ABA Section of Business Law

Shareholders vs.the world

'Revlon Duties' and state constituency statutes

Turner is an associate at Schwabe Williamson & Wyatt P.C. in Portland, Ore.

The buzz phrase, "Merger Mania," headlines business publications on a daily basis. The frenzied wave of hostile takeovers of the 1980s has been largely supplanted by the strategic mergers of today. By some accounts, hostile takeovers account for only one in 200 deals.

A merger now is frequently an integral feature of a long-term strategy designed by corporate directors in the "best interests of the corporation." Companies routinely engage in friendly mergers to generate economic efficiencies, find qualified successors for retiring officers, get into new capital markets, combat competition and complete exit strategies for initial investors. That is especially true for smaller and emerging growth companies. Although most strategic mergers do not generate the tabloid-quality stories of their rancorous counterparts, corporate directors must carefully structure and assess friendly mergers. The risks of bad decision making are simply too great to do otherwise.

Traditionally, it was said that corporate directors owed fiduciary duties exclusively to the company. That duty was generally equated with an obligation to act in the best interests of the shareholders by increasing their wealth. Corporate governance, however, has gradually evolved to include consideration of parties other than shareholders and their bank accounts. What is in the best interests of a corporation is commonly judged by what advances the welfare of shareholders as well as employees, customers, creditors and communities.

Under Delaware law, for everyday decisions, a board has no duty to maximize short-term value. So long as there is a rationally related benefit for shareholders, a board may consider the interests of nonshareholder constituencies. However, the duties of corporate directors change considerably in three basic situations. When a board is on the verge of selling, breaking up or transferring control of the corporation, directors may not consider the interests of nonshareholders and have a narrow duty to maximize shareholder value. Paramount Communications Inc. v. QVC Network Inc., 637 A.2d 34 (Del. 1994).

The duties imposed on directors in these situations are popularly (and unpopularly) known as the "Revlon Duties" named for the infamous case, Revlon Inc. v. MacAndrews & Forbes Holdings, 506 A.2d 173 (Del. 1986). Once Revlon Duties are triggered, consideration of nonshareholder interests potentially constitutes a breach of a board's fiduciary duties. This is the case for both hostile takeovers and strategic, friendly mergers.

A change of control represents the last chance for shareholders to obtain a control premium for their shares. Revlon Duties greatly diminish the risk that directors, whose jobs are on the line, will engage in self-interested transactions at the expense of shareholders. Directors cannot simply approve a friendly merger based on their business judgment that a proposal delivers more value in the long term. A board that initiates a merger that it believes will provide the greatest long-term value to shareholders may trigger Revlon Duties.

The "bidding" and "breakup" triggers are relatively easy to define. If a company actively engages in a bidding process to sell the company or abandons a long-term plan in favor of quick, highly profitable breakup, the imposition of Revlon Duties is easy to justify. Regrettably, what constitutes a change in control has not been settled. What percentage of shares -- 51 percent or less -- constitutes a change in control? A few cases suggest that Revlon Duties are activated on an attempted transfer of effective control, which could be considerably shy of a simple majority. Mills Acquisition Co. v. Macmillan Inc., 559 A.2d 1261, 1285 (Del. 1988).

Revlon Duties do not require getting top dollar through an auction of the company to the highest bidder. A board need only act reasonably to seek the transaction offering the best value reasonably available to the shareholders. Best value may be determined by using various methods other than an auction, including a canvass of the market or the gathering of detailed, reliable evidence to support the proposed price. So long as the approach is conducted even-handedly and without discrimination against any bidders, directors normally discharge their Revlon Duties.

The duty to maximize shareholder wealth by any permissible method is often at odds with plans to merge a company for its continued health or survival. All is not lost for companies with long-range, ambitious plans. State legislation may temper strict Revlon Duties and provide adequate protection for directors of companies engaged in mergers that do not bring short-term value to shareholders. The role of such statutes is especially important in light of the QVC decision, which prohibits directors from simply approving a strategic merger based on their business judgment that the transaction provides more value in the long term.

The takeover hysteria of the 1980s triggered a wake-up call to many states wishing to protect local corporations. The prevalence of junk-bond financing often hamstrung acquiring companies. New owners were forced to cut costs and maximize profits immediately. Many companies were acquired simply for their "bust-up" value and post-acquisition fire sales of assets were commonplace. In response, more than half of the states adopted "nonshareholder constituency" statutes (or simply "constituency" statutes). These statutes permit (or even require) directors to consider the interests of parties other than shareholders when evaluating merger or other consolidation options.

The underlying theme of these statutes is that a director may determine what is in the "best interests of the corporation" apart from what directly and immediately benefits the shareholders. Some statutes are limited to decisions affecting corporation control, but most extend the permissive consideration to any corporate action in calm times as well. Nonshareholder constituencies routinely include employees, customers, creditors, suppliers and communities. In some cases, directors may consider other pertinent factors, such as national and state economies, long-term and short-term effects of a transaction as well as the benefits of remaining independent.

Notably, most statutes do not specify the weight that should be accorded to a particular factor or constituency. The U.S. District Court for the Eastern District of Pennsylvania held in a preliminary injunction hearing that a board did not breach its fiduciary duties to shareholders by rebuffing a rival bid in favor of a less lucrative offer that ostensibly provided better protection for employees. Norfollk Southern Corp. v. Conrail Inc., C.A. No. 96-CV-7167 (E.D. Pa. Nov. 19, 1996). Under the Pennsylvania constituency statute, the court explained that directors are not required to treat the financial welfare of shareholders as the paramount concern. The absence (or oversight) of a shareholder-primacy factor in constituency statutes represents a major, controversial leap away from traditional corporate governance law.

Conspicuously absent from the list of states adopting constituency statutes is Delaware, home of the shareholder-friendly Revlon Duties and state of incorporation of more than 40 percent of the companies listed on the New York Stock Exchange and more than half of Fortune 500 companies. Most states, including those with constituency statutes, look to Delaware law when interpreting local corporate law. Normally, there is no conflict between Delaware takeover law and state constituency statutes. Absent a trigger of Revlon Duties, both permit consideration of nonshareholder interests in making most corporate decisions.

Many constituency statutes go further than Delaware law. Typically, constituency statutes do not require any nexus between nonshareholder consideration and a rationally related benefit for shareholders. In addition, under constituency statutes, there is no magical time when a board must stop thinking about nonshareholders and think only of shareholders. Under constituency statutes, directors may consider nonshareholders at every step of the process.

The vexing question is what are the duties of a board engaged in a change-of-control merger in a state with a constituency statute? Are directors bound by a goal of profit maximization or may they structure mergers to protect employees, customers, creditors and the community to the financial detriment of shareholders? These are very real concerns for high-growth and emerging companies who engage in strategic mergers to replace retiring officers, enter new capital markets and combine strengths to maintain competitiveness. Generating quick profits is often incompatible with their corporate mission. Strategic mergers are unlike hostile takeovers in another important way. Which company will be the surviving entity may be a matter of technology ownership or geographical location rather than strong cash flow or a healthy balance sheet.

Poor initial decision making may lead a corporation down the primrose path. Revlon Duties require that once the decision to transfer control of the company has been made, a board must act solely in the shareholders' best interest by seeking to maximize their wealth. The board may not observe the interests of nonshareholders if such consideration will adversely affect shareholders' wallets.

Corporations may avoid Revlon Duties by structuring transactions in ways that do not constitute a change in controlling ownership of the post-merger entity. One possible solution is to engage in a stock-for-stock merger with a company of equivalent size in which neither company receives a premium. According to the QVC decision, Revlon Duties are inapplicable when control "remains in a large, fluid, changeable and changing market." However, boards should be cautious not to trigger Revlon Duties inadvertently.

QVC left open the question of how many shares must be amassed by a single person or identifiable group before control has shifted. The amount could be significantly less than 51 percent. In addition, strategic mergers protected by agreements containing bust-up fees, stock lock-ups or asset lock-ups may also trigger Revlon Duties.

The Delaware Supreme Court has intimated that post-merger super-majority rights or other minority shareholder protections may preclude imposition of Revlon Duties. In Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334 (Del. 1987) (cited with approval in QVC) the court found that a standstill agreement that limited a shareholder to 49.9 percent of shares and 40 percent board representation prevented application of Revlon Duties in a takeover.

A merger of equals or minority-shareholder protections may be impractical or incompatible with the purposes of a particular strategic combination. However, for target companies housed in states with constituency statutes, corporate boards may be able to avoid Revlon Duties by engaging in mergers that are the product of long-term strategy. Constituency statutes upset Revlon Duties by allowing directors to define the best interests of the corporation according to the interests of employees, customers, creditors and communities at the expense of shareholder wealth.

Because corporate decisions must be supported by standards of rational business judgment, directors should take certain precautions when negotiating and structuring strategic mergers under constituency statutes. Even without the imposition of Revlon Duties, directors maintain the burden of showing that they were adequately informed and acted reasonably. Directors should document and implement company strategies well in advance of courting potential merger partners.

The board should identify specific constituencies and the nonshareholder factors involved in a strategic merger. To the extent that quantification is possible with respect to factors other than price, directors should prepare appropriate documentation for review. Directors should not stubbornly adhere to an initial merger proposal. Other suitors may be more appropriate for fulfilling a long-term strategy.

Because courts have not addressed the interplay between Revlon Duties and constituency statutes, as a practical matter, directors should not overlook shareholders. Shareholders are the only corporate constituency that can enforce a breach of fiduciary duty on behalf of the corporation. Nevertheless, under constituency statutes, directors should feel free to consider a broad array of factors without focusing solely on the short-term gains of a select few.