Gods at War: Shotgun Takeovers, Government by Deal, and the Private Equity Implosion

by Steven M. Davidoff

  The regulation of the takeover decision has also largely focused on the sell side. In the past 20 years, Delaware has erected an elaborate skein to govern the standard by which board decisions to sell—or not to sell—are measured. This is a framework we explore further and in more detail later in this book. But the Delaware courts have placed significantly fewer strictures on the buy side, and absent a conflict of interest, the Delaware courts review these decisions under the lower business judgment standard. Courts reviewing a decision under the business judgment rule will not second-guess the acquisition decision unless it is grossly negligent or irrational—a test almost impossible to fail. The result is that the CEO of a company still has fair leeway to negotiate a takeover and to initiate strategy. Take, for example, Bank of America Corporation’s 2008 acquisitions of Countrywide Financial Corporation and Merrill Lynch & Co, Inc. There a headstrong CEO, Kenneth D. Lewis, appeared to drive two quite risky and hasty acquisitions. These decisions ultimately bit the company hard when it was forced to seek a multibillion-dollar government bailout in light of a $15.3 billion quarterly loss at Merrill Lynch.16 Though but one example, the “deal from hell” phenomenon—buyer acquisitions that have gone stunningly bad as a result of individualized, bad decisions—has been a feature of dealmaking throughout its history.

  The result has been that the personality-driven model of dealmaking has persisted, driven by the individuals who make the decision to buy rather than sell. In the first year of the financial crisis, this was on display as Treasury Secretary Henry J. Paulson Jr. turned into the market arbiter. During this time, it was Paulson who apparently decided which companies died and which lived and were acquired or bailed out. His choices dictated that Bear, Stearns & Co. should live but left Lehman Brothers to fall into bankruptcy. In the process, Paulson demanded, at least initially, that government-facilitated takeovers be structured in a manner that punished shareholders but did not specifically target officers or directors. Secretary Paulson, a veteran dealmaker and ex-CEO of the Goldman Sachs Group Inc., may have been bowing to political and legal reality in his decision-making. But his approach aligned with his dealmaking experience: The bailout can be viewed as a series of deals where the shareholders bore the costs over management.

  The role of personality will be seen in the deals examined in this book and is the reason for its title: Failing to ignore the personality element in deals and dealmaking is to ignore one of its central determinants. But if dealmaking is to truly succeed, this personal element must be restrained. As will be seen, modern dealmaking is often a fight to restrain this element for more rational, economic decision making.

  The Evolution of the Takeover

  While themes emerged and stayed through the past century and a half, change does come to deals and takeovers.The takeover market is a cyclical one. It has evolved over the past century principally through six boom-bust waves. Each of these cycles has had its own unique character and engendered its own differing and sometimes world-redefining change. This change has typically brought a new regulatory response as each wave alters the playing field for takeovers.The result has been that regulation of takeovers has largely been responsive to the prior or current wave. It has failed to anticipate or account for future possible change, instead regulating backward and shaping the course of the next waves.The regulation of dealmaking through history has thus been one of catch-up and circumstance, leaving us with the piecemeal system that we have today, where takeovers are a matter of joint supervision by the Delaware courts and the Securities and Exchange Commission (SEC). Moreover, the regulatory response over the years has revealed another increasingly prominent noneconomic force on the deal market, government, and regulation.

  The first true wave and movement for regulation of takeovers occurred during the period of 1890 through 1907 and in the wake of the American Industrial Revolution. This was the time of the trusts—large corporate entities combining diverse enterprises in a single industry with the purpose to control production and, more important, pricing. John Moody, the founder of Moody’s Investor Service, calculated that during this first wave, approximately 5,300 industrial sites were consolidated into just 318 industrial trusts .17 The wave marked the emergence of the modern industrial corporation as much as it was about the creation of monopoly. During this period, Standard Oil of New Jersey, the United Fruit Company, and the first billion-dollar corporation, U.S. Steel, were all created.18

  The first wave also spurred the first real regulation of corporate combinations, regulation focused on stemming the monopoly power of these new corporate behemoths. Between 1881 and 1901, Congress introduced 45 different antitrust legislative acts intended to regulate the trusts.19 Antitrust regulation did indeed come in the form of the Sherman Antitrust Act, the Clayton Antitrust Act, the creation of the Federal Trade Commission, and increased regulation of railroads through the Interstate Commerce Act, among other regulatory acts.20 Moreover, the first corporate regulators were formed by Congress during this time. In 1898, the U.S. Industrial Commission was formed to investigate these new large businesses, and in 1903, the United States Bureau of Corporations was formed to further investigate antitrust violations.21 But this regulation was focused on the perceived menace of the times—the anticompetitive effects of the trusts—rather than on corporations or takeovers themselves. There were scattered attempts in Congress to adopt a federal incorporation act and to implement a scheme of securities regulation. These attempts failed, and the takeover process was still largely unregulated at the end of this first wave.

  The first takeover wave collapsed in the panic of 1907, but a second wave of merger activity occurred from 1916 to 1929. The trigger for this wave was World War I and a new industrial boom within the United States. This second wave was shaped by the regulation adopted in the prior age and the heightened antitrust enforcement of the time, which provided the government the ability to stall anticompetitive, horizontal takeovers. This second wave avoided horizontal mergers, or mergers of competitors, instead producing oligopolies consisting of vertically integrated industrials.22 But like the prior wave, this takeover cycle did not produce regulation aimed at the takeover process. Rather, the regulatory response to this wave was shaped by the subsequent Great Depression and the general controversy over the collapse of the securities market and the perceived stock-trading abuses of the 1920s. The SEC was formed, and the Exchange Act and Securities Act were enacted to regulate the offering and trading of securities. Although specific regulation of takeovers was forgone, like the first wave of regulation, Congress’ actions would shape the next wave of takeover regulation by providing an apparatus to add on future legislation and rules.

  This third wave of U.S. merger activity transpired during the period 1960-1971 and was largely caused by that generation’s bubble, the conglomerate acquisition craze. 23 At the wave’s height, from 1967 to 1969, more than 10,000 companies were acquired, with approximately 25,000 acquisition transactions throughout the entire period.24 It was in response to this flurry of activity and the consequent emergence of the cash tender offer that modern-day federal takeover regulation originated. In the post-World War II era, takeovers had been staid events conducted primarily through proxy solicitations regulated by both state and federal proxy law. These contests required that the target company approve the transaction and that the target’s shareholders vote to approve or disapprove it. In the mid-1960s, however, at the crest of this third wave, there was a sharp comparative rise in unsolicited or hostile takeover attempts. These unsolicited bidders typically preferred to evade the federal and state regulatory apparatus applicable to proxy contests and, instead, often made their takeover attempts via cash tender offer, a vehicle that allowed them to purchase target shares directly without the approval of the target.25

  These early tender offers were largely unregulated affairs, and bidder conduct was often egregious.The “Saturday night special” was a favorite. In one form, a bidder would embark on a preoffer buying rai
d to establish a substantial beachhead of ownership at a reduced price.This would be followed by a short period of a first-come, first-serve public tender offer. Stockholders would rush to tender, afraid that they would be left in a minority position in the company or that their shares would otherwise be purchased subsequently for less money. In the wake of these new and unfamiliar tactics, stockholders and target corporations were relatively helpless. Takeover defenses at the time were virtually nonexistent. Indeed, surveying takeover manuals published during this time period, one marvels at the breadth of subsequent developments.26

  In light of the states’ failure to respond, the SEC, the agency created at the end of the second wave, became the principal governmental actor in the drive to regulate cash tender offers. In 1968, Congress passed the tender offer regulation bill introduced by Senator Harrison A. Williams. 27 The Williams Act was almost entirely in the form recommended by the SEC. The act both substantively and procedurally regulated tender offers, and its terms were keyed specifically to respond to the perceived abuses of the time. It enacted a scheme of regulation of tender offers that included disclosure requirements as well as substantive requirements regulating how tender offers were made and prosecuted.

  The third wave of merger activity subsided in the early 1970s with the popping of the conglomerate stock bubble and repeated U.S. economic recession. These two events combined to birth the next major issue of takeover regulation: the abusive going-private. These were largely take ’em public high, then buy ’em out low affairs: Majority owners of corporations who had only recently engaged in initial public offerings when stock market prices were substantially higher offered to buy out their own minority publicly held stock at markedly lower prices. Because there was an inherently coercive element in these transactions—the vote was a foregone conclusion since the parent had a controlling interest and the opportune timing was at the parent’s discretion—these purchases engendered cries of fraud and unjust enrichment.28

  In 1975, the SEC launched a fact-finding investigation and simultaneously proposed rules to govern going-private transactions. One form of the proposed rule would have required that a price paid in such a transaction be no lower than “that recommended jointly by two qualified independent persons.”29 Adoption of this rule was delayed, largely because of allegations that the SEC lacked rule-making authority under the Williams Act. Then, in 1977, the Supreme Court in Green v. Sante Fe Industries, Inc. overruled the Second Circuit’s holding that the antifraud provisions of the Exchange Act embodied in Rule 10b-5 constituted a basis to challenge a going-private decision on substantive grounds.30 This decision, as well as continued dissatisfaction with state regulation of going-privates, led the SEC to repropose rules. These rules were finally adopted by the SEC in 1979 and, although not as far-reaching as originally proposed, established a new disclosure-based regime for going-privates. The rules now obligate corporations in going-private transactions to express an opinion as to the fairness of the transaction to unaffiliated stockholders.31 Most notably, the SEC action here marked the first significant regulation not in a takeover wave; takeover regulation had become a full-time affair.

  The fourth wave of takeover activity commenced in the late 1970s and early 1980s and ended in 1989 in the wake of the collapse of the high-yield bond market and the S&L scandal. The heightened activity was again quantitatively marked: The annual value of domestic acquisition transactions rose from $43.5 billion in 1979 to a peak of $246.9 billion in 1988 before bottoming out at $71 billion in 1991.32 Unsolicited takeover activity, mainly cash tender offers, also sharply and fiercely increased from 12 contested tender offers in 1980 to 46 such offers in 1988; the increase was juiced by cheap financing in the form of high-yield or junk bonds.33 This was the time of the corporate raiders, men of brash personalities like T. Boone Pickens, who would launch hostile bids with a goal to break up or restructure the corporate target. Pickens, in fact, was labeled by Fortune magazine as “the most hated man in corporate America” because of his hostile offers for Gulf Oil, Phillips Petroleum, and Unocal Corp., among others.34

  The fourth wave was different in one significant respect: This time, targets were equipped for defense. The fourth wave was notable for the widespread use of takeover defenses, including poison pills, shark repellents, Pac-Mans, golden parachutes, greenmail, and other defenses discussed more thoroughly in Chapter 8.35 The renewed vigor of targets, as well as revised bidder tactics, spurred a revolution in takeover methods, resulted in more extended public takeover battles, and led state courts and legislatures, Congress, and the federal courts, as well as the SEC, to confront this phenomenon.

  In this cauldron, much of the legal doctrine of takeovers was forged, as well as the structure of today’s modern takeover. But to the extent this structure and mode was law-driven, the primary regulator of this period was no longer the SEC and the federal government, but the courts of the state of Delaware. During this time, the Delaware courts promulgated new rules governing the sale or change of control of a company, the appropriate defensive measures a company could use, the applicable standard of review for a going-private transaction, and the validity of the poison pill. The last act was perhaps the most controversial of the court and was opposed by the SEC, which battled and lost in the 1980s to limit takeover defenses. When the takeover market came to a screeching halt in 1989 with the collapse of the high-yield market, dealmaking was a much more regulated affair. The Delaware courts had not only trumped the SEC as the primary regulator of these affairs but also erected a set process for takeovers interlaid with the federal one. It was a regulatory scheme that allowed companies to defend the corporate bastion against hostile raiders and activist shareholders with an array of takeover defenses, the most important and prominent of which was the poison pill.

  The fifth and sixth waves of takeovers are recent history. The fifth coincided with the tech bubble and was marked by strategic transactions using inflated equity securities and breathtaking valuations. Who could forget the $4.66 billion paid by Yahoo in January 1999 for GeoCities, a company with only $18 million in revenues? Yahoo made the acquisition only months after the Disney-Infoseek, AOL-Netscape,@Home-Excite and USA Networks-Lycos deals—and thereby set off the Internet dealmaking craze.36 During this period, debt was less commonplace as a financing tool, and longer term business considerations dominated acquisition decisions.This wave was less beset by new takeover regulation, largely because any excesses were written off as merely a heady response to the tech bubble. The collapse of Enron Corporation and Worldcom Inc. also directed the typical postbubble regulatory impulses toward corporate governance rather than dealmaking.

  The downturn was short, and takeovers quickly entered into a sixth wave—the era of private equity and cross-border and global transactions.

  This wave was boosted by its own bubble, an unprecedented wave of liquidity and cheap credit brought on by inordinately low interest rates and savings imbalances across the world. The twilight of the sixth wave and the financial crisis is the subject of this book. It covers the changing nature of deals and dealmaking in these times and the consequences of the economic crisis we are still witnessing. And while we are currently in a postwave period, the truth is that these waves are coming faster and turning dealmaking into a constant affair. Even in the terrible down year of 2008, takeovers globally still accounted for $2.9 trillion in value, and in 2009 takeovers are still likely to exceed $2 trillion in value.37 Deals are continuing and, as we emerge from this current down cycle, will enter into new and uncharted territory, territory that will be marked by the response to recent events (see Figure 1.1).

  Figure 1.1 Global Takeover Volume 1980-2008

  SOURCE:Thomson Reuters

  The Takeover Revolution

  Dealmaking has evolved and moved past the day when Vanderbilt sent armed goons to assault the Erie Gang. Even then the law remained an important guidepost in deciding takeover battles. This was true despite the corrupt malleability of the judg
es and legislatures enacting these rules. It was, after all, the tainted law enacted by the New York legislature that finally brought the parties to settlement. Since that time, the role of law in deciding and regulating deals, particularly takeovers, has grown increasingly important.

  The real shift in takeovers began in the 1960s. Prior to that time, the thuggery and bribery of Vanderbilt’s era had gradually faded away into a stronger rule of law. But up until the 1960s, there was little law regulating what companies could and could not do in response to and in making takeovers. The change began only when a more active takeover market began to arise in the 1960s.The skein of law imposed created varying takeover standards. The result is that takeovers are now a regulated industry subject to and shaped by the rule of law. This made the industry the playground of lawyers. It also created a more organized, systematic approach to dealmaking.

  This latter aspect is reflected in the deal machine. Takeovers today are about party planning—putting together legal, financial, strategic, investor relations, and publicity considerations into one mix. And each of these elements has its own group of key advisers that one retains. So, for example, you see a handful of public relations firms on almost every large deal. Each has its own personality, depending upon the founder. Brunswick Group LLP, spearheaded in the United States by ex-Wall Street Journal reporter Stephen Lipin, is more staid and corporate; Joele Frank, Wilkinson Brimmer Katcher, led by the energetic Joele Frank, is perhaps more aggressive. The deal machine has become vast and organized.

  In this regard, while central themes have emerged over the years, takeover tactics and strategy have shifted in light of these developments and with each wave. Moreover, as dealmaking has evolved, each wave has brought its own mini-revolution, whereby new tactics and strategy bring further regulation in response. The first wave brought antitrust regulation; the third and fourth brought substantive regulation of the takeover process. The fifth wave was the first not to produce significant revolutionary tactics but also the first to fail to produce substantive regulatory change. Yet, this regulation has largely been adopted piecemeal without any holistic view. The result is that the regulation of takeovers today is a hodgepodge of state and federal regulation that both underregulates and overregulates.