In Part I of this essay, I discussed a new article by Bernard Sharfman and Marc Moore, in which they propose reviving the passivity thesis, which argued that target boards faced with a hostile takeover offer should be passive.
A long time ago, in my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] I explained why I disagree with the passivity thesis. My analysis grew directly out of my director primacy model of corporate governance. Because I still think a board-centric approach to corporate governance is appropriate, even in the context of a hostile takeover bid, let me summarize my argument here. I encourage you to go read the whole thing, however.
Given the Delaware courts’ normal sensitivity to conflicts of interests, the clear evidence that management resistance to unsolicited tender offers is at best a risky proposition for shareholders and at worst economically disastrous (note that I do not quibble with the empirical evidence Sharfman and Moore rehearse at 38-55, I'm just not persuaded it overcomes the arguments herein), and the undeniable fact that the no resistance rule does a more thorough job of removing management’s conflicted interests from the tender offer process than does Unocal, is it not surprising that Delaware courts adopted a standard that permits target resistance? The Delaware courts’ consistent rejection of the no resistance rule suggests that the courts have perceived some dimension to the puzzle that has escaped the attention of academics.
Analysis should begin with the proposition that all doctrinal responses to corporate conflict of interest transactions have two features in common. First, so long as the board of directors is disinterested and independent, it retains full decision-making authority with respect to the transaction.[2] Second, the board’s independence and decision-making process is subject to judicial scrutiny. Here, as ever, we see the competing influences of authority and accountability.
In a sense, Delaware’s takeover cases do no more than to simply bring this traditional corporate governance system to bear on target resistance to tender offers.[3] Admittedly, the form of review is unique, but so too is the context. Just as has been the case with all other corporate conflicts of interest, Delaware decisions in the unsolicited tender offer context strive to find an appropriate balance between authority and accountability. We see the courts’ concern for accountability in, for example, Unocal’s explicit recognition of the conflict of interest that target directors and officers face in an unsolicited takeover bid. Of course, it is one thing to recognize this conflict of interest and quite another to do something about it. As a doctrinal matter, the Delaware supreme court concretely demonstrated its sensitivity to management’s conflicted interests by placing the preliminary burden of proof on the board. This action demonstrated considerable judicial sensitivity to the board’s conflicted interests, because outside of areas traditionally covered by the duty of loyalty, putting the initial burden of proof on the board of directors is a very unusual—indeed, essentially unprecedented—step.
At the same time, however, we see the value of authority reflected in, for example, Unocal’s express rejection of the passivity model. Even plainer evidence of the Delaware courts’ concern for authority came when Chancellor Allen wrote that unless Unocal was carefully applied “courts—in exercising some element of substantive judgment—will too readily seek to assert the primacy of their own view on a question upon which reasonable, completely disinterested minds might differ.”[4] Is it not striking how precisely Allen echoes our argument that one cannot make an actor more accountable without simultaneously transferring some aliquot of his decision-making authority to the entity empowered to hold him to account?
In contrast, virtually all of the policy prescriptions to emerge from the academic accounts of the tender offer’s corporate governance role would create an entirely corporate governance system, in which the board is stripped of some or all of its normal decision-making authority. Recast in our terminology, the academic proposals reflect an overriding concern with accountability. There is no room in the academic account for the value of authority. Indeed, the academic proposals reject the very notion that authority has any legitimate role to play in developing takeover doctrine. Deciding whether the judiciary or the ivory tower has the better argument is the task to which the remainder of this section is devoted.
We approach the problem by asking whether the unsolicited tender offer differs in kind, not just degree, from any other conflicted interest transaction. If so, perhaps a special governance scheme applicable only to unsolicited tender offers can be justified. If not, however, we would expect the law to treat unsolicited tender offers just as it treats other conflicted interest transactions. In other words, the law can be expected to develop mechanisms for policing incumbent conflict of interests, but cannot be expected to deny incumbents a role in the process.
The question of comparative advantage
According to most critics of Delaware’s takeover jurisprudence, corporate law gives the board decision-making authority because in most situations the directors have a competitive advantage vis-a-vis the shareholders in choosing between competing alternatives. They then argue that directors have no such competitive advantage when it comes to making tender offer decisions and, accordingly, reject granting the board decision-making authority in the tender offer context. Certainly, it is true that even the most apathetic investor is presumably capable of choosing between an all-cash bid at $74 per share and an all-cash bid at $76. This analysis, however, obscures two important rationales for granting the board decision-making authority in the tender offer context.
At the outset, it is important to recognize that unsolicited tender offers and negotiated acquisitions have a good deal in common. From a practical perspective, it is often increasingly difficult to tell the two apart. In today’s market place most takeovers follow a fairly convoluted path. They start out quasi-hostile, but end up as quasi-friendly, or vice-versa. They start out as a merger proposal, which is restructured as a tender offer for tax or other business reasons, or vice-versa. The problem is usefully illustrated by Chancellor Allen’s opinion in TW Services v. SWT Acquisition.[5] SWT’s unsolicited partial tender offer for TW Services was subject to a number of conditions, including a requirement that the transaction be approved by TW Services’ board of directors. The TW Services’ board saw the tender offer as a ruse designed to extort greenmail or to put the company into play. Accordingly, the board declined to redeem the company’s outstanding poison pill. SWT filed a lawsuit seeking invalidation of the pill. Because SWT conditioned its offer on the TW Service board’s support, the case presented a problem of characterization that the legal literature largely ignores. If the transaction is characterized as a merger, then most commentators would permit the board an active decision-making role. Conversely, if the transaction is characterized as a tender offer, they would preclude the board from exercising decision-making authority. Categorizing this transaction, however, is a non-trivial task.[6] Attempting to define the scope of the board’s authority by the nature of the transaction at hand thus quickly proves an unsatisfactory resolution.
Even if one were wholly confident of one’s ability to appropriately characterize transactions, however, the comparative advantage argument still would not justify precluding the board from exercising decision-making authority in tender offers. Consider transactions like the defensive restructuring at issue in City Capital Associates v. Interco. In the face of an all-cash hostile bid at $74 per share, Interco’s board of directors proposed to sell certain assets and to borrow a substantial amount of money. The joint proceeds of those transactions would then be paid out to Interco’s shareholders as dividends. The dividends would be paid in three forms: cash, bonds, and preferred stock. The dividends’ total value was said to be $66 per share. Interco’s investment banker opined that, after this series of transactions, Interco’s stock would trade at no less than $10 per share. The proposed defensive measures thus purportedly would give Interco’s shareholders a total value of $76—$2 more than the hostile bid. In rebuttal, the bidder’s investment bankers valued the defensive plan at $68-$70 per share.[7] It is precisely because passive, widely dispersed shareholders have neither the inclination nor the information necessary to decide between these sort of alternatives that the corporate law in other contexts allocates the decision to the board.[8] Only compelling accountability concerns can justify treating tender offers differently. The comparative advantage argument thus collapses into a variant of the agency cost arguments discussed below.
The bypass argument
An alternative justification for treating the tender offer differently than negotiated acquisitions rests on the former’s elimination of the need for target management’s cooperation. As we saw above, the target board’s gatekeeper role in negotiated acquisitions creates a conflict of interest, which is constrained principally by the ability the tender offer gives a bidder to bypass the target’s board by purchasing a controlling share block directly from the stockholders. According to some academics, authority values thus are only appropriate in the negotiated acquisition context if the board is denied the ability to resist tender offers.[9]
This argument looks good on paper, but ultimately is unpersuasive. In the first place, it too ignores the problem of characterization alluded to in the preceding section. In addition, tender offers are not the only vehicle by which outsiders can appeal directly to the shareholders. Proxy contests similarly permit a would-be acquirer to end-run management. How a shareholder votes in director elections seems just as an individual decision as that of whether to tender to a hostile bidder. Yet, nobody expects a board to be passive in the face of a proxy contest. To the contrary, the incumbent board’s role is very active indeed. Why? Because the incumbent board members remain in office and therefore also continue to be legally responsible for the conduct of the business until they are displaced. Complete passivity in the face of a proxy contest thus would be inconsistent with the directors’ obligation to determine and advance the best interests of the corporation and its shareholders.[10]
The same is true of a tender offer. While the analogy between tender offers and proxy contests is unconvincing for most purposes, the courts may have correctly sensed a fit at this most basic level. The directors will remain in office unless the offer succeeds and they thereafter resign or are removed by the new owner. As a doctrinal matter, the board of directors has a “fundamental duty” to protect shareholders from harm, which can include an unsolicited tender offer that the directors truly believe is not in the shareholders’ best interests. As Unocal recognized, complete passivity in the face of such an offer would be inconsistent with their fiduciary duties.[11] To the contrary, their on-going fiduciary duty obliges them to seek out alternatives. At the bare minimum, it thus would be appropriate for the board to use takeover defenses to delay an inadequate bid from going forward while the board seeks out an alternative higher-valued offer, because until the board has time to arrange a more attractive alternative there is a risk that the shareholders will “choose an inadequate tender offer only because the superior offer has not yet been presented.”[12]
The structural argument (a.k.a. shareholder choice)
A more substantial argument against authority values in the unsolicited tender offer context contrasts the board’s considerable control in negotiated acquisitions with the board’s lack of control over secondary market transactions in the firm’s shares. Corporate law generally provides for free alienability of shares on the secondary trading markets. Mergers and related transfers of control, however, are treated quite differently. As we saw above, corporate law gives considerable responsibility and latitude to target directors in negotiating a merger agreement. The question then is whether unsolicited tender offers are more like secondary market trading or mergers.
The so-called structural argument—also known as the shareholder choice argument—asserts that the tender offer is much more closely analogous to the former. According to its proponents, an individual shareholder’s decision to tender his shares to the bidder no more concerns the institutional responsibilities or prerogatives of the board than does the shareholder’s decision to sell his shares on the open market or, for that matter, to sell his house.[13] Both stock and a home are treated as species of private property that are freely alienable by their owners.
The shareholder choice argument actually cuts against one of Sharfman and Moore’s arguments. They suggest (at 23-24) that some hostile bids are motivated by private information asymmetrically held by the bidder. I doubt that happened very often even in the hostile takeover’s heyday, but if true would not allowing a bidder to act on that information be inconsistent with shareholder choice? After all, we no longer live in a world of caveat emptor. Major purchases these days come with masses of disclosure (I vividly recall the mountain of information I reviewed at my house closing). Assume the law requires the bidder to disclose its private information. Would the passivity thesis preclude management from undertaking changes in response to learning that information?
In any case, none of the normative bases for the structural argument prove persuasive. That shareholders have the right to make the final decision about an unsolicited tender offer does not necessarily follow, for example, from the mere fact that shareholder have voting rights. While notions of shareholder democracy permit powerful rhetoric, corporations are not New England town meetings. Put another way, we need not value corporate democracy simply because we value political democracy.[14]
Indeed, we need not value shareholder democracy very much at all. In its purest form, our authority-based model of corporate decision making calls for all decisions to be made by a single, central decision-making body—i.e., the board of directors. If authority were corporate law’s sole value, shareholders thus would have no voice in corporate decision making. Shareholder voting rights thus are properly seen not as part of the firm’s decisionmaking system, but as simply one of many accountability tools—and not a very important one at that.
Nor is shareholder choice a necessary corollary of the shareholders’ ownership of the corporation. The most widely accepted theory of the corporation, the nexus of contracts model, visualizes the firm not as an entity but as a legal fiction representing a complex set of contractual relationships. Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept under this model. Each input is owned by someone, but no one input owns the totality. A shareholder’s ability to dispose of his stock thus is not defined by notions of private property, but rather by the terms of the corporate contract, which in turn are provided by the firm’s organic documents and the state of incorporation’s corporate statute and common law. The notion of shareholder ownership is thus irrelevant to the scope of the board’s authority. As Vice Chancellor Walsh observed, “shareholders do not possess a contractual right to receive takeover bids. The shareholders’ ability to gain premiums through takeover activity is subject to the good faith business judgment of the board of directors in structuring defensive tactics.”[15]
Finally, and most importantly, the structural argument also ignores the risk that restricting the board’s authority in the tender offer context will undermine the board’s authority in other contexts. Even the most casual examination of corporate legal rules will find plenty of evidence that courts value preservation of the board’s decision-making authority. The structural argument, however, ignores the authority values reflected in these rules. To the contrary, if accepted, the structural argument would necessarily undermine the board’s unquestioned authority in a variety of areas. Consider, for example, the board’s authority to negotiate mergers. If the bidder can easily by-pass the board by making a tender offer, hard bargaining by the target board becomes counter-productive. It will simply lead to the bidder making a low-ball tender offer to the shareholders, which will probably be accepted due to the collective action problems that preclude meaningful shareholder resistance. Restricting the board’s authority to resist tender offers thus indirectly restricts its authority with respect to negotiated acquisitions.[16]
Indeed, taken to its logical extreme, the structural argument requires direct restrictions on management’s authority in the negotiated acquisition context. Suppose management believes that its company is a logical target for a hostile takeover bid. One way to make itself less attractive is by expending resources in acquiring other companies. Alternatively, the board could effect a preemptive strike by agreeing to be acquired by a friendly bidder. In order to assure that such acquisitions will not deter unsolicited tender offers, the structural argument would require searching judicial review of the board’s motives in any negotiated acquisition.
To take but one more example, it is quite clear that managers can make themselves less vulnerable to takeover by eliminating marginal operations or increasing the dividend paid to shareholders and thus enhancing the value of the outstanding shares. A corporate restructuring thus can be seen as a preemptive response to the threat of takeovers. It is hard to imagine valid objections to incumbents securing their position through transactions that benefit shareholders.[17] Why then should it matter if the restructuring occurs after a specific takeover proposal materializes? The structural argument not only says that it does matter, but taken to its logical extreme would require close judicial scrutiny of all corporate restructurings.
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