Selling Control for a Premium: Economics and Law

1. Selling Control for a Premium: Economics and Law Chapter 11

2. Evidence on Control Premiums & Voting Rights • If you buy a minority share in a company with a majority holder, will you pay the same price per share as that paid for each share of a controlling shareholder? • If not, what would explain the difference? • How are these price differences related to the value of voting rights? • What happens to the value of minority voting rights when a firm’s controlling block of shares changes hands?

3. Evidence on Control Premiums & Voting Rights • Premiums are paid for controlling block of shares • Stock price falls on the proxy voting date (price cum-vote & ex-vote) in a corporate control contest. • Generally voting rights in firms without a controlling shareholder have significant value only in a corporate control contest

4. Example p. 338 • Corp. has 1 MM shares • Control value = $5 MM • How much would you expect each share value to increase if control value were realized? • If control value were distributed evenly among 1 MM shares, each share would increase by $5 • If a 50.1% group were created, and that group got the entire control premium, those shares would go up apx. $10/share while the rest went up by $0/share • The legal rules determine allocation as much as financial incentives do. $15 MM ($5 MM bigger) $10 MM

5. Perlman v. Feldman

6. Perlman v. Feldman • The time was 1950 in the steel industry. • The Korean War was escalating and so was demand for steel • (leading later to President Truman’s executive order seizing the steel mills and the Supreme Court’s rebuff in the Youngstown Steel case). • But patriotic producers were refraining from advancing prices with the predictable squeeze on supplies. • The market‐clearing price would be at the intersection of the two curves producing a price of P* and a quantity of Q*.

7. Perlman v. Feldman • But at the lower price (a “soft” price control) of P bar, demand would be much higher as reflected by the difference between Qs , the amount that suppliers would supply at price P bar and QD and the amount users would seek at price P bar. • End users of steel, who could not obtain the steel they needed (and presumably would be willing to pay for in the current market) sought an alternative way to acquire steel. • if these soft price controls prevent you from offering a higher price to get the steel you want, they don’t prevent you from buying a steel company and then being able to direct the supply to your end users.

8. Price S PD Price Ceiling P bar Shortage Q* QS QD Quantity of steel Price controls: price ceilings P*= market price in equilibrium Q*= Equilib Q where S=D QD = D at controlled P QS = Supply at controlled P PD = market price at QS P* Price control P + interest subsidy D

9. Price Control Effects

10. Perlman • M&A is an alternative way to obtain steel. • How much would an end user be willing to pay to acquire a steel company and its supply of steel? • See Figure 11‐1, if the quantity being produced is Qs the end users would pay up to the market clearing rice at that quantity of PD. • How much is this amount? • We don’t know exactly, but it is likely to be a substantial part of the premium by which the block sells above the existing market price. • Are they other explanations for the gain? • The Feldmann plan is an alternative way for existing steel users to recover part of that price differential. • By getting a cash advance with no interest, Newport and other sellers would be receiving the time value of money of the use of that amount.

11. Perlman -- The parties • not surprising that the purchasers are a group of end‐users of steel who have not been able to obtain the steel that they want. • The transaction is not a corporate transaction by Newport, but rather . . . • a sale of stock by the controlling shareholder group as individuals selling their shares to Wilport, the group of end users.

12. Perlman v. Feldmann: Economic Explanations Wilport Newport $20/share 37% N stock Feldmann

13. How is the gain from the transaction to be allocated? • Since only members of the control group of shareholders are parties to the deal, only they will receive the consideration in the deal. • How much of the gain from gaining the supply of steel will the purchasers be willing to pay? • Probably the entire amount that the additional steel would be worth to them. • They are indifferent as to whether the premium is shared among all the shareholders or just 37% of them, so long as the purchaser gets control of the steel.

14. How is the gain from the transaction to be allocated? (cont.) • In Birnbaum v. Newport Steel, we read of contemporaneous deal -- another end user of steel (Follansbee) had sought to purchase Newport at $[ ]/ share. • This time, however, the purchaser proposed a merger, in which the premium would have been shared by all shareholders on a pro rata basis. • Feldmann, acting for the company, turns it down. • Note substitutability of the two transactional forms – (but it doesn’t tell us who ought to get the premium)

15. Perlman – legal issues • What is the action for which Feldmann is sued? • There is no corporate action; rather taking what can be seen as a corporate opportunity. • What is the basis for plaintiff’s claim? • Feldmann’sbreach of his fiduciary duty. • In what capacity is Feldmannsued?

16. Perlman – legal issues (cont.) • The court begins with reference to Feldmann’s fiduciary relationship both as a director and as dominant shareholder • Later it says his violation is clearer because of his triple role • although the court does not want “to be understood as saying that we should accept a lesser obligation for any one of his roles alone.” (page 392). • At what point does one become a dominant shareholder with fiduciary duties? • Here 37% was enough, although well short of a majority. • Such holdings were less debatable in the 1950s when shareholders were dispersed and passive so that if one group had 37% (or even less than that) it practically had control since the chances of others organizing against the 37% were unlikely. • That assumption is much less likely to hold today

17. When can a shareholder sell shares for a premium? • This is the crucial question • Is the answer is “Never”? • The court quotes from Cardozo’s punctilio standard in Meinhard v. Salmon and talks about this personal gain as “reprehensible.” • But the opinion also says explicitly (at page 392) “We do not mean to suggest that a majority shareholder cannot dispose of his controlling block of stock to outsiders without having to account to his corporation for profits.” • So when is it wrong? • This case tells us that when there is a “sacrifice of an element of corporate good will and consequent unusual profit.” • Would any premium be a corporate opportunity or is it possible to separate out the unusual ones?

18. Are non‐controlling shareholders better or worse off? • Can we look to the change in position of the non‐controlling shareholders to tell us whether the controlling shareholders have breached a fiduciary duty? • Easterbrook & Fischel (note 4) assert that the minority Perlman non‐controlling shareholders were in fact better off by the sale of control. • They rely on an unpublished paper by Charles Cope that reports a rise in the price of Newport over the remainder of 1950, a gain that remains after accounting for the rising fortunes of the steel companies as a whole during this period of the country’s effort to produce both guns and butter. • Should the control premium rule be that the controlling shareholder can take a premium so long as the minority is no worse off? • Note that the trial court had put the burden of proof on the plaintiff but the court of appeals disagrees noting that fiduciaries always have the burden of proof in establishing the fairness of their dealings with trust property.

19. Economic Impact on Minority Shareholders • Are they worse off? • Change in price for steel received by their company (same as before) • Change from loss of income of the Feldman Plan:Wilport only pays the controlled price for steel and no longer pays Feldmann premium to Newport. • Minority own 63% of Newport shares, so they: • lose 63% of Feldmann Plan interest subsidy’s value • gain 63% of synergies & efficiency gains in control change • How can we assess if minority shareholders have a net gain or loss? • Do expected benefits exceed expected loss of interest subsidy? • Does Newport’s stock price rise or fall? • Would that evidence sufficient to conclude there is no loss? What else would you want to know?

20. Mendel v. Carroll & Sale of Control • Chancellor Allen: • “The law has acknowledged, albeit in a guarded and complex way, the legitimacy of the acceptance by controlling shareholders of a control premium.” • Exceptions: • Negligence/ sale to looter • Sale of office • Sale of Corporate Opportunity • Where do Perlman & Mendel facts fit into that list?

21. Mendel: the deal • two deals that intersect: The first parallels Cox • The family that owns a controlling interest has proposed to acquire all of the non‐family shares originally at a price of $22 when the market price was $16. • Paralleling the process in prior cases, a special committee was appointed; Goldman Sachs was hired as well as a law firm for the committee. • The special committee rejects the $22, there was negotiation back and forth over six months and the parties eventually agreed on a merger at $25.75 leading to a proxy solicitation. • Then eight days after mailing of the proxy solicitation, an outside bidder (led by Pensler, who had worked for an investment banker hired by the company two years before so he likely knew something about the company’s potential) steps in with a $29 bid.

22. Mendel: the deal 2 • After three months of back and forth, the family withdraws its merger, makes clear it is not going to sell to an outsider, but the board and its special committee continue to consider the outside deal, including a provision in the Merger Agreement proposed by the outside bidder that would grant the bidder an irrevocable option to purchase 1.8 million shares at a price equal to the merger consideration. • The board and the committee seek an opinion of counsel as to whether issuing such an option would be a breach of duty. • The special committee’s Delaware counsel issues a 32 page opinion that concluded it was unclear whether granting the option would be legal. • In the face of the uncertainty, the board opts for a special dividend of $14 per share.

23. Mendel: Comparing the Two Offers • Who are the potential acquirers? • The Carroll family • At what price? • $22/$25.75 • Context? • Cash out • Legal Standard • Weinberger • Who are the potential acquirers? • Pensler • At what price? • $29/$27.80 • Context? • Best price • Legal Standard • Revlon

24. Mendel v. Carroll • How is the legal claim in this case different? Against whom is it brought and on what grounds? • Requiring board to grant dilutive option • Unprecedented; radical • When might the court do it? “I suppose” “might permissibly” “exploiting vulnerable minority”

25. Mendel v. Carroll: The resolution • How does the court resolve it? • “to be a protective guardian of the rightful interest of the public shareholders,” but “does not authorize the board to deploy corporate power against the majority shareholders, in the absence of threatened serious breach” • “quite possible that the Carroll $25.75 price may have been fair, even generous, while the $27.80 Pensler price may be inadequate.” • How can this be so? The value of control