Takeover defense when financial markets are (only) relatively efficient.

• Author: Wachter, Michael L.
• Position: Preferences and Rational Choice: New Perspectives and Legal Implications

INTRODUCTION

How does one value a corporation whose shares trade on a public stock exchange? To most commentators the answer to this question is straightforward: the share price measures the pro rata value of the corporation. In Delaware corporate law, however, there is an enigmatic concept of a firm's "intrinsic" or fundamental value that need not be its market value. (1) The assertion that corporations have an intrinsic value that can differ from the stock price has far-reaching implications. For example, in the case of a hostile tender offer, a board wanting to remain independent and informed as to the intrinsic value of the corporation could claim, sincerely or disingenuously, that a hostile bid was inadequate even when it offered a substantial premium over the prebid market price. (2)

The ability of directors and managers to adopt defensive measures to fend off an unwanted hostile tender offer is reviewed under the Unocal standard. (3) As the standard has evolved in Unitrin, directors and managers of a Delaware corporation have been given considerable latitude to adopt and maintain defensive measures, such as poison pills, if, for example, the board believes that the hostile bid is inadequate because it is below the intrinsic value of the corporation's assets. (4) The latitude given to target boards of directors, however, is still very much an open question. Defensive measures must be proportional to the threat and cannot be preclusive or coercive, (5) but there are too few cases to predict how different fact patterns might be decided. Just as undecided is the rationale behind a permissive standard of review of a target management's defensive measures.

Over the past decade, a battle has been waged in the academic and general legal literatures to either justify or vilify the settled features of the Delaware Supreme Court's takeover jurisprudence. (6) The starting point for the debate involves the appropriate allocation of power between managers and shareholders. (7) Although the managers have authority to direct the business and affairs of the corporation under Delaware General Corporation Law section 141 (a), (8) the shareholders have the right to sell their stock. (9) Why, or under what circumstances, should the managers' authority under section 141 (a) reduce the stockholders' rights to freely alienate their shares to a willing buyer? Absent a clearly dominating statutory or caselaw interpretation to resolve the question, the focus of the debate ultimately rests on underlying fundamentals, particularly the extent to which financial capitol markets are efficient. (10)

For purposes of this Article I differentiate between two contending positions. (11) One position, which I shall refer to as the "management discretion" position, has its strongest support among managers and takeover defense lawyers. They advocate that board decisions regarding tender offers should be treated the same as decisions regarding other corporate asset transactions, with the presumption of the business judgment rule (12) being applied, subject to the normal governance mechanism of the corporation, namely, shareholder election of directors. (13) The most prominent spokesman for this group has been Martin Lipton. A central tenet of Lipton's position is that financial markets are inefficient, so there is no reason to assume that shareholders will be either adequately informed or compensated in a hostile tender offer setting. (14)

The current version of the management-discretion position, however, is highly incomplete and cannot withstand detailed analysis. In particular, the management-discretion model has no solution for the agency problems that arise in the hostile takeover setting. In such a situation, management and directors are conflicted and the entirely discretionary standard allows management to act in an interested fashion without a judicial check. This issue needs to be resolved in a fully developed management-discretion model.

On the other side of the debate are the great majority of academic lawyers. Viewing tender offers as a governance mechanism in their own right, they argue that such control battles should be decided in the financial markets. (15) To most members of this group the idea that intrinsic value is a separable measure of value that can differ from the corporation's market value is inexplicable and simply wrong-headed. (16) Although private information held by managers and directors may cause a temporary gap between fundamental value and market value, allowing managers a brief period to either inform the market or seek an alternative transaction is sufficient to bring the market back to perfect efficiency. In this case, if a hostile bidder arrives with a cash offer above the market price, the directors cannot meritoriously claim that the offer is below the intrinsic value of the corporation. (17)

Elements of a shareholder-choice regime can be found in Delaware Chancery Court decisions in the late 1980s, following the Delaware Supreme Court's decisions in Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc. (18) and Moran v. Household International, Inc., (19) with City Capital Associates Ltd. Partnership v. Interco (20) being a primary example. Under Interco, a target management could use its poison pill to hold off the immediate clutches of an unwanted suitor and search for an alternative transaction. But the firm, faced with a noncoercive tender offer, would eventually have to dismantle its defenses, giving shareholders the final say as to the ultimate victor in the control contest. (21) This doctrine was overturned in Paramount v. Time more than a decade ago when the Delaware Supreme Court first leaned heavily toward a management-discretion position. (22)

The reliance that both sides place on the workings of financial markets, although central to their positions, is left either implicit or is only inadequately developed. The same is true of Delaware caselaw, with its reliance on a concept of intrinsic value that can differ from market value. In criticizing Delaware caselaw, Ronald Gilson colorfully notes that a "statute, like a golem, requires an animating principle to come alive," and asks whether there is an "animating justification" for the current state of Delaware takeover defense jurisprudence. (23)

In this Article, I take on the task of exploring the lessons of corporate finance as they relate to the question of contested control transactions. Does finance theory provide some foundations for an animating justification for Delaware takeover defense jurisprudence? I answer this question in the affirmative with the starting point that intrinsic or fundamental value is indeed a viable concept that is separable from market value. I then develop the implications of two alternative views of financial market efficiency.

If financial markets are entirely efficient--the prevailing assumption in the shareholder-choice literature--then the shareholder-choice theory of takeover jurisprudence is clearly the winning argument. If financial markets are efficient, then any hostile bid above market value moves assets to more valued uses, enriches shareholders, and, perhaps most important, disciplines managers to manage the corporation on behalf of shareholders.

The same is not true if financial markets are only relatively efficient. (24) I use the term relatively efficient to signify the prevailing view in the financial market literature that market efficiency, like perfect competition, is an ideal that is unattainable as long as there are market frictions. Specifically, when financial markets are relatively efficient, while investors cannot expect to outperform the market on an ongoing basis, individual stock prices can still be incorrect at any point in time--either under- or overestimating the value of the corporation. (25)

The failure of financial markets to correctly price the pro rata value of the corporation is shown primarily by the inability of existing models (26) to generate a reliable estimate of the appropriate discount rate or market capitalization rate for equity capital on a continuing basis. This rate is a critical building block in determining the company's cost of capital, which in turn drives the firm's capital expenditure investment decisions. It is also the rate investors use to discount the future dividends that the corporation is likely to pay, hence determining the stock market valuation of the company's shares. If the market generates an incorrect or imprecise market capitalization rate, the market's valuation of the company's common stock is likewise incorrect or imprecise.

I next explore the requisite features of financial markets that can lead to the conclusion that shareholders might be better served by a legal regime of management discretion in determining the outcome of hostile tender offers. First, any underpricing of a company's share price by the financial market is temporary so that the stock price ultimately returns to the correct level. (27) Second, due to the presence of asymmetric information, management may be better informed than the market as to the correct market capitalization rate. Third, management's superior information may be difficult to communicate to financial markets in a manner that is verifiable by the market so as to be incorporated into stock prices.

When financial markets are only relatively efficient, hostile tender offers that are above market prices but below fundamental value can succeed. Although the market for corporate control in the form of competitive bidding for target firms may mitigate this underpricing, it is unlikely to entirely eliminate it. Given these results, the signal conveyed by the market for corporate control is, at best, highly noisy and unreliable and, at worst, can distort the decisions made by managers prior to the emergence of a hostile bid.

The final critical step is to recognize that the failure to resolve agency...