Bundling and Entrenchment

In a recently issued discussion paper, “Bundling and Entrenchment,” we present the first empirical study of the bundling problem in corporate law. The paper, which will be published in the May 2010 issue of the Harvard Law Review, is available here.

Our study provides empirical evidence that managements have been using bundling to introduce antitakeover defenses that shareholders would likely reject if they were to vote on them separately. We study a hand-collected dataset of public mergers during 1995–2007. While shareholders were strongly opposed to staggered boards during this period, and generally unwilling to approve charter amendments introducing a staggered board on a stand-alone basis, the planners of these mergers often bundled them with a move to a staggered board. We demonstrate that management has the practical ability to obtain management-favoring charter provisions by bundling them with other measures, and we discuss the significant implications our findings have for corporate law theory and policy.

The Bundling Problem

A widely shared premise in the literature on corporate law and corporate governance is that charter provisions are those viewed by shareholders as efficient. The basis for this view is the assumption that these provisions receive at least implicit shareholder support. When firms go public, investors are presumed to price the provisions contained in the company’s charter; as a result, the founders who take the company public have an incentive to fully take into account shareholders’ preferences. After the company goes public, any amendment to the charter requires shareholder approval. This procedure is presumed to ensure that amendments to the charter are those favored by shareholders.

Against this rosy view of charters, a concern may be raised that management could obtain shareholder consent to a charter amendment disfavored by shareholders by bundling the amendment with a measure that shareholders favor. As long as the package is on the whole value-increasing for shareholders, shareholders will vote for it. Agenda control may thus enable management to obtain charter provisions that shareholders disfavor.

The practice of bundling is well known to political scientists, and concerns that bundling is also used in firms have been expressed in the corporate law literature. However, thus far it has remained unclear whether bundling by corporate managers is a mere theoretical possibility or a practically significant issue. Our study – the first attempt to assess the issue empirically – indicates that bundling is indeed an issue of practical significance that deserves the attention of policymakers.

The Empirical Evidence

Our empirical study focuses on one type of bundling: bundling a move to a staggered-board structure with a merger. We test whether bundling has enabled management to obtain the protection of staggered boards — boards divided into three classes of directors with staggered terms, which delay any hostile takeover by a year — at a time when shareholders would not support stand-alone proposals to stagger the board.

As the paper discusses in detail, during the past fifteen years institutional investors have been strongly opposed to staggered boards. They have been unwilling to vote for stand-alone charter amendments to stagger boards, and companies have not been adopting such amendments. On the contrary, companies with staggered boards have been moving in the opposite direction by repealing their staggered-board structures in response to shareholder pressure. Nevertheless, we show that, during this very period, directors and executives not enjoying the protection of staggered boards have often been able to obtain this protection through bundling.

We study this issue using a hand-collected dataset of the governance consequences of 393 mergers of companies of similar size during the period 1995–2007. In these transactions the assets of two firms are put under one management. The parties to the transaction decide how to divide the economic pie and who will run the combined firm. Whatever choices are made with respect to these key issues, the deal can be designed in a number of ways that enable the combined firm to have a staggered board even if only one of the parties, or neither party, had a staggered board.

We begin by examining mergers in which the combined firm inherited the charter of one of the parties. In this deal structure, one of the two parties became the combined firm and retained its original board structure. These deals increased the incidence of staggered boards by about 8% (from about 61% to about 66%). The trend of moving from nonstaggered boards to staggered boards is even stronger when we focus on deals in which one party had a staggered board while the other did not; that is, the deals in which the choice of the party that remained public determined the combined firm’s board structure. In these deals, the party with a staggered board was about 62% more likely than the other party to become the combined firm. These findings hold true also when we control for other factors affecting this choice.

We continue with mergers in which the combined firm’s board structure was independent of either party’s charter because the combined firm was a new holding company, or the combined firm was one of the parties that modified its board structure through a charter amendment in the course of the deal. In each of these categories, we find that mergers resulted in a significant increase in the incidence of staggered boards. Taken as a whole, these deals increased the incidence of staggered boards by about 31%, from about 58% to about 76%. This increase is larger than in deals in which the combined firm inherited one of the parties’ charter, presumably because the parties assigned greater weight to their preferences regarding board structure when they designed the board from scratch.

Implications

Our results have important implications for corporate law theory and policy. Staggered boards are the key antitakeover defense and have been the subject of widespread criticism. This criticism, however, should address the claim that staggered boards are legitimate because they receive shareholder consent. Our results show that, in a significant number of cases, the adoption of a staggered board is due to bundling rather than to genuine shareholder support. This finding is not meant to add to the existing evidence that staggered boards are inefficient. Rather, it suggests that shareholder consent cannot guarantee their efficiency.

Beyond the particular issue of staggered boards, our results indicate that bundling, which has thus far been viewed as a mere theoretical possibility, is a real-world phenomenon that deserves attention. We show that managers have made significant use of their bundling power to get an economically meaningful increase in the incidence of staggered boards during a period in which shareholders have been opposed to this antitakeover protection. Our results suggest that control of the corporate agenda enables management to obtain governance changes that could not be passed on a stand-alone basis.

These findings also call for reconsideration of fundamental corporate law principles. In particular, they suggest that charter provisions should not always be presumed to be efficient, and make a case for reforms that would constrain management’s ability to manipulate shareholder approval through bundling. A possible reform is to expand the judicial review of shareholder-approved arrangements in general, and stock mergers in particular. Expansion of judicial review, however, could produce legal uncertainty. Our preferred reform is therefore to enable shareholders to unbundle merger proposals, for example, by authorizing them to undo charter changes that were introduced through bundling. If one is concerned that the inability to bundle would discourage managers from pursuing some value-creating mergers, the concern can be addressed by going further and giving shareholders general power to initiate charter amendments.

Finally, our findings warrant further empirical work on the bundling phenomenon. Bundling mergers with moves to a staggered-board structure may well be only the tip of the iceberg. Future work may examine whether management uses bundling to effectuate other governance changes and whether it bundles these changes with sweeteners other than mergers.