Insider deal = Bad, Outsider deal = Okay?

This Forbes article sets forth an interesting analysis on some factors that might impact the pricing of a Microsoft-Yahoo deal. The basic premise is that since many shareholders of one company are [likely] shareholders of the other, these cross-holdings necessarily lead to an optimization analysis. If MSFT shares fall as a result of an increased deal price and YHOO shares rise, then the return to any shareholder is

((YHOOt2-YHOOt1)*YHOOshares) – ((MSFTt1-MSFTt2)*MSFTshares)

[NB: reformatted equation for clarity.] The next complicating issue is the expectation many of these crossholders will be more exposed to MSFT at least in part due to market cap-weighting in index funds and sector funds. The equation and the assumptions seem to indicate that the bid for Yahoo! is unlikely to rise very much.

If detailed shareholder records were available, then the companies, and the market, could analyze the numbers and make an educated guess about what the outcome was likely to be. However, the number of shares held in street name is huge, and brokers often have difficulty identifying individual holder in an expedient fashion. Couple that with mutual funds, pension funds, and endowments holding vast numbers of shares through multiple entities, and the problem now seems unsolvable but not completely unknowable:

When Hilal ran the numbers, he found that 18 of Yahoo!’s top 25 shareholders own more shares of Microsoft than they do of Yahoo!. This is a powerful block. They own 42% of Yahoo! shares. And, on average, Hilal found members of this group owned 4.4 shares of Microsoft for every 1 of Yahoo! “There clearly are some shareholders that are a bit conflicted,” Hilal says.

And there are a few wrinkles left to be explored:

First, we often worry about deals involving insiders because we are unsure whether they are paying a fair price when they are purchasing a company or whether they are exacting extra benefits for themselves. Here, the outsiders, the shareholders, are explicitly and rationally motivated by personal benefit and there is little to counterbalance the threat to non-cross holding shareholders.

Second, the respective boards of the two companies have independent fiduciary duties to their respective shareholders, individually and as a class. How might this play out? YHOO has an obligation to increase the returns of all its shareholders, not just those who are also MSFT holders. If the board believes the price is too low, they have an obligation to recommend against the deal, even if they allow shareholders to vote on the transaction. (As an aside, this is our preferred course of action for strategic transactions — allowing shareholders to vote their shares as they see fit, assuming the board has adequately investigated a proposed transaction and advised shareholders accordingly, is not shirking the board’s duty or allowing the tail to wag the dog. We think differently on say-on-pay, which we’ll try to address in a separate post.) The result is similar to a tender offer, where the board makes a recommendation and individual holders are free to choose to accept or reject.

In general, states do not impose similar fiduciary duties on shareholders. In fact, the idea that shareholders can be at cross-purposes in a transaction makes for good reading. (We’ve got to find a WSJ article, maybe six months old, that described how two hedge funds were fighting over a transaction because one was short the buyer and another long a second acquirer. The true equity hedges and empty voting scenarios were very well explained in the context of an actual deal.) [NB: this post by Larry Ribstein at Ideoblog references the Mylan-King imbroglio in the context of examining empty voting.]

California, it should be noted, is one state where majority and even controlling shareholders can have fiduciary duties imposed on them to the benefit of minority shareholders. While these cases typically revolve around oppression of minority shareholders in closely held small business situations, there is no inherent reason why they may not be expanded to include a “group” of cross-holders working “together” to force a lower bid than might otherwise be presented.

Third, should greater disclosure of private holdings be required? Is it possible that the circumstances that led to holding shares in street name are no longer extant? If one can buy 1000 shares of MSFT in a few minutes online, shouldn’t it be equally possible to track those transactions at the end of the day and disclose them to the companies, the exchanges, or the public? The brokers must have this information already since they know who to collect from and who to pay. Certainly it would make sense to track only closing positions, or even just changes as of the close to allow current holdings to remain undisclosed to eliminate any reporting burden. We do not have an opinion on this issue yet; it would require some substantial amount of further study since there are a number of competing interests. What would be most illuminating is figuring out how much of this information is already publicly available and how much is semi-public, meaning available to market participants who are able to employ that information in their trading without violating securities laws.

Finally, we must say that we are continually surprised at the lengths to which management and boards will go to make it harder for shareholders to sell their shares. Poison pills, retention agreements, and option vesting acceleration clauses are tools that serve primarily to keep existing management and boards in place or transfer benefits to non-shareholders rather than provide additional benefits to shareholders. By making an acquisition more expensive, does anyone actually think that a buyer won’t adjust the price to compensate? If shareholders have the right to vote their shares, and the SEC’s disclosure requirements are followed, what is the harm that these *fiduciaries* are trying to prevent? Shareholders can sell their shares today or tomorrow at any price they wish; why would boards suddenly intervene to restrict that right, particularly at a price that is likely to be far higher than the pre-deal price? In the MSFTYHOO deal, Microsoft has offered a large premium to Yahoo! shareholders. Yahoo! management seems to think that shareholders should wait several years for management’s plans to come to fruition to reap the premium. That’s fine, and we fully support their right, and indeed duty, to make cogent good-faith recommendations. But refusing to allow shareholders to make their own ownership decisions pushes past the boundaries of authority that boards and management should exercise.