The Board of Directors/Management

Corporate board structures differ among countries and have evolved into two basic types: unitary (single) and two-tier (dual) structures. A unitary board is composed of both company managers and independent directors, which make decisions as a group. An independent (or outside) director is someone who has not worked for the firm in the past, is not a current manager, does not stand to benefit financially beyond what is paid to other board directors, and is not a captive of the firm’s current culture or way of doing business. A two-tier board consists of a management board composed only of company executives, including the chief executive officer, whose responsibilities are to run the firm’s operations, and a separate supervisory board comprised only of independent directors. Overseeing the management board, the supervisory board is responsible for strategic decisions and often contains other stakeholders such as employees and environmental groups.

The United States and the United Kingdom are examples of countries having mandated unitary board structures, while Germany and Austria use the two-tiered board structure. In other countries such as France, firms are permitted to switch between the two types of structures. Which structure a firm chooses seems to reflect the extent to which shareholders see potential significant conflicts with management as to how the firm should be managed.

Finance literature commonly presumes a board’s ultimate responsibility is to maximize shareholder wealth. In practice, the way boards view their responsibilities varies widely ranging from German and Austrian firms’ supervisory boards attempting to balance the interests of all stakeholder groups to US firms which view maximizing shareholder wealth as their primary responsibility.²

What follows is more descriptive of a unitary board structure. For such boards, the primary responsibilities are to advise the CEO and to monitor firm performance. The board hires, fires, and sets CEO pay and is expected to oversee management, corporate strategy, and the firm’s financial reports to shareholders. Some board members may be employees or founding family members (so-called inside directors); others may be affiliated with the firm through a banking relationship, a law firm retained by the firm, or someone who represents a customer or supplier. The value of such directors often lies in their substantial organizational knowledge. However, they may be subject to conflicts of interest causing them to act in ways not in the shareholders’ best interests. For example, boards with directors working for banks that have made loans to the firm may favor diversifying acquisitions that are financed with stock rather than cash.³ Such acquisitions may smooth out fluctuations in consolidated cash flow and using stock rather than cash to pay for them preserves the firm’s ability to meet interest and principal payments on its existing debt. However, the use of the stock may dilute the acquiring shareholders ownership interest in the combined firms.

Internal Controls and Incentive Systems

These factors are critical to aligning shareholder and managerial interests. Internal controls help prevent fraud as well as encourage compliance with prevailing laws and regulations. Financial, legal and auditing functions, as well as hiring and firing policies, within the firm are examples of internal controls. Compensation, consisting of base pay, bonuses, and stock options, underpins incentive systems used to manage the firm in the manner the board deems appropriate. Management contracts formally stipulate responsibilities, term of employment, basic compensation arrangements, change in control provisions, and severance packages.

The dark side of financial incentive systems is that they may create abuses as well as positive motivations. To rectify management abuses, the Dodd-Frank Act of 2010 gives shareholders of public firms the right to vote on executive compensation. Under the new rules, such votes must occur at least once every 3 years. There is empirical evidence that this so-called “say on pay” rule helps to align executive compensation with shareholder interests.³¹ The Dodd-Frank Act also requires publicly traded firms to develop mechanisms for recovering compensation based on executive misconduct.

Managerial and shareholder interests can be aligned in other ways. Option exercise prices can be linked to the firm’s share price performance relative to the stock market, ensuring that increases in the stock market do not benefit managers whose companies are underperforming. Another way is for managers to own a significant portion of the firm’s outstanding stock or for the manager’s ownership of the firm’s stock to comprise a substantial share of his or her personal wealth. Aggressive incentive programs tend to improve acquirer abnormal financial returns around acquisition announcement dates for public targets and have had an even greater positive impact after the introduction of Sarbanes Oxley in 2002 which makes senior management more accountable for their actions. Senior managers at firms with high pay for performance incentive plans tend to pay 23.3% lower average merger premiums to public target firm shareholders than firms with more modest incentive plans.³²

An alternative to concentrating ownership in management is for one or more shareholders who are not managers to accumulate a large block of voting shares. These block holders may be more aggressive in monitoring management and more receptive to takeovers, thereby increasing the risk to managers that they will be ousted for poor performance. Block holders can promote good governance and influence a firm’s performance by either making their concerns known to the board and management or by selling their shares. Block holders can include hedge funds, mutual funds, pension funds, individuals and other corporations.³³

The link between block holders and improved firm performance is mixed. Their effectiveness in promoting good governance and in turn improved firm performance is dependent on the quality of their own governance practices. Effective block holders are those whose interests are closely aligned with other shareholders. Some block holders may exacerbate firm performance by acting to benefit themselves rather than all shareholders. Examples of so-called “private benefits” that accrue to such block holders include the payment of dividends rather than reinvestment of funds in the firm, selling products at less than prevailing market prices to firms in which the block holder is an investor, and buying products/services from suppliers in which the block holder is a shareholder.³⁴

While management contracts can guarantee pay for failure,³⁵ they can contribute to shareholder wealth creation by better aligning CEO interests with shareholders. They enable firms to attract and retain the best talent and encourage the pursuit of value enhancing investments, since such contracts generally align their compensation with the long-term performance of the firm and specify severance packages. Management contracts have become more popular over the years, especially for firms that are underperforming their peers or are takeover targets,³⁶ with the percentage of S&P 500 CEOs with contracts increasing from 29% in 1990 to 50% in 2005. Acquirers, whose CEOs have employment contracts, outperform their counterparts without one in terms of financial returns by 1.3 percentage points on average when deals are announced and show greater long-term profitability. Acquirer CEOs with contracts may bargain more aggressively resulting in lower purchase price premiums paid because their total compensation depends on the long-term performance of the firm.³⁷

Antitakeover Defenses

A firm’s board and management may employ defenses to negotiate a higher purchase price with a bidder or to solidify their current position within the firm. The range of defensive actions is detailed later in this chapter.

Corporate Culture and Values

Good governance also depends on an employee culture instilled with appropriate values and behaviors. Setting the right tone comes from the board of directors’ and senior management’s willingness to behave in a manner consistent with what they demand from other employees. A firm’s culture is often viewed by management as a valuable corporate asset; and, as such, their desire to preserve the culture can impact investment policy. For instance, firms whose cultures breed substantial trust between employees and management tend to increase cooperation and the exchange of specialized knowledge. Such firms tend to make acquisitions that are on average one-third the size of those made by other firms enabling their culture to be dominant in defining the behavior of the employees of the combined firms.³⁸

Bond Covenants

Legally binding on both the bond issuer and the bond holder, covenants forbid the issuer from undertaking certain activities, such as dividend payments, or require the issuer to meet specific requirements, such as periodic information reporting. Strong covenants can motivate managers to pursue relatively low risk investments, such as capital expenditures, and avoid higher risk investments, such as research and development spending.

Legislation and the Legal System

The 1933 and 1934 Securities Acts underlie US securities legislation and created the Securities and Exchange Commission, charged with writing and enforcing securities’ regulations. The US Congress has since transferred some enforcement tasks to public stock exchanges operating under SEC oversight.³⁹ Under the Sarbanes-Oxley Act (SOA) of 2002, the SEC oversees the Public Company Accounting Oversight Board, whose task is to develop and enforce auditing standards. State legislation also has a significant impact on governance practices by requiring corporate charters to define the responsibilities of boards and managers with respect to shareholders.

The net effect of stronger investor protections, such as laws and regulations which increase investor access to consistent and accurate financial information, is to limit the ability of managers and controlling shareholders to misuse corporate resources.⁴⁰ Moreover, when investor protections are strong, control is more likely to be transferred through a takeover to those more able to manage the firm.⁴¹ Absent strong investor protections, the perception of agency conflicts is likely to be greater. For example, executives in firms where ownership tends to be highly concentrated earn more than at firms where control is more dispersed.⁴²

Following the reforms introduced by SOX, acquirers have become more strategic in selecting targets. The proportion of synergy-driven deals, as measured by the relatedness of the acquisition target, has escalated since this legislation was introduced. While target shareholders experience the largest gains, acquirer shareholders also are more likely to display positive announcement date abnormal returns.⁴³

Regulators

The SEC, Federal Trade Commission, and Department of Justice can discipline firms through formal investigations and lawsuits as outlined in Chapter 2. In 2003, the SEC approved new listing standards that would put many lucrative, stock-based pay plans to a shareholder vote. The 2010 Dodd-Frank Act requires listed firms to have fully independent compensation committees and promotes more detailed salary transparency for key managers. However, the regulatory drive for greater transparency rather than restraining outsized salary increases may be fueling the upward spiral due to how boards set CEO compensation. Boards look at CEO salaries at comparable firms, pegging salaries at levels above those offered by peer firms to attract or retain the best talent.⁴⁴

Institutional Activists

Pension funds, hedge funds, private equity investors, and mutual funds have become increasingly influential in affecting the policies of companies in which they invest. Activist investors target about one in seven publicly traded firms worldwide and tend to be most prevalent in countries whose laws provide good investor protection.⁴⁵

Shareholders of public firms may submit proposals to be voted on at annual meetings, but such proposals are not binding. The firm’s board can accept or reject the proposal even if approved by a majority of shareholders. Only 30% of proposals receiving majority support are implemented within 1 year of the vote.⁴⁶ Nonbinding proposals approved by shareholders pertaining to takeover defenses, executive compensation, etc., are more likely to be implemented if there is an activist investor likely to threaten a proxy fight.⁴⁷ When nonbinding votes are too close to call, there is evidence that firm value can increase by as much as 1.8% on the day of the vote if it passes and as much as 2.8% if it is later adopted by the firm’s board. The impact on shareholder value is even greater for firms with a substantial number of takeover defenses in place.⁴⁸

Activist hedge funds during the 2008–2014 period demonstrated announcement date returns of 7% on investments in target firms, consistent with those returns observed in earlier periods. The most successful hedge funds were those willing to take minority positions in large targets mired in complicated situations. Such firms had a demonstrated track record of either changing the composition of the target’s board or getting the incumbent board to change strategic direction by using proxy contests, lawsuits, overcoming strong defenses, and replacing board members.⁴⁹ Hedge fund activism often stimulates innovation by redirecting R&D investment to areas more critical to a firm’s core competencies.⁵⁰ Another way in which activist hedge funds create value is by publicizing a firm as a potential takeover target. Such activism increases the likelihood that a firm will receive takeover bids.⁵¹

When institutions hold their investments for long periods of time, they play an important role in promoting good governance and in combating managers’ tendency to focus on short-term performance. As long-term investors with significant ownership stakes in the firm, they can communicate directly with management to influence decision-making and when necessary threaten to sell their shares or initiate proxy fights. They may impact decisions ranging from investment projects to dividend payouts to accounting practices. Long-term investors can improve governance by initiating or supporting shareholder proposals, improve board quality by influencing the election of board members, and affect executive turnover. By convincing the board to lower takeover defenses, they also are able to lessen management entrenchment. By helping management to prioritize investments better, long-term investors can reduce investment in both tangible and intangible assets while increasing corporate innovations measured by the number of patents and citations, as well as their significance.⁵²

The Corporate Takeover Market

Changes in corporate control can occur because of a hostile or friendly takeover or because of a proxy contest initiated by activist shareholders. When a firm’s internal management controls are weak, the takeover market acts as a “court of last resort” to discipline bad management behavior. Strong internal governance mechanisms, by contrast, lessen the role of the takeover threat as a disciplinary factor. However, the disciplining effect of a takeover threat on a firm’s management can be reinforced when it is paired with a large shareholding by an institutional investor.⁵³ Larger firms are more likely to be the target of disciplinary takeovers than smaller firms, and their CEOs are more likely to be replaced following a series of poor acquisitions.⁵⁴ Public firms, whose management and boards tend to engage in frequent acquisitions, often overpaying, are likely to become takeover targets as their firm’s performance suffers from their undisciplined takeover and bidding practices.⁵⁵

Several theories attempt to explain why managers resist a takeover attempt. The management entrenchment theory suggests that managers use takeover defenses to ensure their longevity with the firm. While relatively rare in the United States, hostile takeovers or the threat of such takeovers have historically been useful for maintaining good corporate governance by removing bad managers and installing better ones. Indeed, there is evidence of frequent management turnover even if a takeover attempt is defeated, since takeover targets are often poor financial performers. An alternative viewpoint is the shareholder interest’s theory, which suggests that management resistance to takeovers is a good bargaining strategy to increase the purchase price to the benefit of the target’s shareholders.

Proxy contests are attempts by a group of activist shareholders to gain representation on a firm’s board or to change management proposals by gaining the support of other shareholders. While those that address issues other than board representation do not bind the board, boards are becoming more responsive—perhaps reflecting fallout from the Enron-type scandals in 2001 and 2002.⁵⁶ Even failed proxy contests can lead to a change in management, a restructuring of the firm, or investor expectations that the firm will be acquired.

Implementing a Proxy Contest

When the bidder is also a shareholder, the proxy process may begin with the bidder attempting to call a special shareholders meeting. Alternatively, the bidder may put a proposal to replace the board at a regularly scheduled shareholders’ meeting. Before the meeting, the bidder opens an aggressive public relations campaign, with direct solicitations sent to shareholders and an aggressive media campaign to convince shareholders to support the bidder’s proposals. The target often responds with its own campaign. Once shareholders receive the proxies, they may choose to sign and send them directly to a designated collection point such as a brokerage house or a bank. See Chapter 2 for a detailed discussion of SEC regulations governing the implementation of a proxy contest.

The Impact of Proxy Contests on Shareholder Value

Despite a low success rate, proxy fights often result in positive abnormal returns to target shareholders, regardless of the outcome. The reasons include the eventual change in management, the tendency for new management to restructure the firm, investor expectations of a future change in control, and special cash payouts made by firms with excess cash holdings. However, when management wins by a wide margin, shareholder value often declines, since little changes in how the firm is managed.⁵⁸

Pretender Offer Tactics: Toehold Bidding Strategies

Toehold investments involve a potential bidder taking a less than controlling interest in a target firm. Bidders purchase stock before a formal bid to amass shares at a price less than the eventual offer price. Such purchases are secretive to avoid increasing the average price paid. For public firms, investments exceeding 5% of the target’s shares must be made public. Bidders achieve leverage with the voting rights associated with the stock purchased. The bidder also can sell this stock if the takeover attempt is unsuccessful. Once a toehold position has been established, the bidder may attempt to call a special stockholders meeting to replace the board of directors or remove takeover defenses.⁶⁰

While rare in friendly takeovers, these actions are commonplace in hostile transactions, comprising about one-half of all such takeovers. In friendly deals, bidders are concerned about alienating a target firm’s board with such actions; however, in hostile situations, the target firm would have rejected the initial bid under any circumstances. The frequency of toehold bidding has declined since the early 1990s in line with the widespread adoption of takeover defenses such as poison pills and a decline in the frequency of hostile deals.⁶¹ Acquirers with a toehold investment in the target firm prior to a takeover represent about 5.4% of public firms and 1.4% of private firms. The average toehold investment size is about 31% of the target’s shares (higher in hostile deals and lower in friendly ones) and about 20% for investments made by private equity firms.

Toehold strategies may also be undertaken when a potential bidder lacks access to enough information about a target to determine a realistic offer price. The value of a toehold investment is greatest when one potential bidder has access to significantly less information than competing bidders more familiar with the target firm. Once the toehold investment is made, the more informed bidders can make offers giving the toehold investor a better idea of what constitutes a reasonable bid. However, the incentive for one bidder to make a toehold investment in advance of the bidding process is less if other potential bidders are having similar difficulty in obtaining accurate information. Furthermore, the value of the toehold investment as a means of gaining information is less when the number of potential bidders is large, as some bidders with poor information may make excessive offers for the target based on hubris rather than an accurate assessment of potential synergy.⁶²

Implementing a Tender Offer

Tender offers can be for cash, stock, debt, or some combination. Unlike mergers, tender offers frequently use cash as the form of payment. Securities deals take longer to complete because of the need to register with the SEC, to comply with state registration requirements, and, if the issue is large, to obtain shareholder approval. If the offer involves a share exchange, it is referred to as an exchange offer. Whether cash or securities, the offer made to target shareholders may be extended for a specific period and may be unrestricted (any-or-all offer) or restricted to a certain percentage or number of the target’s shares.

In a tender offer, the bidder may buy all of the target stock that is tendered or only a portion. Those restricted to purchasing less than 100% of the target’s shares may be oversubscribed. For example, if the bidder has extended a tender offer for 70% of the target’s outstanding shares and 90% of the target’s stock actually is offered, then the bidder may choose to prorate the purchase of stock by buying only 63% (i.e., 0.7 × 0.9) of the tendered stock by each shareholder. If the bidder chooses to revise the tender offer, the waiting period is automatically extended. If another bid is made, the waiting period must also be extended another 10 days. Once initiated, tender offers for publicly firms are usually successful, although the success rate is lower if it is contested.⁶³

Federal securities laws impose reporting, disclosure, and antifraud requirements on acquirers initiating tender offers. Once the tender offer has been made, the acquirer cannot purchase any target shares other than the number specified in the offer. Section 14(D) of the Williams Act requires that any individual or entity making a tender offer resulting in owning more than 5% of any class of equity must file a Schedule 14(D)-1 and all solicitation materials with the SEC.

Multitiered Offers

A bid can be either a one- or two-tiered offer. In a one-tier offer, the acquirer announces the same offer to all target shareholders, which provides the potential to purchase control of the target quickly and discourage other possible bidders from disrupting the deal. In a two-tiered offer, the acquirer offers to buy a number of shares at one price and more at a lower price at a later date. The form of payment in the second tier may be less attractive, consisting of securities rather than cash. The intent of the two-tiered approach is to give target shareholders an incentive to tender their shares early in the process to receive a more attractive price. Since those shareholders tendering their shares in the first tier enable the acquirer to obtain a controlling interest, their shares are worth more than those choosing to sell in the second tier.

Once the bidding firm accumulates enough shares to gain control of the target (usually 50.1%), the bidder may initiate a so-called back-end merger by calling a special shareholders meeting seeking approval for a merger, in which minority shareholders are required to accede to the majority vote. Alternatively, the bidder may operate the target firm as a partially owned subsidiary, later merging it into a newly created wholly owned subsidiary. Many state statutes require equal treatment for all tendering shareholders as part of two-tier offers and give target shareholders appraisal rights⁶⁴ that allow those not tendering shares in the first or second tier to ask the state court to determine a “fair value” for the shares.⁶⁵ State statutes may also contain fair-price provisions, in which all target shareholders, including those in the second tier, receive the same price and redemption rights, enabling target shareholders in the second tier to redeem their shares at a price similar to that paid in the first tier.

There are disadvantages to owning less than 100% of the target’s voting stock. These include the potential for dissatisfied minority shareholders owning significant blocks of stock to disrupt efforts to implement important management decisions and the cost incurred in providing financial statements to both majority and minority shareholders.

Poison Pills (Shareholder Rights Plans and Blank Check Preferred Stock)

A poison pill involves a board issuing rights to current shareholders, with the exception of an unwanted investor, to buy the firm’s shares at an exercise price well below their current market value. Because they are issued as a dividend and the board usually has the exclusive authority to declare dividends, a pill can be adopted without a shareholder vote and implemented either before or after a hostile bid. If a specified percentage (usually 10%–20%) of the target’s common stock is acquired by a hostile investor, each right entitles the holder to purchase common stock or some fraction of participating preferred stock⁷⁹ of the target firm (a flip-in pill). If a merger, consolidation, sale of at least some percentage (usually 50%) of the target’s assets, or announced tender offer occurs, the rights holder may purchase acquirer common shares (a flip-over pill). Both the flip-in and flip-over pills entitle their holders upon paying the exercise price to buy shares having a market value on the date the pill is triggered equal to some multiple (often two times) the right’s exercise price.⁸⁰ Rights are redeemable at any time by the board, usually at $0.01 per right, expire after some period (sometimes up to 10 years), and trade on public exchanges.

The flip-in pill discourages hostile investors from buying a minority stake in the firm because it dilutes their ownership interest in the firm as more target shares are issued. For example, if the hostile investor buys a 20% interest in the firm and the number of target shares doubles, the investor’s ownership stake is reduced to 10%. The value of the investor’s investment also decreases as other shareholders buy more shares at a deeply discounted price. Efforts by the hostile investor to sell shares at what he or she paid are thwarted by the willingness of other shareholders, having acquired shares at a much lower price, to sell below the price paid by the hostile investor. The total cost of completing the takeover rises as the number of shares that must be acquired in a cash offer or the number of acquirer shares issued in a share exchange increases, diluting current acquirer shareholders. Similarly, the flip-over poison pill dilutes the acquirer’s current shareholders and depresses the value of their investment as more acquirer shares are issued at below their current market value.

Netflix adopted a poison pill, having both flip-in and flip-over rights, on November 2, 2012, in response to a 9.98% investment stake in the firm by investor Carl Icahn. Each shareholder, except Icahn, received a right for each common share held as of November 12, 2012, to buy one one-thousandth of a new preferred share at an exercise price of $350 per right if an investor acquires more than 10% of the firm without board approval. If triggered, each flip-in right entitled its holder to purchase by paying the right’s exercise price a number of shares of Netflix common stock having a market value of twice the exercise price (i.e., $700). At the time of the issue, Netflix common stock traded at $76 per share. Each right would be convertible into 9.2 common shares [i.e., (2 × $350)/$76] if the pill was triggered. If the firm was merged into another firm or it was to sell more than 50% of its assets, each flip-over right would entitle the holder to buy a number of common shares of the acquirer at the then-market value at twice the exercise price following payment of the $350 exercise price.

Poison pill proponents argue that it prevents a raider from acquiring a substantial portion of the firm’s stock without board permission. Since the board generally has the power to rescind the pill, bidders are compelled to negotiate with the target’s board, which could result in a higher offer price. Pill defenses may be most effective when used with staggered board defenses, because a raider would be unable to remove the pill without winning two successive elections. This increases the likelihood of the target’s remaining independent.⁸¹ Detractors argue that pill defenses simply entrench management.

Recent legal precedents further strengthen a target’s takeover defenses. The unsolicited offer by Air Products for Airgas on February 2, 2010, had been one of the longest running hostile bids in US history. After having revised up its offer twice, Air Products sought to bring this process to a close when it asked the Delaware Chancery Court to invalidate Airgas’s poison pill. On February 15, 2011, the court ruled that the board has the right to prevent shareholders from voting on the takeover offer as long as it is acting in good faith. In the wake of the court’s ruling, Air Products withdrew its bid.

The outcome of the court’s ruling has implications for future hostile takeovers. The ruling upholds Delaware’s long tradition of respecting managerial discretion as long as the board is found to be upholding its fiduciary responsibilities to the firm’s shareholders. The ruling allows target firm boards to use a poison pill as long as the board deems justified, and it is far-reaching because Delaware law governs most US publicly traded firms.

In mid-2014, the Delaware state court blocked efforts by hedge fund mogul Daniel Loeb to overturn a crucial corporate defense at legendary auction house, Sotheby. Loeb had argued that the Sotheby’s poison pill plan unfairly discriminated against his firm and inhibited his ability to wage his proxy campaign. The pill specifically limited him to no more than 10% of Sotheby’s shares while letting passive (long-term) investors hold as much as 20% of Sotheby’s shares without triggering the pill. The ruling justifies the use of such defenses to limit the ownership stake in the company of a specific investor. Sotheby had argued, and the court concurred, that it had adopted the two-tiered poison pill to protect shareholders from coercive takeover tactics. In legitimizing the two-tiered pill, the courts may have limited the future effectiveness of activist investors in some situations.

Blank check preferred stock is a class of preferred shares over which the firm’s board has the authority to determine voting rights, dividends, and conversion rights without shareholder approval. The most common reason for a firm to have such stock is to discourage an unwanted takeover of the firm. Normally a firm must amend its articles of incorporation to create such stock. Once done, the board now has the power to issue a class of preferred shares that can be converted to a substantial number of voting shares intended to increase the cost of a takeover. Other reasons for blank check preferred stock are to allow the board to quickly raise capital or as an equity contribution used in the formation of a business alliance.

Shark Repellents

Shark repellents are takeover defenses achieved by amending either a corporate charter or corporation bylaws.⁸² They predate poison pills as a defense, and their success in slowing down takeovers and making them more expensive has been mixed. Today, shark repellents have largely become supplements to poison pill defenses. Their primary role is to make it more difficult to gain control of the board through a proxy fight at an annual or special shareholders’ meeting. Shark repellents necessitate a shareholder vote because they require amendments to a firm’s charter. Although there are many variations of shark repellents, the most typical are staggered board elections, restrictions on shareholder actions, antigreenmail provisions, differential voting rights (DVR) shares, and debt-based defenses.

Antigreenmail Provisions

Dubbed “greemail,” bidders in the 1980s profited by taking an equity position in a firm, threatening takeover, and subsequently selling their shares back to the firm at a premium over what they paid for them. Many firms have since adopted charter amendments, called antigreenmail provisions, restricting the firm’s ability to repurchase shares at a premium.

Fair-Price Provisions

Requirements that any acquirer pay minority shareholders at least a fair market price for their stock are called fair-price provisions. The fair market price may be expressed as some historical multiple of the company’s earnings or as a specific price equal to the maximum price paid when the buyer acquired shares in the company.⁸⁵

Dual Class Recapitalization

A firm may create more than one class of stock to separate the performance of individual operating subsidiaries, compensate subsidiary management, maintain control, or prevent hostile takeovers. The process of creating another class of stock is called a dual class recapitalization and involves separating shareholder voting rights from cash flow rights. Voting rights indicate the degree of control shareholders have over how a firm is managed, while cash flow rights are rights to receive dividends. Shares with different voting rights, DVR shares, may have multiple voting rights (so-called supervoting shares), fractional voting rights, or no voting rights. DVR shares may have 10–100 times the voting rights of another class of stock or a fraction of a voting right per share (e.g., a shareholder might be required to hold 100 DVR shares to cast one vote). Shares without voting rights but having cash flow rights may pay a dividend higher than those with voting rights. Once approved by shareholders, the new class of stock is issued as a pro rata stock dividend or an exchange offer in which the new class of stock is offered for one currently outstanding.

Dual class structures tend to concentrate voting power as supervoting shares are issued as a pro rata dividend; later, shareholders are given the option of exchanging their supervoting shares for shares offering higher dividends, with managers retaining their supervoting shares. In dual class structures, the largest shareholder owns, on average, about 23% of the firm’s equity and about 58% of the voting rights.⁸⁶ Some studies find that firm value is reduced as controlling shareholders erect excessive takeover defenses, create agency conflicts, and avoid higher risk value-enhancing investments.⁸⁷ Other studies document an increase in firm value when the firm moves from a single to a dual class capital structure as controlling shareholders have more time to focus on longer-term strategies, are subject to less short-term pressure, and are more inclined to pursue higher risk growth opportunities.⁸⁸ The various arguments supporting these different conclusions are discussed in more detail below.

Supervoting shares enable controlling shareholders to diversify their net worth by selling a portion of their equity in the firm without losing control. As such, insiders may be more inclined to pursue higher risk, higher return investments to improve corporate performance.⁸⁹ Dual class IPOs may be particularly appropriate when the founding family or founding entrepreneur(s) are viewed as critical to the firm’s long-term performance.⁹⁰ Examples include Mark Zuckerberg of Facebook and Larry Page and Sergey Brin of Google. Facebook in 2013 and Google in 2014 each issued a new class of nonvoting shares to be used for equity-based employee compensation and for financing new acquisitions out of concern about diluting the founders’ future voting power.

Dual class structures can create agency costs when controlling shareholders receive benefits not available to noncontrolling shareholders. Such benefits could include the sale of the firm’s assets to others with whom the controlling shareholders have a business relationship at a discount from their fair market value. Other benefits accruing to controlling shareholders include the sale of the firm’s products at a discount to businesses owned by the controlling shareholders or requiring the firm to pay higher than market prices to suppliers with whom the controlling shareholders have business ties. When control is concentrated insiders tend to put in place weaker boards allowing the insiders to entrench themselves and continue to receive benefits at the expense of other shareholders.⁹¹ Managers of dual class share firms also have an incentive to manipulate earnings to conceal from outside investors the full extent of the benefits they receive from having control.⁹²

A recent highly publicized conflict between shareholders and management arose when in mid-2016 Facebook announced plans to issue as a dividend two shares of new non-voting (Class “C”) shares to current holders of Class “A” nonvoting shares and Class “B” supervoting shares (10 votes each). This would enable CEO Mark Zuckerberg to sell nonvoting Class C shares to finance philanthropic projects without surrendering control over the firm. Without the new class of stock, he would have to sell his supervoting shares to raise cash and run the risk that over time he could lose control of the firm. A class action lawsuit filed in April 2016 brought by Facebook shareholders sought to block the issuance of the new class of non-voting Class C shares. Facebook settled out of court just days before it was to go to trial on September 26, 2017 by agreeing to drop plans to create the Class C shares.

When agency problems arise at dual class structure firms the remedy often is to “unify” or convert the structure to “one share, one vote.” The elimination of the dual class structure dilutes the voting power of controlling shareholders (whose high vote shares lose their multiple voting rights) making the firm vulnerable to shareholders seeking a change in the control of the firm through proxy contests. In these instances, the firm’s market value often increases following the elimination of the dual class structure.⁹³ Similar findings have been documented in the United Kingdom.

Most studies argue that the reduction in value for dual class structure firms is related to agency problems as holders of supervoting shares extract benefits that do not accrue to shareholders with few or no voting rights. However, the degree to which this occurs varies with the strength of corporate governance. Firms with dual class structures and with strong shareholder rights protections often exhibit increasing firm value. Why? The shareholder protections limit the ability of those with supervoting shares to exploit other classes of shareholders. Such firms allow shareholders to call special meetings, act by written consent, have no poison pill, no staggered board, and offer shareholders cumulative voting rights.⁹⁴

The major US public stock exchanges allow firms to list on the exchanges with dual class shares. However, firms may not take steps to reduce the voting rights of existing shareholders in any way.⁹⁵ Snapchat’s 2017 IPO took dual class structures to an extreme by issuing shares with zero voting rights causing some institutional investors to call for the outright ban on dual class shares. A compromise between the outright ban of dual class shares and one share, one vote structures is to include a “sunset” provision in IPOs. That is, supervoting shares would revert to regular common shares within 5 or 10 years after issuance or once the firm achieves a strategic milestone defined in terms of revenue or profit.⁹⁶

Reincorporation

A target may change the state or country in which it is incorporated to one where the laws are more favorable for implementing takeover defenses by creating a subsidiary in the new state and later merging with the parent. Several factors need to be considered in selecting a location for incorporation, such as how the courts have ruled in lawsuits alleging breach of corporate director fiduciary responsibility in takeovers as well as the laws pertaining to certain takeover tactics and defenses. Reincorporation requires shareholder approval.

Golden Parachutes (Change-of-Control Payouts)

Employee severance packages, triggered when a change in control takes place, are called golden parachutes, which cover only a few dozen employees and terminate following a change in control. They can vary substantially with some including a lump-sum payment (often 3 years’ salary), while others extend to stock grants, options, health insurance, pension plans, consultancy arrangements, and even use of corporate jets. They are designed to raise the bidder’s acquisition cost rather than to gain time for the board. Such packages may serve the interests of shareholders by making senior management more willing to accept an acquisition.⁹⁷ Golden parachutes benefit target firm shareholders by increasing the likelihood deals will be completed, but often at a lower purchase price premium.⁹⁸

Golden parachutes are often associated with a reduction in firm value around their adoption date, although the incentives they create can produce ambiguous results: they may increase the chance of a takeover but destroy firm value by encouraging CEOs to accept deals not in the best interests of the firm’s shareholders. For instance, the target’s CEO may accept overvalued acquirer shares to close the deal and trigger payout of the golden parachute even though such shares are likely to decline in value.⁹⁹ Actual payouts to management, such as accelerated equity awards, pensions, and other deferred compensation following a change in control, may significantly exceed the value of golden parachutes. Tax considerations and recent legislation affect corporate decisions to implement such compensation packages.¹⁰⁰

Greenmail

Greenmail involves paying a potential acquirer to leave you alone. It consists of a payment to buy back shares at a premium price in exchange for the acquirer’s agreement not to initiate a hostile takeover. In exchange for the payment, the potential acquirer is required to sign a standstill agreement, which specifies the amount of stock, if any, the investor can own and the circumstances under which the raider can sell such stock.¹⁰¹

White Knights and White Squires

A target may seek a white knight: another firm that is considered a more appropriate suitor. The white knight must be willing to acquire the target on terms more favorable than those of other bidders. Fearing a bidding war, the white knight often demands some protection in the form of a lockup. This may involve giving the white knight options to buy stock in the target that has not yet been issued at a fixed price or to acquire specific target assets at a fair price. Such lockups make the target less attractive to other bidders.

So called white squires are investors willing to support a firm’s board and management in the event of an unwanted takeover attempt. Unlike a white knight, which agrees to acquire the entire firm, the white squire is willing to purchase a large block of stock often at a favorable price, attractive dividend yield, and for a seat on the board. Such strategies may not be in the best interests of shareholders as they may serve only to entrench management.¹⁰² In an effort to discourage an unwanted bid from newspaper rival Gannett Corporation, Tribune Publishing sold a 12.92% stake in 2016 to billionaire entrepreneur Patrick Soon-Shiong, which is permitted under Delaware corporate law, where Tribune is incorporated.

Employee Stock Ownership Plans

ESOPs are trusts that hold a firm’s stock as an investment for its employees’ retirement program. They can be quickly set up, with the firm either issuing shares directly to the ESOP or having an ESOP purchase shares on the open market. The stock held by an ESOP is likely to be voted in support of management in the event of a hostile takeover attempt.

Leveraged Recapitalization

A firm may recapitalize by issuing new debt either to buy back stock or to finance a dividend payment to shareholders. While debt often is a means of forcing managers to focus on operating performance, it also tends to allow managers to entrench themselves.¹⁰³ The additional debt reduces the firm’s borrowing capacity and leaves it in a highly leveraged position, making it less attractive to a bidder. Moreover, the payment of a dividend or a stock buyback may persuade shareholders to support the target’s management in a proxy contest or hostile tender offer.¹⁰⁴ Recapitalization may require shareholder approval, depending on the company’s charter and the laws of the state in which it is incorporated.¹⁰⁵

Share Repurchase or Buyback Plans

Share buybacks are used to reward shareholders, signal undervaluation, fund ESOPs, satisfy option plans, adjust capital structure, ward off takeovers, and when there are few attractive investment options. When used as a takeover defense, share buybacks reduce the number of shares that could be purchased by the potential buyer or arbitrageurs. What remains are shares held by those who are less likely to sell, namely individual investors.¹⁰⁶ For a hostile tender offer to succeed in purchasing the remaining shares, the premium offered would have to be higher, thereby discouraging some prospective bidders. Ironically, share repurchase announcements may actually increase the probability a firm will be taken over, especially if the firm appears vulnerable to a takeover due to weak defenses or poor governance. Why? Because such firms’ share prices often underperform before buybacks and share buyback announcements call attention to their likely undervaluation.¹⁰⁷ This is particularly true of smaller firms engaging in share repurchases.¹⁰⁸

Corporate Restructuring

Restructuring may involve taking the company private, selling attractive assets, undertaking a major acquisition, or even liquidating the company. “Going private” typically involves the management team’s purchase of the bulk of a firm’s publicly traded shares. This may create a win-win situation for shareholders, who receive a premium for their stock, and management, who retain control. Alternatively, the target may make itself less attractive by divesting assets the bidder wants, with the proceeds financing share buybacks or payment of a special stockholder dividend. A target company also may undertake a so-called defensive acquisition to reduce excess cash balances and its current borrowing capacity. A firm may choose to liquidate the company, pay off outstanding obligations to creditors, and distribute the remaining proceeds to shareholders as a liquidating dividend. This makes sense only if the liquidating dividend exceeds what the shareholders would have received from the bidder.

Litigation

Lawsuits are common during M&As. More than 90% of large deals experience at least one lawsuit, often a class action lawsuit. In 2013, deals valued at more than $100 million experienced an average of seven shareholder lawsuits, an all-time high, up from about two per deal in 2012.¹⁰⁹ Shareholder filed lawsuits challenged 93% of corporate mergers in 2014, up from 44% in 2007.¹¹⁰ Lawsuits may involve alleged antitrust concerns, violations of federal securities laws, undervaluation of the target, inadequate disclosure by the bidder as required by the Williams Act, and fraudulent behavior. Targets seek a court injunction to stop a takeover until the court has decided the merits of the allegations. By preventing a bidder from buying more stock, the target firm is buying more time to erect additional defenses.

While litigation seldom prevents a takeover, it may uncover additional information about the bidder through the discovery, or fact-finding, process that leads to more substantive lawsuits. The majority of lawsuits are settled before going to court. Bidders may sue targets to obtain shareholder mailing lists or to have takeover defensives removed. While the probability of completing deals embroiled in litigation falls by about 8%, the takeover premium for those deals that are completed increases by about 30%.¹¹¹

Most Commonly Used Takeover Defenses

Table 3.7 shows the frequency with which certain types of takeover defenses are employed by firms for the largest publicly traded firms comprising the S&P 500 stock index and for the broader Russell 3000 stock index. The most common include advance notification requirements, blank check preferred stock, and the prohibition of written consent solicitation. While shareholder rights plans are relatively uncommon, the pervasiveness of blank check preferred stock enables most firms to create poison pills using such stock. While staggered or classified boards are relatively uncommon among the largest publicly traded firms, almost one-half of the firms in the Russell 3000 have such boards. Moreover, firms making up the Russell 3000 are more likely to have a greater variety of takeover defenses than larger firms in the S&P 500. This may reflect the tendency of firms that went public through an IPO to use a broader array of defenses to attract, retain and motivate good managers.

Management Entrenchment Theory

The creation of a detailed “management entrenchment index”¹¹⁴ revealed that during the 1990s, firms scoring lower on the index (i.e., exhibiting lower levels of entrenchment) had larger positive abnormal returns than firms with higher scores.¹¹⁵ However, the close correlation between a firm’s entrenchment and abnormal returns disappeared in the 2000s, since investors had already bid up the prices of those firms that had removed takeover defenses in the 1990s and penalized those that had not.¹¹⁶ Another large study concluded that managers at firms protected by takeover defenses are less subject to takeover and are more likely to engage in “empire building” acquisitions that destroy firm value.¹¹⁷ Firm value also may be reduced because managers shielded from the threat of a hostile buyout may be under less pressure to innovate.¹¹⁸ Still another study found that firms moving from staggered board elections to annual elections of directors experience a cumulative abnormal return of 1.8%, reflecting investor expectations that the firm is more likely to be subject to a takeover. More recently, a study found a close positive correlation between the number of takeover defenses in place and director compensation. This suggests that directors who propose such defenses directly benefit to the extent they are insulated from activists and hostile takeovers.¹¹⁹

The negative impact of takeover defenses on firm value is most pronounced after judicial approval of such defenses in the 1985 landmark Delaware Supreme Court decision of Moran v. Household. The court case validated the use of poison pills giving boards of directors the sole right to adopt such measures. The court ruling further granted boards broader powers to adopt other types of takeover defenses as long as they were reasonable and wide legal discretion to reject unsolicited takeover bids. Following the ruling, firms experienced an average 5% reduction in their market value immediately following the announcement that they had adopted a poison pill. Even in the absence of a poison pill, firms adopting other measures restricting shareholder rights exhibited a decline in firm value of averaging 1.7%.¹²⁰

The Moran v. Household essentially reinforced another Delaware Court ruling involving Unocal v. Mesa Petroleum also in 1985 legitimizing the two-tiered tender offer. The effect of these two court cases was to weaken the disciplinary impact of hostile takeover threats by giving boards the legal authority to reject unsolicited takeover bids. While these court cases apply directly to firms incorporated in Delaware, Delaware court decisions shape laws in other states. In fact, many states have adopted Delaware’s poison pill statutes and not a single state has invalidated the use of poison pills. In 1995, additional Delaware court rulings validated additional types of poison pills. These cases include Unitrin, Inc. v. American General Corp. and Moore Corp. v. Wallace Computer Services Inc.

An empirical analysis of family controlled S&P 500 firms documents the potential for entrenchment of family members in senior management positions if such entrenchment achieves family goals such as continued control, dividend payouts, family members among senior management, etc. Family controlled publicly traded firms are those in which members of the founder’s family are officers, directors, or block shareholders allowing for family members to impact corporate governance. As family control increases, the need for entrenchment mechanisms (e.g., poison pills) decreases. Perhaps a result of the family already having substantial control over the business through high levels of equity and voting rights which protect their positions without the need for entrenchment mechanisms.¹²¹

Shareholder Interests Theory

While it is widely believed that the Moran v. Household and Unocal v. Mesa Petroleum cases and the proliferation of poison pills contributed to management entrenchment, there is evidence that poison pills since these cases were litigated have contributed to larger takeover premiums but have had little impact on deal completion rates.¹²² Takeover defenses may not reduce deal completion rates, but they can reduce the chance of a bid. That is, formidable defenses discourage opportunistic bidders seeking buyouts at “bargain” prices. Therefore, the bids that are received by target firms with defenses in place are likely to be higher than they would have been had the firm been defenseless.¹²³ The degree of target resistance to a takeover attempt enables target firm shareholders to realize higher takeover premiums than might have otherwise been the case.¹²⁴ Target defenses can prove particularly effective at raising negotiated takeover premiums when the target’s management is being advised by a top-tier investment bank.¹²⁵

Takeover defenses may also allow a firm’s senior management to communicate potentially negative information to investors on a more timely basis due to their feeling somewhat protected from takeover threats. The gradual release of negative information can allow the firm’s share price to adjust in a more orderly manner rather than to crash when the accumulated information is released to surprised shareholders.

A recent empirical study using a lengthy sample period (1978–2015) finds no evidence that staggered boards have a negative impact on firm value and under certain circumstances can have a significant positive impact.¹²⁶ The authors contend that whether the impact of staggered boards on firm value is positive or negative depends on the situation. Staggered boards so goes the argument can create value by enabling management to focus on long-term value enhancing investments. Making it easier to change the composition of the board can disrupt the firm’s commitment to such investments. Examples of such longer-term investments could include joint product development projects with customers and strategic alliances to facilitate entry into new markets.¹²⁷

Studies also show that staggered boards are effective in lowering a firm’s cost of debt¹²⁸ and enable management to focus on longer term value-enhancing R&D projects.¹²⁹ Staggered boards may allow for more aggressive monitoring of firm performance by board members offsetting the potential negative impact of management entrenchment on firm value. Directors may be more willing to provide more independent and perhaps controversial advice without fear of being replaced by investors with a more short-term focus.¹³⁰

While the threat of corporate takeover can curb empire building and other inefficiencies, it can also create incentives for managers to focus on the short term. In contrast, managerial entrenchment can provide benefits for shareholders by allowing managers to focus more on long-term performance. Researchers have documented that entrenched managers minimize the use of accruals to manage earnings.¹³¹ Firms protected by numerous takeover defenses and committed to long-term performance (as measured by R&D spending and number of patents) are less likely to engage in earnings management than firms having relatively few defenses and are more likely to show higher firm value compared to book value.¹³²

A recent study questions whether takeover defenses have much of an impact on shareholder value. While confirming the reduction in the frequency of hostile takeover attempts, the degree of competition for targets has remained steady during the entire auction process when measured between deal initiation and completion. Competition for takeovers, the authors argue, is now more likely to take place in private through a controlled auction process in which targets contact potential bidders, provide confidential data, and allow bidding until a winning offer is achieved. Moreover, takeover premiums have not declined over time. The researchers conclude that these findings are consistent with the shareholder interests’ hypothesis which suggests that target boards and managers are more likely to negotiate aggressively on behalf of shareholders.¹³³ This conclusion is supported by another recent study that finds that takeover bids are most often rejected because they are of low quality and target management’s primary motive is to negotiate higher bids to increase shareholder value.¹³⁴