Market for Corporate Control
By Jonathan R. Macey
Markets discipline producers by rewarding them with profits when they create value for consumers and punishing them with losses when they fail to create enough value for consumers. The disciplinarians are the consumers. The market for corporate control is no different in principle. It disciplines the managers of corporations with publicly traded stock to act in the best interests of shareholders. Here the disciplinarians are shareholders.
Firms whose share prices are lower than they could be if managed by more talented or highly motivated managers are attractive takeover targets. By buying up enough shares to vote in a new board of directors, a bidder can then replace an inefficient or ineffectual management team. The bidder profits when the new management team gets results, which come in the form of improved corporate performance, higher profits, and, ultimately, higher share prices.
Takeovers are not the only source of market discipline for companies. In particular, robust competition exists in product markets, labor markets, and capital markets for both debt and equity. Competition in these other markets disciplines managers and owners of all firms, both closely held and privately held. The market for corporate control provides an additional source of market discipline for the managers of publicly held companies.
A robust, properly functioning market for corporate control is vital to the performance of a free-enterprise economy with public corporations. A public corporation is a company whose shares are owned by the public—that is, whose shares are publicly traded. Public corporations are highly efficient and socially desirable for a number of reasons (see corporations). Without an effective market for corporate control, however, public corporations are unlikely to perform as well as they would otherwise. Of course, private markets are remarkably flexible and diverse. Economic activity frequently is organized in private, closely held firms as well as in large publicly held companies.
Numerous studies show that shareholders in firms that are the subject of takeovers enjoy significant profits. Gains to target shareholders average 40–50 percent above the prices at which target firms’ shares traded immediately prior to the takeover.
The empirical evidence on returns to bidders, however, is more ambiguous. Early studies showed relatively small (3–5 percent) gains, but later studies have shown negligible gains, and some have shown slight losses. There are two reasons for this result. The first has to do with empirical methodology: takeovers are a surprise for the target firm, and so their share prices jump suddenly on the news of a takeover. Bidders, however, often announce their plans to embark on an acquisition strategy months before they locate a suitable target, much less make an acquisition. This means that any increase in the share price of the bidding company from a particular acquisition or series of acquisitions occurs quite gradually, and is therefore hard to measure empirically. Suppose the market initially expected an acquiring firm to gain 25 percent in value from a particular acquisition program, but the firm announces a particular acquisition that promises gains of only 20 percent. The firm’s share price will decline as a result, because even though the firm is performing well, it is doing a bit more poorly than expected.
The second explanation for a decline in returns to bidders is regulation. The Williams Act,1 a federal law enacted in 1968, requires firms and individuals that make public bids for the shares of publicly traded companies (such public bids are called “tender offers”) to disclose information about themselves, their sources of financing, and their plans for other companies (see insider trading). This regulation ostensibly was enacted to benefit target-firm shareholders by providing them with what supporters falsely claimed were much-needed disclosures. What was never made clear was why shareholders of target firms should have (or would want, much less pay for) this legal privilege. One unintended, but totally predictable, consequence of the regulations is that they deter valuable bids. Once the acquirer announces the information, other share buyers bid up the price of the target company’s shares, giving a gain to the acquirer, who did all the costly research, only on his 5 percent of the shares. The Williams Act therefore acts as a strong disincentive to do the research in the first place.
Unfortunately, bidders cannot avoid the reach of the Williams Act simply by not making a public bid or tender offer. This is because another provision of the statute requires any bidder to make the same disclosures within ten days of acquiring 5 percent of the shares of a public company, regardless of how those shares were acquired.
To understand the importance of the market for corporate control, one must first understand the economics of the public corporation. Public companies can be more efficient at deploying capital than can private (also called closely held) companies, for several reasons. First, public corporations permit accumulations of a large amount of capital without government involvement. When business needs a lot of money to operate, either because there are economies of scale or scope in operation or because the business is highly capital intensive (such as manufacturing), selling shares to the public is often the only—and is generally the most efficient—way to accumulate such capital.
Second, the existence of the public corporation permits the separation of two different economic functions: investment and management. This is efficient because the people who invest often have no expertise, experience, or inclination to manage the companies in which they invest. Many investors, such as doctors, teachers, lawyers, factory workers, and scientists, fit this description. Similarly, entrepreneurs and managers may be able to employ investors’ capital effectively, but they may not have much capital themselves. Specialization, which occurs by separating the investing function from the management function, is therefore often highly efficient.
Finally, the public corporation permits more efficient risk taking in the economy. Public corporations allow for the investment of relatively small amounts of money simultaneously in many corporations, either directly or by investing in mutual funds, which in turn make investments in many companies. Because these investors enjoy the benefits of diversification, they are more willing to invest far more money at far lower expected rates of return than they would be if they had to “put all of their eggs in one basket.”
But along with the massive economic and social benefits of public companies come costs. The costs that result from separating the investing and management functions are called “agency costs” because the managers and directors of public companies are the agents of the investor-shareholders. Because these agents are deploying the shareholders’ money rather than their own when they manage the corporation, they can benefit themselves by acting in their own interests rather than in the interests of the shareholders.
While antifraud laws can deter managers from outright theft and fraud, it is extremely difficult for shareholders, who are widely dispersed, to detect, much less to prevent, mismanagement. Shareholders face an array of collective-action problems that prevent them from coalescing to deal with bad management. One of these problems is the “rational ignorance” phenomenon: the cost to an individual shareholder to investigate and ferret out wrongdoing in a company is far above the amount he or she stands to gain. Consequently, the shareholder remains “rationally ignorant” of what is going on.
A similar problem plaguing shareholders is the “free rider” problem: while individual shareholders must bear all of the costs of correcting managers’ errors themselves, they share the benefits of such corrective action with all shareholders. Thus, the free-rider problem leads to less than the optimal amount of monitoring and other corrective action.
The market for corporate control is the only known antidote for all of these collective-action problems.
A market for corporate control emerges when bidders have incentives to monitor the corporate world for companies that are undervalued due to inattentive or inept managers. Bidders have such incentives in a market for corporate control that is unfettered by regulation because they can profit from such monitoring by buying a controlling interest in the shares of undervalued companies and displacing those managers.
Another important, but often unnoted, feature of the market for corporate control is that its very existence reduces agency costs, the costs associated with the separation of share ownership and management of the corporation that defines the publicly held company. This is the case because no incumbent target management team wants to be ignominiously thrown out of office in a hostile takeover. After all, if the managers did not like their jobs, they could just leave before being removed in a hostile takeover.
Bidders can make mistakes. This is of little concern because bidders’ mistakes manifest themselves only in the form of overpayment for shares in target firms. But shareholders in the target firm benefit when this occurs because they have the opportunity to sell their shares at a premium. The only losers when this happens are the bidders themselves and the management of the target firm. But this is a risk people take when they become managers. Moreover, to the extent that such managers own shares in the companies they run, they benefit from the takeover premium just like any other shareholder.
The market for corporate control need not always involve hostile takeovers, although their possibility is critical to a properly functioning market. Firms in financial distress and firms whose managers’ interests are closely aligned with shareholders’ interests often will welcome friendly acquisitions. These acquisitions generally take the form of mergers in which the board of directors of one company agrees and recommends that its shareholders vote in favor of exchanging their shares to an acquirer, either for cash or for stock in the acquirer.
But no market functions costlessly, and the market for corporate control is no exception. For one thing, bidders, like other capitalists, need financing. The capital markets have been remarkably successful at generating sufficient capital to finance takeovers. For example, in April 2005, the upstart electronic stock exchange Arca/EX was able to engineer the purchase of the venerable New York Stock Exchange, and the over-the-counter market, Nasdaq, Inc., was able to borrow the one billion dollars it needed to acquire the Instinet trading system.
A major financing innovation involves the use of the assets in the target company to secure a loan to acquire the target’s own shares. Transactions that involve the use of leverage, or debt, are known as leveraged buyouts, or LBOs.
Other costs associated with the market for corporate control involve the transaction costs of writing the contracts necessary to protect target-firm shareholders from collective-action problems and to align the incentives of target-firm managers and their shareholders. One potential collective-action problem facing target-firm shareholders is the “prisoners’ dilemma” such shareholders face when presented with a bid for less than 100 percent of the shares in their firm. Suppose, for example, that a firm has 101 shares outstanding. The bidder owns 1 share, and the other 100 shares are divided evenly between two shareholders, Abby and Samantha. Abby and Samantha live far apart, do not know each other, and have no easy way to communicate. Suppose that the bidder makes a bid for 50, and only 50, shares of the company’s stock at a price of $1.40, which is 40 percent higher than the current $1.00 price. Suppose, further, that the bidder is known to be hard-working, diligent, and honest, and, therefore, that market experts predict the firm’s shares to rise to $2.00 per share when the takeover is consummated. Under these facts, the bid might not be successful because Abby and Samantha will each be better off by not selling her shares to the bidder and hoping that the other shareholder will tender her shares. One way to deal with this problem is to permit bidders to disguise their identities and to make their bids on a first-come, first-served basis. Unfortunately, the Williams Act made both of these strategies illegal.
Another, legal, way for bidders to deal with this problem is to make an offer for 100 percent of the shares in the target, and to make their bids contingent on receiving a very high percentage of the target company’s shares. This strategy, while effective, is quite costly, but regulation has made other strategies difficult to implement.
Worse, if the bidder is thought to be lazy or inattentive or dishonest, rational target-firm shareholders may rush to sell their shares in what is known as a “coercive tender offer.” A sort of coercion is said to occur because shareholders want to avoid winding up as minority shareholders in a firm run by an inept or unscrupulous bidder. The only way they can assure themselves of doing this is by selling their shares. If either Abby or Samantha decides to sell her shares, the other will wind up as a minority shareholder in a poorly run company.
Happily, there are many contractual solutions—called “defensive tactics”—to this collective-action problem, and managers have strong incentives to employ these contractual solutions to protect their shareholders and themselves. In fact, the real problem is not that bidders will “coerce” target firm shareholders into selling; it is that managers will engage in defensive maneuvering even when their shareholders do not want them to in order to entrench themselves in their cushy jobs at the shareholders’ expense. This is why investors often criticize defensive tactics.
Some defensive tactics are quite modest and are carefully tailored to deal with the problem of coercive tender offers. “Shark repellant amendments,” for example, require shareholders to vote to approve outside acquisitions by large “supermajorities” of, say, 75 percent in order to complete an acquisition. This sort of defense is ineffective at defeating bids for large blocks of shares that are in the shareholders’ interest because shareholders are happy to approve such transactions.
A more controversial and potent defense is the shareholder rights plan, popularly known as the “poison pill” defense. Poison pills are rights freely distributed to target-company shareholders that give the shareholders the “right” to purchase shares in the target firm (or the bidding firm in case of a merger) at significant discounts in price when a “triggering event” occurs. A typical triggering event is someone’s or some firm’s accumulation of voting shares in the target above a specified threshold, such as 15 or 25 percent, without the approval of the target company’s board of directors. These rights impose severe economic penalties on the hostile acquirer and usually also dilute the voting power of the acquirer’s existing stake in the firm. Poison pills are effective at deterring hostile bidders because when the target-firm shareholders exercise their “rights” under these plans, they severely dilute a bidder’s stake in the target. Target-firm shareholders will exercise these rights because they cannot resist the opportunity to buy shares at a huge discount to market, especially since they understand that their fellow shareholders are doing the same thing. Thus, ironically, poison pills place target-firm shareholders in the same sort of coerced, collective-action problem as the partial bids they ostensibly prevent.
Poison pills are a very popular antitakeover device. Most big companies have them, but, at least to some extent, courts police their abuse by target-company boards of directors. In addition, bidders have some strategies for dealing with poison pills: they can make a tender offer contingent on the target-company board nullifying the pill, and they can launch a proxy contest, in which they solicit target shareholders’ votes to unseat the incumbent directors of the target company. By replacing the directors of the target, the bidder can take control of the board and nullify the pill itself. Another, increasingly popular way to deal with the pill is for large institutional investors to communicate to management that they disapprove of its use. However, as a policy matter, it would be better if the poison pill did not apply to all-cash bids for 100 percent of the stock in the target company because shareholders do not need poison pills to protect themselves from this type of bid.
Thus, the biggest problem with the takeover market is not the poison pill; it is the state and federal laws that impede takeovers. Delaware’s antitakeover law is particularly important because most large public companies are incorporated in Delaware, and thus are subject to Delaware law. The Delaware statute prohibits a hostile acquirer from completing a takeover by merging with the target for at least three years after buying a controlling interest unless the bidder either obtains the approval of the target company’s board of directors or acquires more than 85 percent of the target’s stock.
Like other markets, the market for corporate control has its critics. The main criticism is that this market focuses too much attention on shareholders and not enough attention on other “constituencies” of the public corporation, such as workers and local communities. These arguments are weak for several reasons.
First, antitakeover laws are a bad way to protect these other constituencies because any protections such statutes provide create large inefficiencies by reducing the quantity and quality of the monitoring of public companies’ management. Second, antitakeover statutes do not help workers or local communities or any other nonshareholder constituency; they simply entrench target-company management. Third, the empirical evidence shows that, by improving efficiency, takeovers help rather than hurt workers and local communities by promoting employment and increasing societal wealth.
Finally, no contractual agreement gave these “constituencies” any say in the takeover decision. For them to get that power, they would have to give something up, whether in wages or in other forms. The fact that they did not negotiate that power suggests that they did not value it enough to do so. In fact, those who claim to speak for them have no basis for their claim. Of course, many constituencies would want a say after all the contractual terms are negotiated. But this is no different in principle from the fact that people often want unilateral changes in contracts after the contracts have been agreed to. That does not mean they are entitled to them.
The other major criticism is that the market for corporate control causes managers and boards of public companies to focus on short-term share price performance rather than on long-term projects. This criticism is illogical. Share prices reflect the present value of future returns to shareholders and are, therefore, a measure of the long run. Successful corporate strategies, even those that are not expected to produce positive returns for years, will generate immediate increases in share prices. There is little doubt that if a major pharmaceutical company cut its research and development (R&D) budget to zero, its earnings would rise but its share price would fall. Economists have tested this theory empirically by looking at what happens to corporate expenditures on R&D after takeovers occur. If the short-run story applies, one would expect R&D to fall after a takeover. In fact, the opposite is true. Those who take over companies are usually in it for the long haul.
The market for corporate control is a critical component of a free market. Takeovers vastly improve the efficiency of public companies by providing monitoring and discipline for management and by aligning managers’ incentives with those of outside investors. Regulation, often implemented at the behest of entrenched managers who want to be insulated from this market, provides no benefits to shareholders, who easily can protect themselves via contract. Such regulation impedes the market for corporate control, robs shareholders of wealth, and reduces the efficiency of private enterprise.
Its author, Harrison Williams, a U.S. senator from New Jersey, later went to prison for taking bribes.