Why firms adopt antitakeover arrangements.

• Author: Bebchuk, Lucian
• Position: Delaware - Symposium: Corporate Control Transactions

INTRODUCTION I. THE OPTIMALITY INFERENCE AND ITS SHORTCOMINGS A. The Debate over Board Veto in Corporate Takeovers B. IPO Behavior and Optimality C. Conflicting Midstream Behavior D. Attempting to Reconcile IPO and Midstream Behavior II. EXPLAINING IPO AND MIDSTREAM BEHAVIOR A. A Simple Model B. Efficiency-Based Explanations 1. Inducement to Deconcentrate Ownership 2. Efficient Rent Protection C. Agency-Based Explanations 1. Agency Problems Among Pre-IPO Shareholders 2. Agency Problems Between Pre-IPO Shareholders and Lawyers D. Information-Based Explanations 1. Asymmetric Information 2. Bounded Attention and Imperfect IPO Pricing a. Bounded attention at the IPO stage b. Midstream c. Investment bankers E. Private vs. Social Optimality F. IPO Firms with Private Equity Funding III. POLICY IMPLICATIONS A. No Board Veto Is Best Default B. Limited Menu C. Sunset Arrangements D. Lessons for Corporate Governance in General INTRODUCTION

Strong antitakeover defenses are common among publicly traded firms. Why do firms adopt such arrangements? Does the adoption of such arrangements indicate that a board veto over takeovers enhances share value? What explains the fact that, at the initial public offering (IPO) stage, firms adopt strong takeover provisions, such as effective staggered boards, which shareholders systematically reject midstream? To what extent should corporate law place limits on a firm's choice of antitakeover arrangements? This Article seeks to address each of these questions.

Firms opt for antitakeover protection in two main ways, both of which have attracted some attention. First, firms adopt antitakeover charter provisions. Recent work has documented that, in the last decade, firms choosing to go public have increasingly been incorporating such provisions into their charters. (1) Second, firms incorporate in states that have statutes or case law making takeovers difficult. Recent evidence indicates that states with more antitakeover statutes are more successful in attracting incorporations. (2)

Supporters of board veto have argued that the adoption of antitakeover arrangements at the IPO stage provides "market proof' that board veto is desirable for shareholders. (3) Their inference is unwarranted, however, because the evidence about shareholder preferences for antitakeover protections are, to say the least, rather mixed. While the adoption of antitakeover protections at the IPO stage has increased over the last decade, shareholder opposition to antitakeover protections through voting decisions has increased as well. (4) This seemingly contradictory evidence makes it necessary to have a theory sufficiently rich to account for the behavior of firms and investors both at the IPO stage and in midstream. (5)

I identify and work out below several possible explanations that can account for both IPO and midstream behavior. (6) First, under the explanation based on encouraging deconcentration of ownership, antitakeover provisions serve the interests of shareholders when firms go public. In the absence of such arrangements, founders would be discouraged from subsequently reducing their holdings and relinquishing the lock on control that comes with concentrated ownership. Under this explanation, while public investors would fare best under dispersed ownership with weak antitakeover provisions, having strong antitakeover provisions in the IPO charter is still preferable because it results in less entrenchment. Thus, antitakeover provisions are desirable at the IPO stage only because they encourage founders to break up their control blocks. Then, once ownership is sufficiently dispersed so that the votes of public investors matter, the benefits of antitakeover protections disappear. This change can explain the midstream opposition of such investors to antitakeover arrangements.

Under the efficient rent protection explanation, antitakeover arrangements are always undesirable for public investors and reduce the value of their shares. However, the benefits of rent protection obtained by the founders through the antitakeover provisions are, at least at the IPO stage, greater than the resulting reduction in share price that the provisions cause. Therefore, antitakeover arrangements are efficient overall, and assuming no informational problems, founders find it in their interest to adopt them at the IPO stage even though this reduces the price they can get for their shares. At the midstream stage, however, shareholders have every reason to vote against a proposed antitakeover arrangement unless they receive appropriate compensation for the resulting reduction in the value of their shares. Similarly, if they could undo the antitakeover arrangement, shareholders would likely vote to do so midstream.

Under agency cost explanations, antitakeover arrangements may be adopted even though they are inefficient. That is, the cost to the pre-IPO shareholders from reduced IPO revenues caused by such arrangements is smaller than the rent protection benefits they would receive. And, given that antitakeover provisions reduce share value, shareholders can be expected to vote against such arrangements in midstream. The question remains, however, as to why pre-IPO shareholders adopt such arrangements. The answer given is that agency problems on the side of the pre-IPO shareholders lead them to adopt inefficient charter provisions.

One type of agency problem could arise among IPO shareholders. Here, when only some of the pre-IPO shareholders will continue to run the firm after the IPO, these founder-managers might have an incentive to include antitakeover arrangements in the charter. After all, they will fully capture the benefits of rent protection and will bear only part of the cost of reduced IPO share price.

Another type of agency problem could arise between lawyers and pre-IPO shareholders. To the extent that lawyers' expertise gives them influence over decision making, they might have an incentive to tilt their recommendations in favor of antitakeover arrangements. The downside of not having antitakeover protection--that incumbents might find themselves unprotected from a hostile bid down the road--might be attributed to the lawyers and might negatively affect their reputation. Furthermore, the potential upside of not including antitakeover provisions--a slightly higher IPO share price--would hardly be credited to the lawyers' work. Thus, since the adoption of antitakeover provisions provides a benefit but little cost to lawyers, they have an incentive to use their influence over the drafting of the charter to encourage antitakeover arrangements, even though these arrangements are inefficient for both founders and shareholders.

Under the asymmetric information theory, public investors are assumed to have perfect information about the effect of the provision given any value of the company's assets, but to have imperfect information about the value of these assets. In such a case, assuming that higher asset value is associated with higher expected benefits from rent protection, some or all founders will have an incentive to signal a high asset value by adopting antitakeover arrangements. Although shareholders know that antitakeover arrangements are inefficient and will reduce the share price at the IPO stage accordingly, the increase in share price as a result of the information conveyed concerning asset value outweighs this negative antitakeover consequence. Thus, the signaling effect may provide founders with an incentive to adopt inefficient antitakeover provisions at the IPO stage. Shareholders, however, will oppose such inefficient protections in midstream.

Last, but not least, under the bounded attention theory, investors at the IPO stage do not bother to price antitakeover arrangements that fall within a certain set of conventional arrangements. The exact location of the firm's choice within this set is viewed as relatively less important than the other uncertainties involved in valuing a closely held company that is going public. Without the aid of prior market pricing and exposure to market analysis, the level of uncertainty about the value of the company's assets and management is relatively high. Furthermore, the consequences of the chosen antitakeover arrangement would have impact primarily down the road after shares become more dispersed. As a result, even if investors view some antitakeover arrangements as theoretically inefficient, they might not bother to factor them into the price they are willing to pay for IPO shares.

In contrast, down the road at the midstream stage, questions concerning antitakeover arrangements will come to a vote in circumstances that make investors focus on the issue in isolation from others and that make the issue practically important. At this latter point, the inefficiency of antitakeover arrangements will lead shareholders to vote against them.

In addition to identifying several potentially plausible explanations for observed IPO and midstream patterns, I also discuss why some other potential explanations, including ones put forward by Marcel Kahan and Ed Rock, Lynn Stout, and Michael Klausner, cannot account for these patterns. I thus attempt to provide a comprehensive review of the factors that contribute to producing the observed patterns of behavior.

I also discuss in some detail the policy implications of the analysis. First, I argue that the evidence provides no basis for believing that a board veto is a beneficial default for public investors of companies with dispersed ownership. To be sure, there are explanations under which such arrangements would be desirable if they were clearly made a part of the bargain in the IPO stage. Under all explanations, however, the value of public investors' shares in companies with dispersed ownership is lower under a board veto regime, and there is no reason to impose such a regime on companies in midstream as some judicial...