Putting Directors’ Money Where Their Mouths Are

Nitzan Shilon is Commissioner of the Israel Securities Authority and Assistant Professor at Peking University School of Transnational Law. This post is based on his recent working paper, available here. Related research from the Program on Corporate Governance includes The Case Against Board Veto in Corporate Takeovers, by Lucian Bebchuk. This post is part of the Delaware law series; links to other posts in the series are available here.

In a new paper, Putting Directors’ Money Where Their Mouths Are: A New Approach to Improving Corporate Takeover Dynamics, I put forward a new arrangement to protect shareholders from underpriced bids in takeover situations. Target boards, as stewards of the corporation who typically possess superior information about the desirability of unsolicited bids, could be expected to protect their shareholders from such bids. Unfortunately, because they have a conflict of interest with their shareholders in takeover situations, they tend to reject hostile bids to an excessive degree. Moreover, the current Delaware doctrine is ineffective in monitoring boards’ responses to takeovers, largely because boards might use selective inside information to which the courts lack access and because their judgments are backed by subjective, hard-to-attack legal and financial expert opinions that courts are ill-equipped to challenge.

To rectify the problems of courts’ and shareholders’ inferior information as well as boards’ skewed incentives, I propose an arrangement in which target boards wishing to veto nonstructurally coercive takeover bids would be encouraged to demonstrate their opposition by committing to buy, if the bid fails, and hold for a specified time a certain amount of target stock at the bid price. The directors would be incentivized to follow this arrangement because it would require courts, in a potential fiduciary duties lawsuit, to give the directors’ commitments significant weight when evaluating their defense that they rejected the bid to protect their shareholders.

Adopting the proposed arrangement can significantly address important problems in corporate takeovers that have long claimed the attention of corporate law scholars and financial economists. In particular, inducing target boards to credibly transmit their genuine bottom-line understanding about the desirability of a bid would offset the courts’ inability to review the directors’ decision effectively. Imposing personal costs that the directors would uniquely incur if they wish to reject hostile bids would counteract the directors’ ex-post incentives to reject hostile bids excessively. Increasing the directors’ cost of a takeover attempt would improve market discipline and motivate the directors to increase firm value and reduce agency costs. Finally, favoring firms with high long-term value would protect them from myopic bidders and alleviate the unrelenting pressure on them to meet quarterly earnings expectations. For these reasons, the proposed arrangement could greatly improve corporate takeover dynamics.

Here is a more detailed overview of my analysis:

The Delaware courts have developed a rich takeover doctrine to address the issue of target boards vetoing takeover bids allegedly to protect their shareholders. Target boards, assisted by armies of expensive lawyers and investment bankers, have used the rationale of protecting their shareholders to justify their adoption of various antitakeover tactics, such as the poison pill and the staggered board. In response, shareholder activists, assisted by institutional investors, proxy advisory firms, and academics, have launched successful campaigns to indiscriminately dismantle antitakeover defenses in all S&P 500 companies. This issue, which has received much attention from legal scholars and financial economists, has recently become even more important as shareholder activism and hostile deal making have reached record levels of hundreds of billions of dollars annually worldwide.

Boards of publicly traded companies often argue that their shareholders might accept value-destroying bids because of their ignorance of or mistaken belief about the intrinsic value of the corporation. At least in some subset of takeover situations, this can be a real concern, not only because shareholders face severe challenges in their efforts to access, process, and evaluate important information necessary to estimate the true intrinsic value of the target but also because, even if target boards were motivated to credibly transmit such information to their shareholders, various frictions currently prevent them from doing so. Unfortunately, solving the problem by giving target boards an unfettered power to decide takeovers would result in their rejecting too many bids because boards lack true independence and their directors have a personal interest in avoiding removal. This problem is exacerbated by the fact that courts currently lack sufficient tools to exercise an effective judicial review over both the process and the substance of target boards’ decision making in takeovers.

I argue that the systemic failure in protecting shareholders in takeover situations is not all due to the shareholders’ lack of information, the conflict of interest between target boards and their shareholders or the lack of judicial tools to review board decisions effectively. It is also due, in part, to the legal rules that prohibit boards from showing their genuine opposition to the bid by committing to buy shares of the target firm in connection with the hostile bid. Therefore, I propose removing such regulatory barriers and instituting an altogether different way to protect shareholders from underpriced bids.

Based on a well-established game theory economic model, I propose a multistage, collaborative, decision-making arrangement that boards would initiate and shareholders and courts would engage in and monitor. The core purpose of this arrangement is to enable target boards to prove their opposition to an unsolicited bid by committing to buy, if the bid fails, and hold for a specified time a certain amount of target’s stock at the bid price—in essence, to “put their money where their mouths are.” I show that the directors would be incentivized to make this commitment because they know that, in a potential fiduciary duties lawsuit, the arrangement would require courts to give that commitment significant weight when evaluating the directors’ contention that they rejected the bid to protect their shareholders.

I further discuss the specifications of the proposed arrangement. In particular, I stipulate that the directors’ stock commitments be made only by the target’s outside directors and that the committed stock be purchased from the target rather than the shareholders. I further maintain that the commitments should be made simultaneously with the board’s rejection of the bid and after engagement with the target’s major long-term shareholders, who may be assisted by their proxy advisory firms. To prevent free riding, the arrangement requires boards to recommend the amount of directors’ personal stock commitments, but it maintains that the final commitments be made by each director individually to allow consideration for his idiosyncratic costs and benefits. I also describe a formal and practical technique by which courts and shareholders can infer whether the commitment amounts are high enough to show a genuine belief in opposing the bid, and I review special circumstances under which the arrangement should be adjusted. Finally, I explain how the arrangement would be implemented and enforced within the existing Delaware takeover doctrine.

I then discuss the potential benefits of the proposed arrangement. Specifically, I show that, by imposing variable personal costs on directors that decrease with their genuine belief about the long-term intrinsic value of the target, the arrangement would induce target boards to credibly transmit to courts and shareholders their bottom-line inside understanding about the desirability of the bid; in so doing, it would also empower markets and would likely shift a significant amount of current takeover action away from the courtroom. In addition, by imposing personal costs that they would have to incur if they wish to reject hostile bids, the arrangement would correct directors’ ex-post incentives to reject bids excessively. Ex-ante, by increasing target boards’ incentives to make their firms less attractive to bidders, the arrangement is expected to motivate those boards to increase firm value and reduce agency costs.

I further demonstrate that the arrangement would significantly improve what is perhaps the biggest failure of corporate governance today: its emphasis on short-term performance. Boards are currently consumed by the fear that markets will not understand the positive, long-term effects of actions that sacrifice short-term profits. By making the directors’ stock commitments cheap when the long-term intrinsic value of the firm is high, the arrangement protects firms with a long-term focus from myopic bidders and alleviates the unrelenting pressure on them to meet quarterly earnings expectations. In my view, the arrangement would greatly improve corporate takeover dynamics.

The full paper is available for download here.

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