Inefficient results in the market for corporate control: highest bidders, highest-value users, and socially optimal owners.

• Author: Miller, Robert T.

1. INTRODUCTION II. THE CONCERN FOR EFFICIENCY IN THE MARKET FOR CORPORATE CONTROL A. Hostile Tender Offers and Anti-takeover Devices B. Negotiated Acquisitions and Deal Protection Devices III. PRICE DISTORTIONS ARISING FROM NEGATIVE PECUNIARY EXTERNALITIES AND POSITIVE REAL EXTERNALITIES IN THE MARKET FOR CORPORATE CONTROL A. Highest Bidders, Highest-Value Users, and Socially Optimal Owners B. Negative Pecuniary Externalities Impounded into the Bids of Strategic Acquirers C. Positive Real Externalities Not Impounded into Bids of Strategic Acquirers D. Highest Bidders, Highest-Value Users, and Socially Optimal Owners Redux E. Frequency and Magnitude of the Price Distortions F. A Possible Real-World Example: The Acquisition of 3Par by Hewlett Packard G. How the Market for Corporate Control Differs from Most Other Markets IV. IMPLICATIONS OF THE PRICE DISTORTIONS IN THE MARKET FOR CORPORATE CONTROL A. New Explanation for the Winner's Curse B. The Inapplicability of Auction Theory to the Market for Corporate Control C. The Limited Relevance of Distortions Arising from Anti-takeover and Deal Protection Devices V. THE POSSIBILITY OF A POLICY RESPONSE A. Regulation Under the Federal Securities Laws B. Regulation Under Delaware Corporate Law C. The Possibility of Direct Regulation VI. CONCLUDING OBSERVATIONS I. INTRODUCTION

   For more than thirty years, the leading legal and economic scholarship concerning the market for corporate control has been guided by the principle that outcomes in that market should be efficient and thus that legal rules governing that market should facilitate efficient results. (1) In keeping with the standard assumption that allocating resources to their highest-value user will maximize social welfare and produce an efficient result, the virtually universal assumption in the legal and economic scholarship on the market for corporate control has been that whichever bidder is willing to pay the highest price to acquire the target company should be permitted to do so. When the highest bidder acquires the target, not only is wealth maximized for the target shareholders but, it has been assumed, ownership of the target is also transferred to its highest-value user, and this produces the efficient (that is, socially optimal) result. (2) This is a perfectly commonplace invisible-hand argument: by doing what is best for themselves by selling for the highest price available, the shareholders of the target also do what is best for society as a whole.

   This theme has dominated the literature on both hostile takeovers (3) and negotiated acquisitions. (4) With respect to hostile takeovers, the argument has generally been that, by allowing incumbent management to prevent willing shareholders from selling their shares to willing buyers, anti-takeover devices like poison pills and staggered boards reduce shareholder value, keep control of the target company from shifting to its highest-value user, and so reduce social welfare. (5) With respect to negotiated acquisitions, the scholarship has focused on the efficiency of deal protection devices like cash termination fees and voting agreements, with some scholars arguing that such devices promote shareholder value, the allocation of targets to their highest-value users, and the maximization of social welfare, and others arguing that they have just the opposite effects. (6) To be sure, some scholars have argued that mergers and acquisitions impose costs on third parties such as employees, creditors, suppliers, and the communities in which acquired companies operate and that these costs have to be taken into account in determining whether a corporate control transaction is efficient, but most scholars have concluded that these costs, no matter how important they may be in human terms, are relatively small compared to the gains captured by target shareholders and acquirers and so do not make otherwise efficient transactions inefficient. (7) Whether treating hostile takeovers or negotiated acquisitions, therefore, the consistent assumption has been that selling the target to the highest bidder will maximize not only shareholder value but social welfare, for, it has been assumed, the highest bidder for the target will be its highest-value user and its socially optimal owner.

   This Article demonstrates that this assumption can break down when there are two or more potential strategic buyers for the target, that is, in the large majority of corporate control transactions. In particular, this Article shows that, because of interactions between the market for corporate control and the product markets in which strategic bidders for the target compete against each other, the highest bidder for the target, even after a free and unfettered bidding contest, will not necessarily be the highest-value user of the target, and neither the highest bidder nor the highest-value user will necessarily be the socially optimal owner of the target. Thus, allocating the target to the highest bidder (or even to the highest-value user) may produce inefficient results. Put another way, transactions that maximize value for the target shareholders may fail to maximize social welfare and so may produce inefficient outcomes.

   The argument begins from the observation that, when there are multiple potential strategic acquirers of the target company, such parties are willing to buy the target because ownership of the target's assets will confer on them a competitive advantage in their product markets. (8) For example, the acquirer may expect to use the target's assets to lower its own costs of production, to expand its market share, to open new markets, or to improve the quality of its products. The benefit such a bidder receives from owning the target's assets and thus the value the bidder places on the target itself is the present value of the incremental future profits that the bidder expects to earn if it acquires the target, taking account of synergies and similar benefits. (9) Because the businesses of different strategic acquirers are not identical, different strategic buyers will expect to profit in different ways if they can combine their business with the target business, and so different strategic acquirers will generally value the target business differently. The bidder that expects to realize the greatest present value of incremental future profits is the highest-value user of the target--that is, the party that would realize the greatest private benefit from owning the target relative to the status quo. (10)

   Now, strategic bidders competing to acquire the target often also compete against each other in their product markets, and so when one strategic bidder acquires the target, other strategic bidders will generally incur significant costs because the winning bidder can exploit the competitive advantage that ownership of the target confers in ways that will reduce the future profits of losing bidders. For example, ownership of the target's assets may allow the winning bidder to improve the quality of its products without increasing its marginal costs, and this would allow the winning bidder to increase its market share at the expense of the losing bidders, thus reducing their revenues and earnings. or again, ownership of the target's assets may allow the winning bidder to make its operations more efficient, which would reduce its marginal costs and allow it to lower its prices in the product market; this may force its competitors to lower their prices as well, thus compressing their operating margins and reducing their profits. in such ways, transactions in the market for corporate control tend to produce significant negative externalities for losing strategic bidders. These externalities are merely pecuniary, however, because they are necessarily balanced by benefits received by the winning bidder or by customers in the product market. They are thus irrelevant to an efficient allocation of the target. Nevertheless, because bidders seek to maximize their private wealth and not social welfare, they will pay dollar-for-dollar to avoid suffering such externalities. in fact, a bidder who expects to suffer a pecuniary externality by losing a bidding contest will increase its bid up to the sum of its valuation of the target plus the expected externality that it would suffer if a competitor acquires the target. That is, such a bidder will be willing to incur a loss by paying more for the target than the benefit it expects to receive from owning it. it will do this because the alternative is even worse-- suffering an even greater loss if a competitor in its product market acquires the target. The highest bidder for the target will thus be not the party with the greatest valuation of the target but rather the party for whom the sum of its valuation of the target plus the pecuniary externality that it expects to suffer from losing the bidding contest is greatest. Consequently, even after a free and unfettered bidding contest, allocating the target to the highest bidder will not necessarily allocate the target to its highest-value user.

   Furthermore, allocating a target to either the highest bidder or the highest-value user may produce an inefficient result, for it can happen that neither of these parties is the socially optimal owner of the target, that is, the party whose ownership of the target produces the greatest net benefit to society. For, when the successful bidder uses the target's assets in its business, it generally creates benefits for customers in its product markets by, for example, reducing prices or improving the quality of the goods that they purchase from it. Thus, transactions in the market for corporate control generally produce significant positive externalities. These are generally real benefits, not merely pecuniary ones, so they ought to be taken into account in determining the efficient allocation of the target. of course, since different strategic bidders...