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SECURITIES AND ~:::::~ EXCHANGE COMMISSION i~~)] Washington, D. C. 20549 .~.i2J (202) 272.-2650 CO~~ Remarks to the International Bar Association Toronto, Canada october 6, 1983 MANAGEMENT BUYOUTS: ARE PUBLIC SHAREHOLDERS GETTING A FAIR DEAL? Bevis Longstreth Commissioner

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SECURITIES AND ~:::::~EXCHANGE COMMISSION i~~)]

Washington, D. C. 20549 .~.i2J(202) 272.-2650 CO~~

Remarks to theInternational Bar Association

Toronto, Canadaoctober 6, 1983

MANAGEMENT BUYOUTS:ARE PUBLIC SHAREHOLDERS GETTING A FAIR DEAL?

Bevis LongstrethCommissioner

MANAGEMENT BUYOUTS:ARE PUBLIC SHAREHOLDERS GETTING A FAIR DEAL?

I. Introduction

In management buyouts -- or "going private" transac-tions as they are also called -- do the current rules ofthe game adequately assure a fair deal for public share-holders?

In June 1983 Stokely-Van Camp mailed proxy materialsto its shareholders, seeking approval of a cash buyout ofall public shareholders by a group which included manage-ment. The buyout was to be accomplished through a mergerwith a newly formed private corporation which would borrowthe necessary funds and secure that borrowing with Stokely'sassets. The proposed purchase price of $55 per share wasdetermined by an investment banking firm to be fair toStokely's snareholders, from a financial point of view.The transaction was recommended, first, to the Board ofDirectors by a special commi ttee of non-management directors,and, then, to the shareholders by the full Board, whichconcluded that the transaction was "fair and attractive."

Four weeks later Pillsbury made a cash tender for allStokely shares at $62 per share. Yet Stokely's managementdid not embrace this higher bid. Three weeks later, QuakerOats topped Pillsbury with a successful bid of $77 pershare.

What does "fairness" mean, when management's idea of a"fair and attractive" price is increased in the marketplaceby 40%~ Of what value to shareholders are the blessings ofmanagement's opinion bestowed by investment bankers and non-management directors? These questions need to be addressed.

Of course, in Stokely, the ending was a happy one forthe public shareholders. They got a higher price. Butrather despite management's efforts than because of them.Fortui tously, the management group controlled only 22% ofthe outstanding stock, not enough to block a third-partybid. And both Pillsbury and Quaker Oats had done enough

The views expressed in this speech are my own and donot necessarily represent those of the Commission, my fellowCommissioners or the staff. However, I am indebted to LindaC. Quinn, Associate Director of the Division of CorporationFinance, and D. Michael Lefever of my staff for their helpin preparing this speech.

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analysis of Stokely prior to its announcement to appreciatethe inadequacy of its offer and move swiftly with bids oftheir own.

When management has a control block, the public share-holders may not be so lucky. Several weeks ago, whileworking on this topic, I got a call from an old collegefriend, whom I hadn't heard from for years. He is an in-vestment adviser and was calling to complain about themanagement buyout of a corporation in which he and hisclients were heavily invested. Having followed the companyfor many years, my friend believed the offer, while somewhatabove the market, was substantially below true value. Isuggested trying to find a third-party willing to make ahigher bid. He had thought of that, but unfortunately themanagement controlled over 50% of the stock and was unwillingto sell.

He could go along, receiving what he believed to be aninadequate price, or exercise his appraisal rights understate law. He knew, however, that the appraisal route wascostly and unlikely to be successful, because of the court'stendency to rely heavily on the pre-existing market priceand the fairness opinions used by management to support itsbid. He knew the market price was not indicative of theprice a bidder would offer for the whole company, becauseit hadn't been for sale. Now it was, but only to management.Was it fair, he asked, for management to put the company.upfor sale, so arrange things that it was the only bidder,and then bless its own offer, with the help of friendlyoutsiders?

II. The Problem with Management Buyouts

In talking about these questions, it will help todefine my terms. By "management buyout," I mean an attemptby the management of a public corporation, or some part ofmanagement, acting alone, or frequently with an investorgroup, to acquire all of the corporation's assets or allor enough of its stock to become a private company, free ofthe reporting requirements of the federal securities laws.This kind of transaction is also called a "leveraged buyout"or "LBO," when the company's assets collateral ize loansused to finance the buyout.

For management, these transactions offer an opportunityto obtain a significant equity interest in its company. Thisenhanced stake in the enterprise may resul t in heightenedproductivity on the part of managers, achieving more effi-cient utilization of corporate assets and greater wealth

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for the new investors.* Other reasons for going privateinclude the avoidance of hostile takeover attempts, elimina-tion of public disclosure requirements and other burdensunder the federal securities laws, greater flexibility inmanagement, including the chance to take greater risks,and, last but by no means least, the prospect of a bargainprice.**

A management buyout also occurs when management of adivision or subsidiary acquires that business from itsparent corporation. Since this kind of buyout does notinvolve pUblic shareholders, I do not intend to talk aboutit today.

LBOs have been the subject of widespread attention anddebate since 1974, when A.A. Sommer Jr., then an SEC Commis-sioner, attacked the "going private" phenomenon in a seminaladdress at Notre Dame Law School.*** Following that speech,the Commission published for comment rules that would haveimposed substantive fairness on management buyouts. Con-cerns about its authority to write such substantive rulesforced the Commission to resort to an elaborate set ofdisclosure rules -- contained in Rule 13e-3 -- to addressthe problems identified by Mr. Sommer. This Rule was notfinalized until the Summer of 1979. Since then, the volumeof going private transactions, as measured by Schedule 13e-3filings, has ranged from 133 to 169 transactions per year --enough to warrant an assessment of how well the Rule isworking. Perhaps of more significance, 1983 was at thehigh end of this range, confirming what professionals inthe field see as a rapidly growing level of activity. ****

* Easterbrook & Fischel, Corporate Control Transactions,Yale L. J. 698, 705 (1982).

** See, e.g., Brody, Controversial Issue: A Leveraged Buy-out TOll,Ches Off a Bitter Dispute, Barron's, at p. 15(September lQ, 1983) (describing the motivating factorof the Empire, Inc. buyout).

***

****

"Going Private:" A Lesson in Corporate Responsibility,[1974-75 Transfer Binder] Fed. Sec. L. Rep. (CCH) ~80,010.

See Lederman, Citron & Macris, Leveraged Buyouts -- Anupdate, unpublished outline for presentation at the forth-coming 15th Annual Institute on Securities Regulation tobe held on November 10-12, 1983 in New York, New York.

//

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Recent transactions in which management's inherentconflict appears to be unsatisfactorily resolved reinforcethe need for prompt assessment. Although the SEC's AdvisoryCommi ttee on Tender Offers examined the adequacy of theSEC's regulatory system for takeovers in a report issued onJuly 8, 1983, it did not have time to undertake the neededassessment, nor did the report address the special problemsof management buyouts.

What is special about a management buyout? It issimply this: management is acting on both sides of thetransaction. In its fiduciary capacity, management is seekingto sell the corporation and, therefore, must have concludedthat a sale is in the best interests of the shareholders. Inits proprietary capacity, management is seeking to purchasethe corporation, and must have concluded that it can do soat a price favorable to it. In short, management is dealingwith itself.

Self-dealing problems have ancient origins. So toodoes the duty of loyalty evolved in response. Undervenerable principles of common law, a trustee violated hisduty of loyalty by purchasing trust assets for his ownaccount, even with the consent of his beneficiaries, if, asthe legal scholar Austin Scott puts it:

"the trustee failed to disclose tothe beneficiaries the material factswhich he knew or should have known,or if he used the influence of hisposition to induce the consent, orif the transaction was not in allrespects fair and reasonable."*

Of course, corporate law is not in every respectanalogous to trust law, and management, while viewed asa fiduciary, is not a trustee in the classic sense. I sub-mit, however, that the standard just quoted from ProfessorScott's treatise on trusts expresses an appropriate policyby which to test a management buyout.

If we pass the current rules of play through thispolicy screen, we see that:

1. The need to have all material factsdisclosed is addressed by the securi-ties laws.

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2. The use of influence by managementis handled, at least to some extent,through a committee of non-managementdirectors and the fairness opinion ofan investment banker.

3. It is the requirement that the trans-action be "in all respects fair andreasonable" that poses the maindilemma.

If one turns to corporate law, one finds closelyanalogous principles among the leading cases. In Guth v ,Loft, Inc.,* the Delaware Supreme Court said that "[t]herule that requires an undividerl and unselfish loyalty tothe corporation demands that there shall be no conflictbetween duty and self-interest." But Delaware law has notsought flatly to prohibi t a self-dea ling transaction, assome states have done by statute in the case of trusts.Instead, as the Delaware Supreme Court said recently inWeinberger v. UOP, "[w]hen directors of a Delaware corpora-tion are on both sides of a transaction, they are requiredto demonstrate their utmost good faith and the most scru-pulous inherent fairness of the bargain."**

In 1974 Mr. Sommers believed that fairness demandeda legitimate business purpose for going private. Publicshareholders should not be deprived of their shares, absentsuch a purpose, even if they were paid an adequate price.

The theme of requiring a "legitimate business pur-pose" in order to justify a management buyout was blessedseveral years later by the Delaware courts. In Singer v ,Magnavox,*** the Delaware Supreme Court held that a mergerthat eliminated minority shareholders constituted a breachof fiduciary duty to the minority unless it met the standardof "entire fairness" and did not have as its sole purposea freeze-out of the minority. In other words, eliminationof the minority had to be justified by a legitimate businesspurpose. Judicial scrutiny of whether a minority freeze-outserves an independent business purpose, however, was short-lived, at least in Delaware. In the 1983 case of Weinberger

* 5 A.2d 503,510 (1939).

\

\

**

***

457 A.2d 701, 710 (1983), citing Gottlieb v.ical Corp., 91 A.2d 57, 57-58 (1952).

380 A.2d 969 (1977).

Heyden Chem-

/

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v. UOP,* the Delaware Supreme Court overturned the holdingin SInger, reestablishing statutory appraisal rights as thebasic remedy of a frozen-out shareholder:

"In view of the fairness test ••• ,the expanded appraisal remedy nowavailable to shareholders, and thebroad discretion of the Chancellorto fashion such relief as the factsof a given case may dictate, we donot believe that any meaningfuladditional protection is affordedminority shareholders by the busi-ness purpose requirement."**

This change seems to make sense. Mot ives are hardto probe. And there is social utility in promoting a freemarket for corporate control. *** The only reasonable ex-pectation of a pUblic shareholder should be that, if he isto be deprived of his interest, it be done in a procedurallyfair manner and he receive fair value. The question remainswhether the present rules adequately assure that the share-holder is given his due. Let's look at those rules moreclosely.

III. The Federal Level

At the federal level, the approach is chiefly one ofdisclosure. Rule 13e-3 requires management to express its"reasonable belief" as to whether the transaction is fairto public shareholders. While this requirement may prompta somewhat better deal than might otherwise be offered, itby no means assures a fair deal. Indeed, given management'sconflict of interest, one must question whether its "reason-able belief" as to the fairness of its own offer, or thatof its group, provides any meaningful guidance for theseller. As Professors Brudney and Chirelstein have sug-gested, management will propose a price "as low as reasonablepessimism w iLl. allow. "****

* 457 A.2d 701 (1983).

** Id. at 715.

***

****

Easterbrook & Fischel, Corporate Control Transactions, 91Yale L. J. 698, 705-8 (1982).

Brudney and Chirelstein, Fair Shares in Corporate Mergersand T?keovers, 88 Harv. L. Rp,v. 297, 298 (1974).

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Disclosure serves the goal of informed decision-making,which, in turn, rests on the notion that the decision-maker has viable alternatives. As my college friend quicklyrealized, in management buyouts, viable alternatives aresometimes lacking.

The disclosure approach provides no federal forum forcontesting fairness.* If the material facts are disclosed,a dissenting shareholder will normally be limited to statelaw in seeking redress.

Rule 13e-3 also requires disclosure as to whether afairness opinion was obtained, whether the non-managementdirectors approved the transaction and whether ratificationby a majority of unaffiliated shareholders is required. Asso often is the case, these items of disclosure have tendedto encourage the use of the practices required to be dis-closed. This is no accident. When the Commission backedaway from a substantive rule of fairness, it sought toachieve the same goal through the detailed disclosuresrequired by Rule 13e-3. Perhaps ironically, these rulesmay have put the Commission's imprimatur on managementbuyouts, so long as these indicia of procedural due processare observed. The question, however, is whether, or towhat degree, these procedures actually help to assure sub-stantive fairness.

IV. The State Level

To deflect a successful legal challenge under statelaw, management typically employs a panoply of proceduralprotect ions, of which the three just ment ioned are mostprominent.

Fairness Opinions. The investment banking opInIonserves as a keystone to this support structure. Reflectingthe opinion of an independent entity with demonstrableexpertise, it prov ides powerful support, both legally andpract ically, for the judgment of both the non-management

* See Santa Fe Industries, Inc. v. Green, 430 u.S. 462, 497(1977) (holding that "man ipu La t Lon " under Section 10(b)of the Securities Exchange Act of 1934, while "meant toprohibit the full range of ingenious devices that mightbe used to manipulate securities pr ice s ;" was not meantto cover instances of corporate mismanagement lIin whichthe essence of the complaint is that shareholders weretreated unfairly by a fiduciary.lI)

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directors and the Board as a whole. Investment bankers do,on occasion, decline to render fairness opinions satisfac-tory to management. But this is more the exception than therule. I do not question the good faith or professionalismbrought to fairness opinions. The problem, as Stokely andother recent cases suggest, is simply that the range offairness is too great to expect opinions to be a very goodindicator of what a fair deal for shareholders might be.The proof is in the pudding. Or, in this instance, themarket is the market.

This problem is exacerbated by the limitations thatmanagement often places on the investment banker's review.This practice may result in:

an excessive reliance on market price,

a failure to consider break up orliquidation values, and

a failure to shop the company to deter-mine what a third party would pay.

For example, in one recent fairness opinion, the in-vestment banker noted:

"We were not requested to solicit anddid not solicit other purchasers for[the corporation], the common stockof [the corporation] or the assetsof [the corporation] as part of ourengagement. If purchasers of [thecorporation] were actively solicitedor if the assets held by [the corpora-tion] were liquidated in an orderlyfashion, it is possible that a pricein excess of the equivalent of $68 pershare could be realized."

In another recent proxy statement, the fairness opinionof the investment banker stated:

"However, in rendering this opinion wewere not requested by [the independentcommittee] of the Board of Directors••• to negotiate with [the privateinvestors group] or to investigate orevaluate other alternatives to theMerger proposed by [the private in-vestors group) ."

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This kind of disclosure, while theoretically useful towarn the shareholder that a higher price might be obtainable,is overwhelmed in the practical world by the professional'sopinion that the price offered is, in fact, fair. Thispoint emphasi zes the problem wi th hinging so important aconclusion on what has become so imprecise a concept. Whyshouldn't "fairness" in this context mean the highest pricefor the company reasonably bel ieved by management and itsoutside advisors, after due investigation, to be obtainable?

I should point out that, in asking this question, I amaware of the fact that IIshopping II can have serious adverseeffects on the company, including the loss of key personneland customers to competitors, who may be quick to point outthat the company is "on the block." However, the managementbuyout proceeds from an initial decision by management thatit is in the interest of shareholders to sell the company.

There is also at least the appearance of a problem insome cases, arising out of the method of compensating theinvestment banker. The fee may vary, depending upon whoultimately succeeds in a contested buyout, creating economicpressures to support management's judgment.

outside Directors' Approval. Review by non-managementdirectors also has defects. In the abstract this deviceought to work. outside directors, lacking a proprietaryinterest in the transaction, should be willing to look outfor the interests of public shareholders. In practice,however, review by non-management directors often fails togive shareholders a fair deal. outside directors areinvited to serve, not by the shareholders who routinelyvote for them, but by management or, in some cases, otherouts ide directors. Often they have some business or per-sonal connection with the corporation or its management.In any event, the relationship exerts on them a powerfulforce in support of loyalty to management. However subtleand implicit this force may be, its existence cannot honestlybe denied. By the way, in speak ing of loyalty, I am notsuggest ing a kind of wrongdoi ng, venal ity or ant i-socialbehav ior. Loyalty is a human qual ity -- one we typicallyapplaud. Here it is simply a force to be noted.

If one adds to these tugs of loyalty the wide discre-tion accorded directors under the bus iness judgment ruleand the uncertain contours of the fairness concept itself,one must conclude that the blessing of non-managementdirectors is not likely to assure substantive, fairnessto shareholders in management buyouts. And the ev idencesupports this conclusion.

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Unaffiliated Shareholders' Ratification. A third pro-cedural device is the vote of unaffiliated shareholders.In theory, giving the unaffiliated shareholders a rightto reject an unfair deal ought to suffice. The DelawareSupreme Court has accepted this notion. In Weinberger v.UOP, it said: "[W]here corporate action has been approvedby an informed vote of a majori ty of the minori ty share-holders, we conclude that the burden entirely shifts tothe plaintiff to show that the transaction was unfair tothe minority."*

But again, in reality, there are problems, derivedin part from those just mentioned in regard to fairnessopinions and outside directors' review. The vote of un-affiliated shareholders is effective only if they are in aposition to evaluate the terms and have some viable optionif they reject the deal. Of course, their evaluation willbe heavily influenced by the fairness opinion, which, aswe have seen, is not particularly effective in assuringthem that management's deal is fair.

As for viable options, to date there have not beentoo many. The three devices I have been discussing willtypically assure that management's self-dealing is measured,for all practical purposes, not by the rule of inherentfairness, but by the remarkably elastic rule of businessjudgment. In the absence of fraud, under state law a non-consenting shareholder is left with his right of appraisal,unless he can show that remedy to be inadequate. Appraisalis limited to a cash payment equal to "fair value." Onecan not seek injunctive relief or rescission. The remedyis expensive, and the expenses may not be broadly shared.And it is risky, in that one can end up with less than man-agement offered in the first place. Recently, in Weinbergerv. UOp,** the Delaware Supreme Court sought to broaden thefactors to be considered in valuing a corporation, but itremains unclear to what extent that decision will enhancethe shareholder's prospects. The appraisal route remainsproblematical, at best.

To summarize, the fairness opinion, the approval ofnon-management directors and the ratification by publicshareholders are much more effective in protecting manage-ment than in assuring shareholders "the most scrupulous

* 457 A.2d 701, 703 (1983).

** 457 A.2d 701 (1983).

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inherent fairness of the bargain," as the Delaware SupremeCourt put it. In many cases these indicia of proceduraldue process may prompt management to improve its offerfrom what it might have been without them. And to thisextent the shareholders are better off. There is reasonto believe, however, that often they do not sweeten thedeal enough to make it fair.

V. Lock-ups in Management Buyouts

Management has enormous advantages over the share-holders in seeking to buy the corporation. To serve itsproprietary interest in acquiring the corporation at abargain pr ice, management may use adroi t timing and itsvastly superior knowledge of the corporation's true value.In an apparent effort to add further advantages by dis-couraging competing bids, management used "lock-ups" inthe recent case of Northwest Energy Company.

On August 8, 1983, Northwest announced its plan tomerge with a new company to be owned by an investor groupheaded by Allen & Co. and including members of management.Northwest's publ ic shareholders were to be cashed out at$31 per share. As part of the deal, Northwest grantedAllen two options: one to acquire at book value its "crownjewel", Northwest Central Pipeline, and the other to acquireat S31 per share stock representing 18% of Northwest's thenoutstanding shares. The "crown jewel" option was exercisablewhenever a third party acquired at least 45% of Northwest'soutstandi ng stock, or the Northwest Board consented. Inaddition, Northwest agreed to indemnify its directors andmanagement as well as Allen against claims arising out ofthe proposed buyout.

On September 12, 1983, The Williams Companies tenderedfor Northwest at $39 per share, conditioning its bid on theelimination of the lock-ups; it also brought suit to voidthem. After a skirmish or two, Northwest's Board agreed tothe Williams tender offer, and Williams agreed to pay Allen$26.7 million for relinquishing the lock-ups.

In this case the marketplace operated effectively togive shareholders 26% more than management had offered.How much more might have been offered, by how many otherbidders, had the lock-ups not been used, one will neverknow. We do know, however, that "it cost an undeterredthird party $26.7 million to shove them aside. It is notunreasonable to suggest the possibility that, but for thelock-ups, that sum might have been offered to the Northwestshareholders, adding almost $1.50 per share.

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Whatever one may thi nk of "lock-ups" in third partyacquisi tions, where they might be justif ied in order toattract a competi ng bid, they seem entirely out of placein a management buyout, where their only apparent purposeis to prevent a competing bid.

Judge Abraham Sofaer's thoughtful decision in DataProbe Acquisition Corp. v. Datatab, Inc.* may have casta new cloud of uncertainty over the validity of "lock-ups"under the Williams Act. Judge Sofaer found that legis-lation to have the twofold purpose of providing publicshareholders with all material information and guaranteeingthem a fair opportunity to use it. He granted recourseunder the Williams Act on a manipulation theory, where"lock-ups" impaired the operation of the marketplace andfrustrated a shareholder's exercise of informed choice. **How this theory will play out in subsequent cases is hardto predict.*** But one can not read Judge Sofaer's opinionwi thout gaining a sense of his frustration at the Commis-sion's failure to take the lead in defining such words as"deceptive" and "manipulative" in the context of tenderoffers.**** Pointing to its legislative mandate under theWilliams Act, Judge Sofaer expressed the expectation thatthe SEC "should eventually address the complex, new problemsposed for shareholders by the obscure and sometimes coercive

* [Current Binder] Fed. Sec. L. Rep. (CCH) ~199,45l.

** Id. at 96,569.

***

****

The very recent decision of the Second Circuit in BuffaloForge Co. v. Ogden Corp., Nos. 83-7199, 83-7211 (2d. Cir.Sept. 22, 1983), may have already sapped Data Probe of muchof its vitality as an authoritative interpretation of theWilliams Act. Writing for a three jUdge panel, Judge VanGraafeiland, without mentioning Data Probe, stated thatthe Sixth Circuit's opinion in Mobil Corp. v. Marathon OilCorp., 669 F.2d 366 (6th Cir. 1981) was an unwarranted ex-tension of the Williams Act, which "was designed solely toget needed information to the investor" (citing Piper v.Chris-Craft Indus., Inc., 430 U.S. 1, 31 (1977». How-ever, it may prove important that Buffalo Forge did notinvolve options issued in a leveraged buyout structuredto include equity participation by management.

[Current Binder] Fed. Sec. L. Rep. (CCH) '199,451 at 96,580.

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,nature of the financial terms that tencier offers are in-creasingly assuming."*

I endorse his restrained exhortat ion. I should 1iketo add, however, that, with the recommendation of theAdvisory Committee on Tender Offers in hand, the time isnow ripe for the Commission to act. The field is toocomplex to rely on case-by-case adjudication, althoughopinions such as Judge Sofaer' s help to point the way.The Commission should do what it can under existing law.To the extent-that a federal solution to these problems ispresently beyond its author ity to prov ide, the Commiss ionshould play a leadership role wi th the Congress and thestates in fashioning a satisfactory solution through legis-lation.

VI. The Manipulation problem

The problems with management buyouts that I have beendiscussing provide sufficient warrant for a careful assess-ment. These remarks would be incomplete, however, withoutmention of the potential for management to present its cor-poration to the public in a manner designed to facilitatea future buyout at a price favorable to it. In a word:manipulation. This idea has not only been advanced byscholars. ** Several members of the Advisory Committee onTender Offers, including practical, highly experienced CEOs,pressed the Commission to look at the problem, which theybel ieved to be more than theoret ice l , As one investmentbanker on the committee put it at the final public meeting:

"It's really ••. an SEC enforcementproblem. It's clear there is thesmoke of such a problem out there.1I

It is obvious that there are a variety of techniquesby which management can adversely affect the market pricefor its corporation's stock. They include the selection ofaccounting principles, the application of those principles,management's discussion and analysis in 10-Ks and in pUblicstatements and the nature and timing of its business deci-sions.

* Id. at 96,580.

** See, ~' Brudney, Equal Treatment of Shareholders inCorporate Distributions and Reorganizations, 71 Cal. L.Rev. 1073, 1131-2 (1983).

/

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Earnings can be adversely impacted, for example, byelecting LIFO inventory valuation instead of FIFO, doubledeclining balance depreciation instead of straight line orcompleted contract instead of percentage of completioncontract accounting.

Large discretion is accorded management in the appli-cation of accounting principles, particularly if one seeksto be conservative. Loan loss reserves, allowance foruncollectable accounts, write-offs of obsolete inventoryand accruals for various contingencies offer ample closetspace in which to store both income and assets.

In its interpretat ions of past performance and pro-jections for the future, management has great discretion,which it can exercise so as to encourage or discourage thepurchase of stock. Its annual report can go from 50 pagesof upbeat talk to one page of discouraging prognosis.

Business decisions can have an impact on stock values.Assets, including subsidiaries and divisions, can be soldto book a loss; opportunities can be postponed or even fore-gone. Dividends can be cut, debts paid off, advertisingbudgets employed, all with a view to strengthening thebalance sheet and cash flow, but wi th the interim purposeand effect of depressing the stock price.

Accountants confirm that management can effect a down-ward manipulation much more easily than an upward one.Management's actions must pass muster with the outsideaccountants, whose bias is toward conservatism. Both theseguardians and the accounting rules they administer aredirected chiefly to preventing an unduly optimistic finan-cial picture. The pessimistic view is a somewhat unguardedflank, exposed to the temptations of an unscrupulous manage-ment.

To my knowledge, the Commission has never brought acase alleging this sort of conduct. But we have been cau-tioned by knowledgeable players in the financial communitythat it may happen. Of course, there is no doubt that suchbehavior would constitute a fraud under the federal securi-ties laws. Havi ng been duly warned, the Commission willbe especially watchful in reviewing management buyouts.

The best solution to this problem, as in all the othersI have been discussing today, is to let the marketplace work.Given sufficient time to respond, third party bidders shouldbe able to ferret out enough information to recognize aninadequate bid by the management group. Assuming no IIlock-ups" to bar entry, third parties should be able to top

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management's bid. We saw this process at work in NortonSimon, Stokely and Northwest, among others. Given manage-ment's irrefutable conflict, and the ineffectiveness ofcommonly used procedures to do much more than protectmanagement, sound policy supports a marketplace solution.As regulators, we should strive to enhance the workingsof a free market. Why, for example, shouldn't management-- once it has decided in the interest of shareholders tosell the corporation -- be required to resolve its conflictby remaining open to bids competitive with its own andwilling to sell to the highest bidder? Why shouldn'tmanagement be willing to liquidate if higher values couldbe reasonably expected though this kind of sale?

I realize that management may lose its job if a thirdparty tops its bid. But management initiated the processby concluding that it was in the interest of shareholdersto sell the corporation. Once that decision is made, is itunreasonable to ask management to sell in a manner mostadvantageous to all the shareholders?

This question becomes harder to answer as management'sownership increases. If management has control beforemaking its bid, it can deter third party bids by announcingits unwillingness to sell control to others. Whether,under these circumstances, it is fair to allow managementto hold to itself alone the control premium is an exceedinglydifficult question. If in liquidation, each shareholderwould receive its aliquot share, why not equally so whenmanagement seeks to buyout the minority?

Some have argued that the minori ty is entitIed to nomore than market value, which takes into account the effectsof a control block in the hands of management.* But, ofcourse, the market value is simply a reflection of what thepublic is willing to pay for the corporation's shares,assuming it to be continuing as a public company withcontrol in the hands of management. Once management decideson a buyout, circumstances wi11 change. How they shouldchange is a matter of corporate policy, to be worked outthrough public debate. It may be that, in managementbuyouts, a shareholder's expectation of sharing equally

* See, e.g., Chazen, Fairness From a Financial point of Viewrn-Ac~itions of Public Companies, 36 Bus. Law. 1439(1981); Easterbrook and Fischel, Corporate Control Trans-actions, 91 Yale L. J. 737 (1982).

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with others in the wealth of the enterprise should be giventhe force of law.*

VII. Conclusion

Let me now pull together some conclusions from thisdiscussion:

1. In management buyouts, the current rules of thegame -- both federal and state -- fail adequatelyto assure to publ ic shareholders a fair deal --that is, the highest current price reasonablyobtainable, whether from management or one ormore third party purchasers of stock or assets.

2. The indicia of procedural due process, such as fair-ness opinions, independent directors' approval andshareholder ratification, have become boiler-platedpasskeys to an advantageous buyout, effective inprotecting a conflicted management from successfulattack, but inadequate to give shareholders fullvalue for their shares. Requiring an independentbusiness purpose would suffer from a similar in-firmity.

3. Tighter procedural rules and substantive fairnessdetermined in advance by a governmental agencyare possible solutions to the problem, but neitherapproach seems 1ikely to yield significant bene-fits, net of the new costs it would impose on thesystem.

4. Although some have argued for prohibiting manage-ment buyouts, this is too extreme a solution.These transactions can provide to shareholders anopportunity to realize higher values than availablein the market. In addition, there is a widespreadview that they often result in more efficientasset utilization and other pUblic benefits.

5. Given a chance to work, the marketplace has provedto be the best protector of shareholder interests.

* For _a thoughtful discussion of this issue, see Brudney,Equal Treatment of Shareholders in Corporate Distribu-tions and Reorganizations, 71 Cal. L. Rev. 1073 (1983).

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6. The role of government should be to prevent a con-flicted management from frustrating the operationof the marketplace. How far to go in service tothis goal is a hard question, worthy of wide debate.To get that debate started, here are some tentativeproposals:

(a) Management should be permitted tobuyout the shareholders only afteraffording all potential bidders areasonable opportunity to investigatethe company and make alternative bids.

(b) Management should be prohibited at anytime from granting any option or usingany other device to prevent a third-party bidder from competing fairlywith management in a buyout attempt.

(c) If management has a control block ofstock, and elects to buyout thepublic shareholders, it should bewilling either to match or top ahigher third-party bidder or sellits block to the higher bidder.

If these proposals seem provocative, they are purpose-fully so. We see with increasing frequency the spectacleof a confl icted management surrounding itself wi th proceduralshields to defend a deal widely believed to be substantivelyunfair to shareholders. Such behavior is threatening totarnish the image of our corporate communi ty -- to givecorporate fiduciaries a bad name. The rules that governwhat appears to some as little more than a charade shouldbe re-examined.

I