The Value of Venue in Corporate Litigation: Evidence from Exclusive Forum Provisions

Today's guest post comes from Jared Wilson, a Ph.D. candidate working with me at Drexel University.  Jared concentrates in the area of corporate governance and had recently completed revision on research that examines corporate litigation.

The Value of Venue in Corporate Litigation: Evidence from Exclusive Forum Provisions

Past blog posts have highlighted the growing trend of merger-related shareholder litigation (Doing a (Large) Deal? Expect to Get Sued).  A recent study by Matthew Cain and Steven Davidoff entitled “Takeover Litigation in 2013” reports that while only 40% of large mergers (>$100 million transaction value) involved litigation in 2005, over 90% of deals were litigated in 2012.  Furthermore, the authors document that of the deals litigated in 2012, more than 70% incurred multiple lawsuits and over 50% involved lawsuits filed in multiple states.  For example, target shareholders may file lawsuits in both the state of incorporation and state of headquarters claiming that the board breached its fiduciary duty by agreeing to sell the firm for too low a price.

Many boards of directors have responded to this increased threat of shareholder lawsuits filed in multiple states by adopting exclusive forum provisions to corporate charters or bylaws.  These provisions require that shareholder lawsuits brought against the firm, executives and/or directors must be filed in a single state of the board’s choice.  On the on hand, opponents of these provisions argue that the board’s selection of a state such as Delaware as the exclusive forum insulates managers and directors from the threat and discipline of litigation.  On the other hand, firms suggest that exclusive forum provisions benefit shareholders by eliminating duplicative lawsuits, which saves the firm time and money. 

On June 25, 2013, the Delaware Chancery Court upheld the adoption of exclusive forum provisions confirming that these provisions are here to stay.  In a paper recently made available on SSRN, I find that the impact of exclusive forum provisions on shareholders depends on whether the firm is likely to receive shareholder litigation in future.  Firms that are likely to be takeover targets appear to benefit from these provisions, since targets are likely to be subject to multiple lawsuits in multiple states when a takeover is announced.  Firms that are not likely to receive shareholder litigation in the future, however, appear to incur increased costs to discipline managers and directors through litigation in a state that the board selects, such as Delaware. 

“The Value of Venue in Corporate Litigation:

Evidence from Exclusive Forum Provisions”

Jared I. Wilson

Abstract

In response to the increased threat of shareholder litigation filed in multiple states, firms have adopted exclusive forum provisions which limit lawsuits to a single venue of the board of director’s choice.  It is unclear whether these provisions impose increased costs on shareholders’ ability to discipline managers and directors or provide benefits to shareholders by eliminating duplicative lawsuits.  I use the Delaware Chancery Court’s announcement upholding the adoption of these provisions as a natural experiment to evaluate their wealth implications.  Overall, my findings suggest that exclusive forum provisions create value for shareholders by specifying a required venue for corporate litigation. 

Jared Wilson is a Ph.D. candidate in the finance department at Drexel University. Jared’s main research interests include corporate governance, boards of directors, mergers & acquisitions, and executive turnover.

In particular, Jared’s research focuses on the director and executive labor markets and the governance mechanisms which incentivize managers and the board to act in the best interests of shareholders.  Jared completed his undergraduate degrees at the University of Pittsburgh and currently resides in Philadelphia, PA.  His homepage can be found here.  

Foreign Currency Debt: Free Lunch or Expensive Banquet?

I previously discussed the need to cut thru the foreign exchange veil when evaluating foreign investments. This post focuses on the flip side of the problem; namely the risks involved when borrowing in a currency different from your home currency. This issue has become topical given the recent surprise Chinese Yuan devaluation relative to the U.S. dollar (USD).

Chinese firms were attracted to USD denominated debt for two reasons. First, nominal USD interest rates are lower than Yuan rates. For example, the current Chinese one year base rate is 4.85%-down from 5.6% in January; whereas the one year U.S. Treasury is 30BPs and the prime rate is 3.25%. The second factor is Chinese credit to certain borrowers (e.g. property developers) had tightened forcing these firms to seek alternatives.

Foreign currency borrowing mechanics are simple; borrow USD and then spot back into Yuan. The nominal USD interest expense is lower than Yuan denominated debt. Of course, this is incomplete as it ignores possible foreign exchange losses. Ignorance is bliss is fine provided the exchange rate of USD to Yuan stays unchanged. If the Yuan weakens relative to the dollar, then it takes more Yuan to service the same amount of USD debt. Essentially, you face giving up in the future the benefits of the lower USD rates (AKA-there is no free lunch). Whether the firm borrows USD or Yuan there is no value effect on a covered basis. This is the teaching of interest rate parity which Chinese firms are relearning.

Of course the Chinese firms could have avoided the Yuan devaluation risk by hedging (e.g. cross currency swap). The hedging cost would, however, offset the benefits of lower USD interest rates. Many Chinese firms believed they did not need to incur hedge costs because the Yuan would remain strong relative to the USD. This belief turned into a delusion when the inevitable black swan event occurred.

I experienced something similar when I was a banker. Swiss rates were low compared to the USD at that time. My client borrowed in Swiss and spotted into USD to fund his U.S. operations-all un-hedged. He received a bonus on his ability to keep borrowing costs low. He argued his ability to forecast exchange rates precluded hedging (which would have eliminated the illusory low interest cost scheme and his bonus). Well, you guessed it, the USD weakened, losses occurred, the CFO was fired, and the loan needed to be restructured.

Foreign currency debt can make sense is you have assets in the country from which you are sourcing the debt. You have a natural hedge because the foreign assets produce, hopefully, enough foreign cash flow to service the debt. Thus, you are somewhat insulated from foreign exchange movements. This is why firms acquiring companies in other countries tend to fund a portion of their foreign investments in the countries where the assets are located.

My recommendation is not to speculate in exchange rates with your firm’s balance sheet. If you think you can forecast exchange rates-then join a hedge fund or do so thru liquid exchange trade instruments after receiving your Board’s approval. Many Chinese firms are facing an extended period of indigestion following their un-hedged USD borrowing “free lunch” adventures.

J

Measuring the Crowdfunding Impact on Traditional Investment Banking, Including Mergers and Acquisitions

Today's guest post on Crowdfunding comes from Nate Nead, a Director at CrowdFund.co.

Measuring the Crowdfunding Impact on Traditional Investment Banking, 
Including Mergers and Acquisitions

The rise of crowdfunding has been greatly promulgated by sites like Kickstarter and Indiegogo. In what is being dubbed as the true “democratization of capital” companies with little to no financial resources can pitch an idea to receive small amounts of funding from large swaths of potential “backers.” This new form of non-dilutive financing has been working well for years now. Its sister, equity crowdfunding, is plodding along through regulatory hurdles with some success. This summer’s release of Reg A+ (an update of the long-standing Reg A regulation that expanded the offering amount from $5M to $50M) underscores the fact that regulators have not been completely closed to the idea that true crowdfunding for equity may eventually become a reality. As equity crowdfunding grows from adolescence to full maturity, casualties are sure to follow, including those in traditional finance and investment banking. Once efficient, this new form of capital formation is likely to impact everything from traditional capital raising methods to mergers and acquisitions.

Growth Capital & Alternative Finance

Alternative finance is more than just crowdfunding. The rise of many non-bank lenders over the last several years has proven an effective competitor to some of the largest banking institutions. As regulators and internal controllers have tightened the belt on lending standards for small businesses, others have swooped-in to help fill the void. In some cases, the alternatives have not played well as a good replacement for the more regulated traditional banks, but that doesn’t mean they’re not helping to fill the demand void in the market.

Just as non-bank debt financiers are currently providing a new source of competition for retail and merchant banking, it’s expected a similar phenomenon will follow investment banking with the rise of equity crowdfunding.

As equity crowdfunding becomes more efficient, the cost of capital requisition is likely to decrease over time. Unfortunately, many prognosticators aren’t expecting all the capital efficiency gains to be passed to entrepreneurs in the form of lower fees. While this may be the case in some instances, the greatest advance is likely to be 1) the speed with which capital can be garnered and 2) the confidence in the process. Currently, many “best efforts” offering promoted by investment bankers still go unfulfilled, despite best efforts. The lack of efficient scale can still leave many would-be-successful entrepreneurs empty handed, regardless of the quality of their team and business plan. The increase in the probability and confidence that a full subscription can and will occur further feeds the speed component of getting a deal consummated. While, in the end, the actual paper cost of capital may remain unchanged, the time and confidence factors should fuel the potential for more deals and better deals.

Company Sales & Mergers and Acquisitions

When it comes to crowdfunding, alternative finance and venture capital, the sexy, scalable growth companies get most of the press. This hogging of the limelight may get people excited, but the reality is there are more opportunities to tap existing and profitable companies than there are to seek after pie-in-the-sky growth. The sheer size difference between venture capital and private equity illustrates the point: private equity could be greatly upended by a shift in the process and equity crowdfunding could play a role.

Traditional private equity seeks to raise capital, perform a buyout (LBO or otherwise) and take the platform company on a path toward growth. This path could include organic synergies or a strategic buy-side M&A/roll-up scenario. In almost all cases, there is an extreme focus on eaking out waste and maximizing IRR for fund investors. But how could the crowd upend this deeply-entrenched segment of alternative finance. Here are a few potential ways:

●      Family-owned businesses may opt for next generation transition without the need for controlling outside capital or expensive and often harming Employee Stock Ownership Plans. An equity crowdfunding event could help in the sale of the majority of the shares while still keeping control in the original family.

●      Companies looking to maintain full control of both the board and the shares could vye to sell shares for “taking chips off the table” or for growth capital with an equity crowdfund campaign.

●      Equity crowdfunding may provide capital for the equity funds themselves, allowing them to further growth initiatives and differentiate on a platform company that has massive room for growth.

●      If a business owner wished to sell-out over say a five to ten year horizon, s/he could sell the company off in chunks (say $1M/year) for several years to various investors via a 506(c) offering.

Because a full ¼ of those currently in the workforce will be retiring in the next 15 years, many will be seeking solutions for selling-out prior to retirement. At some point, I would expect a typical sell-side mandate or even an ESOP could be replaced by some creatively-structured equity crowdfunding deal, perhaps even a well-crafted intrastate offering. The creative options for using equity crowdfunding abound and disruption is ultimately inevitable.

Some may claim technological advances in the realm of crowdfunding and other forms of alternative finance are having a deleterious impact on traditional channels for capital advisory. This “upending” may eventually be blamed for net job reduction and ultimately another example of Creative Destruction. As the maturation occurs, other positives are also certain to emerge, however. First, the efficiency of the process may help improve the overall view in what has recently been painted as an industry of money hungry criminals. Second, those working in the capital markets will require greater understanding and more sophistication as it relates to the available tools and options. This will be most important as investment bankers look to act as guides for investors and entrepreneurs along the path from growth to exit.

Nate Nead is a Director at CrowdFund.co. Nate’s roll involves traditional buy and sell-side mergers and acquisitions advisory, investment banking, capital raising and general capital advisory services. Nate specific focus is software and SaaS investment banking where he works with growing middle-market software companies looking for growth capital, buy-side acquisition assistance or sell-side advisory services. Nate resides in Seattle, Washington with his wife and two children.

M&A Activity and the Precision Cast Parts Deal: All M&A Is Local

Ralph’s previous post focused on some questionable M&A motives driving current M&A activity. My experience suggests M&A waves are driven by managerial risk appetite amplified by leverage. Risk appetite is a function of wealth. Managers feel wealthy when their stock price is high(er) reflecting robust earnings. This wealth based confidence encourages them to use leverage, especially when rates are low, to enhance their buying power i.e. do bigger and more expensive deals. Other factors include the pressure to grow and to match acquiring competitors (no one wants to look wimpy). These characteristics underlie the cyclical and mixed M&A record of most acquirers.

Just as in politics, all M&A is local i.e. deal specific. I previously listed a checklist of factors characteristic of questionable acquisitions. The rest of the post focuses upon using the checklist factors to evaluate Berkshire Hathaway’s (BH) announced Precision Cast Parts (PCP) acquisition.

The application is as follows:

1)     Size: bigger transactions entail more financial and integration risks. PCP, while large in an absolute sense, represents less than 10% of BH’s market value. The SVAR appears reasonable as well given the relatively modest premium paid (more on this later). Integration risk is low given BH’s conglomerate strategy of having PCP operate as an autonomous standalone entity. The enduring wisdom of conglomerates will be tested once the uniquely qualified Buffett is gone. Alternatively, I may have misclassified BH as a conglomerate. It could be a stealth PE firm with permanent capital and extremely long hold periods. PE firms operate their portfolio investments on a standalone basis and thereby have low integration risk.

2)     Consideration: using stock indicates a lack of confidence in the acquisition. Here, BH is offering a 100% cash deal-suggesting lots of confidence

3)     Financing: over leveraged (i.e. non investment grade) transactions limit the flexibility to realize on the target’s potential. BH is funding the deal 2/3rds with equity (excess cash) and the remainder with debt. It will operate under the BH investment grade umbrella as well. Thus, flexibility is high.

4)     Buyer: weak deals involve weak buyers buying out of desperation frequently to cover up operating problems. BH is a strong and experienced buyer.

5)     Deal Type: high risk transactions involve transformational and turnaround aspects. This is more of an opportunistic acquisition of a well performing market leader; albeit one operating under some performance problems in its energy sector. Time will tell if the sector recovers-that is the bet.

6)     Timing: acquisitions made later in the M&A cycle are highly competitive and prone to being overpriced. The current M&A cycle could be view as closer to late stage given its current record volume pace. Nonetheless, even in the later stage, it is still possible for disciplined buyers to avoid overpaying as is the case with PCP with a modest purchase premium.

7)     Price:  it appears BH got a relative bargain-subject to due diligence verification. Investors concerned about PCP’ slumping energy segment dumped the stock causing a 30% price drop from the LTM high since the beginning of the year. BH’s modest 20% premium (well below the 40% red zone) is actually 15% below the LTM high. This is rare as most deals are closed above the LTM high which serves as a pricing anchor. Furthermore, the price represents a modest 12X forward EBITDA and 18X forward earnings-both of which (EBITDA and earnings) are expected to be flat this year. BH pricing is similar to PE not strategic acquirers (perhaps, BH is a PE firm not conglomerate after all). BH is capitalizing on a discrepancy between public and private valuation. The question is why PCP would agree to sell at that price?

 Bottom line, BH remains a disciplined buyer able to make promising acquisitions even in a difficult market following a proven formula. As with most things Buffett does-it is easy to understand, but difficult to copy. Unfortunately, many acquirers are prone to the dubious M&A rationales outlined in Ralph’s post.

J

Merger Activity - A Record Year?

Tuesday's Wall Street Journal contains a very interesting article on this year's merger activity. (See Merger Activity is on Pace for Record, by Dana Mattioli and Dan Strumpf).  Citing Deal Logic as a source, the authors note that if the current pace of deals continue, it will outpace 2007 - the last record year.  Illustrative of this is Berkshire Hathaway's $32 billion deal to acquire Precision CastParts Corp.  the largest deal in Berkshire's history.

What interests me most about the article are the reasons cited for the large number of deals.  We've covered most all of these in these posts - and also urged caution.  Some of the main issues are noted below:

• Low interest rates - and the fear future rates will rise
• Executive confidence
• Fear of being left behind
• The desire to boost growth through acquisitions (as growth from other sources becomes limited)
• The "economy isn't in free-fall"
• Accumulated cash on acquirer balance sheets

I firmly believe these concepts are on the minds of today's executives and I don't doubt they are driving deal activity.  What concerns me is that with the possible exception of confidence none of the reasons are valid by themselves for doing deals.

Sure, low interest rates are better than high rates, but if a deal doesn't make strategic sense, low rates are not a sound motive for doing deals.  (See Any Deal is a Bad Deal at Some Price; Not Every Deal is a Good Deal at Some Price).  The same is true of fear of being left behind.  On the face of it, it implies a 'keeping up with the Jones' mentality. It could also imply an 'eat or be eaten' mentality.  While shifting landscapes are certainly catalysts for deals, it is important to understand the economics behind these shifts.  Again, deals that fit the strategic plan of the company are best and sometimes the best deals are those you don't attempt.  In some situations, selling the company is actually the best move for shareholders.

Joe has talked extensively about the attempt to boost growth through acquisitions.  If the benefits don't exceed the costs, the deal is bad, even if it produces a short term boost to earnings.  Unfortunately, it can be easy to get caught up in deal fever and overestimate benefits and understate the difficulty in integration.  (See A Man Hears What He Wants to Hear).

The economy not being in free fall is a good thing, but hardly enthusiastic support for doing deals.  Finally, accumulated cash is absolutely no justification for doing deals.   Each company must ask - can I earn a superior return on this cash for my shareholders.  If not,  it should  be returned to its owners - the shareholders.

So this brings us back to executive confidence.  Confidence can be driven by many desirable qualities - knowledge and experience come to mind.  Confidence can also be driven by emotion and influenced by every one of the other factors in the list.  Bottom line - only attempt deals that make strategic sense and that are justified based on a hard look at the costs and benefits.  Without this step, none of the other items matter.

All the best,

Ralph