Delaware Judge Driven To Possibly Obscene Energy Industry Euphemism By Kinder-El Paso Merger

Delaware Chancellor Leo Strine has a bright future in blogging if chancelling doesn't work out for him. Here's how he describes Kinder Morgan's negotiations to buy El Paso, specifically KMI CEO Rich Kinder's price retrade with EP CEO Doug Foshee: Kinder said “oops, we made a mistake. We relied on a bullish set of analyst projections in order to make our bid. Our bad. Although we were tough enough to threaten going hostile, we just can’t stand by our bid.” Instead of telling Kinder where to put his drilling equipment, Foshee backed down. I umm ... I'm pretty sure that that quote from Kinder is approximate. Anyway, this is from Strine's opinion refusing to block the KMI-EP merger from proceeding even though he is pretty pissed about some of the apparent conflicts of interest in the deal, including that Goldman Sachs owns almost 20% of KMI while also advising EP, that the lead GS banker owned some KMI stock that he didn't disclose, and that Foshee negotiated the merger single-handed while also maybe thinking about possibly LBOing EP's E&P business for his own self. Lucrative though my current pseudoprofession is, I suspect that if Strine ever leaves the chancelling racket he'd probably prefer to try his hand at merging and/or acquiring. Certainly he is fond of dispensing tactical advice:
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Delaware Chancellor Leo Strine has a bright future in blogging if chancelling doesn't work out for him. Here's how he describes Kinder Morgan's negotiations to buy El Paso, specifically KMI CEO Rich Kinder's price retrade with EP CEO Doug Foshee:

Kinder said “oops, we made a mistake. We relied on a bullish set of analyst projections in order to make our bid. Our bad. Although we were tough enough to threaten going hostile, we just can’t stand by our bid.”

Instead of telling Kinder where to put his drilling equipment, Foshee backed down.

I umm ... I'm pretty sure that that quote from Kinder is approximate.

Anyway, this is from Strine's opinion refusing to block the KMI-EP merger from proceeding even though he is pretty pissed about some of the apparent conflicts of interest in the deal, including that Goldman Sachs owns almost 20% of KMI while also advising EP, that the lead GS banker owned some KMI stock that he didn't disclose, and that Foshee negotiated the merger single-handed while also maybe thinking about possibly LBOing EP's E&P business for his own self.

Lucrative though my current pseudoprofession is, I suspect that if Strine ever leaves the chancelling racket he'd probably prefer to try his hand at merging and/or acquiring. Certainly he is fond of dispensing tactical advice:

On September 9, 2011, Kinder Morgan threatened to go public with its interest in buying El Paso. Rather than seeing this as a chance to force Kinder Morgan into an expensive public struggle, the Board entered into negotiations with Kinder Morgan. ... Allowing Kinder to play the tough hostile bidder and then back off the $27.55 per share price can certainly be seen by a rational mind as oddly timid, especially because once El Paso stockholders realized that Kinder Morgan - a supposedly mature market player making an unsolicited bid - had agreed to pay that price, they would be reluctant to accept less.

And he is an ace at valuation*:

Rather than use a perpetual growth model to calculate the pipeline business's terminal value, Morgan Stanley used a mid-point exit EV/EBITDA multiple of 10x, which implied a perpetual growth rather of only 0.7% [?? - ed.]. That is, Morgan Stanley calculated that the pipeline business would grow only 0.7% from 2016 into perpetuity - a rate less than half of the estimated rate of inflation (2%) - an implication which is inconsistent with Foshee's testimony that the pipeline business had strong growth prospects ...

I am somewhat constrained in writing about this because I do know (and like, and respect) a lot of the people involved from my former life. When Strine says that "Moreover, [El Paso] executives wanted to reward Goldman for its 'eight [and a half] years of strategic advisory work for El Paso,'" let's just say I know whereof he speaks.**

So I'll mostly send you to two excellent posts from Steven Davidoff at the Times and Ronald Barusch at the Journal for a breakdown of what this means for the Future Of M&A. You can perhaps go beyond them in places; in particular, Strine's scorn for Kinder's retrading suggests that it might be harder for buyers to get away with retrading in the future, since he more or less says "EP should have just announced that KMI had bid $27.55 per share and then told its shareholders that if they're offered a penny less they should just shake their heads and gesture rudely to their drilling equipment." And he then basically measures the potential damages that EP might have to pay to shareholders as the difference between that $27.55 initial bid and the $26.87 final value that EP obtained - meaning that every penny saved by KMI retrading is part of the damages that directors and bankers are potentially liable for. Given that, what board in the future will be willing to accept a retrade on price? Now go think your thoughts about what that does to ex ante incentives to bid etc.

But the main message of this, plus the Barclays stapled financing case from a while back, is probably: it's asymptotically approaching impossible to manage and disclose around investment bank conflicts in M&A. Goldman's principal conflict here would seem, to a normal person (no, not really, to a Goldman alum), to have been managed in a textbook fashion: the banking team was walled off from the private equity arm that owned a Kinder Morgan stake the GS directors at Kinder recused themselves from merger discussions, everything was disclosed, and an independent advisor was hired to advise on the merger and give a fairness opinion.*** You could certainly come away from this opinion with the impression that a bank can't really advise one party on a merger while owning a big stake in, or having any serious ties to, the other party.

One sort of subversive theory (not mine) suggests that concerning yourself with conflicts like this is pointless, since M&A prices are zero-sum, everyone's basically an index investor, and pushing KMI to overpay serves no social good. On this theory, I guess, an advisor who has a stake in everybody and just wants to broker a mutually acceptable deal, rather than push for the last penny for one side or another, is probably fine - sort of like you see in the capital markets businesses of investment banks. But in M&A, Revlon duties blah blah blah, so let's ignore that theory even though - kind of, right? Reading Strine's opinion, I found myself utterly unable to shed tears for the plaintiffs and their lost 68 cents.

Anyway, though, leaving that aside, you can see Strine's anti-conflict agenda as a second front in the Volcker Rule, anti-too-big-to-fail wars. Whereas lending and investing and financing have long been ways to get M&A business, they're increasingly becoming ways to lose that business too. Too close a relationship with both sides of a deal could prevent you from working for either side. And while Strine scoffs at GS's $20mm merger fee from EP in comparison to its $4bn investment in KMI - a risk-free $20 million is, y'know, better than not having $20 million. At the margin this, like Volcker, makes fee-based, non-capital/investment-intensive businesses more attractive to banks.

You could guess that this will help the M&A boutiques that are sprouting up everywhere these days, whose balance sheets, at least, won't be causing conflicts. That said the news isn't all good for them. One long-standing function of smaller boutiques is to provide second fairness opinions in exactly these situations where a big bank with a good relationship gets the M&A relationship but is too conflicted to be the sole advisor. That is increasingly seeming like not an option. Kick those big banks out of the process entirely and who will be left to recommend bringing in a harmless boutique to bless the deal?

Delaware Court Declines to Block Kinder Morgan’s El Paso Corp. Deal [DealBook]
Deal Professor: The Losers in the El Paso Corp. Opinion [DealBook]
Dealpolitik: Plenty of Warnings As El Paso Deal Squeaks By Judge [Deal Journal]
In re El Paso Corporation Shareholder Litigation

* Though, solid footnote to a different bit of armchair valuation in Strine's opinion: "These are rough approximations and I have applied my own training as a humanities major to arrive at the results. Rely upon them with this caution in mind." As a classics major, I approve.

** But: I at no point was involved in any discussions of or related to the merger or spin-off discussed in the opinion.

*** Strine makes much of the fact that Morgan Stanley only got paid if the merger happened. Welcome to all mergers! That, by the way, is actually a real conflict. But it's hallowed by tradition so whatever.

Related

Shareholders Seem Unfazed By Evildoing In Kinder Morgan - El Paso Deal

The shareholder meeting to approve the sale of a public company is always a special occasion, both intense and bittersweet. Shareholders who have loyally stood by the target through its ups and downs over the years want to take some time to say goodbye, but they also know that the debate will be lively and spontaneous and that anything can happen: one passionate orator can sway the crowd for or against the deal. With so much riding on the meeting, space is at a premium; smart shareholders book their flights early, and I would not be surprised if El Paso shareholders camped out outside the Hyatt Regency Houston*, 1200 Louisiana Street, Houston, Texas 77002, far in advance of the shareholder meeting scheduled for 9 a.m. tomorrow. And they will be distraught to learn that the meeting was just moved to Friday. No, just kidding, nobody goes to these** and they're pointless formalities. You can tell because: El Paso today said it was adjourning the shareholder vote on its proposed sale to Kinder Morgan until Friday, instead of Tuesday, following a judge’s criticism of the company’s sale negotiations. But at the same time, El Paso said as of Friday it has received votes from 70% of the outstanding shares, with 98.5% of those shares voting in favor of the deal. That tally is not official and could change. Shareholders that had already cast their ballots now have until Friday’s deadline to change their votes. A simple majority is all that is needed for the vote to be approved. Votes could change until Friday. ARE YOU DYING OF SUSPENSE? I guess everyone already knows this but here we are with an internet so it bears repeating: Shareholder litigation challenging merger and acquisition (M&A) deals has increased substantially in recent years. To study this increase and characterize the recent litigation, Cornerstone Research and Professor Robert Daines of the Stanford Law School reviewed reports of M&A shareholder litigation in Securities and Exchange Commission (SEC) filings related to acquisitions of U.S. public companies valued over $100 million and announced in 2010 or 2011. We found that almost every acquisition of that size elicited multiple lawsuits, which were filed shortly after the deal’s announcement and often settled before the deal’s closing. Only a small fraction of these lawsuits resulted in payments to shareholders; the majority settled for additional disclosures or, less frequently, changes in merger terms, such as deal protection provisions. Interestingly, while requiring additional disclosures is a common outcome, we have not encountered a case in which shareholders rejected the deal after the additional disclosures were provided. That's from this blog post; the slightly longer paper is here. The emphasis is mine and, y'know, look at it: every M&A deal is challenged (actually 96% of deals over $1bn), virtually none (5%) of the challenges result in any improved payment to shareholders, and all the terrible information about conflicts that plaintiffs' lawyers discover somehow never convinces shareholders to change their votes. The one constant is that plaintiffs' lawyers get paid - an average of $1.2mm in the settlements that Cornerstone and Daines looked at. These suits often focus on incentives of the target's investment bankers, who are paid only if a deal is completed; I suspect those bankers would love to be in an industry where they could be paid on 100% of assignments while only succeeding at 5% of them. The El Paso case is interesting because judge is pretty pissed at the conflicts there and how they were handled, and sort of made known that he was thinking about awarding damages to El Paso shareholders - possibly in the form of judicially raising the deal price by 68 cents or so. (That's the difference between, roughly, the price that KMI and EP ultimately agreed on and the higher price of $27.55 in cash that KMI had initially offered.) That's pretty rough justice. Your model of merger negotiations could be that you negotiate to the one market-clearing price where, for a penny more, the acquirer would say no, and for a penny less, the target would say no, but that of course isn't the case. There's just a range of plausible prices and you sort of hope that the deal shakes out in that range based on negotiating acumen or whatever on either side. You sort of hope - I do, anyway - that it doesn't shake out based on a judge picking a number out of a hat. You see that here. Kinder Morgan of course has every incentive now to testify that the final price - call it $26.87, loosely - was as high as it was willing to go, and that it would have walked if El Paso had pushed for any more. But it's willing to close the deal even though it seems like, I dunno, a 50/50 chance that a judge will in effect force it to $27.55. And El Paso shareholders - well, maybe they were screwed by missing out on the chance to get paid $27.55. But of course if that was the only price they were willing to sell at, they wouldn't be selling at $26.87. And 98.5% of them seem fine right there. El Paso Delays Shareholder Vote, But Early Tally Shows Approval Likely [Deal Journal] El Paso Delays Vote on Kinder Morgan Deal (by a Few Days) [DealBook] Developments in M&A Shareholder Litigation [Harvard Law School Monstrosity] * As it happens I've probably spent more time at that hotel than any other in the world, and would be remiss not to recommend the burger at the Shula's in the lobby.. ** I actually went to one once and it was exactly what you'd expect: some executives say nice things about each other for 20 minutes, then about half a dozen retirees get up one at a time to be like "I remember when stamps were a nickel."

One More Thing For Governance Day

Felix Salmon put up a great note from a reader about investment banking conflicts; it's fantastic so go read it. But this is a tiny bit unfair: You and many other commentators seem to have some misconceptions about what exactly large, sophisticated clients such as El Paso’s board hire investment bankers to do. Its always funny how, in the minds of pundits everywhere, those conniving and all-powerful one-percenters who sit on corporate boards become impotent and completely incapable of independent decision-making once an investment banker walks into the room. The basic argument is that repeat-player investment bankers provide value not by telling brainless executives whether to accept or reject a merger, but by providing intelligent decisionmakers with access and relationships, and relationships come with conflicts. As he says: When sophisticated clients (management teams, company boards, PE funds, etc) hire M&A bankers, they typically hire them for two main reasons (in addition to the legally required shams referred to as “fairness opinions”): Execution and Connections. Of those things, connections are higher-value and inextricable from conflicts. If you're hiring someone to sell you to Company X, a bank who has done work for Company X - heck, who owns 20% of Company X - is the bank you want. And sure maybe their "conflict" will cause them to advise you to sell for a lowball price so that Company X appreciates them more but, hey, nobody's forcing you to take their advice. So, yes, this is all true. But he's maybe a little too harsh on the commentators and their misconceptions.