with legislation allowing corporations to exculpate directors for monetary liability for breaches of the duty of care (8 Del. C.§ 102(b)(7)).16 The courts soon followed suit. In some cases, this was accomplished by taking a deferential approach to heightened scrutiny, while in others it was accomplished by providing some form of safe harbor in the presence of procedural safeguards. As to the former, in a series of cases, the Delaware courts made clear that there is “no single blueprint” for satisfying a board’s Revlon duties, and that Revlon certainly does not require management to conduct a full-scale auction in order to sell the firm (e.g., Lyondell Chemical Co. v. Ryan, 2009). Instead, the board must simply behave in a “reasonable” fashion and in “good faith” (Lyondell Chemical Co. v. Ryan, 2009). Similarly, the scrutiny promised by Unocal has dissolved into wide latitude for boards to employ defensive tactics to defeat an unwanted takeover. Most notably, under Unitrin, Inc. v. American General Corp. (1995), a board need only show a threat to the firm—which can be as basic as management believing the proposed takeover price undervalues the firm—and that the takeover defenses employed were reasonable and not coercive or preclusive. After Unitrin, a board can refuse to redeem a poison pill and allow a hostile offer to proceed even where the offer is non-coercive, at a large premium to market price, and clearly acceptable to stockholders (Air Products and Chemicals, Inc. v. Airgas, Inc., 2011).
As for procedural safe harbors, the Delaware Supreme Court gradually enumerated various procedural safeguards which, if employed, would subject the transaction to less searching review. Important early cases include Rosenblatt v. Getty Oil (1985), in which the court held that approval of a controlling stockholder squeeze-out by an informed vote of the minority stockholders would shift the burden of proof on entire fairness to the plaintiff, and Kahn v. Lynch (1994), which similarly allowed the burden of proof to be shifted following approval of a squeeze-out by a committee of independent directors. More recently, in Kahn v. M&F Worldwide Corp. (2014), the Delaware Supreme Court determined that business judgment rule deference is appropriate where the transaction has been approved by both an informed vote of the minority stockholders and a committee of independent directors. Similarly, in the recent case Corwin v. KKR (2015), the court extended business judgment rule deference in post-closing damages actions to third-party mergers that have been approved by an informed, uncoerced vote of the stockholders.
In appraisal litigation, the Delaware Supreme Court in Weinberger (1983) rejected the old, more mechanical Delaware Block Method for calculating fair value, and instructed trial courts to instead consider any generally accepted financial techniques for determining fair value (p. 711).17 This instruction was in keeping with the language of the then-recently amended appraisal statute, which instructed courts to consider “all relevant evidence” of fair value. At the same time, the Weinberger Court emphasized that the target company should be valued as a standalone firm, excluding any synergies or other gains from the merger (p. 711). In recent appraisal decisions, the Delaware Supreme Court has paralleled its increasing deference in the fiduciary duty conflict, holding that, when the deal process has the trappings of arm’s-length bargaining, the resulting negotiated deal price should be entitled to heavy and perhaps dispositive weight in calculating fair value (Dell, Inc. v. Magnetar Glob. Event Driven Master Fund Ltd., 2017; DFC Glob. Corp. v. Muirfield Value P’nrs, L.P., 2017).
While much of Delaware’s merger jurisprudence is consistent with the economic reasoning canvassed in the section “Foundational Principles and the Role of Corporate Law,” in some ways it departs from the economic understanding of the proper role of merger law. On the one hand, corporate law has broadly facilitated merger activity, declining to impose meaningful ex ante regulation that might impede the market for corporate control, and instead relying on ex post litigation to police managerial opportunism. To the extent ex ante regulation exists, it is primarily imposed by the federal government, and comes from outside corporate law—for example, antitrust and securities regulation (e.g., Hart-Scott-Rodino Antitrust Improvements Act, 1976). In addition, Delaware courts have not imposed any strong “sharing” requirement that would imperil the functioning of the market for corporate control. They have also, in theory, applied heightened scrutiny to the use of takeover defenses that might tend to entrench existing management, as well as to other managerial decisions in the context of a final period change-of-control transaction. Via appraisal, Delaware law also provides a backstop to ensure minority stockholders are not having their interests cashed out for less than their proportional share of the standalone value of the firm.
On the other hand, Delaware jurisprudence tends to make little distinction between public-to-public mergers, where shareholders can plausibly protect themselves against expropriation by diversification, and public-to-private mergers where they cannot. Instead, the same standards and level of scrutiny are applied to both types of transactions. Moreover, Delaware provides both more and less scrutiny to merger-related decisions than is called for by the economic reasoning of Foundational Principles and the Role of Corporate Law. The “entire fairness” standard for controller squeeze-outs, for example, sometimes appears to verge on a sharing requirement. The Model Business Corporations Act approach—using appraisal for standalone value as the sole remedy in squeeze-outs—is arguably more in keeping with the law and economics understanding. Moreover, in practice, incumbent management is given almost free rein to employ defensive tactics to defeat a takeover at a premium to the market price, apparently out of a belief that management knows the value of the firm better than the market, and that such tactics are necessary in order for management to extract more of the gains from a merger for their stockholders.18
Additionally, the heightened scrutiny of final period decisions promised by Weinberger, Revlon, and Unocal can be easily avoided in practice by the employment of procedural safeguards such as an independent negotiating committee and informed stockholder vote. Delaware courts have generally justified this relaxation of scrutiny on two grounds. First, the procedural safeguards themselves largely vitiate the agency problems that might otherwise pollute final period decisions, in effect allowing independent directors and stockholders, rather than courts, to serve as monitors. Second, the incentives involved in merger litigation were such that it could serve no useful purpose, rendering enhanced scrutiny pointless in the first place. These propositions, which are the subject of substantial dispute and stand at the forefront of current research, are discussed further in the section “Merger Litigation and Statutory Appraisal.”
Merger Litigation and Statutory Appraisal
Given corporate law’s reliance on ex post litigation to police managerial opportunism in connection with mergers, the efficient functioning of this litigation takes on special significance. Three types of litigation are most prominent: actions by thwarted bidders; stockholder fiduciary duty class actions; and appraisal actions. Actions by thwarted bidders are rare given the poor track record of success since the mid-1990s, leaving class actions and appraisal as the main bulwarks. Unfortunately, a large body of legal and economic scholarship has shown that merger class actions—plagued by agency costs—have not functioned well, leading the Delaware courts to curtail them, as described in the section “Fiduciary Duties and Takeover Defenses.” Recent research suggests that appraisal is functioning better, though the proper role of appraisal remains controversial, and the appropriate contours of appraisal remain the subject of dispute.
The class action mechanism itself is designed to overcome the collective action problems endemic to mass litigation such as stockholder actions. In the absence of aggregation via a class action, each aggrieved stockholder has an incentive to free ride and let someone else bear the cost of litigation, which may be too great for even a meritorious suit to be worthwhile for any individual stockholder (Romano, 1991).19 Aggregation via class action, however, replaces this collective action problem with an agency problem. In practice, the plaintiff’s attorney bringing the action typically has a more concentrated economic interest than any individual stockholder, and may have interests that diverge from those of the stockholders (Burch, 2012, p. 1292; Korsmo & Myers, 2016, pp. 1333–1337). Dispersed stockholders will typically have little incentive or ability to engage in effective monitoring of the attorneys.20
The agency problems in stockholder litigation—which were first brought to prominence by scholars examining the functioning of securities and mass torts class actions (e.g., Alexander, 1991; Coffee, 1995; Romano, 1991, p. 55)—lead to several predictable consequences. First, plaintiff’s attorneys will seek to divert as much of the value of the litigation as possible to themselves. Second, in the absence of effective monitoring by anyone with a stake in the affected firms, plaintiff’s attorneys will bring value-destroying nuisance actions designed to extract quick settlements by threatening the defendant with high litigation costs. Nuisance suits are especially likely where, as in merger litigation, the costs of discovery are highly asymmetric, falling primarily on the defendant (Alexander, 1991; Bebchuk, 1988; Coffee, 1995; Rosenberg & Shavell, 1985).21 Third, plaintiff’s attorneys will be tempted to settle even meritorious claims for too little, given that “a settlement offer that provided recovery of the attorney’s tangible and opportunity costs could loom larger than the prospect of aggressively pursuing the action . . . .” (Cox, Thomas, & Kiku, 2006, p. 1593). In this, plaintiff’s attorneys find an enthusiastic partner in defendants able to secure broad releases of claims at low cost (Griffith & Lahav, 2013, pp. 1057–1058).
Scholars have observed all of these predicted consequences in merger litigation. By the 2010s nearly every economically significant merger transaction was facing at least one fiduciary duty class action (Cain & Solomon, 2015). These claims were being brought indiscriminately, with no apparent relation to the adequacy of the merger consideration, and thus served no meaningful deterrence purpose (Korsmo & Myers, 2014). The claims were then almost all being settled quickly, with plaintiff’s attorneys receiving substantial fees, defendants receiving broad releases, stockholders receiving little or nothing of value—usually only additional disclosures of dubious value—and courts exercising little meaningful supervision (Fisch, Griffith, & Solomon, 2015).
In response to the evidence that merger class actions were serving no valid purpose, Delaware courts took two steps. First, as discussed in the section “Fiduciary Duties and Takeover Defenses,” they expanded the safe harbor of business judgment rule deference to transactions where the procedural safeguards of independent director and minority stockholder approval are employed. Scholarly opinion is divided on this step. Some view it as a justified response to the increasing incidence of independent directors and the increasing sophistication of large institutional stockholders (Solomon & Thomas, 2017), and as an important incentive for management to employ such safeguards in the first place (Gilson & Gordon, 2003, pp. 839–840; Subramanian, 2005, pp. 60–61). Other research has called into question the ability of independent directors and institutional stockholders to effectively police insider opportunism (Bhagat & Black, 1999; Korsmo, forthcoming 2019; Langevoort, 2001; Romano, 2005; Velikonja, 2014, p. 864). The impact of MFW and Corwin on M&A practice will likely be one of the primary questions for law and economics scholars in the coming years.
The second recent step taken by Delaware courts was to crack down on the collusive disclosure-only settlements that drove the wave of abusive merger litigation. Most prominently, in In re Trulia (2016), the Court of Chancery rejected a proposed settlement that had provided only for additional, arguably non-material disclosure, a broad release, and fees for the plaintiff’s attorneys. More importantly, the court made clear that, going forward, disclosure-only settlements will only be approved where the new disclosures are “plainly material” and the accompanying releases of liability are “narrowly circumscribed” (In re Trulia, 2016, p. 898).
Trulia’s impact on patterns of merger litigation and settlement is an area of active study. Early indications are that the number of filings in Delaware has dropped dramatically, but that much of the litigation has migrated into federal and other state courts that have not adopted the Trulia standard (Cain, Fisch, Solomon, & Thomas, 2018; Neuwirth et al., 2017; Wolters & Emeritz, 2017). The issue of “multi-forum” litigation has been a topic of research for some time (Griffith & Lahav, 2013; Myers, 2014; Micheletti & Parker, 2012; Thomas & Thompson, 2012), but has taken on increased significance in the wake of Trulia. While some argue that firms could avoid the problem by adopting exclusive forum bylaws to force stockholder suits back into Delaware court (Grundfest, 2012; Grundfest & Savelle, 2013), others have suggested such bylaws are unlikely to be successful, in part because defendants have an incentive to enforce them selectively, declining to do so where they can inexpensively obtain a broad release outside of Delaware (Chandler & Rickey, 2017; Griffith, 2017). The contours of multi-forum litigation and methods for addressing it remain an active field of law and economics research.
Stockholder appraisal, the other primary avenue of redress for merger-related misconduct, also represents a burgeoning field of research. The structure of the appraisal remedy is such that it does not suffer from the serious agency costs that plague the fiduciary duty class action. Appraisal actions are individual rather than class actions, with appraisal petitioners typically amassing a substantial position in the stock after the challenged deal has been announced. This ensures that the petitioner has a concentrated economic position and is able to effectively monitor the attorneys (Korsmo & Myers, 2016, pp. 1333–1337). The petitioner must also forgo the merger consideration and bear their own litigation expenses in order to pursue appraisal, making a claim far more expensive to bring and reducing the incentives to bring nuisance claims (Korsmo & Myers, 2014, 2016).
The past decade has seen a dramatic increase in both the number and size of appraisal petitions (Korsmo & Myers, 2015). This surge in appraisal activity has been controversial, and has sparked a growing wave of law and economics research. Some have argued that appraisal can serve as a valuable deterrent against managerial opportunism and a protection for minority stockholders, thus reducing the cost of capital for public companies (Callahan, Palia, & Talley, 2018; Korsmo & Myers, 2015). Others have argued that appraisal represents a new avenue of nuisance litigation and functions as a litigation tax, potentially reducing gains to minority stockholders as acquirers hold back value in anticipation of appraisal costs (Jiang, Li, Mei, & Thomas, 2016; Kalodimos & Lundberg, 2017). Early empirical evidence suggests that the decision to bring an appraisal claim is far more related to the merits than the decision to bring a fiduciary duty class action (Kalodimos & Lundberg, 2017), and that appraisal increases premiums paid to minority stockholder (Boone, Broughman, & Macias, 2017), but further research is necessary to assess the impact of appraisal.
An active scholarly debate also exists over how courts ought to assess fair value in appraisal proceedings, in particular as to the extent to which courts should defer to the negotiated deal price as an indicator of fair value (Hamermesh & Wachter, 2018). This debate is embodied in dueling amicus briefs in a recent appraisal case before the Delaware Supreme Court (DFC Glob. Corp. v. Muirfield Value P’nrs, 2017). One group of prominent corporate law professors argued that trial courts ought not second guess the transaction price where the transaction price arises from “an arm’s-length auction process” (Brief of Law and Corporate Finance Professors as Amici Curiae in Support of Reversal, p. 2). The competing brief by a group of corporate law and finance professors, including the 2007 Nobel Prize winner Eric Maskin, argued that “a facially disinterested process can still render a price falling short of fair value” and used auction theory to argue that the threat appraisal award untethered from the merger price would improve the functioning of the M&A market (Brief of Law, Economics and Corporate Finance Professors as Amici Curiae in Support of Petitioners-Appellees and Affirmance, p. 2). Elsewhere, law and economics scholars have argued that the deal market is insufficiently efficient to justify judicial deference, and that excessive deference to the negotiated price would nullify the appraisal remedy as a backstop against managerial opportunism and value-destroying transactions (Choi & Talley, 2018; Korsmo & Myers, 2018). Recent Delaware Supreme Court decisions have erected a high evidentiary bar for finding a fair value above the negotiated merger price (Dell, Inc. v. Magnetar Glob. Event Driven Master Fund, 2017; DFC Glob. Corp. v. Muirfield Value Partners, 2017), while disavowing the general conclusion that market pricing will always be the best evidence of fair value (Verition Partners Master Fund Ltd. v. Aruba Networks, Inc., 2019). As with merger litigation more generally, the role and design of the appraisal remedy looks to remain a fruitful field of legal and economic research in the coming years.
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(1.) Bainbridge (1997, p. 859): “Most law and economics scholars embrace a model of business organizations known as the ‘nexus-of-contracts theory of the firm.’” Other key corporate constituents, such as employees and creditors, typically have fixed claims on the assets of the firm, and are relegated to the protections of standard contract law, or special regulation like labor law. Similarly, third parties who may be affected by the operations of the firm are typically protected via regulatory law—such as environmental or antitrust regulation—rather than via corporate law.
(2.) Easterbrook and Fischel (1991, p. 34): “corporate law is a set of terms available off-the-rack so that participants in corporate ventures can save the cost of contracting . . . Corporate codes and existing judicial decisions supply these terms ‘for free’ to every corporation, enabling the venturers to concentrate on matters that are specific to their undertaking.”
(3.) Easterbrook and Fischel (1991, p. 35): “Court systems have a comparative advantage in supplying answers to questions that do not occur in time to be resolved ex ante. Common law systems need not answer questions unless they occur. This is an economizing device.”
(4.) Easterbrook and Fischel (1991, p. 34): “Corporate law—and in particular the fiduciary principle enforced by courts—fills in the blanks and oversights with the terms that people would have bargained for had they anticipated the problems and been able to transact costlessly in advance”; Posner, Economic Analysis of Law 372 (3d ed. 1986, p. 372) argues that default rules should “economize on transaction costs by supplying standard contract terms that the parties would otherwise have to adopt by express agreement.”
(6.) Ayres and Gertner (1989, p. 91): “Penalty defaults are designed to give at least one party to the contract an incentive to contract around the default rule and therefore to choose affirmatively the contract provision they prefer”; Scott (1990, p. 625): “Certain default rules are set, not because they represent the ultimate allocations preferred by most bargainers, but rather because they are best suited to inducing one party to share important information with the other.”
(8.) More precisely, the shareholders are entitled to the residual cash flows of the firm.
(9.) A number of early scholars called for some form of sharing requirement in connection with merger transactions, above and beyond ordinary fiduciary duty scrutiny of target management (see, e.g., Brudney & Chirelstein, 1974, 1978).
(10.) Easterbrook and Fischel (1991, p. 123): “Of course some investors will not be diversified.” To take just a few examples, employee pension plans may be heavy on the employer’s stock, and activist investors and active managers may take concentrated positions to exert control or profit from perceived mispricings (see Korsmo, 2016, pp. 1600–1601).
(11.) Bainbridge (2013, pp. 3291–3292): “structural decisions—such as corporate takeovers—present a final period problem entailing an especially severe conflict of interest”; Griffith (2003, p. 1947): “Another corporate law last period problem occurs when a company is sold . . . .”
(12.) Griffith (2003, p. 1945): “Because it simultaneously releases managers and directors from their ordinary mid-stream constraints and increases the temptation to enrich oneself at the expense of a dying corporation and its anonymous shareholders, the last period signals a structural dilemma in corporate law, a point at which managers and directors have greater incentives to favor selfish objectives rather than the best interests of their shareholders. In the context of a negotiated acquisition, the target corporation’s board and management may demand side payments from the acquirer, thus effectively diverting a portion of the merger consideration from the shareholders to the management team”; see also Jensen (1986).
(13.) It is worth noting that managers should want the same thing as stockholders. While, ex post, management and stockholders may face serious conflicts of interest, ex ante their interests are largely aligned, in that to the extent the law fails to protect stockholders, managers will have to discount their shares to attract equity capital. See Easterbrook and Fischel (1991, p. 17): “Unless entrepreneurs can fool the investors, a choice of terms that reduces investors’ expected returns will produce a corresponding reduction in price. So the people designing the terms under which the corporation will be run have the right incentives.”
(14.) Easterbrook and Fischel (1991, p. 126) suggest that “[a] legal rule that permits unequal division of gains from corporate control changes, subject to the constraint that no investor be made worse off by the transaction, maximizes investors’ wealth. This is really nothing more than an application of the Pareto principle of welfare economics.”
(15.) See DGCL Sec. 262.
(16.) See DGCL Sec. 102(b)(7).
(18.) See, e.g., Paramount Commc’ns, Inc. v. Time Inc. (1990), agreeing with the Time board that stockholders might tender “in ignorance or a mistaken belief” as to the value of an alternative merger; Unitrin, Inc. v. American General Corp. (1995), finding it reasonable for the Unitrin board to believe “that Unitrin’s shareholders might accept American General’s inadequate Offer because of ‘ignorance or mistaken belief’ regarding the Board’s assessment of the long-term value of Unitrin’s stock”; See Air Products and Chemicals, Inc. v. Airgas, Inc. (2011), describing the board’s use of a poison pill to “hold out for the proper price.”
(19.) Romano (1991, p. 55): “The efficacy of shareholder litigation as a governance mechanism is hampered by collective action problems because the cost of bringing a lawsuit, while less than the shareholders’ aggregate gain, is typically greater than a shareholder-plaintiff’s pro rata benefit”; Alexander (1991, p. 535): “The class action makes private enforcement economically feasible for small investors by allowing a large number of small individual claims to be aggregated and permitting the costs of litigation to be recouped from the total recovery . . . .”; see also McLean (1987); Olson (1971).