Bring Back the Hostile Takeover By Henry G. Manne 972 words 26 June 2002 The Wall Street Journal A18 English (Copyright (c) 2002, Dow Jones & Company, Inc.) Since Enron, there has been an outbreak of regulatory fever in Washington: A tide of "solutions" has sluiced from the pens of journalists and the mouths of politicians. Apparently forgotten is how Enron and other recent scandals were the direct result of regulatory and judicial efforts to stem abuses in the takeover arena 20 and more years ago. They still haven't learned just how high the cost of interfering with salutary market forces can be. Among current proposed guardians of executive morality are auditors, lawyers, analysts, financial intermediaries, independent directors, and government officials. But no proposal involving these actors addresses the real problem. New scandals will continue until we bring back the most powerful market mechanism for displacing bad managers: hostile takeovers. The principle is simple: If a corporation is badly enough managed, its share price will decline relative to other companies in the industry. At that point it can be profitable for a new group to make a tender offer, bringing in more efficient leadership. Just the threat of a takeover provides incentive for managers to run companies in the interest of the shareholders. In 1932, a book called "The Modern Corporation and Private Property" by Adolf Berle and Gardiner Means popularized the concept of the "separation of ownership and control." The book argued that the managers of large, publicly held corporations could cheat, manipulate, and steal blind the shareholders, since they were not subject to effective monitoring. Not least among the evils attributable to this separation were extravagant salaries, self-perpetuating boards of directors, insider trading and various perquisites for the top executives. For Berle and Means, the solution lay in the realm of political theory. If corporations could be made more democratic, shareholders could "vote the rascals out," and the effects of the separation could be averted. By 1965 however, when I introduced the concept of a market for corporate control, economists and others began explicitly to recognize that the corporation was not a political institution but a creation and function of the marketplace. The separation of ownership and control problem, tidily renamed in modern corporate governance literature as the problem of "agency costs," was seen as largely amenable to the forces of a market for corporate control. For a brief period in the late '50s, until the mid-'60s, when modern hostile takeover techniques were perfected, we had a pretty much unregulated market for corporate control. Shareholders received on average 40% over the pre-bid price for their shares. But the chorus of screams by threatened executives and their lawyers became politically excruciating enough that Congress, in 1968, passed the Williams Act, which made it vastly more expensive for outsiders to mount successful tender offers. The highly profitable element of surprise was removed entirely. The even stronger inhibition on takeovers resulted from actions taken by state legislatures and state courts in the '80s. The number of hostile tender offers dropped precipitously and with it the most effective device for policing top managers of large, publicly held companies. There continue to be changes of control in publicly held corporations even if hostile tender offers are discouraged. But now, with the legal power to shift control in the hands of the incumbents, they, rather than shareholders, will receive any premium paid for control. Ironically, this is the same premium that has been made larger by their own poor management. This transfer of control may take the form of a merger, or simply a series of agreed-upon high-level resignations after a new board has been put in place. The compensation paid the managers for their assent to such a change may take the form of a lucrative consulting arrangement, stock or stock options in the acquiring company, a generous severance package, or some other bonus. But the salient fact in each of these situations is that the managers and not the shareholders receive the premium being paid for control. It should come as no surprise then that, as hostile takeovers declined to 4% from 14% of all mergers, executive compensation started a steep climb, eventually ending for some companies with bankruptcy and management scandal. The largely mythical abuses alleged to result from an unfettered takeover system were less costly to investors than what has occurred since. Every statute, adjudication, or regulation that in any way inhibited the free functioning of the market for corporate control simply raised the real cost of ousting inappropriate managers. Dollar for dollar, every increase in those costs could be claimed by incumbent managers, either in greater rewards to themselves or in inefficient management policies. Until the real cost of wastefulness equals the cost of a successful takeover fight, they remain secure behind a legal barrier to their ouster, at least until the whole house of cards collapses. Enron is a predictable consequence of rules that inhibit the efficient functioning of the market for corporate control. The solution is straightforward but by no means simple: repeal and reverse all the many statutes, rules, and case holdings that interfere with tender offers. American corporations would have to restructure themselves, as they did in the '70s and '80s, to live in a more deregulated market. There would be heavy human costs in the ensuing dislocations, and we could expect a screeching replay of the spurious arguments that won the day in the late '60s and mid-'80s. But with such a reversal of policy, however unlikely, executive compensation would begin to plummet, there would be less pressure on accountants to cook the books, and American corporations would probably enter another period of innovation, efficiency, and profitability. Regulators vs. Adam Smith By Herbert Grubel 1,155 words 3 October 2002 The Wall Street Journal A14 English (Copyright (c) 2002, Dow Jones & Company, Inc.) The scandals involving major U.S. companies such as Enron, Global Crossing and WorldCom have been used to support recommendations for stricter regulations of American corporations and their accounting practices. As a result, the Sarbanes-Oxley Act, by far the most significant change to American corporate governance since the Securities Act of 1933 and the Securities and Exchange Act of 1934, was signed into law. A similar push for more regulation is on in Canada. As difficult as it may be in the current political climate, the Canadian government and regulators should resist these demands. There, as in the U.S., the remedy for business scandals is to restore the market for corporate control. The demands for more regulation are due to a number of recent developments. The compensation of executives relative to that of workers has risen dramatically. Much of that compensation is due to bonus payments and stock options designed to reward performance. Yet these incentive rewards often were paid when companies were mismanaged and sometimes went bankrupt, as with Enron. The accounting practices of some important corporations were found to have been deceptive, if not outright fraudulent, and often designed to fill the pockets of insiders. Shareholders were the victims of this behavior. There have been two distinct kinds of responses to these alleged market failures in the U.S. One stems from politicians, government regulators and most of the usual suspects in the chattering class of academics and commentators who are skeptical of the capitalist system. These people saw the corporate wrongdoings as yet another confirmation that free markets are dominated by personal greed and cannot be trusted to serve consumers, stockholders, workers and the general public interest. Government regulation, they argue, is needed to make corporations behave in the best interest of all stakeholders. The second group of people is in a distinct minority. They believe that Adam Smith was right -- individuals mostly pursue their self-interest and are greedy. But the invisible hand of competition constrains this selfish behavior and channels it into the service of the common good. The baker wants to produce bread with inferior and cheap inputs and charge $100 a loaf. Competition prevents him from doing so and we all enjoy the high quality products sold at low prices in our bakeries. Of course, Enron's executives presided over a business more complex than baking bread. But basically, their behavior is still subject to competition in the market. Many in history have tried to corner the markets for silver, wheat and energy. None have succeeded. Substitute supplies and other market responses always prevent the success of such activities. However it is less well known that markets also work to prevent greed in the form of excessive compensation, bonuses, stock options, insider trading and cheating on the published accounts. There are financial specialists and competitors in the industry, who watch public corporations and note when such practices reduce the value of the offending companies' shares. These depressed share values provide the opportunity for financial gain through a number of strategies. These involve the surreptitious purchase of a controlling interest of offending companies in the open market. More often, the hostile takeover involves also the offer to buy shares at a premium above the market rate. The takeover sometimes is financed by the issuance of junk bonds. Alternatively, a takeover company offers to swap its own shares for those of the target company at rates that the existing shareholders cannot refuse. Throughout history, such hostile takeovers were profitable because the board of directors installed by new owners would eliminate practices that caused share prices to be depressed. Thus, executives with excessive compensation are replaced, bonus and option plans adjusted and shady accounting and self-dealing eliminated. The resultant increase in the value of the company's shares would be sufficient to repay bonds used to finance the takeover, leaving a tidy profit as the return to the activities that led to the discovery of the improperly managed company. The hostile takeover by rival firms in the same industry often also ended practices that depressed the value of the target companies. In addition, they gained from economies of scale and organizational synergies. Of course, the business of hostile takeovers has always been risky. Information about the potential profit opportunities is uncertain. Awakened to the threat of a takeover, managers often mend their ways. Competitors prepare alternative takeover plans. As a result, sometimes the shares of the companies taking over decrease, often while the shares of the target companies rise in value. But studies have shown that most hostile takeovers have been profitable in the sense that they resulted in an increased share values for the two companies combined. Executives, boards of directors, unions and many others in the companies taken over through hostile bids do not like what happens to them in the aftermath. They lose their jobs and prestige while the takeover specialists make huge profits. It is understandable that these people have a strong incentive to appeal to governments and regulators to make hostile takeovers more difficult. In the U.S., during the 1960s and 1980s these appeals resulted in new regulations. The Williams Act of 1968 required the notification of the SEC of the intent of hostile takeovers and made it much more difficult to carry them out successfully. State regulators authorized the easy use of poison pills and other practices that allow the managers of firms targeted to delay or prevent the takeover. They also permit executives to exact large settlements for themselves before they lose their jobs. During the late 1980s, after a rash of hostile takeovers and during a business downturn, new state regulations made the practice even more difficult. The State of Delaware made its regulatory environment so attractive that many companies moved there from other parts of the U.S. A number of analysts have concluded that the recent rash of corporate scandals in the U.S. can be attributed directly to the aforementioned legislation, which has reduced the opportunities for and increased the cost of hostile takeovers. Government regulation in effect has allowed greed to run free. It is as if the government had protected bakers from all competition and they used that freedom to enrich themselves. In this tale lies a lesson for Canada. The government and regulatory authorities in Canada must not give in to demands for more regulation of the capital markets. Policies designed to protect shareholders inevitably end up serving the interest of existing companies, their executives, directors and unions. Instead, many existing regulations should be scrapped and more of the powerful policing forces of the market given free reign. Shareholders and the general public would benefit immensely. Barbarians in the Valley. 1,221 words 28 June 2003 The Economist English (c) The Economist Newspaper Limited, London 2003. All rights reserved Oracle versus PeopleSoft Oracle's hostile bid for PeopleSoft will supply the best evidence yet about whether the rules of American business are changing FANS of the raw-meat variety of capitalism are finding much to admire in Oracle's hostile bid for PeopleSoft, a big rival in the software business. There is the theatre: two sworn enemies slugging each other senseless. But there are also the growing signs that Oracle's bid may come to mark a departure from the previous rules of business in America. The business culture of the 1990s - defined, above all, by the consensual business matings that spawned the greatest merger boom in history - now looks too cosy. As agitation for system-wide reform continues, Oracle's bid is the latest evidence that managers, boards and shareholders have begun to play a less friendly game. Nobody knows what the new rules will look like. This battle may provide the first real clues. On June 2nd, PeopleSoft said that it would buy J.D. Edwards, a smaller rival. Four days later, Oracle announced its own bid for PeopleSoft, and invited the firm's board to talk. Furious that his own plans had been endangered, PeopleSoft's boss, Craig Conway, called Oracle's offer "diabolical", and its boss, Larry Ellison, a "sociopath" - not the worst thing ever said of the colourful billionaire also famed for his love of things Japanese and trying to win the America's Cup for yachting. Moreover, said Mr Conway, he "could imagine no price nor combination of price and other conditions to recommend accepting the offer". On June 12th, PeopleSoft turned Oracle down. It said there was a big risk that antitrust authorities would block the merger; that uncertainty, plus Oracle's stated intention to discontinue PeopleSoft's products, would damage the company; and that Mr Ellison's $16 a share offer was too low. Mr Conway's comments were a gift, allowing Oracle to claim that PeopleSoft's management was entrenched and deaf to the interests of its shareholders. On June 16th, PeopleSoft amended its bid for J.D. Edwards in a way that allowed it to avoid putting the matter to a vote of PeopleSoft shareholders - claiming it did so to accelerate the merger and limit the harm from Oracle's bid. Oracle said PeopleSoft was once again frustrating the will of shareholders. Larry's art of war On June 18th, Mr Ellison raised his bid to $19.50 - and also filed suit against PeopleSoft, alleging that the board's actions, including its refusal to dissolve the firm's strong "poison pill" anti-takeover defence, breached its fiduciary duties to shareholders. Two days later, this time after "careful consideration and acting upon the recommendation of a committee of independent directors", PeopleSoft's board again rejected Oracle's offer, for the same three reasons as before. Oracle says PeopleSoft's board has never made contact. The first item before PeopleSoft's shareholders is the sincerity of its antitrust defence. Mr Ellison says that PeopleSoft's arguments are specious. Business software is a highly competitive market, he says, with the biggest firm, SAP of Germany, enjoying just a 17% share. Moreover, he asks, why would the authorities allow PeopleSoft and J.D. Edwards, the third-and fourth-biggest firms, to merge, but not Oracle and PeopleSoft, the secondand third-biggest? PeopleSoft responds that Mr Ellison is defining the market too loosely. In the market for software sold to large firms, it says, there are only three suppliers: SAP, Oracle and itself. In announcing his bid, Mr Ellison said that, although he would continue to support PeopleSoft's existing software, Oracle would no longer develop future versions. That has given PeopleSoft a lot of angry customers to marshall in its defence. As one source close to PeopleSoft puts it, "software is like fish: if it stops swimming, it dies". Eventually, customers know they will have to switch to different software, which will cost money. By itself, this does not violate antitrust law (although the state of Connecticut, which is suing to block the merger, appears to think differently). But it does create a strong motive for customers to oppose the merger. With the Department of Justice likely soon to announce it needs more time to study the deal (a routine request, says Oracle), Mr Ellison says he is willing to be "very patient, for as long as it takes". If that is true, the focus is likely soon to turn to PeopleSoft's antitakeover defences, notably its poison pill and its staggered board. Poison pills, which use the threat of a massive issuance of new shares and other complicated tactics to thwart takeovers, spread as managers sought protection from the sort of hostile takeover popular in the 1980s. Of the 5,529 publicly owned firms that Institutional Shareholder Services monitors, 2,024 have a poison pill. Staggered boards (in which directors, serving multi-year terms, get elected in different years, making it impossible to replace an entire board at once) are even more popular: 3,052 of ISS's firms have a staggered board. It would take two annual meetings to elect a majority of PeopleSoft's board. The respectable defence for these practices, sanctioned by the courts, is that they stop a "rush to judgment" during a hostile bid, an argument PeopleSoft now echoes. The counter-argument is that they entrench management, discourage takeover attempts and depress the share price. Shareholders are becoming more suspicious of poison pills. Recent shareholder pressure on Hewlett-Packard, another west-coast technology firm, forced its board to dissolve its poison pill. A shareholder resolution asking that the firm put the creation of future pills to a shareholder vote passed this year, despite management opposition. The way PeopleSoft handles its defences could crystallise attitudes. Ultimately, the courts in Delaware (where most American firms are incorporated) may be asked to rule on the board's behaviour at PeopleSoft. This would also be an important test of changing attitudes. Recent Delaware rulings (including sharp words for Disney's board over an obscene pay-off to Michael Ovitz, a failed former company president) suggest that its judges have begun to rethink the latitude with which they have allowed directors to exercise their "business judgment". Delaware has a bad name, as a haven for incumbent management. But of late, say its supporters, its judges have become more sensitive to the wishes of big shareholders, and they will be listening attentively. Mr Ellison may have to raise his offer if he wants to convince the world that PeopleSoft's management really is entrenched and calls the shots over what one Oracle adviser calls a "typical, light-weight Silicon Valley board". Shareholders, meanwhile, will have to decide whether they need to push harder for more power. Next month, the Securities and Exchange Commission will decide whether to propose new rules giving shareholders the right to nominate candidates for directors themselves. Some institutional investors champion the idea. Most managers hate it. The SEC is also thinking of giving shareholders an annual vote on the boss's pay. That may be something to which Mr Ellison, America's unlikely new shareholder champion, needs to devote some thought. In 2001, including share options, Oracle's famously imperial boss collected over $700m.