Merger arb funds step up to the plate

THE NEW WAVE of US mergers and acquisitions activity involves a cast of characters that have emerged bruised and battered from the market meltdown determined never to be shortchanged again: shareholders, profit-hungry hedge fund managers, and securities class-action lawyers.  After seemingly never-ending corporate scandals, the actions of politically driven public prosecutors, court decisions, and legislative reform, shareholder rights are now central to M&A deals. These rights, once seen as a loose code of honour rather than any type of serious rule, are now vigorously promoted and protected. 

In this world post Enron, Eliot Spitzer and Sarbanes-Oxley, the deal presently attracting most attention is the battle for MCI, the telecoms firm that emerged from WorldCom's collapse. As two bidders, Verizon and Qwest, jostle for victory, all those involved know all their actions will be subject to close scrutiny.

Boards accountable

Class-action lawyers are waiting to pounce on any decision that might be seen to contravene shareholder rights. In effect, these lawyers and the shareholders they might represent are as much deal-makers – or deal-breakers – as the investment bankers advising their clients.

"Shareholders are now extremely sophisticated," says James Rosenor, a partner in the mergers and acquisitions group at US law firm Pepper Hamilton. "Institutional investors, particularly pension fund managers, have stood up and taken notice of exactly what boards are doing. The aggressiveness with which shareholders are holding boards accountable has become far more acute." 

Under US common law, which defines the fiduciary duty of corporations to act in the best interests of their shareholders, courts apply a loosely defined "business judgment" rule in assessing the actions of a board of directors. That is, judges find it extremely difficult to step in and substitute their own decisions for the business judgment of a board as long as it acted with good faith and in the absence of fraud. 

However, once a corporation is effectively up for sale, what has come to be known as the Revlon Rule kicks in. Established in 1985 when Ronald Perelman and Ted Forstmann fought for control of cosmetics and consumer goods manufacturer Revlon, the rule in its strictest sense states that the board of directors of a corporation has a fiduciary duty to act in the best interest of investors when making decisions regarding a proposed merger and must simply accept the highest price on offer.  Although there is conflicting case law as to whether the interests of bondholders, who have a senior claim over assets in bankruptcy, should take precedence over shareholders, there is clear direction in the case of a proposed acquisition: the higher price must win.  In the case of an all-cash deal where buyer A offers $30 a share and buyer B offers $40 – assuming both are similarly creditworthy – a board has no choice but to pick the higher price. 

However, there is room for manoeuvre in making a qualitative assessment of the net present value of each competing offer, particularly as most offers consist of packages of cash and shares and involve uncertain closing times and transaction risks. 

Heart of the battle

Risk analysis is exactly where room for discretionary judgment, argument, and potential for shareholder litigation arises. It is at the heart of the current battle for MCI.

Verizon is the largest telecoms firm in the US, with extensive free cashflow, market capitalization of about $100 billion, and an investment-grade rating.  By contrast, Qwest is the US's fourth-largest telephone company, with market cap of about $7 billion and debt of about $17.3 billion, thus presenting much more risk. 

If the two firms offered a similar amount for MCI, the choice would be simple. A $6.8 billion offer comprising cash and shares from Verizon (the company's original offer for MCI) would appear superior to the same $6.8 billion offer from Qwest, which might or might not be able to complete the deal.  The Qwest offer involves transaction risk since the company might find it more difficult to come up with the cash part of the bid.  Further, there is liquidity risk in that MCI shareholders, who would be left holding some 40% of the combined entity, could not simply dump their new Qwest shares on the market.

It is not that simple. Richard Notebaert, Qwest's CEO, made an original bid of $8 billion, outstripping Verizon by $1.2 billion in notional terms.  As Euromoney went to press, MCI had agreed to accept an increased Verizon bid of $7.5 billion over Qwest's most recent $8.9 billion.  Notebaert then called a press conference and quipped: "The last time I checked with the Federal Reserve, $1.4 billion was a lot of money to leave behind on the table."

The issue for MCI's board is that it is living in a new era of corporate governance; it must act in a way that is not only within its fiduciary duties, but must also be seen by the market to be doing so. Its conundrum was made even more complex in early April when Mexican billionaire Carlos Slim Helu decided to cash in his investment in MCI.  Slim started accumulating the defaulted bonds of WorldCom for pennies on the dollar. After WorldCom's restructuring, emergence from bankruptcy, and name change,he found he held 13% of the new MCI, a profitable company with a clean balance sheet. 

A special deal

Verizon said it would purchase Slim's 13% stake in MCI for $25.72 a share in cash and throw into the deal an effectively free call option on any appreciation in MCI shares above $35 within one year. Analysts value the option at about $1.55 a share. It is a clear premium to the $23.10 in the cash-and-stock package that Verizon agreed to pay other MCI shareholders in the takeover deal announced in late March. Qwest's latest bid values MCI at $27.50 a share. 

Legal experts argue that it could be unprecedented for MCI directors to let the current proposed two-tiered merger deal with Verizon go forward. "I am not aware of any deal like this when after the deal is struck, a minority shareholder goes out and gets a better price. I do not see how this could stand up in a Delaware Court," says Samuel Thompson, a law professor and director of the Law Center for the Study of Mergers and Acquisitions at the University of California, Los Angeles.

And Legg Mason Capital Management chief executive Bill Miller, now the largest stakeholder in MCI, with roughly 13%, said in a letter to MCI chief executive Michael Capellas that MCI shareholders "would be outraged" if MCI's board were to fail to insist on equal terms for all MCI shareholders.

At what point the room for manoeuvre permitted under the business judgment rule extends to enforcing the stricter Revlon Rule of taking the highest price on the table is highly debatable. If the deal ultimately accepted is just a few percentage points below a higher deal that was rejected, qualitative arguments about transactional risk, probability of successful financing and liquidity would most likely justify the board's decision – or at least head off litigation.  If the accepted deal were perhaps 20% or more below the rejected deal, most merger-arb funds would probably take a view that the arguments would end up in court.

Politics of public opinion

"At a minimum, MCI's board has got to try to get for the other shareholders what Slim got," adds Thompson. "Litigation is likely if the MCI board doesn't get the price paid to Slim for its other shareholders.  If the board just sits on their hands, I do not see how this could stand up in court. MCI's board is run by a former deputy US attorney general [Nicholas Katzenbach]. The last thing in the world he wants is to be defending himself before a judge on allegations that he failed in his fiduciary duties."

Although there is ample room to debate legal technicalities over the qualitative valuations of competing deals, in the final analysis shareholders must be won over.  Corporate directors can no longer be content with simply taking legal advice in possibly plotting out an effective legal defence strategy. And legal arguments aside, the politics of public opinion, or more specifically shareholder opinion, has changed dramatically. 

Fred Lipman, a partner specializing in mergers & acquisitions at law firm Blank Rome, says: "My own view is that Verizon will raise its offer to the level given to Slim – and be forced very reluctantly by the MCI board to do so. There is now more of a political problem than a legal problem if the rest of the MCI shareholders get a lower price than Slim did."

Referring to the high concentration of MCI's free float held by merger-arb funds, which some analysts estimate to be as high as 40%, Lipman adds: "Many hedge funds did not exist five years ago. Today, there is huge pressure on these fund managers to produce quick short-term profits. These guys are not at all shy about promoting their interests in a very aggressive, strident manner. It is a significant change."

In terms of protecting their liability, MCI's board is clearly treading cautiously in analyzing every angle of the competing offers. "I am certain that MCI is establishing a complete record of their decision making and has very substantiated, documented, defensible reasons for their valuation," Lipman adds. 

Greater accountability

Regardless of whether Verizon or Qwest emerges as the winner in the battle for MCI, shareholders' rights and standards of corporate governance might be the ultimate victor. "The MCI board is now held to a far greater standard of accountability for their actions. After Enron, WorldCom and Tyco, where there was clearly a lack of corporate governance, major reforms have been implemented, such as Sarbanes-Oxley, that have very clearly put the onus about fiduciary responsibilities on the board of directors," says Rick Black, senior telecom analyst at New York based investment bank Blaylock & Partners. "MCI is such a widely talked about deal that you are now seeing the results of all these changes. Five years ago, there would not be as much emphasis on shareholder rights." 

Black, who indicated that neither he nor his firm owned shares in MCI, also feels that this deal has little in common with the shareholder value destroying merger mania transactions of the 1990s when companies run by deal-hungry CEOs took on large amounts of debt by bingeing on overpriced acquisitions. If Qwest is successful in the bid for MCI, Qwest's leverage on an ebitda basis should fall from 4.5 to 2.5 times.  "Qwest is pursuing this deal not for improving their fundamentals, but for reducing their leverage. If Qwest does complete this deal, its share price would be able to increase," Black says.

Perhaps the most significant development in this takeover battle is the nature of the debate. "Changes in the system, like Sarbanes-Oxley, have certainly served to better protect shareholder value," says UCLA's Thompson. "The debate over MCI is about the fulfilment of a director's fiduciary duties owed to all shareholders. These duties can and will be enforced in court."

If any future case does come to the legal arena, there will be no shortage of specialist lawyers looking for a piece of the action.

Class action

As a result of the highly entrepreneurial nature of the contingency fee payments set-up in the US legal system, shareholders of US corporations have automatic access to a brutally effective means of ensuring their rights when corporate boards fall short in their duties; the class-action lawsuit. Leading the plaintiff bar in the cut-throat multi-billion-dollar industry is the most hated or most respected Wall Street attorney – depending on which side you sit on. 

Bill Lerach is widely recognized as the most successful shareholder class-action lawyer in the US. He founded west coast firm Milberg Weiss 30 years ago. Since then, he has spearheaded the prosecution of hundreds of securities class and stockholder derivative actions. Now running his own firm, Lerach Coughlin Stoia Geller Rudman & Robbins, based in San Diego, California, Lerach estimates that he and his team have collected more than $25 billion in damages through class-action lawsuits. 

Many of the beneficiaries of the $25 billion jackpot never lifted a finger to litigate. In the US, an attorney, or anyone else for that matter, can seek out damages caused by a corporation against a broadly defined class. The attorney with the foresight, luck, and tenacity to be the first to court can claim class-action status and position himself for up to one-third of the damages won by the aggrieved class. 

For example, Lerach represented pension plan CalPERS, the largest US fund, with more than $167 billion in assets, in a class action against specialist firms on the New York Stock Exchange. Lerach alleged that "an unholy alliance between the exchange and the specialists has served not only to rob investors of potentially billions of dollars, but has also served as yet another demonstration of how unchecked greed continues to adversely affect the institutional investor community on Wall Street." 

In the end, five of the largest floor-trading specialist firms agreed to pay out about $240 million to members of the affected class – an enormous variety of investors whose shares were traded on NYSE. 

Blue-chip victims

Lerach's list of victims includes such big names as Enron, WorldCom, Marsh & McLennan, Aon, Dell Computer, eBay, Dynegy, AOL Time Warner, US West, Sprint, AT&T, Cisco Systems, Oracle, Honeywell, Pfizer and Warner-Lambert. And he has represented, directly or indirectly, the vast majority of state, local and private pension funds in the US. 

As a result of these types of lawsuits, corporations paid a record $5.4 billion to settle securities class actions in 2004 and will probably pay more in coming years as the plethora of investor fraud claims work their way through the legal system. 

Of the $5.4 billion paid to investors, $2.6 billion went toward a partial settlement of fraud claims at WorldCom, the predecessor to MCI.  (Again, this was a massive class action instigated by Lerach.) The WorldCom settlement was the second-largest securities class settlement, behind Cendant Corp, which paid $3.1 billion in 2000 to settle allegations of accounting fraud.

The number of claims settled in 2004, 118, was also a record, up from 96 in 2003.  The size of last year's settlements reflected the fall in share prices of defendant companies, which lawyers use in estimating the amount plaintiff shareholder suffered as a result of management failure. 

Class-action lawyers show no signs of sitting on their hands. Last year, 212 suits were filed on behalf of shareholders against corporate management, up from 181 in 2003. Many of those big losses are tied to claims of fraud at pharmaceutical firms that recalled key drugs.

Private investors have acted as lead plaintiffs in roughly 65% of all cases, with institutional investors constituting the remainder. Of all institutional-led actions, Lerach's present and former firms took the lion's share of business, with involvement in 51% of all cases that were settled. 

Hostile takeovers are nervous situations. As executives and advisers to MCI, Verizon and Qwest look nervously over their shoulders at Lerach and his peers, it might be enough to tip them off the edge.

[See related story- Euromoney March 2005; Telecoms fuel a new M&A boom]