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.