Taxing control.

• Author: Hynes, Richard M.
• Position: Corporate governance distortions resulting from taxation

1. INTRODUCTION II. THE CHOICE OF GOVERNANCE TERMS IN A TAX-FREE WORLD III. NON-PECUNIARY BENEFITS AND TAX DISTORTIONS IV. EXAMINING THE FUNDAMENTAL ASSUMPTIONS A. The Private Benefits of Control B. The Taxation of Pecuniary and Non-Pecuniary Benefits V. CORRECTIVE ACTION IN AN IMPERFECT WORLD VI. CONCLUSION I. Introduction

   Academics and activists advocate for corporate governance reforms designed to increase the value of publicly traded firms by making managers more accountable to shareholders. (1) After years of struggle, they are finally having some success. Publicly traded firms are eliminating staggered boards of directors, (2) providing shareholders with a "say on pay," (3) and directors are paying closer attention to shareholder desires. (4) Yet not all of the evidence fits neatly in this trend toward "good governance." Firms continue to adopt anti-takeover protections when they make their initial public offerings. over 86% of firms that went public in 2012 have a staggered board of directors, (5) and both Google and Facebook chose dual-class capital structures that allow the founders to retain voting control disproportionate to their economic stake. (6)

   The inclusion of anti-takeover protections in initial public offerings presents a puzzle. Much of the corporate governance literature suggests that anti-takeover protections are inefficient because they make it harder to remove ineffective or unfaithful management and therefore increase agency costs. (7) But this literature also suggests that firms will adopt efficient corporate governance terms before their initial public offering because concentrated ownership reduces agency costs. (8) Firms with better terms should command a higher price from new investors in an initial public offering, and this higher price will lead to greater wealth for the managers and investors who control the firm.

   Other scholars have noted this puzzle and have offered a number of explanations. (9) Capital market imperfections may prevent initial public offering prices from reflecting differences in corporate governance terms. (10) Firms may choose inefficient terms due to bad legal advice (11) or because of frictions in the market for financing prior to the initial public offering. (12) Anti-takeover protections could be efficient after all, at least for some firms, because they correct for myopic investors or some other problem. (13) Finally, managers may choose anti-takeover provisions to signal something about their firms. (14) This Article advances a very different explanation, one based on the Internal Revenue Code (Tax Code). (15)

   This Article begins with a variant of one of the existing efficiency explanations for anti-takeover protections. The heart of the argument is that managers are not driven solely by a desire for material gain but derive some happiness or utility from the control they exercise over their firms. (16) When investors removed Steve Jobs from Apple, (17) he did not just lose a future stream of income as CEO, he lost control of "his" firm. To the extent that managers derive happiness from control, they may not choose governance terms that maximize the dollar value of the firm. However, unless there is some contracting failure, they will still choose efficient terms--terms that maximize the total value of the firm (the dollar value plus the control value).

   Once we introduce taxation, the manager no longer chooses efficient terms because the government taxes pecuniary benefits more effectively than it taxes non-pecuniary benefits. Even if the manager can increase the total value of the firm by ceding some control, she may fail to do so as she must share some of the increase in the monetary value of the firm with the public treasury. (18) The government could eliminate this distortion by taxing the potential value of a firm (its value with optimal governance terms) or by taxing the benefits of control. However, these may be difficult or impossible to estimate. The government could also mitigate the problem by taxing devices that allow the manager to retain control such as dual-class common stock, staggered boards, and poison pills, or by simply prohibiting devices that it finds unreasonable. (19)

   Nearly all taxes distort incentives. For example, income taxes distort a worker's choice between labor and leisure. (20) The government could avoid this distortion if it could tax individuals on the basis of their potential income (what they could earn) instead of their actual income or if the government could impose the appropriate offsetting tax on leisure. (21) In the real world, the government cannot observe potential income or leisure, and efforts to tax proxies for potential income or complements for leisure create their own distortions. (22) Standard income or wealth taxes may be the best taxes that can be implemented in a world of limited information.

   The existing Tax Code's focus on pecuniary returns may provide the second-best taxation of public firms. For example, if we assess taxes on anti-takeover devices used by a publicly traded firm (or if we prohibit these terms), we distort the manager's decision to sell shares to the public. In the world of the second-best, there are no easy choices. Whether the distortions that corrective measures would create exceed those created by the existing Tax Code is a difficult empirical question that is left to future research. However, even if we choose not to adopt corrective measures we should still recognize the distortion of corporate control as an additional cost of taxation.

   Part II examines the choice of corporate governance terms in a world with no taxation. Part III shows that if managers receive both pecuniary and non-pecuniary rewards from their firms and if the government taxes the pecuniary rewards more heavily, then managers will choose corporate governance terms that give them an inefficiently high level of control. Part IV examines the validity of the fundamental assumptions of this argument--that managers receive non-pecuniary returns and that these returns are less heavily taxed. Part V examines the conditions under which the government should take corrective action. Part VI concludes.

2. The Choice of Governance Terms in a Tax-Free World

   The corporate governance literature suggests that anti-takeover provisions such as dual-class common stock, poison pills, and staggered boards of directors increase agency costs by making it harder for shareholders to remove ineffective or unfaithful managers. (23) Much of this literature, therefore, suggests that these protections (or at least the strongest protections) reduce the value of publicly traded firms, and a growing body of empirical evidence supports this claim. (24)

   Agency costs exist because managers and other controlling persons generally hold a small percentage of the stock of publicly traded firms, and thus, they do not feel the full consequences of their decisions. By contrast, before a firm makes its initial public offering, its share ownership is generally concentrated in the hands of the managers and a few others who provided early assistance. Better governance terms should make the firm more valuable and enrich the managers and concentrated investors who own the firm and have the power to choose these terms. The literature, therefore, suggests that firms will adopt efficient corporate governance terms before they make their initial public offerings. (25) One early work claimed that "firms go public in easy-to-acquire form: no poison pill securities, no supermajority rules or staggered boards. Defensive measures are added later, a sequence that reveals much [about the inefficiency of anti-takeover provisions]." (26) However, subsequent research shows that this is simply not true.

   A number of studies show that firms do, in fact, adopt anti-takeover protections before they make their initial public offerings. Field and Karpoff studied firms that went public between 1988 and 1992, and found that firms averaged 1.71 takeover defenses at their initial public offering and acquired an average of just 0.19 takeover defenses subsequently. (27) Daines and Klausner studied firms that went public between 1994 and 1997, and found that nearly all (94.5%) authorized blank-check preferred stock (allowing a poison pill to be adopted quickly), and a great many had other protections including a classified board of directors (43.5%), limits on shareholder access to the agenda (53.8%), or action by written consent (24.5%). (28) The popularity of anti-takeover provisions may have increased over time. Coates found that "[t]he overall rate of defense adoption increased in the 1990s," (29) and news reports suggest that firms continue to make public offerings with classified boards and dual-class common stock. (30)

   The literature offers a number of explanations for this puzzle. Some of these explanations suggest that anti-takeover provisions may be inefficient despite their presence in the market. If investors misunderstand the importance of corporate governance terms, differences in the terms will not be reflected in the initial public offering price, and controlling parties will have an incentive to include terms that entrench their control. (31) Managers often own just a portion of the equity of a firm before its initial public offering, and they may include anti-takeover protections because the cost of these terms is shifted onto other pre-IPO investors. (32) Of course, this just moves the contracting puzzle back one period; one must then ask why the pre-IPo investors did not negotiate in advance for a lack of anti-takeover protections when the manager owned all of the shares of the firm. Klausner suggests that this is due to transaction costs in the market for pre-IPo financing. (33)

   Other scholars suggest that some anti-takeover protections may be efficient after all, or may be efficient for at least some firms. (34) Anti-takeover protections may...