A Critical Test of Corporate Governance
Takeover battles are epic struggles between management and raiders. Right now, the strategic edge lies with management. When takeovers became a significant threat to firms in the early 1980s, incumbent managers and their lobbyists obtained layer upon layer of anti-takeover legislation from compliant state legislatures. Even more important, state courts stopped policing management’s use of the all-powerful poison pill takeover defense.
The poison pill prevents takeovers by giving target-company shareholders the right to buy stock in the bidding firm at huge discounts, if the target is ever merged with the bidder. In today’s legal environment, only the boldest and best-financed bidders can complete an unso- licited acquisition.
But the takeover world is about to change dramatically. A new invention, the “shareholder rights bylaw,” promises to revitalize the moribund market for corporate control. The shareholder rights bylaw is a simple but ingenious innovation. It eliminates the ability of target company boards of directors to keep their poison pills in place once an outside bid is made. The poison pills of companies with rights bylaws expire automatically whenever there is an all-cash offer for 100% of the company’s stock at a price at least 25% above the market. Once a bylaw is passed, the only way managers can keep the firm’s poison pill in place, once an offer is made, is by getting shareholder approval.
Legal approval of the shareholder rights bylaw would have a dramatic effect on stock prices. The prices would soar as the market anticipated the effects on share prices of future takeover bids. They would continue to rise as managers of public companies began to enhance firm value in order to discourage outside bidders. This is how the market for corporate control is supposed to work.
The only obstacle to the shareholder rights bylaw is the danger that it will be struck down by state courts. Favoring the legality of these bylaws is the fact that virtually all states, including the important state of Delaware, have laws declaring that a company’s bylaws may contain any provisions relating to the conduct of the directors. New York law is particularly clear in giving shareholders control over the bylaws. California courts are likely to be sympathetic to shareholders as well.
Managers and their lawyers will argue that shareholder rights bylaws conflict with ancient state laws stipulating that corporations are to be managed by their boards of directors. This argument is weak since most of these statutes say that directors manage the corporation “unless the bylaws say otherwise.”
The issue will be resolved soon. The Securities and Exchange Commission has decided that companies must include shareholder rights bylaws in their annual proxy solicitations at shareholders’ request. This means shareholders can force a vote on shareholder-rights-bylaw proposals in their firms’ annual corporate proxy solicitations. Managers will inevitably respond with a legal challenge to the bylaws, claiming they interfere with the directors’ legal authority.
Like other high-stakes corporate-governance games, political considerations will count for at least as much as economic and legal factors in determining the outcome of this dispute. State law judges are likely to think that declaring shareholder rights bylaws invalid will be the safest strategy. After all, managers are a powerful political force, and the stakes are high enough that they might threaten to move corporate charters to states more friendly to incumbent managers. A number of states have been quick to pass laws favorable to management in hopes of gaining an edge in the jurisdictional competition for charters.
But the political situation is far different now than in the 1980s, when the poison pill came on the scene. Institutional investors are not only more important, they are also better organized, more sophisticated and more inclined to express their views. This time, savvy fund managers at behemoths such as CREF (College Retirement Equity Fund) and Calpers (California Public Employees Retirement System) will object if managers try to thwart shareholder rights bylaws.
The only question is: How far is the institutional investor community willing to go in support of shareholder rights? If a state declares the bylaw invalid, these investors may insist that the companies they are investing in look for jurisdictions more attentive to shareholder value.
Just as New Jersey lost its dominant position in the corporate-chartering wars at the end of the 19th century by failing to keep up with the times, Delaware risks losing its dominant position in the 20th century if it fails to recognize the importance of institutional investors. The shareholder rights bylaw is likely to be the critical test of corporate governance in the ‘90s because it offers courts such a clear choice between management prerogatives and shareholder value.
