In discussing how companies are using delaying tactics to stall hostile takeover bids (a subject for another day), Steven Davidoff opines:
The trick is for courts to prevent this manipulation from depriving shareholders of the ultimate choice of when to sell the company.
Although Davidoff says that so matter of factly that one might assume the claim is not contestable, in fact it's not at all clear that shareholders have "the ultimate choice of when to sell the company" and its perfectly clear (at least to me) that, as a matter of policy, they should not possess that right.
I devoted 90 odd pages to this topic in Unocal at 20: Director Primacy in Corporate Takeovers, so I don't expect to be able to make the complete case in a blog post. Go read the article before deciding I'm wrong, if you please. In the meanwhile, I'm putting the key section of the article below the fold.
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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.181 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 shown in Part II.E, corporate law gives considerable responsibility and latitude to target directors in negotiating a merger agreement. The question has become whether unsolicited tender offers are more like secondary market trading or like 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.182 Both stock and a home are treated as species of private property that are freely alienable by their owners.
The trouble is that none of the normative bases for the structural argument prove persuasive. The idea 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 shareholders 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.183
Indeed, we need not value shareholder democracy very much at all. As previously discussed, what is most striking about shareholder voting rights is the extensive set of limitations on those rights.184 These limitations reflect the presumption in favor of authority. They are designed to minimize the extent to which shareholders can interfere in the board of directors’ exercise of its discretionary powers. In fact, as noted in Part II.D, if authority were corporate law’s sole value, shareholders would have no voice at all in corporate decision making. Instead, all decisions would be made by the board of directors or those managers to whom the board has delegated authority. Shareholder voting rights are properly seen as simply one of many accountability tools available, not as part of the firm’s decision-making system.185
Nor is shareholder choice a necessary corollary of the shareholders’ ownership of the corporation. As described in Part II.B, the nexus of contracts model visualizes the firm 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. A shareholder’s ability to dispose of his stock is merely defined by the terms of the corporate contract, which in turn is provided by the firm’s organic documents and the state of incorporation’s corporate statute and common law. As Vice Chancellor Walsh observed, “[S]hareholders 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.”186
Walsh’s observation is given particular significance when considered in light of the nexus of contracts theory described in Part II.A, which posits that the law generally should provide default rules for which the parties would bargain if they could do so costlessly.187 Walsh’s dictum, therefore, suggests shareholders would bargain for rules allowing a target’s board of directors to function as a gatekeeper even with respect to unsolicited tender offers.
The empirical evidence supports this hypothesis. It is well-established, for example, that the combination of a poison pill and a staggered board of directors is a particularly effective takeover defense.188 Yet, almost 60% of public corporations now have staggered boards.189 Even more striking, the incidence of staggered boards has increased dramatically among firms going public (from 34% in 1990 to over 70% in 2001).190 Finally, activist shareholders have made little headway in efforts to “de-stagger” the board.191 These findings are highly suggestive, as Easterbrook and Fischel observe:
Although agency costs are high, many managerial teams are scrupulously dedicated to investors’ interests. . . . By increasing the value of the firm, they would do themselves a favor (most managers’ compensation is linked to the stock market, and they own stock too). Nonexistence of securities said to be beneficial to investors is telling.192
The existence of securities having certain features seems equally telling.193 Indeed, if what investors do matters more than what they say, one must conclude that IPO investors are voting for director primacy with their wallets.194
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.195 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 bypass the board by making a tender offer, hard bargaining by the target board becomes counter-productive. It will simply lead the bidder into making a low-ball tender offer to the shareholders. This offer, in turn, would probably be accepted due to the collective action problems that preclude meaningful shareholder resistance.196 Restricting the board’s authority to resist tender offers thus indirectly restricts its authority with respect to negotiated acquisitions.197
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.198 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, a potential target can make itself less vulnerable to a takeover by eliminating marginal operations or increasing the dividend paid to shareholders, either of which would enhance the value of the outstanding shares.199 Thus, a corporate restructuring can be seen as a preemptive response to the threat of takeovers.200 Although such transactions may aid incumbents in securing their positions, it is hard to imagine valid objections to incumbents doing so through transactions that benefit shareholders.201 Why should it matter if the restructuring occurs after a specific takeover proposal materializes? On the contrary, the structural argument not only says that it does matter, but taken to its logical extreme, it would require close judicial scrutiny of all corporate restructurings.202
Lastly, restrictions on the board’s authority to function as a gatekeeper with respect to unsolicited tender offers might have a multiplicative effect on the board’s authority generally. Because “the efficiency of organization is affected by the degree to which individuals assent to orders, denying the authority of an organization communication is a threat to the interests of all individuals who derive a net advantage from their connection with the organization.”203 Hence, by calling into question the legitimacy of the central decision-making body’s authority in this critical decision-making arena, a passivity rule might reduce the incentive for subordinates to assent to that body’s decisions in other contexts as well, thereby undermining the efficient functioning of the entire firm.
181The bypass argument discussed in the preceding section focuses on the outside bidder’s ability to bypass the board of directors; the argument discussed here focuses on the target shareholders’ ability to dispose freely of their shares. Obviously, there is considerable overlap between the two.
182See, e.g., Dynamics Corp. of Am. v. CTS Corp., 794 F.2d 250, 254 (7th Cir.1986), rev’d on other grounds, 481 U.S. 69 (1987); Hanson Trust PLC v. ML SCM Acq’n Inc., 781 F.2d 264, 282 (2d Cir. 1986); Norlin Corp. v. Rooney, Pace Inc., 744 F.2d 255, 258 (2d Cir. 1984); see generally Dooley, supra note 2, at 514 (explaining that a shareholder’s decision to sell shares does not affect institutional responsibility). In addition to the normative arguments discussed in the text, Bebchuk advances two other justifications for shareholder choice: moving corporate assets to their highest valued user and encouraging optimal levels of investment in target companies. See Lucian Arye Bebchuk, Toward Undistorted Choice and Equal Treatment in Corporate Takeovers, 98 Harv. L. Rev. 1693, 1765-66 (1985). Neither of these legitimate goals requires shareholder choice; rather, they require only a competitive process that produces the highest valued bid. In other words, they require only fair competition for control.
Gilson criticizes Unocal for having created a regime under which shareholder choice, exercised collectively through voting rather than individually through selling, is determinative of the outcome of takeover fights. Gilson, supra note 12, at 502-06. In contrast, Thompson and Smith criticize Unocal for not creating a “sacred space” within which shareholders can exercise choice by voting and selling. Thompson & Smith, supra note 16, at 299. As developed below, I reject both critiques.
183The analogy between political and corporate voting rights is especially apt in light of the significant differences between the two arenas. First, voting rights are much less significant in the corporate than in the political context. Second, unlike citizens, shareholders can readily exit the firm when dissatisfied. Third, the purposes of representative governments and corporations are so radically different that there is no reason to think the same rules should apply to both. For example, if the analogy to political voting rights was apt, it would seem that the many corporate constituents affected by board decisions would be allowed to vote. Yet, only shareholders may vote. Bondholders, employees, and the like normally have no electoral voice.
184See supra notes 44-49 and accompanying text.
185In light of the limitations to which those rights are subject, shareholder voting rights are not a very important accountability tool.
186Moran v. Household Int’l, Inc., 490 A.2d 1059, 1070 (Del. Ch.), aff’d, 500 A.2d 1346 (Del. 1985). Accord Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 257, 272 (Del. Ch. 1989) (observing “stockholders have no contractual right to receive tender offers or other takeover proposals”). I am using the term “corporate contract” here in the economic sense rather than the legal sense of the term. On the distinction between the legal and economic concepts of contract, see Bainbridge, supra note 35, at 27-28. Thus, the “corporate contract” consists of a host of explicit and implicit understandings embodied in statute, judicial decisions, and the corporation’s organic documents, not just of a single written document. Cf. id. at 29-31 (discussing the role and selection of default rules in corporate law). Those understandings certainly include a right of alienation, as reflected in the statutory restrictions on contractual prohibitions of alienation. See, e.g., Del. Code Ann. tit. 8, § 202 (2001). They do not, however, include the right to sell into a tender offer.
A distinguished Delaware jurist has criticized this argument:
While Professor Bainbridge argues that stockholders who buy shares have opted for a contractual stew made up of statutory, charter, bylaw, and common law ingredients, he has not articulated which of those ingredients—before Moran—would have put a stockholder on notice that his right to sell his shares in a tender offer could be blocked by the board of his company. In the normal order, contractual and statutory restrictions on the alienability of shares tend to be specifically articulated; in the absence of such explicit restrictions, it can be argued that a reasonable stockholder buying shares would assume she was free to sell to whomever she wished whenever she wished without board interference. While Bainbridge’s idea of the underlying “corporate law” contract has normative appeal as a justification for a director-centered approach to the exercise of corporate power, its accuracy as a positive description of the bargain stockholders think they make when they buy shares is less obvious.
Strine, supra note 107, at 869-70 n.15. In fact, the “contractual stew,” taken as a whole, would put shareholders on notice the board likely had a gatekeeping function. In all change of control transactions, except tender offers and stock purchases, the board of directors has always acted as a gatekeeper. See supra notes 3-6 and accompanying text. When Unocal was decided, the use of an unsolicited tender offer as a mechanism for bypassing the board’s gatekeeping function was still relatively new. See Bainbridge, supra note 35, at 652 (noting that the tender offer emerged as an important takeover device in the 1960s). Almost from the outset of the tender offer’s rise to prominence, efforts were made to restore the board’s gatekeeping function through the use of takeover defenses and state takeover legislation. See supra text accompanying note 6. The Delaware Supreme Court endorsed that effort at least as early as Cheff v. Mathes, 199 A.2d 548, 556 (Del. 1964). Long before Moran, it was well-known Cheff effectively confined judicial review of target board actions that limit a shareholder’s ability to sell into a tender offer to the highly deferential treatment of board decisions. See supra text accompanying note 105. In light of this history, it is difficult to believe shareholders’ bargained-for rights have ever included the right to sell their shares into a tender offer without interference by the board of directors.
187For an overview of the nexus of contracts model, as well as a discussion of the conditions under which mandatory rules are preferable to defaults, see Bainbridge, supra note 35, at 27-33.
188Lucian Arye Bebchuk et al., The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy, 54 Stan. L. Rev. 887, 931 (2002) (combining a staggered board and a poison pill almost doubled the chances of a target corporation remaining independent); Robert B. Thompson, Shareholders As Grown-Ups: Voting, Selling, And Limits On The Board’s Power To “Just Say No,” 67 U. Cin. L. Rev. 999, 1017-18 (1999) (using legal treatment of poison pill and classified board provisions as a measure of jurisdictional commitment to shareholder primacy); Neil C. Rifkind, Note, Should Uninformed Shareholders Be a Threat Justifying Defensive Action by Target Directors in Delaware?: “Just Say No” After Moore v. Wallace, 78 B.U. L. Rev. 105, 111 (1998) (observing that “[w]hen poison pills and classified boards are used in tandem, the bidder either must mount two consecutive proxy contests to elect a majority of directors, or convince a court that the target directors’ opposition to the offer constitutes a breach of the directors’ fiduciary duties”).
189Bebchuk et al., supra note 188, at 895. Another published estimate puts the figure even higher, at more than 70% of U.S. public corporations. Robin Sidel, Staggered Terms for Board Members Are Said To Erode Shareholder Value, Not Enhance it, Wall St. J., Apr. 1, 2002, at C2.
190Bebchuk et al., supra note 188, at 889.
191Id. at 900.
192Easterbrook & Fischel, supra note 20, at 205.
193Bebchuk, Coates, and Subramanian argue shareholders could not have consented to the adoption of effective staggered boards because shareholders were unaware of their effectiveness when most such classification schemes were adopted. Bebchuk et al., supra note 188, at 941. If shareholders are that myopic, why do we want to give them the final say? In any case, Bebchuk, Coates, and Subramanian’s own data confirm that increasingly, corporations making IPOs have a staggered board when they go public. See supra text accompanying note 190. They glide over that problem by claiming shareholder approval “was not necessary” in the IPO context. Bebchuk et al., supra note 188, at 942. This is technically true in the sense there was no vote of public shareholders, but it ignores the fact investors were willing to buy stock in the IPO despite the presence of a staggered board. In doing so, the shareholders effectively manifested their consent to the classification scheme through the working of the pricing mechanism. Cf. Easterbrook & Fischel, supra note 20, at 18 (stating “[t]he mechanism by which stocks are valued ensures that the price reflects the terms of governance and operation”).
194Lynn A. Stout, Bad and Not-So-Bad Arguments for Shareholder Primacy, 73 So. Cal. L. Rev. 1189, 1206 (2002) (summarizing evidence “shareholders display a revealed preference for rules that promote director primacy at early stages of a firm’s development”).
Bebchuk has argued shareholder attitudes cannot be inferred from the IPO data, offering as a counterfactual the declining number of attempts by established corporations to amend their articles to allow for a staggered board. Bebchuk, supra note 20, at 1017. As noted in his article with Coates and Subramanian, Bebchuk showed that almost 60% of public corporations now have staggered boards; however, they gave no data on the remaining 40%. Bebchuk et al., supra note 188, at 895. Perhaps the remaining public corporations lacking a staggered board do not need one as a takeover defense because they have other strong takeover defenses in place (such as the existence of a friendly controlling shareholder or dual-class stock). Consequently, contrary to Bebchuk’s claim, the declining number of management-initiated staggered board proposals may be attributable to factors other than shareholder opposition to a gatekeeping role for the board of directors.
195See supra Part II.E.
196David D. Haddock et al., Property Rights in Assets and Resistance to Tender Offers, 73 Va. L. Rev. 701, 738 n.98 (1987).
197Many acquisitions are initiated by target managers seeking out potential acquirers. A no-resistance rule would discourage these takeovers, thus harming shareholders. No sensible seller would seek out potential buyers unless it is able to resist low-ball offers. Haddock et al., supra note 196, at 709-10. Note there is a subtle difference between the position advanced in the text and what might be called the “management as negotiator” model of takeover jurisprudence. Under this model, management can resist a tender offer in order to extract a better offer from the bidder. Suggestions of this model can be found in some of the Delaware cases. See, e.g., Mills Acq’n Co. v. Macmillan, Inc., 559 A.2d 1261, 1287 (Del. 1989) (distinguishing between target board defensive maneuvers that draw an otherwise unwilling bidder into the contest and those that end an active auction by effectively foreclosing further bidding). Ultimately, however, it proves unworkable. For example, how target directors are supposed to use takeover defenses as a negotiating tool never has been made entirely clear. Johnson & Siegel, supra note 3, at 375. Unless the directors can plausibly threaten to preclude the bid from going forward, their defensive tactics have no teeth and thus provide no leverage. Yet, in light of management’s conflict of interest, a board’s refusal to drop its defenses is necessarily suspect. Judicial review of such a refusal, moreover, requires courts to pursue some very thorny lines of inquiry: Is target management correct in believing they are better managers than the bidder? Or would the company, in fact, be better off with the bidder at the helm? Neither is the sort of question courts are comfortable asking about business decisions, including those involving self-dealing. As described below, my approach centers not on how the board used takeover defenses but on whether the board’s decisions were tainted by conflicted interests.
198Richard S. Ruback, An Overview of Takeover Defenses, in Mergers and Acquisitions 49, 64 (Alan J. Auerbach ed., 1988).
199Dooley, supra note 2, at 516-17.
200See Michael Useem, Executive Defense: Shareholder Power & Corporate Reorganization 26-27 (1993); John C. Coffee, Jr., Shareholders Versus Managers: The Strain in the Corporate Web, 85 Mich. L. Rev. 1, 40-60 (1986); Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers, 76 Am. Econ. Rev. (Papers & Proceedings) 323, 328-29 (1986).
201See Dooley, supra note 2, at 517 (making this point); cf. Shamrock Holdings, Inc. v. Polaroid Corp., 559 A.2d 257, 276 (Del. Ch. 1989) (upholding an employee stock ownership plan despite its anti-takeover effects, because the plan was “likely to add value to the company and all of its stockholders”).
202A related cost of shareholder choice is that it may encourage directors and managers to refrain from investments that have a positive net present value but also make the firm more attractive to potential hostile acquirers. See Richard E. Kihlstrom & Michael L. Wachter, Why Defer to Managers? A Strong-Form Efficiency Model, available at http://ssrn.com/abstract= 803564.
203Chester I. Barnard, The Functions of the Executive 169 (30th anniversary ed. 1968).
