Takeovers: Folklore and Science

From 1981 to 1983, the number of large U.S. corporate acquisitions grew at a rate roughly double that of the 1970s and even exceeded the one realized during the famous merger wave of the 1960s. The drama of 2,100 annual takeovers valued at more than $1 million—much of it played out in heated, public battles—has generated an enormous amount of criticism, not only from politicians and the media but also from high-level corporate executives.

Commenting in the Wall Street Journal on the Bendix and Martin Marietta takeover battle, for example, Lee Iacocca, chairman of Chrysler, argued.

“It’s not a merger. It’s a three-ring circus. If they’re really concerned about America, they’d stop it right now. It’s no good for the economy. It wrecks it. If I were in the banking system I’d say no more [money] for conglomerates for one year.”

A former director at Bendix added.

“I think…it’s the kind of thing corporate America ought not to do, because the poor stockholder is the one whose interest is being ignored in favor of the egos of directors and executives. And who the hell is running the show—the business of making brakes and aerospace equipment—while all of this is going on?”

In a 1984 New York Times piece on the “surge of corporate mergers,” Felix Rohatyn noted.

“All this frenzy may be good for investment bankers now, but it’s not good for the country or investment bankers in the long run. We seem to be living in a 1920s, jazz age atmosphere.”

Just as the public outcry over excesses on Wall Street in the early 1930s led to the Glass-Steagall Act regulating banking, so the latest criticisms of mergers have brought enormous political pressure to bear on Congress to restrict takeovers. The July 1983 report of the SEC Advisory Committee on Tender Offers contained 50 recommendations for new regulations. Democratic Representative Peter Rodino has cosponsored a bill that would require advance notice of proposed acquisitions resulting in assets of $5 billion and 25,000 employees and a judgment by the Antitrust Division of the Justice Department or the FTC whether such acquisitions “serve the public interest.”

The popular view underlying these proposals is wrong, however, because it ignores the fundamental economic function that takeover activities serve. In the corporate takeover market, management teams compete for the right to control—that is, to manage—corporate resources. Viewed in this way, the market for control is an important part of the managerial labor market, which is very different from, and has higher stakes than, the normal labor market. After all, potential chief executive officers do not simply leave their applications with personnel officers. Their on-the-job performance is subject not only to the normal internal control mechanisms of their organizations but also to the scrutiny of the external market for control.

Imagine that you are the president of a large billion-dollar corporation. Suddenly, another management team threatens your job and prestige by trying to buy your company’s stock. The whole world watches your performance. Putting yourself in this situation leads to a better understanding of the reasons behind the rhetoric, maneuverings, and even lobbying in the political and regulatory sectors by managers for protection from unfriendly offers.

The Bendix attempt to take control of Martin Marietta in 1982 gained considerable attention because of Marietta’s unusual countertakeover offer for Bendix, called the “Pac-Man defense,” whose principle is: “My company will eat yours before yours eats mine.”¹ Some describe this kind of contest as disgraceful. I find it fascinating because it makes clear that the crucial issue is not whether the two companies will merge but which managers will be in control.

At the end of the contest, Bendix held 67% of Martin Marietta while Martin Marietta held 50% of Bendix. United Technologies then entered as Martin Marietta’s friend and offered to buy Bendix. But it was Allied, coming in late, that finally won the battle with its purchase of all of Bendix’s stock, 39% of Martin Marietta’s, and a promise not to buy more. When the dust had cleared, shareholders of Bendix and Martin had both won; their respective shares gained roughly 38% in value (after adjusting for marketwide stock price change). Allied’s shareholders, on the other hand, lost approximately 8.6%.²

Given the success and history of the modern corporation, it is surprising how little the media, the legal and political communities, and even business executives understand the reasons behind the complexities and subtleties of takeover battles. Prior to the last decade, the academic community made little progress in redressing this lack of understanding. But research efforts in business schools across the country have recently begun to overcome it.

In this article I summarize the most important scientific evidence refuting the myths that swirl around the controversy. The research shows that:

• Takeovers of companies by outsiders do not harm shareholders of the target company; in fact, they gain substantial wealth.

• Corporate takeovers do not waste resources; they use assets productively.

• Takeovers do not siphon commercial credit from its uses in funding new plant and equipment.

• Takeovers do not create gains for shareholders through creation of monopoly power.

• Prohibition of plant closings, layoffs, and dismissals following takeovers would reduce market efficiency and lower aggregate living standards.

• Although managers are self-interested, the environment in which they operate gives them relatively little leeway to feather their nests at shareholders’ expense. Corporate control-related actions of managers do not generally harm shareholders, but actions that eliminate actual or potential takeover bids are most suspect as exceptions to this rule.

• Golden parachutes for top-level executives are, in principle, in the interest of shareholders. Although the practice can be abused, the evidence indicates that shareholders gain when golden parachutes are adopted.

• In general, the activities of takeover specialists benefit shareholders.

Before exploring the evidence, I consider why shareholders are the most important constituency of the modern corporation and why their interests must be held paramount when discussing the current wave of acquisitions and mergers.

The Nature of the Corporation

Stockholders are commonly portrayed as one group in a set of equal constituencies, or “stakeholders,” of the company. In fact, stockholders are not equal with these other groups because they are the ultimate holders of the rights to organization control and therefore must be the focal point for any discussion concerning it.

The public corporation is the nexus for a complex set of voluntary contracts among customers, workers, managers, and the suppliers of materials, capital, and risk bearing. The rights of the interacting parties are determined by law, the corporation’s charter, and the implicit and explicit contracts with each individual.

Corporations, like all organizations, vest control rights in the constituency bearing the residual risk.³ (Residual risk is the risk associated with the difference between the random cash inflows and outflows of the organization.) In partnerships and privately held companies, for example, these residual claims and the organizational control rights are restricted to major decision agents (directors and managers); in mutuals and consumer cooperatives, to customers; and in supplier cooperatives, to suppliers.

Corporations are unique organizations because they make no restrictions on who can own their residual claims and this makes it possible for customers, managers, labor, and suppliers to avoid bearing any of the corporate residual risk. Because stockholders guarantee the contracts of all constituents, they bear the corporation’s residual risk. The absence of restrictions on who can own corporate residual claims allows specialization in risk bearing by those investors who are most adept at the function. As a result, the corporation realizes great efficiencies in risk bearing that reduce costs substantially and allow it to meet market demand more efficiently than other organizations.

Although the identities of the bearers of residual risk may differ, all business organizations vest organizational control rights in them. For control to rest in any other group would be equivalent to allowing that group to “play poker” with someone else’s money and would create inefficiencies that lead to the possibility of failure. Stockholders as the bearers of residual risk hold the right to control of the corporation, although they delegate much of this control to a board of directors who normally hire, fire, and set the compensation of at least the CEO.

Proof of the efficiency of the corporate organizational form shows dramatically in market performance. In principle, any marketer can supply goods and services. In reality, all organizational forms compete for consumers, managers, labor, and supplies of capital and other goods. Those that supply the goods demanded by customers at the lowest price win out. The dominance of the corporate form of organization in large-scale nonfinancial activities indicates that it is winning much of this competition.

Acquisition Folklore

Takeovers can be carried out through mergers, tender offers, and proxy fights, or sometimes through elements of all three. A tender offer made directly to the stockholders to buy some or all of their shares for a specified price during a specified time period does not require the approval of the target company’s management or board of directors. A merger, however, is negotiated with the company’s management and, when approved by its board of directors, is submitted to the shareholders for approval. In a proxy contest the votes of the stockholders are solicited, generally for the election of a new slate of directors.

Takeovers frequently begin with what is called a “friendly” merger offer from the bidder to the target management and board. If management turns down the offer, the bidder can, and often does, take the offer directly to the shareholders in the form of a tender offer. At this point, target company managers usually oppose the offer by issuing press releases condemning it as outside the shareholders’ best interest, by initiating court action, by requesting antitrust action against the bidder, by starting a countertakeover move for the bidder, and by other actions designed to make the target company a less desirable acquisition.

Target company management often casts about for a “white knight”—a friendly merger partner who will protect the “maiden” from the advances of the feared raider and, more important, who will pay a higher price. When the company doesn’t find a white knight, and an unfriendly bidder takes it over, its leaders will likely look for new jobs. The takeover process penalizes incompetent or self-serving managers whose actions have lowered the market price of their corporation’s stock. Although the process operates with a lag, the forces are strong and persistent. Of course—as a result of economies of scale or other efficiencies—some efficient managers lose their jobs after a takeover through no fault of their own.

This kind of romantic language has been used to offer comic relief, but it contributes to the atmosphere of folklore that surrounds a process fundamental to the corporate world. The resulting myths and misunderstandings distort the public’s perception and render a meaningful dialogue impossible.

Folklore: Takeovers harm the shareholders of target companies.

Fact: The pejorative term raider used to label the bidding company in an unfriendly takeover suggests that the bidder will buy control of a company, pillage it, and leave the stockholders with only a crumbling shell.

More than a dozen studies have painstakingly gathered evidence on the stock price effect of successful takeovers (see Exhibit I for a summary of the results).⁴According to these studies, companies involved in takeovers experience abnormal increases in their stock prices for approximately one month surrounding the initial announcement of the take-over. (Abnormal stock price changes are stock price changes customarily adjusted by regression analysis to eliminate the effects of marketwide forces on all corporations.)⁵ The exhibit shows that target company shareholders gain 30% from tender offers and 20% from mergers.

Because tender offers are often extended for less than 100% of the outstanding shares and because not all takeover announcements result in acquisitions, stock prices do not increase at the announcement of the offer by the full amount of the premium offered. Consequently, average target stockholder returns in takeovers are actually higher than the estimates in Exhibit I because the abnormal stock price changes it summarizes generally exclude the purchase premiums shareholders receive when they surrender their shares.

The shareholders of bidding companies, on the other hand, earn only about 4% from tender offers and nothing from mergers. If the much feared raiding has taken place, it seems to be of a peculiar, Robin Hood variety.

When an insurgent group, led by a dissatisfied manager or a large stockholder, attempts to gain controlling seats on the board of directors of a company (thereby taking over the company through an internal proxy fight), shareholders also gain. As Exhibit I shows, the stock prices of these companies gain 8% on average.

Because target companies are usually a lot smaller than the bidders, you cannot calculate total returns to both parties from the data in Exhibit I. An analysis of more than 180 tender-offer acquisitions, however, indicates statistically significant gains to target and acquiring company shareholders equal to an average 8.4% of the total market value of the equity of both companies.⁶

In sum, contrary to the argument that merger activity wastes resources without benefiting stockholders, stockholders earn substantial gains in successful takeovers. In the Texaco takeover of Getty, for example, Getty Oil shareholders realized abnormal stock price gains of $4.7 billion, or 78.6% of the total equity value, and Texaco shareholders, abnormal returns of $1.3 billion or 14.5%. Gains for both totaled $6 billion, 40% of the sum of their equity values. Gulf stockholders earned abnormal returns of $6.2 billion (79.9%) from the Socal takeover, and Socal stockholders earned $2.8 billion (22.6%). The total gains of $9 billion in this merger represent a 44.6% increase in the total equity values of both companies.

In light of these shareholder benefits, the cries to eliminate or restrain unfriendly takeovers seem peculiar (and in some cases self-serving). In a January 5, 1983 Wall Street Journal article, Peter Drucker called for such controls: “The question is no longer whether unfriendly takeovers will be curbed but only when and how.” He went on to say:

Such arguments may comfort concerned managers and board members who want protection from the discipline of competition in the market for managers. But they are based on false premises. The best way to discourage the competing manager (that’s what raider means) is to run a company to maximize its value. “Will this decision help us obtain maximum market value?” is the only logically sensible interpretation of “What is best for the business?”

Folklore: Takeover expenditures are wasted.

Fact: Purchase prices in corporate takeovers represent the transfer of wealth from the stockholders of bidding companies to those of target organizations, not the consumption of wealth. In a takeover, the resources represented in the cash received by the target shareholders can still be used to build new plant and equipment or for R&D.

The only resources consumed are those used to arrange the transaction, such as the time and fees of managers, lawyers, economists, and financial consultants. These expenses are often large in dollar terms; the financial fees of the U.S. Steel/Marathon Oil merger were more than $27 million, and those received by four investment banking firms in the Getty takeover hit a record by exceeding $47 million. But they are a tiny fraction of the dollar value of the acquisition; total financial and legal fees usually amount to only about .7%. More significantly, they help shareholders achieve their much larger gains of 4% to 30%.

In fact, the stock price change is the best measure of the takeover’s future impact on the organization. The vast scientific evidence on the theory of efficient markets indicates that, in the absence of inside information, a security’s market price represents the best available estimate of its true value.⁷ The evidence shows that market prices incorporate all current public information about future cash flows and the value of individual assets in an unbiased way. Stock prices change, of course, in response to new information about individual assets. Because market prices are efficient, however, the new information is equally likely to cause them to decrease or increase, after allowing for normal returns. Positive stock price changes, then, indicate a rise in the total profitability of the merged companies. Furthermore, because evidence indicates it does not come from the acquisition of market power, this increased profitability must come from the company’s improved productivity.

Folklore: The huge bank credit lines used to carry out large takeovers siphon credit from the financial system and crowd out “legitimate” borrowing for productive investments.

Fact: First, the increases in shareholder wealth I’ve discussed indicate that takeover activities are productive investments; credit lines are not wasted. Second, companies that make acquisitions with stock or other securities, or with cash on hand or capital acquired from the sale of assets, do not use bank credit.

More important, even when companies accomplish takeovers with bank loans, they do not waste credit because most, if not all, of it is still available for real investment such as new plant and equipment. Let me illustrate the point by using a simple example.

When an acquiring company borrows from a bank for an acquisition, it receives the funds in the form of a credit to its bank account. When target company stockholders deposit receipts from the takeover in their accounts, the bank’s total deposits remain unchanged because the acquirer’s deposits are reduced by the same amount.

Now, however, the portfolios of the target company shareholders are unbalanced. In response, they can make new investments either directly or by purchasing newly issued shares, and if they do so the credit goes directly into productive real investments. If they take the opposite course of action and reduce their bank debt, the bank will have the same amount of loans and deposits as before the acquisition; total outstanding credit is unchanged and there is no waste.

Alternatively, target company shareholders can purchase securities from other investors, but the sellers then are in the same position as the target company shareholders after the acquisition.

If the recipients of the funds from the takeover don’t make new investments or pay down debt, they must increase either their cash holdings or their consumption. If their wealth hasn’t changed, they have no reason to change either their cash balances or their consumption, and, therefore, the proceeds will go to make new investments and/or reduce debt. If investor wealth increases, investors will increase their consumption and their cash balances. The value of the consumption and cash balance increases will only be a small fraction of the wealth increase (the capital gains, not the proceeds) from the take-over; the remainder will go for new investments and/ or debt reduction. The increase in cash balances and consumption will be the same as that coming from increases in wealth generated by any other cause. Thus, takeovers waste no more credit than any other productive investment.

Folklore: By merging competitors, takeovers create a monopoly that will raise product prices, produce less, and thereby harm consumers.

Fact: The evidence from four studies of the issue indicates that takeover gains come not from the merger’s creation of monopoly market power but from its productive economies and synergy.

If the gains did come from the creation of companies with monopolistic powers, industry competitors would benefit, in turn, from the higher prices and would enjoy significant increases in profits and stock prices. Furthermore, the stock prices of rivals would fall if the FTC or the Antitrust Division of the Justice Department cancelled or challenged the merger.

The evidence indicates, however, that competitors gain when two other companies in the same industry merge. But these gains are not related to the creation of monopolistic power or industry concentration. Moreover, the stock prices of competitors do not fall on announcement of antitrust prosecution or cancellation of the acquisition. This evidence supports the hypothesis that takeover gains stem from real economies in production and distribution realized through the takeover and that it signals the availability of similar gains for rival companies.⁸

In fact, the evidence raises serious doubts about the wisdom of FTC or Justice Department policies concerning mergers. The cancellation of an acquisition erases virtually all the stock price increases occurring on its announcement—with no apparent offsetting benefits to anyone.⁹

Folklore: Consolidating facilities after a takeover leads to plant closings, layoffs, and employee dismissals—all at great social cost.

Fact: No evidence with which I am familiar indicates that takeovers produce more plant closings, layoffs, and dismissals than would otherwise have occurred.

This charge raises a serious question, however, about the proper criteria for evaluation of the social desirability of takeovers. The standard efficiency yardstick measures increases in the aggregate real standard of living. By these criteria the wealth gains from takeovers (and their associated effects) are good as long as they do not come from the creation of monopolistic market power. Therefore, even if takeovers lead to plant closings, layoffs, and dismissals, their prohibition or limitation would generate real social costs and reduce aggregate human welfare because of the loss of potential operating economies.

Some observers may not agree that the standard efficiency criterion is the best measure of social desirability. But the adoption of any other criterion threatens to paralyze innovation. For example, innovations that increase standards of living in the long run initially produce changes that reduce the welfare of some individuals, at least in the short run. The development of efficient truck and air transport harmed the railroads and their workers; the rise of television hurt the radio industry. New and more efficient production, distribution, or organizational technology often imposes similar short-term costs.

The adoption of new technologies following takeovers enhances the overall real standard of living but reduces the wealth of those individuals with large investments in older technologies. Not surprisingly, such individuals and companies, their unions, communities, and political representatives will lobby to limit or prohibit takeovers that might result in new technologies. When successful, such politics reduce the nation’s standard of living and its standing in international competition.

Folklore: Managers act in their own interests and are in reality unanswerable to shareholders.

Fact: Because executive compensation is related to company size, critics charge that a top officer’s desire for wealth and an empire drives merger activity while the stockholders pay the bill. But as Exhibit I shows, there is no systematic evidence that bidding company managers are harming shareholders to build empires. Instead, the evidence is consistent with the synergy theory of takeovers. This theory argues that the stock price increases for target companies come from the increase in value obtained by consolidating or altering control of the assets of the companies involved, perhaps because of cost savings from economies of scale or from a highly complementary combination of employees and assets in production and distribution.

The evidence shows that target companies get a large share of the gains; indeed, the gains in mergers go to the target companies while virtually none accrue to bidding companies on the average. Bidding wars such as the DuPont-Seagram-Mobil competition for control of Conoco push up the gain for target companies.

The zero returns to bidders in mergers noted in Exhibit I are puzzling. For several reasons, however, this particular estimate has more uncertainty built into it and is probably biased downward. My own assessment is that the returns to bidding companies in mergers are closer to the 4% shown for bidders in tender offers. An examination of the total dollar gains to both bidding and target company shareholders shows that both get about the same amount of dollars but not of percentage gains. The disparity results because bidding companies are generally larger than target companies and the same dollar gains translate into different percentage gains. Because the stock prices of larger companies vary more widely relative to gains in an acquisition than do the stock prices of target companies, their returns cannot be estimated as precisely.

Furthermore, bidders often engage in a prolonged acquisition program. The benefits for target companies from a particular merger occur around the time of the takeover announcement and therefore can be more easily estimated than the bidders’ benefits, which may be spread out over several acquisitions.

Often the stock price of a company that seeks several acquisitions reflects the projected benefits of future deals at an early date.¹⁰When a particular acquisition is announced, the bidder’s stock price will change only to the extent that there is a difference between the actual and the previously expected profitability of the merger and on average this will be zero in an efficient market. And because mergers involve negotiations that do not occur in tender offers, more information about the intentions of bidders will leak than will information about the identity of the target; the effect on the bidder’s price will therefore be spread out over time.

The record of several large takeovers shows mixed evidence on the returns to acquiring shareholders. In the $13.2 billion takeover of Gulf, Socal shareholders earned $2.77 billion (22.6%) after adjustment for the effects of marketwide price changes (from January 23, 1984 to May 3, 1984). Similarly, in the $10.1 billion takeover of Getty Oil, Texaco shareholders earned $1.3 billion (14.5%, from December 13, 1983 to February 7, 1984). In contrast, Allied shareholders lost $100 million (18.6%) in the acquisition of Bendix; DuPont lost $800 million (110.0%) in the take-over of Conoco, while Conoco shareholders realized a gain of 71%, or about $3.2 billion.¹¹

On the other hand, Occidental Petroleum shareholders did not lose in Occidental’s takeover of Cities Service, whose shareholders gained about $350 million (12.5%).¹² Mesa Petroleum initiated the Cities Service war with a bid of $45 per share. Cities Service countered with a bid for Mesa Petroleum. Gulf Oil then announced completion of negotiations to merge with Cities Service for $63 per share; Cities Service stock immediately gained over 43%, or $1.25 billion. In contrast, the Gulf stock price fell over 14%, or slightly over $900 million. The $350 million difference between the gain to Cities Service shareholders and the loss to Gulf shareholders measures the market’s estimate of the net increase in value from the merger.

Citing antitrust difficulties with the FTC, Gulf cancelled its acquisition of Cities Service seven weeks later. Cities Service countered with a breach of contract suit against Gulf for $3 billion. All the earlier gains in the price of Cities Service stock were eliminated, but only one-third of the Gulf loss was recovered—perhaps because the market forecast that legal action might hold Gulf liable for part of the premium offered to Cities Service shareholders or that Gulf would make more overpriced takeover attempts. Within four weeks of the Gulf cancellation, Cities Service merged with Occidental for a $350 million premium—an amount identical to the estimated value of the net merger gains from the aborted combination of Cities Service and Gulf.

A good way for a company to become a takeover target is to make a series of acquisitions that reduce value but allow the value to be recovered through divestiture. A bidder that realizes it can make money by selling off the pieces at a profit will likely seize the initiative. Victor Posner’s attack on Marley Company in 1981 is an extreme example. Marley, which manufactured water-cooling towers and heat exchangers, took control of Wylain, a manufacturer of air conditioning, heating, and pumping systems, for an 87% premium over Wylain’s previous market value. Marley’s stock price fell 21%. Posner bought 11.2% of Marley during the first six months of 1980. Unable to find a white knight, Marley sold its assets, dissolved, and distributed the proceeds in June 1981. Posner received $21.9 million for his investment of $12.5 million in Marley.¹³

Manager-Shareholder Conflicts

The interests of managers and shareholders conflict on many, but certainly not all, issues. The divergence intensifies if the company becomes the target of an unfriendly takeover. Exhibit I indicates that target shareholders benefit when the bidders offer substantial premiums over current market value. During a takeover top managers of target companies can lose both their jobs and the value of their talents, knowledge, and income that are particular to the organization. Threatened with these losses, such officers may try to reduce the probability of a successful unfriendly takeover and benefit themselves at the expense of shareholders.

Management struggles

The attempt by Carter Hawley Hale to acquire Marshall Field is an interesting example of a management struggle to retain control. Marshall Field, a high-quality department and specialty store chain, enjoyed less growth than other retailers but consistently rejected merger bids. In early 1978, Carter Hawley Hale, another retailer, offered $42 per share for Marshall Field stock, which was selling for less than $20. Resisting, Marshall Field filed a lawsuit that argued the acquisition would violate securities and antitrust laws. It informed shareholders that the asking price was inadequate and made several defensive acquisitions that aggravated potential antitrust problems and made it less attractive to Carter Hawley. Marshall Field’s board authorized top officials to take “such action as they deemed necessary” to defeat the offer. After Carter Hawley withdrew the offer, Marshall Field’s stock fell back to $20 per share.

In April 1984, another retailer, The Limited, tried to take over Carter Hawley Hale, whose stock then experienced abnormal gains of 49% in the ensuing conflict. Carter Hawley filed suit against The Limited, claiming securities law violations and antitrust problems, and gave up 33% of its voting rights through the sale of $300 million of convertible preferred stock to General Cinema Corporation. Carter Hawley then gave General Cinema a six-month option to buy the Waldenbook chain, one of its most profitable subsidiaries, and repurchased 51% of its own shares. As a result The Limited withdrew its offer in May and Carter Hawley stockholders lost $363 million—the entire 49% abnormal stock price gain.

Both of these cases show what happens to stock prices when acquisition bids fail. Exhibit II summarizes the general evidence obtained from ten studies on stock price behavior during unsuccessful takeover attempts. The average abnormal stock price changes surrounding unsuccessful takeover bids are uniformly small and negative, ranging from –1% to –5%. The exception is the 8% positive return to shareholders of companies subjected to unsuccessful proxy contests. It is interesting that a proxy contest causes an abnormal stock price gain even when the challengers fail, perhaps because the contest threat motivates incumbent managers to change their strategies.

The uncertainty of the estimates, however, means that only the 15% return for unsuccessful bidders is statistically significantly different from zero. The other negative returns can arise by chance if the true returns from such unsuccessful offers are actually zero. In conclusion, the Marshall Field experience that target company shareholders essentially lose all the offered premiums when an acquisition bid fails, fits the general evidence.

Exhibit II, however, simplifies the story. Sometimes stockholders benefit greatly from opposition to takeover bids.

Uncoordinated, independent decisions by individual shareholders regarding the acceptance or rejection of a tender offer can cause most of the takeover gains to go to bidding company stockholders.¹⁴ If target managers act as the agents for all target shareholders in negotiating with the bidder for a higher price, however, this “free rider” problem can be alleviated.

Empirical evidence also indicates that some managerial opposition benefits target shareholders. For example, on the failure of a tender offer, target stock prices do not on average immediately lose the 30% average increase in price they earned when the offer was made. In fact, they generally stay up, apparently in anticipation of future bids. And target companies that receive at least one more bid in the two years following the failure of a tender offer on average realize another 20% increase in price. Those targets that do not receive another bid, however, lose the entire initial price increase.¹⁵ Apparently, a little opposition in a merger battle is good, but too much can be disastrous if it prohibits takeover of the company.

The corporate charter

Corporate charters specify governance rules and establish conditions for mergers, such as the percentage of stockholders who must approve a takeover. Since constraints on permissible charter rules differ from state to state, changing the state of incorporation will affect the contractual arrangement among shareholders and the probability that a company will be a takeover target. It is alleged that some states desiring to increase their zncorporate charter revenues make their statutes appealing to corporate management. Allegedly, in doing so they provide management with great freedom from stockholder control and therefore provide little shareholder protection. Delaware, for example, has few constraints in its rules on corporate charters and hence provides much contractual freedom for shareholders. William L. Cary, former chairman of the Securities and Exchange Commission, has criticized Delaware and argued that the state is leading a “movement towards the least common denominator” and “winning a race for the bottom.”¹⁶

But a study of 140 companies switching their state of incorporation reveals no evidence of stock price declines at the time of the change, even though most switched to Delaware.¹⁷ In fact, small abnormal price increases are usually associated with the switch. This evidence is inconsistent with the notion that such charter changes lead to managerial exploitation of shareholders.

Without switching their state of incorporation, companies can amend corporate charters to toughen the conditions for the approval by shareholders of mergers. Such antitakeover amendments may require a “super majority” for approval or for the staggered election of board members and can thus lower the probability that the company will be taken over and thereby reduce shareholder wealth. On the other hand, the amendments can also benefit shareholders by increasing the plurality required for takeover approval and thus enable management to better represent their common interests in the merger negotiations.

Two studies of adoption of antitakeover amendments in samples of 100 and 388 companies reveal no negative impact on shareholder wealth.¹⁸ One exception may arise if the super-majority provisions grant effective power to block mergers to a manager-stockholder. The market value of R.P. Scherer, for example, fell 33.8% when shareholders adopted an 80% super-majority merger approval provision. Because the wife of Scherer’s CEO owned 21.1% of the stock, she then had the power to block a proposed takeover by FMC. In fact, FMC withdrew its offer after Scherer stockholders approved the 80% majority provision and the price of Scherer stock plummeted.

Repurchase standstill agreements

Currently available evidence suggests that management’s opposition to takeovers reduces shareholder wealth only when it eliminates potential takeover bids. In a privately negotiated or targeted repurchase, for example, a company buys a block of its common stock from a holder at a premium over market price—often to induce the holder, usually an active or a potential bidder, to cease takeover activity. Such repurchases, pejoratively labeled “greenmail” in the press, generate statistically significant abnormal stock price declines for shareholders of the repurchasing company and significantly positive returns for the sellers.¹⁹ These stock price declines contrast sharply with the statistically significant abnormal stock price increases associated with nontargeted stock repurchases found in six studies.²⁰

The managers of target companies also may obtain standstill agreements, in which one company agrees to limit its holdings in another. Announcements of such agreements are associated with statistically significant abnormal stock price declines for target companies. Because these agreements almost always lead to the termination of an acquisition attempt, the negative returns seem to represent the merger gains lost by shareholders.

Again, however, the issue is not clearcut because closer examination of the evidence indicates that these takeover forays by competing managers benefit target shareholders. Within ten days of an acquisition of 5% or more of a company’s shares, the SEC requires the filing of information giving the identity of the purchaser, purpose of acquisition, and size of the holding. The significantly positive increase in stock price that occurs with the initial purchase announcement indicates that potential dissident activity is expected to benefit shareholders even given the chance that the venture will end in a targeted repurchase. Moreover, this is confirmed by the fact that on average during the period from the SEC filing through the targeted repurchase of the shares, target company shareholders earn statistically significant positive abnormal returns.²¹

Thus, when you look at the whole process, repurchase agreements are clearly not “raiding” or “looting” but are profitable for the target shareholders—although not as profitable as a takeover. The stock price decline at repurchase seems due to the repurchase premium that is effectively paid by the nonselling shareholders of the target firm and to the unraveling of takeover expectations with consequent loss of the anticipated takeover premium.

Because, on average, target shareholders lose the anticipated takeover premiums shown in Exhibit I when a merger or takeover fails for any reason, we cannot easily tell whether they were hurt by a repurchase. If the takeover would have failed anyway and if the target company’s stock price would have fallen even more without the repurchase, then the repurchase benefited target company shareholders. Such additional price declines might be caused, for example, by the costs of dealing with a disgruntled minority shareholder.

Although the issue requires further study, current evidence implies that prohibition of targeted large-block repurchases advocated by some may hurt target shareholders. Moreover, since shareholders can amend corporate charters to restrict targeted repurchases, there is little justification for regulatory interference by the state in the private contractual arrangements among shareholders. Such repurchase restrictions might well restrict the vast majority of stock repurchases that clearly benefit shareholders. In addition, by reducing the profitability of failed takeovers, such restrictions would strengthen the position of entrenched managers by reducing the frequency of takeover bids. Doing so would deprive shareholders of some of the stock price premiums associated with successful mergers.

Going private

The phrase going private means that publicly owned stock is replaced with full equity ownership by an incumbent management group and that the stock is delisted. On occasion, when going private is a leveraged buy out, management shares the equity with private investors. Some believe that incumbent managers as buyers are exploiting outside shareholders as sellers in these minority freeze outs.

Advocating restrictions on going-private transactions, in 1974 Securities and Exchange Commissioner A.A. Sommer, Jr. argued.

“What is happening is, in my estimation, serious, unfair, and sometimes disgraceful, a perversion of the whole process of public financing, and a course that inevitably is going to make the individual shareholder even more hostile to American corporate mores and the securities markets than he already is.”²²

Study of stockholder returns in 72 going-private transactions, however, reveals that the average transaction offers a premium 56% over market price and that abnormal stock price increases on announcement of the offer average 30%. The gains apparently arise from savings of registration and other public ownership expenses, improved incentives for decision makers under private ownership, and increased interest and depreciation tax shields. Outside shareholders are not harmed in going-private transactions.²³

Golden parachutes

Some companies provide compensation in employment contracts for top-level managers in the event that a takeover occurs—that is, golden parachutes. Allied agreed, for example, to make up the difference for five years between Bendix CEO William Agee’s salary in subsequent employment and his former annual $825,000 salary in the event of a change in control at Bendix. Much confusion exists about the propriety and desirability of golden parachutes, even among senior executives.

But the detractors fail to understand that the parachutes protect stockholders as well as managers. Think about the problem in the following way: top-level managers and the board of directors act as stockholders’ agents in deals involving hundreds of millions of dollars. If the alternative providing the highest value to stockholders is sale to another company and the retirement of the current management team, stockholders do not want the managers to block a bid in fear of losing their own jobs. Stockholders may be asking managers to sacrifice position and wealth to negotiate the best deal for them.

Golden parachutes are clearly desirable when they protect stockholders’ interests. Like anything else, however, they may be abused. For example, a stockholder doesn’t want to pay managers so much for selling the company that they hurry to sell at a low price to the first bidder. But that is a problem with the details of the parachute’s contractual provisions and not with the existence of the parachute itself. An analysis of 90 companies shows that adoption of golden parachutes on average has no negative effect on stock prices and provides some evidence of positive effects.²⁴

The thing that puzzles me about most golden parachute contracts is that they pay off only when the manager leaves his job and thus create an unnecessary conflict of interest between shareholders and executives. Current shareholders and the acquiring company will want to retain the services of a manager who has valuable knowledge and skills. But the officer can collect the golden parachute premium only by leaving; the contract rewards him or her for taking an action that may well hurt the business. As the bidder assimilates the knowledge that turnover among valuable top-level managers after the acquisition is highly likely, it will reduce its takeover bid. A company can eliminate this problem by making the award conditional on transfer of control and not on the manager’s exit from the company.

Selling the “crown jewels”

Another often criticized defensive tactic is the sale of a major division by a company faced with a take-over threat. Some observers claim that such sales prove that managers will do anything to preserve their tenure, even to the extent of crippling or eliminating major parts of the business that appear attractive to outside bidders. Such actions have been labeled a “scorched earth policy.”

Studies of the effects of corporate spinoffs, however, indicate they generate significantly positive abnormal returns.²⁵ Moreover, when target managers find a white knight to pay more for the entire company than the initial, hostile bidder, shareholders clearly benefit.

In the same way, when an acquirer is interested mainly in a division rather than the whole company, shareholders benefit when target management auctions off the unit at a higher price. Brunswick’s sale of its Sherwood Medical Industries division to American Home Products shows how the sale of a crown jewel can benefit shareholders. Whittaker Corporation made a hostile takeover bid for Brunswick in early 1982. In defense, Brunswick sold a key division, Sherwood Medical, to American Home Products through a negotiated tender offer for 64% of Brunswick’s shares. American Home Products then exchanged these shares with Brunswick for Sherwood’s stock. Because its main interest lay in acquiring Sherwood, Whittaker withdrew its offer.²⁶

The value of the Whittaker offer to Brunswick shareholders ranged from $605 million to $618 million, depending on the value assigned to the convertible debentures that were part of the offer. The total value to Brunswick shareholders of the management strategy, selling off the Sherwood division, was $620 million. Moreover, because of the structure of the transaction, the cash proceeds went directly to the Brunswick shareholders through the negotiated tender offer. The $620 million value represents a gain of $205 million (49%) on the total equity value of Brunswick prior to the initial Whittaker offer. The Brunswick shareholders were $2 million to $15 million better off with the management strategy, hardly evidence of a scorched-earth policy.

Takeover artists

Recently, criticism has been directed at corporate takeover specialists who are said to take advantage of a company’s vulnerability in the market and thus ultimately harm shareholders. While acting in their own interests, however, these specialists also act as agents for shareholders of companies with entrenched managers. Returning to the Marshall Field story, for example, Carl Icahn launched a systematic campaign to acquire the chain after it had avoided takeover. When it looked as if he would achieve the goal, Marshall Field initiated a corporate auction and merged with BATUS (British American Tobacco Company, U.S.) for $30 per share in 1982. After adjustment for inflation, that price was slightly less than the $20 price of Field’s stock in 1977, when it defeated Carter Hawley’s $42 offer.

Takeover specialists like Icahn risk their own fortunes to dislodge current managers and reap part of the value increases available from redeploying the assets or improving the management. Evidence from a study of 100 such instances indicates that when such specialists announce the purchase of 5% or more of a company’s shares, the stockholders of that company on average earn significantly positive abnormal returns of about 6%.²⁷

The Effectiveness of the Market

The corporation has contributed much to the enhancement of society’s living standards. Yet the details of how and why this complex institution functions and survives are poorly understood, due in part to the complexity of the issues involved and in part to the political controversy that historically surrounds it. Much of this controversy reflects the actions of individuals and groups that wish to use the corporation’s assets for their own purposes, without purchasing them.

One source of the controversy comes from the separation between managers and shareholders—a separation necessary to realize the large efficiencies in risk bearing that are the corporation’s comparative advantage. The process by which internal control mechanisms work so that professional managers act in the shareholders’ interest is subtle and difficult to observe. When internal control mechanisms are working well, the board of directors will replace top-level managers whose talents are no longer the best ones available for the job.²⁸

When these mechanisms break down, however, stockholders receive some protection from the take-over market, where alternative management teams compete for the rights to manage the corporation’s assets. This competition can take the form of mergers, tender offers, or proxy fights. Other organizational forms such as nonprofits, partnerships, or mutual insurance companies and savings banks do not benefit from the same kind of external market.

The takeover market also provides a unique, powerful, and impersonal mechanism to accomplish the major restructuring and redeployment of assets continually required by changes in technology and consumer preferences. Recent changes occurring in the oil industry provide a good example.

Scientific evidence indicates that activities in the market for corporate control almost uniformly increase efficiency and shareholders’ wealth. Yet there is an almost continuous flow of unfavorable publicity and calls for regulation and restriction of unfriendly takeovers. Many of these appeals arise from managers who want protection from competition for their jobs and others who desire more controls on corporations. The result, in the long run, may be a further weakening of the corporation as an organizational form and a reduction in human welfare.