Director primacy in corporate takeovers: preliminary reflections.

Publication: Stanford Law Review

Publication Date: 01-DEC-02

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COPYRIGHT 2002 Stanford Law School

This Response comments on an article by Harvard Professors Bebchuk, Coates, and Subramanian: Lucian Ayre Bebchuk, John C. Coates IV & Guhan Subramanian, The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy, 54 STAN. L. REV. 887 (2002). Bebchuk, Coates, and Subramanian's data demonstrate that (1) the incidence of staggered boards has increased substantially in the last two decades and (2) most, if not all, of this increase can be linked to the staggered board's utility as a takeover defense. In response, they offer a policy prescription "stated simply" as: "Courts should not allow managers to continue blocking a takeover bid after they lose one election conducted over an acquisition offer." It is this recommendation and the normative foundations on which it is premised, rather than the minutiae of their empirical analysis and theoretical models, which are the focus of this Response. Like much of modern academic commentary on corporate law, Bebchuk, Coates, and Subramanian's policy recommendation rests on the principle of shareholder primacy. In contrast, this Response argues that corporate law is better understood as a system of director primacy in which the board of directors is not a mere agent of the shareholders, but rather is a sort of Platonic guardian serving as the nexus of the various contracts making up the corporation. The Response concludes by proposing a director primacy-based standard for reviewing the tandem use of classified boards and poison pills as an alternative to Bebchuk, Coates, and Subramanian's proposed prophylactic bar on their use.

INTRODUCTION

Who decides? This question lies at the heart of corporate takeover jurisprudence. Shall it be the shareholders who decide whether an acquisition shall occur or, as with virtually all other important policy questions, shall it be the board of directors? (1) In statutory acquisitions, such as mergers or asset sales, the answer is clear--the target corporation's board of directors decides. If the board rejects a proposed merger or asset sale, the shareholders are neither invited to, nor entitled to, pass on the merits of that decision. (2) Only if the target's board of directors approves the transaction are the shareholders invited to ratify that decision. (3) In nonstatutory acquisitions, such as tender offers, the answer is more complicated. A bidder makes a tender offer directly to the shareholders of the target corporation, thereby bypassing the board of directors. (4) When the hostile tender offer emerged in the 1970s as an important acquiror tool, however, lawyers and investment bankers working for target boards responded by developing defensive tactics designed to impede such offers. (5) Takeover defenses reasserted the target board's primacy, by extending the board's gatekeeping function to the nonstatutory acquisition setting. These developments have prompted a vast academic literature, most of which is quite hostile to granting the target board a significant gatekeeping function. (6)

In recent years, a particularly potent takeover defense has emerged via the combination of a poison pill and a classified board (a.k.a. a staggered board). (7) In their new article on staggered boards, Bebchuk, Coates, and Subramanian opine that a poison pill and staggered board used in tandem have had a substantial impact "on the market for corporate control [that] has not been adequately recognized by courts, academics, or practitioners." (8) Strikingly, they find that during a recent five-year period (1996-2000), combining an effective staggered board and a poison pill almost doubled the chances of a target corporation remaining independent. (9)

Bebchuk, Coates, and Subramanian's data demonstrate that (1) the incidence of staggered boards has increased substantially in the last two decades, and (2) most, if not all, of this increase can be linked to the staggered board's utility as a takeover defense. (10) Standing alone, of course, their data is but a mere observation--albeit an empirically interesting one. (11) In the penultimate section of their article, however, Bebchuk, Coates, and Subramanian move from the positive to the normative. Specifically, they offer a policy prescription "stated simply" as: "Courts should not allow managers to continue blocking a takeover bid after they lose one election conducted over an acquisition offer." (12) It is this recommendation and the normative foundations on which it is premised, rather than the minutiae of their empirical analysis and theoretical models, which will be the focus of my remarks here.

In fairness, developing a comprehensive normative justification for shareholder choice was not the task Bebchuk, Coates, and Subramanian set for themselves on this occasion. Instead, they have addressed that task independently elsewhere. (13) Having said that, however, their article proposes a rather dramatic change in Delaware law, a change which is grounded on contestable normative principles. It is therefore appropriate to challenge those foundational premises.

Like most modern academic commentary on corporate law, (14) Bebchuk, Coates, and Subramanian's policy recommendation rests (mostly implicitly) on the principle of shareholder primacy. Although it takes various guises, shareholder primacy generally contends (1) that shareholders are the principals on whose behalf corporate governance is organized and (2) that shareholders do (and should) exercise ultimate control of the corporate enterprise. (15) It is the latter aspect of shareholder primacy on which I diverge from Bebchuk, Coates, and Subramanian. (16) Their recommended new prophylactic rule is explicitly intended to "revitalize the ballot box route" for takeovers, (17) which necessarily presumes the desirability of ultimate shareholder decisionmaking authority. In contrast, my recent scholarship has emphasized a competing understanding of corporate governance, which I refer to as "director primacy." (18) In the director primacy model, the board of directors is not a mere agent of the shareholders, but rather is a sort of Platonic guardian serving as the nexus of the various contracts that make up the corporation. (19) As a positive theory of corporate governance, director primacy claims that fiat--centralized decisionmaking--is the essential attribute of efficient corporate governance. (20) As a normative theory of corporate governance, director primacy claims that resolving the resulting tension between authority and accountability is the central problem of corporate law. (21)

Unfortunately, time and space limitations preclude me from addressing all of the arguments advanced by Bebchuk, Coates, and Subramanian--all highly prolific--in their various articles, let alone the extensive literature by other scholars, in favor of the shareholder primacy approach to takeovers. Doing so is a task for another day and a future full-blown article. Instead, herein I use Bebchuk, Coates, and Subramanian's article as a jumping-off point for sketching out the director primacy approach to takeover jurisprudence. In the course of doing so, however, I hope to show that Delaware courts should not adopt Bebchuk, Coates, and Subramanian's proposed policy prescription.

Part I of this Response briefly elaborates on Bebchuk, Coates, and Subramanian's policy recommendations and the normative foundation on which they rest. Part II summarizes my director primacy model. Part III suggests a director primacy-based standard for reviewing the tandem use of classified boards and poison pills as an alternative to Bebchuk, Coates, and Subramanian's proposed prophylactic bar on their use.

I. BEBCHUK, COATES, AND SUBRAMANIAN'S POLICY RECOMMENDATION

Standing alone, neither a poison pill nor a staggered board is a particularly effective takeover defense. A standard poison pill typically contains a provision for redemption by the board of directors, which makes the pill vulnerable to a preoffer proxy contest in which the hostile bidder seeks to elect a new slate of directors committed to redeeming the pill. (22) A classified board shark repellent is almost wholly ineffective unless it is buttressed by provisions insulating the classification scheme from removal of directors without cause or packing of the board with new appointments supported by a hostile bidder. (23) Unless the incumbent directors have unusually strong backbones, moreover, they will often play along with a hostile bidder who succeeds in winning a proxy contest to elect one of the board classes. (24)

When a pill and a classified board shark repellent are deployed in tandem, however, they become a far more effective defense. The pill deters a hostile bidder from buying a control block of stock prior to the pill being redeemed. (25) Instead, in the face of board resistance, the acquiror must conduct a proxy contest to elect a slate of directors committed to redeeming the pill. (26) When a classified board shark repellent is added to the equation, moreover, the bidder must go through two successive proxy contests in order to obtain a majority of the board. (27) Prevailing in two such successive contests without owning a controlling block of stock is extremely difficult, and Bebchuk, Coates, and Subramanian therefore predict that the poison pill and staggered board tandem constitutes a significant deterrent to hostile takeovers. (28)

Bebchuk, Coates, and Subramanian's empirical research confirms their theoretical argument. When the staggered board/poison pill tandem is in place, the odds that the target will remain independent increase from thirty-four to sixty-one percent. (29) Strikingly, they also find that the theoretical option of conducting two consecutive proxy contests provides an ineffectual "safety valve": During the 1996-2000 period they studied, there was no "ballot box victory" by a bidder facing the staggered board/poison pill tandem. (30) Finally, they conclude that shareholders have suffered a significant economic injury--in terms of lost or reduced takeover premia--from the growing use of a staggered board/poison pill tandem. (31)

Bebchuk, Coates, and Subramanian advocate a prophylactic rule pursuant to which corporations would not be barred from using a staggered board/poison pill tandem. In order to "revitalize the ballot box" "safety valve," however, they argue that the incumbent directors and managers should not be allowed to "continue blocking a takeover bid after they lose one election conducted over an acquisition offer." (32) They leave much of the heavy lifting of implementing this rule to the courts. They do not, for example, explain how one tells the difference between an "election conducted over an acquisition offer" from a standard proxy contest. (33) Similarly, they do not explain what happens if the incumbent board of directors is reelected but the margin by which they are elected is less than the number of votes cast by incumbent directors or managers or by an ESOP. And so on. (34)

II. DIRECTOR PRIMACY

Today, most corporate law scholars embrace some variant of shareholder primacy. (35) In its various guises, shareholder primacy contends not only that shareholders are the principals on whose behalf corporate governance is organized, but also that shareholders do (and should) exercise ultimate control of the corporate enterprise. (36) Some form of shareholder primacy presumably provides the normative foundation on which Bebchuk, Coates, and Subramanian's policy recommendation rests. As noted, their proposal is expressly intended to "revitalize the ballot box" in corporate takeovers. (37) At least implicitly, this proposal reflects Bebchuk's preference for what he calls "undistorted shareholder choice"--i.e., a mechanism requiring "winning a shareholder vote as a formal or practical condition for a takeover." (38) Although not all shareholder-primacy theorists accept Bebchuk's theory of undistorted shareholder choice, (39) there is little doubt that his theory is based on the shareholder-primacy model's emphasis on ultimate shareholder control. (40) Consequently, Bebchuk, Coates, and Subramanian's policy recommendation rises and falls with the validity of shareholder primacy.

A. De Jure Director Primacy

What is the corporation? In the eyes of the law, the corporation is a legal fiction, possessing some attributes that are contractual in nature and others that are entity-like. (41) In economic terms, however, the corporation is a unique vehicle by which large groups of individuals, each offering a different factor of production, privately order their relationships so as to collectively produce marketable goods or services. (42) To facilitate this process of private ordering, the state's corporation code offers a basic set of default rules that the parties are generally free to accept, reject, or modify as they see fit. (43) In the familiar terminology of the prevailing nexus-of-contracts model, the firm thus is referred to as a nexus of contracts. (44)

The firm is more accurately described, however, as having a nexus of contracts. (45) This claim is premised on Kenneth Arrow's work on organizational decisionmaking, which identified two basic decisionmaking mechanisms: "consensus" and "authority." (46) Consensus is utilized where each member of the organization has identical information and interests, facilitating collective decisionmaking. In contrast, authority-based decisionmaking structures arise where team members have different interests and amounts of information. Because collective decisionmaking is impracticable in such settings, authority-based structures are characterized by the existence of a central agency to which all relevant information is transmitted and which is empowered to make decisions binding on the whole. (47) Not surprisingly, the...

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