How the SEC Should Consider Possible Changes in Section 13(d) Rules

Posted by Lucian Bebchuk, Harvard Law School, and Robert J. Jackson, Jr., Columbia Law School, on Tuesday July 12, 2011 at 10:21 am
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Editor’s Note: Lucian A. Bebchuk is Professor of Law, Economics, and Finance at Harvard Law School, and Robert J. Jackson, Jr. is Associate Professor of Law at Columbia Law School. This post is based on the authors’ submission to the SEC available here. An earlier post describing the Wachtell, Lipton rulemaking petition to which this post refers is available here.

In a letter submitted yesterday to the Securities and Exchange Commission, we provide a detailed analysis of the policy issues relevant for the Commission’s ongoing examination of changes to its rules under Section 13(d) of the Securities Exchange Act of 1934. These rules, which govern share accumulation and disclosure by blockholders, are the subject of a recent rulemaking petition submitted by Wachtell, Lipton, Rosen and Katz, which proposes that the rules be tightened.

We argue that the Commission should not view the proposed tightening as merely “technical” changes needed to modernize its Section 13(d) rules. In our view, the proposed changes should be examined in the larger context of the beneficial role that outside blockholders play in American corporate governance and the broad set of rules that apply to such blockholders.

Our analysis proceeds in five steps. First, we describe the significant empirical evidence indicating that the accumulation and holding of outside blocks in public companies benefits shareholders by making incumbent directors and managers more accountable and thereby reducing agency costs and managerial slack.

Second, we explain that tightening the rules applicable to outside blockholders can be expected to reduce the returns to blockholders and thereby reduce the incidence and size of outside blocks—and, thus, blockholders’ investments in monitoring and engagement, which in turn may result in increased agency costs and managerial slack.

Third, we explain that there is currently no empirical evidence to support the Petition’s assertion that changes in trading technologies and practices have recently led to a significant increase in pre-disclosure accumulations of ownership stakes by outside blockholders.

Fourth, we explain that, since the passage of Section 13, changes in state law—including the introduction of poison pills with low-ownership triggers that impede outside blockholders that are not seeking control—have tilted the playing field against such blockholders.

Finally, we explain that a tightening of the rules cannot be justified on the grounds that such tightening is needed to protect investors from the possibility that outside blockholders will capture a control premium at other shareholders’ expense.

We conclude by urging the Commission to pursue a comprehensive examination of the rules governing outside blockholders and the empirical questions raised by our analysis. In the meantime, the Commission should not adopt new rules that tighten restrictions on outside blockholders. Existing research and available empirical evidence provide no basis for concluding that tightening the rules governing outside blockholders would satisfy the requirement that Commission rulemaking protect investors and promote efficiency, and indeed raise concerns that such tightening could harm investors and undermine efficiency.

Our letter to the SEC is available here.

  1. Imprecise Boundaries and Eroding Legitimacy of “Control Premium” Rhetoric

    Having re-read Wachtell’s rule-making proposal with respect to Section 13 (d) of the Securities and Exchange Act of 1934 (the “1934 Act”), the Securities and Exchange Commission’s (“SEC”) proposals, and a further reaction by Wachtell thereto from earlier in the year, especially in light of your fifth point (“Is a Tightening of the Rules Necessary to Protect Control Premia?” p. 11), I would like to add an observation that you seem to neglect.
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    In the Looming Era of a new World Fiscal Crisis, New Rules of Prudence and Frugality Dominate “Control” Premium Talk and Quantification in Public M&A Transactions
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    One key factor has emerged from the past World Financial Crisis that seems still valid in this current period morphing into what is best called the new “World Fiscal Crisis” [in Europe and the United States]: Potential bidders – regardless of whether publicly traded strategic acquirors, sponsors/fund managers or family offices – are reluctant to compute, add on several layers of, and pay out ultimately the kind of indiscriminate and conventional rigmarole of takeover premiums (variously also called “acquisition”, or “synergy” premiums) parading as “control premiums” that market participants, especially recipient shareholders and the Wall Street machinery of investment bankers and legal technicians have come to expect. You likewise – citing Dyck and Zingales – seem to take some of this stuff for granted as sound, reasonable and legitimate manifestations of a premium for a “controlling” block of shares to be paid out to selling shareholders all over the world as some broad consensus, including the Delaware courts and the SEC. I would like to take issue with this assertion.
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    As far as the precise demarcation of “control” premium from other manifestations of premium razzmatazz is concerned, the bidders we meet believe, of course, in the axiom that (i) the private benefit of control have a certain value and justifiably extracts a price in order to protect minority shareholders from the potential tyranny of the majority; yet the concession of a steep control premium hinges predominantly on (ii) poor current target management performance, prompting the necessity and/or (iii) an acquiror’s actual ability and likelihood to enhance target performance through management improvements.
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    Some voices in the literature argue that control premiums represent exclusively the value that can be extracted by controlling shareholders at the expense of minority interests. They reason furthermore that such control talk is nonsense because the expropriation of a target’s wealth to the benefit of the new managers in the form of diversion and appropriation by the controlling agent implicitly assumes a violation of fiduciary responsibilities by the Board under – say – U.S. or German or U.K. law. Others focus exclusively on management changes and the probability of managerial improvements. In general, however, the literature concurs that a “control” premium is due if and when both elements and components are reflected and computed diligently, i.e. (a) the difference between the value of a controlling interest and a minority interest (discounted), and (2) the right of the new controlling shareholder to effect a management change and probability of such value increase.
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    It is worth to remember, however, that such control premium talk presupposes a controlling block of shares to change hands, not a mere stake-building and block-aggregation exercise leading to the 5% notification threshold of Rule 13 (d). Delaware law assumes the size of such a block to be in the 27% – 30% range and vicinity in order to trigger the presumption of a control change. Under modern-day U.K. and German rules, we arrive at presumably a similar, 30% threshold for control to be imputed by operation of takeover legislation, triggering a mandatory bid to protect the minority.
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    Empirically it is true that acquirors pay premiums of 25 – 40% (if not more) in public deals, but that’s no control premium, rather a simple computation comparing negotiated or hostile acquisition share price to pre-deal stock price. “Synergy” is usually a plug variable to camouflage the difference between share price paid and ‘estimated value’. Further, “acquisition” or “takeover” or “synergy” premium talk usually boils down to wishful premium justification and neither “takeover” nor “acquisition/M&A” premiums are anything different from “control” or “synergy” premium add-ons or a combination of both to begin with. However, is it an accident that in the main family offices and strategic acquirors are interested in shaving these types of premiums off the purchase price tag as far as legitimately possible, without infringing on minority shareholder concerns as safeguards? It is implausible to reduce this debate to a new generation of fortune hunters and alternative asset managers out for a quick buck. We are dealing here with our traditional corporate client base, senior corporate directors, executives and family offices that emphasize their fiduciary duty to avoid overpayment in takeovers and visit with us in order to inquire how to lower acquisition funding costs as much as possible. Are we to turn these debates away from our doorsteps and request further regulatory constraints in an already overregulated environment, by engaging in divisive, emotively charged discourse?
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    This aforementioned potential bidder population has reached the inescapable conclusion that “takeover” premiums, “M&A/acquisition” premiums, “control” and “synergy” premiums have become poorly demarcated and empty words synonymous with target management entrenchment and the vague expectations on part of target shareholders to take the lion’s share of any hoped-for value increases in connection with public business combinations.
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    A New Universe of Potential Bidders Wishes to Tone Down the Premium-Inflating Rhetoric Associated with Delaware Case Law and Wall Street Defensive Techniques such as Rights Plans in Various Manifestations
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    These potential bidders wish to tone down the premium-inflating rhetoric and excesses from years past. Rather, they have formed the conviction that a combination of tactical moves such as (a) staying away from auctions, (b) pre-transaction share accumulations and stake-building via synthetic cash-settled, total return equity swaps, or their physical equivalents such as certain puts and calls, or some such other mechanisms (we know of about a dozen similar techniques under U.K., U.S. and European-continental legal regimes), resulting (c) in a certain block ownership concentration requiring notification of the kind under discussion here with Wachtell and the SEC, constitute smart and justifiable conceptual attacks on target price inflation due to imprecise general “premium” rhetoric inimical to the new prudence and frugality in the post-World Financial Crisis era and pending World Fiscal Crisis-environment.
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    By paying control premiums only on those shares required to actually obtaining control rather than those accumulated in the pre-tender, pre-exchange offer or pre-statutory merger stock concentration phase, these bidders avail themselves of a certain strategic rationale: We pay a control premium only where required by law on the premise of sound valuation. It is an old concept that worked for the Hanson Trust (represented by Weil) and Sir James Goldsmith (Crown Zellerbach, represented by Skadden) alike in the 1980s as “street sweeps” or “creeping takeovers”, a perfectly legitimate course of action under the 1934 Act, without the European 30% threshold triggering a mandatory offer to all remaining shareholders at equal conditions/price.
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    Why should shareholder value from the publicly traded bidder’s perspective count any less than target premium expectancy established by Wall Street and the Delaware courts over the last 30 years? Sophisticated corporate finance theory has been moving away from these premium presuppositions of the corporate establishment for the last decade or so, allowing for bidder tactics that balance out decades-old, target-favoring habits. Value creation has always been acknowledged a post-transaction process, not a pre-transaction fiat. So long as “control”, “takeover”, “M&A/acquisition” or “synergy” premiums, whatever their nomenclature, can be justified as sound and reasonable additional aspects to a given publicly traded target’s stand-alone valuation, bidders voice no objections.
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    However, in this age of newfound frugality and seriousness of purpose that prices the virtues of production over financial shenanigans as bedrocks of value-creation, there is very limited conceptual tolerance for premium largess of the inflationary kind that many market participants in a self-perpetuating fashion have come to expect that enjoys little justification in economic theory or grounding in verifiable post-transaction value-building.
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     Against this backdrop of the past World Financial Crisis and looming World Fiscal Crisis, permit me to state the following suppositions: Since almost 30 years, under the influence of the Delaware courts (influential as the pacemaker of corporate law development in the absence of a federal corporation law of the United States), beyond the necessary protection of minority shareholder interests, the seller perspective and sale price maximization obligations of Boards have led to auction settings [best value for shareholders as the Board’s principal role in M&A transactions under Unocal (1985) and Revlon (1986) decisions] and negligence if not disregard for legitimate buy-side concerns
     Return of robust M&A activity hinges on the new frugality on part of buy-side strategic corporate decision-makers, family offices and sponsors/fund managers in terms of fair target sale price composition and the lowest justifiable control premiums
     It will be central to clarify first and foremost notions such as “control” premium, “synergy” add-ons, “M&A/acquisition” or “takeover” premiums and distinguish between “control” premium and minority discount, while from the practical legal point of view compare European-continental and German law with U.S. and U.K. developments, the latter so influential in Australasia at the moment, to obtain a well-rounded picture updating Dyck’s and Zingales’ findings dating from the end of 2002, almost a decade ago (when they were accepted for eventual publication in 2004).

    Comment by Ami de Chapeaurouge — July 17, 2011 @ 3:39 am

 

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