In 1965, my friend and mentor the late Henry Manne published the seminal article on the market for corporate control, Mergers and the Market for Corporate Control.[1] As my friend Bill Carney explains, Manne “rejected the received wisdom: ‘Take-overs of corporations are too expensive generally to make the ‘purchase’ of management compensation an attractive proposition.’”[2] “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.”[3]
As a result, Manne argued, a market for corporate control exists because outsiders can profit by buying control of a poorly managed company, firing the incompetent or venal incumbent managers, and replacing them with competent managers who would focus on shareholder wealth maximization:
The market for corporate control is really to be understood in consumer-protection terms, with “consumers” in that market being shareholders. In the pre-Manne era, the prevailing academic paradigm treated shareholders--that is, consumer-purchasers of corporate shares--as chumps. They were routinely, and so predictably, bamboozled by managers supposedly advancing shareholder welfare but really maximizing their own welfare. Management operated seemingly without constraints in bilking shareholders.
But, Manne noted, the corporate control needed to undertake such machinations is subject to market forces. And if markets ordinarily operate reasonably competitively, would not shareholder sovereignty emerge in this market, just as consumer sovereignty emerges in competitive markets generally? So, Manne wrote, mergers “are of considerable importance for the protection of individual non-controlling shareholders . . . .” Thus, … for the first time the famous Berle-Means concern about the separation of ownership and control was seen for what it truly is: an undeniable fact but one that invites, and has elicited, a market solution because it offers manager-entrepreneurs individual gains while protecting other shareholders as well.[4]
The chief difficulty with Henry’s thesis was that the principal acquisition technique of the time—the merger—is ill-suited to play a role in hostile takeovers, because approval of a proposed merger by the target’s board of directors is an essential prerequisite to the accomplishment of a merger.
The solution was coming down the tracks of history at high speed, however. One piece of the puzzle was the emergence of the tender offer. Tender offers were possible in 1965—the first hostile tender offer reportedly took place in 1956[5]—but two barriers had to be overcome before they could become commonplace.
First, as Carney explains, new sources of financing were necessary:
Remarkably, the article predicted leveraged buyouts, noting that any gains from efficient management could be leveraged through borrowed funds, “although American commercial banks are generally forbidden to lend money for this purpose.” It took development of other sources of funds--notably junk bond markets and non-bank institutional lenders--for this leveraging to flower two decades later.[6]
Second, as I have explained elsewhere, there needed to be a major cultural shift on Wall Street:
Given the tender offeror's comparative advantages, it is somewhat surprising that they were relatively rare before the 1960s. Although there are various explanations for that phenomenon, I suspect that the social mores of the business, financial, and legal communities played a major role. Before the 1960s, hostile tender offers were regarded as bad form by most of the key players. See David Halberstam, The Reckoning 674-75 (1986).[7]
Once those pieces were in place, sometime in the mid-1970s,[8] the short-lived era of the hostile takeover began.
In response to the emergence of the hostile takeover, incumbent managers hired talented lawyers to develop an array of defenses—such as the shark repellent, the poison pill, and the Pac-man defense—that allowed the target board to assert a gatekeeping function in the tender offer comparable to the one it long played in the merger.[9]
That development led to one of the most famous of all corporate law review articles; namely, Easterbrook and Fischel’s The Proper Role of a Target's Management in Responding to a Tender Offer.[10] As John Coffee summarizes their argument:
Viewed through the lens supplied by the “market for corporate control” thesis, the role of the tender offer is to replace inefficient management. The bidder, it is argued, pays a premium over the market price because it believes that the target's assets have not been optimally utilized and that under superior management they would earn a higher return, thereby justifying the tender offer premium. In this light, the higher the premium, the greater the degree of mismanagement that the bidder must perceive. So viewed, the hostile tender offer appears a benign and socially desirable phenomenon, which benefits both the bidder and the target's stockholders, who simply divide among themselves the value that the incumbent management's inefficiency denied them.
The Disciplinary Hypothesis places special weight on the target management's resistance to the takeover to demonstrate that the anticipated gain that motivated the acquisition was probably predicated upon the displacement of an inefficient target management. … [According to Easterbrook and Fischel, managerial] resistance is comprehensible only if the interests of the target's management deviated from those of its shareholders. Such a conflict would arise either because the management of the target expected to be replaced by the bidding firm, or because it saw an opportunity to demand a side payment for its acquiescence. The significance of this perspective then lies in its clear implication that “hostile” acquisitions are disproportionately motivated by the bidder's desire to realize enhanced value through replacing an inferior management while “friendly” acquisitions are typically motivated by other business considerations that pose less of a threat to the incumbent management. This logic also leads to the conclusion that hostile bids have a unique role in corporate governance as a policing mechanism.[11]
In turn, those insights led Easterbrook and Fischel to advance what became known as the passivity thesis:
They propose that the management of a corporation subject to a tender offer, the target, should be prohibited from resisting the offer in any fashion. The authors view hostile takeovers as a significant means of displacing poor managers and argue that facilitating tender offers increases the incentive of all managers to perform in the best interests of their shareholders. The passivity thesis has found a sympathetic audience. Many legal scholars have accepted the basic claim that most defensive tactics are undesirable, although some authors would preserve management's right to engage in some limited responses.[12]
Despite their success in the academic arena, Easterbrook and Fischel lost where it matters; namely, in the real world. The passivity thesis developed no traction in the courts. In particular, the one court system that really matters in corporate law—that of Delaware—summarily dismissed the passivity thesis:
It has been suggested that a board's response to a takeover threat should be a passive one. Easterbrook & Fischel, supra, 36 Bus.Law. at 1750. However, that clearly is not the law of Delaware, and as the proponents of this rule of passivity readily concede, it has not been adopted either by courts or state legislatures. Easterbrook & Fischel, supra, 94 Harv.L.Rev. at 1194.[13]
Now, however, come Bernard Sharfman and Marc Moore—two respected and thoughtful corporate law commentators with whom I have frequently corresponded to my benefit—to argue for a restoration of the passivity thesis:
Unfortunately, while a vibrant hostile takeover market did exist in the United States during the 1960s, 70s, and 80s, this has not been the case for many years. By contrast, the United Kingdom, despite having a broadly similar capital market environment and corporate governance system to the U.S., has gone down the path of allowing its hostile takeover market to flourish. Thus, the U.K. has been able to successfully retain the hostile takeover as a corrective mechanism in corporate governance.
We find the current domestic state of affairs unacceptable. Without a vibrant hostile takeover market, a significant corrective mechanism has been lost. Therefore, with a view to correcting this inefficiency, we use as our primary authority the core principles identified in the U.K.’s regulatory legal framework, and especially its longstanding board passivity (or “non-frustration”) rule. More than any other element of the British framework, the board passivity rule has allowed for the creation of an enduring and successful hostile takeover market in the U.K. Accordingly, this Article recommends that domestic state corporate law statutes be amended to include a safe harbor for a hostile bidder when making an all-cash, all-shares tender offer that includes a guarantee of the same or higher price if a back-end or squeeze-out merger occurs.
The use of the above safe harbor would effectively disallow a board’s use of the poison pill as a takeover defense unless a specific takeover defense, such as a poison pill, is provided for in the corporate charter. In this way, private ordering can always be used to trump the statutory safe harbor.[14]
I strongly encourage you to read their article. It is an excellent, yet concise, history of the evolution of the market for corporate control, the academic theorizing about that market, and the development of the law. It also provides a very useful and insightful comparative law treatment of the problem by contrasting US and UK law. In addition, they offer a very helpful review of the empirical literature on the costs and benefits of hostile takeovers. They also make a unique contribution by tying the Delaware courts’ resistance to the passivity thesis to the Delaware courts’ resistance to private ordering in the corporate context, which leads them to proffer a private ordering solution, as noted above.
In Part II, however, I will explain why I don't buy the passivity thesis.
. It got a positive review from the 
