Pills and partisans: understanding takeover defenses.

AuthorBarry, Jordan M.

Corporate takeover defenses have long been a focal point of academic and popular attention. However, no consensus exists on such fundamental questions as why different corporations adopt varying levels of defenses and whether defenses benefit or harm target corporations' shareholders or society generally. Much of the disagreement surrounding takeover defenses stems from the lack of a fully developed formal analytical framework for considering their effects. Our Article presents several formal models built upon a common core of assumptions that together create such a theoretical framework. These models incorporate the reality that target corporate insiders have superior information about the target but are imperfect agents of its shareholders. They suggest that modern defenses enable target shareholders to extract value from acquirers by empowering corporate insiders, but that takeover defenses do not benefit society as a whole. They also help explain why corporations with different characteristics may choose to adopt varying levels of takeover defenses. Our findings have implications for the longstanding debate about who is best served by state-level control of corporate law and the desirability of increased federal involvement in corporate law.

INTRODUCTION I. BACKGROUND A. Conceptual Framework of the Public Firm B. Poison Pills C. Effective Staggered Boards D. Takeover Defenses in the Academic Literature II. THE MODELS A. Common Framework: Players and Incentives B. The No Poison Pill Model C. The Poison Pill with an Effective Staggered Board Model D. The Poison Pill Without an Effective Staggered Board Model E. The Integrated Model 1. Shareholder Primacy Approach 2. Managerialist Approach 3. Social Welfare Analysis III. FURTHER PREDICTIONS AND EXPANSIONS A. Predictions and Implications 1. State Competition for Charters and Federalization of Corporate Law 2. Variation in Corporate Takeover Defense Levels 3. Post-Takeover Attempt Performance 4. Optimal Level of Private Benefits B. Relaxing Simplifying Assumptions 1. Parameter Independence 2. Invariable and Observable Parameters 3. Uniform Distribution 4. Zero Transaction Costs 5. Shareholder Uniformity CONCLUSION APPENDIX A. The Models 1. The No Poison Pill Model 2. The Poison Pill with an Effective Staggered Board Model 3. The Poison Pill Without an Effective Staggered Board Model B. Optimal Level of Takeover Defenses INTRODUCTION

Corporate takeovers have occupied a prominent position in the popular imagination, the financial press, and corporate law scholarship for a generation. (1) Yet despite all the thought and ink that have been devoted to analyzing takeovers, many questions remain unsettled. There is no consensus on the systemic effects of takeover defenses in general, or of the most important defense mechanism--the shareholder rights plan or "poison pill"--in particular. Scholars disagree on why different public firms exhibit varying levels of takeover defenses, what causes these levels to change over time, and whether the interests of shareholders or managers determine the level of takeover defenses that a firm adopts. These unresolved questions have fueled the debate about whether regulatory competition encourages states to enact socially optimal corporate laws, as well as the related issue of what role, if any, the federal government should play in corporate law.

Much of the disagreement surrounding takeover defenses stems from the lack of a fully developed formal analytical framework for considering their effects. Although a significant number of legal and economic academic papers have discussed takeover defenses from a theoretical perspective, (2) very few have included formal models. (3) Those that have proposed formal models have only focused on certain facets of the takeover market, which has limited those models' applicability. (4)

Empirical investigations into the effects of takeover defenses on firm performance have failed to resolve these debates. Given the lack of theoretical guidance, it is not surprising that these investigations have yielded little insight. (5) Nonetheless, the sheer magnitude of variation in the empirical findings is shocking. As one commentator has stated,

[S]tudies of [takeover defenses] have been remarkably unproductive over the past twenty years. Not a single strong finding has been confirmed in other studies. Little or no consensus exists on why [takeover defenses] are adopted or what effects they have. Given that as much academic energy has been poured into studying [takeover defenses] as into almost any other area of applied financial economics, the dearth of results is astonishing, and itself in need of explanation. (6) This Article attempts to fill this gap in the dialogue by presenting several formal models, built upon a common core of assumptions. Taken together, these models create a theoretical framework for analyzing the effects of different levels of takeover defenses. They are the first models of modern takeover defenses to incorporate the widely accepted propositions that a target corporation's managers and directors have the best information about the target and are unfaithful agents of its shareholders.

These models yield many novel and important insights. They suggest that poison pills enable target shareholders to extract value from acquirers by empowering corporate insiders. Even though these insiders are unfaithful agents of the shareholders, their superior information and higher reservation price can ultimately redound to the shareholders' benefit.

Our models also provide an explanation for the diverse levels of takeover defenses that different public corporations exhibit. They predict that the level of takeover defenses preferred by both shareholders and managers will vary depending upon several firm-specific characteristics. These characteristics include the degree of uncertainty about the value of the firm as a going concern, the potential synergy gains that the firm offers potential acquirers, and the degree to which the firm's managers are faithful agents of the shareholders. Corporations for which an acquirer is likely to pay the highest premiums are likely to elect higher levels of takeover defenses.

Unlike previous theories, our models predict that shareholders will never choose the lowest possible level of takeover defenses and that managers will not always choose the highest possible level. Therefore, the diversity of defense levels that corporations adopt poses no challenge to theories that shareholders control choices of defense levels or to theories that managers control such choices. Further, the models suggest that, with respect to takeover defenses, the interests of both shareholders and managers diverge from those of society. This highlights the fact that, even if regulatory competition creates a "race to the top," it is a race with respect to shareholder interests and not with respect to those of society. These findings have significant implications for the optimal scope of federal involvement in corporate law. Our models also provide several testable hypotheses to guide future empirical work.

This Article begins with a short overview of the conceptual framework of the public firm and modern takeover defenses. Part II then presents and analyzes several formal game theoretic models, using repeated illustrative numerical examples. Part III discusses some additional implications of these models, compares their predictions to what the existing body of empirical literature has documented, and suggests further empirical work that could be done to test these models. We also include a mathematical appendix for more technically inclined readers.

  1. BACKGROUND

    Before presenting formal models, it is worth providing some background on how scholars conceptualize the modern public corporation, as well as how the poison pill and the staggered board work in practice.

    1. Conceptual Framework of the Public Firm

      The chief lens through which corporate law views the corporation envisions shareholders as principals and corporate managers as their agents. (7) Like most real-world agents, managers are not perfectly faithful to their principals. Their incentives are likely to diverge from those of the shareholders (8) and, when this happens, managers may be expected to pursue their own interests at the shareholders' expense. (9) These phenomena are known as "agency costs." (10)

      A variety of market and legal mechanisms help discipline managers and reduce agency costs. The capital, product, and labor markets all impose constraints on managers. (11) Much of the law that governs the structure of business associations is geared toward this concern. (12) For example, corporate law imposes a duty of loyalty on corporate managers that prohibits them from self-dealing to the detriment of the shareholders. (13)

      One of corporate law's most important mechanisms for reducing agency costs is the board of directors. (14) The corporation's shareholders elect its directors, who are legally obligated to monitor the managers and protect the shareholders' interests. (15) The law gives directors vast power over the corporation, including the power to hire and fire the corporation's chief executive officer (16)

      Yet despite the board's great power, it is an imperfect monitoring device. The board frequently includes members of management, or "inside directors," and the CEO often serves as its chairman. (17) Nonmanager directors, also called "outside directors" or "independent directors," may be dependent on the managers for information about the company's operations. (18) In addition, the board is a body composed of agents, and is itself susceptible to agency costs.

      Another important mechanism for constraining the behavior of corporate managers is the threat of a corporate takeover. If a potential acquirer--be it a competitor, investment fund, or otherwise--determines that a public corporation is being...

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