Thanks for joining this episode of the No. 86 lecture series, where we discuss basic principles and applications of Corporate Law along with landmark cases. Today’s episode features Robert T. Miller, the F. Arnold Daum Chair in Corporate Finance and Law. Professor Miller’s research concerns corporate and securities law, the economic analysis of law, and the philosophy of law. As always, the Federalist Society takes no position on particular legal or public policy issues; all expressions of opinion are those of the speaker. Professor Miller, let’s talk about what a transactional lawyer does. In a previous podcast you mentioned they represent their clients in deals like mergers and acquisitions. Why do companies engage in mergers and acquisitions in the first place? So why do companies engage in business combination transactions, mergers and acquisitions, buying and selling the whole company, or a division thereof? Well, it all goes back to Ronald Coase. This is the Coase behind the famous Coase Theorem, The Problem of Social Cost article. But to an earlier article, he wrote, an article called Theory of the Firm, and as a young man, a young economist, Ronald Coase asked a question that no one had thought to ask. He essentially asked the following question, "If markets are so wonderful," and he thought they were, of course, "if markets are so wonderful for organizing economic activity, why is it that we see gigantic firms, companies, where inside the company, large amounts of economic activity is organized, not on the basis of market transactions, but in a command and control way?" What the CEO says goes, in terms of where assets go, where employees will work, what they'll do and so on. "Why do we have command and control inside the firm? And then a boundary at the firm where economic activity starts getting organized in a market way with companies outside the firm?" And what Coase suggested is that there were two types of transactions costs in the world you might face. You can face market transactions costs, if you organized your activity across markets. And in that case, you have to find the right person to contract with. You have to bargain out a contract with them. Then you have to monitor their performance under the contract. You face that set of transactions costs. Alternatively, you can pull an activity inside the firm and have it done by your own employees with your own property and your own assets. But in that case, you have employees. You have to pay the employees. You have to monitor them to make sure they're actually doing their jobs. And you have therefore a different set of transactions costs. For every type of problem, you can either contract for someone to do it for you on the market and face market transactions costs, or you can pull the function inside the firm and face agency costs. Now, if you're operating a business, and you decide that there is a function, some type of economic activity, that you would be better off having inside your firm than paying for someone on the market to do it, so for example, you’re Amazon. You sell all kinds of products. In the early days of Amazon, Amazon relied on the United States Postal Service, FedEx, the UPS, or other people to deliver their packages. Well now, Amazon has decided it might be better off, if it had that functionality of delivering packages inside the firm itself. When a company faces a problem like that, it has two choices. It can build up the functionality itself. That's what Amazon is doing. They buy their own vans. They hire people to drive them. They'll buy their own fleet of airplanes to deliver packages, build their own logistical centers. You can build the functionality on the inside, or you could go buy it. In other words, Amazon could go out and buy, say, FedEx. And then it would have all the functionality of FedEx, in one fell swoop, move inside the firm. Occasionally, firms will do the exact opposite. They'll have a function that was originally inside the firm, and they'll move it outside the firm. How do you do that? One possibility is you can just sell a division of your business. Another possibility is you engage in what's commonly known as outsourcing. Outsourcing and mergers are, as it were, inverse operations. Whereas the merger takes a functionality that's outside the firm and pulls it in, outsourcing takes a function that's inside the firm and pushes it out, where this in and this out are the barrier between the firm and the market, the point where the agency costs inside the firm exactly equal the transactions costs of the market outside the firm. If you want to know, for example, what was wrong with communism, communism said that that boundary didn't exist, that the boundary between agency costs and transactions costs was at the very perimeter of the economy. Everything was on the inside of the firm. Communism tried to treat the whole economy as if it were a firm under one central authority for command and control. That would make sense, if agency costs were always lower than transactions costs. The sad history of communism, of course, proves that that's not true, and the boundary is actually usually quite near the center of the firm, that agency costs soon exceed transactions costs, and the cheaper and more efficient way of organizing resources is across market transactions. How do those types of market transactions work? What are the steps when two companies agree to enter into a merger or acquisition? How do lawyers make arrangements that are optimal for all parties involved? Imagine you're buying a house. When people buy a house, it's always, what we, corporate lawyers, would call, a two-step transaction. In step one, you enter into a contract to buy the house. After you enter into the contract, you don't immediately get the house. You don't immediately pay the purchase price. But there's this time lag, between the time you enter into the contract to buy and sell the house, and the closing, when you pay the purchase price, and the seller gives you the house, or the deed to the house, and hands you the keys. Now, in the case of residential real estate, why is there a time lag between signing and closing? One of the reasons, usually, is that the buyer wants to hire a home inspector to come check the home, to make sure it doesn't have termites and the roof's not leaking and all those sorts of things. Another reason is the buyer may have to line up his financing to get a mortgage. It also might be certain transactional problems like arranging for movers to get furniture in and out, and so on. When you buy or sell a company, you often face a similar problem. When you sign up to buy a company, and the buyer agrees to buy, and the seller agrees to sell the company, almost always, if the transaction is of any significant size, you have the same problem of a delay between signing and closing. Why? Well, one of the most common reason is that, if the transaction is of any significant size, you're not permitted to complete the transaction until you've done a filing with the antitrust authorities. Because, under the antitrust laws, mergers are always subject to a certain degree of scrutiny, because they can be used to create market power or, worse yet, monopoly power or have some other type of anti-competitive effect, and the government wants to make sure that doesn't happen. So you have to do a filing and get clearance from the antitrust authorities. If you're operating in a regulated industry, banking, for example, you may need to get the approval of some other regulator, before you're allowed to close your merger. And, if you have a public company, at least the selling shareholders have to have a shareholders meeting to vote on the transaction. And that can't be done instantaneously either. So there's usually a delay between signing and closing in any large business combination transaction. That produces all kinds of problems. Because between signing and closing, things can go wrong. Like what? Well, imagine you signed up to buy a company in January of 2020, and you expected the closing to occur later in 2020. And then, oh, I don't know, a worldwide pandemic breaks out. And that adversely affects the company you intended to buy. Perhaps you were intending to buy a chain of retail stores. And now suddenly, no one's interested in buying those products. And even if they were, the government has ordered the stores closed. And so, the company's revenues and earnings have fallen over an absolute cliff, because they're not selling anything to anybody. As a result, the company has furloughed, or just outright fired, lots of its sales staff and knows full well that when the stores reopen, they're not going to be able to rehire all of those people. Some of them will have found other jobs or moved away, or don't want to come back to work for one reason or another. When something like that happens between signing and closing, is the acquirer still required to close the deal? Or is it allowed to walk away? That's a risk that all transactional lawyers worry about. The way we deal with that contractually is that, we say that the obligation of the acquirer to close the deal, that is to say to show up with the purchase price and pay it, is conditional. And it'll be conditioned on a set of expressed conditions set out in the merger agreement. Some of those conditions are easy to understand. There will always be a condition that says, "No court of competent jurisdiction will have entered an injunction restraining the closing of the deal." Obviously, if that happens, you can't expect the buyer to close. There will be other conditions that say, "If shareholder approval is required for this deal, the shareholders will have approved." We're not going to make the acquirer close, if the shareholders haven't actually approved the deal. The most interesting one, however, is the so-called no material adverse effect condition. There, the seller will say that it's a condition of the buyer's obligation to close, that there has occurred no material adverse effect. And then, if you look up what material adverse effect means in the agreement, you'll find a definition that goes on for, say, some six or 700 words, explaining what will and what will not count as a material adverse effect. This is an area, a very fertile area, for transactional lawyers. Why? What do we try to do in that area? What we try to do in material adverse effect clauses is, we look at all the possible risks that could materialize, between signing and closing, that could adversely affect the value of the target, the company being sold. And we allocate them, some to one party, and some to another. How do we do that? We do it in such a way, that each party bears the risk, if it is the cheaper cost avoider, or the superior risk bearer of that risk, roughly speaking, whether it can bear the risk more cheaply than the other party. So this is a good example of transaction engineering that transactional lawyers do. The whole game is to move every right to the party who values it most highly, every obligation to the party who can fulfill the obligation most cheaply, and every risk to the party who is the cheaper cost avoider or superior risk bearer of that risk. One of the most obvious examples is what we call deal risk, bad things that can happen between signing and closing. And, the way to handle it, as I say in the material adverse effect definition, is to carefully allocate each risk to the party who can best bear it. Are there standard ways of structuring these types of transactions? One of the biggest problems a mergers and acquisitions lawyer faces at the beginning of every transaction is to figure out how to legally structure it. Roughly speaking, there are three ways of doing a business combination deal. If you picture in your mind, the corporate entity itself, above the corporate entity are the shareholders who own the shares in the corporate entity. Below the corporate entity are the assets that the corporation owns, its real estate, its equipment and so on. There are also down at that level, below the corporation, are the contractual relationships the corporation has, contracts with its suppliers, contracts with its customers, employment agreements with its employees and so on. That's where all the real assets are, both the hard assets, the tangible assets, the intangible assets, like the IP and the human assets, the employees, the other talent that makes the corporation work. If you're a mergers and acquisitions lawyer, and you want to acquire this business, there are basically three ways you can structure it, corresponding to these three levels. Way number one, you could go to the shareholders and buy from them their shares. Before the transaction, the shareholders own the corporation, which operates the business. After the transaction, the acquirer would own the shares, which are the shares in the corporation, which operates the business. You can do the transaction at the shareholder level. You can also go down to the bottom, and do the transaction at the asset level. So in other words, you can have the acquirer enter into a contract with the legal party who owns the assets, the corporation, and the corporation would agree to sell the assets themselves to the acquirer, assign the contracts over to the acquirer. And then what happens to the employees, technically, is that they are one day all fired by the corporation selling, and, the next instant, hired by the corporation buying. You transfer over the employees, by terminating one employment relationship and immediately starting another. So you can have a stock sale at the top level. You can have an asset sale at the bottom level. But most interesting of all is, you can do something at the corporate level. And that, technically, is what a merger is. In a merger, the acquirer and the target company, by the magic of the law, become one corporation. We speak of the target merging with and into the acquirer. You have to imagine it's like the acquirer is a gigantic amoeba that comes along and swallows up the target. The merged company, which we call the surviving corporation, by operation of law owns everything that either corporation before owned. Is a party to every contract that either corporation before was a party to. Is liable for every type of obligation that either company was liable for, both civil obligations, criminal obligations, regulatory fines... Everything transfers over from the target and the acquirer into the surviving corporation. Now, one of the biggest issues in M&A law in each instance is how you decide to structure the transaction. If you have a relatively small number of shareholders, then you can get those people in a room and you can negotiate with them to get them to sell you their shares. But once there goes beyond even one shareholder, there's the danger that the shareholders will have inconsistent bargaining positions. That one might be willing to sell at $100 a share and the other wants 120. If you start having large numbers of shareholders, it becomes quickly impossible to negotiate with all of them. The transactions costs get too big. So you cannot acquire the shares from the shareholders directly because it's too hard to negotiate with large numbers of shareholders. You might not even be able to find all of them. Some of them might be disgruntled former employees of the company. The last thing they're going to do is what the company wants and sell their shares to the acquirer. It doesn't work. On the other hand, if you have a large number of assets, you own real estate in all 50 states, in 27 foreign jurisdictions, you have thousands and thousands of contracts, some of which include provisions that say they cannot be assigned, you have thousands of employees who have to be transferred over... Then the asset deal begins to look like a bad idea from a transactional cost point of view as well because transferring all these titles, filing all the filings you would have to do to record transfers of real estate, all the paperwork to move the employees over, it gets incredibly expensive. You don't want to do that either. So if you have a company with a large number of shareholders and a large number of assets, you pretty much have to do the transaction at the corporate level. At the merger level, using the merger structure. Are there different types of merger agreements? If you want to buy a public company, although you will certainly have to do a merger at some point, it turns out there are two different ways of structuring a public company transaction. They're called one-step transactions and two-step transactions. The easier one to understand is the one-step transaction. That's what we've talked about before. The acquirer and the target negotiate deal. They enter into a merger agreement. It's approved by the boards of directors of both companies. And you have to hold a shareholder vote at least on the target side to approve the transaction. And the target will then merge, usually with a subsidiary of the acquirer. That's a one-step transaction. There's another way of doing it as well. Once again, we negotiate a transaction. We enter into a merger agreement. But in this case, the merger agreement says that the acquirer will promptly, after the announcement of the merger agreement, open a tender offer for the shares of the target. A tender offer is a public announcement by the acquirer that it is willing to purchase the shares of the target on stated terms. $100 a share, send them in. If the terms of the tender offer are attractive, what usually happens is that the shareholders will want to sell and take the price. Now, tender offers are regulated by the federal government, under what's known as the Williams Act, part of the federal securities laws. So in theory, you could do a tender offer and be done in a day or two, but the Williams Act requires that you hold open tender offers for 20 business days. So that's about a month. If you have a successful tender offer and the price is attractive, on the last day of your tender offer, all the shares will come pouring in and you'll have 98, 99% of the shares. Not 100; it never turns out that every last shareholder sends in his or her shares, but you have almost all of them after 20 business days. At that point, you close your tender offer, which means that you purchase the shares. And then under a special provision of the Delaware General Corporation Law designed for exactly this situation, you then do what is known as a medium form merger. And you can close the merger transaction later the same day on which you close your tender offer. You can, in effect, get your merger transaction done in about a month. If you go the one-step route, however, the problem is that you have to have a meeting of your shareholders. To have a meeting of your shareholders, you have to solicit proxies from those shareholders. To solicit proxies from the shareholders, you have to file a proxy statement with the Securities and Exchange Commission and get it to clear your proxy. That tends to take about 90 days from signing the agreement to having a shareholder meeting and getting the approval of your shareholders. So ironically, the one-step transaction takes about 90 days; the two-step transaction takes about 30 days. You would ask yourself, if that's the case, why would anybody ever do a one-step deal? Wouldn't it always be better to do a two-step deal? Get the deal done faster. You can get the organized business off the ground faster because you've closed earlier. Less things can go wrong in one month than in three months. Why not always use the two-step form? The short answer is, everybody uses the two-step form when they can, but often they can't. And the reason is that something else holds up the deal. If you are going to have a complicated antitrust review, if you were going to need the approval of some government regulator, and there's not any chance in the world that that government regulator is going to approve the deal on anything less than nine months or a year, then there's no point in doing the two-step transaction because you can't close on your tender offer until you get the approval of the regulator. Rather, what you do is the one-step deal, and you hold your shareholder meeting on the 90th day or so; you get the approval of the shareholders, and then you just wait for the approval of the regulator. And once you get the regulator's approval, then you close later the same day you get the regulator's approval. So when you structure a transaction as a transactional lawyer, you have to ask yourself, what is going to hold up my deal the most? Is it antitrust approval? Is it some regulatory approval? Is it something else? If the answer is that there is something not corporate in nature... in other words, not involving the shareholder approval or the sale of the shares... that's going to take longer than 90 days, then you want to use a one-step deal. If there is no such regulatory hurdle and the thing that's going to take longest is getting shareholder approval, then we get shareholder approval in the quickest way possible. We do a two-step deal with a tender offer followed by a so-called medium form merger. What sort of market factors influence decisions about mergers and acquisitions? If you look at the history of mergers and acquisitions, while usually the amount of merger and acquisition activity increases every year with the size of the economy increasing, it's also true that mergers and acquisitions come in great waves. There's a great wave of merger activity in the 1980s, for example, and another big wave in the 1990s, and another one in the 2000s. Why is that? The answer usually is, there are fundamental economic reasons for it. So if you look at the merger wave of the 1980s, some of the most famous takeover battles of the time, the way it was presented in the press is that, sleazy New York financiers, and other people using money that who knows where it came from, went out and bought a bunch of old line, great American companies, and wrecked them and destroyed them and sucked out all the value, and left the husks for other people to pick up. Nothing like that actually ever occurred. What really happened in corporate America was this. In the 1950s and the 1960s, people graduating with MBAs had learned about the value of diversification in investments. And, they convinced the senior managers of many big American companies, with the help of a bunch of investment bankers who got fees for doing it, that what they needed to do was create conglomerates, in which one company would own a bunch of utterly diverse businesses. If you're a petroleum company, you need to buy a women's shoes company. And, if you are a telephone company, why then you need to go into the rental car business, something completely unrelated to your other business. So that at any given year, when one business was up, the other one would likely be down, and your earnings would smooth out over time, and you would capture the benefits of having a diverse investment portfolio. Whether that made any sense in the 1960s is questionable. But by the 1980s, it became apparent that it made no sense at all. It turns out that people who run an oil company don't know much about women shoes, and people who run a women's shoes company don't know much about exploring for oil. There was a great inefficiency in running these businesses together. Moreover, the cost of trading securities, commissions on the New York Stock Exchange and NASDAQ, had plummeted by this point. And, the invention of mutual funds made it very easy for diversification to take place at the shareholder level, rather than at the company level. The rational way of organizing economic activity at that point was to have each company do one, or at least a small number of things, at which it was very good, and for the shareholders to hold shares in a great number of companies, and capture the diversification benefit at the shareholder level, rather than the company level. So as we entered the 1980s, there are a large number of companies that are conglomerates, that are running several businesses that have nothing to do with each other, together under one roof. Very often, if you looked at the financial statements of these companies and the market prices of their shares, they were trading at a discount to their book value. In other words, the value of the businesses, on the accounting statements of the company, exceeded the market value of the company as a whole. Why? Because everybody knew it was grossly inefficient to run them this way, and value was being destroyed by running these businesses together as conglomerates. Well, people like Henry Kravis, at Kohlberg Kravis Roberts, and Ron Perelman and Ted Forstmann invented the private equity industry. And what they discovered was, they could buy one of these companies, at or above its market price, and sell off the pieces at a value that exceeded, often by hundreds of millions of dollars, what they had paid for them. They were reorganizing economic activity, to separate things that had no business ever being together. It might look, from the outside, that a great American company was being destroyed. The reality was, those different business units were being reorganized under people who actually knew how to run them, and they would operate as independent businesses going forward. There's another great wave of merger activity in the late 1990s, but that one was totally different. What was going on there was that, the changes in trade laws and the opening up of global markets suddenly made it very useful for large companies to be not national or international, but global. If you're operating in the United States, you also had to be able to operate in Europe and China and the Middle East, and maybe some other places as well. And once that happens, everybody needs large scale. So you're going to see mergers between large oil companies, mergers between large consumer product companies, and so on. When I was in practice, I did a number of deals in the advertising industry. And what happened there is that the advertising industry followed the consumer products companies. Once the consumer products companies became global, those globalized consumer products companies did not want to deal with one ad agency in Europe, and another in the UK, and yet another in North America and a fourth one in Brazil. What they wanted was one stop shopping, to go to one gigantic ad agency that could provide them with advertising services in all these markets simultaneously. So the ad companies had to consolidate on a worldwide basis, and that's very largely what happened in the late 1990s. We opened this episode with Ronald Coase. Let’s close with Coase also. The Coase Theorem was developed in 1960, right before some of the “waves” that you just described. The theorem is now a fundamental principle of law and economics. Can you give us a quick explanation of it, and discuss how it applies in particular to mergers and acquisitions? Probably the most fundamental idea in the economic analysis of law is the Coase Theorem, a proposition first enunciated by Ronald Coase in his famous paper on The Problem Of Social Cost by 1960. What Coase showed in this paper is that, what's wrong with the world is transactions costs. What do I mean by that? Prior to Coase, what people thought was really wrong with the world was externalities. That is to say, "I would engage in some activity that produces cost for other people. And if I do that, and I don't bear those costs myself, why then I'll engage in a lot of this activity, and while it might benefit me, it will harm you. And if it turns out that the harms to you exceed the benefits to me, well, then it's inefficient from a societal point of view." What Coase showed is that those situations would not exist, if transactions costs were zero. If transactions costs were zero, people would always bargain to the efficient solution. Now, of course, in the real world, as Coase himself pointed out over and over and over again, transactions costs are never zero. Sometimes they're low, so low that we can count on people bargaining to the efficient solution. But in many cases, they're high. And in those cases, we can be sure that people will not bargain to the efficient solution. So, when a transactional lawyer approaches any problem, he very often does it from a transactions cost point of view. The things where people can easily bargain against each other, they will tend to bargain to the correct solution very easily. The problem is, what happens when transactions costs get high? So, when you are engaged in a market transaction, say a merger and acquisition, one of the major problems is that, the buyer and the seller approach the transaction with vastly different levels of information. The seller knows all about its company. After all, it's been running the company for a long time. The buyer will probably know very little about the company. If the target company, the seller, is a public company, well, then a sophisticated buyer will have read all the publicly available information about the company. But very often, that's far from the whole picture. Very often, some of the most important information is still inside the company. So how do you go about solving that problem, hopefully, at the lowest level of cost, transactions costs, imaginable? Well, one thing that always happens is due diligence. The seller agrees to share with the acquirer confidential information, non-public information about itself. How do we structure that as lawyers? Well, we do it under, what's known as, a confidentiality agreement. The seller agrees to provide the information. The buyer promises to, first of all, keep the information confidential, not disclose it to other people, and then to use the information solely for the purpose of evaluating the transaction. Now, you may ask, how would the seller ever know if the buyer breached this agreement, if it started using the seller's confidential information, for example, to compete better against the seller, or for some other purpose outside the scope of the agreement? The short answer to that is usually, the seller couldn't know that. These agreements are notoriously hard to monitor. For that reason, you usually only turn over confidential information to someone in whom you have a great deal of trust, when you think a deal between you and them is fairly likely. If you look at confidentiality agreements, however, you will discover one of the most interesting provisions you will ever see, a shockingly surprising position. There'll be a provision in that agreement that says the following, "Even though the seller is turning over huge amounts of confidential information to the buyer, the seller makes absolutely no representations or warranties about the accuracy or completeness of that information. In fact, the seller doesn't even guarantee that it's not fraudulent, that it's not intentionally false. And moreover, the parties agree that there will be no representations or warranties from the seller to the buyer that could form the basis of any type of legal claim, except for those representations and warranties that get incorporated in the definitive written agreement between the parties." This is the exact opposite of the common law rule. So what's going on here? What's going on is that, very sophisticated parties, large companies with huge amounts of information, huge amounts of money at stake, and a large cast of characters, business people, lawyers, accountants, investment bankers, teams of people working on both sides, find that the solution offered by the common law, the common law doctrine of fraud, for example, doesn't work at all well for them, and therefore, they contract around it. They contract around it in two ways. First, they say the rules of fraud, no representations or warranties about the information, that the rules of fraud will not apply in the due diligence process. They're only going to apply for the representations and warranties in the definitive written agreement. Why is that? Well, recall I said earlier that what transactional lawyers do is they structure the transaction to have the highest possible value for the parties to the transaction. Well, whether or not a certain representation from the seller to the buyer is going to get included in the agreement will then be turned into the following question. Does the buyer benefit more by having the representation, than the seller suffers a cost from making it? When the seller makes the representation, it bears a certain cost of making the representation. The buyer captures a certain benefit. In an efficient agreement, we want to include only those representations, with the benefit to the buyer exceeds the cost to the seller. But here's the catch. Whether or not a certain representation falls into that class, whether the benefit of the representation to the buyer exceeds the cost to the seller, depends on, among other things, all the other provisions in the agreement. Are the representations and warranties going to survive the closing? If so, for how long? What type of indemnification will the seller provide to the buyer for breaches of those representations? The values of the representations can only be determined in the context of the definitive written agreement. And for that reason, we are going to be any representations or warranties, except for those in the definitive written agreement. One of the beauties of Delaware Law is that these provisions, which are called non-reliance provisions, are enforceable at law at Delaware. Under the Federal Securities Law, they're enforceable in most circuits, but not all, which occasionally creates a serious problem for an unwary buyer. Thank you for listening to this episode of the No. 86 Lecture series on Corporate Law. The spirit of debate of our Founding Fathers animates all of the No. 86 content, encouraging discussion and critical reflection relative to how each subject is widely understood and taught in law schools and among law students. Subscribe to the No. 86 Lecture series on your favorite podcast platform to have each episode delivered the moment it’s released. You can also go to no86.fedsoc.org for lectures and videos on Federalism, Contracts, Jurisprudence and more. Thanks for listening. See you in class!