Ronald Coase (1959, 1960)[1] [2] insightfully noted that with well-defined property rights, resources flow to their highest-valued use. In a recent paper, we apply this view of property rights to the corporate takeover market in the United States. Observers such as Jensen (1993)[3] argue that the major corporate-control activity beginning in the 1980s in the United States emanated from political, economic, and technological shocks that upset the existing structure of American industry. Indeed, innovations in junk bond financing and the relaxation of antitrust laws made large firms targets of corporate takeovers for the first time. In our analysis, we document how the takeover auction process underwent fundamental changes as an outgrowth of this sea change in the market for corporate control.

The increased susceptibility of large firms to takeovers was followed by major alterations in the legal and governance setting related to the corporate takeover market. Lobbied by the large firms in their jurisdictions, state legislators passed antitakeover laws. Major corporations themselves instituted poison pills and other takeover hurdles. These legal and governance changes provoked lawsuits between bidders and targets to determine the degree to which the boards of target firms could repel a takeover. Alchian (1965) defines a property right as protection against the use of a resource against the owner’s will. Using Alchian’s terminology, the courts in Delaware and other states were faced with determining the appropriate property rights to grant to target boards in the new takeover environment: When could a target board just say no to a prospective bidder? While the legal process evolved and often failed to please academic commentators such as Gilson (2001)[4], the courts in Delaware ultimately clarified the property rights of the boards of directors of target firms.

A focal case amid this changing takeover environment was the 1986 Revlon case, in which the Delaware Court of Chancery ruled that once a target firm is up for sale, the duty of the target board changes from a defender of corporation to an auctioneer. However, the Revlon decision did not clearly define “auction.” This ambiguity induced further lawsuits. Through, as in the model of Rubin (1977)[5], common law cases clarified when and whether target boards must conduct an auction, the provision of information during an auction, and the allowance of takeover hurdles during the auction process. By 1989, in the Time Inc. decision, the courts had clarified the property rights during corporate control transactions by moving to broad deference with the business judgment rule, which granted relatively strong property rights to target boards.

In our empirical work, we compare and contrast the takeover auction process in the Revlon period of 1986 to 1989 with later time periods following the Time Inc. decision. We document the following fundamental changes in takeover auctions:

• After the Time Inc. decision, takeover auctions moved behind the scenes, where a significant portion of the bidding process now occurs prior to the public revelation of the takeover.
• In conjunction with this movement to hidden auctions, target boards are much more likely to initiate the takeover process rather than wait for an initial bid.
• The time between the initiation of a deal in private and the public announcement of a transaction has lengthened significantly.
• Accounting for this longer period between hidden deal initiation and deal announcement, target premiums have increased significantly since the Time Inc. decision.

Our results have important implications for research on corporate takeovers and corporate governance. Research of increasing sophistication such as that done by Cain, McKeon, and Solomon (2017) [6]is attempting to determine whether and which state laws and legal cases matter for the market for corporate control. The gauge of what matters focuses on the impact of laws and legal cases on the rate of hostile takeovers. Yet our results point to a more fundamental effect on the conduct of corporate takeover auctions. Target boards exert more control of the auction process. While competition within such auctions has not abated, it has moved from the public sphere of hostile deals to a more private process.

Moreover, these fundamental changes in the process have not occurred in response to a single type of state law or a specific court decision. Instead, they came about through a series of court decision between the 1986 Revlon decision and the 1989 Time Inc. case. More important, these cases themselves were a reaction to the imposition of takeover hurdles that were a response to the sea change in the corporate takeover market wrought by shocks such as the relaxation of antitrust laws and junk bond financing that made large firms vulnerable to being taken over. As in the model of Rubin (1977), these changing conditions led to lawsuits that clarified the property rights of target boards when defending the corporate bastion.

In a Coasian vein, we interpret the decline of hostile takeovers following the Time Inc. decision as being directly due to the clarification of property rights. Indeed, the burst of hostile takeovers that we document following the 1986 Revlon decision can be viewed as stemming from the ambiguity of the auction duties prescribed in that case. Our view contrasts with the standard argument that the Time Inc. decision entrenched incumbent management. The entrenchment view implies that hostile deals are associated with poorly performing targets, which is at odds with the results in Schwert (2000)[7] as well as our own analysis. Moreover, the view that target management could become entrenched and refuse to enter into value-enhancing deals is distinctly in opposition to the main point in Coase (1959, 1960) that well-defined property rights facilitate exchange.

Indeed, the extant literature’s (over) emphasis on hostile takeovers seems somewhat out of place when studying takeover auctions. In any setting of scarcity, markets and private property rights prompt conflicts over the use of scarce resources (Alchian and Demsez (1973)[8]). Hence, any contest for the control of a corporation could be deemed hostile in the sense that competing parties aim to attain control. But the incumbent party controlling the corporation need not be managers determined to resist. The destiny of the modern corporation as modeled by Alchian and Demsetz (1972)[9] is that if the stock price under the incumbents is lower than that deemed appropriate by outside  mangers, then competition for control will ensue. Our main result on takeover auctions is that this competition has moved from outwardly visible contests to more behind the scenes auctions.

ENDNOTES

[1] Coase, R.H., 1959. “The Federal Communications Commission.” Journal of Law and Economics 2, 1-40.

[2] Coase, R.H., 1960. “The Problem of Social Cost.” Journal of Law and Economics 3, 1-44.

[3] Jensen, Michael, C., 1993. “The Modern Industrial Revolution, Exit and the Failure of Internal Control Systems.” Journal of Finance 48, 831-880.

[4] Gilson, Ronald J., 2001. “Unocal Fifteen Years Later (And What We Can Do About It).” Delaware Journal of Corporate Law 26, 491-513.

[5] Rubin, Paul H., 1977. “Why is the Common Law Efficient?” Journal of Legal Studies 6, 51-63.

[6] Cain, Matthew D., Stephen B. McKeon and Steven Davidoff Solomon, 2017. “Do Takeover Laws Matter? Evidence from Five Decades of Hostile Takeovers.” Journal of Financial Economics 124, 464-485.

[7] Schwert, G. William, 2000. “Hostility in Takeovers: In the Eyes of the Beholder?” Journal of Finance 55, 2599-2640.

[8] Alchian, Armen A. and Harold Demsetz, 1973. “The Property Rights Paradigm.” Journal of Economic History 33, 16-27.

[9] Alchian, Armen A. and Harold Demsetz, 1972. “Production, Information Costs, and Economic Organization.” American Economic Review 62, 777-795.

This post comes to us from Professor Tingting Liu at Creighton University, Professor J. Harold Mulherin at the University of Georgia, and Professor William O. Brown at the University of North Carolina at Greensboro. It is based on their recent article, “The Development of the Takeover Auction Process: The Evolution of Property Rights in the Modern Wild West,” available here.