Nikolas R. Ortega
Comments on Corporate Governance and Innovation: Theory
and Evidence1
This Paper is a commentary on the findings of Corporate Governance and
Innovation: Theory and Evidence compared and contrasted with Do Hostile Takeovers
Stifle Innovation? Evidence from Antitakeover Legislation and Corporate Patenting. It
seeks to examine the worth of current takeover laws with the mindset that fostering
innovation should be the paramount goal of our federal and state governments when it
comes to corporate law, specifically, the law that governs mergers and acquisitions. The
Corporate Governance and Innovation: Theory and Evidence report offers a theory that
corporate innovation is maximized in two scenarios. The first scenario is in a legal
environment that creates a purely free market for corporate takeovers. The second
scenario is where corporate law eliminates all takeovers. Shareholders, and in turn the
United States economy, face concerns in both of these extreme scenarios. Because
banning all corporate mergers is not realistic and it would infringe on fundamental
shareholder rights, the government should err on the side of a free market for corporate
takeovers. Therefore, United States legislatures should strive to create a corporate legal
environment designed to balance the problem of suppressed innovation with the problems
that would arise from corporate marauding in a purely free market for corporate
takeovers. Maximizing innovation through the law, or at least creating a legal
environment in which innovation can thrive, will enable United States companies to
remain competitive in the global marketplace.
Organizational Structure
The organizational structure of this Paper follows: (1) The Paper begins with an
“Introduction” section designed to provide a factual background on the authors of
Corporate Governance and Innovation: Theory and Evidence, and the thesis of this
Paper. (2) Next, there is a section to provide the reader with a brief summary of the
report this Paper analyzes. (3) After the summary of Corporate Governance and
Innovation: Theory and Evidence, there is a section that summarizes and compares a
Journal of Finance article on the same topic titled Do Hostile Takeovers Stifle
Innovation? Evidence from Antitakeover Legislation and Corporate Patenting2 with
1
HARESH SAPRA ET AL., COMMENTS ON CORPORATE GOVERNANCE AND INNOVATION:
THEORY AND EVIDENCE (2013) available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2210609.
2
Julian Atanassov, Do Hostile Takeovers Stifle Innovation? Evidence from Antitakeover
Legislation and Corporate Patenting, J. FIN., Jan. 30, 2013, available at
http://onlinelibrary.wiley.com/doi/10.1111/jofi.12019/pdf.
1
Sapra and his coauthors report. (4) Then, there is a section that describes the current state
of external mechanisms3 and their evolution. (5) Next is a section discussing the
importance of innovation for corporations and, in turn, the economy. (6) Following the
state of the law section is a section that analyzes the findings of Sapra and his coauthors
while commenting on the current legal environment for innovation. This section also
examines the importance of innovation and provides several examples of the positive
impact of corporate innovation. (7) Finally, there is a conclusion section that summarily
presents the essential points of this paper.
Introduction
On February 26, 2013, Haresh Sapra, Ajay Subramanian, and Krishamurthy V.
Subramanian published a report regarding their findings on the relationship between
corporate governance and innovation.4 The report is an international collaboration
among business management scholars with Sapra representing the Booth School of
Business at the University of Chicago, A. Subramanian representing the J. Mack
Robinson College of Business at Georgia State University, and with K. V. Subramanian
representing the Indian School of Business located in Hyderabad, India.5 The report
details a theory its authors developed to show how both internal and external corporate
governance mechanisms affect corporate innovation.6
Shortly before Sapra and his coauthors published Corporate Governance and
Innovation: Theory and Evidence, Julian Atanassov published an article titled Do Hostile
Takeovers Stifle Innovation? Evidence from Antitakeover Legislation and Corporate
Patenting that also explores the relationship between takeovers and corporate innovation.
The Journal of Finance published Atanassov’s article on January 30, 2013, just one
month before Sapra’s article was published. Atanassov is an assistant professor in the
department of finance of the Lundquist College of Business at the University of Oregon.
The Corporate Governance and Innovation: Theory and Evidence report is discussed
first.
Corporate Governance and Innovation: Theory and Evidence Report
Sapra and his coauthors found that “there is a U-shaped relation between
innovation and external takeover pressure, which arises from the interaction between
expected takeover premia and private benefits of control.”7 The data supporting this
conclusion came from observations before and after the occurrence of innovation.8 To
3
E.g. antitakeover laws.
SAPRA ET AL., supra note 1.
5
Id. at abstract.
6
Id.
7
Id.
8
Id.
4
2
provide a more robust analysis, the authors took advantage of data about the differences
in takeover pressure among the fifty states generated by anti-takeover laws.9 The Ushaped relationship the team observed signifies that “Innovation is fostered either by an
unhindered market for corporate control, or by anti-takeover laws that are severe enough
to effectively deter takeovers.”10
The graph below is a simple illustration of this relationship:
This graph is a simple visualization of Sapra and his coauthor’s theorized relationship
between the level of corporate innovation and the legal environment for corporate
takeovers. The Y-axis represents the level for corporate innovation with corporate
innovation increasing as the curve’s Y coordinate moves up the Y axis. The X axis is a
spectral representation of the legal environment for takeovers. The further left the current
state of the legal environment, the freer the market for takeovers becomes. At the leftmost
point there is literally no regulation governing takeovers. The further right, the legal
environment for takeovers becomes harsher. At the right most point, the law entirely
prohibits corporate takeovers. As shown by the graph, innovation is maximized at the
extremes of the legal environment axis. Conversely, innovation is minimized at the
center of the two extremes.
9
Id.
Id.
10
3
United States economic growth is directly affected by state and federal law as
well as by institutions that influence corporate governance.11 In particular, it is clear that
“economic growth results from firm-level innovation.”12 However, the exact manner in
which laws and institutions influencing corporate governance affect firm-level innovation
is less clear.13 Anti-takeover laws influence managers’ performance incentives, and
managers’ incentives in turn influence their level of ingenuity.14
The point of the Corporate Governance and Innovation: Theory and Evidence
report is to attempt to explain a possible way that “external mechanisms for corporate
governance, such as anti-takeover laws, interact with a firm’s internal mechanisms, such
as managerial incentive contracts, to affect firm-level innovation.”15 Represented
graphically, the impact these external mechanisms have on firm-level innovation appears
as a U-shape with the amount of firm-level innovation being the greatest in both legal
environments where there is a purely free market for corporate control and legal
environments that entirely eliminate the threat of corporate takeovers.16 If true, this
theory is groundbreaking because previous theories have only posited monotonic17
relations, with either positive or negative slopes, between external mechanisms affecting
corporate governance and firm-level innovation.18
In order to discover this previously unknown appreciated relationship between
external mechanisms of corporate governance and innovation, a sufficiently variable data
set is needed, as is true with all statistical relationships. The authors of Corporate
Governance and Innovation: Theory and Evidence found such a sufficiently varied data
set by observing the differences between anti-takeover laws across the United States and
the dates when legislatures passed the laws.19 Specifically, Sapra and his coauthors’
provided empirical support for their findings by:
exploiting the staggered passage of anti-takeover laws by U.S. states as a
source of cross-sectional and time-series variation in takeover pressure,
and using ex-ante as well as ex-post proxies for innovation. [the authors
conducted] several tests to account for the effects of unobserved
determinants of innovation that may accompany the anti-takeover law
passages. In particular, [the authors exploited] hand-collected data on
patents filed by the specific subsidiaries/divisions of a firm that are located
11
Id. at 1.
Id.
13
Id.
14
Id.
15
Id.
16
See Id.
17
Used in this context, “monotonic” means a straight line regardless of the value of its
slope as opposed to a curve that possesses different slopes at different points of its
horizontal axis.
18
Id.
19
Id.
12
4
outside the state of incorporation of the parent firm to isolate the pure
effects of anti-takeover law passages on innovation.20
This analysis of external methods of corporate control as they relate to firm-level
innovation yields the core thesis of Corporate Governance and Innovation: Theory and
Evidence. Put simply, the thesis is that “innovation is fostered either by practically nonexistent anti-takeover laws that permit an unhindered market for corporate control, or by
anti-takeover laws that are severe enough to effectively deter takeovers.”
To provide a concrete example of how their theory would affect a realistic
situation, Sapra and his coauthors provide the reader of Corporate Governance and
Innovation: Theory and Evidence with a scenario about a pharmaceutical company.21
The sample scenario consists of a pharmaceutical company manager deciding between
two mutually exclusive options.22 The first option is for the manager to invest in a
project that would require a higher level of innovation, creating an entirely new drug.23
The second option is for the manager to pursue a generic substitute for a drug that is
already on the market, requiring a smaller degree of innovation than creating an entirely
new drug.24 Particularly, most uncertainties with a generic drug arise in the marketing
context while considerably greater uncertainties arise in the research and development
stage of creating a new drug.25
This hypothetical model has several constraints to simplify Sapra and his
coauthors’ analysis. Primarily, the model follows the manager of the pharmaceutical
company through two periods.26 After the first period, the model provides that there is a
chance that an acquirer could take over the pharmaceutical company through a tender
offer.27 After the second period, there is a qualitative assessment of the chosen project’s
profitability. This model creates a scenario where the manager is forced to trade “off the
positive effect of greater innovation on the expected unconditional payoff and the
expected takeover premium against its negative effect on the expected lost of control
benefits.”28 It is this tradeoff that is responsible for the predicted U-shaped relationship
between innovation and external takeover pressure.
Innovation and external takeover pressure have a U-shaped relationship because
of the different incentives managers have at the extremes of a purely free market for
takeovers and a market that does not allow for take overs. In the exact words of Sapra
20
Id.
Id. at 2.
22
See Id.
23
See Id.
24
Id. (noting that “[l]aunching a generic substitute involves uncertainties due to customer
demand and competition. In contrast, inventing a new drug entails additional
uncertainties associated with the process of ‘exploration.’”).
25
Id.
26
Id.
27
Id. at 3.
28
Id. at 4.
21
5
and his coauthors the U-shaped relationship predicted by their analysis arises because:
When the takeover pressure is very low, the low likelihood of a takeover
implies that the expected takeover premium and the expected loss of
control benefits are insignificant for both projects. Therefore, the manager
chooses greater innovation because it has a higher expected unconditional
payoffs. When takeover pressure is very high, the expected takeover
premium and the expected loss in control benefits are both high. At high
levels of takeover pressure, the takeover probabilities are similar for both
projects so that the expected loss of control benefits are also similar. The
expected takeover premium, however, is higher for the more innovative
project because it depends not only on the probability of a takeover, but
also on the size of the takeover premium conditional on a takeover.
Consequently, it is again optimal to choose greater innovation when
takeover pressure is high. For moderate levels of takeover pressure, the
effect of the higher loss of control benefits associated with greater
innovation dominates. It is therefore optimal for the manager to choose
lower innovation to reduce the likelihood of losing her control benefits.29
In light of this relationship between external takeover pressures and innovations, this
Paper posits that the optimal legal environment for corporate takeovers is one that falls on
a position of the U-shaped relationship that is to the left of the innovation minimum but
to the right of a purely free takeover market. Such a position would serve United States
Economic interests only if it balanced the problems associated with a free takeover
market against the problem of stifling corporate innovation. The extent to which the
potential of a takeover, particularly a hostile takeover, stifles corporate innovation is the
subject of the next article discussed.
Do Hostile Takeovers Stifle Innovation? Evidence from Antitakeover Legislation and
Corporate Patenting Report
Similarly but less broadly than Sapra and his coauthors, Atanassov seeks to
explore an aspect of the relationship between innovation and takeovers. Specifically,
Atanassov examines “how strong corporate governance proxied by the threat of hostile
takeovers affects innovation and firm value.”30 Based on his extensive research, he
concludes that firms are awarded less patents and receive less citations per patent if they
are incorporated in a state that has passed an antitakeover statute than if the same firm
was incorporated in a state with a legal environment that exposed the firm to the threat of
takeover.31 The impact a change in the legal environment for takeovers has on corporate
innovation typically takes two or more years to manifest.32 Interestingly, Atanassov finds
“[t]he negative effect of antitakeover laws is mitigated by the presence of alternative
29
Id. at 4—5.
Atanassov, supra note 2.
31
Id.
32
Id.
30
6
governance mechanisms such as large shareholders, pension fund ownership, leverage,
and product market competition.”33
Atanassov begins by explaining that capital markets have the potential to
stimulate economic growth through two channels.34 One way is through their ability to
provide the necessary capital to fund projects that become profitable, but the other way,
which is more important in this context, is “by providing the right incentives to managers
through their monitoring and disciplining mechanisms.”35 Scholars generally agree on
the manner in which capital markets impact economic growth when they do so by
providing funding.36 They do not, however, agree on the way capital markets,
specifically takeovers, impact economic growth through providing incentives to
managers.37
In an attempt to combat the uncertainty covering the way that capital markets
impact the economy through providing incentives to managers, Atanassov picks a prime
example. He chooses the threat of takeover as the incentive provider, and he attempts to
measure how this pressure impacts innovative decisions by top management.38 The
purpose of his article is to “evaluate how the threat of hostile takeovers, which is
considered one of the most extreme examples of external pressure on top management,
impacts innovation.”39
Hostile takeovers are a double-edged sword when it comes to their direct effect on
corporate governance and their indirect affect on the United States economy. “While
hostile takeovers are considered one of the strongest corporate governance mechanisms
to discipline managers and provide them with incentives to make value-enhancing
decisions, numerous academics and policy makers argue that perhaps the greatest public
concern about takeovers is that they stifle innovation.”40 In order to determine how the
threat of hostile takeovers impact corporate-level innovation, Atanassov, like Sapra and
his coauthors, utilizes the differences between the various state antitakeover laws.41 He
argues that his methodology enables him “to evaluate the impact of hostile takeovers on
the quantity and quality of innovative output measured by patents and patent citations. It
also enables him to assess the importance of alternative governance mechanisms on
disciplining managers when the threat of hostile takeovers is absent.”42
Next, Atanassov delves into some of the prevailing schools of thought seeking to
33
Id.
Id. at 1.
35
Id.
36
Id.
37
Id.
38
Id. SAPRA ET AL., supra note 1.
39
Atanassov, supra note 2, at 1.
40
Id.
41
Id.
42
Id.
34
7
explain how hostile takeovers influence mergers. The first school of thought is the
“agency view.”43 The agency view theory proposes that managers who are more
effectively monitored perform better than managers who do not have anyone looking
over their shoulder.44 As the theory goes, the threat of a hostile takeover counteracts the
human nature to shirk when a person lacks either an effective monitor or an intrinsic
motivation.45 The more managers fear losing their jobs in a hostile takeover, the more
likely they are to pursue innovative courses of action.46 However, another school of
thought predicts the opposite.
Some scholars believe that when takeover pressure is too high, the current
managers of a firm have little incentive to take risks in the form of innovative projects
because they already believe their job is lost.47 These managers, according to this theory,
“fear a hostile acquirer who will dismiss them after the innovation is created, and take
advantage of the profits resulting from that innovation without bearing the costs for
creating it.”48 One of the possible causes of this phenomenon is that shareholders lack
the knowledge and experience of managers, and therefore, they cannot properly evaluate
the risk-reward tradeoff of a manager’s innovative actions.49
Atanassov ultimately concludes that for firms incorporated in a state that passes
an anti-takeover law, innovation is stifled.50 It is important to note that Atanassov’s
theory predicts that corporate innovation declines as the threat of a hostile takeover
weakens. See the graph below:
43
Id.
Id.
45
Id. at 2.
46
Id.
47
Id.
48
Id.
49
Id.
50
Id.
44
8
The axes of the graph are exactly the same as in the Sapra graph on page three of this
Paper. However, the curve has changed. According to Atanassov, corporate innovation
is at its highest when managers are under the greatest threat of a hostile takeover, and as
take over pressure wanes, so does their level of innovation.
While this prediction is in line with Sapra and his coauthor’s prediction that when
the legal environment is conducive to takeovers (i.e. a purely free market for takeovers),
Atanassov’s model diverges when the legal environment prevents all mergers.
Corporate Governance and Innovation: Theory and Evidence v. Do Hostile Takeovers
Stifle Innovation? Evidence from Antitakeover Legislation and Corporate Patenting
It is interesting that despite analyzing almost the exact same issue at almost the
exact same time while analyzing almost the exact same data sets,51 Sapra and his
coauthors develop differing theories. The theories do not directly contradict each other,
but when Atanassov’s model is extrapolated, the predictions are inconsistent. Atanassov’s
model differs from Sapra and his coauthors’ when external mechanisms, whatever they
may be, effectively eliminate corporate takeovers. In a legal or regulatory environment
that forbids takeovers, Sapra and his coauthors believe that corporate innovation is
51
Both works base their findings on mergers and acquisitions data from roughly the last
four centuries. Id. at 4; SAPRA ET AL., supra note 1, at 63—65.
9
maximized.52 However, in the same style of legal environment, Atanassov predicts that
corporate innovation is minimized.53 There are several reasons this discrepancy may
have arisen between the two models.
The first reason that the models may differ is that Atanassov may have only
intended to analyze the relationship between takeover pressure and corporate innovation
in a legal environment with some form of takeover statute in play. Atanassov may have
only attempted to analyze the relationship between innovation and takeovers in legal
environments where mechanisms preventing takeovers are prevalent. In other words, he
may have only contemplated legal environments starting at the minimum of the U-shaped
graph54 and to the left.
However, this is unlikely. If Atanassov analyzed a large enough pool of data that
adequately represented the entire United States, he should have seem the same corporate
innovation levels start to increase as jurisdictions became more hospitable to acquirers.
This is assuming, of course, that Sapra and his coauthors are correct in their analysis.
Another reason for the discrepancy could arise from the fact that qualitative
attributes are notoriously difficult to measure. There are metrics for measuring some
qualitative traits, but they are by no means perfect. There is great difficulty in charting
characteristics such as the level of corporate innovation accurately. The articles
discussed in this paper gravitate towards patents filed, but there are many innovations to
which patents are not applicable.
Finally and most likely, the two models may differ because Sapra and his
coauthors sought to analyze the relationship between external takeover measures and
corporate innovation across the entire spectrum of possible legal environments, real and
hypothetical. It seems as though Atanassov was only interested in actual takeover legal
environments. That is, Atanassov analyzed and reported on external takeover pressures
only in measurable contexts while Sapra and his coauthors extrapolated their findings to
both extremes of the legal environment spectrum. This is readily apparent by Sapra and
his coauthor’s thesis: “Innovation is fostered either by an unhindered market for
corporate control, or by anti-takeover laws that are severe enough to effectively deter
takeovers.”55 There are no “unhindered markets for corporate control” in the United
States the same way there are no jurisdictions with “anti-takeover laws that are severe
enough to effectively deter takeovers” in the United States.
Since there are no observable data sets (or certainly not enough to have a
statistically significant sample) at the extremes of the legal environment spectrum, Sapra
and his colleagues must have extrapolated their data. Atanassov did not take this
approach. Instead, he analyzed real data and noticed a trend among United States
52
SAPRA ET AL., supra note 1, at 4—5.
See Atanassov, supra note 2.
54
See supra p. 9 graph and accompanying text.
55
SAPRA ET AL., supra note 1, at abstract.
53
10
jurisdictions: Innovation is stifled for firms incorporated in a state that passes an antitakeover law relative to firms incorporated in states where the legal environment is more
conducive to hostile takeovers.56 Observing this trend does not involve extrapolation
because Atanassov does not attempt to predict what happens at the logical extremes of
the legal environment spectrum. He attempts to create a workable model for how
innovation levels respond to external takeover pressures in existing United States
jurisdictions. This is not to say that Sapra and his coauthors are incorrect in their analysis
of the relationship between takeover pressure and innovation.
The differences between the two models are most likely created by Sapra and his
colleagues extrapolation. A way to picture the problem is that Atanassov is focused only
on a small portion of the Sapra et al. graph on page three, the portion halfway between
the purely free market extreme and the minimum and extending to the minimum. This
represents the observable portion of the spectrum of legal environments for takeovers in
the United States. Sapra and his coauthors take a step back and attempt to take a broader
view of the legal environment for takeovers. Using the data they observe they predict
how innovation levels react to external takeover pressures across the entire universe of
legal environments for takeovers.
Sapra and his coauthor’s broader view of the legal environment spectrum for
takeovers explains the seeming inconsistency between their theory and Atanassov’s. The
two models are harmonized when Atanassov’s model is considered a subset of Sapra and
his coauthors’ model. Atanassov’s theory would then accurately describe a subset of the
data while Sapra and his coauthor’s theory describes the entirety of the data as well as an
extrapolation into the areas where there are no data.
The next section describes the current state and evolution of external mechanisms
influencing corporate governance in the United States. This section is important because
it provides the reader with information that will help him or her to appreciate how
takeover attempts are governed and how this governance could impact innovation. While
the articles discussed above shed light on the relationship between antitakeover laws and
corporate innovation, they do not provide an in depth explanation of the current state or
history of the external mechanisms that influence corporate governance in the United
States.
The Current State and Evolution of External Mechanisms Influencing
Corporate Governance
In response to a great increase in the number of corporate takeovers, state
legislatures began enacting antitakeover statutes to protect domestic corporations from
hostile takeovers. While the stated purpose of these laws is to protect investors by
significantly weakening the ability of outside bidders to purchase a corporation,
antitakeover statutes also safeguard local economies from economic and job losses by
56
Atanassov, supra note 2, at 2.
11
keeping domestic corporations incorporated and operating in the state.57 In addition,
state antitakeover statutes provide further defenses for corporate management to resist
takeovers.58 Today, most states have some type of law regulating takeovers,59 and ninety
percent of American corporate capital is protected by state antitakeover statutes.60 As
such, antitakeover law is one of the most heavily debated and litigated areas in corporate
law.61 See the graph below for worldwide, announced merger and acquisition activity
over the past three decades.62
57
David J. Marchitelli, Annotation, Construction and Application of State Antitakeover
Statutes, 37 A.L.R. 6th 1 (2008).
58
John C. Anjier, Anti-Takeover Statutes, Shareholders, Stakeholders and Risk, 51 LA. L.
REV. 561, 568 (1991).
59
California and Texas, which have not enacted antitakeover laws, are the major
exceptions. Roy Harris, States of Grace: The State with the Toughest Antitakeover
Statutes? It’s not Delaware., CFO, July 1 2002,
http://www.cfo.com/article.cfm/3005340/1/c_3046525.
60
Id.
61
Michal Barzuza, The State of State Antitakeover Law, 95 VA. L. REV. 1973, 1975
(2009).
62
INST. OF MERGERS ACQUISITIONS AND ALLIANCES (May 16, 2013), http://imaainstitute.org/statistics-mergers-acquisitions.html#MergersAcquisitions_Worldwide
(follow the *Worldwide* hyperlink found under “number and value of announced M&A
transactions” heading).
12
State regulation of hostile takeovers suffered a setback in 1982 when the Supreme
Court struck down a state antitakeover statute as unconstitutional under the Commerce
Clause, reasoning that the statute imposed a substantial burden on interstate commerce
that outweighed the interests the statute sought to protect.63 States responded by enacting
several different types of antitakeover statutes intended to survive constitutional
scrutiny—the two main types of which are control share acquisition statutes and business
combination statutes.64 Control share acquisition statutes generally regulate the initial
acquisition of shares by the bidder by requiring that the bidder obtain prior approval of
current target stockholders before the purchases are allowed.65 Business combination
statutes, on the other hand, limit the bidder’s ability to complete the second step of a
transaction by preventing business agreements between the target company and the
bidder for a certain time period.66
Delaware Antitakeover Law
Because half of all publicly held companies are incorporated in Delaware,
Delaware’s antitakeover statute is by far the most important antitakeover law in the
United States.67 The Delaware statute, a business combination statute, prevents a bidder
who acquires more than fifteen percent of a target company’s stock from completing a
hostile takeover for a period of three years unless: (1) the board of directors approved the
takeover prior to the transaction; (2) the bidder purchased at least eight-five percent of the
target company’s stock in a single transaction; or (3) the target company’s board of
directors and holders of two-thirds of the outstanding shares approve the takeover at or
after the transaction.68 These exceptions make the Delaware law less onerous than
antitakeover laws adopted by other states.69
Thirty-two other states have adopted business combination statutes that are
comparable to the Delaware statute.70 Most of these other statutes are just as or more
63
Edgar v. MITE Corp., 457 U.S. 624, 643–45 (1982).
See Marchitelli, supra note 57.
65
PATRICK A. GAUGHAN, MERGERS, ACQUISITIONS, AND CORPORATE RESTRUCTURINGS
97 (5th ed. 2010).
66
Id.
67
Id. (“[T]he debate over antitakeover law has tended to focus almost exclusively on
Delaware law.”); Guhan Subramanian et. al., Is Delaware's Antitakeover Statute
Unconstitutional? Evidence from 1988-2008, 65 BUS. LAW. 685, 686 & n.1 (2010)
(“Delaware corporations comprise 51% by number and 61% by market capitalization of
all U.S. public companies.”).
68
DEL. CODE ANN. TIT. 8, § 203(a) (2001 & Supp. 2008).
69
See Lucian Arye Bebchuk & Alma Cohen, Firms’ Decisions Where to Incorporate, 46
J. L. & ECON. 383, 406 (2003).
70
Subramanian et al., supra note 67, at 688.
64
13
powerful than the Delaware statute.71 The Delaware statute is a relatively mild version of
the business combination statute.72 For example, the Delaware statute does not apply to a
bidder that purchased eighty-five percent of the target company’s shares in a single
transaction, and the statute’s three-year prohibition period on business combinations is
shorter compared to those of other states, such as New York’s five-year limitation
period.73
While courts apply the highly deferential business judgment rule when reviewing
corporate management’s conduct in running the day-to-day affairs of the company,
Delaware courts impose heightened fiduciary duties on directors in takeover situations.74
For instance, when directors receive a hostile bid and use defensive tactics to remain
independent, Delaware courts apply the Unocal standard.75 The Unocal standard ensures
that the directors’ defensive tactics are reasonable in relation to their belief regarding the
danger of the takeover to the corporate policies and proportionate to the magnitude of the
perceived threat to the corporate policies.76 Therefore, it may be more difficult for
directors of Delaware corporations to resist a takeover attempt. Furthermore, while many
states have adopted laws that allow the use of poison pills, a particularly potent defensive
tactic, Delaware courts allow directors only to make limited use of the poison pill either
to get a better offer for shareholders or to suggest a superior alternative plan.77
The Unocal standard is not the only standard Delaware courts apply in hostile
takeover situations. There are two others triggered by different actions of the board of
directors of the target company.78 The first came about in case familiar to any law
student who as taken a mergers and acquisitions course, Revlon, Inc. v. MacAndrews &
Forbes Holdings, Inc.79 The Revlon standard is a higher standard than the Unocal
standard, and it applies when a target’s board of directors tries “to avoid the bid by
selling to a friendly buyer or a ‘white knight’. . . .” When the Revlon standard is
triggered, “Delaware courts [hold] that managers should not be allowed to prefer a lower
bid to a higher one by reasoning that the lower bid arguably has better long-term
prospects. Rather, they should simply pick the highest bid for the shareholders.”80 The
last standard applicable to hostile takeovers, the Blasius standard, is even more strenuous.
Delaware courts apply the Blasius standard, created in Blasius Indus., Inc. v. Atlas
71
Id.
Roberta Romano, The Need for Competition in International Securities Regulation, 2
THEORETICAL INQUIRIES L. 387, 531–33 (2001).
73
Compare DEL. CODE ANN. TIT. 8, § 203(a) (2001 & Supp. 2008) with N.Y. BUS. CORP.
LAW § 912 (McKinney 1998).
74
Barzuza, supra note 61.
75
Barzuza, supra note 61, at 1980–81.
76
Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, 955 (Del. 1985).
77
City Capital Assocs. v. Interco Inc., 551 A.2d 787, 798 (Del. Ch. 1988).
78
See Barzuza, supra note 61, at 1980–81.
79
506 A.2d 173, (Del. 1986).
80
Barzuza, supra note 61, at 86.
72
14
Corp.81 when a target’s board of directors attempts to defend the target from takeover by
interfering with shareholder voting rights “to circumvent the hostile bidder's attempt to
use the proxy machinery.”82 When Delaware courts invoke the Blasius standard they
“require [the target’s board of directors] to meet an almost impossible standard. In
particular, they have to convince the court that there was a compelling justification for
preventing shareholders from exercising their voting rights.” Most other jurisdictions
take a more lenient approach when evaluating the legality of a target’s use of defensive
tactics.
Antitakeover Law Everywhere Else
The antitakeover statutes of Maryland,83 Indiana,84 North Carolina,85 Ohio,86
Pennsylvania,87 and Virginia88 reject the heightened fiduciary standards imposed on
directors in takeover situations established under Delaware case law. Instead, these
statutes help companies by applying the business judgment rule to the use of defensive
tactics. That is, if directors act with care, decisions will not be second-guessed by judges,
including decisions regarding takeovers. The North Carolina statute, for example, applies
the business judgment rule stating that “duties of a director weighing a change-of-control
situation shall not be any different, nor the standard of care any higher, than otherwise
provided in this section.”89 Explicitly rejecting Delaware’s heightened fiduciary
standards, the Indiana statute provides that “[c]ertain judicial decisions in Delaware and
other jurisdictions . . . that impose a different or higher degree of scrutiny on actions
taken by directors in response to a proposed acquisition of control of the corporation, are
inconsistent with the proper application of the business judgment rule under this
article.”90 The map below provides a visual of which states had antitakeover laws as of
200391:
81
564 A.2d 651, 655-56 (Del. Ch. 1988).
Barzuza, supra note 61, at 1987.
83
MD. CODE ANN., CORPS. & ASS'NS § 2-405.1(d)(1), (f) (West 2007).
84
IND. CODE ANN. § 23-1-35-1(f) (West 1999).
85
N.C. GEN. STAT. ANN. § 55-8-30(d) (West 2000).
86
OHIO REV. CODE ANN. § 1701.59(C) (West 2004).
87
15 PA. CONS. STAT. ANN. § 1715(d) (West 1995).
88
VA. CODE ANN. § 13.1-727.1 (West 2007).
89
N.C. GEN. STAT. ANN. § 55-8-30(d) (West 2000).
90
IND. CODE ANN. § 23-1-35-1(f) (West 1999).
91
Theodore Bolema, Repeal Michigan’s Anti-Takeover Law, MACKINAC CENTER FOR
PUB. POL’Y , (Aug. 4, 2003), http://www.mackinac.org/5576.
82
15
Twenty-seven states have enacted control share acquisition statutes.92 First
enacted by Ohio in 1982, a control share acquisition statute typically allows a bidder to
exercise his ability to vote shares acquired in a tender offer only after getting approval
from a majority of disinterested shareholders.93 Put simply, control share acquisition
statutes allow shareholders to vote on whether they want hostile bidders in control.
These statutes are typically triggered by stock purchases beyond a threshold percentage
of the outstanding stock set forth in the statutes, which vary among states.94 The Ohio
statute, for example, requires bidders to win a majority approval before they can purchase
shares beyond twenty percent.95
Now that a background has been provided regarding the state of antitakeover law
and its relationship to corporate innovation has been discussed, the importance of having
a system of corporate laws that facilitate innovation can be explained.
Commentary on the Importance of Corporate Innovation
While the authors of Corporate Governance and Innovation: Theory and
Evidence provide an excellent analysis of the relationship between innovation and the
state of the market for corporate takeovers, they do not suggest the appropriate structure
92
Roberta Romano, The States as a Laboratory: Legal Innovation and State Competition
for Corporate Charters, 23 YALE J. ON REG. 209, 215 (2006).
93
Id. at 227.
94
Marchitelli, supra note 57.
95
See OHIO REV. CODE ANN. § 1701.01 (West 1999).
16
for the legal environment governing takeovers.96 Despite finding the two scenarios in
which a manager’s incentives to innovate are maximized, Sapra and his coauthors say
nothing regarding what level of innovation is optimal for the shareholder and by
extension the economy.97 They also mention nothing about the relationship between
corporate innovation and the economy on a macro scale.98 In this regard, Atanassov does
marginally better in Do Hostile Takeovers Stifle Innovation? Evidence from Antitakeover
Legislation and Corporate Patenting but not by much. Atanassov does, however, state
fairly clearly that antitakeover laws stifle innovation so from that it can be assumed that
he believes legislatures should strive to create legal environments that encourage optimal
levels of innovation.99 Without innovation, the United States would be obliterated by its
competitors. In the words of Jackie and Kevin Freiberg, “Innovation must become a
collective mindset and effort. Everyone must look for and engage in innovations in their
spaces of influence, to include product, service, cost, design, and efficiency
innovations.”100
Innovation is Key to a Vital Economy
United States legislatures should seek to enact legislation that will foster optimal
levels of innovation because innovation is a catalyst for economic growth. If firms had
not produced and strived to perfect gunpowder, the steam engine, the computer, and the
now ubiquitous Internet, the proverbial economic pie would shrink to a sliver or at least
become vastly smaller than it is today. None of these economic growth catalysts would
have come to be without innovation. Having said that, unchecked levels of careless
innovation could lead to disaster. An easily imagined, but perhaps farfetched, example of
this is the scenario where humanity destroys itself with its own weapons. The atomic
bomb is as much a product of innovation as antibiotics. Therefore, the pertinent
questions are what level of innovation is economically optimal, and what must be done to
create a legal environment that fosters an optimal level of innovation?
A unique era of human history is being embarked upon. The way innovation
takes place in Western societies is changing, and companies are primed to make
technological advances like never before.101 “The [innovation] revolution spurred by
venture capitalists decades ago has created the conditions in which scale enables big
companies to stop shackling innovation and start unleashing it.”102 Because of new
technologies, specifically technologies that facilitate cheap, instantaneous sharing of
96
See generally SAPRA ET AL., supra note 1.
Michael Abramowicz, Speeding Up the Crawl to the Top, 20 Yale J. on Reg. 139, 145
(2003).
98
Id.
99
Atanassov, supra note 2, at 2.
100
Jackie Freiberg & Kevin Freiberg, Innovation Vertigo What, Where, When and How?,
Leadership Excellence, May 2013, at 15.
101
Scott D. Anthony, The New Corporate Garage, Harv. Bus. Rev., Sept. 2012, at 45.
102
Id.
97
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information, combined with the globalization phenomenon have catapulted the business
world into an arena where only firms able to innovate at breathtaking speeds will
survive.103 Current examples of relevant corporate level innovation include: Medtronics
Healthy Heart which is a program by Medtronic (“the world’s largest stand-alone medical
device manufacturer”) to help rural Indians gain access to heart healthcare through a
businesss model innovation;104 Unilever’s “Purelt, a portable water purification system
[that] provides safe water at half a cent per liter;”105 Syngenta’s “Uwezo crop-protection
chemicals and seeds [which] use the [innovative] sachet distribution model plus
supportive education and training to drive adoption by smallholders;”106 and IBM’s plan
to build smarter cities which “bundles technology and related services to help cities
efficiently manage energy, water, traffic, parking, public transit, and crime.”107
In light of these examples of corporate innovation, it becomes easy to see that
corporate innovation is not just important because of the way it impacts the United States
economy. Many people’s quality of life around the world benefit from the innovations of
corporations. For example, if a pharmaceutical company innovates in a way that makes a
previously unaffordable drug affordable to the citizens of a third-world country, then the
people who can now afford the drug have a much better chance to be healthy. It is
through this lens that state legislatures must look when they decide whether they will
actively pursue the enactment of legislation that will strive to optimize innovation.
In the past, corporate law scholars have referred to the evolution of corporate law
as a “race to the bottom.”108 Others have argued conversely that it is a “race to the
top.”109 It could be argued that without innovation there could be not improvement.110
Without improvement, corporate law would be stagnant or worse; it truly would be a race
to the bottom. A legal environment that fosters an optimal level of innovation by either
encouraging or discouraging corporate takeovers is more in line with the “race to the top”
ideology than is a legal environment that minimizes innovation.
103
Id.
Id. at 47.
105
Id. at 49 (noting that “[m]illions of units have been sold throughout India. The goal is
to provide clean water to 500 million people”).
106
Id. at 49.
107
Id. at 49 (noting that “[a] Stockholm project reduced carbon emissions by 17% and
traffic delays by 50%. Projects have been completed in at least seven other cities”).
108
William L. Cary, Federalism and Corporate Law: Reflections Upon Delaware, 83
YALE L.J. 663, 666 (1974).
109
Ralph K. Winter, Jr., State Law, Shareholder Protection, and the Theory of the
Corporation, 6 J. LEGAL STUD. 251 (1977).
110
Even in the case where a person is practicing to make become better at something she
already knows how to do, it can argued that practice without innovation will do her
absolutely no good. If she does the same thing exactly the same way every time, she
cannot improve.
104
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If corporate law is going to foster an environment in which mergers and
acquisitions are a significant driver behind corporate innovation, the corporate law itself
must change. Shareholders, and by extension citizens of the United States, should favor
change of the corporate law in this direction.111 Many scholars believe that competition
among the states to develop the most desirable corporate law structure for companies to
enjoy will facilitate the race to the top. In his article published in the Yale Journal on
Regulation titled Speeding up the Crawl to the Top, Michael Abramowicz notes that
prominent law and economics scholars believe:
[S]elf-interested entrepreneurs and managers, just like other investors, are
driven to find the devices most likely to maximize net profits. If they do
not, they pay for their mistakes because they receive lower prices for
corporate paper. Any one firm may deviate from the optimal measures.
Over tens of years and thousands of firms, though, tendencies emerge. The
firms and managers that make the choices investors prefer will prosper
relative to others.112
State legislatures should not make it more difficult for managers to optimize innovation.
They should do their best to not be reactive but proactive in enacting takeover laws. The
results are in and Sapra and his coauthors as well as Atanassov have found that, at the
very least, innovation is stifled in the face of lukewarm antitakeover laws. While it is
true Sapra and his coauthors found that innovation is maximized when takeovers are
entirely prohibited, it would not be possible or practicable, for a myriad of reasons, for
legislatures to eliminate takeovers. Instead, the legislatures should legislate laws that
would create a legal environment that optimally balances innovation concerns against the
concerns of hostile acquirers running roughshod over unwilling targets. This legal
environment most likely falls somewhere to the left of the minimum of the U-shaped
relationship predicted by Sapra and his coauthors and the far left of the U where
innovation is maximized.
Without innovation there is stagnation. Stagnation is very bad for corporations,
especially in today’s hyper-competitive, global market place. Encouraging and fostering
innovation should be a top priority for any United States legislature, federal or state, that
is considering enacting laws that affect the corporate landscape and specifically, the legal
environment in which mergers and acquisitions take place. Otherwise, the United States
will face significant hardships as the global economy marches on without it.
Conclusion
Mergers and acquisitions are an enormously important part of the corporate law
landscape. In addition, they are one of the most significant drivers of corporate
111
See Abramowicz, supra note 97, at 145.
Id. at 140—41 (citing FRANK H. EASTERBROOK & DANIEL R. FISCHEL, THE
ECONOMIC STRUCTURE OF CORPORATE LAW 6 (1991)).
112
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innovation. The ability for corporations to innovate is critically important in any
economy and especially so in the global economy. Haresh Sapra, Ajay Subramanian, and
Krishamurthy V. Subramanian undertook to analyze the relationship between external
takeover pressure and corporate innovation. In their report Corporate Governance and
Innovation: Theory and Evidence, they theorize that “Innovation is fostered either by an
unhindered market for corporate control, or by anti-takeover laws that are severe enough
to effectively deter takeovers.”113 Another scholar researching the same field, Julian
Atanassov, concludes that the states stifle innovation when they enact antitakeover
laws.114 While at first these two theories seem to be at odds with each other, they can be
harmonized. The theories are not inconsistent if Atanassov’s analysis is seen as a subset
of the analysis of Sapra and his coauthors.
The current state of antitakeover laws in the United States is summarized above.
It is safe to say that most jurisdictions have an antitakeover statute or at least some form
of law that impedes corporations trying to acquire unwilling targets. It is of paramount
importance that legislatures attempt to optimize innovation as opposed to other goals
such as appeasing special interests when enacting legislation that affects mergers.
Corporate innovation has made the quality of life of the average human exponentially
better. It is critically important to the success of the United States economy. United
States legislatures, state and federal, should only enact laws they believe will help them
win what should be the “race to the top.” Enacting laws that optimize innovation should
be an ever present goal of United States legislatures.
113
114
SAPRA ET AL., supra note 1.
Atanassov, supra note 2, at 2.
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