In an article entitled Unocal at 20, I built upon my "director primacy model of corporate governance and law" to argue that "Unocal strikes an appropriate balance between two competing but equally legitimate goals of corporate law: on the one hand, because the power to review differs only in degree and not in kind from the power to decide, the discretionary authority of the board of directors must be insulated from shareholder and judicial oversight in order to promote efficient corporate decision making; on the other hand, because directors are obligated to maximize shareholder wealth, there must be mechanisms to ensure director accountability. The Unocal framework provides courts with a mechanism for filtering out cases in which directors have abused their authority from those in which directors have not."
As I read today's WSJ, however, I was prompted to wonder whether my analysis left enough room for the market for corporate control to do its part in the process of creative destruction that makes capitalism work.
In a 1999 University of Cincinnati Law review article, my friend Bill Carney explained how my friend Henry Manne made the breakthrough argument about the critical role the market for corporate control plays in a capitalist economy:
[Manne’s article] Mergers and the Market for Corporate Control [73 J. Pol. Econ. 110 (1965)] was the natural culmination of Manne's writing and thinking on the role markets played in constraining managers. … Manne noted that shareholders were primarily interested in having managers maximize profits, and that stock prices reflected the success of their efforts.
In 1962 Manne’s article] The Higher Criticism introduced the notion that weak management that caused profits to decline would also cause share prices to decline, which would in turn attract outsiders as buyers because of the votes attached to the shares. These buyers would in turn use the votes they had purchased with their shares to seek better management and the rewards of higher earnings and stock appreciation. In this first article, Manne had made the critical linkage between share voting and share transferability, which he would develop more fully in 1964 and 1965.
In 1964 [Manne’s article] Some Theoretical Aspects of Share Voting first developed the notion that there were positive returns to acquiring voting control of firms, and that these returns come from improved management. Manne described shares as consisting of a bundle of rights--one being the investment and the other being the right to vote. He noted that the value of the share vote rose as the value of the share itself declined from poor management, and that the difference represented the control premium that outside management teams would be willing to pay for control. … It was this 1964 article that first introduced the phrase, “the market for corporate control.”
But it was Mergers and the Market for Corporate Control that gained the most attention in this remarkable series. … The returns from acquiring control, Manne argued, were from improving management. Improving management would, in turn, increase cash flows that would be capitalized by the market. …
In the context of mergers, Manne recognized the value of the veto power held by managers over this form of takeover, and the likelihood that this veto would encourage side payments to management to persuade it to allow shareholders to accept a premium for their shares. This observation has obvious implications, of which we all became acutely aware later on. First, if managers can extract a part of the economic rents available to shareholders in a target corporation, returns to target shareholders in mergers should be smaller than in tender offers. Later evidence has borne this out. Second, if changes of control are efficient and are furthered by management acquiescence, how much power should target-management possess in order to extract part of the gains? The struggles of the Delaware courts in attempting to delineate how much corruption is too much in this setting have occupied corporate lawyers for the past fifteen years. But the outline of the problem has been present for the last 34 years.
The … most important contribution of this article was its description of the market for corporate control as a serious constraint on management misbehavior. As Manne wrote:
Only the take-over scheme provides some assurance of competitive efficiency among corporate managers and thereby affords strong protection to the interests of vast numbers of small, non-controlling shareholders. Compared to this mechanism, the efforts of the SEC and the courts to protect shareholders through the development of a fiduciary duty concept . . . seem small indeed.
What prompted me to ruminate on all this was the Journal's coverage of Kodak's rumored bankruptcy filing. Kodak long was a great success story. But all things--including corporations--have a life cycle. Kodak got old. It became a mature cash cow. Managers of mature cash cows all too often succumb to a mid-life crisis. The firm must be revitalized. It needs the corporate equivalent of botox. Just as Hollywood types with too much money to spend on plastic surgery all too often end up with duck lips and chipmunk cheeks, corporate managers with too much free cash flow often end up with bloated, dysfunctional conglomerates.
Kodak's sad story is a classic example of the phenomenon:
The company ... invented the digital camera—in 1975—but never managed to capitalize on the new technology.
Casting about for alternatives to its lucrative but shrinking film business, Kodak toyed with chemicals, bathroom cleaners and medical-testing devices in the 1980s and 1990s, before deciding to focus on consumer and commercial printers in the past half-decade under Chief Executive Antonio Perez.
None of the new pursuits generated the cash needed to fund the change in course and cover the company's big obligations to its retirees. A Chapter 11 filing could help Kodak shed some of those obligations, but the viability of the company's printer strategy has yet to be demonstrated, raising questions about the fate of the company's 19,000 employees.
A viable market for corporate control might well have prevented Kodak from spending the last few decades flailing from one failed strategy to another. Back in the 1980s, before Martin Lipton invented the poison pill, bankers like Michael Milken and buyout boutiques like KKR put Manne's theories to the test by taking on the economic dinosaurs of that day--i.e., conglomerates. Managers of that era thought good managers could manage anything. They also thought intrafirm diversification was superior to diversification at the shareholder level. Looser antitrust rules on horizontal acquisitions than on vertical acquisitions further encouraged the building of huge conglomerate empires by imperially-minded CEOs. The result was bloated businesses that did everything from -- as the Kodak case exemplifies -- film to "chemicals, bathroom cleaners and medical-testing devices" to "consumer and commercial printers." Those managers were wrong. Just as Kodak's managers have been wrong in more recent times.
The conglomerates suffered from a form of reverse synergy. They worth more broken up into pieces with the various lines of business sold off as individual firms. And that's precisely what happened because the market for corporate control worked.
Sometimes the process of breaking up conglomerates included the sad but necessary task of killing off lines of business that had outlived their expiration date. If it were not for the creative destruction process, after all, buggy whip companies would still be in business because we'd all still be driving buggies.
Kodak has outlived its expiration date. The cash cow of film has died. The cupboard is empty. If we had a functioning market for corporate control, somebody would buy the shell, sell off whatever assets remain of value, and kill the rest.
I feel badly for the people who work at Kodak. Ideally, public policy would provide mechanisms for retraining and transitioning of employees adversely affected by corporate takeovers. After all, if corporate takeovers really are Kaldor-Hicks efficient, there should be some money available for the state to redistribute to those who suffer from the externalities of that market. But Kodak still should die.
All of which leaves me with a coupe of basic questions to ponder: Did Unocal at 20 properly strike the balance between protecting director primacy and preserving an functional market for corporate control? And does current delaware law do likewise?
Ponder. Not blog. Not yet.
