It may be time for corporate boards which reject takeover offers to get more skin in the game.
Hostile takeover attempts have become much more common in recent years, accounting for 16% of the US$126bn of US takeovers in the year to August, according to Dealogic data.
While activist investors and their hostile bids have generally been shown to create value for shareholders, their actions, and the responses of company boards, can cut both ways.
On the one hand, as corporate boards are paid to serve rather than to sell at the highest price, they have a built-in bias against accepting offers and relinquishing control.
Conversely, activist investors, who generally themselves are being judged on yearly performance, can have a short-term focus which destroys value. Boards may, in an effort to buy off hostile bidders, take steps like buying back shares or cutting back on research which may prove myopic.
It is also hard for courts to hold corporate boards accountable. They are expected to act on subjective and inside information which courts find difficult to judge from outside.
Therefore we have a system under which it seems likely that boards are often, out of self-interest, rejecting offers they ought to accept or making conciliatory gestures with high long-term costs.
Nitzan Shilon, of the Peking University School of Transnational Law, proposes a novel solution: encouraging outside directors of boards to put “their money where their mouths are” in rejecting bids.
In brief, the idea is to encourage outside board members to pledge, at the same time as they reject a bid, to buy shares in the company at the bid price and hold them for a pre-agreed time.
“The systemic failure in protecting shareholders in takeover situations is not all due to the conflict of interest between target boards and their shareholders or to the lack of judicial tools to review board decisions effectively; it is also due in part to the legal rules prohibiting boards from showing their genuine opposition to the bid by committing to buy, if the bid fails, some shares of the target firms,” Shilon writes in an August paper.
Boards may decline to put an offer to shareholders, asserting that owners will wrongly accept an inadequate offer. A board whose outside directors pledge to use one third of their cash compensation to purchase stock from the corporation, for example, and hold it for at least three years, would send a very clear and valuable signal to shareholders.
Costly rejections
Rejections can be costly for shareholders, who on average see the value of their stock fall 28% in the immediate aftermath of a rejected bid. Targets which stay independent for 30 months see stocks returns which are, on average, 53% lower than targets which were acquired.
As it stands, shareholders, knowing where boards’ bread is buttered, may disbelieve them if they advise against a bid, making it more likely that they accept an underweight offer, and more likely that boards decline to let them vote or resort to takeover defense measures like poison pills.
An arrangement, if allowed, where outside directors put up cash to back their analysis would make them more credible and have a lot of benefits.
“The potential improvement in information embedded in the arrangement is expected not only to enhance markets’ informational efficiency but also to improve asset allocation efficiency,” Shilon writes.
Not only would shareholders get a better read on boards’ actual views on the intrinsic value of the company, but so would bidders and potential bidders. A virtuous circle of information, feedback and capital allocation can follow.
It might also help companies wanting to make long-term investments and create long-term value, with the information from a board stock purchase counterbalancing the information contained in a hostile bid. Consultation with long-term shareholders as part of the process would help, another point Shilon advocates, and might counterbalance pressure from activists and arbitrageurs with shorter attention spans.
To be sure, this wouldn’t work in every instance, and should not be allowed in nuisance bids or those which aren’t fully financed.
Interestingly, a case can be made that such a provision, if it became popular, might actually cut down on activist investment but ironically improve shareholder returns long term.
Activists exist in large part because insiders’ interests are misaligned with shareholders. Activists generally seek to lower the gap between market and intrinsic value by some amount and then move on to the next deal.
Using hostile bids as a means to pressure boards to be more honest about their views will ultimately help to improve returns.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
