The Logic and Morality of Takeovers
Do Corporate Takeovers Deserve Their Reviled Status?
JULY 01, 2000 by NORMAN BARRY
The late Norman Barry was a professor of social and political theory at the University of Buckingham in the UK.
Of all the features of the market, the takeover process is still the most reviled. Assailed by moralists for encouraging greed and antisocial individualism and for breaking up stable communities; by some economists for its alleged short-termism, irrational stock-market speculation, and the loading of companies with debt; and by politicians who, while anxious not to appear opposed to capitalism, are eager to make political capital out of any slightly disreputable feature. Look at Germany and Japan, they say. Those economies rarely use takeovers, and they are doing pretty well, though the use of the present tense in both substantive parts of that sentence might well be questioned. The language used to describe takeovers is emotive—those who bring about necessary corporate restructuring are called predators and raiders, as if they belonged either to the jungle or the criminal class.
But it is easy to show that they are doing something which is intrinsically part of the market economy’s search for efficiency and that it is quite consistent with the high standards of the morality of the market, for example, ensuring that fiduciary duties to owners are fulfilled, something that is not a striking feature of the German or Japanese market systems. The takeover phenomenon has developed its own exotic language—poison pills, golden parachutes, greenmail, and junk bonds are good examples. All sound slightly sinister and are things that respectable capitalism apparently could do without.
Takeovers arise out of something endemic to the market system—the agency problem. In a publicly quoted company, characterized by the separation between ownership and control, how can the dispersed stockholders protect themselves against opportunism from the management? Will the latter not be tempted to spend company assets on themselves, their personal ambitions (often dressed up as morality), and empire-building, rather than paying the highest feasible dividends to stockholders? Adam Smith was aware of the problem and had a well-known hostility to the joint stock company. He preferred owner-managed enterprises. Indeed, America in the 1960s and 1970s experienced a version of economically mistaken and morally reprehensible takeovers. Cash-rich companies did not return money to the stockholders but embarked on counterproductive takeovers and the creation of unwieldy conglomerates that contributed only to the well-being of the managements. It was the legendary corporate raider T. Boone Pickens, who, in an Israel Kirzner-like manner, noticed that the oil companies were not extracting the full value of the reserves but instead were embarking on quite unnecessary research, exploration, and expansionism. He therefore pioneered the economically productive strategy of taking them over and then breaking them up—spinning off unwanted parts and working the viable parts more efficiently. The fears of the left, that takeovers always lead to the swallowing up of small companies and the concentration of industry, are groundless. The efficient ones do the reverse and lead to the survival of lean and economical companies.
The takeover process is part of a normal market system—it is the market for corporate control. Those who succeed in this market have, in effect, secured the best use of managerial talent. Without all this, the modern company really would produce industrial “princes” over whom the dispersed stockholders would have no control. It might be that other economies, perhaps those that rely on trust rather than contract, can induce good behavior in other ways, but as economies become more anonymous they have to resort to this method. It has never been without its critics. Surely, the immense costs involved through the payment of lawyers and financial intermediaries can be avoided. Will not the emphasis on the takeover method induce managers, through fear of losing their jobs, to concentrate more on the share price than on long-term research and development? What has mere paper shuffling got to do with running a successful company?
All these questions have been decisively answered by serious research. The takeover method does add value in terms of increased share prices, though it is true that the owners of target companies do significantly better than stockholders in the acquirer. The owners of the target have to be offered a premium to persuade them to part with their stock, but the movement of the share price for the significant period after the acquisition indicates that almost everybody gains. The fees earned by the various intermediaries are simply the price we pay for increased efficiency. Perhaps managements have an interest in provoking an unproductive takeover, but the market has its own solution to such opportunism—increased stockholder vigilance, although there is the problem of dispersed shareholders’ having little or no incentive to act.
The claim that the process leads to paper shuffling at the sacrifice of long-term development is refuted by research showing that the price of stock tends to rise on the announcement of future research and development. It might be that “firm specific human capital” (labor appropriate for only one enterprise) is vulnerable to the predator concerned only with extracting more or less immediate value, and this might lead to under-investment, but all sorts of contracts have been devised to protect such labor from the vicissitudes of economic fortune.
Efficient Markets Hypothesis
Underlying the rationale of the takeover process is the “efficient markets hypothesis”: the claim that at any point the capital market reflects all the profitable opportunities available. But the hypothesis does not predict the future; it simply accurately records the past. Entrepreneurial opportunities cannot be predicted from it. Does anybody really suppose that anybody else, for example, government, can improve on the entrepreneurial market in spotting investment opportunities?
In an efficient market there is said to be a “random walk,” meaning that any investor can choose any stock with an equal chance of being successful. The share price embodies all the information currently available. In these circumstances the only person who can beat the market is the insider trader. Yet insider trading is neither inefficient nor necessarily immoral. If the insider is not in breach of an employment contract, he is contributing to the efficient running of the market by speeding up the flow of information.
Undoubtedly, the current economic success of America is a function of the massive corporate reorganization that took place as a result of the 1980s takeover boom. Yet it has been subject to the most severe, almost hysterical, criticism, as well as some rather good Hollywood movies. At that time, corporate governance was heavily biased toward management: shareholders were difficult to organize; very large companies were virtually bid-proof; and the loan process was controlled by established investment banks supported by very conservative credit-rating, agencies (Moody’s and Standard and Poor’s in New York) that would give triple-A evaluations only to established blue-chip corporations. Indeed, the majority of companies could not get their bonds an investment rating at all, such was the (needless) fear of default. Then along came Michael Milken, who financed some of the most controversial takeovers of the era by the use of the inaptly, and ineptly, named “junk bond.” Milken’s genius almost guaranteed him a jail sentence.
His entrepreneurial flair was to notice that the default rate on non-investment-grade debt was in fact quite low and that by offering high interest rates to compensate for what was originally quite a low risk he could attract big funds for investment. His first ventures were in start-up companies that had no financial records at all (CNN, for example, was made possible by junk bonds), and it was only later that he began to finance hostile bids. He struck fear into corporate America by returning power to the stockholders, and his creative methods posed a serious threat to the banking establishment. To use the pretentious language of the philosophy of science: the conventional rating agencies were crude empiricists; they only went on past company records and had no gift for spotting future successful entrepreneurs. Milken was, in the terms used by Sir Karl Popper, the bold innovator who discovered new opportunities for the advancement of knowledge. But there is nothing unusual in all this. America’s financial history is very much a story of how upstarts upset the conventions and threaten the power and wealth of the elite. Milken effected a revolution in banking equivalent to that achieved by J. P. Morgan earlier in the century and by the much-castigated robber barons in business itself. Indeed, Milken’s critics found a surprising affection for the robber barons, who at least, they said, made things.
Like many innovators before him, Milken had to pay the price of success. He and the investment bank he led, Drexel Burnham Lambert, were subjected to relentless persecution by the Securities and Exchange Commission, the Justice Department, and hostile news media. The leading figure in the move against Wall Street (although Milken worked out of Los Angeles) was that icon of the Republican Party, Rudolph Giuliani, the U.S. Attorney who aspired to be mayor of New York City and obviously saw political advantage in bringing financiers to book.
The pursuit of Milken was an affront to the rule of law. He originally faced a 98-count indictment (including insider trading charges), which the Justice Department knew would not stick. So the department managed to coerce Milken to plead guilty to a six-count rap that consisted of trivial offenses. Traders don’t really know what is legal or illegal, and past legal decisions are no real guide. If they want you, they will get you. Milken’s problem was his success: he made $550 million in 1987 (that is not technically illegal and he was only the third-highest earner that year). He was duly given an original sentence of ten years in prison, which was later significantly reduced once the judge, Kimba Wood, had acquired some elementary knowledge of finance.
What Goes on in Takeovers?
If there is any force to the charges of immorality, they relate to some of the practices that have developed in the conduct of takeovers. It is advisable to look at these briefly one by one, but most of them relate to the battle between stockholders and management. Analysis reveals that the guilty parties are not the raiders but company employees. They have every incentive to resist corporate restructuring—their jobs are at stake. They have initiated all sorts of arcane devices to put off predators. The “poison pill” is a method for making hostile bids extremely costly. The managers get the rules of a publicly quoted company changed so that, for example, existing shareholders get enhanced voting rights and the privilege of selling stock at inflated prices. These are triggered in the event of a hostile bid and can make it prohibitive. They are used by managements to prevent a genuine sale of the company and then to favor a suitor more amenable to them. They are forbidden by the British Takeover Code, but were upheld by the Delaware courts (via a perverse interpretation of the business judgment rule) in the 1980s. (Incidentally, this made it possible for the merger of Time and Warner, even though Paramount had made a higher bid for Time’s stock).
There could be a case for poison pills if approved by the stockholders, who might think that better long-term value can be secured by resisting a possible breakup. There is evidence that these poison pills are economically successful. But poison pills normally are devices to enable managements to evade their fiduciary duties to owners.
“Greenmail” occurs when a raider buys a portion of the stock and then refrains from the takeover only if he is bought out by an offer for the stock that is not available to other stockholders. The villains here are not the greenmailers; they are simply putting out a signal that the company is undervalued and is a target. It is managements that are responsible, for they load the company with debt to buy off the greenmailer so that their positions in the company are saved. If they were acting in the interests of stockholders, they would not pay the greenmailer, but simply wait to see what happens. Managements are also helped by “golden parachutes,” favorable severance terms, should the deal go ahead (one recalls James Garner’s extremely generous one in the movie Barbarians at the Gate).
There may be an economic rationale for golden parachutes. Existing managers occupy key positions in the company, and it may be commercially viable to buy them off. Indeed, many managers negotiate such deals before they take up their positions. Of course, it might be in the interests of managers to provoke a takeover so as to secure a parachute. But here, as in so many areas, it is up to vigilant stockholders to look out for opportunism. Institutional shareholders have the major responsibility here because they are less vulnerable to the free-rider problem that faces the small, private shareholder.
Takeovers Are Good for Us
Despite the desperate ululating of communitarians, the takeover process has not led to the collapse of caring societies and the triumph of greed. Corporate and individual giving has never been higher in America, and membership of voluntary groups is as great as it was when Tocqueville first noticed it. America is a highly mobile society, and her citizens have always been prepared to go where the jobs are. Communities are quite safe from the ravages of the market because they emerge from the conditions of the market itself: free choice under the rule of law.
Even the introverted Japanese and European economies are succumbing to the value-enhancing allure of the takeover. T. Boone Pickens made a famous and unsuccessful venture into Japan in the late 1980s. But last year the British firm Cable and Wireless took over the privatized Japanese telecommunications company against formidable local opposition, and in Italy, Olivetti successfully pulled off a reverse takeover of the Italian telecommunications business. Even the hitherto power-hungry Agnelli family found the lure of shareholder value irresistible.
Germany has, until recently, been slow to adopt the new method of industrial reorganization. Indeed, the originally hostile bid that Krupp made for Thyssen was turned into a tame merger by a formidable array of stakeholders. But things are changing. Vodafone-Airtouch (a mainly British company) has just achieved the most audacious takeover bid of all time in its $160 billion-plus capture of Mannesmann. The combined value of the companies is approximately $342 billion (and they are still counting). This is way ahead of that for the Time-Warner and America Online merger. Again, the deal was nearly spoiled by stakeholders (which included German Chancellor Gerhard Schroeder, who in late-1970s language worried deeply about the threat to the “culture” of the company). A big factor in the titanic battle (the most exciting event in Anglo-German history since the World Cup soccer final in 1966, which England also won) was the move on the part of some shareholders to get a German court to enforce the fiduciary duties on Mannesmann’s management.
But let us not get too complacent. The animus against takeovers persists. It was so great that by the late 1980s almost every American state had passed restrictive legislation, such as limitations on the loss of employment that could result from takeovers, to reduce corporate raiding. These laws were generally promoted by managements and others desirous of protection against competition. It would be a tragic irony if America were to adopt the anti-takeover measures that rival capitalist systems are just beginning to abandon.
- See Michael Jensen, “Takeovers: Their Causes and Consequences,” Journal of Economic Perspectives, 1988 (2), pp. 21-48.
- Henry Manne, “Mergers and the Market for Corporate Control,” Journal of Political Economy, 1965 (75), pp. 110-18.
- Jensen, pp. 26-27.
- For an analysis of Milken’s activities from an Austrian perspective, see Norman Barry, Business Ethics (London: Macmillan, 1998), pp. 141-45.
- For a superb legal defense of Milken, see Daniel Fischel, Pay-back (New York: HarperBusiness, 1995).
- See Martin Ricketts, The Economics of Business Enterprise (London: Harvester Wheatsheaf, 1994).
- See Norman Barry, Respectable Trade (London: Adam Smith Institute, 2000).