Replacing hostile takeovers.

• Author: McGinty, Park

Introduction

The displacement of inefficient managers ranks among the chief problems of corporate law. Inefficient managers underutilize corporate assets, erode shareholder wealth, and reduce the share price of the corporation's common stock. In theory, shareholders' remedy for inefficient management is to elect new directors who will displace them and operate the corporation more efficiently, driving its stock price higher. In practice, however, managers' control over the proxy machinery and the shareholders' collective action problems make voting inefficient management out of office virtually impossible.

The fallback remedy has been the hostile takeover. In a hostile takeover, a bidder perceives that the target corporation's value under incumbent management is less than it could be in the bidder's hands. The bidder purchases a controlling block of the target corporation's stock at a substantial premium above the then market price, installs its own board of directors, and squeezes out any remaining shareholders through a second-step, cash-out merger.

Takeovers provide shareholders with a better return on their investment than they would have received had incumbent management remained in control. The takeover (or "control") premium compensates the target's shareholders for much of their loss due to the incumbent management's inefficiency. The possibility of takeover pressures managers of other corporations to maximize shareholder value.

The primary disadvantage of takeovers is that they place shareholders at the mercy of other persons - either the bidder or incumbent management. Specifically, takeovers can force shareholders to tender their shares even when they value the shares more than the tender offer price.(1) Two-tiered, front-end-loaded take-overs confront dispersed shareholders with a "prisoner's dilemma" - unless they tender, they can be squeezed out of their equity ownership later at a lesser price. Thus, opponents of takeovers claim, shareholders do not tender voluntarily.(2)

On the other hand, sophisticated takeover defenses currently block shareholders from selling to bidders, even when they wish to do so.(3) Shareholders remain at the mercy of managers, who can remove the market's most serious constraints on managerial inefficiency and, in effect, entrench themselves.

This Article will demonstrate that voluntary dissolution can and should replace hostile takeovers as the preferred means to oust inefficient corporate management. In a voluntary dissolution, shareholders of the subject corporation ("S") holding a specified percentage of stock would initiate a vote to dissolve the corporation. If holders of a majority of the shares(4) vote to dissolve S, the law would require the board to obtain the highest value by auctioning the corporation. Such auctions will almost always produce substantial premiums for S shareholders.

Voluntary dissolution provides all of the benefits of the takeover, while avoiding all of its harms. First, dissolution does not expose shareholders to the prisoner's dilemma. If holders of sufficient shares vote to dissolve, dissenting shareholders still receive a pro rata share of the proceeds; they are not treated discriminatorily or otherwise exploited.(5) If the initiative fails, no dissolution will occur, and S's stock price should resume trading at its pre-vote level. Consequently, shareholders will vote for voluntary dissolution only when they genuinely wish to force an auction.

Second, voluntary dissolution circumvents takeover defenses. At the corporate level, voluntary dissolution triggers an auction of the corporation.(6) The duty of the S board shifts from managing S's ongoing business to getting the best price for the stockholders at a sale of the company.(7) Getting the best price necessitates that the board redeem any poison pill in order to accept the winning bid. State anti-takeover statutes consistently permit management to accept "friendly" bids. Since the auction's winning bid will have been invited by shareholder-initiated dissolution, by definition it will be friendly. Management must approve the best bid, and this approval will disarm all the anti-takeover laws' potentially negative consequences.(8)

Third, dissolution will discipline managers sooner than takeovers, thus reducing impairment of shareholder wealth and disruption to non-shareholder constituencies. Dissolution will enable shareholders to trigger an auction and displace inefficient managers well before occurrence of the major erosion of shareholder value normally required before bidders launch takeovers. In addition, dissolution will empower shareholders to accept whatever sized premiums they choose, making it more likely that shareholders will accept smaller premiums than management would otherwise force bidders to pay.(9)

Fourth, dissolution frees shareholders from having to rely on bidders identifying and pursuing takeover targets. Dissolution allows public shareholders to initiate an auction even before a bidder has surfaced. As such, dissolution would be a kind of servomechanism that automatically disciplines managerially-created losses of value.

Finally, as I demonstrate elsewhere,(10) in addition to its superiority to hostile takeover as a method for redeploying corporate assets, voluntary dissolution would provide effective protections against acute managerial opportunism, against inefficient business combinations - such as the merger between Time, Inc. and Warner Communication, Inc.(11) - that preclude shareholders from more wealth-producing transactions, and against inadequate compensation in corporate freezeouts by majority shareholders.

The rest of this Article comprises six parts. Part I explains the current need for a mechanism to replace inefficient management. Part II compares the use of involuntary judicial dissolution in the close corporation with the use of voluntary dissolution in the public corporation. Part III explains how dissolution would work as a business matter, while Parts IV and V explain how dissolution would work under state corporate law and federal securities law, respectively. Although most states do not provide shareholders a realistic ability to initiate voluntary dissolution in spite of board opposition,(12) a surprisingly substantial number of states do provide such a right.(13) For simplicity, Part IV will restrict itself to analyzing the corporate law of the three most important commercial jurisdictions outside Delaware: New York, California, and Illinois. Finally, Part VI suggests a mechanism whereby shareholders can vote to forgo dissolution for five-year periods, thereby minimizing unnecessary monitoring costs.

1. The Current Need for a Mechanism to Replace

   Inefficient Management

   Traditionally, corporate law delegates to the board of directors the power to manage the corporation because such delegation is efficient. According to the standard view, shareholders specialize in bearing the risk of their investment, and management specializes in running the corporation's affairs. Consequently, shareholders in American corporations have very few positive rights. They do, however, enjoy the essential authority to elect directors and to sell their shares.

   Experts have traditionally characterized public corporation shareholders as capable of escaping managerial oppression by selling their stock in liquid securities markets.(14) However, markets discount the firm's shares to the extent that managerial underperformance destroys wealth. Thus, the public shareholder may escape by selling, but if no one constrains management from decreasing firm value, the selling shareholder may be largely shorn of the value of her investment.

   As recognized as early as 1963,(15) hostile takeovers or, more formally, the market for corporate control has played a central role in reducing agency costs when shareholders are too dispersed to discipline management directly. Hostile takeovers played an active role through the 1970s and 1980s. Through the mid-1980s, a fully financed and determined bidder that had purchased a substantial block of target company stock could expect to see the target taken over. The bidder would profit whether it or another bidder acquired the target corporation or whether the target restructured itself so as to maximize share value.(16) Shareholders would receive a premium, and underutilized assets would move to higher valued uses. On balance, takeovers significantly benefitted society, yielding huge premiums to target shareholders and leading to a resurgence of American productivity.(17)

   Towards the end of the 1980s, however, corporations increasingly employed new takeover defenses that effectively prevented target shareholders from selling their shares to a bidder without incumbent management's approval.(18) At the corporation level, shareholders' rights plans, or "poison pills," made hostile takeovers prohibitively expensive.(19)" Most states also enacted effective anti-takeover legislation.(20) While hostile takeovers do occur, in comparison to the 1980s, they are rare and, thus, no longer pose the same disciplinary threat to management.

   Today, management can normally prevent any unsolicited takeover it disfavors (and, most likely, it disfavors them all). Courts have only rarely nullified management's decisions and intervened to enable shareholders to obtain generous takeover premiums.(21) Indeed, in Paramount Communications, Inc. v. Time Inc.,(22) the Delaware Supreme Court signalled a willingness to allow management to block hostile takeovers, no matter how generous the premium.(23) Management can thus hold hostage the corporation's value, including any takeover premium that might be offered to shareholders.(24) Public shareholders, thus, now resemble close corporation shareholders in being trapped by those controlling the firm from exiting the corporation at something approaching their pro rata share of the corporation's full value, even...