Do antitakeover defenses decrease shareholder wealth? The ex post/ex ante valuation problem.

• Author: Stout, Lynn A.

INTRODUCTION

Consider the following scenario. The directors of company A learn that company B is about to make a tender offer for 100% of A's shares. The offer is for cash, at a price that represents a fifty percent premium over the price at which A's shares have been trading in the market. In response, A's directors adopt an antitakeover defense commonly known as a "poison pill." Because the pill can only be disarmed by the vote of a majority of A's directors, B must win control of A's board before it can proceed with its hostile offer. This is made far more difficult by the fact that A's corporate charter includes a second antitakeover device, a "staggered board" clause that allows directors to serve three-year terms and provides that only a third face reelection in any single year. To win control, B accordingly must win not one but two proxy contests, spaced a year apart.

Faced with A's antitakeover provisions and its board's resistance, B decides to withdraw its tender offer. B's plans to acquire A evaporate--and with them, the A shareholders' opportunity to sell at a premium.

Commentators often cite this sort of scenario as evidence that antitakeover defenses (ATDs) that impede hostile bids reduce the wealth of target shareholders. (1) Indeed, the notion that ATDs destroy shareholder wealth has inspired an entire genre of legal scholarship attacking various types of ATDs found in modern corporate by-laws, charters, and statutes. (2) A characteristic example can be found in a recent study by Professors Lucian Bebchuk, John Coates, and Guhan Subramanian. (3) Analyzing a five-year sample of hostile takeover bids, the authors conclude that ATDs of the sort adopted by company A (a staggered board combined with a poison pill) make hostile deals significantly less likely to succeed, and reduce the average returns of target shareholders in the nine months following a hostile bid by eight to ten percent when compared to the returns to shareholders in target firms that lack these ATDs. (4) From this, the authors conclude that the combination of a poison pill and a staggered board has a "negative wealth effect," and that Delaware corporate law ought to be changed to preclude target managers from using such an ATD mix. (5)

Yet did the shareholders of target company A really lose money as a result of the firm's ATDs? Although on first inspection the answer to this query seems rather obviously to be yes--if ATDs had not allowed A's board to defeat B's takeover attempt, A's shareholders could have sold their shares at a substantial premium--this Response argues that the relationship between ATDs and shareholder wealth is more complex. In particular, the notion that discouraging premium bids necessarily reduces target shareholder wealth relies entirely on ex post analysis. In other words, it considers only how ATDs affect target shareholders after an offer is made. But this is not the only time at which one can, or should, consider the influence of ATDs on shareholder wealth. To the contrary, it may be impossible to fully understand the purpose or effects of antitakeover rules without also examining them from an ex ante perspective.

This Response offers such an ex ante analysis. It considers not only how ATDs influence shareholder returns when a hostile bid is made, but also how they influence shareholder returns well before then--indeed, how they influence returns from the moment they are put into place, as early as when the corporation is first created. Viewed from an ex ante perspective, there is both substantial theoretical reason and substantial empirical evidence to believe that in many cases ATDs do not reduce target shareholders' wealth, but increase it. What's more, ATDs accomplish this by doing exactly what critics condemn them for doing--making takeovers less likely.

1. SOME THEORETICAL EX ANTE BENEFITS OF ATDS

   To understand how target firm shareholders can benefit from ATDs, we must begin by considering what it takes to build a successful public corporation. Shareholders alone cannot make a company. Other groups--including most obviously executives and other employees--also make essential contributions. Modern corporate production accordingly is a form of team production. Just as it takes two people to move a large sofa, with both parties' efforts indispensable to the job, it takes inputs and efforts from financial investors (including shareholders and creditors) and human capital investors (including executives and rank-and-file employees) to build a successful firm. (6)

   Why do nonshareholder groups contribute to corporate production? Part of the reason can be found in the explicit contracts these groups enter into with firms. For example, executives and other employees work in part because they are entitled to some contractually defined mix of wages, deferred compensation, and perquisites.

   Many firms, however, also rely on "implicit" contracts--informal and legally unenforceable understandings. For example, employees often believe that if they stay with the firm, perform well, and the firm prospers, they will receive in the future not just the benefits they are entitled to under their explicit employment contracts (when these exist) but also raises, promotions, and some job security. What's more, firms often encourage such beliefs. By signaling to their hires that if they remain loyal and do a good job they will receive discretionary future rewards beyond those mandated by the firm's explicit contracts, firms can inspire employees from the shop floor to the executive suite to work harder and to invest more in firm-specific human capital--knowledge, skills, and relationships that are valuable to the firm, but worthless to any other potential employer. Implicit contracts thus serve both sides to the deal.

   As common as these understandings are in the business world, they rarely appear as formal contracts that can be enforced in a court. The reason lies in the contracting problems that are endemic to team production under conditions of uncertainty. (7) It is impossible, for example, to anticipate in advance every contingency that might affect team members (if a competitor fails and the firm as a result enjoys an increase in revenues, should the employees get a raise or should the shareholders get a dividend?), or to prove in a court of law that a team member has failed to perform according to the terms of the implicit bargain (did the CEO truly devote her best efforts to the firm?).

   The observation that implicit contracts are not enforced in courts naturally raises the question of where they are enforced. Enforceability matters, because otherwise team members might try to opportunistically renege on their implicit commitment by shirking or expropriating wealth from the team. One alternative might be to leave enforcement of implicit contracts up not to judges, but to another, more informed referee--the corporation's board of directors.

   I have explored this idea in detail in other writings with Margaret Blair, in which we suggest that public corporations raise team production problems that cannot be resolved satisfactorily through explicit contracting or other common solutions. (8) We argue that as an alternative, participants in public firms-including most obviously shareholders, creditors, executives, and rank-and-file employees--address their contracting problems and mutual vulnerability by giving up control over the firm's assets and earnings to a board of directors. (9) The board in turn is charged with running the firm in a fashion that not only increases the wealth of the firm's shareholders, but also provides extracontractual benefits to other corporate participants. (10)

   This description of the board's role as a "mediating hierarch" is consistent with the way modern corporate law actually works. Although a number of commentators have argued over the years that directors ought to consider only shareholders' interests in running the firm, (11) as an empirical matter modern corporate law grants boards of public firms tremendous freedom to use their control over the firm to benefit nonshareholder constituencies, often at the shareholders' apparent expense. (12) Indeed, ATDs themselves evidence this pattern.

   Granting directors such freedom can impose costs on shareholders ex post, because shareholders who cede control of the firm to a board inevitably run the risk the board will use that authority to serve other corporate participants' interests. This may be especially likely when board members develop personal ties of empathy and loyalty to the firm's executives and employees. Nevertheless, shareholders can benefit from "tying their own hands" and giving up control over the firm in this fashion. They can benefit because, ex ante, they get something more valuable in return--the ability to recruit and retain talented managers and employees, and to inspire them to far greater effort and investment in the firm than any formal contract could. (13)

   This analysis does not imply that antitakeover defenses always create wealth for shareholders. As I discuss in detail later, there may be cases in which boards adopt ATDs that reduce shareholder wealth ex post without providing any offsetting ex ante benefit, or where ATDs that were once wealth-enhancing become inefficient and obsolete. (14) Team production analysis does imply, however, that ATDs can increase net shareholder wealth in some, and possibly many, situations.

2. THE PLAUSIBILITY OF EX ANTE BENEFITS

   As the previous Part observes, theoretical support exists for the proposition that corporate governance rules that grant directors discretion to favor nonshareholder groups--including but not limited to ATDs--can provide shareholders with ex ante benefits that outweigh their ex post costs. Indeed, while team production analysis offers many fresh insights into this notion, (15) the basic idea is neither novel nor particularly controversial. It...