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E-MailRonald J. Gilson is Marc & Eva Stern Professor of Law and Business at Columbia Law School, Meyers Professor of Law and Business (Emeritus) at Stanford Law School, and a fellow of the European Corporate Governance Institute. Alan Schwartz is Sterling Professor of Law, Yale Law School, and Professor, Yale School of Management. This post is based on a recent paper by Professors Gilson and Schwartz and is part of the Delaware law series; links to other posts in the series are available here. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell (discussed on the Forum here).
The appropriate division of authority between a company’s board and its shareholders has been the central issue in the corporate governance debate for decades. This issue presents starkly for defensive tactics: the extent to which a target board is allowed to prevent the shareholders from accepting a hostile bid. In the U.S., the board’s power is extensive; control largely lies with directors. While a poison pill would preclude a hostile offer, the Delaware Supreme Court held in Unitrin that the pill is preclusive only if it makes a successful proxy fight “mathematically impossible or realistically unattainable.” That a staggered board together with a pill would require a bidder to run two successive proxy fights does not reach this very high hurdle, despite the Delaware Chancery Court’s observation in Airgas that no bidder has attempted this extended effort.
Normative evaluations of current law face a critical obstacle: defensive tactics raise the social welfare question: to what extent these tactics deter ex ante efficient takeovers. This question cannot be answered empirically because the econometrician can observe bids but cannot observe deterred bids. In our working paper, Defensive Tactics and Optimal Search: A Simulation Approach (July 2016), we write a search equilibrium model of the market for corporate control and solve it by simulating plausible parameters for the variables of interest. Because we specify the number of ex ante efficient acquisitions that could be made, we can estimate market efficiency—the ratio of made matches to good matches—under legal regimes that are more or less friendly to defensive tactics. Also, we argue that the common metric among defensive tactics is time: the ability of various tactics to delay bid completion and thus reduce bidder, and thereby increase target, returns.
We have three important results: First, strong defensive tactics reduce market efficiency significantly. Our simulations suggest that approximately a $100 billion in deal value is lost each year in consequence of these tactics. Simulations are only suggestive and our simulated model likely overstates the welfare loss. Nevertheless, the result that defensive tactics cause economically significant welfare losses would stand even if our magnitude estimate is halved. Second, the defensive tactics level that maximizes target shareholder welfare is materially higher than the level that maximizes social welfare. These results also support a methodological claim: equilibrium analysis can illuminate regulatory issues regarding the market for corporate control. Third, our simulation supports the conclusion that an internal solution to a target board’s maximization problem exists: that is, for each target there is a delay facilitating defensive tactics level lower than allowed by the ability to fully block a hostile offer that maximizes the target’s expected return from a sale of the company.
We do not interpret our results regarding the match dampening effect of defensive tactics and the incentive of loyal target boards to choose tactics that are socially inefficient as supporting a clarion call for regulatory action. Our simulated equilibria and our target shareholder welfare analysis are intended to restart the debate over defensive tactics rather than end it. Rather, we want to situate defensive tactics in the larger debate about the desirability of shareholder control. The preliminary results suggest that defensive tactics, considered in isolation, are unequivocally bad for acquirers; good for target shareholders at some levels, but not at higher levels; and can materially reduce efficiency in the market for corporate control. Thus, we suggest that the defensive tactics issue should again occupy a prominent place in the corporate governance debate.
Finally, we examine the implications of our simulation model for a long-standing disagreement between the Delaware Chancery Court and the Delaware Supreme Court over what limit on defensive tactics maximizes target shareholder welfare. The statement of takeover law that is characterized in our model and simulations sheds light on this still live dispute. Following the Delaware Supreme Court’s original decision in Unocal to impose a higher standard of review on a board’s deployment of defensive tactics, the Chancery Court in Interco addressed how this higher standard would be applied. Under the Chancery Court’s regime, a target board confronted by a hostile bid could deploy defensive tactics, such as the poison pill, to buy sufficient time to seek higher bids or to explain to its shareholders why the target’s market price understates the target’s real value. Once the target’s board has had that opportunity, however, the shareholders had to be allowed to decide whether to accept the offer. The Delaware Supreme Court in Time-Warner and Unitrin rejected that time limit on defensive tactics in favor of a rule that, with the help of a poison pill and a staggered board, allows a target board to delay a bid for as long as two election cycles, a period that as observed by the Chancery Court in Airgas no bidder has attempted. Thus, the legal debate between the Chancery and Supreme Court is between an interior and a corner solution.
Our analysis shows that the critical issue in assessing defensive tactics is time: the delay from defensive tactics increases target shareholder welfare at the outset but then reduces it as the delay extends past the point where the reduced number of bids resulting from delay is outweighed by the increased target share of the surplus created by an actual bid. Seen through the prism of our model and simulations, the Chancery Court was correct in giving the board the time to increase the premium received by the target shareholders, but also correct in constraining the length of that delay. The Chancery Court’s informal analysis and our model and simulation point generally in the same direction: giving the target board too much discretion to delay a hostile tender offer not only is socially inefficient; it also reduces target shareholder welfare.
The full paper is available for download here.
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We are extremely grateful to Sarah Braasch for creating the MATLAB code that permitted us to simulate a model of the market for corporate control, and for running the simulations. This paper also benefited from comments at law and economics workshops at Tel Aviv and Columbia Law Schools, the Theoretical Law and Economics Conference (2015), the American Law and Economics Association Meeting (2016), the SOIE Meeting (2016) and a Networks, Information and Business Conference, Toulouse (2016); and from comments by Albert Choi, Gerard Hertig, Stephen Fraidin, Zohar Goshen, John Macey and Roberta Romano.
