Unregulable defenses and the perils of shareholder choice.

• Author: Arlen, Jennifer
• Position: Symposium: Corporate Control Transactions

A significant debate rages within corporate law scholarship as to whether shareholders or managers should be granted authority over the tender offer process once a bid is imminent. Both sides generally agree that the issue depends on whether shareholders are capable of exercising informed choice over takeover bids. Supporters of managerial veto power contend that the arguments favoring professional management of publicly held firms carry over into the tender offer context. Proponents of shareholder choice, on the other hand, argue that shareholders can act on their own behalf in the special circumstances surrounding contests for corporate control.

This Article challenges the premise that the case for shareholder choice turns principally on whether shareholders are capable of making informed choices. It argues that adopting a strong shareholder choice regime may be value reducing even if shareholders can effectively manage the firm post-bid. In particular, a shareholder choice rule would give managers an incentive to search for alternative defenses not practicably regulable by any legal regime--ones that may impose greater costs on the firm than existing defenses. We demonstrate (a) that a number of such unregulable, value-reducing defenses exist, (b) that managerial threats to use them are credible under plausible conditions, and (c) that their use would be difficult or impossible for courts to regulate. Furthermore, we find empirical support for these hypotheses. Consequently, we conclude that an immutable, one-size-fits-all shareholder choice rule is unlikely to improve shareholders' welfare.

INTRODUCTION I. THE DOMAIN OF SHAREHOLDER CHOICE A. Advantages of Managerial Control of Publicly Held Firms B. The Case for Shareholder Control over Tender Offers C. Taxonomy of Defensive Measures 1. Pre- Versus Post-Bid Defenses 2. Pure Versus Embedded Defenses D. The Importance of the Unexamined Fourth Quadrant 1. Unregulable Defenses 2. The Problem of Substitution II. AVAILABILITY OF PRE-BID EMBEDDED DEFENSES A. The Degree of Targeting B. Retaining Managerial Control over Tender Offers 1. Targeted Defenses Supported by Shareholder Approval 2. Targeted Defenses Not Requiring Shareholder Approval C. Impediments to All Changes of Control 1. Change of Control Provisions in Third-Party Agreements a. Termination clauses b. Penalty provisions 2. Change of Control Provisions Under Shareholder Choice D. Pre-Bid Measures Granting Managers Private Benefits III. THE INCENTIVE TO EMPLOY EMBEDDED DEFENSES A. The Costs and Benefits to Managers of Blanket Defenses B. Managers' Incentives Under Managerial Choice C. Managers' Incentives Under Shareholder Choice IV. FORMAL ANALYSIS A. Framework B. No Market for Corporate Control C. Market for Corporate Control 1. Managerial Choice Regime 2. Shareholder Choice Regime D. Incentive Pay Under Shareholder Choice E. Numerical Example V. INTERMEDIATE REGIMES A. Categorical Regulation of Defenses B. Strategic Uncertainty Regarding Managerial Authority VI. EMPIRICAL FIT A. Shareholder Attitudes Toward Managerial Choice B. Evidence on Defenses and Executive Compensation CONCLUSION INTRODUCTION

In the years since the takeover wave of the 1980s, managers of public corporations have developed increasingly successful strategies for deterring or defeating unwanted tender offers. Although courts initially viewed defensive strategies (such as poison pills, staggered boards, and dual class stock capitalization) with suspicion, over time they have embraced a significantly more deferential approach to antitakeover defenses. Indeed, under current law, managers of Delaware corporations (1) face few impediments when erecting defenses that deter unwanted acquisitions (2), provided that they are not selling control of the firm. (3) All the while, shareholders generally have not attempted to counter this jurisprudential trend by imposing ex ante limitations on managers' control over tender offers. (4)

Nevertheless, many corporate law scholars view the extant regime with a mixture of skepticism and alarm, arguing that it has exacerbated the agency cost problems endemic to publicly owned firms. Directors and officers, (5) they claim, systematically collaborate to employ antitakeover defenses that deter hostile acquisitions (which portend managerial turnover), while simultaneously encouraging friendly bids (which confer substantial private benefits on incumbents). (6)

Managerial freedom to adopt defenses thereby hurts nonmanagerial shareholders, both by removing the disciplinary effect of potential hostile offers and by enabling managers to appropriate private gains from acquisitions that rightfully belong to all shareholders. (7)

Accordingly, skeptics of managerial discretion argue that shareholders should have ultimate authority to choose among tender offers, on the grounds that, all things considered, shareholders' judgment in such contexts is ultimately more reliable than that of professional (but irremediably conflicted) managers. (8) Although the universe of "shareholder choice" proposals is relatively varied, all share at least a few common, prescriptive features: most notably, they propose that shareholders should have authority over managers' defensive actions when shareholders have sufficient incentives and capacity to choose between the managers' preferred action and the hostile bid. The most aggressive shareholder choice proposals assume that, post-bid, shareholders have sufficient incentives and capacity to evaluate any business decision affecting takeovers, and thus conclude that shareholders should be granted authority to overturn managers' takeover defenses when either a bid has already emerged or when the firm adopts a policy whose sole purpose is to grant managers control over hostile tender offers. (9)

At the same time, most serious shareholder choice proponents stop short of extending their argument to all decisions that are currently undertaken by managers. Rather, they accept the foundational precept (reflected in the "business judgment rule") that publicly held firms maximize value when managers control ordinary business decisions since shareholders have little incentive or ability to obtain the information necessary to make such routine, day-to-day decisions. (10)

Consequently, much of the debate over shareholder choice is thought to turn on whether, all things considered, shareholders can be expected to exercise informed choice within the specific nexus of activity related to tender offers. Underlying this fundamentally empirical question, however, is a deeper logical proposition: that the demonstrated decision-making capacity of shareholders is both a necessary and sufficient condition to establish the superiority of shareholder choice relative to the status quo of managerial control. (11)

This Article refutes that proposition. In particular, we show that even when shareholders can effectively assess and react to hostile bids, shareholder choice may not be the optimal legal policy. Indeed, allowing informed shareholders to exercise control over tender offers may, ironically, make shareholders worse off than they would be under the status quo, where self-interested managers effectively choose among takeover options.

Our argument hinges on recognizing that a shareholder choice regime may significantly affect how managers govern the firm ex ante. While shareholder choice limits the defenses available to managers, it does not reduce managers' desire to deter hostile bids. If anything, an effective shareholder choice regime enhances managerial incentives to deter acquisitions by suppressing hostile offers. (12) Consequently, under shareholder choice, managers have an incentive to search for effective defenses that are not plausibly susceptible to legal regulation of any stripe. (13) In the extreme, managers may be willing to employ value-reducing defenses that they would not utilize under a regime where they had substantially more control over which tender offers are allowed to go forward.

Under even the broadest shareholder choice proposal, managers would have available to them a wide range of unregulated and unregulable defenses. (14) Existing shareholder choice proposals do not regulate all possible defenses. They generally limit the domain of shareholder choice to managerial actions that are targeted at, or occur during, hostile tender offers; they do not seek to regulate all ordinary business transactions that might deter tender offers, given shareholders' accepted inability to regulate such transactions. Thus, a substantial zone of business action would likely remain unregulated, even by the strongest shareholder choice regime.

Managers precluded by shareholder choice from pursuing currently popular defenses can utilize this unregulated zone to deter acquisitions, "embedding" defenses within a host of seemingly ordinary, and otherwise legitimate, pre-bid business transactions. (15) Because these arrangements largely mimic transactions that are frequently value enhancing, they would almost certainly be beyond the purview of a shareholder choice regime, enabling managers to escape effective oversight of such defenses even when they reduce firm value.

A notable example of such an embedded defense is the inclusion of a "change of control" provision in an everyday business contract (such as a lease, joint venture, license, employment agreement or debt instrument) that imposes costs on the firm in the event of a change of control. (16) Many companies use these provisions at present to enhance firm value by reducing the costs of contracting with a third party, albeit at the cost of deterring some acquisitions. Under shareholder choice, however, managers could employ similar measures to deter acquisitions in situations where firm value is reduced. Such provisions are likely not regulable because shareholders and courts cannot reliably distinguish change of control provisions...