VIEWPOINTS : Directors Must Learn to Say No

Two dramatically opposite views of takeovers compete for public attention. The first, which prevails in the academic journals, is that takeovers are good for shareholders and hence benefit the economy. The public debate, however, is dominated by sweeping condemnations of the entire takeover process.

As both a corporate director who has taken part in takeover battles and a researcher who has contributed to the literature on the subject, I want to weigh in with a third view. The battles for controlling American corporations are far more complex than either side acknowledges.

Takeovers generate both benefits and costs, both winners and losers. Common sense leads to the obvious--and correct--conclusion: Some takeovers are good, replacing inept managements, while others do not work out. Just recall the numerous acquisitions that have been sold off at a loss.

Let us analyze the impact of takeovers a step at a time. First of all, what happens to the price of the stock of the company being taken over? In virtually every case, the stock market value of the target company rises during the takeover battle. The stockholders--large and small--gain, often very substantially. Should we expect anything else? What raider would make a bid for a company below its current market value? Naturally, the bidding for a company’s stock raises its price. As we teach in Economics 101, an increase in demand for an item, without a commensurate increase in supply, will result in a higher price.

But, for each seller there is a buyer. What happens to the stock of the firm that does the taking over? The answer to this question is played down in the academic journals, something like sweeping the dirt under the rug. The stock of the acquiring firm usually declines after the announcement of the merger.

In general, the owners of the “raider’s” stock evaluate a takeover announcement negatively. The widely held belief that shareholders generally benefit from takeovers does not hold up. There are both winners and losers. But the distribution of investors within the two categories is counter-intuitive: Typically, the owners of the “winning” firms lose or, at best, receive no gain; the owners of the “losing” firms win.

Furthermore, takeovers in general do not generate positive gains to society, at least not on the basis of stock market values. Of the studies that show the dollar amounts of the gains and losses to both groups of shareholders, several show net gains, several net losses, but few of these results are statistically different from zero. From the viewpoint of the economy as a whole, little net benefit accrues from the entire takeover process.

Warning: That does not signify that every takeover is a dud. Rather, it means that the odds are that companies doing series of takeovers will do well on some and poorly on others. In some cases, the company taken over will do better because a stick-in-the-mud entrenched management is replaced. At other times, the hot shots who take control do not know enough about the business to run it well.

All this does not seem to generate a need for government intervention. But the pervasiveness of zero or negative returns to shareholders of raiding firms raises an important question: “What motivates the managements of these acquiring firms?” We can dismiss out of hand the notion that the raiders are such altruists that they are willing to use the resources of their own companies (at the expense of their own shareholders) in order to liberate the down-trodden owners of some other company.

Corporate managers are no different than other individuals. Self interest should be expected to dominate their decision making. I do not underestimate the benefits to management from directly controlling larger enterprises. I have to confess that, as a board member, on occasion I have shared those perks.

A recent study by the Conference Board underscores the point that increasing the size (rather than merely the profitability) of the firm promotes management’s own interests. Statistical analysis confirms the common sense observation. In plain English, you get more money for running a big outfit than a small outfit.

The uncritical academic supporters of takeovers look down at existing managements of target firms because of their supposed lack of concern for their shareholders. To be consistent, it is equally hard to deify the managements of the “sharks,” who often show little more regard for their own shareholders. What should be done?

I part company with the advocates of more government intervention. Given the complexity of corporate takeovers, it is difficult to see how government regulators could be relied upon to select only mergers that work well. If we have learned anything from the long history of government regulation of business, it is that Uncle Sam usually does more harm than good when he intervenes in internal business decision making. Moreover, the very threat of takeovers may get a complacent management to pay closer attention to the company’s performance.

But my preference is not to follow a do-nothing approach. The proper answer to corporate takeovers is in the corporation itself.

In addition to “takeover artists” and “entrenched managers,” there is a third force in battles for corporate control--the firm’s board of directors. Too many boards still view their prime task as supporting the management. Surely the outside directors and the senior managers who serve as inside directors should develop good working relationships. But they need to understand that, at times, their interests diverge. The board is elected to represent the shareholders.

The most important, and rarely performed, duty of the board is to learn how to say no. It often falls on the outside directors to favor a dividend increase over a marginal project, even if it is the pet of a key manager. And it is up to the board to oppose a prospective merger that would, over the long run, dilute the earnings of existing shareholders--and, in the short run, reduce the market value of their shareholdings. Similarly, it is the responsibility of the board to decide when an offer for the corporation’s shares is sufficiently attractive to accept over the protestation of management.

The rubber-stamp director has not vanished from the board room. The increasing frequency of legal challenges to board decisions from shareholder derivative suits, however, makes it more likely that more board decisions will be based on considerations other than management preferences. That trend is reinforced by the rising cost and declining coverage of directors’ and officers’ liability insurance.

The heart of a positive response to unsolicited takeovers is neither a passive attitude on the part of the target firm nor government restraints on raiders. It is responding more fully to the desires of the owners of the business.

The competitive “market” for controlling American companies is an example of a private enterprise economy at work, producing winners and losers. The government can try to prop up the losers by making change more difficult. But government barriers to takeovers will not create any winners. It will merely solidify the status quo.