U.S. Proxy Voting Manual
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Mergers and Acquisitions (Including Share Issuance for M&A)

For every M&A analysis, ISS reviews publicly available information and evaluates the merits and drawbacks of the proposed transaction, balancing various and sometimes countervailing factors including:

  • Valuation – Is the value to be received by the target shareholders (or paid by the acquirer) reasonable? The fairness opinion provides an initial starting point for assessing valuation reasonableness, but ISS also places emphasis on the offer premium, market reaction and strategic rationale.
  • Market reaction – How has the market responded to the proposed deal? A negative market reaction will cause ISS to scrutinize a deal more closely.
  • Strategic rationale – Does the deal make sense strategically? From where is the value derived? Cost and revenue synergies should not be overly aggressive or optimistic, but reasonably achievable. Management should also have a favorable track record of successful integration of historical acquisitions.
  • Negotiations and process – Were the terms of the transaction negotiated at arm’s-length? Was the process fair and equitable? A fair process helps to ensure the best price for shareholders. Significant negotiation “wins” can also signify the deal makers’ competency. How the target was shopped (e.g., full auction, partial auction, no auction) can also affect shareholder value.
  • Conflicts of interest – Are insiders benefiting from the transaction disproportionately and inappropriately as compared to non-insider shareholders? As the result of potential conflicts, the directors and officers of the company may be more likely to vote to approve a merger than if they did not hold these interests. ISS will consider whether these interests may have influenced these directors and officers to support or recommend the merger. The CIC figure presented in the “ISS Transaction Summary” section of this report is an aggregate figure that can, in certain cases be a misleading indicator of the true value transfer from shareholders to insiders. Where such figure appears to be excessive, ISS will analyze the underlying assumptions to determine whether a potential conflict exists.
  • Governance – Will the combined company have a better or worse governance profile than the respective current governance profiles of the respective parties to the transaction? If the governance profile is to change for the worse, the burden is on the company to prove that other issues (such as valuation) outweigh any deterioration in governance.

ISS Analytical Focus

The case-by-case basis is the appropriate and correct approach to analyzing M&A, but the emphasis of any ISS analysis will be first and foremost on shareholder value. Of course, ISS recognizes the importance of other factors, including corporate governance, to our clients, yet cases where corporate governance dominate an M&A vote decision will be rare.

Moreover, ISS cannot hold itself out as an industry expert. Any ISS analysis of strategic rationale will be limited to general comments on the typical strategic rationales themselves (e.g., economies of scale, aggressive/conservative synergy assumptions, horizontal vs. vertical vs. conglomerate mergers, etc.).

In short, our vote recommendation will be based on an analysis of shareholder value, which itself can be affected by ancillary factors such as the negotiation process. However, our research product can be distinguished from Wall Street analysis by the inclusion of intelligent discussions, where appropriate, of such ancillary factors.

M&A analysis will always be a balancing of competing factors. Bright line rules are difficult if not impossible to apply to a world where every deal is different.

The ultimate question for shareholders (both of the acquirer and the target) is the following: Is the valuation fair? Shareholders of the acquirer may be concerned that the deal values the target too highly. Shareholders of the target may be concerned that the deal undervalues their interests. At the end of the day, it is shareholder value that is the primary focus of our clients.

If the shareholder value is indeed fair, then all the other considerations listed above (e.g., conflicts, process, etc.) become secondary. However, negative factors may indicate that the valuation of a proposed transaction is not in fact “fair.” For example, a poor process can lead to a less than ideal valuation, or excessive change-in-control payments may transfer some of the rightful value due shareholders to conflicted insiders. In these cases, ISS will scrutinize a deal’s valuation more closely to determine whether it is fair to shareholders despite the applicable negative ancillary factors. A transaction can be fair from a valuation standpoint despite being “unfair” in other aspects. In such cases, shareholder value is the trump card.

Framework for Evaluating Mergers

For shareholders of acquired firms, a long line of research indicates that mergers are good news. Over a long-term period prior to the announcement of a merger, acquired firms' stockholders earn negative abnormal returns. Following the announcement of a merger, acquired companies' shareholders earn large abnormal positive returns of 20 percent to 60 percent, according to available information on mergers from the 1960s through the present. Therefore, unless a merger clearly does not make sense from an economic or operational viewpoint, shareholders of the acquired firm often benefit from the proposed transaction. The decision to support a merger boils down to whether the premium is attractive and, if the shareholder chooses to remain an investor in the surviving company, whether the combined firms are likely to produce positive returns in the future.

In stock-for-stock merger deals, shareholders of the target company effectively trade in their shares for shares of the acquiring company. After the deal is closed, the acquiring company will either integrate the purchased company or operate it as a wholly owned subsidiary. An investor who intends to hold the investment, rather than sell his shares at a gain or loss, should evaluate the prospects of the combined company by examining the motives for merging.[1]

This can become a difficult, but important task for proxy analysts who regularly encounter stated merger rationalizations which indiscriminately include terms such as economies of scale, synergy, and competitive advantage as if they were a natural consequence of all mergers.

Strategic Rationale

Generally, mergers are categorized as horizontal, vertical or conglomerate. Horizontal mergers occur between two companies within the same industry, for example, a merger of two airlines. In vertical mergers, the buyer expands backward to acquire basic components or raw materials, or forward to acquire the ultimate consumer, possibly through acquisition of downline distribution channels. An example would be an airline that acquired a company which operates a computer reservations system. Conglomerate mergers involve companies in unrelated lines of business.

Clearly, there are sensible, as well as dubious, reasons for mergers. One legitimate reason for merging is economies of scale. Economies of scale has become a catch phrase almost always claimed as a benefit of a given merger. Economies of scale refers to the benefit of having average unit costs decline as production increases. This is accomplished by spreading fixed costs over a larger volume of production. Most often, economies of scale are a benefit of horizontal mergers in which two firms in the same industry can expand more cheaply by merging than they could as separate entities. However, this advantage is often claimed in proxy statements for other types of mergers. Therefore, be extremely skeptical of vertical or conglomerate mergers which claim to create economies of scale unless the companies provide detailed plans of how such benefits will be achieved. Economies are difficult to achieve unless there are duplicative functions which can be eliminated, or other sources of cost savings. While conglomerate mergers may entail savings through the centralized management, conglomerate acquisitions, much to the contrary, often result in increased bureaucracy and higher costs.

For example, in conglomerate mergers, companies often argue that economies of scale arise from centralized administration and sharing of resources. However, all too often conglomerate integration increases staff and complicates corporate structure, making the achievement of economies of scale elusive. Companies may also merge to achieve economies of vertical integration. Large industrial companies may desire to gain greater control over the production processes by merging with a supplier and a customer.

Mergers can be beneficial to the combining parties when the two companies have complementary resources. Such mergers generally occur between a small firm and a large one. For example, a small R&D firm may have developed a proprietary product, but lacks engineering or sales support to produce and market it on a large scale. In some cases, it may be cheaper to acquire these capabilities through a merger than attempt to develop them from scratch.

When deciding whether to vote in favor of an acquisition of their company, shareholders should closely examine the past performance of their investment and decide whether a merger could eliminate management inefficiencies. Merger targets are generally those which have performed poorly for a significant period. K.G. Palepu of Harvard Business School found that firms that were subsequently acquired significantly underperformed the market for a number of years prior to the merger.[2] In such cases, investors should carefully review the performance of the acquiring firm and whether the new managers are indeed more successful and capable than the target company's executives.

Reliable sources of information for this research include press articles, analytical reports and, perhaps most significant, an evaluation of the effect of the merger announcement on the acquiring company's stock price. If the market does not perceive that the acquiring company can manage the poorly performing company any better than its existing managers, bidder firms may experience a substantial price decline, indicating that long-term investor interests might not best be served by a merger.

There are other legitimate financial reasons for mergers, including avoidance of bankruptcy costs, use of surplus funds,[3] and utilization of unused tax shields.[4] However, some merger rationalizations are highly suspect. The most loosely used justification is that of "synergies," a term that implies that the combination of two firms will be worth more than the sum of their parts. Clearly, this is a laudable goal, as research supports the notion that gains to shareholders arise from increases in synergies.[5] However, few takeover experts have been able to quantify or pinpoint the exact source of these benefits, and, as a result, it is easy for potential synergies to be claimed in almost any proposed transaction.

Synergies can be categorized in three ways: short-term financial, long-term financial, and operational.[6] Short-term financial synergies consist of the apparent "bootstrapping" effect a merger may have on the earnings per share of the acquiring company when it buys a company with a low price-earnings ratio. Theoretically, the artificial increase in earnings per share will result in an increased stock price. However, research suggests that the market quickly corrects for such mechanical manipulations.[7]

Another supposed short-term financial synergy is improved liquidity. Companies may acquire other firms with excess cash in order to increase their own liquidity. However, this alleged synergy also falls short of the mark. If markets are efficient, it makes little sense for an acquirer to dole out a substantial premium for the cash of another firm when it can raise cash on similar terms in the capital markets.

One short-term consideration widely recognized by academics as a legitimate source of financial synergy is a tax shield for the acquiring firm.[8] For example, if the target firm has substantial amounts of tax-loss carryforwards, an acquiring firm can use those loss benefits against current income to reduce the taxes it must pay. Moreover, if the target firm's assets are recorded on its books well below market value, then upon acquisition the acquiring company may be allowed to "writeup" the assets and take advantage of the depreciation tax benefits over a period of years. These uses of mergers to exploit the tax laws result in realizable gains in after-tax cash profitability of the total firm.

Mergers are also said to create long-term financial synergies. An acquisition may give a target company access to capital for investment opportunities that it may not have been able to secure on its own. In addition, companies often argue that the larger size of the combined entity can increase debt capacity by providing lenders with greater protection through the accumulation of assets and through a more stabilized earnings stream. However, while the combined firm can borrow at a lower rate, the shareholders of both firms are guaranteeing each other's debt, they have given the company's bondholders increased protection without receiving anything for it. For shareholders of the acquired firm, there is only a net gain from lower future debt costs if the premium paid is extremely large.

In summary, there are few widely accepted, purely financial synergistic reasons for takeovers. Attempts to boost stock price through "bootstrapping" of earnings per share, increased liquidity or lower financing costs have been found questionable by a number of experts. Among the more acceptable synergy-based financial rationales for mergers are the avoidance of bankruptcy costs and the use of tax shields.

In analyzing merger rationale, shareholders of target firms should be alert for valid operational synergies, including some of those mentioned above, such as economies of scale, increasing market power, and competitive posture, and vertical integration forward toward the consumer or backward toward the client.

Table 5-8. Merger Motives[9]

  Short-Term Long-Term Operational
Synergies EPS effects, Improved liquidity, Tax shields Increased debt capacity, Capital redeployment, Bankruptcy avoidance, Stabilize earnings Economies of scale, Low ind. Growth, Market power,Managerial/technical knowledge, Diversification
Target under-valuation Market inefficiency Inside information Displace inefficient management
Managerial motives Power, size Executive compensation Insider trading

Shareholders should be aware of certain dubious reasons for mergers and acquisitions that are never stated in the proxy. Many of these reasons are based on management's need or desire for increased powers and compensation. For example, a CEO may view a merger as a means to increase the size of the company he runs, and ultimately boost his own salary. These motivations may be difficult to detect. But, if a company engages in a series of unsuccessful mergers which result in increases to the CEO's pay as the company grows larger, shareholders may be correct in assuming that management is engaging in "empire building" which is not necessarily in the best interests of shareholders.

Evaluating Premiums

While estimates vary from study to study, there is a clear consensus among researchers that mergers cause significant positive returns to target shareholders. (Research on returns to shareholders of acquiring firms has produced mixed results.) The main source of these returns is the premium contained in the bidding firm's offer price. In stock transactions, the premium is reflected in the exchange ratio terms included in the proposed deal. Indeed, an evaluation of the merger premium may be the most critical task for the stockholder in voting his proxy. As aptly stated by Professors Michael Jensen (Univ. of Rochester) and Richard Ruback (MIT):

In the market for corporate control, the stockholder may have little use for detailed knowledge of the firm or plans of competing management teams beyond that normally used for the market's price setting function. Stockholders have no loyalty to incumbent managers; they simply choose the highest dollar value offer from those presented to them in a well functioning market for corporate control.[10]

Jensen and Ruback conclude that the merger market is the mechanism through which economies of scale or other synergies are realized. Therefore, while shareholders should look for increased long-term share value in mergers, it should be recognized that a substantial portion of the total value derived from the deal comes from the premium built into the offer price. Note that fiduciaries and other shareholders are not required to accept a potential acquirer's offer merely because it represents a premium above the then current market price.[11]

How should shareholders of target companies evaluate merger premiums? Answers to this question come from many sources, including investment bankers' "fairness opinions," academic research regarding historical merger and tender offer premiums, and public sources of information which track recent merger activity. The answer is also affected to some extent by several important corporate governance issues such as whether the target company solicited offers from multiple bidders (i.e., shopped the company for a buyer), whether an independent or special committee of the board was established to review offers, and whether certain executives stand to benefit from the merger at the expense of at-large shareholders.

Calculation of Premium

In cases where the dollar consideration per share is fixed (whether paid in cash or stock), the offer price does not vary from the date of announcement. However, where the dollar consideration is not fixed and the offer price can vary from the date of announcement, it is important to clarify the date at which the offer price should be calculated.

This situation applies specifically for stock transactions where there is a fixed or semi-fixed exchange ratio. Given that the offer price (and therefore the premium) varies with movements in the acquirer’s stock price, the relevant alternatives to consider are the price at the date of announcement or the current price.

The offer price at the date of announcement should be the basis for calculating merger premiums. This will not impact the results for those deals where the offer price is fixed, but will provide a simple and comparable basis for those deals where the offer price can vary (i.e. a stock deal with a fixed or semi-fixed exchange ratio.) The industry norm for analyzing merger premiums is based upon the offer price at the date of announcement (Wall Street research, Bloomberg, etc.) and therefore such a policy would be more consistent with other market commentators.

However, for purposes of completeness, ISS will present also the premium based on the current offer price compared to the target’s “pre-offer” share price. This will provide a basic representation of the market’s reaction to the transaction and, where warranted, trigger a more detailed analysis. However, it is important to note that the current value approach is tainted by the impact of company risk, market risk and technical shorting pressure on the value of the acquirer’s stock since the date of announcement. Therefore, where appropriate, the more detailed analysis should adjust for these intervening factors.

Assessment of Premium

The challenge is to determine whether the premium being offered in a particular transaction is fair with reference to the specific industry sector and market climate.

As can be seen from the table below, the level of premium can vary dramatically with the industry sector and the underlying market climate. Market commentators have stated that premiums in 2004 are around their “historical average” of 20% to 30%, down from the “heated” 50%-plus premiums of 1999 and 2000 (Brad Whitman, managing director of Lehman’s M&A Group). While this does not necessarily help in terms of identifying whether the premium offered is fair, it can be used as the basis for identifying those transactions that warrant further assessment and analysis.

Average Deal Premium, by sector

  2003 2004
Industry Deals Average Premium Deals Average Premium
Telecoms
21
48.4%
29
92.4%
Auto / Truck
9
24.4%
9
47.5%
Mining
na
na
10
31.9%
Healthcare
34
51.3%
38
30.9%
Professional services
36
40.4%
24
22.6%
Construction
31
30.8%
21
22.3%
Computers / electronics
72
47.7%
69
22.1%
Agribusiness
na
na
1
19.6%
Consumer products
20
32.2%
20
18.7%
Dining & Lodging
na
na
15
16.6%
Finance
92
45.3%
83
15.2%
Food & beverage
22
25.4%
17
14.6%
Chemicals
16
43.8%
13
12.1%
Leisure & recreation
14
23.3%
10
12.1%
Retail
24
30.2%
12
11.9%
Government
na
na
1
11.7%
Machinery
14
33.5%
9
11.7%
Oil & gas
25
44.8%
32
11.2%
Utility & energy
na
na
8
10.5%
Insurance
6
208.7%
na
na
Holiding companies
5
63.1%
na
na
Metal & Steel
19
34.7%
na
na
Real estate / property
30
27.0%
na
na
Defense
2
23.2%
na
na
 
 
 
 
 
Source: Dealogic

 

However, as is demonstrated by the data above, the average premium level will vary over time and, as such, it will be important to ensure that the analyst uses up-to-date data. The premium being offered in any specific transaction will also be heavily determined by the strategic opportunities. Therefore, while premium analysis will be an important aspect of ISS analysis, it is important to emphasize that the analysis must be considered on a case-by-case basis with reference to the specific characteristics of the transaction.

Research on Merger Premiums

Ideally, shareholders should perform discounted cash flow analyses of the surviving company in order to determine an adequate premium. Under such a scenario, shareholders would determine the present value of the future cash flows of the firm, adjusted for any expected synergies or economies of scale arising from the merger. However, such a task would require shareholders to have the ability to produce accurate cash flow forecasts, or, at the very least, have access to the merging companies' internal forecasts. But research shows that such forecasts are likely to be severely flawed as they are simply educated estimates.

Alternatively, shareholders have access to a wealth of research on merger premiums that can provide a starting point for evaluating an offer. In addition, through proxy statements, shareholders can also carefully scrutinize data presented in the investment banker's fairness opinion which explains, from the bankers' point of view, why the premium offer is fair to the shareholders of the company.

As mentioned above, it is clear that sellers in mergers receive substantial short-term gains. In a study by Paul Asquith of about 200 mergers in the 1960s and 1970s, sellers enjoyed premiums of close to 20 percent above normal market returns.[12] Jensen and Ruback found that sellers received, on average, excess returns of 20 percent in mergers and 30 percent excess returns in the case of tender offers for deals occurring between 1958 and 1978.[13] Merger premiums appear to have declined gradually in the 1980s, but remain at a healthy 30 percent over target company prices one month prior to a merger announcement. However, premiums vary significantly by industry, with the highest premiums in the early 1990s (approximately 70 percent) going to shareholders of computer and data processing companies and the lowest (about 15 percent) going to owners of acquired media companies.[14] Studies that cover long periods of time seem to confirm that, on average, premiums have been in the 20 percent to 30 percent range. Shareholders can periodically update their knowledge of the current merger market by consulting Mergers & Acquisitions, a bimonthly publication of Investment Dealers Digest (New York), which regularly reports the prices paid for target companies in mergers and tender offers.

Fairness Opinions

While academic studies may enable investors to make generalizations regarding the appropriate size of merger premiums, more specific information can be obtained by examining the discussion of the actual premium offered as contained in a fairness opinion. Fairness opinions are discussed generally in a merger's accompanying proxy statement. Although the supporting research document is never included in the statement, there is usually a fairly detailed discussion of the methods used to evaluate the adequacy of the merger consideration. The methods and assumptions underlying these analyses vary depending on the investment banker employed. Some of the means used to evaluate offer prices are:

  • Comparable company analysis

  • Breakup valuation analysis

  • Discounted cash flow/terminal share value analysis

  • Relative stock trading prices

  • Contribution analysis

  • Transaction analysis (peer group analysis)

Most investment bankers use some or all of these methods in determining appropriate offer prices. In fact, in most cases, the final offer price may reflect a blend of the results from a number of different analyses based on the judgment of the investment banker. Some of the methods mentioned above may be more appropriate in specific situations and each method has its strengths and weaknesses. Below, we will briefly describe these methods of analysis.

Comparable Company Analysis (Trading Comps)

In this type of analysis, an investment banker compares selected historical share prices, earnings, operating and financial ratios for the target company to the corresponding data of comparable publicly traded companies. Ratio analysis typically includes a review of the share price in relation to the most recent 12 months of earnings, revenues, cash flow (earnings plus depreciation, amortization, and deferred taxes) and book value per share. Ratios are also calculated for multiples of estimated future operating data based on research analyst forecasts, usually for a three-year period. A range of average multiples is stated for the comparable company group, giving shareholders an idea of how well the offer price for their company compares to similarly situated firms.

Breakup Valuation Analysis

This method is perhaps the most subjective. It requires the analyst to estimate the market value of the component parts of the target company if each were acquired separately. This may be done based on the investment banker's experience with other companies, but in some cases may require a subjective estimate. Added to the per share value of the assets would be an estimate of the per share value of the expected synergies resulting from the proposed acquisition. For example, if two banks serving an overlapping market were to merge, an analyst could calculate the present value of the cost savings from eliminating duplicative bank branches and give a per share value of the savings. In addition, if the merger permits the bidder to expand or acquire a new line of business, an analyst could also estimate the present value of cost savings to the acquiring company from not having to incur the cost of building new facilities or developing a new business from scratch. The sum of these components can yield an implied share price which can be compared to the offer price.

Discounted Cash Flow Analysis

Based on estimates of future cash flow and the terminal value of a business after a given period of time, analysts can estimate the present value of the equity (or what an investor would be willing to pay for the business). If, for example, a six-year period were selected, an analyst would calculate the present value of the company's free cash flows for the six-year period and the terminal value of the company in the sixth year (i.e., the value of the asset at the end of a specific time period). Terminal values are difficult to estimate. A common rule of thumb is to use price-earnings (p/e) ratios for a comparable group of companies. For example, if the p/e ratio for similar companies is 11, then 11 times the earnings per share in year six would be discounted to present value. This terminal value would be added to the present value of the discounted cash flows to give a total present value per share for the target business. This value can easily be compared with the bidder's offer price.

A critical issue in this form of analysis is the selection of a discount rate. Discount rates reflect the rate of return required by investors in a given company. Analysts can greatly deflate the present value of a company by selecting an excessively high discount rate. A good rule of thumb for evaluating the discount rate selected is to add the historical risk premium for common stocks (about four or five percent) to the current risk-free rate of return. Discount rates should not exceed this rate by a great deal unless the company is in a high growth industry. Because this kind of analysis relies heavily on selecting the appropriate discount rate and cash flow estimates, large errors are possible. Another source of errors is in the selection of the appropriate terminal year.

Relative Stock Trading Prices

A fairly simplistic way of analyzing merger premiums is to examine the history of the trading prices and volumes of the two companies in relation to each other. The companies' stock price movements would also be compared to industry and market indices. These relationships can be used to determine a benchmark exchange ratio for the proposed stock-for-stock transaction against which a premium can be measured.

Contribution Analysis

Analysts may examine the company resulting from a merger on a pro forma basis to determine the relative contribution of the merging firms to the combined company's revenues, assets and stockholders' equity. Although not a clear indicator of appropriate premium in a merger case, shareholders of the target firm may compare their ownership percentage of the surviving company following the merger with its relative percentage contribution to revenues, assets, etc., to determine whether they have been adequately compensated for their proportionate contribution to the surviving firm.

Precedent Transaction Analysis – Multiples and Premiums (M&A Comps)

Perhaps the most expedient and intuitive method for the average shareholder is transaction analysis, or simply comparing the premium being offered with premiums offered in similar mergers. In transaction analyses, the merger price is compared to a peer group of comparable mergers in two ways. First, multiples for each comparable transaction are calculated based on the offer price to the comparable companies' operating results for the latest 12 months. Certain industries have specific multiples that are relevant for example, in the banking industry, multiples of offer price to book value per share may be calculated. These numbers can be compared to the multiples contained in the proposed deal to determine the reasonableness of an offer. A second, even more direct comparison is usually performed based on the average percentage premium of a selected peer group of mergers based on the offer price and closing price per share of the target following the merger announcement.

Shareholders should be alert to two important factors when reviewing these comparisons. First, the precedent transactions reviewed by the investment adviser should be truly comparable to the proposed merger being reviewed. For example, if two computer firms are merging and premiums are higher for computer industry mergers than for all recent mergers in general, then comparison with a broader group of merger transactions might cause a premium to be appear more attractive.

A second important factor in evaluating the transaction analysis is the time period used to determine the size of the premium. Typically, investment bankers present the percentage premium based on closing stock prices one day and either one week or one month prior to the public announcement date of the merger agreement. In many cases, these dates may be appropriate. However, if events unrelated to the merger depress share prices during the period in question, then the reported premium may be greatly exaggerated. Furthermore, long-term investors may be less interested in the short-term premium from a merger.

Therefore, shareholders should use a longer-term horizon in evaluating premiums and carefully screen press articles and other information to ensure that the reported premium is genuine. Note that most academic studies on the subject examine stock prices for a 120-day period around the announcement date. For example, in one study of merger premiums, stock performance was reviewed from 60 days prior to the announcement date to 60 days following. It was determined that shareholders began to enjoy excess returns between 20 days and 40 days prior to the public announcement of a deal.[15]

The actual premium realized by long-term investors can be affected by the terms of the exchange. In some cases, the final exchange ratio will be determined by average trading prices for a predetermined period of time just prior to the closing date of the merger. Furthermore, to control the potential cost of the merger, the parties may agree to a "collar" which limits the upper and lower bounds of the final conversion ratio. Should the stock price of the acquiring company fall substantially after the merger announcement, target company shareholders could experience a significant reduction in the anticipated premium.

Governance and Process

Clearly, evaluation of the potential long-term benefits of a merger is a shareholder's first concern. However, several important corporate governance issues come into play in determining whether the board's decision to enter into a merger agreement is in the best interest of shareholders. The principal considerations that should be part of a shareholder's checklist in reviewing merger proxies include the following:

  • Evaluation of offers by a special committee of independent directors;

  • Managerial motives-impact of executive compensation on the merger decision;

  • Solicitation of multiple offers;

  • Objectivity of investment bankers' fairness opinion; and,

  • Effect of potential reincorporation and changes to the surviving company's articles of incorporation, bylaws, and charter.

Evaluation by Independent Directors

Shareholder interests are best served in merger transactions when the board establishes a special committee of independent outside directors to review the solicitation process, evaluates all offers under consideration, and makes a recommendation to the board. A committee of nonmanagement directors whose professional futures and personal compensation are not wholly tied to the outcome of a proposed merger can provide a more objective evaluation of a merger than an officer who stands to lose his job.

Certain situations may significantly increase the importance of having an independent committee ensure that the best interests of at-large shareholders are met. For example, when insiders have a controlling interest in a company and plan to take the company private in a "minority squeezeout" transaction, the acquiring party has substantial leverage over the unaffiliated shareholders by virtue of their majority position. Ideally, shareholders should be permitted to hire their own investment banker and negotiate a deal with management. However, this rarely happens. Therefore, at a minimum, a committee of outside directors should review offers and determine whether the offer price is fair from an unaffiliated shareholder's point of view.

Managerial Motives

Do managers make investment decisions which maximize long-term shareholder value? This question is as pertinent to managerial decisions on mergers as in other areas of strategic decision making. In fact, it has been shown that certain types of executive compensation plans can have a significant impact on the types of mergers pursued by managers.[16] For example, Professor David Larcker of Northwestern University found that executives who are remunerated by short-term accounting based incentive plans tend to engage in mergers which increase pro forma earnings per share. As mentioned earlier, this practice of "bootstrapping" earnings per share has not been shown to create value for shareholders. The same study did find that incentive plans which were market-based resulted in mergers which were consistent with shareholder wealth maximization.

Furthermore, merger proxy materials normally include a section on "conflicts of interest." This section of the proxy should be carefully reviewed to determine whether inside directors have conflicts arising from special employment agreements with the surviving firm, grants of bonuses or stock options, etc., which may have enticed them to enter into deals which were not in the best interest of shareholders.

Change in Control Payments

ISS evaluates M&A transactions on a case-by-case basis. Such analysis is inherently a balancing of numerous, sometimes contradictory factors. An egregious "goodbye package" may raise a red flag, causing us to examine the other aspects of the deal more critically. Before an intelligent analysis can be completed, however, a proper assessment of the real value transfer to insiders that is due solely from the transaction itself must be conducted. With the resulting more accurate data point, one can then intelligently analyze the reasonableness of the package itself.

Applicable Insiders. When evaluating a "goodbye package" in connection with a proposed merger transaction, ISS is primarily concerned with the potential for rich exit payments to adversely affect the negotiation of the deal terms from the perspective of the non-insider shareholder. Because of the contingent nature of payments triggered upon a change in control, target company insiders may have a greater interest in seeing a deal done – even at an unfavorable valuation – than they have in walking away from a otherwise poor deal for shareholders.

Of utmost concern from our perspective therefore is the potential conflicts facing the shareholder representatives "in the room" negotiating the deal terms (i.e., the executive officers at the highest levels of responsibility at a given firm). Although payments to the more rank and file executives who are not involved in negotiating the deal can in certain cases be egregious enough to warrant examination (e.g., if the aggregate value of such payments constitutes an unwarranted transfer of shareholder value), such payments are not themselves warning signs for potential conflicts.

Retention vs. Severance Payments. ISS is less concerned with completion bonuses that are contingent upon key employees remaining at the combined firm to assist in the often difficult post-merger transition period as compared to payments to executives simply for being fired. In our opinion, ensuring some degree of continuity may benefit all shareholders and may help ensure the realization of expected synergies going forward.

Acceleration of Options. Proxy disclosure is often confusing when it comes to the discussion of the value of options acceleration or the lapsing of restrictions on restricted stock. The true value transfer is not the difference between the exercise price of the option and the offer price (i.e., the “intrinsic value” of the option); it is instead the increased value attributed to having the opportunity to exercise such options now, versus waiting for them to vest over time. Put another way, upon a change in control and subsequent termination of an employee, his or her options in effect transform from "European-style" options (exercisable only at some point in the future) to "American-style" options (exercisable immediately).

The value of this transformation is considerably less than the intrinsic value of the option. In addition, these options were granted to the covered executives in prior periods, not in connection with the proposed merger. Covered executives already own their options, and because such options commonly are time-vesting, it is often inevitable that such options will become exercisable within a few years after the proposed merger, regardless of the performance of the company. In short, the value transfer from shareholders to management inherent in the grant of such options took place in prior years. This transfer cannot be reclaimed and would occur even if the proposed merger did not take place. (A similar argument can be made with respect to SERP plans. The acceleration of SERP benefits indeed has some value, but that value is not the sum total of the SERP balance, which has been earned in prior periods and is already "owned" by the employee). ISS tends to discount such sunk costs when evaluating mergers.

In our opinion, the more effective time to criticize such costs is at the time of grant, or at the time authority to grant such compensation is sought.

Quantitative Analysis. Once we have discerned what the true value transfer is with respect to a proposed merger, we then turn to evaluating the reasonableness of such value transfer. There are several methods by which to evaluate exit pay packages.

  • Compare the aggregate payout to insiders to the total size of the deal. Some clients have suggested to us that 3 percent of deal size is a trigger for further exploration. As ISS begins to track this data going forward, we will be able to establish a market norm threshold level.
  • Compare the payout to the aggregate shareholdings of the covered insiders – large aggregate shareholdings in relation to potential exit payments help to ensure that management is incentivized to negotiate the highest price possible rather than the best exit package. No specific guideline is required – simply compare financial incentives and apply common sense.
  • Compare the payout size to the size of the premium received by all shareholders. Large increases in value implied by large premiums benefit all shareholders, not just insiders. Again, no specific guideline is required, but at a minimum, the premium amount should exceed the size of the package going to insiders.

Ideally, ISS should endeavor to collect relevant data to determine the current “norm” with respect to CIC payments as a percentage of total deal value, percentage of premium and as a percentage of share ownership. In the meantime, we can at least identify clearly disproportionate payout packages without any specific threshold.

“No change” CIC Agreements. Issuers in rare instances have in place a CIC agreement that allows for payments to executives regardless of whether the CIC transaction is actually consummated. In effect, such agreements pay insiders for a change in control where no actual change occurs. ISS finds such agreements extremely detrimental to shareholder value, and in most cases will recommend shareholders vote against a transaction where such agreements may be triggered

Summary. Shareholders are often faced with a difficult choice – vote against an otherwise attractive merger, or ratify by implication the arguably excessive compensation awarded to key executives in the past. At the end of the day, ISS should continue to balance the positive factors of a proposed combination against the deleterious effect of egregious “goodbye” packages. We should continue to compare the change-in-control payments to director and officer share ownership, to the size of the premium received by all shareholders and to aggregate deal size. In addition, we should continue to differentiate between true change-in-control costs and the sunk costs that in our opinion are better reviewed by the compensation committees at the time employment agreements are executed and/or by shareholder proposals seeking ratification of such agreements. However, in cases like AXA-MONY, where the change-in-control payments are particularly egregious, ISS may issue a “no” vote recommendation regardless of whether it would have been theoretically more ideal to attack such agreements in prior years.

An important M&A theme of the 2004 proxy season, and a theme that ISS expects to continue to be of prime importance to shareholders going forward, is the interplay between executive compensation and mergers and acquisitions. Shareholders have of course always been concerned about excessive severance payments. Usually, however, such concerns have been expressed through compensation-related shareholder proposals. This past season, in contrast, shareholders cried foul at the point of the transactional voting decision. We outlined above our current thinking with respect to this issue, which was applied in two recent merger meetings: AXA-MONY and Anthem-WellPoint.

Arm's-Length Negotiations

Most merger proxies contain a background section describing the events and the negotiations which led to the final merger agreement. These descriptions can provide answers to several important questions regarding whether the board made its best effort to obtain the most favorable offer for the company's shares. Research indicates that firms which solicit bids from multiple bidders obtain a substantially better result for shareholders than companies which are targeted by only one bidder.[17] Therefore, shareholders should be alert to situations when management either failed to solicit, or intentionally limited competing bids.

Furthermore, shareholders should look for evidence that merger talks between the ultimate parties were conducted at arm's-length to ensure that the best possible offer price was vigorously negotiated. The issue becomes increasingly important when evaluating vertical integration mergers when negotiations take place between companies which already have a supplier or customer relationship. Arm's-length negotiations are also critically important when the potential merger parties have interlocking directorates.

Contested Transactions

ISS applies a case-by-case approach to contested bids (such as where a hostile third party makes a late bid for a target which has already agreed to merge with another company). This approach balances the “bird in the hand” value inherent in the original bid against the uncertainty of a third party bid, as well as the potential value-destroying disruption of a hostile bid.

If the original transaction is in the latter stages (having been announced months before), ISS will set a high hurdle in terms of the value offered by a hostile third party before we will recommend that the target put the original process on hold to consider the new deal. Some of the issues worthy of examination include the financing commitment level, the relative increase in valuation being offered, the potential breakup fee liability, any due diligence or antitrust contingencies, and the potential ramification to the target if no deal whatsoever is struck. In addition, market reaction to the competing bids may provide clues as to shareholder opinion on the relative merits of the two offers.

Hostile Actions. The 2004 season saw an increase in hostile activity, including “11th hour” hostile bids by third parties attempting to break up friendly mergers. Recently, financial entities have been more willing to launch hostile or unsolicited takeover bids. According to Thomson Financial, hostile and unsolicited activity as a percentage of total M&A volume has been 23 percent in 2004 YTD, as compared to a 5-to-13 percent range for the years 2000 through 2003. Industry participants cite “cleaned up” balance sheets from the last few years’ scandal shakeout (i.e., balance sheets which require a less rigorous due diligence investigation) and increased governance activism as two of the key factors driving the increased hostile activity. ISS needs to be prepared to address the increased possibility of “eleventh hour” hostile bids.

Case Study – Butler Manufacturing. In April 2004, shortly before the Butler Manufacturing special meeting of shareholders, Robertson-Ceco Corporation (“RCC”) submitted a $23.00 per share cash bid (with a share election option) for Butler after Butler had already agreed to be sold to BlueScope Steel Limited for $22.50 per share in cash. Butler demurred, claiming that the RCC bid was not a “superior proposal” under the merger agreement, citing the lack of evidence of committed funding and the complexity of the proposed transaction.

ISS agreed that the 50-cent increase in purchase price was not enough to overcome the uncertainty of the RCC proposal, especially in light of Butler’s precarious financial position. We acknowledged that Butler shareholders had to weigh the certainty of the BlueScope offer against the contingent RCC offer, all for a mere 50 cents per share difference in price. We also noted that RCC could have launched its bid earlier in the process, thus allowing for the securing of binding financing commitments and a completed due diligence process well in advance of an April 30th noteholder deadline. Instead, RCC issued its press release identifying financing sources a mere seven business days prior to the scheduled shareholder meeting. Moreover, we noted that the RCC proposal was somewhat complex, involving multiple parties, and that even if only perfunctory due diligence was required, there still remained uncertainty as to both the time required to consummate the deal, and the ultimate signoff by the financing partners. For all of those reasons, we concluded that we should continue to recommend that shareholders vote to approve the original BlueScope merger agreement.

Case Study – Cole National. In January 2004, Cole National Corporation (“Cole”) agreed to be bought by Luxottica Group S.p.A (“Luxottica”) at $22.50 per share in cash. In April 2004, Moulin International Holdings Limited (“Moulin”) offered to buy Cole for $25.00 per share in cash. As a result of this new bid, Cole postponed the special meeting and entered into discussions with Moulin. In May, 2004, Moulin advised Cole that one of its financing sources had backed out. Cole indicated that it would proceed with its original suitor, but if Moulin was able to finalize financing arrangements that would allow its $25.00 bid to proceed, Cole had the right to terminate its agreement with Luxottica and enter into a "superior proposal."

In July, 2004, Moulin resubmitted its $25.00 per share cash offer for Cole, this time with the committed financing that was absent from its April bid. Under the terms of the Cole-Luxottica merger agreement, Cole was obligated to give Luxottica three days notice to respond to any potentially superior proposal. Cole then announced that Luxottica had raised its cash offer to a minimum of $26.00 per share. If Cole shareholders would approve the Luxottica bid at the upcoming shareholders’ meeting, the offer would be raised to $27.50, plus a previously disclosed 4-percent-per-annum additional payment for the period between the shareholder meeting and the closing of the merger. In addition, Luxottica’s "best efforts" commitment to obtain antitrust clearance (including required divestitures) became no longer qualified. In return, the circumstances under which Cole could terminate the Luxottica merger agreement in order to accept a competing offer were narrowed (e.g., Cole would not be able to terminate the merger agreement and enter into a superior proposal after Cole shareholders approved the Luxottica merger). We noted that the minimum $26.00 merger price was 15.6 percent higher than the original $22.50 offer and 4.0 percent higher than the competing Moulin bid. If Cole shareholders approved the Luxottica offer by the deadline, they would receive an additional $1.50 per share plus the 4-percent additional consideration, which would make the Luxottica offer even more attractive compared to the Moulin offer. We also noted that, even though Moulin obtained more committed financing, its offer was still subject to significant uncertainty due to its structural complexity and certain requirements of the Hong Kong Stock Exchange in connection with Moulin shareholder approval. For these reasons, we reaffirmed our recommendation that shareholders vote to approve the Luxottica merger.

Objectivity of Investment Bankers' Fairness Opinion

While the investment bankers' fairness opinion is a key source of information, shareholders should consider the source, or at least whom the source works for and how it is paid. As described above, there are numerous methods of evaluating merger offers and just as many ways to rationalize a given merger offer price. Fairness opinions are usually provided by investment bankers for a fee. Frequently, the investment banker will receive a retainer fee up front, but will receive a much larger fee contingent on the closing of the transaction at hand. Obviously, it is not in the best financial interest of the banker to scuttle deals from which it stands to earn a substantial fee.

This is not to suggest that all fairness opinions are merely rubber stamps provided by an investment banker to its client. While fairness opinions have been relied upon to provide a legal defense in shareholder lawsuits alleging that the corporation has not obtained a fair price for its shares,[18] some courts have found hastily prepared opinions to be inadequate.[19] It should be noted that fairness opinions have in some cases been prepared almost overnight and vary in quality. Shareholders should review the opinion for several factors:

  • Structure of Payment. Is the investment banker paid a flat fee regardless of the merger outcome, or is his fee heavily reliant on the closing of the deal? Fairness opinions should be suspect when investment bankers accept compensation which is heavily contingent on the closing of a deal.

  • Client Relationship. Does the investment banker have a long-term relationship with his client? The proxy should mention whether the provider of the opinion has participated in the merger negotiations or has previously assisted the company in public offerings, and whether the investment banker stands to gain from the transaction beyond payment of the fee.

  • Transaction History. A good sign that the investment banker is helping the company maximize shareholder value is if there is an indication in the proxy that the banker has found preliminary offers not to be in the best interest of shareholders.

  • Opinion Quality. Although it may be difficult to assess the depth and quality of a fairness opinion from the proxy disclosure, shareholders should check to see that the fairness opinion indicates that the following financial factors were considered by the investment bankers:

    • Historical financial results and present condition.

    • Evaluation of management's projects for the next two to five years and ability to fund future projects.

    • Market or replacement value of assets.

    • Evaluation of management's ability.

    • Historical and comparative price-earnings ratios, market trends, comparative premiums, and general economic conditions.

    • Comment on the timing of the sale.

    • Current availability of a better offer.[20]

Investment bankers should not always be blamed for unattractive deals. It is the board of directors that ultimately is required to make its best effort to maximize shareholder value. The investment banker may be called upon only to give an opinion on the "fairness" of a deal. However, in some cases, the opinion may reveal that an investment adviser was specifically instructed not to solicit offers or consider other investment alternatives. Therefore, to the extent that the investment banker's hands are tied by the board, its opinion may not reflect the best deal available.

In 2004, the NASD sent letters to several Wall Street firms requesting information about their recently issued fairness opinions. This was the start of a potentially far-reaching inquiry into the fees, methods and possible conflicts of interest connected with fairness opinions. While we note that any NASD proposals would require approval by the SEC, nevertheless this inquiry can be seen as indicative of broader concerns associated with conflicts of interest across Wall Street.

Fairness opinions are provided routinely for a variety of financial transactions to corporate boards that seek to protect themselves against legal challenges over a decision to do a deal. While fairness opinions are sometimes prepared by bankers not involved in the underlying transaction, they are more often prepared by the bankers leading the M&A transaction. Indeed, the fairness opinion fee is often creditable against the much larger “success fee” payable to the leading bank.

However, fairness opinions are not intended to be (nor can they be seen to be) assurances or guarantees that any transaction is the best deal for shareholders. Rather, they are more simply statements that a transaction falls within the boundaries of fairness.

While the NASD inquiry confirms that this potential conflict exists, it also highlights the limited level of importance that industry participants and shareholders place on fairness opinions. Much of the news comment has highlighted that participants believe that the potential conflict is widely recognized and adequately catered for with existing disclosure requirements. Indeed, further disclosure would not remove or dilute the potential conflicts that have been discussed.

One aspect that has been highlighted as a concern has been the lack of disclosure within the fairness opinion about change-in-control payments. However, various market participants have debated how much additional benefit further disclosure within the fairness opinion would give.

ISS accepts that the function of a fairness opinion is more to insure directors from future criticism than to give shareholders assurance of a good deal. Therefore the ISS approach to the issue will be to follow the industry’s lead and place less emphasis upon the fairness opinion, and place greater emphasis on the premium and the market’s reaction to the transaction.

Track Record

ISS will scrutinize more closely an acquirer which has a history of value-destroying M&A transactions. Acquirers with poor track records and a history of executing value-destroying M&A transactions should receive greater scrutiny when proposing new acquisitions. Evidence of poor historical M&A decision making include material write-offs or the failure to meet synergy targets of past acquisitions. Analysts will drill down into synergy assumptions and question the acquirer’s ability to integrate target operations. Analysts will continue to call each deal on its merits as a standalone transaction, however.

Currently, there is little accountability for poor M&A decisions. Investment bankers, attorneys, accountants and consultants all profit from greater deal flow. Incumbent management usually benefits financially, sometimes at very significant levels. Board members are generally not held accountable for approving bad deals or for inadequate execution of the all-important integration process, except in the rare case where such issues are brought up in the context of a proxy contest. At the end of the day, it is primarily the acquirer shareholders, especially passive investors such as pension funds who are locked in to the combined company’s shares (and who can’t “do the Wall Street walk”), who suffer when deals go bad.

We believe that, at a minimum, boards with poor reputations for deal making should have a higher “burden of proof” to garner ISS support for a proposed acquisition as compared to those firms that have a track record of value-creating deals.

Case Study – Safeway. One recent high profile example of this issue involved the 2004 “vote no” campaign against Safeway directors, and in particular CEO and chairman Steven Burd. Although institutional shareholder opposition was primarily predicated on corporate governance issues, an additional argument against Mr. Burd’s leadership was the failure of the company’s acquisition growth strategy. Beginning in 1997, Safeway embarked on an acquisition program that ended with the purchase of Genuardi in 2001. The company made three acquisitions in markets outside their traditional west coast footprint. Two of these three out-of-market transactions – Dominicks in Chicago (Nov. 1998) and Randalls in Texas (Sept. 1999) – are particularly notable due to both the magnitude of the failure and in the case of Randalls the conflict of interest with KKR sitting on both companies boards. Safeway took write-offs of approximately $2.0 billion for Dominicks and $1.3 billion for Randalls. As revealed in the company's 2003 10-K, Dominick’s incurred operating losses and declining sales in the prior three fiscal years and faced substantial hurdles to achieving satisfactory operating profit in the future. Safeway invested a significant amount of capital on Randalls and Dominicks and several years later both operations continue to struggle. Were Safeway to propose a new transaction for shareholder approval, ISS would hold its poor track record against it in evaluating the purported synergies, strategic rationale, and other motives for the deal.

Adjournment Proposals

In merger proxies, company management sometimes submit a proposal seeking authorizing to adjourn a shareholder meeting to solicit additional proxies to approve the merger agreement.

Where ISS is supportive of the underlying merger proposal, we believe that this provides a sufficient, compelling reason to support the adjournment proposal, and therefore should recommend FOR the proposal.

Logically, it is more consistent to link our recommendation on the adjournment proposal to our proposal on the underlying merger proposal.

This policy is limited to adjournment proposals that are narrow in scope (i.e., the proposal language requests authority to adjourn solely to solicit proxies to approve a transaction that ISS supports). ISS will continue to recommend against open-ended “other business” proposals.

Merger of Equals (MOEs)

ISS will scrutinize the facts behind a MOE to determine whether in fact the merger is truly one of equals. If the merger is not a true MOE, then a takeover premium should be paid to target shareholders. If such a premium has not been paid, then ISS may recommend target shareholders vote against the transaction.

As the name implies, MOEs theoretically combine “equal” companies, be it by market capitalization, revenue or some other metric. Control of the board of directors of the combined company generally is split 50-50 between the merging parties. Key management positions are likewise divvied up as equally as practicable. Management sells the deal not as a takeover, but as a cooperative transaction between two peers. Consequently, no takeover premium is required to be paid to either party.

When ISS analysts are confronted with a self-styled “merger of equals,” they will scrutinize the facts to determine whether the proposed merger is in fact an MOE. In many cases, the facts will reveal that the merger is not really “equal” at all. For example, it may be clear from announced succession plans that one of the parties will control the combined entity if not immediately, than at some time in the near future. Or one party may in an economic sense be much larger than the other. In such cases, an actual takeover has arguably occurred, albeit a takeover that may occur a year or two in the future. As Robert Bruner stated in an article in the Wall Street Journal dated Jan. 20, 2004: “The MOE merely defers judgment about who will rule, creating a real option in favor of the target and at the expense of the buyer, a rational deal for the buyer if it is confident it has the clout to win.” Of course, if a de facto takeover has occurred, a takeover premium is warranted.

A study by Julie Wolf at the University of Pennsylvania argues that target shareholders capture less value from a MOE than they do in a traditional non-MOE merger. Why would the management of a target sell shareholders short? As Ms. Wolf concludes: “The evidence suggests that CEOs [of target companies] trade power for premium by negotiating shared control in the merged firm in exchange for lower shareholder premiums.” ISS should recommend against transactions that make such a tradeoff.

Breakup Fees

ISS will apply additional scrutiny to deals that have breakup fees as a percentage of transaction value above the current norm (approximately 3.5 percent). If a proposed transaction has an above average breakup fee, target shareholders should be receiving at least an average premium, and preferably an above-average premium in return for giving up the chance to be acquired at a higher price by a third party.

Breakup fees serve an important function in helping to induce an acquirer to commit to an acquisition. On the other hand, an excessive breakup fee acts as a deterrent to potential third parties who may, upon announcement of the proposed transaction, wish to make their own bid for the target. In the end, target shareholders may not recognize the premium they could have absent the breakup fee. ISS therefore will balance the competing functions of breakup fees by comparing a fee to the current industry standard fee for a deal of like size.

According to Dealogic data, for the nine months through March 19, 2004, the average breakup fee as a percentage of (enterprise) deal value was 3.2% for deals under $5 billion. It was 3.4% for deals over $5 billion. From our data mining of deal information for 2004, we have discovered the following breakup fee splits:

Break Up Fee Summary

Transaction Size Median Mean
> $1 billion 3.5% 3.4%
$250m - $1b 3.4% 3.5%
$100m - $250m 3.3% 3.5%
< $100m 4.1% 4.4%

We note that transaction size in the above table is equity value, and therefore the data implies that the median breakup fee percentages should be slightly lower than the above figures (enterprise value being greater than equity value in most cases).

Reincorporation and Changes in Articles, Bylaws, and Charters

In stock-for-stock acquisitions, shareholders of the acquired company assume the shareholder rights of the acquiring firm. Shareholder rights are determined by a combination of state corporation law and the company's governing documents-articles of incorporation or charter, and bylaws.

In many acquisitions, shareholders become investors in a company incorporated in a different state than the company in which they originally invested. Though sometimes ignored, place of incorporation is a vital subject of shareholder concern. State antitakeover statutes vary, and individual states place certain restraints on charter rules. Therefore, the variation in state laws can be interpreted to mean that mergers which change the state of incorporation for certain shareholders affect the contractual arrangement between the shareholder and the company. At stake is the ability of shareholders to influence effective governance of the corporation as well as their future ability to consider premium offers for their shares in the surviving company. Comparisons of the state laws as well as differences and similarities between the parties' articles of incorporation, bylaws, and charters are discussed in each merger proxy statement. However, the depth of these discussions tends to vary. To the extent possible, shareholders should independently investigate the differences between state corporation laws as well as the differences in the acquirer's governing documents.

It is not suggested that the decision to approve an operationally and economically sound merger be hinged upon the relative differences in state corporate law and company articles alone, but rather in conjunction with financial and operational considerations. While shareholders should actively oppose reincorporation proposals which are undertaken simply to afford management a more favorable structure to resist hostile takeovers, or to allow management to act as an intermediary between shareholders and outside offers, it is important to recognize that changes in shareholder rights are never the driving force behind a merger proposal. Generally, shareholders should expect the positive financial benefits of a merger to clearly outweigh its potential negative governance aspects. However, in cases where shareholders find little value in a particular merger offer, the prospect of an exceedingly poor governance profile which includes a plethora of takeover defenses and stakeholder provisions could tip the balance.

Notes

[1]

Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 3d ed., McGraw Hill, 1984, pp. 796-802.

[2]

K.G. Palepu, "Predicting Takeover Targets: A Methodological and Empirical Analysis," Journal of Accounting and Economics, Vol. 8 (March 1986), pp. 3-36.

[3]

Michael Jensen of Harvard Business School has argued that acquiring companies in a wide array of industries have been motivated by the need to invest surplus cash in order to avoid a takeover themselves. In this way, the threat of a takeover can serve to promote more efficient use of cash. See "The Takeover Controversy: Analysis and Evidence," Midland Corporate Finance Journal, Vol. 4 (Summer 1986), pp. 6-32.

[4]

Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance, 3d ed., McGraw Hill, 1984, op. cit., p. 798.

[5]

Michael C. Jensen and Richard S. Ruback, "The Market for Corporate Control, The Scientific Evidence," Journal of Financial Economics, Vol. 11 (April 1983) pp. 5-50.

[6]

Baruch Lev, "Observations on the Merger Phenomenon and a Review of the Evidence," presentation from the Berkeley Conference, reprinted in The Revolution in Corporate Finance, Joel M. Stern and Donald H. Chew (eds.), 1986, p. 357.

[7]

Baruch Lev, "Observations on the Merger Phenomenon and a Review of the Evidence," presentation from the Berkeley Conference, reprinted in The Revolution in Corporate Finance, Joel M. Stern and Donald H. Chew (eds.), 1986, p. 360.

[8]

Baruch Lev, "Observations on the Merger Phenomenon and a Review of the Evidence," presentation from the Berkeley Conference, reprinted in The Revolution in Corporate Finance, Joel M. Stern and Donald H. Chew (eds.), 1986, p. 360.

[9]

Source: The Revolution in Corporate Finance, Stern and Chew, eds. (1986).

[10]

Michael C. Jensen and Richard S. Ruback, "The Market for Corporate Control, The Scientific Evidence," Journal of Financial Economics, Vol. 11 (April 1983), op. cit., p. 6.

[11]

The Department of Labor and Treasury Department have taken the position that ERISA does not require fiduciaries to accept all tender offers that involve a premium over the prevailing market price. Rather, the agencies have stated that fiduciaries are required to make investment decisions, including tender offer decisions, based on the facts and circumstances applicable to the investment and the plan. U.S. Departments of Labor and Treasury, Joint News Release, Jan. 31, 1989, pp. 1-2.

[12]

Paul Asquith, "Merger Bids, Uncertainty and Stockholders Returns," Journal of Financial Economics, Vol. 11 (April 1983), pp. 51-83.

[13]

Michael C. Jensen and Richard S. Ruback, "The Market for Corporate Control, The Scientific Evidence," Journal of Financial Economics, Vol. 11 (April 1983), op. cit., p. 7.

[14]

Mergers and Acquisitions, Jan./Feb. 1992, pp. 56-61.

[15]

Paul Asquith, "Merger Bids, Uncertainty and Stockholders Returns," Journal of Financial Economics, Vol. 11 (April 1983), op. cit., pp. 51-61.

[16]

David Larcker, "Managerial Incentives in Mergers and Their Effect on Shareholder Wealth," from The Revolution in Corporate Finance (Joel M. Stern and Donald H. Chew eds.), Basil Blackwell Ltd., pp. 380-86.

[17]

Michael Bradley, A. Desai and E.H. Kim, "The Rationale Behind Interfirm Tender Offers: Information or Synergy," Journal of Financial Economics, Vol. 11 (April 1983), pp. 301-28.

[18]

See, e.g., Panter v. Marshall Field & Co., 646 F. 2d 271 (7th Cir. 1981) and Danziger v. Kennecott Copper Corp., Order (Sup. Ct. N.Y. Co. Dec. 5, 1977), aff'd mem. 60 A.D. 2d 552.

[19]

Royal Indus., Inc. v. Monogram Indus. , (CCH) Fed. Sec. L. Rep. Para. 95,863, at pp. 91, 139-40.

[20]

Martin Lipton and Erica H. Steinberger, Takeovers and Freezeouts, Sec. 8.06[3], "Dealer-Manager & Investment Banker," Law Journal Seminars-Press (1991).

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