Advising Shareholders in Takeovers

Doron Levit is Assistant Professor of Finance at The Wharton School of the University of Pennsylvania. This post is based on his recent article, published in the Journal of Financial Economics.

The decision of shareholders of public firms to accept a takeover offer is typically marred by two problems. First, shareholders generally do not have a precise estimate of the fair value of their shares, and without more information they cannot distinguish between inadequate and attractive offers. Second, unless shareholders can coordinate their collective decision, there is a free rider problem when they decide whether to accept a tender offer. To assist target shareholders, the board of directors is expected to use its superior knowledge about the company and advise shareholders whether accepting the takeover offer is in their best interests. Indeed, most takeover attempts are accompanied by a public recommendation from the target board to its shareholders. [1] Target shareholders, however, do not always follow these recommendations. [2] What determines whether target shareholders listen and follow the recommendations of their board? Is it necessarily in their best interests to have an influential board? In the paper entitled Advising Shareholders in Takeovers, which now appears at the Journal of Financial Economics, I study the advisory role of the board of directors in takeovers.

In my model, “Grossman and Hart (1980) meet Crawford and Sobel (1982).” Specifically, a bidder makes a tender offer to acquire the firm. In response, the target board posts a public recommendation to shareholders, advising them whether to accept or reject the offer. The board is not necessarily maximizing shareholder value; it may have self-serving motives. However, the board has private information about the value of the target. Communication is modeled as cheap talk à la Crawford and Sobel (1982). Given the board’s recommendation, each shareholder decides whether to accept or reject the offer. The takeover is approved if and only if the majority of target shareholders tender their shares, and as in Grossman and Hart (1980), there is a free-rider problem.

In equilibrium, there is an interplay between the takeover premium that is offered by the bidder and the ability of the target board to influence the decision of shareholders, as both are endogenous. If the premium is sufficiently high (too low), the recommendation from the board is uninformative and target shareholders accept (reject) the offer even if it is against their board’s will. If the premium is “moderate”, the success of the takeover is uncertain and depends on the board’s recommendation, which is informative. Building on this characterization, the analysis provides novel predictions with respect to the likelihood that target shareholders ignore the recommendations of their board and the reaction of the market to these recommendations. The analysis ties these variables to the type of the recommendation (accept or reject) and various characteristics of the bidding firm (e.g., empire building motives or the ability to make a “best and final offer”), the independence and industry related expertise of target board members, and the uncertainty about the value of target.

For example, the model predicts that the influence of the board on its shareholders can increase with its bias against the takeover. Intuitively, due to free-riding, shareholders inevitably reject offers that benefit them collectively. To overcome this coordination failure, a value-maximizing board would be tempted to pretend that the offer is more attractive than it really is. In equilibrium, shareholders do not take these recommendations on face value, and the board loses credibility. At the same time, if the board is biased against the takeover then it would recommend shareholders to reject some value-increasing offers. These self-serving motives can offset the inherent paternalism of the board (to overcome the free-rider problem) and thereby increase its credibility.

The analysis also shows that in the context of takeovers, the optimal board structure requires the board to be informed but also biased against the takeover. Moreover, it shows that in equilibrium under the optimal board structure target shareholders accept the takeover offer irrespective of the recommendation of the board, which is uninformative. In other words, the inability to influence the decision of target shareholders in equilibrium is a robust feature of an optimal board structure. Note however, that a failure to influence shareholders does not imply that the board has no effect on the outcome of the takeover. On the contrary, the optimal board is designed to convince the bidder to make an offer so high that shareholders cannot refuse, no matter what the board recommends them to do. Effectively, the optimal board deters the bidder from low-balling the offer and at the same time guarantees the success of the takeover if the offer is sufficiently high.

Overall, the analysis emphasizes that in the context of takeovers, a biased board has significant advantages that have been previously overlooked. This observation is consistent with Bange and Mazzeo (2004) who find that the takeover premium and the target shareholder value are higher for targets with non-independent boards. Furthermore, the model predicts that if corporate boards are structured optimally (with respect to takeovers), takeover offers would embed a relatively high premium, these offers are likely to be supported by the target board (since the premium is abnormally high), but when the board is recommending against the takeover, the target shareholders are likely to ignore these recommendations which are often uninformative.

The complete article is available for download here.


1SEC rule 14d-9 requires the target board to post a recommendation in response to a tender offer in the US.(go back)

2The evidence suggests that the ability of the target board to sway the collective decision of its shareholders varies across firms. For example, Baker and Savasoglu (2002) study 1901 US takeover offers between 1981 and 1996, and find that around 20% of the offers either succeeded despite the resistance of the target board, or failed in spite of the board’s support.(go back)

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