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.
In Part II of this essay, I discussed my article, Unocal at 20: Director Primacy in Corporate Takeovers,[1] in which 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.
In this Part, I discuss the final and perhaps most important argument for treating negotiated and hostile acquisitions differently with respect to the scope of the target board’s authority, which rests on the conflicted interests inherent in corporate takeovers.
The conflicted interest argument
Put in my director primacy terminology, the conflicted interest argument is that accountability concerns are so severe in this context that they must trump authority values. Unsolicited tender offers implicate accountability concerns in at least two ways, which might be referred to respectively as transactional and systemic. The former relates to the effect of a hostile takeover on the target in question, while the latter relates to the effect resistance to hostile takeovers can have on public corporations as a whole. Neither justifies wholly barring authority values from playing a part in developing the governing legal rules.
Transactional accountability. As with business judgment rule scholarship generally, a failing of the academic literature on takeovers is the almost universal tendency to conflate the roles of corporate officers and directors. The legal literature speaks of “management resistance” and “management defensive tactics,” rarely recognizing any separate institutional role for the board. Most commentators simply assume that even independent directors are in thrall to senior managers and will ignore shareholder interests if necessary to preserve their patrons’ jobs.[2]
In contrast, the Delaware courts take the board’s distinct role quite seriously, especially with respect to its independent members. As a doctrinal matter, the board’s burden of proof is more easily carried if the key decisions are made by independent directors.[3] As a practical matter, the court’s assessment of the outside directors’ role often is outcome-determinative.[4]
Why have the Delaware courts insisted on drawing such sharp distinctions between the board’s role and that of management? Because while the conflict of interest unsolicited tender offers pose for the target company’s managers is inescapable, the independent director’s conflict of interest is merely a potential problem. For the independent directors, the conflicts posed by unsolicited tender offers are no different than those posed by freezeout mergers, management buyouts, interested director transactions, or a host of similar situations. Corporate law neither prohibits these transactions, nor requires complete board passivity in connection with them, simply because they potentially involve conflicts of interest. Instead, it regulates them in ways designed to constrain self-interested behavior. Unless one makes a living on the buy-side of corporate takeovers, it is not clear why hostile takeovers should be treated differently.
Consider, for example, the somewhat analogous case of management-sponsored leveraged buyouts. Like unsolicited tender offers, these transactions inherently involve a strong risk of management self-dealing. While management is acting as the sellers’ agents and, in that capacity, is obliged to get the best price it can for the shareholders, it is also acting as a purchaser and, in that capacity, has a strong self-interest to pay the lowest possible price. Like unsolicited tender offers, management buyouts also create conflicts of interest for the independent directors. Just as an independent director may resist an unsolicited tender offer to avoid being fired by the hostile bidder, he may go along with a management buyout in order to avoid being fired by the incumbent managers. Alternatively, if an independent director is inclined to resist a hostile takeover because of his friendship with the insiders, why should he not go along with a management-sponsored buyout for the same reason? Strikingly, however, the empirical evidence indicates that shareholder premiums are essentially identical in management-sponsored leveraged buyouts and arms-length leveraged buyouts.[5] This evidence suggests that the potentially conflicted interests of independent directors are not affecting their ability to successfully constrain management misconduct. Accordingly, while judicial review of management buyouts tends to be rather intensive, courts have not prohibited such transactions, but have addressed the problem of conflicted interests by encouraging an active role for the firm’s independent directors in approving a management buyout proposal.[6] Why should the same not be true of the board’s response to unsolicited tender offers?
In sum, the conflict of interest present when the board responds to an unsolicited tender offers thus differs only in degree, not kind, from any other corporate conflict. Although skepticism about their motives is thus appropriate, their conflict of interest does not necessarily equate to blameworthiness. Rather, it is simply a state of affairs inherently created by the necessity of conferring authority in the board of directors to act on behalf of the shareholders. To be sure, proponents of the no resistance rule will respond that such a state of affairs could be avoided by declining to confer such authority on the board in this context. Yet, if the legal system deprives the board of authority here, it will be hard-pressed to decline to do so with respect to other conflict transactions. As has been the case with other situations of potential conflict, we therefore would expect the courts to develop standards of review for takeover defenses that are designed to detect, punish, and deter self-interested behavior. Because the risk may be greater in this context, stricter than normal policing mechanisms may be required, but this does not mean that we must set aside authority values by divesting the board of decisionmaking authority.
Systemic accountability. Because the incumbent directors and management’s transactional conflict of interest is neither so severe nor unusual as to justify a wholly new governance system for tender offers, opponents of target resistance to tender offers must find some other basis for depriving the board of its normal decisionmaking authority. For most critics of takeover defenses, such a basis is to be found in the systemic agency cost effects of management resistance. Sharfman and Moore, for example, make this point at pp. 22-23.
In agency cost theory, disciplinary actions against employees and mid-level managers are expected to take the form of dismissals, demotions, or salary adjustments imposed by senior management. Where it is senior management that requires discipline, however, alternative mechanisms become necessary. According to the standard academic account, hostile takeover bidders provide just such a mechanism. Making the standard efficient capital market assumption that poor corporate performance will be reflected in the corporation’s stock price, opponents of target resistance claim that a declining market price sends a signal to prospective bidders that there are gains to be had by acquiring the corporation and displacing the incumbent directors and managers. Of course, the signal will not always be correct. Sometimes the firm’s market price may be declining despite the best efforts of competent management, as where some exogenous shock—such as technological change or new government regulation—has permanently altered the corporation’s fundamentals. If close examination by a prospective bidder reveals that the declining market price is in fact attributable to shirking by senior management, however, a disciplinary takeover could produce real gains for division between the target’s shareholders and the successful acquirer. This prospect creates positive incentives for potential bidders to investigate when the market signals a firm is in distress. Conversely, because keeping the stock price up is the best defense managers have against being displaced by an outside searcher, the market for corporate control—more specifically, the unsolicited tender offer—is an important mechanism for preventing management slacking. Indeed, some would argue, the market for control is the ultimate monitor that makes the modern business corporation feasible.
By making possible target resistance to unsolicited takeover bids, so the theory goes, takeover defenses thus undermine the very foundations of corporate governance. The first prospective bidder to identify a prospective target incurs significant search costs, which become part of the bidder’s overall profit calculation. By announcing its offer, however, the first bidder identifies the prospective target to all other potential bidders. Subsequent bidders thus need not incur the high search costs carried by the first bidder, perhaps allowing them to pay a higher price than is possible for the first bidder. If target resistance delays closing of the offer, subsequent bidders have a greater opportunity to enter the fray. At the very least, target resistance may force the initial bidder to raise its offer, reducing the gains to search. Target resistance therefore reduces bidders’ incentives to search out takeover targets. Reductions in bidders’ search incentives results in fewer opportunities for shareholders to profit from takeover premia. More important, a reduction in search incentives also reduces the effectiveness of interfirm monitoring by outsiders. In turn, that reduces the market for corporate control’s disciplinary effect. A rule prohibiting target resistance is therefore likely to decrease agency costs, and increase stock prices, benefiting shareholders of all firms, even those whose companies are never targeted for a takeover bid.[7]
All well and good, but who died and left the unsolicited tender offer in charge? A no resistance rule in effect creates a kind of private eminent domain: bidders can effectively “condemn” target shares by offering even a slight premium over the current market price.[8] Awarding the lion’s share of the gains to be had from a change of control to the bidder, however, only makes sense if all gains from takeovers are created by bidders through the elimination of inept or corrupt target managers and none are attributable to the hard work of efficient target managers. Unfortunately for proponents of the no resistance rule, the evidence is that takeovers produce gains for a variety of reasons that are likely to differ from case to case.[9]
In order for a no resistance rule to make sense, the unsolicited tender offer also must be the critical mechanism by which incumbents are disciplined. In fact, however, unsolicited tender offers are so rare and sporadic that a director or manager who shirks his responsibilities by playing golf when he should be working is undoubtedly more likely to be struck by lightening while on the course than to be fired after a hostile takeover. As a result, the disciplinary effect of takeovers has been grossly overstated by proponents of the no resistance rule. Instead, as our analysis of Delaware’s takeover jurisprudence will suggest, the critical disciplinary mechanism is the board of directors, especially the independent directors. In turn, the tenure and reputation of outside board members are determined by the performance of the inside managers, which gives independent directors incentives to be vigilant in overseeing management’s conduct.
If independent directors were the sole bulwark against managerial shirking, concerns about structural and actual bias might be troubling, but they do not stand alone. Although monitoring by institutional investors is weak, and problematic given our theory of the firm, it likely has some effects on the margins. Whatever one makes of institutional investor activism as a monitoring device, important accountability mechanisms continue to be supplied by the product market in which the firm operates and the internal and external job markets for the firm’s managers.[10] Corporate directors and managers do not get ahead by being associated with sub-par performance in the product markets. Indeed, as between shareholders and managers, it is the latter who have the greatest incentives to ensure the firm’s success. Shareholders can and should hold diversified portfolios, so that the failure of an individual firm will not greatly decrease their total wealth, while managers cannot diversify their firm-specific human capital (or their general human capital, for that matter). If the firm fails on their watch, it is the incumbent directors and managers who suffer the principal losses.
It is for this reason that the capital markets also have a disciplinary function. Incompetent or even unlucky management eventually shows up in the firm’s performance. These signs are identified by potential debt or equity investors, who (if they are willing to invest at all) will demand a higher rate of return to compensate them for the risks of continued suboptimal performance. In turn, this makes the firm more likely to flounder—taking the incumbent managers down with it.
Our point is not that the tender offer has no disciplinary effect, but merely that the tender offer is only one of many mechanisms by which management’s behavior is constrained. Once we view corporate governance as a system in which many forces constrain management behavior, the theory of the second best becomes relevant. In a complex, interdependent system, it holds that inefficiencies in one part of the system should be tolerated if “fixing” them would create even greater inefficiencies elsewhere in the system as a whole.[11]Even if we concede the claim that a no resistance rule would reduce agency costs, such a rule would still be inappropriate if it imposes costs in other parts of the corporate governance system. By restricting the board’s authority with respect to tender offers, the various academic proposals impose just such costs by also restricting the board’s authority with respect to the everyday decisions upon which shareholder wealth principally depends. Accordingly, it is not surprising that Delaware has rejected the academic approach to the unsolicited tender offer. This half of Delaware’s takeover jurisprudence, like that regulating negotiated acquisitions, is best explained as implicitly concluding that the benefits of preserving authority outweighs the costs of doing so.
Reminder: If you want much more detail, be sure to check out my article Unocal at 20: Director Primacy in Corporate Takeovers, 31 DEL. J. CORP. L. 769 (2006), on which the posts have drawn.
[1] Stephen M. Bainbridge, Unocal at 20: Director Primacy in Corporate Takeovers, 31 Del. J. Corp. L. 769 (2006).
[2] E.g., Dynamics Corp. of Am. v. CTS Corp., 794 F.2d 255, 256 (7th Cir. 1986), rev’d on other grounds, 481 U.S. 69 (1987); Norlin Corp. v. Rooney Pace, Inc., 744 F.2d 255, 266 n.12 (2d Cir. 1981); Panter v. Marshall Field & Co., 646 F.2d 271, 300 (7th Cir.) (Cudahy, J., dissenting), cert. denied, 454 U.S. 1092 (1981). Professor Michael Dooley notes that management resistance to unsolicited tender offers may not deserve the opprobrium to which it is usually subjected. Dooley acknowledges that it seems inappropriate even to raise this question, because it suggests tolerance for a clear managerial conflict of interest. As suggested by our discussion of the motives driving corporate acquisitions, however, it would be naive to assume that takeovers displace only “bad” or “inefficient” managers. While blamelessness does not eliminate the managers’ conflict of interest, it does suggest that resistance may not deserve the opprobrium usually attached to self-dealing transactions. Indeed, Dooley observes, it may often be shareholders rather than managers who act opportunistically in the takeover context. 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. 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. See Michael P. Dooley, Fundamentals of Corporation Law 561-63 (1995).
[3] Moran v. Household Int’l, Inc., 500 A.2d 1346, 1356 (Del. 1985); Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985).
[4] See Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 518-19 (1992); see also William T. Allen, Independent Directors in MBO Transactions: Are They Fact or Fantasy?, 45 Bus. Law. 2055, 2060 (1990).
[5] Jeffrey Davis & Kenneth Lehn, Information Asymmetries, Rule 13e-3, and Premiums in Going-Private Transactions, 70 Wash. U.L.Q. 587, 595-96 (1992).
[6] See, e.g., In re RJR Nabisco, Inc. Shareholders Litigation, [1988-89 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 94,194 (Del. Ch. 1989); Freedman v. Restaurant Assoc. Indus., Inc., [1987-88 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 93,502 (Del. Ch. 1987).
[7] Frank H. Easterbrook & Daniel R. Fischel, The Proper Role of a Target’s Management in Responding to a Tender Offer, 94 Harv. L. Rev. 1161 (1981). Some commentators who generally accept the this account nonetheless have rejected the no resistance rule. These critics concede that the rule maximizes search incentives, but question the amount of search activity that is socially desirable. In particular, they assert, the benefits of increased search must be compared with the costs imposed on target companies if shareholders are coerced into selling at a price that they do not perceive to be higher than the value of the target to them. See, e.g., Lucian A. Bebchuk, The Case for Facilitating Competing Tender Offers: A Reply and Extension, 35 Stan. L. Rev. 23, 33-38 (1982). Alternatively, they posit that the benefits of permitting corporate control auctions can outweigh the costs of doing so. E.g., Jonathan R. Macey, Auction Theory, MBOs and Property Rights in Corporate Assets, 25 Wake Forest L. Rev. 85 (1990). We need not resolve this dispute within the ranks, because we believe that both sides have missed the central point by focusing solely on accountability concerns and ignoring the equally important role of authority values.
[8] Lucian Arye Bebchuk, The Sole Owner Standard for Takeover Policy, 17 J. Leg. Stud. 197, 200 (1988). As Bebchuk notes, the taking implications of the no resistance rule are inconsistent with the passivity model’s chief proponents’ strong preference in other contexts for property rights and freedom of contract. Id. at 200-03. See generally Michael P. Dooley, Fundamentals of Corporation Law 552 (1995) (discussing Bebchuk’s analysis).
[9] Useful summaries of the empirical literature include Bernard S. Black, Bidder Overpayment in Takeovers, 41 Stan. L. Rev. 597 (1989); Roberta Romano, A Guide to Takeovers: Theory, Evidence, and Regulation, 9 Yale J. Reg. 119 (1992). Among the more intriguing, albeit controversial, aspects of the empirical puzzle are the findings of industrial organization economists that takeovers and mergers generally do not result in increased revenues, market share, profitability, or cost efficiency on the target’s part. See, e.g., David J. Ravenscraft & F.M. Scherer, Mergers and Managerial Performance, in Knights, Raiders, and Targets: The Impact of the Hostile Takeover (John C. Coffee et al. eds., 1988). But see Paul M. Healy et al., Does Corporate Performance Improve after Mergers?, 31 J. Fin. Econ. 135 (1992) (answering their titular question affirmatively and criticizing Ravenscraft and Scherer’s work).
[10] See Barry D. Baysinger & Henry N. Butler, Antitakeover Amendments, Managerial Entrenchment, and the Contractual Theory of the Corporation, 71 Va. L. Rev. 1257, 1272 (1985).
[11] See Michael P. Dooley, Two Models of Corporate Governance, 47 Bus. Law. 461, 525 (1992).
