Corporate policy and the coherence of Delaware takeover law.

• Author: Kihlstrom, Richard E.
• Position: Symposium: Corporate Control Transactions

INTRODUCTION

Does the Delaware case law, which gives management considerable discretion to defeat a hostile tender offer, rest on unsupportable and inconsistent assumptions? (1) A number of leading corporate law scholars have made exactly that claim. For example, Ronald Gilson argues that the Delaware standard of management discretion is formalistic and incoherent, lacking an animating principle that explains why it protects shareholders' interests. (2) More recently, Bernard Black and Reinier Kraakman have proposed principles to explain Delaware corporation law based on what they call a "hidden value" model. (3) However, they quickly conclude that the Delaware takeover cases are inconsistent with their reading of the empirical evidence and with each other. In both critiques, the case law is characterized as contradictory with any "sensible allocation of power between managers and shareholders," allowing managers to entrench themselves. (4) Entrenchment occurs when managers maintain takeover defenses even when they believe that the hostile tender offer is in the best interest of shareholders. Critics of the Delaware approach favor an alternative standard, which provides for considerably more shareholder choice; essentially allowing shareholders rather than managers to decide the outcome of contests for control. (5) There have been fewer supporters of the Delaware court's position, with the earliest and most vocal being Martin Lipton. (6)

The landmark Delaware case that provided for management discretion in the context of a hostile tender offer is Paramount Communications, Inc. v. Time, Inc. (hereinafter "Time-Warner"). (7) In that case, the Delaware Supreme Court permitted Time to complete a strategic merger with Warner despite an all-cash bid by Paramount to buy Time at a substantial premium to the market price. In addition, the supreme court used Time-Warner to jettison an emerging chancery court doctrine that limited management's ability to maintain takeover defenses, specifically a poison pill, to a period only long enough to develop an alternative transaction. (8) The Time-Warner decision was interpreted as fortifying the power of a board to 'just say no" to an uninvited tender offer, thereby tilting the balance strongly toward management discretion and away from shareholder choice. (9) The bidder could still succeed, but only by either mounting a proxy contest for board seats or encouraging financial market pressure to force target management to accept the bid.

Now fourteen years after the Delaware Supreme Court's pivotal decision in Time-Warner, few have offered a model that can explain the logic of the case to justify the court's preferences for management discretion over shareholder choice in deciding the outcome of contested control transactions. (10)

In this Article we provide what we believe to be the first formal model to explain Delaware corporate case law with respect to takeover defenses. (11) The goal is thus to develop the animating principles under which management discretion is arguably the appropriate standard for takeover defenses, with the corollary that Time-Warner was correctly decided. (12) As we will show, the key to the court embracing management discretion in Time-Warner was the development of a threat to the corporate policy as a cognizable threat under Unocal's standard of review. (13) In most of the cases preceding Time-Warner, the threats that satisfied the first prong of Unocal were threats to shareholders in the form of coercion or some inchoate reference to inadequate value. Time-Warner recognized a threat to corporate policy that is separable from a threat to shareholders. (14)

Using a threat to corporate policy to satisfy the first prong in Unocal's two-part analysis significantly changed the analysis of the second prong. What degree of management discretion is "reasonable" under the second prong depends on the nature of the threat under the first prong. (15) Between the Delaware Supreme Court decisions in Revlon and Time-Warner, target boards frequently responded to hostile tender offers by proposing a financial restructuring of the corporation, while using takeover defenses to effectively force acceptance of their proposed restructuring. (16) We argue below that such action is an unreasonable response when the threat posed is inadequate value of a financial restructuring. In that case, shareholders are well informed and well suited to determine the value of alternative financial restructuring plans so that using takeover defenses unduly thwarts an informed choice by shareholders. This changes, however, when the target board responds by continuing to pursue an existing informed corporate policy while using takeover defenses to support that action. In this case, managers are arguably well informed and shareholders are not, so that it is reasonable to allow greater management discretion in choosing a response to a threat posed to corporate policy.

For a satisfactory explanation of the case law, we provide a theoretical framework in which corporate policy is explicitly modeled in the context of occasional financial market mispricing. Our focus on corporate policy is a break with the previous debate on takeover defense law. That debate has largely ignored corporate policy, treating it as an academic black box, and it has insisted on the complete efficiency of financial markets. These are fundamental mistakes that we propose to correct. We also focus primarily on the effect that legal rules have on the corporate policy decisions made prior to the emergence of a hostile bid but in anticipation of the possibility that one might arise. The focus is not new since the traditional defense of greater shareholder choice is that a competitive market for corporate control disciplines managers in a way that reduces agency costs. While recognizing the discipline of the market for corporate control, our model introduces a distinct incentive effect on managers that works in the opposite direction.

This then is the critical insight of the corporate policy model in the context of occasional market mispricing: managers who wish to extend their job tenure can best achieve this goal by managing to the market's implicit assessments. By so doing, the managers can best maximize the stock price in each period and minimize the possibility of market underpricing that would make the managers vulnerable to a hostile offer. In effect, managers in each period forego unpopular investment opportunities in favor of popular ones, as assessed by the market rather than by their own assessment of the discounted cash flows that the investments will generate. If, as seems plausible, managers have better information than the market about specific investment opportunities, managing to the market fails to maximize the value of the corporation over time.

Corporate policy becomes a decisive variable when there are limits to the efficiency of financial markets. Limits to market efficiency are commonly assumed in the finance literature and it is uncontroversial even for those who believe that financial markets are generally efficient. (17) It does, however, imply a failure of strong form market efficiency. Essentially, there are times when managers have better information than the market as to the corporation's value (that is, the pro rata value of the discounted free cash flows generated by a company's existing assets and investment opportunities). As we interpret the assumption, the market knows what the managers might know and with what probability. The managers use their information to determine corporate policy and their valuation of the firm reflects their privileged information. Because the market simply uses its expectations to value the firm, managers sometimes value the firm more highly than the market and sometimes the market's valuation is higher.

The problem for corporate law arises in a world where there are agency costs resulting from managers' interest in retaining their position. Because of these costs, there is no credible way for the managers to reveal that their valuation is high when it truly is. Similarly, it follows that when the managers have a low valuation they not only have no incentive to reveal that fact, but they also may claim a high valuation because there is no way the market can determine that they have misrepresented their position.

We model corporate policy as the investment or capital expenditure (CAPX) decision that managers adopt in a given period. When the managers are better informed than the market as to the value of alternative investment opportunities, they face a choice: make decisions that rely on their own information as to the future value of investment opportunities or make decisions that rely on the market's implied value of investment opportunities. When managers rely on their superior information to set corporate policy they make value-enhancing investment decisions. We refer to this as the "value-creating" corporate policy. We show that in a shareholder choice regime, managers may feel pressured to manage to the market's information, thereby foregoing value-creating investment opportunities.

However, providing managers with the freedom to ignore financial market valuations when setting corporate policy raises the potential that managers may use that discretion to act in their own interest rather than in the interests of the corporation. This problem was recognized by the Delaware Supreme Court in Unocal when it noted the omnipresent threat of management entrenchment. (18)

Despite agency cost problems with management discretion, we argue that a legal rule favoring shareholder choice raises its own, heretofore unappreciated, agency costs and this arguably exacerbates, rather than reduces, total agency costs. (19) In our model, managers impose agency costs when they choose to manage to the market even though they credibly believe that their own...