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The New York Times reports that five independent ACS directors have resigned, after the CEO seems to have demanded their resignations.  The resignations appear to hinge on the directors’ objections to the manner in which ACS Founder and Chairman Darwin Deason wanted to buy out ACS.  (The NYT article indicates Deason was trying to favor himself by precluding management talks with other potential buyers, among other things.)

 Two points strike me as particularly interesting:

First, the resigning directors allege Cravath acted improperly as both Deason’s counsel in connection with his bid and counsel to corporation in responding to the bid.  (The directors said in a letter to Deason “We also find it curious that your counsel in connection with your [purchase] proposal, Cravath, Swaine & Moore, is now serving as the company’s outside counsel.”  Cravath’s response to the NYT was “We had no conflict. We represent Mr. Deason, the chairman of the board of directors.”  Uhm, what?

Second, Marc Baylin, a portfolio manager with OppenheimerFunds, which holds 7% of the ACS stock, appears to side with Deason, saying the board’s lack of favorable action on Deason’s proposal “has actually lowered the current market value of A.C.S. stock.”  My response:  So what?  What does that tell us about whether Deason’s proposal was the best possible proposal?  Almost nothing.  A short-term stock drop tells us only a bit about the short-term view of perhaps short-term holders of ACS stock, but those interests do not and should not control the board of directors when responding to an actual control bid.

So, the $50,000 going private transaction question again rears its ugly head, as I ask:  When a founder such as Deason starts to make a bid for a firm, when, if at all, is the obligation to actually auction the firm ala Revlon triggered?Â

I’ve been watching the news coverage of the San Diego fires this evening hoping for any bit of good news. It hasn’t come yet (a map of the San Diego fires, evacuation centers, and some photos is available here). I was born and raised in San Diego and many family members still live there. At least one family member and several friends have been evacuated. It appears that the total number of San Diegans displaced by the fires thus far has exceeded 500,000 (and does not include the other fires across southern California). My thoughts and prayers go out to all of those affected by the fires.

For those who are interested, donations can be made to the San Diego Red Cross here.

UPDATE: Professor Bainbridge adds links to Catholic Charities in Los Angeles and San Diego.

I have long held reservations about corporate governance research that hinges on event studies.  (An event study is “an analysis of whether there was a statistically significant reaction in financial markets to past occurrences of a given type of event that is hypothesized to affect public firms’ market values.” An example of the sort of study that makes me a bit nervous is the study of derivative lawsuits done by Professors Fischel and Bradley in their 1986 paper titled “The Role of Liability Rules and the Derivative Suit in Corporate Law.”)  I have been leery of sharing my views regarding event studies, however, because it seems that most folks in my area of the academy have no similar reservations.  Discretion being the better part of valor, I would prefer not to be viewed as standing alone off in left field.  After spending some time a few afternoons ago chatting about my concerns with my mathematician friend John Armstrong, however, I am emboldened to share my thoughts here.

In a nutshell, I worry that event studies as traditionally conducted in the context of corporate governance undervalue the long term implications of and cumulative effects of various events.  I worry that, relying on event studies, we might be quick to undervalue activity that does not immediately generate a market reaction but that, in the bigger picture, lays the foundation for achieving a meaningful goal.Â

For purposes of discussion here, let us use an event study designed as follows:  A researcher wants to know what impact, if any, an institutional shareholder announcing its intention to withhold its affirmative vote on a slate of directors at an annual meeting has on the market.  In the typical event study, the researcher would look at the stock price of the stock of the company at issue on the day before the institutional shareholder’s announcement and the researcher would look at the stock price the day after.  If the stock price moved only minimally (in a way that was not “abnormal” for the market), the researcher would conclude that the institutional shareholder’s announcement did not matter to the market.  If the researcher were being thorough, I suppose the researcher might also look at how many shareholders at the next annual meeting, a week hence, actually withheld their votes.  If the number withholding was not abnormal, I imagine the researcher would believe his view of the irrelevance of the institutional investor’s pronouncement confirmed.

But what troubles me is that this ignores the long view.  Stay with me:  Assume that, 11 months after the above-mentioned institutional investor airs its concerns, an article appears in the WSJ reporting that the much-loved, long-serving CEO of the company at issue was arrested for drunk driving.  Assume that, the day after the drunk driving announcement, the stock price of the company at issue dropped 20%.  A researcher with an event study affinity might say that the drunk driving announcement moved the market.  But what of the notion that the announcement PLUS the recall of the institutional investor’s concerns actually cumulatively moved the market?  How do event studies account for time lag?  How do event studies account for the accumulation of information?  Surely just the announcement that the CEO was arrested for drunk driving should not, in and of itself, move the market.  But I can easily imagine situations where that might just be the straw that broke the camel’s back, so to speak.  Yet your typical event study would not account for that, would it?  Moreover, what if, at the annual meeting several weeks later, an abnormal number of investors withheld their votes for the nominated panel of directors?  Would we attribute that to the drunk driving instance?  I cannot imagine we would.  Yet would our scholarly memories be long enough to remember to attribute it to the institutional investor’s disavow of faith a year prior?

To be clear:  I much admire the scholars in our field who are aggressively using all research tools, event studies and otherwise.  I share my unease with event studies for what it is worth, which might be nothing.  (My hope, however, is that a useful exchange of ideas will occur here.)

I would have to think long and hard about writing a book titled “My Grandfather’s Daughter.”  If I wrote such a book, you see, I would feel compelled to do justice to the memory of my grandfather(s) with the book.  The book would need to be incredibly well-written, well-researched, and respectful, to reflect positively on the memories of two men who had impeccable moral fiber, character, and work ethic.  My mother’s father was a hard-working immigrant, who came to this country as a teenager with no money and no English language skills.  He worked two jobs for most of his life, he was promoted to a supervisor position in his blue-collar job where he was known for his kindness, fairness, and good nature, he raised four wonderful children, he lived an honorable life, and, when I reflect on him and all he stood for, I am motivated to work a little harder, be a little kinder, and love a little more.  My father’s father was a first generation American with little education, who worked his way up at GE to be a head foreman with GE’s Schenectady, New York, operations.  He, too, was known to be an exceedingly good manager, with a strong backbone and sense of fairness and justice.  He gave up his hard-earned position with GE and moved the family across the country to Arizona – no questions asked – when my father’s asthma proved unmanageable in the Northeast.  Years later, when the family was finally able to return to the Northeast, my grandfather spent his nights for an entire year building a home with his own bare hands for his family, after laboring long days in the factory.Â

My reverence for my two grandfathers is what underpins my … shock at Justice Clarence Thomas’s decision to take cheap shots at Anita Hill in Thomas’s new book titled “My Grandfather’s Son.”  Perhaps I am misunderstanding – perhaps Thomas viewed his grandfather as a man of weak character, with a propensity to hurt others and err on the side of needless, small-minded jabs.  I have not read Justice Thomas’s book, so I do not know.  But somehow I doubt he thought ill of his grandfather.

And, for that reason, the media quotes I have read that indicate Thomas revisits Anita Hill in his book to refer to her work as mediocre and her character as immature baffle me.  Why bother, Clarence Thomas?  Why take the opportunity to sling mud?  Why revisit Anita Hill personally?  The confirmation hearings for Justice Thomas were of historic import, and I certainly understand Thomas’s desire to memorialize the events.  What I do not understand, however, is Thomas’s choice to revisit negatively Anita Hill’s character and professional performance, and I think Thomas’s choice in this regard reflects poorly on him and, given the book’s title “My Grandfather’s Son,” his grandfather.

My father has a quote from his father that I cannot help but call to mind in light of Thomas’s comments about Hill.  The quote is:  “The other guy has got to live.”  I have always taken this quote to mean “cut the other guy some slack” or “just let it go.”  When I am in a position where I am in the right, and I can go in for the jugular, but I would have to do it at the expense of someone else who is just struggling to do the best they can, I stop, and I tell myself “the other guy has got to live.”  Were I in Thomas’s shoes, writing my autobiography, angry as I might be about the Anita Hill hearings even 15 years later, I would like to think that I would look seriously at the opportunity to slam Hill in my book but I would ultimately conclude “the other guy has got to live,” and I would pass up the chance to speak ill of her personally or professionally.  That is what I was raised to do; that is what my grandfathers would have wanted me to do.  I would like to think that I would have the strength of character to take the high road and err on the side of largess.

For that reason, even though, as a Catholic, Republican, conservative, I am perfectly teed up to favor Clarence Thomas, I cannot begin to understand why, in a book titled “My Grandfather’s Son,” Thomas would choose to take cheap shots at Anita Hill instead of taking the high road.  (Note that, because the book is not yet available, all I know about the book is what the media has written and Thomas himself has admitted.)

Have any of you actually watched the video of the University of Florida student, Andrew Meyer, who was tasered (shocked with a stun gun that emits a “debilitating electrical charge“) by UF Police at a discussion with Senator John Kerry?  The student was asking a series of questions of Senator Kerry, and apparently the student did not want to give up his line of questioning and sit down when his time was up.  The student appears to be loud and obnoxious, but I cannot hear him saying or doing anything dangerous or threatening.

The UF police drag the student away from the microphone, to the back of the auditorium, and they take the student down to the ground.  It appears from the video that multiple UF police officers are on top of him.  The student is on the ground, begging the police not to taser him, … but they do.  His screaming as he is being tasered and after being tasered is astounding.

The link to the video is half-way down the linked page

Watch the video.  Pay attention to the part at the bitter end, where the student is on the ground, with multiple police officers on top of him.  He is screaming, “don’t taser me,” and it sounds like he is saying “I’ll leave” (as in, “I’ll leave the conference – I’ll leave the room”).  And then the police taser him.

I am without words.

Steven Davidoff responded to my blog here last week regarding Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. and made the excellent point that just how bad for Merrill the representation I quoted really was depends in part on the limitations on indemnification that were included in the purchase agreement. For example, if the representations survived for only a short period and were subject to a large deductible and low cap, Merrill’s liability under the representation would be sharply limited. Unfortunately, the second circuit opinion says nothing about the indemnification provisions, and so I don’t know how much Merrill’s lawyers were able to take back with the left hand what they had given away with the right.

Steven also mentioned a representation that as counsel on the buy-side he generally tried to get and that is in some ways similar to the one I so criticized Merrill’s lawyers for giving on the sell-side. The representation Steven mentioned provides as follows:Â

There does not now exist any event, condition, or other matter, or any series of events, conditions, or other matters, individually or in the aggregate, adversely affecting Seller’s assets, business, prospects, financial condition, or results of its operations, that has not been specifically disclosed to Buyer in writing by Seller on or prior to the date of this Agreement.Â

As seller’s counsel, I would be willing to give this representation only if a few key changes were made. First and most important, it would have to be qualified by some materiality threshold. Every day any number of things “adversely affect” the company—far too many to be listed on a disclosure schedule—and so this representation would be false when made unless qualified as to materiality. In my view, the correct qualification here would be qualification to a “MAC”—a “material adverse change” on the company (defined with all the usual carve-outs, etc.). If the buyer’s counsel argued for a lower level of materiality—say anything “materially adversely affecting” the company—I would push back very hard. I think the seller ought not be in the position of having to determine for the buyer what is “material” to the value of the business from the buyer’s point of view.

This brings me to the second change I would think necessary: the MAC in the qualification should be a MAC on the company as a whole (including its “business” and “financial condition”), not on the company’s “assets” and certainly not on its “prospects.” “Assets” is wrong because something can adversely affect the company’s assets and not make the company itself worse off (e.g., a fully-insured asset is destroyed in an act of God). “Prospects” is wrong because no rational seller guarantees the future results of the business.Â

Third, the representation should be qualified as to time, meaning that it should pertain only to the period beginning on the date of the most recent audited financial statements of the company. Anything prior to the date should be covered in those financial statements.

With these three changes, the representation would sayÂ

Since the date of the Seller Financial Statements, there has not occurred any Material Adverse Effect on the Seller, its business or financial condition, except as has been specifically disclosed to Buyer in writing.Â

Thus modified, the representation is, I believe, customary. A representation substantially identical to it appears, for example, in the KKR-First Data merger agreement (the merger proxy for the deal, with the agreement appended, is available here):Â

Section 4.7 Absence of Material Adverse Change. Since December 31, 2006, … there has not been any Material Adverse Change or any Effect that would, individually or in the aggregate, reasonably be expected to have a Material Adverse Effect on the Company.

Representations like this, I think, are significantly different from the representation Merrill gave in the Allegheny deal. For one thing, the representation above does not amount to representing that all statements in the diligence materials were true. To prove a breach of the representation above, the buyer would have to show (a) there was a fact that amounts to a MAC on the company, and (b) the seller didn’t disclose that fact in diligence. It would be a question of a MAC-level omission from diligence, not a question of a false statement in the diligence materials. From a litigation point of view, the issue would probably come down to the seller combing the diligence materials and arguing that some obscure statement in the materials really did disclose the fact in question. From an economic point of view, the representation above creates an incentive for the seller to disclose more information rather than less in diligence, and that sounds efficient to me.

Although the representation in Merrill-Allegheny makes Merrill liable for omissions from diligence and so creates a similar incentive, it also creates an exactly opposite incentive as well. For, under the Merrill-Allegheny representation, the buyer can comb the diligence materials for an arguably-false statement and then argue that the falsity of the statement breaches the representation. Hence, the representation creates an incentive for the seller to disclose less information rather than more. To this extent, it’s very likely inefficient.

There’s another difference too. Nothing in the representation above requires the seller to make normative judgments about whether the information delivered is “appropriate” to value the company. The only judgment that the seller has to make is whether a fact amounts to a MAC on the company. It would seem possible that the seller could disclose all negative information about the company while still not disclosing some information needed to “appropriately” value the company. Imagine, for example, that inventory turnover rates are very important in the business being sold, and so valuation methodologies for this kind of business usually make use of such information. Under the Merrill Lynch representation, I think the seller would have to disclose inventory turnover information, even if there was nothing “bad” in the information (e.g., even if the turnover rates were average for the industry) and even if the buyer never asked for it. Under the representation above, as long as the turnover rates were not unusually bad, I don’t think the failure to disclose information about them would amount to a breach.

So although I didn’t want to harsh all over Merrill’s lawyers, I still think they gave a representation that was unreasonably unfavorable for their client. Steven and I both recall seeing counsel, even from elite firms, make serious mistakes similar to this—missing double materiality qualifications and so on. Steven suggested that the explanation may lie in the negotiation process being private (hence most mistakes don’t lead to public embarrassment), in an unthinking adherence to the firm’s form agreements (hence once a mistake is incorporated into the form, it gets repeated), or in over-reliance on network effects (other lawyers know what they are doing and so the associates will learn from them).

I’m inclined to think the problem is simply one of agency costs. Clients don’t read business combination agreements, and they certainly don’t read the representations—much less do they understand what can reasonably be given in representations and what cannot. Hence, when lawyers make a serious mistake, it’s often the lawyers themselves who are advising the client as to how serious the mistake was and how it ought be handled. The clients are ill-equipped to make an independent judgment. The lawyers can thus cover up the mistake at the client’s expense.

Unless, of course, some tiresome law professors want to blog about them.Â

Last week the Second Circuit Court of Appeals decided Merrill Lynch & Co., Inc. v. Allegheny Energy, Inc. (available here), which involved fraudulent inducement and breach of warranty claims in connection with a business combination agreement. The case is a straightforward application of familiar principles of blackletter law. I mention it because of certain highly unusual provisions in the purchase agreement between the parties.

First, some background. Back in 2000, Allegheny was considering purchasing GEM, a subsidiary of Merrill involved in trading energy commodities. In connection with Allegheny’s due diligence review, Merrill provided Allegheny with a great deal of information about GEM. The opinion doesn’t say what happened in this case, but usually such information is delivered under a confidentiality agreement that provides not only that the potential buyer will not disclose the information but also that the potential seller makes no representations or warranties as to the completeness or accuracy of the information provided. Such a disclaimer makes perfect sense. The materials being produced are the business records of the seller, and they were generated in the ordinary course of running the company, not to be relied on by third parties with interests adverse to those of the seller. The efficient error rate for business records is presumably much higher than the efficient error rate for contractual representations, breaches of which will almost inevitably subject the person making them to liability. Hence, if the seller represented that materials produced in due diligence were, say, “true and complete in all material respects,” this representation would very likely be false. The usual thing, therefore, is for the seller to make no representations or warranties on such materials.

Merrill and Allegheny eventually entered into a definitive purchase agreement for the sale of GEM, and this agreement, like virtually all business combination agreements, included elaborate representations and warranties by the seller about the condition of the business. This too makes sense. Limiting representations to ones expressly made in the agreement reduces uncertainty and forces the parties to bargain over exactly which representations will be made.

After the deal closed, Allegheny discovered that some of the key financial information Merrill provided in due diligence was false. The facts get very complicated at this point, in part because the Merrill employee running the GEM business prior to the transaction had embezzled millions of dollars from Merrill (he’s now in jail) and in part because of disputes about accounting methodologies used in preparing the information. The parties disagree about exactly which statements in the information Merrill produced in due diligence were false, why they were false, and what various of Merrill employees knew or should have known about their falsity at the time the agreement was signed.

A disappointed buyer like Allegheny can make either or both of two claims. It can argue fraudulent inducement, and so have to prove that the seller knowingly (or recklessly) included false information in the due diligence materials and that the buyer justifiably relied on such information to its detriment. Or, the buyer can argue breach of warranty, and so have to prove that the seller made a false statement in the representations in the agreement and the buyer was harmed thereby. In the first case, the universe of relevant statements is much wider, but the buyer has to prove not only that one such statement was false but also that the seller made the false statement knowing it was false (or in reckless disregard of its truth). In the second, the universe of relevant statements is confined to those made in the agreement, but all the buyer has to prove is that one such statement was false; the seller’s knowledge of its falsity is irrelevant.

The agreement between Merrill and Allegheny, however, contained some highly unusual provisions. In particular, Merrill warranted that the information provided to Allegheny “in the aggregate, in [Merrill’s] reasonable judgment exercised in good faith, is appropriate for [Allegheny] to evaluate [GEM’s] trading positions and trading operations.” This should take the breadth away from any practicing M&A lawyer. In effect, Merrill is representing not only that it believed the information provided in due diligence was true but also that it reasonably believed such information was true. Hence, any false statement in the diligence materials becomes potentially actionable: the seller will argue that Merrill should reasonably have known such statement was false.

Even worse, Merrill is representing that the information it provided was “appropriate” for Allegheny’s evaluating the business. At the very least, this means that Merrill is warranting that it reasonably believed that it delivered all the information that Allegheny needed to value the business. Hence, omissions from due diligence will become actionable. If Merrill had any information it did not produce to Allegheny in due diligence, Allegheny will now argue that such information was reasonably necessary for it to value the business and so its non-delivery to Allegheny was a breach.

Moreover, representing about whether the materials produced were “appropriate” for valuing the business also requires Merrill to make judgments about what information a buyer reasonably needs in a valuation study and so involve making judgments about what were appropriate valuation methodologies for the business in question. That, quite simply, is not the seller’s job. How the buyer values the business is something only the buyer can really know. After deciding how to value the business, the buyer should ask for what information it needs, and, even better, bargain for representations in the agreement concerning that information.

Not surprisingly, the Second Circuit reversed the district court’s summary judgment in favor of Merrill and remanded for further proceedings. The lesson here—besides the obvious one that Merrill cut a very bad deal and should hire better lawyers—is that representations should be about matters of fact the seller can be fairly certain it knows to be true, not normative judgments about what’s “appropriate,” especially from the point of view of an adverse party. Voluntary exchanges are efficient because each of the parties prefers the result of the exchange to the status quo ante. A representation by one party that the other party has evaluated the change correctly—i.e., “really” prefers it—is beyond what that party could know. Giving such a representation almost amounts to insuring the transaction for the other party. Merrill, I suspect, did not realize that it was doing that, but the result follows from the contract language, and the Second Circuit quite properly is holding Merrill to the bargain it struck.

Yesterday, Former Brocade CEO Steve Reyes was convicted of all criminal charges brought against him in the Brocade backdating scandal.  (The ten charges included fraud, conspiracy, lying to the SEC, falsifying books, etc.)  I am thrilled.  Professor Larry Ribstein is not.

To remind you, backdating stock options basically means lying and maintaining that stock options were granted on a date that they were not.  Backdating stock options is a bad thing for many reasons, not the least of which is because it usually is contrary to the terms of the stock option plan at issue (the plan approved by stockholders).  Moreover, backdating stock options implies that the options are ultimately not accounted for correctly, such that investors are misled as to the true “cost” (paper or otherwise) of the options and the financial condition of the corporation.  While we could argue about the actual impact backdating has on a corporation’s financial picture, the upshot is that backdating options and accounting for them accordingly is deceitful.

Regarding the Reyes jury verdict, I am thrilled because the jury verdict makes clear to former CEO Reyes and, by example, senior management of corporations in general that lying to investors about matters relevant to their securities is not acceptable.  Moreover, the jury rejected Reyes’s argument that he did not commit fraud because he did not know that backdating was illegal (indeed, there was some speculation that Reyes’s attorney would call Larry Sonsini to the stand to try to point the finger at him for blessing the backdating).  That, to me, is a huge step in tagging corporate executives with the responsibility of actually knowing enough about accurate accounting to be able to actually accurately account.

But, as noted, Professor Larry Ribstein was not similarly elated.  Professor Ribstein opined that that “The thought of more of these misguided criminal prosecutions of backdating is disturbing, to put it mildly.”  Professor Ribstein went on to say “These problems with criminalization of backdating are especially striking in a case like Brocade, where the defendant was trying to maximize shareholder value by recruiting the best people, not line his pockets, and where it’s unlikely any misstatements hurt investors….”  Well, that’s a non sequitur.  Breaking the law is breaking the law.  Who *cares* whether Reyes was trying to benefit himself, the Pope, or the investors?  AAT&T v. Miller, loosely paraphrased:  “Don’t break the law, even if you are doing it to try to benefit the corporation.”  (What if Reyes hired prostitutes or gave out cocaine to entice the best possible people to come work for Brocade?  Would that be acceptable?  Of course not.)

After scary verdicts like these (“scary” meaning even mildly imposing accountability), the big law firms often send out memos to their corporate and management clients, explaining the legal impact or import.  Allow me to draft the memo to clients on this one:

Don’t lie to investors.  Don’t lie to the government.  Don’t lie to the corporate auditors/accountants.  Follow the rules.  Don’t break the law.

******Question for the fed courts wonks out there:  the 29 motion is still open, such that the judge could, in theory, set aside the verdict, yes?

Josh, Thom, and I all predicted correctly that Dr. Miles would be overruled. We even predicted the vote count! I had hoped that Justice Breyer would join the majority, but instead he joined with Justices Ginsberg, Souter, and Stevens (as predicted) in dissent.

The opinion is here.

My future colleague, Danny Sokol (who’ll be visiting at Missouri Law next year), is one of the authors of the fantastic Antitrust & Competition Policy Blog. Danny requested that I post the following:

I am surveying countries around the world that are not OECD members and not members of the EU to determine whether and at which universities are antitrust/competition law and/or industrial organization taught.

Please respond to this post rather than email me directly with the following information:
University (specify department- e.g., economics department or law

For example, an entry may look like the following:
Universidad Diego Portales – law school
Competition law, seminar in competition law and intellectual property

I’m not sure how many non-American antitrusters read this blog, but if you’re out there, Danny would appreciate your participation.