Corporate constitutionalism: antitakeover charter provisions as precommitment.

• Author: Kahan, Marcel
• Position: Symposium: Corporate Control Transactions

Constitutions constitute a polity and create and entrench power: A corporate constitution--the governance choices incorporated in state law and the certificate of incorporation--resembles a political constitution. Delaware law allows parties to create corporations, to endow them with perpetual life, to assign rights and duties to "citizens" (directors and shareholders), to adopt a great variety of governance structures, and to entrench those choices. In this Article, we argue that the decision to endow directors with significant power over whether and how to sell the company is a constitutional choice of governance structure. We then argue that it is, on theoretical and empirical grounds, a perfectly intelligible choice: shareholders "reasonably might opt for board entrenchment--implemented, for example, by means of a staggered board--in order to enable a board to employ selling strategies more effectively and, thus, to increase the premium shareholders receive when the company is sold. Such a decision is a kind of precommitment whereby shareholders, by binding themselves ex ante, may be able to improve their collective position ex post.

After examining how shareholders can entrench particular governance structures under Delaware law, we examine two issues that arise once shareholders have chosen to entrench a governance structure: the question of incomplete implementation that arises in cases such as Blasius and Liquid Audio; and the questions of when and whether changed circumstances justify ex post judicial negation of shareholders' prior commitments.

INTRODUCTION

Companies, like many other complex assets, are almost always sold by negotiation. The hostile tender offer, so beloved by corporate law scholars, has never been a major mode for control transactions. This Article focuses on three interrelated issues: why rational shareholders, aware of the full range of agency costs, might commit to have their company sold through a negotiated process controlled by the board; how they implement this preference; and how courts or legislatures should deal with claims that commitments either have not been properly implemented or have backfired and should be set aside. As such, this is an article about "corporate constitutionalism," about the governance commitments made by shareholders, and about how Delaware deals with these commitments in a dynamic world.

A scene from the real world may help frame our argument. In 1991, when its stock was trading at around $20 per share, Neutrogena, the niche soap maker, put itself up for sale. (1) Dissatisfied with the interest in the company, CEO and controlling shareholder Lloyd Cotsen took Neutrogena off the market and continued to pursue its expansion strategy. (2) Three years later, when Neutrogena was again put on the market, Johnson & Johnson bought it for $35.25 per share. (3) Wrote the New York Times, "Though the price of $35.25 a share, more than three times 1993 sales, is high, analysts said Neutrogena's strong brands and its untapped overseas potential were worth the price." (4)

The Neutrogena case is hardly unique. A board may seek the sale of a company, find market conditions are not right, pull back, and then two or more years later, go to market again and get a "blow away" price. This can be because economic conditions or industry conditions have improved, because the business has done better, or because buyers have just decided the acquisition is "strategic." Often it is not generally known that the company has been up for sale previously.

What one does hear about, however, are cases in which a hostile bidder approaches the company and the board refuses to sell because, it says, conditions are not right. These events have generated, and continue to generate, substantial controversy. Most of the commentary on hostile takeovers falls in one of two broad schools of thought.

The Hamiltonian "board veto" school holds that shareholders are not well-equipped to make the decisions involved in the sale of the company and should thus leave these decisions to the board. Believing both in the correctness of their views and in the inability of shareholders to grasp that correctness, board veto proponents are quick to call for legal intervention when shareholders are unwilling on their own to grant to the board the powers demanded. (5)

The Jacksonian "shareholder choice" school holds that boards are self-interested in responding to hostile bids and that shareholders should independently determine whether to accept or reject an offer. But most shareholder choice advocates have no deeper commitment to shareholder autonomy than do board veto proponents. When shareholders consent to rules that enshrine board power, they call for legal intervention to set these rules aside. (6)

By contrast, we believe that shareholders should be taken seriously, not only when deciding on an actual bid, but also when setting up the rules as to who decides. (7) When shareholders entrench some power in the board (and when they do not)--through a shareholder vote or an investment decision when a company goes public--courts and legislators should presumptively respect that decision. As we argue, neither the theoretical arguments for shareholder choice and board veto nor the empirical evidence are strong enough to overcome that presumption on a wholesale basis. Companies should thus be free to set up their own regime. Moreover, companies may adopt some intermediate regime between shareholder choice and board veto--an opportunity that Delaware law affords and many companies exercise.

The remainder of this Article is organized as follows: in Part I, we identify two aspects of the decision to sell the company--determining its value, and devising and implementing a selling strategy. As we explain, the selling strategy is an integral element of a sales mechanism.

In Part II, we analyze different paradigms for the allocation of decision-making power when a public firm receives an acquisition offer. The classic debate has been dominated by Hamiltonian proponents of the board veto school and Jacksonian proponents of shareholder choice. We describe the tradeoffs between these two regimes and put forward and defend a third, Madisonian, option of corporate constitutionalism. Specifically, we argue that shareholders may rationally entrench board power because shareholders on their own cannot pursue an effective selling strategy. (8)

Part III examines how constitutional choices are implemented. In Delaware, companies have great flexibility in their constitutional choices: through proper charter or bylaw provisions they can entrench board structure and shareholder rights inter se and choose different degrees of entrenchment. For example, board power can be entrenched, in declining degrees, through differential voting rights, staggered boards, or barriers to shareholder removal of directors between annual meetings.

Part IV reviews the empirical evidence regarding these entrenchment modes to determine whether it points to the general superiority of a particular decision-making paradigm. We discuss the evidence regarding antitakeover provisions in initial public offerings (IPOs), the effect of staggered boards on hostile bids, the effect of poison pills on takeover premia, legislatively imposed staggered boards, and shareholder votes on staggered boards. We conclude that the empirical evidence does not support an imposition of shareholder choice or board veto as a mandatory governance structure.

Part V addresses two issues that arise once shareholders choose to entrench a governance structure. First, we examine the problem of incomplete implementation: when the board left a loophole in the governance structure and a bidder tries to take advantage of it, how should the courts view last-minute attempts to close the loophole? Second, we address the claim that changed circumstances--in particular, the judicial sanctioning of the poison pill--justify a legal bailout of shareholders from their choice to entrench the board through a staggered board. While we conclude that a wholesale judicial bailout is not warranted, we argue that there may be a plausible case for a narrowly targeted legislative bailout structured to minimize transaction costs and the loss of commitment value.

1. SELLING THE FIRM

   Buying and selling firms is a complicated undertaking, out of which investment bankers and other professionals make a good living. It is as much an art as a science, with experience providing much of the instruction. In this Part, we identify two aspects of the decision to sell a company: determining the value of the company as an independent entity; and devising and implementing a selling strategy. We place particular emphasis on the latter aspect, which we believe has not been properly emphasized in the takeover literature.

   In deciding whether to sell an asset, an owner must first consider the value of the asset if it is not sold and how much effort to expend in determining that value. The value of the asset if not sold forms a floor to the price the owner would be willing to accept for the asset under any circumstance--the reservation price.

   Second, the owner must consider its selling strategy. By selling strategy, we mean any action designed to increase the price for the asset beyond the reservation price. A selling strategy can, among other things, entail choosing the time to sell, soliciting offers from other bidders or threatening to do so, haggling over price, disclosing information to bidders, rejecting an offer, making "take-it-or-leave-it" counter-offers, or misrepresenting one's willingness to sell.

   From the owner's perspective, devising and implementing a good selling strategy is very important. While knowing the reservation price protects the owner against suffering losses from selling the asset, it is the selling strategy that determines how much the owner will profit from a sale. A well-designed selling...