Mergers & Acquisitions  |  Deal Professor  |  June 12, 2013, 1:53 pm

The Management Buyout Path of Less Resistance

By STEVEN DAVIDOFF

David H. Murdock’s effort to take the Dole Food Company private shows how a recent Delaware case has made these types of management buyouts easier, perhaps too easy.

I’ve been writing this column for more than five years, and during that time management buyouts have been low-hanging fruit for material and criticism (pun fully intended). Time and again, management buyouts have gone awry as executives allegedly used their position to buy companies on the cheap. Just recall buyouts for Landry’s, CSX and J. Crew. And the new management buyout drawing criticism is the proposed $24.4 billion acquisition of Dell Computer by its founder and chief executive, Michael Dell, and the private equity firm Silver Lake.

But while management buyouts are subject to easy criticism that executives are using their position to try to force through a deal at a low price, there is a set of best practices that has emerged over the years to try to manage the inherent conflicts present in such buyouts.

These controls include the creation of a special committee of independent directors with independent advisers, a go-shop provision to allow the company to seek other offers once the deal is announced and a provision that the transaction be approved by a majority of the shareholders not part of the buyout group to ensure that independent shareholders can veto the deal. The central idea behind all of these is to empower boards and shareholders to say no and negotiate a deal with management on terms the company would get from other bidders.

Mr. Murdock, who is the chairman and chief executive of Dole Food, appears well advised because he has specifically conditioned his bid on the approval of a special committee as well as a majority of the remaining shareholders. This is not just to meet with best practices but to comply with a recent Delaware decision that is likely to change the way these deals are done. Many companies, including Dole, are incorporated in Delaware and subject to its laws.

Traditionally, Mr. Murdock’s bid, which values the company at $1.1 billion, would be subject to heightened scrutiny not just because he is management but because he already owns a 40 percent stake. If Mr. Murdock was only management and owned a smaller stake, Delaware law is likely to require only that the deal be approved by the disinterested shareholders or directors in order for a Delaware court to apply the so-called business judgment rule to the transaction, a form of deferential review that essentially means that no court will question the acquisition further.

But when the acquirer is a controlling shareholder, Delaware has traditionally imposed a higher standard of review to ensure that this type of transaction, commonly known as a freeze-out transaction, is fair to shareholders. In fact, the standard is often referred to as an entire fairness review. Under this standard, the Delaware courts will scrutinize a freeze-out transaction for fair price and fair dealing. Mr. Murdock does not own a majority stake, but he still probably owns enough shares to propel him into the category of higher scrutiny.

Delaware courts have been debating for more than a decade whether the entire fairness standard should still be imposed if there were procedures in place to remove the conflict, like an independent committee of directors and a condition of majority approval by the remaining shareholders. The latest decision to address this problem was issued just last month. Chancellor Leo E. Strine, Jr. held in In re MFW Shareholders Litigation that approval of a going-private transaction by both a committee of independent directors and a majority-of-minority condition would result in the lower business judgment standard of review and that Delaware courts would not review the transaction for fairness.

This has excited deal lawyers, who don’t often get excited, because it creates a real path for a controlling shareholder to acquire a company without having to deal with significant litigation risk.

Mr. Murdock’s lawyers have clearly read this case, and Mr. Murdock appears to be angling to obtain this lower level of court review by including these provisions.

But the real question is whether the protections commonly used in these conflicted transactions actually work.

In an article written by Matthew D. Cain and myself and published in 2011, we studied all management buyouts from 2003 to 2009, 103 in total, to determine what procedures actually worked to protect shareholders. We found that buyouts with independent committees resulted in 14 percent higher premiums on average for shareholders. Boards that actively negotiated against a management bidder and negotiated competitive acquisition contracts protective of shareholders also resulted in 15 percent higher premiums on average than buyouts with noncompetitive contracts. These were two provisions that benefited shareholders.

But we did not find any significant results that the inclusion of a majority-of-minority condition resulted in higher premiums. Similarly, we also found that inclusion of a go-shop provision had no effect on the deal premium, consistent with the finding of a previous study by Guhan Subramanian that go-shop provisions were ineffective and appeared to serve to cover up undervalued management buyouts.

These findings are not just relevant to management buyouts but to going-private transactions, as we had many of these dual-type transactions in our sample.

In fairness to the chancellor, he was trying to avoid running afoul of a previous Delaware Supreme Court ruling that held that an independent committee of directors was not enough to avoid an entire fairness review.

Looking at the evidence, however, it’s not clear why Chancellor Strine’s approach should make a difference. Instead, the evidence points to the fact that simply including an independent director committee should be an effective way to deal with the management conflict by having an independent force to negotiate on behalf of the shareholders.

If only it were that simple.

The problem is that we also found in our paper that the size of the premium paid changed depending on who initiated the transaction. We found that when the deal was initiated by management, premiums were significantly lower than if it was initiated by the board itself or a third party. We did not report the actual premium difference in our paper, but for our sample, takeovers initiated by directors produced premiums that were 9.4 percent higher, on average, than those initiated by management. And transactions initiated by third-party bidders were associated with premiums that were 12.8 percent higher, on average, than those initiated by management.

These findings appear to bear out the hypothesis that management can use its knowledge of the company and position to obtain lower premiums. This occurs even when there is an independent committee of directors.

These findings suggest that Delaware courts may still want to scrutinize these transactions more heavily even when there are procedural protections in place, particularly when management is initiating the transaction. It it likely the MFW decision will be appealed, and so now the Delaware Supreme Court will decide this matter.

Which brings us back to Dole. While all of the procedures listed above — and that Mr. Murdock has requested — are likely to be put in place, not surprisingly the initiating entity here is Mr. Murdock. He has, after all, taken the company private once before. This puts this deal in that category of real danger — where the premium may be lower because management can use its influence and perfectly time the transaction to get a good deal. This doesn’t mean that it is the case here, just that the shareholders and board of Dole might want to be careful as they move to negotiate a sale.

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