It’s time to exempt a certain type of hostile bid – an all-cash, all-shares tender offer – from a poison pill defense. In essence, I propose a statutory rule requiring a board to remain neutral in the face of such an offer unless the company’s certificate of incorporation allows otherwise. This would be similar to but less general than Rule 21 of the UK’s Takeover Code.
Argument for Change
In Unocal Corp. v. Mesa Petroleum, the Delaware Supreme Court created the so-called Unocal test, a standard of review for board actions aimed at warding off a hostile bidder (defensive measures). In theory, it provides “enhanced scrutiny” to guard against boards acting in bad faith or to entrench themselves.
Yet under the Unocal test, Delaware courts have been very permissive in allowing boards to maintain and implement defensive measures, such as poison pills, for purposes well beyond protecting shareholders from “coercive two-tier tender offers,” the offending hostile transaction in the Unocal case. Courts have even allowed boards to maintain poison pills to protect against all-cash offers for 100 percent of the company’s shares, as in the famous case of Paramount Communications v. Time Inc.
The question is whether courts should apply this overly permissive test to all-cash, all-shares tender offers in a financial environment where institutional investors’ dominance reduces the need for gatekeepers to protect the interests of retail investors, and where institutional investors have easy access, either internally or through others, to sophisticated analysis on the pros and cons of a particular tender offer. Even the Delaware Supreme Court acknowledged in Corwin v. KKR Financial Holdings that times have changed. In Corwin, the court held that the business judgment rule is the appropriate standard of review for a post-closing damages action when a merger was approved by a fully informed, uncoerced majority of disinterested stockholders and there was no controlling shareholder:
In this day and age in which investors also have access to an abundance of information about corporate transactions from sources other than boards of directors, it seems presumptuous and paternalistic to assume that the court knows better in a particular instance than a fully informed corporate electorate with real money riding on the corporation’s performance.
Unfortunately, the Unocal test does not take this into consideration, and the overly-permissive approach in applying it has created the classic example of how corporate law can destroy the value of a “corrective mechanism.” According to Sharfman, “a corrective mechanism is defined as a part [or potential part] of a public company, other than the [current] Board or executive management, which may have, from time to time, superior decision‑making skills in the making of major corporate decisions.” In this case, it is the hostile bidder who is the corrective mechanism seeking to correct managerial inefficiencies by replacing existing management. The courts, in their application of the Unocal test, along with the Williams Act (15 U.S.C. 78m(d)-(e) and 15 U.S.C. 78n(d)-(f)), and state takeover statutes (e.g., Del. Code Ann. tit. 8, § 203) have played a major role in eliminating an important technique for correcting managerial inefficiencies: the hostile tender offer. According to Macey when discussing the permissive use of the poison pill:
Thus, by judicial fiat, the Delaware courts have removed from the marketplace the hostile tender offer, which is the most powerful corporate governance device in the shareholders’ corporate governance arsenal. As Baums and Scott presciently have observed, “Delaware jurisprudence seems to be willing, in substance . . . to give management something approaching an absolute veto over hostile tender offers despite overwhelming evidence that they confer large benefits on target shareholders.
The inability to apply a nuanced approach that would have allowed hostile tender offers as a corrective mechanism is a judicial failure. Once the law allowed the use of a poison pill to defend against a hostile tender offer, there were no longer any incentives for a hostile bidder to search for inefficiently managed companies that resisted correction through a friendly merger. Thus, corporate law effectively killed the hostile tender offer. Viewed from this perspective, the idea of a statutorily imposed “passivity rule,” a mandatory legal rule that would not allow Boards to take defensive actions in the face of an all-cash, all-shares tender offer seems reasonable as a means to enhance shareholder wealth.
Empirical evidence to support my proposal may seem hard to come by, given that the poison pill and other defensive measures have sidelined hostile bidders for more than 30 years. However, the numerous studies done on hedge fund activism can be used to provide such support.
In general, shareholder activism has not been shown to be wealth enhancing. However, hedge fund activism, which pushes for significant changes in corporate strategy to increase the market price of a company’s stock, is an exception. It typically begins with an unregulated investment fund (the activist hedge fund) accumulating a significant amount of a public company’s stock, usually around 5 percent to 10 percent of the shares outstanding. The activist hedge fund makes these purchases based on its determination that the target company has serious managerial inefficiencies. It believes that if management adopts its recommended strategies, the value of the company’s common stock will substantially increase.
Like a hostile bidder, an activist hedge fund can be quite aggressive, often publicly criticizing management and threatening a proxy contest. Nevertheless, hedge fund activism tries to effect change without gaining control, even though a successful campaign typically results in board representation. Therefore, hedge fund activism exists in a “market for corporate influence,” not corporate control. However, hedge fund activism does bridge the two markets when it encourages firms to enhance shareholder wealth through a friendly merger. At that point, the market for corporate influence is positioned as closely as possible to Henry Manne’s market for corporate control.
Numerous empirical studies have shown hedge fund activism to be wealth enhancing. However, not all such activism is equal. The empirical results show that the biggest boost to shareholder wealth occurs when the fund recommends the sale of the company. That is, hedge fund activism has significant value as long as it is associated with recommendations that encourage a target company to enter the market for corporate control, a role once dominated by hostile bidders. If so, then these empirical results also provide support for the argument that hostile bidders will create value if they can once again enter the market for corporate control.
Given the changing structure of the investor base, where there is less need for boards to act as gatekeepers in change of control transactions, perhaps it is time to consider a selective passivity rule that would statutorily limit the use of defensive actions, including the poison pill, when the hostile bidder is making an all-cash, all-shares tender offer, unless they are permitted in the original charter or through a charter amendment. Such a statutory change may allow hostile tender offers to reappear in the market for corporate control in a limited but significant way and permit shareholders to once again benefit from this corrective mechanism.
 Lucian A. Bebchuk, Alon P. Brav and Wei Jiang, The Long-Term Effects of Hedge Fund Activism, 115 Colum. L. Rev. 1085 (June 2015); Alon Brav, Wei Jiang, Frank Partnoy & Randall Thomas, Hedge Fund Activism, Corporate Governance, and Firm Performance, 63 J. Fin. 1729, 1731 (2008); Nicole M. Boyson & Robert M. Mooradian, Corporate Governance and Hedge Fund Activism, 14 Rev. Derivatives Res. 169, 175–78, 201 (2011); Christopher P. Clifford, Value Creation or Destruction? Hedge Funds as Shareholder Activists, 14 J. Corp. Fin. 323, 324 (2008); Robin M. Greenwood & Michael Schor, Investor Activism and Takeovers, 92 J. Fin. Econ. 362, 374 (2009); April Klein & Emanuel Zur, Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors, 64 J. Fin. 187, 213, 217–18 (2009). But see, K.J. Martijn Cremers, Erasmo Giambona, Simone M Sepe, & Ye Wang, Hedge Fund Activism and Long-Term Firm Value (January 2016), available at http://ccl.yale.edu/sites/default/files/files/leo16_Sepe.pdf; Martijn Cremers, Saura Masconale, and Simone M. Sepe, Activist Hedge Funds and the Corporation, 94 Wash. U. L. Rev. 261 (2017).
This post comes to us from Bernard S. Sharfman, who is an associate fellow at the R Street Institute, a member of the Journal of Corporation Law’s editorial advisory board, a visiting professor at the University of Maryland School of Law (Spring 2018), and a former visiting assistant professor at Case Western Reserve University School of Law (Spring 2013 and 2014). The post is based on a proposal that Sharfman made at the twelfth annual symposium of the Journal of Law, Economics, and Policy, an event honoring the legacy of Henry G. Manne. A discussion of the proposal in the context of the poison pill is in Part IV of Sharfman’s recent symposium article, “The Tension Between Hedge Fund Activism and Corporate Law,” available here.