Famed law and economics scholar Henry Manne has a very fine essay on
corporate governance in today's WSJ($). He begins with an analysis
of proposals to increase disclosure of executive compensation and to
enhance the power of shareholders, concluding:
Only in the make-believe world of SEC regulation could
anything like the proxy fight be seen as a significant solution to the
agency-cost problem of exorbitant salaries.
I agree,
for the reasons detailed at length in my article The
Case for Limited Shareholder Voting Rights.
Henry's proposed alternative solution to the ills of corporate
governance will come as no surprise to those who know him; namely, a
reinvigorated market for corporate control.
Tags: Business Organizations Research Law
Henry writes:
... free markets do not
tolerate economic inanities for long, even in the case of large,
publicly held companies. Contrary to the popular liberal shibboleth,
markets do not often fail on their own. It usually requires help from
the government. In the late '50s and '60s, we witnessed the early
development of the hostile tender offer -- the most powerful market
tool ever devised for dealing with non-profit-maximizing managers in
publicly held companies. It did not appear before this time for the
simple reason that there were very few companies that had the wide
diffusion of stock ownership prerequisite to hostile tender offers. Tax
laws and a growing understanding of the virtues of share
diversification changed all that, and hostile takeovers were not slow
then in making their appearance.
But their appearance was, for incumbent managers, a
terrifying thing: surprise offers for almost all outstanding shares at
a huge premium over current market price -- and with little time for
shareholders or the corporation to shop the offer, or for the
incumbents to mount a counterattack or defense. The opportunity for
affording such a premium, of course, was created by the low stock
market value generated by the policies of the incumbent managers. There
were no inefficiencies in the stock market that generated incorrectly
low prices for these companies' shares.
... Until we return to something like the pre-
Williams-Act market for corporate control, we shall continue to see
egregious salaries, crazy option grants, and golden handshakes and
parachutes. Disclosure as a solution to that problem is a bit like a
New Orleans levee faced with Katrina. A return to the takeover law of
the '60s would substantially solve the compensation problem without
ungainly regulation, and it would also deliver us from vacuous and
harmful notions of corporate social responsibility. All that is
required is a little guts from Mr. Cox, confidence in free markets from
the managers of large corporations, and some humility about economic
regulation from the U.S. Congress.
I
would quibble with Henry on a couple of points. First, I don't
entirely share his faith in the efficiency of the stock
market. As I detail in my book Mergers and Acquisitions (at 54-56): In standard economic
theory, a control premium is not inconsistent with the efficient
capital markets hypothesis. The pre bid market price represented the
consensus of all market participants as to the present discounted value
of the future dividend stream to be generated by the target?in light of
all currently available public information. Put another way, the market
price represents the market consensus as to the present value of the
stream of future cash flows anticipated to be generated by present
assets as used in the company's present business plans. A takeover bid
represents new information. It may be information about the stream of
future earnings due to changes in business plans or reallocation of
assets. In any event, that pre bid market price will not have impounded
the value of that information. To the extent the bidder has private
information, moreover, the market will be unable to fully adjust the
target's stock price.
Some commentators contend that the demand curves for
stocks slope downwards and may even approximate unitary elasticity. If
so, buying 50% of a company's stock would require a price increase of
50%. If so, little or no new wealth is created by takeovers. Instead,
takeover premia are largely an artifact of supply and demand.
Put another way, the downward sloping demand curve
hypothesis takeover premium implies that many investors have a
reservation price higher than the pre-bid market price of the target
corporation?s stock. Indeed, because investors with a reservation price
below the prevailing market price should already have sold, most
investors? reservation price will be near or above the prevailing
market price. Accordingly, a bidder must offer a control premium simply
to induce those investors to sell. As to those investors, however, the
portion of the control premium reflecting their reservation price
really should not be considered new wealth.
Second, I find the notion that takeovers are
driven by disciplinary concerns unpersausive. If there are
alternative explanations of how takeovers create value, the market for
corporate control loses some of its robustness as a policy engine. Put
another way, awarding the lion's share of the gains to be had from a
change of control to the bidder only makes sense if all gains from
takeovers are created by bidders through the elimination of inept or
corrupt target managers and none of the gains are attributable to the
hard work of efficient target managers.
The empirical evidence suggests that takeovers produce
gains for many reasons, of which the agency cost constraining function
of the market for corporate control is but one. Studies of target
corporation performance, for example, suggest that targets during the
1980s generally were decent economic performers. Second, studies of
post takeover workforce changes find that managers are displaced in
less than half of corporate takeovers. Third, as already noted,
acquiring company shareholders frequently lose money from takeovers. If
displacing inefficient managers was the principal motivation for
takeovers, acquiring company shareholders should make money from
takeovers. Finally, there is little convincing evidence that acquired
firms are better managed after the acquisition than they were
beforehand. In sum, displacement of inefficient managers is a plausible
way in which takeovers create value, but it is hardly the only way?and
it may not even be a particularly important way. (I cite these studies
at pages 48-49 of my Mergers and Acquisitions text.)
Finally, there is a very strong argument for
allowing incumbent target managers to at the very least compete to
retain control. (I discuss this argument in my recent paper Un
ocal at 20: Director Primacy in Corporate Takeovers, which
also makes a number of other arguments for granting target management a
gatekeeping function in takeover fights.)
Michael Dooley has suggested that management
resistance to unsolicited tender offers may not deserve the opprobrium
to which it is usually subjected. Michael P. Dooley, Fundamentals of
Corporation Law at 561-63. Observing that it would be naive to assume
that takeovers displace only ?bad? or ?inefficient? managers, while
acknowledging that blamelessness does not eliminate the managers?
conflict of interest, he suggests that ?resistance may not deserve the
opprobrium usually attached to self-dealing transactions.? Id. at
562.
Indeed, Dooley observes, it may often be shareholders
rather than managers who act opportunistically in the takeover context.
Id. Much of the knowledge a manager needs to do his job effectively is
specific to the firm for which he works. As he invests more in firm
specific knowledge, his performance improves, but it also becomes
harder for him to go elsewhere. An implicit contract thus comes into
existence between managers and shareholders. On the one hand, managers
promise to become more productive by investing in firm specific human
capital. They bond the performance of that promise by accepting long
promotion ladders and compensation schemes that defer much of the
return on their investment until the final years of their career. In
return, shareholders promise job security. See Stephen M. Bainbridge,
Interpreting Nonshareholder Constituency Statutes, 19 PEPPERDINE L.
REV. 971, 1004-08 (1992).
Viewed in this light, the shareholders? decision to
terminate the managers? employment by tendering to a hostile bidder
?seems opportunistic and a breach of implicit understandings between
the shareholders and their managers.? DOOLEY at 562. Shareholders can
protect themselves from opportunistic managerial behavior by holding a
fully diversified portfolio. By definition, a manager?s investment in
firm specific human capital is not diversifiable. Shareholders? ready
ability to exit the firm by selling their stock also protects them. In
contrast, the manager?s investment in firm specific human capital also
makes it more difficult for him to exit the firm in response to
opportunistic shareholder behavior. See John C. Coffee, Jr.,
Shareholders versus Managers: The Strain in the Corporate Web, 85 MICH.
L. REV. 1, 73-81 (1986).
Dooley concedes that this analysis certainly helps
explain the courts? greater tolerance of conflicted interests in this
context than in, say, garden variety interested director transactions.
But he also argues that the possibility that the shareholders? gains
come at the expense of the managers does not justify permitting
management to block unsolicited tender offers. Rather, he argues, the
managers? loss of implicit compensation appears to be a particularly
dramatic form of transaction costs, which could be reduced by
alternative explicit compensation arrangements, such as payments from
shareholders to managers who lose their jobs following a takeover. It
thus may be that courts tolerate management involvement in the takeover
process not because they perceive management as having a right for
management to defend its own tenure, but rather a right to compete with
rival managerial teams for control of the corporation. By allowing
management to compete with the hostile bidder for control, the courts
provide an opportunity for management to protect its sunk cost in firm-
specific human capital without adversely affecting shareholder
interests. Indeed, allowing them to compete for control will often be
in the shareholders? best interests. There is strong empirical evidence
that management-sponsored alternatives can produce substantial
shareholder gains. See Michael C. Jensen, Agency Costs of Free
Cashflow, Corporate Finance, and Takeovers, 76 AM. ECON. REV. 323, 324-
26 (1986) (summarizing studies of shareholder gains from management-
sponsored restructurings and buyouts). A firm?s managers obviously have
significant informational advantages over the firm?s directors,
shareholders, or outside bidders, which gives them a competitive
advantage in putting together the highest valued alternative.
Management may also be able to pay a higher price than would an outside
bidder, because to a firm?s managers? the company?s value includes not
only its assets but also their sunk costs in firm specific human
capital. Shareholders thus have good reason to want management to play
a role in corporate takeovers, so long as that role is limited to
providing a value maximizing alternative.
It is certainly true that any management response to
an unsolicited tender offer, other than pure passivity, triggers a
competition between two or more rival managerial teams for control of
the corporation. The competition is obvious when an unsolicited tender
offer is made to the shareholders of the target of a locked-up
negotiated acquisition. But a competition also results when management
defends against a standard hostile takeover bid by putting forward a
management-endorsed white knight bid, a management-sponsored leveraged
buyout proposal, a restructuring of the corporation?s control structure
transferring effective voting control to management and its allies, a
restructuring preserving management?s incumbency by making the target
unpalatable to hostile bidders, or even merely a management statement
urging shareholder to reject the bid. Revlon?s progeny appear to
encourage this sort of competition, so long as it is conducted fairly,
by making it clear that the board in conducting an auction must have a
very good reason for skewing the auction in favor of one of the
competing bidders. Paramount Communications Inc. v. QVC Network Inc.,
637 A.2d 34, 45 (Del. 1993); Barkan v. Amsted Indus., Inc., 567 A.2d
1279, 1286 (Del. 1989); Mills Acquisition Co. v. Macmillan, Inc., 559
A.2d 1261, 1286-87 (Del. 1989).
Yet, to focus on competition between incumbent
management and the outside bidder would obscure the critical role
played by the board of directors. The Delaware courts have rejected
formalistic and formulaic approaches to takeovers. Instead, they have
adopted a case-by-case search for conflicted interests. Where the facts
suggest that the directors have allowed self-interest to affect their
decisions, they have lost, but where the directors pursued the
shareholders? interests, Delaware courts have deferred to their
decisions, even where the court might not have made the same
decision.
Update: Larry Ribstein has a nice post on Henry's essay, which takes a
somewhat different approach to the problem than I do. (No surprise
there to those who know us both!)
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