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!)
