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Journal ArticleDOI

White Knights and Black Knights – Does the Search for Competitive Bids always Benefit the Shareholders of “Target” Companies? –

19 Dec 2006-European Company and Financial Law Review (De Gruyter)-Vol. 3, Iss: 4, pp 408-425

AbstractAccording to the EC Directive on Takeover Bids, defensive measures should be authorised by the general meeting of the target company. The incumbent board can, nonetheless, search for a competing bid, a so-called “white knight”. The rationale underpinning this exception is that competing bids always benefit target’s shareholders. In this paper I will tackle this rationale, arguing that even competing bids could generate a pressure to tender on target’s shareholders and, therefore, in this case should not be considered as a benefit for them.

Topics: Commercial law (52%), Comparative law (51%)

Summary (3 min read)

Introduction

  • According to the EC Directive on Takeover Bids, defensive measures should be authorised by the general meeting of the target company.
  • The rationale underpinning this exception is that competing bids always benefit target’s shareholders.

1. The general issue

  • Any decision of target shareholders on the merit of an offer is affected by collective action problems 7, as it happens in every case when more persons should take individually a decision on a certain problem without having the ability to coordinate among themselves and the utility of each person depends on the choices made by the others.
  • The following arguments are based on the assumption that shareholders behave rationally in order to maximise their utility.
  • Preferences are transitive in this case: if some good “A” is preferred to a good “B”, and this latter good “B” is preferred by the same person to a good “C”, then should follow that also “A” is preferred to “C”.
  • Thus, after a takeover bid is launched, shareholders compare the price of the bid with the expected value of minority shares if the bid succeeds.
  • But a shareholder can not know what other fellow shareholders are going to decide on the merit of the offer, and coordination among them is too costly and almost impossible.

2. Free-riding

  • If the expected value of minority shares under the new controlling shareholders is considered by the majority of shareholders as higher than the value under the incumbent shareholders, then it is rational for shareholders to hold their shares, hoping that other shareholders will sell them.
  • The success of the bid is not impeded by the fact that a minority of shareholders, or even only one of them, did not sell their shares 8.
  • If every shareholder behaves in this way, however, none of them will tender, hoping that fellow shareholders will sell their shares.

3. Pressure to tender

  • If the expected value of minority shares after a successful bid is presumed to be lower than the price offered, shareholders are forced to sell, although under an ex post point of view this is not the best choice for them (so-called pressure to tender); in this case a value-decreasing takeover bid is going to succeed 10.
  • If the bid succeeds shareholders risk to lose the price of the offer, bearing only under-priced minority shares; hence, the decision to tender is 8 Goshen, “Voting in Corporate Law”, 2 Theoretical Inq. L. (2001) 815.
  • Shareholders cannot coordinate themselves and they do not know whether fellow shareholder will tender or not tender.

III. Seeking a white knight

  • The general meeting is competent on decisions which could indirectly influence the composition of share ownership21; the board can nevertheless seek a competing bid without the need to be authorised by shareholders.
  • The goal of this “white knight exception” seems clear.
  • An auction on target shares pursues shareholders’ interests; hence it is not necessary to attribute to the competence of the general meeting the decision to seek for a potential bidder and to transfer to him any useful information.

IV. Black knights

  • In the former section I have shown the argument supporting the “white knight exception”.
  • In the next section I will point out that some defensive takeover-bids could be coercive, or more coercive than the first hostile bid.
  • I will make firstly two examples which do not consider any specific set of rules.

1. The power of “two-tiered” defensive bids

  • The authors can begin depicting the following example, where a defensive “two-tiered” bid is launched against a first 100% all-cash hostile takeover-bid.
  • The listed company A has 10 outstanding shares.
  • The blended price of this competing takeover bid is therefore 9€, which is lower than the price offered by the first offeror B.
  • Target shareholders face a heavy pressure to tender.

2. “Two-tier” vs. “two-tier”

  • After this bid, the board of the target company seeks a third person, C, for launching a competing tender offer.
  • Shareholders will rationally choose to tender to the competing offer.
  • The reason is that the difference between the “front-end” price and the “back-end” price of the first offer is lower than the same difference in the second offer; hence the latter is more coercive than the former28.

1. A world with the mandatory bid rule

  • As the authors have seen in the second section, the EC Directive provides for a general mandatory bid rule, according to which if a person purchases the control of a company, she should then launch an offer for all the outstanding shares.
  • The payout of the competing game depends on the price which should be paid for the mandatory bid.
  • The hostile bid launched by B on A’s shares is followed by a competing partial bid; both bids are conditioned upon the fact that the majority of shareholders will tender.
  • Austrian law changed relating to this issue in order to comply with the Directive: see the new § 26 Übernahmegesetz, as changed by the law 75/2006.
  • The authors should not forget that the mandatory bid rule at the highest price paid for crossing the relevant threshold faces a significant drawback under the viewpoint of social welfare.

2. Facilitating auctions on target’s shares

  • Law can mitigate the pressure to tender caused by competing tender offers, allowing the first bidder to increase the price offered or to extend the offer to all outstanding shares.
  • If the law provides for these rules in order to place the hostile bidder and the competing bidder at the same footing, the former can increase the price offered and can win the battle.
  • Let us come back to the examples made before.
  • 36 Fleischer “Konkurrenzangebote und due diligence”, ZIP (2002) 653; Hopt, “Übernahmen, Geheimhaltung und Interessenkonflikte.
  • Probleme für Vorstände Aufsichtsräte und Banken” ZGR (2002) 358.

3. Drawbacks of the auctions

  • A regulation which allows the incumbent board to seek competing bids has a significant drawback in terms of social welfare and efficiency.
  • This outcome does not change even if the board has a duty to provide the hostile bidder with the same information given to the white knight, as this duty does not help the first bidder to gain information for discovering and assessing a potential target.
  • The authors can make following simplified example.
  • Assume that N is the cost suffered by the first bidder (B) for discovering the target A; the expected value of the target after the bid succeeds is V1.
  • In other words, this is a so-called “common value auction”, where all competing bidders attach the same value to the target; this is the case if takeover-bids are motivated by mismanagement of the incumbent board, not by synergy gains, which would be different for each bidder38.

VI. Conclusions

  • The purpose of the present work was to address the question whether seeking a competing bid should be allowed to the incumbent board without any limitation and without being approved by the general meeting.
  • If a competing bid is coercive depends also on the applicable law, which can mitigate or eliminate the “pressure to tender” through a mandatory bid rule or allowing the first bidder to increase the offered price.
  • In all other cases, Member States are free to hold their own conflict rules also for takeover law43, which usually refer to the law of the country where the company is listed, being the regulation of competing takeover-bids part of the market regulation, not of company law44.
  • The incumbent board would be able to seek for a coercive competing bid that would force shareholders to tender even if this is not in their interests under an ex post viewpoint.
  • Indeed, the rationale of the “white knight exception” is to allow the incumbent board to enhance shareholders’ wealth, putting their shares up for auction; seeking a coercive bid does not fit the ratio of the “white knight exception”, and the exception has no reason to be applied.

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White Knights and Black Knights
– Does the Search for Competitive Bids always Benefit
the Shareholders of “Target” Companies? –
by
Federico M. Mucciarelli*
According to the EC Directive on Takeover Bids, defensive measures should
be authorised by the general meeting of the target company. The incumbent
board can, nonetheless, search for a competing bid, a so-called “white knight”.
The rationale underpinning this exception is that competing bids always
benefit target’s shareholders. In this paper I will tackle this rationale, arguing
that even competing bids could generate a pressure to tender on target’s
shareholders and, therefore, in this case should not be considered as a benefit
for them.
Table of Contents ECFR 2006, 408–425
I. Defending the besieged castle . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
II. The shareholder in his labyrinth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
1. The general issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 410
2. Free-riding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
3. Pressure to tender . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 411
III. Seeking a white knight . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
IV. Black knights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
1. The power of defensive “two-tiered” bids . . . . . . . . . . . . . . . . . . . . . . . 417
2. “Two-tier” vs. “two-tier” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
V. Law matters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 418
1. A world with the mandatory bid rule . . . . . . . . . . . . . . . . . . . . . . . . . 418
2. Facilitating auctions on target’s shares . . . . . . . . . . . . . . . . . . . . . . . . . 420
3. Drawbacks of the auctions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422
VI. Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423
*
Assistant professor of business law, Bologna University, Faculty of Economics – federico.
mucciarelli@unibo.it
A previous version of this paper has been presented at the European Masters of Law and
Economics Program Conference, University of Hamburg School of Law, February 10
th
2006. For some helpful comments I would like to thank Luca Enriques, Reiner Kulms,
Paolo Santella and Alexander Schall. All errors are mine.

I. Defending the besieged castle
According to the EC Directive, which was approved at the end of 2003 after
a lengthy debate
1
, the board of the “target” company should remain passive
in front of a takeover-bid
2
. More precisely, Article 9 of the Directive, which
follows the model of the City Code on takeovers and mergers of the London
Stock Exchange
3
and of many other European legal systems, provides that
the board of the offeree company shall obtain the prior authorisation of
the general meeting of shareholders given for this purpose before taking any
action, other than seeking alternative bids, which may result in the frustration
of the bid
4
.
Therefore, defensive measures are not forbidden, on the contrary they are
allowed if they are expressly authorised by the shareholders. Put in another
way, the general meeting of a listed company is competent to authorise meas-
ures which can obstacle the choice of shareholders on whether to tender or
not, this means on decisions which could indirectly influence the ownership
of the company.
The board of the target company can nevertheless seek a competing bid
without being authorised by the general meeting
5
even if this can frustrate the
first takeover-bid. This rule meets a wide acceptance, being applied by most
Member States; similarly, Delaware case law, which does not give to the gen-
eral meeting the competence on defensive measures, requires the target’s
board to promote an auction when the sale or the break-up of the company
becomes unavoidable
6
.
ECFR 4/2006 409White Knights and Black Knights
1 Directive 2004/25/EC of the European Parliament and of the Council of 21
st
April 2004
on takeover bids. OJEU, 30. 4.2004, L 142/12, cf. Edwards, “The Directive on Takeover
Bids – not worth the paper it’s written on?”, ECFR (2004) 416.
2 This “passivity” or “neutrality” rule was nonetheless weakened by an “opt-out” option
given to the Member States by the Directive itself: Article 12.
3 City Code on Takeover and Mergers, General principle n. 7: “At no time, after a bona
fide offer has been communicated to the board of the offeree company, or after the board
of the offeree company has reason to believe that a bona fide offer might be imminent,
may any action be taken by the board of the offeree company in relation to the affairs of
the company, without the approval of the shareholders in general meeting, which could
effectively result in any bona fide offer being frustrated or in the shareholders of the
offeree company being denied the opportunity to decide on its merits.”
4 Article 9 (2).
5 In the following text I will call this rule for simplicity “white knight exception”.
6 Revlon v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173 (Del. Super 1985), 182;
City Capital v. Interco, 551 A.2d, 787 (Del. Ch. 1
st
November 1988) ; Paramount com-
munications inc. v. Time, 571 A.2d 1140 (Del., 24
th
July 1989).

If we admit that during a takeover contest, the board of the target company
should pursue only, or at least mainly, shareholder’s interests, the “white
knight exception” should be praised, because in this way the board puts the
shares up for auction, enhancing shareholders wealth.
I will nonetheless argue that this exception could be unfair for shareholders’
interests. After the launch of a takeover bid, shareholders face collective
action problems, which compel them to tender even though this is not in
their collective best interest (so-called pressure to tender). Competing bids
could be coercive as well, forcing shareholders to tender even if the bid
launched at first is more convenient; hence, seeking a coercive competing
takeover-bid does not fit the rationale underpinning the “white knight ex-
ception”.
The work will proceed as follows. In the second section I will briefly summa-
rise the issue of collective action problems related to takeover bids. In the
third section I will describe the arguments supporting the case for seeking a
competitive bid by the incumbent board without being authorised by the
general meeting. In the forth section I will discuss some examples of coercive
competing takeover bids; I will argue that if the competitive bid raises collec-
tive action problems this is neither efficient nor coherent with the ratio legis
of the Directive, admitting the incumbent board to seek a white knight
without being authorised by the general meeting.
II. The shareholder in his labyrinth
1. The general issue
Any decision of target shareholders on the merit of an offer is affected by
collective action problems
7
, as it happens in every case when more persons
should take individually a decision on a certain problem without having
the ability to coordinate among themselves and the utility of each person
depends on the choices made by the others. In case of takeover-bids share-
holders should choose whether to sell their shares to the offeror or to hold
410 ECFR 4/2006Federico M. Mucciarelli
7 The following arguments are based on the assumption that shareholders behave ration-
ally in order to maximise their utility. I assume that a person acts rationally if she acts in
the best way in order to reach a specific goal and her preferences are transitive.
Preferences are transitive in this case: if some good “A” is preferred to a good “B”,
and this latter good “B” is preferred by the same person to a good “C”, then should
follow that also “A” is preferred to “C”. (Putting it in a formal way, we write it as follow:
A B c B C A C.) See Ulen, “Rational choice theory in law and economics”, in
Encyclopaedia of Law and Economics, http://encyclo.find.law.com, 790.

them. Thus, after a takeover bid is launched, shareholders compare the price
of the bid with the expected value of minority shares if the bid succeeds. But
a shareholder can not know what other fellow shareholders are going to
decide on the merit of the offer, and coordination among them is too costly
and almost impossible. We can distinguish two cases indeed.
2. Free-riding
If the expected value of minority shares under the new controlling share-
holders is considered by the majority of shareholders as higher than the value
under the incumbent shareholders, then it is rational for shareholders to hold
their shares, hoping that other shareholders will sell them.
The success of the bid is not impeded by the fact that a minority of share-
holders, or even only one of them, did not sell their shares
8
. If every share-
holder behaves in this way, however, none of them will tender, hoping that
fellow shareholders will sell their shares. If this happens, a value-increasing
takeover-bid is going to fail
9
.
3. Pressure to tender
If the expected value of minority shares after a successful bid is presumed to
be lower than the price offered, shareholders are forced to sell, although
under an ex post point of view this is not the best choice for them (so-called
pressure to tender); in this case a value-decreasing takeover bid is going to
succeed
10
.
Indeed, shareholders do not know whether other shareholders will tender
their shares or not and they cannot coordinate their behaviour among each
other. If the bid succeeds shareholders risk to lose the price of the offer,
bearing only under-priced minority shares; hence, the decision to tender is
ECFR 4/2006 411White Knights and Black Knights
8 Goshen, “Voting (insincerely) in Corporate Law”, 2 Theoretical Inq. L. (2001) 815.
9Grossman – Hart, “Takeover bids, the free-rider problem and the theory of the corpo-
ration”, 11 Bell Journal of Economics (1980) 42.
10 Bebchuk, “Toward undistorted choice and equal treatment in corporate takeovers”,
98 Harv. L. Rev. (1985) 1693 and “The pressure to tender: an analysis and proposed
remedy”, 12 Delaware Journal Corp. Law (1987) 926. On a side note, it is woth
mentioning that the German companies’ group law provisions, in particluar on domin-
ion agreements, that have often been criticised as overcomplicated, mitigate the value
decreasing problem and compensate the loss of the minority shareholder, §§ 304, 305
Aktiengesetz [AktG]. On group law, cf. further the article by Girgado in this issue.

dominant. Of course, the choice made by shareholders depends on how the
bid is likely to be successful: the more shareholders hold for likely that the
bid succeeds, the more they are coerced to sell their shares.
a) Partial and “two-tiered” bids
Law and economics theory suggests that partial and “two-tier” offers place
on shareholders the biggest pressure to tender.
Partial bids. After the bid has succeeded, tendering shareholders hold only
an average value among the price offered and the value of the minority
shares under the new management
11
. Therefore, shareholders would be
better-off if they could coordinate themselves not selling their shares. Since
any sort of coordination is too expensive, the optimal strategy for share-
holders, under an ex ante point of view, is to tender
12
.
“Two-tiered” bids. The offeror launches a first partial “front-end” offer at
a high price, promising to launch a second “back-end” bid for the rest
of the shares at a lower price. For shareholders this situation is similar to
the one faced when a partial offer is launched, the “back-end” price being
comparable with the expected value of the minority share if the partial
offer succeeds
13
. Shareholders will rationally tender, fearing to gain only
the lower “back-end” price.
The difference between the “front-end” and the “back-end” price is of great
relevance on shareholder’s choices: the greater this difference is, the greater is
the potential loss for non-tendering shareholders and the more shareholders
are forced to tender
14
.
412 ECFR 4/2006Federico M. Mucciarelli
11 The value depends on the amount of shares which the offeror is keen to purchase
through the bid, and the number of tendered shares.
12 If shareholders sell, they lose the difference between the offered price and the lower
value of minority share they will hold after the bid succeeds.
13 Brudney – Chirelstein, “Fair shares in corporate mergers and takeovers”, 88 Harvard
Law Journ. (1974) 297; Subramanian, “A new takeover defense mechanism: using an
equal treatment agreement as an alternative to the poison pill”, 23 Del. Journ. Corp.
Law. (1998) 402; Mülbert – Birke, “In defense of passivity – on the proper role of a
target’s management in response to a hostile tender offer”, 1 EBOR (2000) 468.
See also Delaware Supreme Court Paramount (n. 6) at HN7 “In a two-tier, highly
coercive tender offer, the threat is obvious: shareholders may be compelled to tender to
avoid being treated adversely in the second stage of the transaction”.
14 Bradley – Kim, “The evolution of the tender offer as a takeover device: an analysis of
ownership structure, the free rider problem, and the prisoner’s dilemma”, unpublished,
(1984) 295; Oesterle, “The negotiation model of tender offer defences and the Delaware
Supreme Court”, 72 Cornell L. Rev. (1986), 127.

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