How to fix WCOM, LU, NT etc: Resurrect Hostile Takeover
June 26, 2002 Wall Street Journal
COMMENTARY
Bring Back the Hostile Takeover
By HENRY G. MANNE
Since Enron, there has been an outbreak of regulatory fever in Washington: A tide of "solutions" has sluiced from the pens of journalists and the mouths of politicians. Apparently forgotten is how Enron and other recent scandals were the direct result of regulatory and judicial efforts to stem abuses in the takeover arena 20 and more years ago. They still haven't learned just how high the cost of interfering with salutary market forces can be.
Among current proposed guardians of executive morality are auditors, lawyers, analysts, financial intermediaries, independent directors, and government officials. But no proposal involving these actors addresses the real problem. New scandals will continue until we bring back the most powerful market mechanism for displacing bad managers: hostile takeovers.
Gordon Gekko is good for the market.
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The principle is simple: If a corporation is badly enough managed, its share price will decline relative to other companies in the industry. At that point it can be profitable for a new group to make a tender offer, bringing in more efficient leadership. Just the threat of a takeover provides incentive for managers to run companies in the interest of the shareholders.
In 1932, a book called "The Modern Corporation and Private Property" by Adolf Berle and Gardiner Means popularized the concept of the "separation of ownership and control." The book argued that the managers of large, publicly held corporations could cheat, manipulate, and steal blind the shareholders, since they were not subject to effective monitoring. Not least among the evils attributable to this separation were extravagant salaries, self-perpetuating boards of directors, insider trading and various perquisites for the top executives. For Berle and Means, the solution lay in the realm of political theory. If corporations could be made more democratic, shareholders could "vote the rascals out," and the effects of the separation could be averted.
By 1965 however, when I introduced the concept of a market for corporate control, economists and others began explicitly to recognize that the corporation was not a political institution but a creation and function of the marketplace. The separation of ownership and control problem, tidily renamed in modern corporate governance literature as the problem of "agency costs," was seen as largely amenable to the forces of a market for corporate control.
For a brief period in the late '50s, until the mid-'60s, when modern hostile takeover techniques were perfected, we had a pretty much unregulated market for corporate control. Shareholders received on average 40% over the pre-bid price for their shares. But the chorus of screams by threatened executives and their lawyers became politically excruciating enough that Congress, in 1968, passed the Williams Act, which made it vastly more expensive for outsiders to mount successful tender offers. The highly profitable element of surprise was removed entirely.
The even stronger inhibition on takeovers resulted from actions taken by state legislatures and state courts in the '80s. The number of hostile tender offers dropped precipitously and with it the most effective device for policing top managers of large, publicly held companies.
There continue to be changes of control in publicly held corporations even if hostile tender offers are discouraged. But now, with the legal power to shift control in the hands of the incumbents, they, rather than shareholders, will receive any premium paid for control. Ironically, this is the same premium that has been made larger by their own poor management.
This transfer of control may take the form of a merger, or simply a series of agreed-upon high-level resignations after a new board has been put in place. The compensation paid the managers for their assent to such a change may take the form of a lucrative consulting arrangement, stock or stock options in the acquiring company, a generous severance package, or some other bonus. But the salient fact in each of these situations is that the managers and not the shareholders receive the premium being paid for control.
It should come as no surprise then that, as hostile takeovers declined to 4% from 14% of all mergers, executive compensation started a steep climb, eventually ending for some companies with bankruptcy and management scandal. The largely mythical abuses alleged to result from an unfettered takeover system were less costly to investors than what has occurred since.
Every statute, adjudication, or regulation that in any way inhibited the free functioning of the market for corporate control simply raised the real cost of ousting inappropriate managers. Dollar for dollar, every increase in those costs could be claimed by incumbent managers, either in greater rewards to themselves or in inefficient management policies. Until the real cost of wastefulness equals the cost of a successful takeover fight, they remain secure behind a legal barrier to their ouster, at least until the whole house of cards collapses. Enron is a predictable consequence of rules that inhibit the efficient functioning of the market for corporate control.
The solution is straightforward but by no means simple: repeal and reverse all the many statutes, rules, and case holdings that interfere with tender offers. American corporations would have to restructure themselves, as they did in the '70s and '80s, to live in a more deregulated market. There would be heavy human costs in the ensuing dislocations, and we could expect a screeching replay of the spurious arguments that won the day in the late '60s and mid-'80s.
But with such a reversal of policy, however unlikely, executive compensation would begin to plummet, there would be less pressure on accountants to cook the books, and American corporations would probably enter another period of innovation, efficiency, and profitability.
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Mr. Manne is dean and professor emeritus of George Mason University School of Law.
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Updated June 26, 2002 |
