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Principal-Agent Issues in Going Private Transactions

“Going private,” as it has been called, describes a process by which a public company becomes private. Though there are several different means of accomplishing such a transition, this post will cover that which private equity firms execute, by buying out a majority of the company’s shares to effectively take control of that public company. It has become a much more attractive option for businesses to take, especially since the financial scandals of Enron, WorldCom, and Tyco brought along with it a more demanding regulatory environment. That being said, however, the past year has seen a marked decline in the total value and number of “going private” transactions spurred by a continually improving economy.

The public corporate form comes with its advantages and drawbacks. It is largely an attractive method of organization for businesses in need of large amounts of capital. Advantages extend to investors in the company’s shares as well, since the shares themselves are transferrable and the offering of those shares essentially means that investors who hold that company’s stock have liquid assets. Despite these advantages, accounting scandals revealed in the early 2000s have introduced changes in the federal regulatory scheme that have proved burdensome enough to cause public businesses to question the aforementioned benefits of staying public.

The Sarbanes-Oxley Act of 2002 (SOX) was the federal government’s response to such scandals, which introduced, among other federal government oversight mechanisms, requirements for public companies to carry out internal control assessments and abide by accounting and financial disclosure demands. On top of what the Securities Exchange Act of 1934 already required, SOX imposes costs that businesses would consider onerous—external auditing and accounting costs, higher costs of internal controls, increasing SEC reporting costs, and more.1 All of these requirements are in addition to the required quarterly earnings report that public companies must also provide, which companies contend limit their focus to short-term objectives, almost at the exclusion of seriously prioritizing long-term goals.

“Going private” means public companies are no longer public; hence, they do not need to abide by such cumbersome regulatory requirements.2 Private equity firms, after having secured financing from an investment bank, would buyout the company by purchasing a majority stake in its publicly offered shares. The private equity firm would then repay the debt that it took on through the hoped-for increased cash flow. In the interim, the private equity firm can restructure the once-public company to improve efficiency and make it more profitable overall.

This stage of the transaction is where legal complications may arise, namely in the arena of principal-agent law. The initial decision of whether to go public or not is, in and of itself, agency law at work. In evaluating the merits of “going private,” a company’s board of directors must exercise reasonable business judgment to satisfy their “common law and statutory fiduciary duties, particularly the duty of loyalty and the duty of care.”3

Even after the decision to exit the public market has been made, there are pressures from the acquiring firm on the new board of directors. The acquiring firm usually entices the board of the public company to go private by offering to pay significantly over the stock price at the time. Furthermore, the board may include directors appointed by the acquiring firm. These transition dynamics may seriously jeopardize board members’ fiduciary duty of loyalty to the remaining shareholders of the acquired company.4

Faced with this threat to “going private” deals’ legitimacy, the Delaware courts have adopted an “entire fairness” standard of review to the exclusion of others.

The concept of fairness has two basic aspects: fair dealing and fair price. The former embraces questions of when the transaction was timed, how it was initiated, structured, negotiated, disclosed to the directors, and how the approvals of the directors and stockholders were obtained. The latter aspect of fairness relates to the economic and financial considerations of the proposed merger, including . . . assets, market value, earnings, future prospects, and any other elements that affect the intrinsic or inherent value of a company’s stock.

 

((Kahn v. Lynch Commc’n Syss., Inc., 638 A.2d 1110, 1115 (Del. 1994) (citing Weinberger v. UOP, Inc., 457 A.2d 701, 711 (Del. 1983)).)) When private equity firms take control of “going private” deals, they become the controlling stockholder, which has the initial burden of establishing “entire fairness.”5 The fact that there are subsequent procedural safeguards, such as approval by an independent committee of directors, however, does not lower the standard of review that courts will exercise; it merely shifts the burden onto the directors to demonstrate. Either way, the fiduciary duties of loyalty and care are those to be reckoned with and firms entering into “going private” transactions must be cognizant of them.

In spite of the aforementioned benefits of “going private,” 2014 has thus far been a very slow year for such transactions. Compared to last year’s figure of $80 billion, these deals have totaled just $3 billion thus far this year.6 Major private equity firms, such as Blackstone and Kohlberg, Kravis, and Roberts (KKR), have looked outside the US for public companies to acquire. A big driver for this has actually been a domestic stock market on the rise, because now, it has become more expensive to buyout these companies. “[P]urchase price is one of the greatest determinants of investment performance.”7


  1. See Ellen Engel et al., The Sarbanes-Oxley Act and Firms’ Going-Private Decisions, 44 J. of Acct. & Econ. 116, 117 (2007). 

  2. Marc Morgenstern et al., Going Private: A Reasoned Response to Sarbanes-Oxley? 1 (2004), available at http://www.sec.gov/info/smallbus/pnealis.pdf. 

  3. Id. at 4. 

  4. Id. at 9-10. 

  5. Id. at 1117 (citing Weinberger, 457 A.2d at 710-11). 

  6. William Alden, Take-Private Deals Are Nearly Extinct on Wall Street, N.Y. Times (Sept. 9, 2014, 1:58 PM), http://dealbook.nytimes.com/2014/09/09/take-private-deals-are-nearly-extinct-on-wall-street/. 

  7. Id

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Ki Hoon Kim