Archives For takeovers

[TOTM: The following is part of a blog series by TOTM guests and authors on the law, economics, and policy of the ongoing COVID-19 pandemic. The entire series of posts is available here.

This post is authored by Geoffrey A. Manne, (President, ICLE; Distinguished Fellow, Northwestern University Center on Law, Business, and Economics); and Dirk Auer, (Senior Fellow of Law & Economics, ICLE)]

Back in 2012, Covidien, a large health care products company and medical device manufacturer, purchased Newport Medical Instruments, a small ventilator developer and manufacturer. (Covidien itself was subsequently purchased by Medtronic in 2015).

Eight years later, in the midst of the coronavirus pandemic, the New York Times has just published an article revisiting the Covidien/Newport transaction, and questioning whether it might have contributed to the current shortage of ventilators.

The article speculates that Covidien’s purchase of Newport, and the subsequent discontinuation of Newport’s “Aura” ventilator — which was then being developed by Newport under a government contract — delayed US government efforts to procure mechanical ventilators until the second half of 2020 — too late to treat the first wave of COVID-19 patients:

And then things suddenly veered off course. A multibillion-dollar maker of medical devices bought the small California company that had been hired to design the new machines. The project ultimately produced zero ventilators.

That failure delayed the development of an affordable ventilator by at least half a decade, depriving hospitals, states and the federal government of the ability to stock up.

* * *

Today, with the coronavirus ravaging America’s health care system, the nation’s emergency-response stockpile is still waiting on its first shipment.

The article has generated considerable interest not so much for what it suggests about government procurement policies or for its relevance to the ventilator shortages associated with the current pandemic, but rather for its purported relevance to ongoing antitrust debates and the arguments put forward by “antitrust populists” and others that merger enforcement in the US is dramatically insufficient. 

Only a single sentence in the article itself points to a possible antitrust story — and it does nothing more than report unsubstantiated speculation from unnamed “government officials” and rival companies: 

Government officials and executives at rival ventilator companies said they suspected that Covidien had acquired Newport to prevent it from building a cheaper product that would undermine Covidien’s profits from its existing ventilator business.

Nevertheless, and right on cue, various antitrust scholars quickly framed the deal as a so-called “killer acquisition” (see also here and here):

Unsurprisingly, politicians were also quick to jump on the bandwagon. David Cicilline, the powerful chairman of the House Antitrust Subcommittee, opined that:

And FTC Commissioner Rebecca Kelly Slaughter quickly called for a retrospective review of the deal:

The public reporting on this acquisition raises important questions about the review of this deal. We should absolutely be looking back to figure out what happened.

These “hot takes” raise a crucial issue. The New York Times story opened the door to a welter of hasty conclusions offered to support the ongoing narrative that antitrust enforcement has failed us — in this case quite literally at the cost of human lives. But are any of these claims actually supportable?

Unfortunately, the competitive realities of the mechanical ventilator industry, as well as a more clear-eyed view of what was likely going on with the failed government contract at the heart of the story, simply do not support the “killer acquisition” story.

What is a “killer acquisition”…?

Let’s take a step back. Because monopoly profits are, by definition, higher than joint duopoly profits (all else equal), economists have long argued that incumbents may find it profitable to acquire smaller rivals in order to reduce competition and increase their profits. More specifically, incumbents may be tempted to acquire would-be entrants in order to prevent them from introducing innovations that might hurt the incumbent’s profits.

For this theory to have any purchase, however, a number of conditions must hold. Most importantly, as Colleen Cunningham, Florian Ederer, and Song Ma put it in an influential paper

“killer acquisitions” can only occur when the entrepreneur’s project overlaps with the acquirer’s existing product…. [W]ithout any product market overlap, the acquirer never has a strictly positive incentive to acquire the entrepreneur… because, without overlap, acquiring the project does not give the acquirer any gains resulting from reduced competition, and the two bargaining entities have exactly the same value for the project.

Moreover, the authors add that:

Successfully developing a new product draws consumer demand and profits away equally from all existing products. An acquiring incumbent is hurt more by such cannibalization when he is a monopolist (i.e., the new product draws demand away only from his own existing product) than when he already faces many other existing competitors (i.e., cannibalization losses are spread over many firms). As a result, as the number of existing competitors increases, the replacement effect decreases and the acquirer’s development decisions become more similar to those of the entrepreneur

Finally, the “killer acquisition” terminology is appropriate only when the incumbent chooses to discontinue its rival’s R&D project:

If incumbents face significant existing competition, acquired projects are not significantly more frequently discontinued than independent projects. Thus, more competition deters incumbents from acquiring and terminating the projects of potential future competitors, which leads to more competition in the future.

…And what isn’t a killer acquisition?

What is left out of this account of killer acquisitions is the age-old possibility that an acquirer purchases a rival precisely because it has superior know-how or a superior governance structure that enables it to realize greater return and more productivity than its target. In the case of a so-called killer acquisition, this means shutting down a negative ROI project and redeploying resources to other projects or other uses — including those that may not have any direct relation to the discontinued project. 

Such “synergistic” mergers are also — like allegedly “killer” mergers — likely to involve acquirers and targets in the same industry and with technological overlap between their R&D projects; it is in precisely these situations that the acquirer is likely to have better knowledge than the target’s shareholders that the target is undervalued because of poor governance rather than exogenous, environmental factors.  

In other words, whether an acquisition is harmful or not — as the epithet “killer” implies it is — depends on whether it is about reducing competition from a rival, on the one hand, or about increasing the acquirer’s competitiveness by putting resources to more productive use, on the other.

As argued below, it is highly unlikely that Covidien’s acquisition of Newport could be classified as a “killer acquisition.” There is thus nothing to suggest that the merger materially impaired competition in the mechanical ventilator market, or that it measurably affected the US’s efforts to fight COVID-19.

The market realities of the ventilator market and its implications for the “killer acquisition” story

1. The mechanical ventilator market is highly competitive

As explained above, “killer acquisitions” are less likely to occur in competitive markets. Yet the mechanical ventilator industry is extremely competitive. 

A number of reports conclude that there is significant competition in the industry. One source cites at least seven large producers. Another report cites eleven large players. And, in the words of another report:

Medical ventilators market competition is intense. 

The conclusion that the mechanical ventilator industry is highly competitive is further supported by the fact that the five largest producers combined reportedly hold only 50% of the market. In other words, available evidence suggests that none of these firms has anything close to a monopoly position. 

This intense competition, along with the small market shares of the merging firms, likely explains why the FTC declined to open an in-depth investigation into Covidien’s acquisition of Newport.

Similarly, following preliminary investigations, neither the FTC nor the European Commission saw the need for an in-depth look at the ventilator market when they reviewed Medtronic’s subsequent acquisition of Covidien (which closed in 2015). Although Medtronic did not produce any mechanical ventilators before the acquisition, authorities (particularly the European Commission) could nevertheless have analyzed that market if Covidien’s presumptive market share was particularly high. The fact that they declined to do so tends to suggest that the ventilator market was relatively unconcentrated.

2. The value of the merger was too small

A second strong reason to believe that Covidien’s purchase of Newport wasn’t a killer acquisition is the acquisition’s value of $103 million

Indeed, if it was clear that Newport was about to revolutionize the ventilator market, then Covidien would likely have been made to pay significantly more than $103 million to acquire it. 

As noted above, the crux of the “killer acquisition” theory is that incumbents can induce welfare-reducing acquisitions by offering to acquire their rivals for significantly more than the present value of their rivals’ expected profits. Because an incumbent undertaking a “killer” takeover expects to earn monopoly profits as a result of the transaction, it can offer a substantial premium and still profit from its investment. It is this basic asymmetry that drives the theory.

Indeed, as a recent article by Kevin Bryan and Erik Hovenkamp notes, an acquisition value out of line with current revenues may be an indicator of the significance of a pending acquisition in which enforcers may not actually know the value of the target’s underlying technology: 

[Where] a court may lack the expertise to [assess the commercial significance of acquired technology]…, the transaction value… may provide a reasonable proxy. Intuitively, if the startup is a relatively small company with relatively few sales to its name, then a very high acquisition price may reasonably suggest that the startup technology has significant promise.

The strategy only works, however, if the target firm’s shareholders agree that share value properly reflects only “normal” expected profits, and not that the target is poised to revolutionize its market with a uniquely low-cost or high-quality product. Relatively low acquisition prices relative to market size, therefore, tend to reflect low (or normal) expected profits, and a low perceived likelihood of radical innovations occurring.

We can apply this reasoning to Covidien’s acquisition of Newport: 

  • Precise and publicly available figures concerning the mechanical ventilator market are hard to come by. Nevertheless, one estimate finds that the global ventilator market was worth $2.715 billion in 2012. Another report suggests that the global market was worth $4.30 billion in 2018; still another that it was worth $4.58 billion in 2019.
  • As noted above, Covidien reported to the SEC that it paid $103 million to purchase Newport (a firm that produced only ventilators and apparently had no plans to branch out). 
  • For context, at the time of the acquisition Covidien had annual sales of $11.8 billion overall, and $743 million in sales of its existing “Airways and Ventilation Products.”

If the ventilator market was indeed worth billions of dollars per year, then the comparatively small $108 million paid by Covidien — small even relative to Covidien’s own share of the market — suggests that, at the time of the acquisition, it was unlikely that Newport was poised to revolutionize the market for mechanical ventilators (for instance, by successfully bringing its Aura ventilator to market). 

The New York Times article claimed that Newport’s ventilators would be sold (at least to the US government) for $3,000 — a substantial discount from the reportedly then-going rate of $10,000. If selling ventilators at this price seemed credible at the time, then Covidien — as well as Newport’s shareholders — knew that Newport was about to achieve tremendous cost savings, enabling it to offer ventilators not only to the the US government, but to purchasers around the world, at an irresistibly attractive — and profitable — price.

Ventilators at the time typically went for about $10,000 each, and getting the price down to $3,000 would be tough. But Newport’s executives bet they would be able to make up for any losses by selling the ventilators around the world.

“It would be very prestigious to be recognized as a supplier to the federal government,” said Richard Crawford, who was Newport’s head of research and development at the time. “We thought the international market would be strong, and there is where Newport would have a good profit on the product.”

If achievable, Newport thus stood to earn a substantial share of the profits in a multi-billion dollar industry. 

Of course, it is necessary to apply a probability to these numbers: Newport’s ventilator was not yet on the market, and had not yet received FDA approval. Nevertheless, if the Times’ numbers seemed credible at the time, then Covidien would surely have had to offer significantly more than $108 million in order to induce Newport’s shareholders to part with their shares.

Given the low valuation, however, as well as the fact that Newport produced other ventilators — and continues to do so to this day, there is no escaping the fact that everyone involved seemed to view Newport’s Aura ventilator as nothing more than a moonshot with, at best, a low likelihood of success. 

Curically, this same reasoning explains why it shouldn’t surprise anyone that the project was ultimately discontinued; recourse to a “killer acquisition” theory is hardly necessary.

3. Lessons from Covidien’s ventilator product decisions  

The killer acquisition claims are further weakened by at least four other important pieces of information: 

  1.  Covidien initially continued to develop Newport’s Aura ventilator, and continued to develop and sell Newport’s other ventilators.
  2. There was little overlap between Covidien and Newport’s ventilators — or, at the very least, they were highly differentiated
  3. Covidien appears to have discontinued production of its own portable ventilator in 2014
  4. The Newport purchase was part of a billion dollar series of acquisitions seemingly aimed at expanding Covidien’s in-hospital (i.e., not-portable) device portfolio

Covidien continued to develop and sell Newport’s ventilators

For a start, while the Aura line was indeed discontinued by Covidien, the timeline is important. The acquisition of Newport by Covidien was announced in March 2012, approved by the FTC in April of the same year, and the deal was closed on May 1, 2012.

However, as the FDA’s 510(k) database makes clear, Newport submitted documents for FDA clearance of the Aura ventilator months after its acquisition by Covidien (June 29, 2012, to be precise). And the Aura received FDA 510(k) clearance on November 9, 2012 — many months after the merger.

It would have made little sense for Covidien to invest significant sums in order to obtain FDA clearance for a project that it planned to discontinue (the FDA routinely requires parties to actively cooperate with it, even after 510(k) applications are submitted). 

Moreover, if Covidien really did plan to discreetly kill off the Aura ventilator, bungling the FDA clearance procedure would have been the perfect cover under which to do so. Yet that is not what it did.

Covidien continued to develop and sell Newport’s other ventilators

Second, and just as importantly, Covidien (and subsequently Medtronic) continued to sell Newport’s other ventilators. The Newport e360 and HT70 are still sold today. Covidien also continued to improve these products: it appears to have introduced an improved version of the Newport HT70 Plus ventilator in 2013.

If eliminating its competitor’s superior ventilators was the only goal of the merger, then why didn’t Covidien also eliminate these two products from its lineup, rather than continue to improve and sell them? 

At least part of the answer, as will be seen below, is that there was almost no overlap between Covidien and Newport’s product lines.

There was little overlap between Covidien’s and Newport’s ventilators

Third — and perhaps the biggest flaw in the killer acquisition story — is that there appears to have been very little overlap between Covidien and Newport’s ventilators. 

This decreases the likelihood that the merger was a killer acquisition. When two products are highly differentiated (or not substitutes at all), sales of the first are less likely to cannibalize sales of the other. As Florian Ederer and his co-authors put it:

Importantly, without any product market overlap, the acquirer never has a strictly positive incentive to acquire the entrepreneur, neither to “Acquire to Kill” nor to “Acquire to Continue.” This is because without overlap, acquiring the project does not give the acquirer any gains resulting from reduced competition, and the two bargaining entities have exactly the same value for the project.

A quick search of the FDA’s 510(k) database reveals that Covidien has three approved lines of ventilators: the Puritan Bennett 980, 840, and 540 (apparently essentially the same as the PB560, the plans to which Medtronic recently made freely available in order to facilitate production during the current crisis). The same database shows that these ventilators differ markedly from Newport’s ventilators (particularly the Aura).

In particular, Covidien manufactured primarily traditional, invasive ICU ventilators (except for the PB540, which is potentially a substitute for the Newport HT70), while Newport made much-more-portable ventilators, suitable for home use (notably the Aura, HT50 and HT70 lines). 

Under normal circumstances, critical care and portable ventilators are not substitutes. As the WHO website explains, portable ventilators are:

[D]esigned to provide support to patients who do not require complex critical care ventilators.

A quick glance at Medtronic’s website neatly illustrates the stark differences between these two types of devices:

This is not to say that these devices do not have similar functionalities, or that they cannot become substitutes in the midst of a coronavirus pandemic. However, in normal times (as was the case when Covidien acquired Newport), hospitals likely did not view these devices as substitutes.

The conclusion that Covidien and Newport’s ventilator were not substitutes finds further support in documents and statements released at the time of the merger. For instance, Covidien’s CEO explained that:

This acquisition is consistent with Covidien’s strategy to expand into adjacencies and invest in product categories where it can develop a global competitive advantage.

And that:

Newport’s products and technology complement our current portfolio of respiratory solutions and will broaden our ventilation platform for patients around the world, particularly in emerging markets.

In short, the fact that almost all of Covidien and Newport’s products were not substitutes further undermines the killer acquisition story. It also tends to vindicate the FTC’s decision to rapidly terminate its investigation of the merger.

Covidien appears to have discontinued production of its own portable ventilator in 2014

Perhaps most tellingly: It appears that Covidien discontinued production of its own competing, portable ventilator, the Puritan Bennett 560, in 2014.

The product is reported on the company’s 2011, 2012 and 2013 annual reports:

Airway and Ventilation Products — airway, ventilator, breathing systems and inhalation therapy products. Key products include: the Puritan Bennett™ 840 line of ventilators; the Puritan Bennett™ 520 and 560 portable ventilator….

(The PB540 was launched in 2009; the updated PB560 in 2010. The PB520 was the EU version of the device, launched in 2011).

But in 2014, the PB560 was no longer listed among the company’s ventilator products:  

Airway & Ventilation, which primarily includes sales of airway, ventilator and inhalation therapy products and breathing systems.

Key airway & ventilation products include: the Puritan Bennett™ 840 and 980 ventilators, the Newport™ e360 and HT70 ventilators….

Nor — despite its March 31 and April 1 “open sourcing” of the specifications and software necessary to enable others to produce the PB560 — did Medtronic appear to have restarted production, and the company did not mention the device in its March 18 press release announcing its own, stepped-up ventilator production plans.

Surely if Covidien had intended to capture the portable ventilator market by killing off its competition it would have continued to actually sell its own, competing device. The fact that the only portable ventilators produced by Covidien by 2014 were those it acquired in the Newport deal strongly suggests that its objective in that deal was the acquisition and deployment of Newport’s viable and profitable technologies — not the abandonment of them. This, in turn, suggests that the Aura was not a viable and profitable technology.

(Admittedly we are unable to determine conclusively that either Covidien or Medtronic stopped producing the PB520/540/560 series of ventilators. But our research seems to indicate strongly that this is indeed the case).

Putting the Newport deal in context

Finally, although not dispositive, it seems important to put the Newport purchase into context. In the same year as it purchased Newport, Covidien paid more than a billion dollars to acquire five other companies, as well — all of them primarily producing in-hospital medical devices. 

That 2012 spending spree came on the heels of a series of previous medical device company acquisitions, apparently totally some four billion dollars. Although not exclusively so, the acquisitions undertaken by Covidien seem to have been primarily targeted at operating room and in-hospital monitoring and treatment — making the putative focus on cornering the portable (home and emergency) ventilator market an extremely unlikely one. 

By the time Covidien was purchased by Medtronic the deal easily cleared antitrust review because of the lack of overlap between the company’s products, with Covidien’s focusing predominantly on in-hospital, “diagnostic, surgical, and critical care” and Medtronic’s on post-acute care.

Newport misjudged the costs associated with its Aura project; Covidien was left to pick up the pieces

So why was the Aura ventilator discontinued?

Although it is almost impossible to know what motivated Covidien’s executives, the Aura ventilator project clearly suffered from many problems. 

The Aura project was intended to meet the requirements of the US government’s BARDA program (under the auspices of the U.S. Department of Health and Human Services’ Biomedical Advanced Research and Development Authority). In short, the program sought to create a stockpile of next generation ventilators for emergency situations — including, notably, pandemics. The ventilator would thus have to be designed for events where

mass casualties may be expected, and when shortages of experienced health care providers with respiratory support training, and shortages of ventilators and accessory components may be expected.

The Aura ventilator would thus sit somewhere between Newport’s two other ventilators: the e360 which could be used in pediatric care (for newborns smaller than 5kg) but was not intended for home care use (or the extreme scenarios envisioned by the US government); and the more portable HT70 which could be used in home care environments, but not for newborns. 

Unfortunately, the Aura failed to achieve this goal. The FDA’s 510(k) clearance decision clearly states that the Aura was not intended for newborns:

The AURA family of ventilators is applicable for infant, pediatric and adult patients greater than or equal to 5 kg (11 lbs.).

A press release issued by Medtronic confirms that

the company was unable to secure FDA approval for use in neonatal populations — a contract requirement.

And the US Government RFP confirms that this was indeed an important requirement:

The device must be able to provide the same standard of performance as current FDA pre-market cleared portable ventilators and shall have the following additional characteristics or features: 

Flexibility to accommodate a wide patient population range from neonate to adult.

Newport also seems to have been unable to deliver the ventilator at the low price it had initially forecasted — a common problem for small companies and/or companies that undertake large R&D programs. It also struggled to complete the project within the agreed-upon deadlines. As the Medtronic press release explains:

Covidien learned that Newport’s work on the ventilator design for the Government had significant gaps between what it had promised the Government and what it could deliverboth in terms of being able to achieve the cost of production specified in the contract and product features and performance. Covidien management questioned whether Newport’s ability to complete the project as agreed to in the contract was realistic.

As Jason Crawford, an engineer and tech industry commentator, put it:

Projects fail all the time. “Supplier risk” should be a standard checkbox on anyone’s contingency planning efforts. This is even more so when you deliberately push the price down to 30% of the market rate. Newport did not even necessarily expect to be profitable on the contract.

The above is mostly Covidien’s “side” of the story, of course. But other pieces of evidence lend some credibility to these claims:

  • Newport agreed to deliver its Aura ventilator at a per unit cost of less than $3000. But, even today, this seems extremely ambitious. For instance, the WHO has estimated that portable ventilators cost between $3,300 and $13,500. If Newport could profitably sell the Aura at such a low price, then there was little reason to discontinue it (readers will recall the development of the ventilator was mostly complete when Covidien put a halt to the project).
  • Covidien/Newport is not the only firm to have struggled to offer suitable ventilators at such a low price. Philips (which took Newport’s place after the government contract fell through) also failed to achieve this low price. Rather than the $2,000 price sought in the initial RFP, Philips ultimately agreed to produce the ventilators for $3,280. But it has not yet been able to produce a single ventilator under the government contract at that price.
  • Covidien has repeatedly been forced to recall some of its other ventilators ( here, here and here) — including the Newport HT70. And rival manufacturers have also faced these types of issues (for example, here and here). 

Accordingly, Covidien may well have preferred to cut its losses on the already problem-prone Aura project, before similar issues rendered it even more costly. 

In short, while it is impossible to prove that these development issues caused Covidien to pull the plug on the Aura project, it is certainly plausible that they did. This further supports the hypothesis that Covidien’s acquisition of Newport was not a killer acquisition. 

Ending the Aura project might have been an efficient outcome

As suggested above, moreover, it is entirely possible that Covidien was better able to realize the poor prospects of Newport’s Aura project and also better organized to enable it to make the requisite decision to abandon the project.

A small company like Newport faces greater difficulties abandoning entrepreneurial projects because doing so can impair a privately held firm’s ability to raise funds for subsequent projects.

Moreover, the relatively large share of revue and reputation that Newport — worth $103 million in 2012, versus Covidien’s $11.8 billion — would have realized from fulfilling a substantial US government project could well have induced it to overestimate the project’s viability and to undertake excessive risk in the (vain) hope of bringing the project to fruition.  

While there is a tendency among antitrust scholars, enforcers, and practitioners to look for (and find…) antitrust-related rationales for mergers and other corporate conduct, it remains the case that most corporate control transactions (such as mergers) are driven by the acquiring firm’s expectation that it can manage more efficiently. As Henry G. Manne put it in his seminal article, Mergers and the Market for Corporate Control (1965): 

Since, in a world of uncertainty, profitable transactions will be entered into more often by those whose information is relatively more reliable, it should not surprise us that mergers within the same industry have been a principal form of changing corporate control. Reliable information is often available to suppliers and customers as well. Thus many vertical mergers may be of the control takeover variety rather than of the “foreclosure of competitors” or scale-economies type.

Of course, the same information that renders an acquiring firm in the same line of business knowledgeable enough to operate a target more efficiently could also enable it to effect a “killer acquisition” strategy. But the important point is that a takeover by a firm with a competing product line, after which the purchased company’s product line is abandoned, is at least as consistent with a “market for corporate control” story as with a “killer acquisition” story.

Indeed, as Florian Ederer himself noted with respect to the Covidien/Newport merger, 

“Killer acquisitions” can have a nefarious image, but killing off a rival’s product was probably not the main purpose of the transaction, Ederer said. He raised the possibility that Covidien decided to kill Newport’s innovation upon realising that the development of the devices would be expensive and unlikely to result in profits.

Concluding remarks

In conclusion, Covidien’s acquisition of Newport offers a cautionary tale about reckless journalism, “blackboard economics,” and government failure.

Reckless journalism because the New York Times clearly failed to do the appropriate due diligence for its story. Its journalists notably missed (or deliberately failed to mention) a number of critical pieces of information — such as the hugely important fact that most of Covidien’s and Newport’s products did not overlap, or the fact that there were numerous competitors in the highly competitive mechanical ventilator industry. 

And yet, that did not stop the authors from publishing their extremely alarming story, effectively suggesting that a small medical device merger materially contributed to the loss of many American lives.

The story also falls prey to what Ronald Coase called “blackboard economics”:

What is studied is a system which lives in the minds of economists but not on earth. 

Numerous commentators rushed to fit the story to their preconceived narratives, failing to undertake even a rudimentary examination of the underlying market conditions before they voiced their recriminations. 

The only thing that Covidien and Newport’s merger ostensibly had in common with the killer acquisition theory was the fact that a large firm purchased a small rival, and that the one of the small firm’s products was discontinued. But this does not even begin to meet the stringent conditions that must be fulfilled for the theory to hold water. Unfortunately, critics appear to have completely ignored all contradicting evidence. 

Finally, what the New York Times piece does offer is a chilling tale of government failure.

The inception of the US government’s BARDA program dates back to 2008 — twelve years before the COVID-19 pandemic hit the US. 

The collapse of the Aura project is no excuse for the fact that, more than six years after the Newport contract fell through, the US government still has not obtained the necessary ventilators. Questions should also be raised about the government’s decision to effectively put all of its eggs in the same basket — twice. If anything, it is thus government failure that was the real culprit. 

And yet the New York Times piece and the critics shouting “killer acquisition!” effectively give the US government’s abject failure here a free pass — all in the service of pursuing their preferred “killer story.”

As has been rumored in the press for a few weeks, today Comcast announced it is considering making a renewed bid for a large chunk of Twenty-First Century Fox’s (Fox) assets. Fox is in the process of a significant reorganization, entailing primarily the sale of its international and non-television assets. Fox itself will continue, but with a focus on its US television business.

In December of last year, Fox agreed to sell these assets to Disney, in the process rejecting a bid from Comcast. Comcast’s initial bid was some 16% higher than Disney’s, although there were other differences in the proposed deals, as well.

In April of this year, Disney and Fox filed a proxy statement with the SEC explaining the basis for the board’s decision, including predominantly the assertion that the Comcast bid (NB: Comcast is identified as “Party B” in that document) presented greater regulatory (antitrust) risk.

As noted, today Comcast announced it is in “advanced stages” of preparing another unsolicited bid. This time,

Any offer for Fox would be all-cash and at a premium to the value of the current all-share offer from Disney. The structure and terms of any offer by Comcast, including with respect to both the spin-off of “New Fox” and the regulatory risk provisions and the related termination fee, would be at least as favorable to Fox shareholders as the Disney offer.

Because, as we now know (since the April proxy filing), Fox’s board rejected Comcast’s earlier offer largely on the basis of the board’s assessment of the antitrust risk it presented, and because that risk assessment (and the difference between an all-cash and all-share offer) would now be the primary distinguishing feature between Comcast’s and Disney’s bids, it is worth evaluating that conclusion as Fox and its shareholders consider Comcast’s new bid.

In short: There is no basis for ascribing a greater antitrust risk to Comcast’s purchase of Fox’s assets than to Disney’s.

Summary of the Proposed Deal

Post-merger, Fox will continue to own Fox News Channel, Fox Business Network, Fox Broadcasting Company, Fox Sports, Fox Television Stations Group, and sports cable networks FS1, FS2, Fox Deportes, and Big Ten Network.

The deal would transfer to Comcast (or Disney) the following:

  • Primarily, international assets, including Fox International (cable channels in Latin America, the EU, and Asia), Star India (the largest cable and broadcast network in India), and Fox’s 39% interest in Sky (Europe’s largest pay TV service).
  • Fox’s film properties, including 20th Century Fox, Fox Searchlight, and Fox Animation. These would bring along with them studios in Sydney and Los Angeles, but would not include the Fox Los Angeles backlot. Like the rest of the US film industry, the majority of Fox’s film revenue is earned overseas.
  • FX cable channels, National Geographic cable channels (of which Fox currently owns 75%), and twenty-two regional sports networks (RSNs). In terms of relative demand for the two cable networks, FX is a popular basic cable channel, but fairly far down the list of most-watched channels, while National Geographic doesn’t even crack the top 50. Among the RSNs, only one geographic overlap exists with Comcast’s current RSNs, and most of the Fox RSNs (at least 14 of the 22) are not in areas where Comcast has a substantial service presence.
  • The deal would also entail a shift in the companies’ ownership interests in Hulu. Hulu is currently owned in equal 30% shares by Disney, Comcast, and Fox, with the remaining, non-voting 10% owned by Time Warner. Either Comcast or Disney would hold a controlling 60% share of Hulu following the deal with Fox.

Analysis of the Antitrust Risk of a Comcast/Fox Merger

According to the joint proxy statement, Fox’s board discounted Comcast’s original $34.36/share offer — but not the $28.00/share offer from Disney — because of “the level of regulatory issues posed and the proposed risk allocation arrangements.” Significantly on this basis, the Fox board determined Disney’s offer to be superior.

The claim that a merger with Comcast poses sufficiently greater antitrust risk than a purchase by Disney to warrant its rejection out of hand is unsupportable, however. From an antitrust perspective, it is even plausible that a Comcast acquisition of the Fox assets would be on more-solid ground than would be a Disney acquisition.

Vertical Mergers Generally Present Less Antitrust Risk

A merger between Comcast and Fox would be predominantly vertical, while a merger between Disney and Fox, in contrast, would be primarily horizontal. Generally speaking, it is easier to get antitrust approval for vertical mergers than it is for horizontal mergers. As Bruce Hoffman, Director of the FTC’s Bureau of Competition, noted earlier this year:

[V]ertical merger enforcement is still a small part of our merger workload….

There is a strong theoretical basis for horizontal enforcement because economic models predict at least nominal potential for anticompetitive effects due to elimination of horizontal competition between substitutes.

Where horizontal mergers reduce competition on their face — though that reduction could be minimal or more than offset by benefits — vertical mergers do not…. [T]here are plenty of theories of anticompetitive harm from vertical mergers. But the problem is that those theories don’t generally predict harm from vertical mergers; they simply show that harm is possible under certain conditions.

On its face, and consistent with the last quarter century of merger enforcement by the DOJ and FTC, the Comcast acquisition would be less likely to trigger antitrust scrutiny, and the Disney acquisition raises more straightforward antitrust issues.

This is true even in light of the fact that the DOJ decided to challenge the AT&T-Time Warner (AT&T/TWX) merger.

The AT&T/TWX merger is a single data point in a long history of successful vertical mergers that attracted little scrutiny, and no litigation, by antitrust enforcers (although several have been approved subject to consent orders).

Just because the DOJ challenged that one merger does not mean that antitrust enforcers generally, nor even the DOJ in particular, have suddenly become more hostile to vertical mergers.

Of particular importance to the conclusion that the AT&T/TWX merger challenge is of minimal relevance to predicting the DOJ’s reception in this case, the theory of harm argued by the DOJ in that case is far from well-accepted, while the potential theory that could underpin a challenge to a Disney/Fox merger is. As Bruce Hoffman further remarks:

I am skeptical of arguments that vertical mergers cause harm due to an increased bargaining skill; this is likely not an anticompetitive effect because it does not flow from a reduction in competition. I would contrast that to the elimination of competition in a horizontal merger that leads to an increase in bargaining leverage that could raise price or reduce output.

The Relatively Lower Risk of a Vertical Merger Challenge Hasn’t Changed Following the DOJ’s AT&T/Time Warner Challenge

Judge Leon is expected to rule on the AT&T/TWX merger in a matter of weeks. The theory underpinning the DOJ’s challenge is problematic (to say the least), and the case it presented was decidedly weak. But no litigated legal outcome is ever certain, and the court could, of course, rule against the merger nevertheless.

Yet even if the court does rule against the AT&T/TWX merger, this hardly suggests that a Comcast/Fox deal would create a greater antitrust risk than would a Disney/Fox merger.

A single successful challenge to a vertical merger — what would be, in fact, the first successful vertical merger challenge in four decades — doesn’t mean that the courts are becoming hostile to vertical mergers any more than the DOJ’s challenge means that vertical mergers suddenly entail heightened enforcement risk. Rather, it would simply mean that that, given the specific facts of the case, the DOJ was able to make out its prima facie case, and that the defendants were unable to rebut it.  

A ruling for the DOJ in the AT&T/TWX merger challenge would be rooted in a highly fact-specific analysis that could have no direct bearing on future cases.

In the AT&T/TWX case, the court’s decision will turn on its assessment of the DOJ’s argument that the merged firm could raise subscriber prices by a few pennies per subscriber. But as AT&T’s attorney aptly pointed out at trial (echoing the testimony of AT&T’s economist, Dennis Carlton):

The government’s modeled price increase is so negligible that, given the inherent uncertainty in that predictive exercise, it is not meaningfully distinguishable from zero.

Even minor deviations from the facts or the assumptions used in the AT&T/TWX case could completely upend the analysis — and there are important differences between the AT&T/TWX merger and a Comcast/Fox merger. True, both would be largely vertical mergers that would bring together programming and distribution assets in the home video market. But the foreclosure effects touted by the DOJ in the AT&T/TWX merger are seemingly either substantially smaller or entirely non-existent in the proposed Comcast/Fox merger.

Most importantly, the content at issue in AT&T/TWX is at least arguably (and, in fact, argued by the DOJ) “must have” programming — Time Warner’s premium HBO channels and its CNN news programming, in particular, were central to the DOJ’s foreclosure argument. By contrast, the programming that Comcast would pick up as a result of the proposed merger with Fox — FX (a popular, but non-essential, basic cable channel) and National Geographic channels (which attract a tiny fraction of cable viewing) — would be extremely unlikely to merit that designation.

Moreover, the DOJ made much of the fact that AT&T, through DirectTV, has a national distribution footprint. As a result, its analysis was dependent upon the company’s potential ability to attract new subscribers decamping from competing providers from whom it withholds access to Time Warner content in every market in the country. Comcast, on the other hand, provides cable service in only about 35% of the country. This significantly limits its ability to credibly threaten competitors because its ability to recoup lost licensing fees by picking up new subscribers is so much more limited.

And while some RSNs may offer some highly prized live sports programming, the mismatch between Comcast’s footprint and the FOX RSNs (only about 8 of the 22 Fox RSNs are in Comcast service areas) severely limits any ability or incentive the company would have to leverage that content for higher fees. Again, to the extent that RSN programming is not “must-have,” and to the extent there is not overlap between the RSN’s geographic area and Comcast’s service area, the situation is manifestly not the same as the one at issue in the AT&T/TWX merger.

In sum, a ruling in favor of the DOJ in the AT&T/TWX case would be far from decisive in predicting how the agency and the courts would assess any potential concerns arising from Comcast’s ownership of Fox’s assets.

A Comcast/Fox Deal May Entail Lower Antitrust Risk than a Disney/Fox Merger

As discussed below, concerns about antitrust enforcement risk from a Comcast/Fox merger are likely overstated. Perhaps more importantly, however, to the extent these concerns are legitimate, they apply at least as much to a Disney/Fox merger. There is, at minimum, no basis for assuming a Comcast deal would present any greater regulatory risk.

The Antitrust Risk of a Comcast/Fox Merger Is Likely Overstated

The primary theory upon which antitrust enforcers could conceivably base a Comcast/Fox merger challenge would be a vertical foreclosure theory. Importantly, such a challenge would have to be based on the incremental effect of adding the Fox assets to Comcast, and not on the basis of its existing assets. Thus, for example, antitrust enforcers would not be able to base a merger challenge on the possibility that Comcast could leverage NBC content it currently owns to extract higher fees from competitors. Rather, only if the combination of NBC programming with additional content from Fox could create a new antitrust risk would a case be tenable.

Enforcers would be unlikely to view the addition of FX and National Geographic to the portfolio of programming content Comcast currently owns as sufficient to raise concerns that the merger would give Comcast anticompetitive bargaining power or the ability to foreclose access to its content.

Although even less likely, enforcers could be concerned with the (horizontal) addition of 20th Century Fox filmed entertainment to Universal’s existing film production and distribution. But the theatrical film market is undeniably competitive, with the largest studio by revenue (Disney) last year holding only 22% of the market. The combination of 20th Century Fox with Universal would still result in a market share only around 25% based on 2017 revenues (and, depending on the year, not even result in the industry’s largest share).

There is also little reason to think that a Comcast controlling interest in Hulu would attract problematic antitrust attention. Comcast has already demonstrated an interest in diversifying its revenue across cable subscriptions and licensing, broadband subscriptions, and licensing to OVDs, as evidenced by its recent deal to offer Netflix as part of its Xfinity packages. Hulu likely presents just one more avenue for pursuing this same diversification strategy. And Universal has a history (see, e.g., this, this, and this) of very broad licensing across cable providers, cable networks, OVDs, and the like.

In the case of Hulu, moreover, the fact that Comcast is vertically integrated in broadband as well as cable service likely reduces the anticompetitive risk because more-attractive OVD content has the potential to increase demand for Comcast’s broadband service. Broadband offers larger margins (and is growing more rapidly) than cable, and it’s quite possible that any loss in Comcast’s cable subscriber revenue from Hulu’s success would be more than offset by gains in its content licensing and broadband subscription revenue. The same, of course, goes for Comcast’s incentives to license content to OVD competitors like Netflix: Comcast plausibly gains broadband subscription revenue from heightened consumer demand for Netflix, and this at least partially offsets any possible harm to Hulu from Netflix’s success.

At the same time, especially relative to Netflix’s vast library of original programming (an expected $8 billion worth in 2018 alone) and content licensed from other sources, the additional content Comcast would gain from a merger with Fox is not likely to appreciably increase its bargaining leverage or its ability to foreclose Netflix’s access to its content.     

Finally, Comcast’s ownership of Fox’s RSNs could, as noted, raise antitrust enforcers’ eyebrows. Enforcers could be concerned that Comcast would condition competitors’ access to RSN programming on higher licensing fees or prioritization of its NBC Sports channels.

While this is indeed a potential risk, it is hardly a foregone conclusion that it would draw an enforcement action. Among other things, NBC is far from the market leader, and improving its competitive position relative to ESPN could be viewed as a benefit of the deal. In any case, potential problems arising from ownership of the RSNs could easily be dealt with through divestiture or behavioral conditions; they are extremely unlikely to lead to an outright merger challenge.

The Antitrust Risk of a Disney Deal May Be Greater than Expected

While a Comcast/Fox deal doesn’t entail no antitrust enforcement risk, it certainly doesn’t entail sufficient risk to deem the deal dead on arrival. Moreover, it may entail less antitrust enforcement risk than would a Disney/Fox tie-up.

Yet, curiously, the joint proxy statement doesn’t mention any antitrust risk from the Disney deal at all and seems to suggest that the Fox board applied no risk discount in evaluating Disney’s bid.

Disney — already the market leader in the filmed entertainment industry — would acquire an even larger share of box office proceeds (and associated licensing revenues) through acquisition of Fox’s film properties. Perhaps even more important, the deal would bring the movie rights to almost all of the Marvel Universe within Disney’s ambit.

While, as suggested above, even that combination probably wouldn’t trigger any sort of market power presumption, it would certainly create an entity with a larger share of the market and stronger control of the industry’s most valuable franchises than would a Comcast/Fox deal.

Another relatively larger complication for a Disney/Fox merger arises from the prospect of combining Fox’s RSNs with ESPN. Whatever ability or incentive either company would have to engage in anticompetitive conduct surrounding sports programming, that risk would seem to be more significant for undisputed market leader, Disney. At the same time, although still powerful, demand for ESPN on cable has been flagging. Disney could well see the ability to bundle ESPN with regional sports content as a way to prop up subscription revenues for ESPN — a practice, in fact, that it has employed successfully in the past.   

Finally, it must be noted that licensing of consumer products is an even bigger driver of revenue from filmed entertainment than is theatrical release. No other company comes close to Disney in this space.

Disney is the world’s largest licensor, earning almost $57 billion in 2016 from licensing properties like Star Wars and Marvel Comics. Universal is in a distant 7th place, with 2016 licensing revenue of about $6 billion. Adding Fox’s (admittedly relatively small) licensing business would enhance Disney’s substantial lead (even the number two global licensor, Meredith, earned less than half of Disney’s licensing revenue in 2016). Again, this is unlikely to be a significant concern for antitrust enforcers, but it is notable that, to the extent it might be an issue, it is one that applies to Disney and not Comcast.

Conclusion

Although I hope to address these issues in greater detail in the future, for now the preliminary assessment is clear: There is no legitimate basis for ascribing a greater antitrust risk to a Comcast/Fox deal than to a Disney/Fox deal.

Henry Manne first theorized the market for corporate control, but the man who first put the concept into action was Louis E. Wolfson.  I blogged briefly about Wolfson when he died in 2008.  Now you can read more about him in Alan M. Weinberger, What’s in a Name?– The Tale of Louis Wolfson’s Affirmed, 39 Hofstra L. Rev. 645 (2011) (not on SSRN).  Here’s the abstract:

Why would someone choose to name a thoroughbred racehorse “Affirmed” after his conviction for federal securities laws violations had been affirmed on appeal? This inquiry is the basis for exploring the enigmatic life and spectacular career of Louis E. Wolfson, owner and breeder of the last winner of horse racing’s Triple Crown.

Perhaps best known as the central figure in the scandal that resulted in the forced resignation of Supreme Court Justice Abe Fortas, Wolfson left a sizable footprint on corporate legal history. He has been described as the original corporate raider, the inventor of the market for corporate control through the hostile tender offer, and the founder of the first modern conglomerate. Principal cases involving Wolfson appear in virtually all Corporations and Securities Regulation casebooks. Long the subject of academic study, commentary, and controversy, these decisions continue to be cited as authority for the partial indemnification of officers and directors, and the proposition that controlling persons expose themselves to criminal liability for effecting a distribution of unregistered shares through a broker.

Steve Bainbridge is offering his new book, Directors as Auctioneers: A Concise Guide to Revlon-Land, as a Kindle eBook. Here’s his discussion of the book and of his decision to go the e-book route.  I’ve bought it already and presumably will have it when I turn my Kindle on.

Steve’s reasoning is plausible:  he gets more money than for law review articles, controls the marketing and price, and keeps all the proceeds instead of just royalties. He doesn’t get any quality signal, but at his career stage doesn’t need another one. His Revlon book offers him an opportunity to “update, expand, and augment older work on Revlon and offer up a new and improved analysis in a different package” that provides analysis relevant to some recent Delaware decisions. 

I would add that the format provides a marginal incentive that could produce scholarship that might not otherwise get produced.  This is what markets are supposed to do.

Needless to say, I’m interested in how this works out for Steve.  Given rapid developments in publishing, I expect that this is just the first stage of an interesting evolutionary process.

The so-called “Dodd-Frank Wall Street Reform and Consumer Protection Act” was supposed to fix the problems that led to the financial bust.  Of course, that would require some understanding of what, exactly, those problems were, which Congress lacked.  The Act did little to fix the credit raters or the derivatives market that surely had something to do with the crash.  But it did include countless ill-considered provisions and rules lying in wait behind studies.  I’ve already commented (here and here) on the Act’s unwarranted federal intrusion into aspects of corporate governance that had little to do with the meltdown. And I’ve noted the Act’s contribution to hobbling initial public offerings.

Yale’s Jon Macey comments in today’s WSJ on the potential fallout from one of D-F’s most buried little gems:  Section 929R(a)’s authorization to the SEC to reduce the period for reporting 5% share acquisitions from ten days to “such shorter time as the Commission may establish by rule.”  Marty Lipton’s takeover defense firm, Wachtell, Lipton, Rosen & Katz, has seized on this provision to propose that the SEC reduce that period to one day. 

Alerting the market to a potential impending bid raises share prices and therefore the takeover’s overall cost. This would add to the effects of a long-term trend at both the state and federal level of allocating increasing shares of the potential gains from takeover-induced governance reforms to the incumbent shareholders and away from the bidder. This is fine for the shareholders, given the existence of a bid.  But if you increase the price of bids you’re likely to decrease the supply.  Fewer bids = more power to incumbent managers. 

As Macey notes:

Shareholders benefit from the reforms of corporate governance initiated by these activist investors. So does the economy generally, because the overall economy performs better when companies perform better. But managers are not so fond of this process because activist investors push incumbent senior managers hard to improve their performance. Occasionally they even fire them.

Since incumbent managers sometimes lose to activist investors in fair corporate elections, their preferred strategy for dealing with them is to hire legal talent and team up with friendly regulators to make new rules and to concoct anti-takeover devices like poison pills.

Macey observes that the success of these efforts explains “why the market for corporate control is relatively moribund, particularly when compared to the robust markets of the past.”

One would think that true financial reform would seek to have the opposite effect — to increase the pressure on incumbent managers, whose comfortable entrenchment helped them ignore huge risks that ended up destroying some big companies.

The roots of the W-L initiative lie in two other developments. First, as Macey notes, “changes in technology and other advances have made it possible for investors to buy shares and to file reports with the SEC in less time than before.”  Thus, incumbent managers fear losing some of the edge they’ve accumulated over bidders.  But this just returns to the question of how great that edge should be.

Second, and more important for present purposes, Steve Davidoff notes the role here of yet another formerly obscure Dodd-Frank provision, §766(e), which empowers the SEC to count cash-settled derivatives in their holdings for 13D purposes.  Davidoff suggests the real problem here isn’t reporting, but the fact that bank parties to these transactions hedge their positions by buying target shares. They can then vote those shares although they lacks a real economic interest in the company — i.e., the “empty voting” problem.  Davidoff suggests the solution is simply preventing the hedged parties from voting these shares.  Of course this would open for analysis the large can of “empty voting” worms.  As Kobayashi and I have written, this problem is much less obvious and more complex than meets the eye.  

Davidoff has discussed the interest group battle over the W-L proposal:

Corporate America is divided over the Wachtell petition. According to people close to the firm, an earlier draft of the petition was circulated among seven law firms, a working group of well-known corporate law firms commenting on Dodd-Frank initiatives. But the other law firms begged off signing the petition. * * * Wachtell portrays itself as a firm that favors management. It actively represents companies against hostile takeovers and activist shareholders but appears to have only one large hedge fund activist client* * *

Wachtell appears to have the ear of the S.E.C. Michele M. Anderson, the agency’s chief of mergers and acquisitions, said last month that the S.E.C. staff was planning to recommend that the reporting period be shortened.

The more basic issue here is the battle for control of corporate governance law between the states, who compete for business, and the federal legislators and regulators, who collect rents from powerful interest groups.  On the other side of the takeover argument from Wachtell are those who are pushing increased application of federal law to restrict state law regulation of takeovers.  I’ve argued that these moves are also ill-advised.

And then there is what Davidoff refers to as the “larger war against hedge funds.”  He sees the SEC as

desperately struggling for relevance. Hedge funds are rich but often unpopular. Wachtell, through its focus on protecting shareholders rather than corporate boards, is using the agency’s struggles to push through its agenda.

This might have something to do with a certain insider trading trial going on in NYC.

To make a long story short, rather than solve the problems that led to the financial crisis, Dodd-Frank included myriad buried treasures that are now serving as platforms on which interest groups and federal agencies can battle for control of large corporations.  In the case of 929R and 766(e), “financial reform” may well lead to more federalization of corporate governance law and more power for incumbent managers — exactly what the financial crisis demonstrated we do not need.

The Airgas decision

Larry Ribstein —  16 February 2011

So Chancellor Chandler, in deciding Airgas, preserved the board’s power to decide when to sell the company.  If a company’s shareholders don’t like it, they need to replace the board.  If shareholders generally don’t like it they need to change the Delaware statute.

In upholding the board’s power, and confirming what most astute observers knew the law likely was, despite very strong facts the other way (no “coercion” or other obvious reason why the pill was needed), the court preserved the stability of Delaware law. Hard facts don’t have to make bad law.  Although the Air Products bid was $70, the shares had been trading around $63.  They fell from $63.73 to $61 after the decision, suggesting clarification of a small residual amount of uncertainty.

The decision illustrates one reason why Subramanian, et al, were wrong to suggest the Delaware anti-takeover statute is preempted by the Williams Act.  If the statute, why not the pill — and other aspects of Delaware law that block takeovers?  Here’s my response along these lines to the Subramanian et al argument.

Of course Congress theoretically could pass a law that explicitly preempts poison pills.  Dodd-Frank’s intrusion into corporate governance makes this plausible.  But such additional federal interference would not be wise.

Bebchuk, Cohen and Wang have posted Staggered Boards and the Wealth of Shareholders: Evidence from a Natural Experiment.  Here’s the abstract:

While staggered boards are known to be negatively correlated with firm valuation, such association might be due to staggered boards either bringing about lower firm value or merely being the product of the tendency of low-value firms to have staggered boards. In this paper, we use a natural experiment setting to identify how market participants view the effect of staggered boards on firm value. In particular, we focus on two recent rulings, separated by several weeks, that had opposite effects on the antitakeover force of the staggered boards of affected companies: (i) an October 2010 ruling by the Delaware Chancery Court approving the legality of shareholder-adopted bylaws that weaken the antitakeover force of a staggered board by moving the company’s annual meeting up from later parts of the calendar year to January, and (ii) the subsequent decision by the Delaware Supreme Court to overturn the Chancery Court ruling and invalidate such bylaws.

We find evidence consistent with the hypothesis that the Chancery Court ruling increased the value of companies significantly affected by the rulings –namely, companies with a staggered board and an annual meeting in later parts of the calendar year –and that the Supreme Court ruling produced a reduction in the value of these companies that was of similar magnitude (but opposite sign) to the value increase generated by the Chancery Court ruling. The identified positive and negative effects were most pronounced for firms for which control contests are especially relevant due to low industry-adjusted Tobin’s Q, low industry-adjusted return on assets, or relatively small firm size. Our findings are consistent with market participants’ viewing staggered boards as bringing about a reduction in firm value. The findings are thus consistent with institutional investors’ standard policies of voting in favor of proposals to repeal classified boards, and with the view that the ongoing process of board declassification in public firms will enhance shareholder value.

The paper reports on the Airgas/Air Products takeover battle.  Interestingly, it relies heavily on Steve Davidoff’s excellent reporting on this contest.

I have not studied the empirical test closely.  Taking the results at face value, I have a couple of observations.  First, although this evidence helps persuade Bebchuk et al that declassification “will enhance shareholder value,” proponents of strong boards who distrust markets driven by arbs and hedge funds would disagree.  I think the ultimate answer is best given by the corporate contract.  As interpreted by the Delaware courts in Airgas, that contract (reading the corporate charter in conjunction with the statute) favors strong board control.  See generally my venerable but still relevant article on interpreting the corporate contract in this context, Takeover Defenses and the Corporate Contract, 78 Georgetown Law Journal 71 (1989). This contract gives boards the power to, for example, maintain management continuity and long-run vision, at the possible cost of foregoing agency cost discipline. 

Second, there is, of course, another way — the uncorporation which, as I discuss in my Rise of the Uncorporation, may combine strong protection from takeovers with other mechanisms for disciplining managers.  For a recent article focusing on staggered boards in a particular type of uncorporation, see Corporate Governance and Performance in the Market for Corporate Control: The Case of REITs (no free online version available):  

We examine 132 mergers and acquisitions by Real Estate Investment Trusts (REITs) during 1997-2006 and explore the relationship between acquirer external and internal corporate governance mechanisms and announcement abnormal returns. We argue that in regulated industries with absent active takeover market, the importance of outside governance mechanisms is diminished and substituted by internal governance controls. We focus on the REIT industry. We find that bidder returns are higher for REITs with smaller boards, with more experienced CEOs, but with shorter tenure. Acquirers’ announcement returns are also significantly and positively related to higher ownership by their CEOs and board directors. We find no significant relationship between presence of staggered board and abnormal bidder returns, which supports our hypothesis that anti-takeover defense measured have reduced importance for REITs.

Abercrombie goes to Ohio

Larry Ribstein —  28 December 2010

Steve Davidoff has the story, and it’s an interesting exercise in corporate contracting complicated by jurisdictional choice.

Abercrombie’s proposed reincorporation is essentially a takeover defense.  Unlike Delaware, Abercrombie’s current state of incorporation, Ohio  

  • Has a business combination statute that’s triggered by a 10% acquisition rather than 15% as in Delaware.
  • Has a control share acquisition statute requiring shareholder approval of an acquisition of shares that would put the acquirer over the statutory level of control.
  • Would disenfranchise shareholders (i.e., arbs) who acquire a more than .5% block after an acquisition proposal.
  • Does not have a “Revlon rule” subjecting director decisions to sell the company to a higher scrutiny level.
  • Is Abercrombie’s home state, and therefore a friendly forum in a takeover battle.

This situation illustrates how jurisdictional choice makes contractual what would otherwise seem to be mandatory takeover rules.

Is it a problem that Abercrombie is changing the original statutory “bargain” based on Delaware incorporation its shareholders may have relied on?  Steve notes that Abercrombie proposed the reincorporation after the announcement of buyouts for competitors J. Crew and Jo-Ann Stores which may have put Abercrombie in play. 

It would be interesting to do an event study on Abercrombie shares. I wonder if they (1) took a hit from reducing the probability of a bid; (2) got a boost because any takeover will be after an auction and possibly at a higher price; (3) got a boost because the move communicates information about the likelihood of a bid; (4) didn’t move because a reincorporation was already priced in; or (5) didn’t move because the shareholders still  have to vote on the reincorporation, and proxy advisors may weigh in against it.

Finally, was there adequate disclosure to shareholders about the reason for and implications of the move?  Does it matter if there were enough sophisticated or well-advised institutional shareholders to help ensure an informed vote?

The bottom line is that the Law Market is a significant part of the transactional environment.

Last fall Guhan Subramanian, Steve Herscovici and Brian Barbetta (“SHB”) posted a paper claiming that Delaware’s antitakeover statute (Delaware GCL Section 203) was preempted by the Williams Act because it did not leave hostile bidders the “meaningful opportunity for success” required by three 1988 federal district courts which had upheld the Delaware law back in 1988. Specifically, SHB concluded:

Using a new sample of all hostile takeover bids against Delaware targets that were announced between 1988 and 2008 that were subject to Section 203 (n=60), we find that no hostile bidder in the past nineteen years has been able to avoid the restrictions imposed by Section 203 by going from less than 15% to more than 85% in its tender offer. At the very least, this finding indicates that the empirical proposition that the federal courts relied upon to uphold Section 203’s constitutionality is no longer valid. While it remains possible that courts would nevertheless uphold Section 203’s constitutionality on different grounds, the evidence would seem to suggest that the constitutionality of Section 203 is up for grabs. This Article offers specific changes to the Delaware statute that would preempt the constitutional challenge. If instead Section 203 were to fall on constitutional grounds, as Delaware’s prior antitakeover statute did in 1986, it would also have implications for similar antitakeover statutes in thirty-two other U.S. states, which along with Delaware collectively cover 92% of all U.S. corporations.

SHB has now been published in The Business Lawyer with several responses, including mine, Preemption as Micromanagement. Here’s the abstract of my paper:

Guhan Subramanian, Steven Herscovici & Brian Barbetta, Is Delaware’s Antitakeover Statute Unconstitutional? Evidence from 1988–2008 , 65 BUS. LAW. 685 (2010) (“SHB”), argues that the constitutionality of the Delaware takeover statute is “up for grabs” because it denies bidders the “meaningful opportunity for success” three Delaware district court opinions require to avoid preemption by the Williams Act. However, this comment on SHB argues that, even assuming the applicable federal cases might be construed to support SHB’s conclusion, courts almost certainly would not follow this approach once they saw, with the aid of SHB’s analysis, the extent to which it requires courts to micromanage state corporate law. Moreover, from a policy standpoint, this micromanagement could have a significant negative effect on the development of state law. In short, rather than providing an argument for preempting the Delaware statute, SHB’s analysis demonstrates why it is important to avoid this result.

SHB respond to the comments, including mine (most footnotes omitted):

Professor Ribstein argues that “[i]t would be inconsistent with [the Delaware trilogy’s] reliance on the legislature’s judgment to invalidate the statute based on circumstances arising after the legislature had applied its judgment.” We know of no principle in constitutional law, nor does Ribstein offer one, suggesting that when the legislature makes a constitutional assessment, and a court later acknowledges that assessment, the constitutional question becomes untouchable. Ribstein states that courts “did not necessarily contemplate that plaintiffs could return to court more than a generation after the [Delaware trilogy],” but this is precisely what the Delaware trilogy envisioned.22 It should be remembered that Delaware passed its first antitakeover statute in 1976 and took it off the books in 1987 because it was likely unconstitutional. It is not obvious why Ribstein’s hypothesized statute of limitations on constitutional claims should run longer than eleven years but shorter than twenty-two.

 22 See SHB, supra note 1, at ___ (citing relevant cases). Professor Ribstein also states that “SHB suggest that the poison pill itself avoids preemption.” Ribstein, supra note 16, at ___. We do not suggest this in our Article; therefore the “attempted distinction” between Section 203 and the pill that Ribstein criticizes, id. at ___, is not a distinction that we try to make. Ribstein then criticizes our Section 203 analysis because (he argues) if it were correct it would call into question defenses of unquestioned constitutional validity, such as the staggered board. See id. at ___. In fact, there is a natural distinction between transactional defenses, such as Section 203 and the pill, and other corporate governance provisions, such as the staggered board. See, e.g., CTS Corp. v Dynamics Corp. of Am., 481 U.S. 69, 99 (1987) (White, J., dissenting) (describing the “fundamental distinction” between transactional defenses such as the Indiana antitakeover statute and other corporate governance provisions, such as cumulative voting and staggered boards).

I do not, in fact, argue for “a statute of limitations.” Rather, my point is that any approach to the Supremacy Clause that would imply a continuing and detailed federal judicial power to review the entire body of state corporate law from a single federal statute would amount to a quite significant federal intrusion into a traditionally state-dominated area. Indeed, SHB call attention to this effect by their attempts to distinguish the poison pill, staggered board provisions and Delaware Section 203.

The SHB analysis is particularly uncalled for given a far less intrusive alternative which the Supreme Court suggested more than 25 years ago – that is, a presumption against preemption of state regulation of internal corporate governance. This was the point I made in discussing SHB’s article when it first appeared last year:

I’m skeptical of the authors’ unconstitutionality claim. Notably, Section 203 is part of the Delaware’s corporate statute, and therefore an integral part of its regulation of internal corporate governance, like its jurisprudence on the poison pill. This is important because, as Erin O’Hara and I explain in The Law Market (p. 126, footnote omitted): “Although the U.S. Constitution probably does not forbid a state from regulating the internal governance of a firm that is incorporated elsewhere, it may confer some extra regulatory power on the incorporating state. In CTS Corp. v. Dynamics Corp. of America, the Court reasoned that “no principle of corporation law and practice is more firmly established than a State’s authority to regulate domestic corporations, including the authority to define the voting rights of shareholders.”  This “authority” in CTS allowed the incorporating state to regulate the governance of firms based in other states, consistent with the Commerce Clause, and to preserve a state corporate law provision notwithstanding a potentially preemptive federal law, under the Supremacy Clause.  

The dangers of superbroad implied preemption of state corporate law are particularly salient in light of the imminent adoption of federal financial reform, as I discussed a few weeks ago:

Although none of the [corporate governance provisions in the Dodd bill] is individually earth-shaking, they cumulatively touch many major aspects of corporate governance formerly left to contract and state law.  This bill thus clearly adds to the framework for federal takeover of internal governance that SOX established. The overall effect is that it will be increasingly difficult to demark an area left exclusively for state law. This leaves little “firebreak” to protect against judicial incursions in the spaces not yet covered by explicit federal provisions.  This could ultimately profoundly affect the relationship between federal and state law regarding business associations. 

A generation ago the Supreme Court could say that “no principle of corporation law and practice is more firmly established than a State’s authority to regulate domestic corporations, including the authority to define the voting rights of shareholders.” CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69, 89 (1987). 

Erin O’Hara and I have argued that this separation between federal and state spheres does and should affect the scope of implied preemption of state law by federal statutes.  Thus, when the Court held that state securities actions were preempted by the Securities Litigation Uniform Standards Act, it emphasized “[t]he magnitude of the federal interest in protecting the integrity and efficient operation of the market for nationally traded securities.” Merrill Lynch, Pierce, Fenner & Smith, Inc. v. Dabit, 547 U.S. 71, 78 (2006). See also my article on Dabit.

However, we noted that “[m]any federal ‘securities’ laws reach deep into the kind of internal governance issues covered by the [internal affairs doctrine].” Thus, corporate internal affairs are only “relatively safe from federal preemption” and internal affairs is not “a constitutional boundary, as shown by the continuing forward march of federal corporation law.”

Under the Dodd bill, the forward march picks up the pace.  

The combination of increasing federal regulation of corporate governance, the cumulative preemption effects inherent in this regulation, and the extremely broad view of preemption that SHB endorse would effectively annihilate state corporate law. We can only hope that Congress eventually comes to its senses. We shouldn’t add to the political mess by inviting the courts to join in the destruction.