THE RECENT DECISION ON THE HEWLETT-PACKARD/COMPAQ MEGA-MERGER:
How The Court Ignored The Psychological Reality Of Over-Optimistic CEOs

By JAMES FANTO

Tuesday, May. 14, 2002

Recently, Chancellor William Chandler of the Delaware Chancery Court issued an important decision in the case of Walter Hewlett v. Hewlett-Packard Co., which concerned the friendly merger between Hewlett-Packard and Compaq. Unfortunately, the decision showed that the Court continues to be unable, or unwilling, to reign in the excesses of chief executive officers and boards of directors of public companies when they decide upon a mega-merger.

What is the cause of this inability? The root of the problem is the failure of the Delaware courts--the nation's premier forum for corporate law--to develop a law that is based upon adequate psychological foundations.

Mega-Mergers Usually Harm Both Companies' Stockholders

The merger at issue was designed as a stock-for-stock deal; shareholders of Compaq would receive shares of Hewlett-Packard. As such, the transaction is emblematic of the mega-mergers of the 1990s and 2000s, which produced the behemoths of our corporate landscape (Citigroup, AOL-Time Warner, Global Crossing, and so on).

According to financial evidence, well over a majority of these transactions end up being failures: Shareholders of both companies would have generally been better off without a merger. This evidence has been well-known among financial economists for some time. Nevertheless, the transactions, as the Hewlett-Packard/Compaq merger shows, remain popular.

Why? In the heady days of the 1990s' market excesses, CEOs justified the deals with tales of "synergy," and used their overinflated stock as acquisition currency. Boards went passively along.

The professionals who worked on the deals did not intervene to question the wisdom of the mergers. Paid by the number of deals and deal size, investment bankers had no reason to caution CEOs about the risks of the transactions. Accountants and lawyers abandoned all pretensions of independent thinking and were only too happy to join in the feeding frenzy of large fees.

Meanwhile, the business press, itself owned by mega-media firms that were created by these mergers, fawned over the CEOs and extolled the transactions. (Recall, for example, the praise lavished on former Worldcom CEO Ebbers a few years ago.)

A Board Member Fails In a Challenge to the Hewlett-Packard/Compaq Merger

What made the Hewlett-Packard/Compaq merger different was that there was a board member and shareholder with enough independence, voting power and financial clout to question the transaction. In the corporate world, this is a very rare event.

Walter Hewlett is the son of one of the founders of Hewlett-Packard, and a trustee of a foundation that owned a substantial number of Hewlett-Packard shares. He took the understandable position that the merger would likely be bad for Hewlett-Packard and its shareholders.

In the final vote, Hewlett-Packard prevailed by a small margin. Undeterred, Hewlett brought suit before the Chancery Court. He alleged that Hewlett-Packard had failed to make adequate disclosure to its shareholders about the growing internal evidence that the merger synergies would not be realized. He also alleged that Hewlett-Packard had essentially bought the votes of a significant shareholder, Deutsche Bank Asset Management, by threatening to withhold future business from Deutsche Bank.

Chancellor Chandler allowed Walter Hewlett to go to trial on these claims but, in the end, he decided that Hewlett had not prevailed at trial on either claim. That decision, however, was a serious error on the part of the court.

Why CEOs Don't See, or Tell, the Truth About a Merger

Walter Hewlett had to wage an uphill battle in the courtroom. He had to establish that Hewlett-Packard "knowingly and intentionally made material misrepresentations about the progress of" the merger. (Merging companies start their integration immediately following the announcement of the merger, even if the merger cannot legally take place until after the shareholder vote.) Similarly, he had to present "significant evidence" that Hewlett-Packard had coerced Deutsche Bank asset managers into voting for the merger.

The "knowing and intentional" standard means plaintiffs like Hewlett will lose in all but the most egregious cases. After all, how often does a CEO intentionally lie to shareholders? And even it does occur, how easily can it be proven?

The standard is seriously mistaken, and should be revised. As the case shows, this standard completely ignores the psychology of merger decision-making, particularly in mega-mergers. The issue is not that CEOs knowingly and intentionally harm shareholders, but that they unwittingly do so, believing all the while in the rightness of their actions.

The main problem is not that CEOs are intentionally hiding negative data about the proposed combination. Rather, the chief psychological problem is that CEOs' over-optimism blinds them to the very real negative consequences of the deal.

The Problem with Failing to Account for CEOs' Over-Optimism

This over-optimism makes CEOs dismiss or explain away any piece of negative evidence about the transaction. It also allows them to sound absolutely rational in their explanations (particularly in court).

Several factors combine here: There is the "knowing and intentional" legal standard, which is so hard for a plaintiff to meet. There is this psychological reality about merger decision-making. Finally, there is the tendency of Delaware Chancery Court judges to favor corporate management.

Given the combination of all these factors, the outcome of Walter Hewlett's (or virtually any other similar plaintiff's) claim was, though unfortunate, entirely predictable.

How Over-Optimism Played a Decisive Role In the Hewlett Case

Indeed, Chancellor Chandler's opinion reads as if it were scripted. Hewlett-Packard and Compaq executives paraded through the courtroom, explaining in a straightforward way why they thought that the announced merger synergies were likely to be realized. Chancellor Chandler accepted their testimony at face value - noting that they "testified credibly."

Walter Hewlett, however, showed that Hewlett-Packard had evidence that the merger was not succeeding. Moreover, studies of past mergers suggested that this was likely to be the most reliable evidence available - evidence far more reliable than CEO's over-optimistic assessments.

In addition, the fact that any such evidence existed should have been weighed heavily against management. Since so many of these transactions fail, if any negative evidence appears at the beginning of the merger process, it is very bad sign for the deal.

Nevertheless, Walter Hewlett did not prevail on his claim of nondisclosure. Why? The negative evidence came from those outside the inner circles of the CEOs and their counselors - from the business groups that would have to implement the merger. Accordingly, management was able to craft a response dismissing this evidence, though not a convincing one.

Management's explanation was that the business groups generating the negative information could not see the "big picture" and appreciate the synergies of the mega-merger. Predisposed to believe the executives, and with no smoking gun to suggest that they were scoundrels, Chancellor Chandler bought their explanation, and dismissed the claim.

Suspicious Conduct Gave Credence to the Vote-Buying Claim

The Deutsche Bank and Hewlett-Packard dealings during the merger would have made anybody suspicious. Once the deal was announced, the Deutsche Bank analyst who followed this business sector was enthusiastic about it.

Accordingly, Deutsche Bank investment bankers urged Hewlett-Packard Chief Financial Officer Robert Wayman to give them a piece of the action. (Not surprisingly, perhaps; the recommendations of an investment bank's analyst are often designed to generate investment banking business and it is possible this was the case here.)

Hewlett-Packard put off Deutsche Bank, however. But when Walter Hewlett announced his opposition to the merger, Hewlett-Packard seemed to change its mind. It began efforts to bring Deutsche Bank into its circle of advisors. No doubt, Hewlett-Packard realized that it might need the votes under Deutsche Bank's control and thus wanted Deutsche Bank on its side.

All parties assumed that Deutsche Bank Asset Management, which controlled 17 million Hewlett-Packard shares, would vote them in favor of the merger. That was because Deutsche Bank's asset managers had, in the past, typically followed the recommendation of Investor Shareholder Services, an independent shareholder services firm that supported the merger. This time, though, it was Deutsche Bank that changed its mind: The asset managers changed their practice in this case, and decided to vote against the merger.

Shortly before the shareholders' meeting, Fiorina heard of this development. She responded by telling Wayman that the company might have to do "something extraordinary" to secure the asset managers' vote. What that "something extraordinary" might have been turned out to be a crucial issue in the case.

Subtly Coercing Deutsche Bank's Vote? An Implicit, Not An Express, Threat

A Deutsche Bank investment banker- the banker who oversaw the Deutsche Bank/Hewlett-Packard relationship - then organized a call between Fiorina and the asset managers and participated in it. (Meanwhile, Walter Hewlett received the same privileges to discuss his side in a separate call.)

Not surprisingly, the Hewlett-Packard executives did not openly threaten Deutsche Bank with a loss of business, and only discussed the merits of the transaction during the call. Nor did the Deutsche Bank asset managers make any express reference to the overall business relationship when, after the call, they decided to switch their vote to approve the merger.

The subtext, however, was very clear: the Hewlett-Packard/Deutsche Bank relationship would go dramatically south if the asset managers voted against the merger. If there were any doubt, the presence of the relationship banker on the call would have made the implicit threat clear to them.

And he also accepted the Deutsche Bank investment bankers' story that the call had not occurred to implicitly threaten the asset managers so that they would switch their vote. Rather, they said, the call was arranged because they were embarrassed at having misled Fiorina into thinking that the managers would vote for the merger.

In the end, having essentially required Hewlett to prove the threat with a "smoking gun," and seeing no smoking gun, Chancellor Chandler dismissed the vote-buying claim.

Again, Disregard of Psychological Realities Marred The Court's Decision

Chancellor Chandler did express mild disapproval that the "wall" between Deutsche Bank investment banking and asset management did not keep the two absolutely separate in this case. But his remark was too little, too late.

Once again, Chancellor Chandler missed the psychological realities of the situation. Hewlett-Packard executives did not have to communicate openly, whether inside or outside the call, any threats to Deutsche Bank about the loss of future business. It would have been clear to everyone involved what would have happened had Deutsche Bank failed to change its vote. (It had similarly been clear to Hewlett-Packard, following Walter Hewlett's declared opposition to the merger, that it had to compensate Deutsche Bank for its support and votes by hiring it as an advisor).

It is not at all surprising that there was no express threat. One would expect that the conversation, both during the call and among the asset managers following it, would deal only with the merits of the transaction.

Indeed, the managers might not even have realized they had capitulated to an implicit threat. Rather, under the influence of the groupthink mentality, the asset managers would naturally rationalize, to themselves and others, that they had made the vote switch only because of their own independent assessment of the merger. Certainly they would not have liked to think they had cravenly switched their honest opinion in order to prevent Deutsche Bank from losing business.

The Increasing Irrelevance of the Delaware Chancery Court

Criticizing Chancellor Chandler may be somewhat unfair, for he may have felt bound by Delaware precedent to decide the way he did. Changing the law is arguably the province of the Delaware Supreme Court, not the Chancery Court.

Moreover, insisting on a smoking gun to show coercion in a vote-buying claim is similarly naive. Psychological reality suggests that coercion may be part and parcel of the relationship between a corporation and a shareholder (in this case, between Hewlett-Packard and Deutsche Bank Asset Management), not the result of a specific verbal threat.

The Supreme Court should recognize and account for the over-optimism and groupthink that can make disclosure flawed and that can contribute to coercion of shareholders who, like Deutsche Bank, have much to lose if they object to the merger.

More generally, the Supreme Court should also address the abuses of the popular, but disastrous, stock-for-stock mega-mergers. Delaware courts have, at times, used their equity powers to curb unfair corporate behavior. This is an occasion when those powers should be invoked.

If the Delaware courts continue on their current path, declining to address problems that are plain for all to see, they may lose power in an area - corporate law - that has always been their special province. The Enron scandal, and the increasingly apparent problems in the mega-firms that grew through mega-mergers, have led to calls for more federal government intervention in corporate governance. These calls are likely to grow louder, so long as the Delaware courts refuse to recognize psychological reality.


James Fanto is a Professor at Brooklyn Law School and has written about the psychological and legal problems with mega-mergers.

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