Protecting Boards from Their Own Shareholders

By James Kwak

I teach corporate law, and one of the topics in a typical introductory corporate law course is hostile takeovers. The central legal question is: to what extent is a board of directors allowed to undertake defenses against a takeover bid, even if (as is always the case) the potential acquirer is offering a premium over the current market price?

Whenever I teach one of these cases, I always bring up the nagging economic question: if the share price is $20, and Big Bad Raider is offering $30 in cash to each and every shareholder, where does the board get the chutzpah to claim that, under its leadership, the true value of the company is more than $30? (I understand the argument that Bigger Badder Raider might be convinced to pay more than $30, but the law, at least in Delaware, allows boards to use some takeover defenses to fend off any acquirer.) This always baffles me, but the law is premised on the idea that there is some fundamental value that is hidden deep inside the current board’s “strategic plans,” and that Big Bad Raider may rob shareholders of this fundamental value.

One of the intellectual rationales for takeover defenses, as for several other devices that insulate current boards from the outside world (such as staggered boards) is the idea that too much shareholder pressure can cause corporations to make decisions that are good in the short term but bad in the long term. Again, this raises the question of why board members (or the lawyers and academics who support them) should be trusted when they say that policy X, even though it increases the stock price in the short term, is really bad in the long term. The short-term price increase can only occur if the market, in aggregate, believes that policy X is good for the company in the long term. So, in essence, board members are claiming that they are smarter than the market. Yes, the market makes mistakes (I’m no believer in perfect efficiency), but you should rarely trust someone who claims to know when those mistakes occur.

In a new paper, Lucian Bebchuk attempts to dismantle “The Myth That Insulating Boards Serves Long-Term Value.” His argument come in at least three forms. The first is that even if it were true that shareholder pressure (whether actual shareholder activism, or board decisions taken because of the threat of shareholder activism) could produce decisions that are good in the short term and bad in the long term, this must be balanced against the other benefits of shareholder pressure. Activists will also favor decisions that are good in the short term and in the long term. Furthermore, shareholder pressure is what constrains managers who might otherwise use the corporation’s resources for their own ends—whether empire building, preparing campaigns for political office, or lavishly redecorating their executive suites.

The second is a review of empirical studies showing:

  • Shareholder activist campaigns produce increases in short-term stock prices
  • Those short-term increases are not reversed in the following five years
  • Those increases are not reversed even after the initial activist fund sells its holdings (meaning that the people it sells to are not harmed)
  • Activist campaigns result in improvements in operating performance over the next several years (often reversing previous declines)
  • Various measures of board insulation, including staggered boards, are associated with lower stock returns and operational performance

The third is Bebchuk’s observation that, in a world of investment vehicles seemingly catering to every taste, there are no funds that attempt to make money by systematically betting against shareholder activists and holding their positions for the long term. If activism were bad, you would think someone wuld be betting real money on that principle. Not only that, but the investment funds that do have a long-term horizon, such as CALPERS, have voted consistently against board insulation, and continue to do so.

None of this should be surprising. Even if it were possible for some clever hedge fund manager to pressure a company into doing things that are good in the short term but bad in the short term, what is the alternative? Without accountability to shareholders, why would we expect board members to serve any interests other than their own? The typical independent board member is the CEO or former CEO of some other company. His reputation depends on that company and a large chunk of his net worth is tied up in that company’s stock—not the company on whose board he sits. What penalty is there for being a director of a failing company? None. (See Rubin, Robert.) If we insulate boards from shareholder pressure, we are essentially counting on directors’ altruistic feelings toward shareholders. Hope is not a strategy.

But this myth will no doubt persist. Why? One reason is that, in academia (legal academia, at least), there is a market for entirely theoretical models that are devoid of any empirical support. More important, the myth of board insulation benefits corporations’ current directors and executives by freeing them to pursue their own interests.

Among the major supporters of board insulation are the U.S. Chamber of Commerce and the Business Roundtable. These organizations often hold themselves out as defenders of capitalism and free markets. But on this issue, it’s clear that they are not taking the side of corporations themselves or their shareholders. Instead, they are on the side of the select few who run those corporations. The ability of that privileged elite to mobilize corporate resources to protect themselves from their own shareholders is what ensures that the myth will persist.

54 thoughts on “Protecting Boards from Their Own Shareholders

  1. Since the CEO is generally the one with the most stock in a company, it is his task to prove the value of the stock, or take the profits and run to another position.

  2. ‘Since the CEO is generally the one with the most stock in a company….’

    What’s the source for that claim?

    Though it’s good to see Mr Kwak admit that markets might know something.

  3. Another problem is management compensation. Compensation plans approved by shareholders always focus on making profits on operations and/or steady growth of the given company and therefore assumes the company will keep running. In the scenario of a takeover bid the management is influenced by the compensation plan since if they agree to the takeover there is no more future earning, no more future stock options and fat bonuses. Personally I share the view of Benjamin Graham who was always very much on the shareholder’s side against management.

  4. You need a source for everything? If you believed everything that was published, your country would be in a heap o trouble right now with no answers and only questions. Oh yea, it already is.

  5. Since corporations are a creature of statute, we should presume corporate law might reasonably protect social values in addition to those who hold something called “equity.” Corporation law might, for example, impose more duties on management as it does trustees or vest more power in management as it often does with limited partnerships. What might be some of the other social values that corporation law might protect? Legislatures might reasonably conclude after watching decades of leveraged buyouts that such disinvestments in businesses that make and deliver goods and services need stability and medium to long-term planning horizons in order to invest in R&D and to venture into new lines that will initially be a drag on earnings. Legislatures might also be concerned about employment and/or community stability.

    I’ve been watching private equity, aka leveraged buyout firms, since the 1960s as a business lawyer, business executive, and public company board member. I see that they more often than not leave behind fewer employees with reduced compensation, more difficulty recruiting, crushing leverage, less investment in real assets and R&D, slower growth, and no long-term vision. Looking at each firm and transaction in isolation, this doesn’t seem terrible, but when you put all this activity (and threat of activity) together, the result is excessive liquidity, extreme quarteritis, and disinvestment in the real economy. In purely financial terms, perhaps the legislature is entitle to discount future earnings at a lower rate than shareholders who, by the way, are predominantly fund managers desperate to out-perform each other in this very quarter.

    On the other hand, I get the point that shareholders seem to be the only constraint on management, but having every corporation potentially levered to the eyeballs and not investing in the future is too high a social price to pay, in my opinion. What America needs in the 21st Century is not more quarteritis but a little less.

  6. ‘I’ve been watching private equity, aka leveraged buyout firms, since the 1960s as a business lawyer, business executive, and public company board member. I see that they more often than not leave behind fewer employees with reduced compensation, more difficulty recruiting, crushing leverage, less investment in real assets and R&D, slower growth, and no long-term vision.’

    Congratulations, since you undoubtedly made piles of money shorting these corporations. However, could you explain how you get both ‘crushing leverage’ and ‘excessive liquidity’ at the same time?

  7. Actually, consumers can now only get the quality and innovation, but not the “social value”, that they want if they go after the shareholders, legally. Since every decision that impacted the quality and innovation that reached the consumer was legally made to justify the interests of “shareholders”, and they went about it by delivering a far inferior product to increase the profit taking for themselves, not the talent or even the corporations. A true case of robbing Peter to pay Paul….next target after screwing the consumer and the talent is the only one left – the Bored Members. Gird your loins…

    Life-maintenance is an algorithm that none of the nimrods have the “rights” to change in the software :-) So if they’re not using the only algorithm that works…..

  8. I expect a major part of the puzzle is that these issues are governed by Delaware law for a substantial percentage of major American companies. As long as it is the Boards and management which determine state of organization, and you have what is arguably a race to the bottom led by Delaware which depends on the status quo as a major source of revenue, you are likely to have the governing law highly favorable to board and management interests.

  9. Responding to PRS: In the macro sense in which I discussed this, excessive liquidity means that investments in the real economy are increasing difficult to make and keep in place in a public company because our financial markets have become increasingly dominated by traders instead of investors. Management and key shareholders may think they’re in it for the long haul, but when the raiders arrive the forces for partial liquidation are overwhelming.

  10. No one has mentioned the effect of the tax code regarding carried interest. Often, a company is taken over in a way that creates significant debt for the acquired company. The deductibility of interest expenses for corporations means that the tax rate can often be driven down to virtually nothing. Thus, the acquirer can pay “$30” by no longer paying significant income taxes. The company is often worth more to the acquirer than the current stockholders because of distortions in the tax code.

  11. ‘…excessive liquidity means that investments in the real economy are increasing difficult to make and keep in place in a public company because our financial markets have become increasingly dominated by traders instead of investors.’

    Where does the ‘crushing leverage’ come into this?

  12. Good question PRS, even the second time you are asking it :-)

    This is neither here nor there, but I am all ears waiting to hear what kind of “immigration policy” the legislative branch is going to come up with after they just shot down background checks for gun purchases.

    Might be as “complex” as having crushing leverage and excessive liquidity in the system at the same time…

  13. “there is a market for entirely theoretical models that are devoid of any empirical support” seems to be a problem in many disciplines these days. Maybe because we devalue science and it’s mehods.

  14. I’m a little surprised to hear that any of this, or this line of argument, actually comes out of the mouths of our free market titans. I guess they just don’t want it *too* free.

  15. James – As you correctly note: “None of this should be surprising.” What is surprising, disappointing rather, (if it’s true) is that the wide body of economic and management research – on the firm, on corporate governance, etc. – has not found/reported this before. Because the empirical research you cite is (very helpfully) backing up what would anyway seem intuitive.

  16. I’d be happy if corporate board elections were more competitive. The re-election record of corporate boards makes even incumbent US House Members jealous.

    The cozy relationship between Boards and management has created a situation where companies are run, first and foremost, for the benefit of top management. It almost doesn’t matter how badly a company is run. In my experience, the situation is worst for smaller public companies – particularly community banks. Many of the chumps who made the riskiest bets took their banks to the brink, and sometimes past it, yet still have their jobs.

  17. I wish that the top 9 (or however many) shareholders each annually appoint their own director to the board. Then the board would be independent of management, and it would at least be clear to whom the directors are responsible. The board elections that we currently have are an embarrassment.

  18. More to the point: what role is a board really capable of playing? Modern companies are incredibly complex and compete in highly competitive, typically very complex markets. Effective managers deeply understand their businesses and spend most of their waking hours obsessing on that business. What value could even a highly seasoned, brilliant board member who engages a few times a year actually bring? Possibly the wisdom to occasionally ask the right question. But a board hardly runs the company, so why does the law pretend it does?

  19. I would be interested in seeing how board-protection measures impact corporate stakeholders other than shareholders. I can see why equity returns would be higher when boards have less protection from shareholders, but if the impact of these higher returns are also lower wages for employees or increased layoffs, lower community service involvement, fewer environmental or health safeguards, etc. than we are not seeing any actual increasing returns from shareholder activism, only increasing externalization of social costs. The real question needs to be whether these policies increase the overall economic return taking into account the externalities, or whether they are nothing more than a redistribution of wealth from employees and the community to the shareholders.

  20. You write, “Even if it were possible for some clever hedge fund manager to pressure a company into doing things that are good in the short term but bad in the short term, what is the alternative?” I believe you want a “long” in there.

  21. ‘The real question needs to be whether these policies increase the overall economic return taking into account the externalities, or whether they are nothing more than a redistribution of wealth from employees and the community to the shareholders.’

    You aren’t talking about externalities with wages and layoffs. Those are internalized. And it’s a little hard to see how less protection for Boards of Directors would affect the actual externalities like pollution.

  22. It’s how you make your numbers that’s in question.

    Sure, because there are fewer people having their limbs blown off in war, layoffs in the factory making artificial limbs is inevitable if that is all that factory was capable of making – that it can’t be re-tooled to make something else as sophisticated that would be in high demand during a time of peace.

    Fortunately, there’s always a way to drum up business instead of re-tooling which costs too much. Bombs at marathons work….19 year olds raised by the internet could buy that excuse if the ultimate goal is to meet the numbers…

    Why was the MIT security guard in the wrong place at the wrong time….?

  23. War industry wasn’t re-tooled for civilian uses after 1945? Since GM, Ford, Kaiser, etc were re-tooled in 1942 for military uses from civilian, it really wasn’t really all that difficult. And, when we de-mobilized, millions of men who’d been engaged in blowing off the limbs of Japanese and Germans were able to transition to civilian life pretty seamlessly.

    However, your believe that the Boston bombing Chechens were merely corporate executives ‘meeting the numbers’, might not be as sound as your confidence indicates.

  24. @Paddy – I thought I made it clear that how shareholders get their numbers is the issue….480 people being worth a collective total of 2.08 TRILLION is a wonderment of USA exceptionalism and must in some way be tied to how commerce operates in a country that “owns” the world record for a military budget. Boyz with their toyz? Makes the potato gun outlet for bad-boy nihilists in post WWII seem so quaint…

    And at least the kids back then were taught in grammar school chemistry class that for every gallon of gasoline used to power their Cadillac, there was 1,000 gallons of chemicals left behind to be made into some kind of “product”. Voila, a disposable plastic covered “convenience” planet!

    Next up – “digital” world litter….GIGO

    Garbage in, garbage out….

  25. Yes, Paddy, kids were introduced to “chemistry” in grammar school.

    Don’t insult me when the evidence is out there in the textbook that was used back then, you clown.

  26. Funny, I recently tutored a grammar school student, from 2nd-5th grade. Wasn’t any chemistry homework, just readin’, writin’, and ‘rithmetic. So, that leaves 1st grade or 6th for chemistry. Waddya think?

    Btw, why is it all right for you to hurl numerous insults at ‘Boyz with their toyz’, ‘nimrod’ shareholders, and ‘Bored members’–none of whom are here to defend themselves–but not legitimate for me to comment on things you have specifically said?

  27. The issue here is a conflict between management and ownership. A takeover means the likely loss of jobs for senior managers and the directors. So, even good results for shareholders will generally be bad for them.

    Delaware doctrines of board supremacy (of which Bainbridge is the most well known proponent) essentially favor management to the detriment of shareholders. This is true because generally management has de facto control over the board. Corporate boards in publicly held companies are elected in Soviet style elections except during rare takeover bids. Essentially this bias respects the de facto division of power.

    The normative argument for this approach from a legal realist’s perspective is really that management makes up the group of people who are creating value, while shareholders are dumb money, and therefore the better rule is to let management protect itself since they deserve the rewards in all but the most blatent cases of abuse.

    But, in any fair analysis using the theoretical legal framework of the management-board-shareholder relationships this is unfair and the fact that “smart money” like CALPERS takes the stance that it does reflects this fact.

    Also, as the comments bear out, it is frequently the case that senior managers (who often have stock option compensation) have interests no aligned with shareholders since stock options are heads I win, tails you lose instruments, while stock ownership generally includes both upsides and downside risk on the same basis as other shareholders (but often with less liquidity).

  28. @Paddy, “….Funny, I recently tutored a grammar school student, from 2nd-5th grade…..”

    Try to keep up, weren’t we talking about textbooks from the 1950s – not “recently”….?

    Your spin just made the case for how you are heavily invested in “dumbing down”.

  29. Since I myself was in grammar school in the 1950s, I can report that my experience as a tutor now was pretty much that the same elementary knowledge was taught in both decades. After all, one has to learn to walk before one can run.

    I’m sure you went to a school for extremely gifted children, but did you really learn chemistry before learning to add, subtract, multiply and divide?

  30. @Paddy – no matter how much mental contortionism you apply to try configure me into your deformed straw man, the chemistry of the petrol industry remains what it IS. Everyone and their uncle being IGNORANT of it does not mean things are not what they are. It just means criminal activity has bent science education. You must be insane to think there won’t be push backs.

    Introducing chemistry to elementary school kids is completely NORMAL – their curiosity and capacity to understand it is also NORMAL.

  31. You’re USELESS, Paddy. Which is not what the problem is with the politician making laws today – is it? They’re ignorant and greedy liars thieves and murderers. So, yeah. That’s not the “government” that We The People planted, is it? But then you aren’t the government, either, because your goal is just that beer at the end of the day….

  32. What is so difficult about understanding governmental replanting? Fully comprehending that solves a bunch issues at a moments notice, and it’s easy too.

  33. I’m sorry…did you say “his reputation.” you mean “he might be a man of enormous integrity and that’s what matters most”? hmmm. imagine that. in world of posers and run of the mill dirt bags “there actually might be someone who is actually interesting in the enterprise itself.” let me guess…they call him “a real loser” and “a friggin’ dope” then proceed to stare in wonder when their gold miners index fund completely collapses while the overall market powers forward thus becoming “the first money manager in history to be down 90% relative to the market average”…with a few billion more to blow of course.

  34. LK, you’re close to describing Hank Greenberg of AIG. He built that company into probably the world’s biggest insurance company. Carefully controlling for any risk he could identify. Controlling executive compensation so no one could imperil the organization (executives and managers could not sell their AIG stock until they retired).

    Even AIG Financial Products was on a short leash as Greenberg forbid it to enter into interest rate or credit default derivatives except using AIG’s AAA credit rating as collateral. The only collateral.

    All was well until an ambitious politician name Eliot Spitzer saw an opportunity. He essentially took over AIG in 2005 by legalized extortion, ousted Greenberg and his team, and replaced it with the trendiest ideas in ‘corporate governance’. In the process destroying AIG’s credit rating.

    Thereafter AIG FP could only insure financial instruments by posting collateral. Which undid it when the financial system crashed in 2008 and that collateral was illiquid. Had Greenberg been left unmolested to run his company without the bright ideas of politicians we would never have heard AIG’s name mentioned along with ‘bailout’.

    Just another example of why government should be kept far away from any investment decisions.

  35. “@Paddy – Granted, there is no “edit” feature on this site, but you can’t be serious about this paragraph making sense the way it is written, much less the way it is supposedly your case for keeping gubmint out of the insurance industry – what the hell are you insuring? Financial ruin for everyone who participated in insuring a value that was set for a product like the Queen Mary ocean liner or the Space Station…?

    you wrote, “…”Even AIG Financial Products was on a short leash as Greenberg forbid it to enter into interest rate or credit default derivatives except using AIG’s AAA credit rating as collateral. The only collateral.”…”

  36. Yeah, Paddy. Got it, You got ownership rights to it ALL by inventing a rating not tethered to the value of a Space Station and putting that rating up as the only collateral.

  37. AIG didn’t invent it’s credit rating, that’s determined by credit rating agencies. The importance of this is that when it’s only your rating used to back up your insurance policies, you aren’t subject to collateral calls when the market value of collateral declines and you have to engage in fire sale dispositions of your assets. That transforms a liquidity problem into a solvency one.

    You knew that, right?

  38. @Paddy – I know when the monkey business started with *insurance*. New Orleans – when there were no assets to sell. Ditto for aftermath of Superstorm Sandy….

    And wasn’t there a problem with the “ratings” issued by credit rating agencies?

    One big circle jerk to cover up that the premiums never went into that rainy day cookie jar to cover the losses when trouble hit. Another “you’ve been punk’d” episode….

    So 40 years of Middle Class surplus disappears into the Middle East, then natural disasters, but the ever nimble ARMY of morphing S&L/Enron/Fraudclosure wiz bookkeepers always find a way to keep shoveling the guvno around…

    No need to worry about a “First World” gene pool threatening America with civilization and culture ever again in the future. Good job, Brownie, herding them all in for the slaughter – 480 people owning it ALL, including the Moon real estate. So yeah, your next wave of immigration will lick the hand that gave it indoor plumbing, but they have to give over their whole week’s paycheck to pay for the water to flush the toilet once a day….

  39. ‘And wasn’t there a problem with the “ratings” issued by credit rating agencies?’

    Yes, of Mortgage Backed Securities, not of insurance companies.

    The point being that until Eliot Spitzer came along, AIG had plenty of cookies in their jar. That’s why they had an AAA rating.

  40. @Paddy – Yeah, because not really having the cookies, and/or not wanting, to pay out claims after disasters like Katrina and Sandy had nothing to do with anything – it’s all just another mighty mouse whore mongering Zionist in NYC who tricked America out of trillions…so if it was all SPITzer, then how “safe” is USA….? Congolese savage economy, no?

    Like I said before, the word is OUT and USA need not fear that any more immigrants from “First World” will darken the door of the NYC banksters with civilization and culture. An Empire without a single friend left in the whole wide world….

    40 years, and the song remains the same – even FAR more delusional and sadistic thanks to that Gen X touch of extremism – extreme jealousy and extreme ignorance…you are PREDATORS and history will judge you harshly, more harshly than your willful ignorance can grasp as you blather on with the SPIN…

  41. Hey Paddy, you got Jesuits in the Vatican, so here’s some ideas about how you can get *god* involved in removing the Annies from USA gene pool – true story:

    “….This idea about the universe did not sit well with the Catholic Church. They lured Giordano Bruno to Rome with the promise of a job, where he was immediately turned over to the Inquisition and charged with heresy.
    Giordano Bruno spent the next eight years in chains in the Castel Sant’Angelo, where he was routinely tortured and interrogated until his trial. Despite this, he remained unrepentant, stating to his Catholic Church judge, Jesuit Cardinal Robert Bellarmine, “I neither ought to recant, nor will I.” Even a death sentence handed down by the Catholic Church did not change his attitude as he defiantly told his accusers, “In pronouncing my sentence, your fear is greater than mine in hearing it.”
    Immediately after the death sentence was handed down, Giordano Bruno’s jaw was clamped shut with an iron gag, his tongue was pierced with an iron spike and another iron spike was driven into his palate. On February 19, 1600, he was driven through the streets of Rome, stripped of his clothes and burned at the stake.”

    The article inspiring the re-telling of that particular tale of history above was this:…hp_ref=politics”

    Have a wonderful day!

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