Visages of Janus: The Heavy Burden of Other Constituency Anti-Takeover Statutes On Shareholders and The Efficient Market for Corporate Control
By Ryan York
[Winter 2002]

Copyright © 2002 Willamette Law Review; Ryan J. York
Reprinted with permission

I. Introduction

Weyerhaeuser's ongoing hostile attempt to acquire Oregon-based Willamette Industries is likely to present the first test of Oregon's so-called "other constituencies" anti-takeover statute. ¹ Weyerhaeuser initially attempted to acquire Willamette through a part stock, part cash friendly acquisition. ² Willamette's board rejected Weyerhaeuser's friendly overture on September 8, 2000, ³ and Weyerhaeuser responded on November 13 with a hostile $7.1 billion offer to acquire Willamette Industries.⁴ The Willamette board dug in their heels and fought Weyerhaeuser's take-over attempt. That fight continues today as Willamette prepares to spend up to $6 million per quarter to fight off Weyerhaeuser's unwelcome advance. ⁵

However, Willamette's Board of Directors has a new weapon in its defensive arsenal, thanks to the recent enactment of an "other constituencies" anti- takeover statute in Oregon.⁶ This statute allows corporate managers to take into account the best interests of various nonshareholder constituencies, such as the "communities" and "the economy of the state and nation," when evaluating whether to accept or reject a merger or tender offer.⁷ The wisdom of Oregon's other constituencies statute has yet to be tested, but this takeover attempt may present the perfect opportunity.

Willamette Industries, one of only two Fortune 500 companies headquartered in Oregon, employs almost 15,000 individuals.⁸ Many nonshareholder constituencies, such as the small town of Albany, are against Weyerhaeuser's acquisition and wish to retain local jobs and the Oregon-based control of the company.⁹ However, Willamette's shareholders are enticed by Weyerhaeuser's offer of $50 per share, which represents more than a 38% premium over the pre-announcement share price.¹⁰ In short, the battlefield is set with nonshareholder constituencies at odds with Willamette's shareholders. Should the nonshareholder constituencies win? Should the Willamette shareholders or the Willamette board of directors win? Prior to the enactment of Oregon's other constituencies anti-takeover statute, Willamette's Board of Directors owed their fiduciary duties only to the corporation and its shareholders. The Willamette-Weyerhaeuser deal may present the first test of the wisdom of Oregon's other constituencies statute. Because the issues raised by Oregon's other constituencies statute are common to all states that have similar statutes, this Comment takes a multi-state perspective in addressing the issues raised by other constituency statutes.

Under relatively recent anti-takeover legislation corporate managers look, as the two-faced Roman God Janus did, in two directions at once; one face looking to the interests of nonshareholder constituencies and the opposite face looking to the interests of the corporation's shareholders. The interests of these two groups are often at odds with one another. Corporate managers play the impossible role of acting in the best interests of both sides. In the end, everyone suffers, except for the managers themselves.

Takeovers play a critical function in disciplining the decisions of corporate managers. In a Darwinian sense, takeovers "thin the herd," replacing poor managers with more efficient management. The threat of takeover disciplines managers by weeding them out, but anti-takeover statutes risk leaving inefficient managers to continue running the corporation. Because takeover threats discipline mangers by forcing them to shape up, any law that places a significant barrier in the way of a takeover attempt must be scrutinized carefully from both a legal and an economic perspective.

After Pennsylvania enacted its first other constituencies statute in 1983,¹¹ other states quickly followed, with twenty-eight such statutes enacted by 1991.¹² As of 1999, forty-one states had enacted some form of other constituencies statute.¹³ Delaware, the state of incorporation for the most U.S. companies, is noticeably absent.

Other constituency anti-takeover statutes effectively negate the check on corporate management's discretion in rejecting a tender offer provided by a successful shareholder derivative suit. The removal of this limitation on management discretion leads to two possible results: (1) a reduction in the number of corporate takeovers, which diminishes the effectiveness of the efficient market for corporate control; and/or (2) a wealth transfer from target shareholders to target management.

This Comment concludes that the combination of the business judgment rule and other constituencies statutes eliminates a check on corporate management's discretion to accept or reject tender offers, thereby limiting the likelihood of successful shareholder derivative suits. Fewer successful derivative suits means fewer corporate takeovers. A reduction in the number of corporate takeovers leads to a weakening of the efficient market for corporate control. Furthermore, reducing the efficacy of shareholder derivative suits in the takeover context injures shareholders financially. After the enactment of an other constituencies statute, shareholders of the target corporation will be forced to transfer a portion of their takeover premium to target management.

II. Background

A. The Business Judgment Rule Largely Insulates Managerial Action

According to the Supreme Court of Delaware, the business judgment rule "itself is a presumption that in making a business decision, the directors of a corporation acted on an informed basis, in good faith and in honest belief that the action taken was in the best interests of the company."¹⁴ A decision the Board of Directors makes in reliance on the business judgment rule insulates the Board of Directors from ultimate liability for their actions.¹⁵ In a takeover attempt, the target managers must inform themselves and act in good faith and in the best interests of the company--i.e., in satisfaction of their fiduciary duties to the company. While the business judgment rule appears at first glance to impose a somewhat stringent requirement of fiduciary duties akin to the partnership standard in Meinhard v. Salmon, "[n]ot honesty alone, but the punctilio of an honor the most sensitive,"¹⁶ the actual standard of fiduciary duties owed to the corporation under the business judgment rule is far less stringent. In fact, according to the Delaware Supreme Court, "under the business judgment rule director liability is predicated upon concepts of gross negligence."¹⁷ Thus, unless the board of directors pursues a recklessly negligent course of action, their actions generally will be protected under the ambit of the business judgment rule.

In itself, the business judgment rule provides a nearly insurmountable bar for shareholders seeking recovery from directors for their breach of fiduciary duty. According to Easterbrook and Fis-chel, "[a]lthough defeat of the takeover attempt may deprive the target's shareholders of a substantial premium, shareholders' suits against management to recover the loss are almost always unsuccessful."¹⁸ The presence of other constituencies anti- takeover statutes raises the bar to shareholder recovery.

B. Other Constituencies Anti-Takeover Statutes

In a typical other constituencies statute, the target's Board of Directors are permitted, and under some statutes required, ¹⁹ to take into account the effect of a proposed takeover on broadly defined other constituencies. Other constituency statutes have been characterized as falling into four categories: (1) permissive, (2) mandatory, (3) those involving a conclusive presumption of validity of directors' determination, and (4) bondholder protection. ²⁰

This Article focuses on the more common permissive other constituencies statute, analyzing its effect on the efficient market for corporate control. A typical permissive statute reads:

When evaluating any offer of another party to make a tender or exchange offer for any equity security of the corporation, or any proposal to merge or consolidate the corporation with another corporation or to purchase or otherwise acquire all or substantially all the properties and assets of the corporation, the directors of the corporation may, in determining what they believe to be in the best interests of the corporation, give due consideration to the social, legal and economic effects on employees, customers and suppliers of the corporation and on the communities and geographical areas in which the corporation and its subsidiaries operate, the economy of the state and nation, the long-term as well as short-term interests of the corporation and its shareholders, including the possibility that these interests may be best served by the continued independence of the corporation, and other relevant factors.²¹ As a result of the permissive other constituencies provision, target management's fiduciary duties that are owed to the corporation, and by imputation its shareholders, are no longer the sole consideration in a takeover situation. Under these statutes, target management is allowed to take into account the potential effects of the merger on such entities as employees, customers and suppliers.²² In fact, under the typical statute, target management can even consider the economy of the state, the nation, the effect on the community and geographical area, and (under some statutes) any other considerations the directors consider pertinent.²³ This Comment focuses on the more common permissive other constituencies statute, and analyzes its effect on the efficient market for corporate control.

Other constituencies statutes differ in relation to which types of corporate decisions directors are permitted to consider nonshare-holder constituencies. According to Professor Hanks, "many nonshareholder constituency statutes apply to all decisions and actions but some are limited to the takeover context."²⁴ In sum, other constituencies statutes allow the Board of Directors to consider not only the effects of a takeover on the corporation and its shareholders (the traditional focuses), but also on a variety of other constituencies, many of which are incapable of precise definition.

C. The Efficient Market for Corporate Control

The basic theory of the Efficient Market for Corporate Control (EMCC) is:

[S]hare prices work to discipline the behavior of corporate management. Inefficient management of a firm or management behavior that is inconsistent with profit maximization, will cause the price of the firm's shares to fall to a level that is consistent with the degree of mismanagement. Lower stock prices make it easier (i.e., less costly) for outsiders to gain control of the corporation and to generate profits for themselves through the increase in share values that results from efficient management."²⁵ The EMCC depends upon the stock price accurately reflecting all information regarding the firm. The Efficient Market Hypothesis (EMH) is based on the premise that security prices reflect all available information concerning a firm and that security prices change rapidly in response to new information.²⁶ EMH can take many different forms. There is weak form of EMH, where the stock price reflects only the technical information on the firm.²⁷ There is semi-strong form of EMH, where "the current price of a stock reflects all of the public's information concerning the company."²⁸ Finally, there is strong form of EMH, which "asserts that the current price of a stock reflects all known (i.e., public) information and all privileged or inside information concerning the firm."²⁹ The EMCC can work only where there is a securities market that exhibits a strong or semi-strong form of the EMH.

If the securities markets exhibited only a weak form of the EMH, the result would be "inefficiently priced stocks [which] will distort the functioning of the market for control."³⁰ In contrast, if a securities market exhibited a semi-strong form of the EMH, a potential raider would be able to identify improperly managed companies only if the public information regarding the firm were accurate. An optimal EMCC arises in a securities market exhibiting strong form EMH, because the securities price of the firm reflects all public and nonpublic information allowing raiders to more accurately determine when firm management is operating inefficiently. While there is much conjecture over which form of EMH is exhibited in U.S. capital markets, most researchers agree that the semi-strong form is most prevalent. ³¹

The two theories EMH and EMCC are interdependent. For instance:

[I]n an efficient market, the expected earnings of the corporation are reflected in the trading price of its shares. [Thus], [w]hen a bidder offers to buy the corporation at a price higher than market price, the bidder must believe that under his control the corporation will have higher earnings than at present. ³² Obviously, in order for the EMCC to work, the stock price must accurately and quickly reflect all known information about the company; if it does not, the stock price would be incapable of signaling to a raider when a company is ripe for a takeover. There are several obvious limitations to the EMH, and by imputation, to the EMCC.

Closely held or private corporations are incapable of stock price measurement because they are not publicly traded. Because the EMCC depends on the EMH to signal poor management, the EMCC is unlikely to be a check on firm management decisions in privately held firms or companies whose stock trades in thin markets. EMH is strongest in the securities price of large publicly traded firms, which are akin to S-3 reporting companies under the 1934 Act.³³ However, according to Professor Stout, the EMCC is beneficial to many different constituencies:

Society benefits from the increased productivity that results when corporations are controlled by those who make them more profitable. Only corrupt and incompetent management loses. Therefore, according to the market for control theory, we should favor changes in control when the bidder is willing to offer more for the shares of a corporation than its prevailing market price.³⁴ Because of the disciplining effects, the EMCC is a desirable component of the capital and securities markets.

III. Analysis

A. Deeper Look at Other Constituencies Statutes

Other constituencies statutes are problematic in three respects. First, the broad definition of nonshareholder constituencies creates confusion over who, exactly, these other constituencies are. Second, the lack of quantifiable repercussions against nonshareholder constituencies creates an economic measurement problem. The third problem is the incentive for nonshareholder constituencies to free-ride at the expense of the corporation's shareholders.

A deeper look at these so-called other constituencies, particularly the "economy of the state and the nation" and the "community" constituencies, reveals that these entities are incapable of asserting a preference for or against a proposed takeover of the target. These constituencies cannot assert a preference because they are disaggregated and, short of some form of election, are incapable of speaking with one voice. This means that in an extreme case, target management can reject a tender offer or takeover attempt by citing the best interests of the community or the economy of the state or nation. In fact, under the Ohio other constituencies statute, this has already happened. ³⁵

In Abrahamson v. Waddell, a plaintiff shareholder brought a derivative action against Star Banc Corporation's Board of Directors for improper rejection of an acquisition overture. ³⁶ The court dismissed the shareholder's claim, relying in part on Ohio's other constituencies statute. "Star Banc's directors . . . [i]n determining what they believe to be in the best interest of the corporation, in addition to considering the interest of the corporation's shareholders, directors are expressly authorized by statute to consider other factors, such as community and societal considerations. . . ." ³⁷ While there is very little case law construing any of the various state's other constituencies statutes, the possibility certainly exists that many shareholder derivative actions may be dismissed, as in Abrahamson, on FRCP 12(b)(6) grounds. After Abrahamson, it appears unlikely that an affected shareholder could support a claim that the rejection of a takeover attempt was not in the best interests of so-called other constituencies. Because these constituencies are incapable of asserting a preference and of speaking with a concerted voice, the target managers' claim of acting in their best interests is nearly incapable of contradiction by these constituencies.

In addition, there is little to be gained from taking into account the social costs imposed by a takeover on these types of other constituencies. According to Professor Ribstein, "[t]here is no evidence that, on net, communities are injured by corporate dislocations resulting from takeovers. One community's loss is likely to be another's gain." ³⁸ The "social costs" avoided by deferring to community concerns are likely to be outweighed by the resultant loss to the working of the EMCC.

The second major problem posed by other constituencies statutes arises from the lack of personalized quantifiable repercussions to these constituencies because of opposing or preferring a takeover of the target. Target shareholders have an economic incentive to assert a preference in a takeover situation. If a target shareholder rejects a merger where the raider's acquisition would improve the stock price, the target shareholder realizes a direct economic loss as a result of her decision to reject the takeover.

By contrast, communities and the economy of the state and nation have no such identifiable stake in the proposed takeover, aside from a possible reduction in tax revenues and a loss of local jobs. If the stock-price-improving takeover is rejected, these constituencies do not realize a direct economic loss because they have no quantifiable financial stake in the company. This presents a problem, and an opportunity, for target management. Target management is now allowed to reject a takeover attempt that would have maximized shareholder wealth by citing considerations in favor of these other constituencies. This is particularly a problem where there is an expansive other constituencies statute, such as Pennsylvania's.³⁹ The Pennsylvania statute states that directors need not consider the interests of one group as dominant with respect to the interests of other corporate constituencies. ⁴⁰ Thus, the unknowable interests of nebulous other constituencies can override the interests of the target company's shareholders.

The third major problem posed by other constituencies statutes arises in a so-called "tragedy of the commons" or "free-rider problem," where a party using the good is not forced to pay the full costs of using that good. This problem generally arises where there is a public good--for instance, national defense:

Everyone agrees that national defense is needed. But will everyone, as individuals, supply it, or will everyone rely on someone else to do it? Rational, self-interested people would like to enjoy the benefits of national defense while letting everyone else pay for it. Because national defense is a public good, if someone else defends the country, you are defended for free. You can be a free rider. The problem is that everyone has an incentive to be a free rider, but if everyone is a free rider, then there won't be any national defense.⁴¹ In the takeover context, the other constituencies are allowed to free-ride at the expense of the target shareholders. An example is the proposed takeover of Willamette by Weyerhaeuser. If Weyerhaeuser improves management of Willamette and increase the share-price, then Willamette shareholders financially benefit. Suppose further that Weyerhaeuser relocates Willamette to the state of Washington. The relocation of Willamette is of no economic interest to a rationally self- interested target shareholder who is apathetic to the location of the company. If, however, Willamette is located in Oregon, then Oregon has some interest in Willamette remaining in the state, which will enrich the tax base, provide employment to its citizens, etc. If Willamette's management also has an interest in rejecting the takeover--i.e., they would be replaced by Weyerhaeuser's management in the event of a takeover--they may reject the takeover, citing the interests of the community or Oregon economy under the other constituencies anti-takeover statute. If the takeover is rejected, Oregon continues to receive its tax revenues and employment of its citizens, but at the expense of the Willamette shareholders' wealth. Thus, Oregon, which pays nothing to Willamette's shareholders, free-rides at the expense of these shareholders. In fact, every constituency (including the state, employees, and customers) other than the target shareholder receives the benefit of the target rejecting the takeover while paying none of the costs of the rejected takeover. Further, the other constituencies statute also protects target management from a suit by its shareholders for improper rejection of the tender offer.

B. The Combination of Other Constituencies Provisions and the Business Judgment Rule

The combination of the business judgment rule's gross negligence standard, which is already difficult for an affected shareholder to meet,⁴² and the other constituencies statute may effectively bar a breach-of-fiduciary-duty suit by a target shareholder for improper rejection of a tender offer.⁴³ Prior to the enactment of other constituencies statutes, a target shareholder who felt that target management had rejected a takeover attempt improperly had at least some opportunity to recover if target management acted in a grossly negligent manner.⁴⁴ Other constituencies anti-takeover statutes enlarged the universe of parties to whom target management can consider in a takeover situation.

Target management now has duties to act in the best interests of the corporation and its shareholders and the best interests of these various other constituencies. This bifurcation of the parties to whom duties are owed makes it more difficult for target shareholders to recover in a derivative suit. A target shareholder seeking redress for improper rejection of the tender offer faces an additional hurdle to recovery because of the specious classifications of these other constituencies. The disaggregation of these other constituencies makes them practically incapable of asserting a preference regarding the takeover. The inability to assert a preference allows target management to act ostensibly in the interests of a constituency incapable of asserting a breach-of-fiduciary-duty cause of action against them. Even if an affected shareholder brought suit, there is no practical method of proving that the target's Board of Directors did not act in the best interests of some loosely defined other constituency. In theory, the combination of the business judgment rules gross-negligence standard and the other constituencies statutes completely insulates target management from liability for abreach of fiduciary duty cause of action by a target shareholder. This insulation from liability has profound effects on the efficient market for corporate control.

C. The Efficient Market for Corporate Control

Under the EMCC, the raider can offer to purchase the target company at a premium price only because the raider thinks it can improve efficiency by diminishing agency costs. ⁴⁵ Agency costs are high in an underperforming corporation, according to Easterbrook and Fischel, "[b]ecause no manager can obtain all of the benefits available to the firm from making good decisions, none takes all cost-justified steps to recruit and train those employees best suited for their jobs." ⁴⁶ As a result, the corporation operates at an inefficient level. Under the EMH, the firm's failure to minimize agency costs is reflected in the firm's stock price. Again, according to Easterbrook and Fischel, when the raider sees that, "the difference between the market price of a firm's shares and the price those shares might have under different circumstances becomes too great, an outsider can profit by buying the firm and improving its management." ⁴⁷ In simple economic terms, the raider analyzes the target company's production function.

This production function is symbolized by an isoquant curve, which represents all possible combinations of total quantity produced as a function of the inputs.⁴⁸ Graphically, QQ is the isoquant curve, which is the production function of inputs A and B (see infra figure A). The isoquant curve represents all the combinations of inputs A and B that produce a given quantity of output. The isoquant curve corresponds to all total production possibilities. The cost-component of the firm's production function is represented by an isocost curve. This is represented below graphically, where CC1represents the isocost curve which, "shows all the combinations of two inputs that can be hired at a given total expenditure on inputs."⁴⁹ Where the total expenditures on inputs is held constant, C C is a straight line.⁵⁰ Intuitively, the isocost curve is a straight line because the amount of money a firm can spend on production is a fixed amount in the short run. Thus, a firm has the choice of spending all of its fixed amount of money on (1) input A (where the isocost curve CC touches the X axis), (2) input B (where the isocost curve touches the Y axis), or (3) on some combination of A and B (all points along the isocost line). The combination of the firm's isoquant and isocost curves yields a simple production function.

Figure A

TABULAR OR GRAPHIC MATERIAL SET FORTH AT THIS POINT IS NOT DISPLAYABLE

Now suppose that input A is labor and input B is the raw material the company uses. If agency costs are not being minimized--i.e., if employees are performing in a capacity less than their most valuable use--the company will use too much of input A (labor) and too little of input B (raw materials). This results in the company operating at a less efficient point on the isoquant curve. Graphically, the company failing to diminish the agency costs produces at point Y, which is below the efficient isoquant curve.⁵¹ Because Y is below the isoquant curve, the firm is producing less output, but at the same total cost as the firm operating at X. Thus, the company employing input of A at A2 and input B at B2 is operating with a less efficient use of inputs than the company operating at A, B, or point X.

Under the EMCC, the company operating at point Y is the target company; and under the EMH, the target's stock price reflects the information that the target is operating with an inefficient mix of inputs. In contrast, the raider, through the minimization of agency costs, would operate at X. For this reason, the raider can offer a premium for the target's shares. This premium is equal to the difference in total production between X and Y, multiplied by the per-unit selling price.⁵² In addition, because price has been held constant (isocost CC), the raider will not have to spend any more money to get the increased production.⁵³ This is the economic basis of the EMCC and it means that the raider can operate the company at the same level of production for less money. The increased profit to be made by implementation of the raider's production scheme provides two things: (1) it acts as incentive for the raider to acquire the target; (2) target shareholders have an incentive to replace incumbent management with raider management. These two incentives make maintaining an efficient market for corporate control desirable.

D. Interdependency of Raider, Target Shareholders, and Target Management

The EMCC is enforced by the joint effort of both the raider and the target shareholders. The raider must identify inefficiently operating target companies. Once the underperforming target has been identified, the raider must determine the source of the inefficiency, how the raider could fix it and the amount of increased revenues obtainable from the inefficiency.

The target shareholder, also critical to the operation of the EMCC, must have two attributes. First, the target shareholder must lack a sufficient economic incentive to personally correct the inefficiency of the target. Second, the raider's offer must be sufficient to induce the target shareholder to part with her stock.

The shareholder must lack the financial incentive to monitor the activities of target management. "[S]hareholders are characterized as rationally ignorant because of the large costs associated with staying informed about the corporation's internal affairs and the very small expected benefits to the individual shareholder of being informed."⁵⁴ Even if the shareholder expended enough resources to become informed, there is little chance that a minority shareholder could effect a change in corporate management through the available avenue of voting for a new Board of Directors. Thus, "small shareholders find it rational to free ride on other shareholders' monitoring activity."⁵⁵

The second attribute of target shareholders under the EMCC requires that the raider's tender offer is sufficient to induce a target shareholder to sell her shares. Assuming that shareholders are rational, profit-maximizing individuals, any premium above the current or recent stock price would induce the shareholder to either sell or attempt to retain her shares and replace target management by raider management. Retaining the shares is risky because if too few shares are tendered to the raider, his takeover bid will fail, leaving the shareholder with incumbent management. In either event, the target shareholder will prefer the raider to incumbent management.

In total, the raider has an economic incentive to seek underperforming companies and attempt to take them over. The target shareholder has little or no incentive to monitor target management for inefficiencies and every incentive to sell stock to the raider for a higher price. These two actors provide the impetus for the EMCC. In contrast, target management's incentives in a takeover are almost entirely opposite from those of the raider and the target shareholder.

Target managers generally receive compensation from three different components: (1) salary, (2) compensation based on stock prices, such as options, and (3) compensation based on accounting, such as profit sharing.⁵⁶ Of these three, salary and accounting-based compensation are arguably within management control. The second, stock-based compensation, is within management's control only indirectly. Because some of management's compensation is based on the stock price of the corporation, management has some incentive to maximize efficiency in the corporation; to that extent, management's incentives are in line with shareholder incentives. However, salary and accounting-based compensation are not necessarily in line with the best interests of shareholders.

For example, when compensation is based on accounting, management may maximize short-term accounting profits at the expense of the long-term success of the corporation.⁵⁷ Thus, a target manager would be acting in his profit-maximizing best interests to take short-term paper profits at the long- term expense of the corporation and its shareholders. This represents one divergence between management and shareholder incentives. The salary component of management pay may be the largest portion of the manager's compensation. Absent an extremely noticeable drop in the corporation's share price, which may induce shareholders to vote incumbent management out of office, target managers are relatively safe from shareholder dissatisfaction with the managers' methods. As noted earlier, individual shareholders have little incentive to monitor corporate management. Thus, target managers are largely insulated from the economic consequences of their management decisions. Relating this back to the EMCC, target managers may continue to operate without maximizing efficiency due to the shareholders' inability to monitor activities. Without the threat of takeover from a raider or a precipitous drop in stock price, which would induce the corporation's shareholders to vote out management, managers are largely free to run unfettered. According to Professor Subramanian, "[t]he problem is that agency issues and entrenchment problems might prevent efficient tender offers from being completed. To take the simplest example, management clearly has an incentive to reject an offer that would provide high value to shareholders but would lose management their jobs."⁵⁸ Not only does management risk losing their jobs, but perversely, according to Easterbrook and Fischel, "the less effective they have been as managers, the greater their interest in preventing a takeover." ⁵⁹ Thus, the managers who least deserve to keep their jobs will fight the hardest to retain them. This anomaly represents a second significant divergence between the incentives of management and the incentives of shareholders.

This is not the only example of opposing incentives between management and shareholders. Opposing incentives are created where management owes duties to nonshareholder constituencies. This misalignment of incentives most often arises in an instance when management's duties to its employees are allowed to supersede those of its shareholders. For example, Professors Shliefer and Summers argue that management's bargaining costs with employees are lower because employees expect management to fight a hostile takeover to protect their jobs. ⁶⁰ However, Professor Ribstein argues that this divided loyalty creates two new problems.⁶¹ First, it increases the corporation's cost of capital, thereby making the corporation less efficient.⁶² Second, the "divided loyalty would create serious agency problems with respect to all stakeholders. In other words, there is no more reason to assume that managers would use their entrenchment for the benefit of stakeholders than they would act in the shareholders' interests."⁶³ In effect, this allows management to adopt a Janus-faced role. Management can claim to be acting in the best interests of the stakeholder/employees when questioned by their shareholders, and vice-versa when questioned by their employees. Easterbrook and Fischel conclude that in this situation, "[a] manager responsible to two conflicting interests is in fact answerable to neither."⁶⁴ The presence of an other constituencies statute expands this dilemma because "[i]nstead of following an explicit standard of maximizing shareholder welfare, the managers can hide behind the vague duties to conflicting groups."⁶⁵ Before the advent of such other constituencies provisions, target management rejected a tender offer at their own peril because of the threat of a shareholder suit against them for breach of fiduciary duty for improperly rejecting a tender offer. Now, in repelling a takeover attempt, target management can always claim they were acting in the best interests of constituencies, such as the economy of the state and nation, which are incapable of asserting a claim against target management.⁶⁶

E. Target Management's Possible Responses to a Takeover Threat

The protection of target management from a shareholder breach of fiduciary duty suit occasioned by an other constituencies statute leaves three possible methods of dealing with a raider's takeover attempt. First, target management can reject the takeover attempt. Second, they can erect defenses that make the proposed takeover too expensive and force the raider to drop its attempt. Finally, target management can allow the takeover and extract takeover proceeds for itself. This Comment now addresses each of these alternatives.

Target management can reject the tender offer or other takeover attempt. Because target management is insulated from a shareholder suit by means of the other constituencies statute, it can cite the best interests of one of the more nebulous other constituencies. The rejection of the tender offer maximizes the welfare of target management because they retain their jobs--assuming, of course, that the raider would oust incumbent management. The rejection of the takeover attempt results in a minimization of target shareholder welfare. This occurs because target shareholders will not receive the takeover premium for their shares nor the improved efficiency offered by the raider's management of the target under a successful acquisition.

The second option is for target management to erect defenses in an attempt to make the takeover cost prohibitive for the raider. According to the economics of the EMCC, the raider is willing to pay only a premium for the target that is equal to or less than the amount of money the raider can make by resolving the inefficiency in the target's production function. Thus, if the target's defenses effectively raise the acquisition price by an amount greater than the gains from improved raider efficiency, the raider, acting rationally, will drop his takeover attempt. Before the advent of the other constituencies provisions, target management was basically excluded from bargaining with the raider in a tender offer situation because the raider needed to convince only enough shareholders to accept the offer to take control of the target. As a result of other constituencies provisions, target management can reject the takeover attempt, citing the interests of these other constituencies. Thus, the raider must now negotiate with target management and persuade them not to assert the protections of the other constituencies anti-takeover provisions.

The final option for target management in a takeover attempt is to allow the takeover attempt to succeed, with increased proceeds going to target management. The protection other constituencies statutes afforded to target management enables them to allow a takeover only if they so choose. In the absence of an other constituencies statute, target management's discretion in rejecting a takeover attempt would be limited by the threat of a shareholder breach of fiduciary duty suit. It follows that acting as profit-maximizing individuals and without a threat of a shareholder suit, target management will accept a takeover only when their individual positions are maximized.

The amount of the premium the raider offers in a takeover attempt is limited to the value that the raider expects to receive by improving the functioning of the target. Suppose that the amount of the premium is $10 over the current target's share price. The amount of the takeover premium offered by the raider must not only compel the target shareholders to tender their shares, but also induce target management not to invoke the protection of an other constituencies statute and reject the raider's offer. In the absence of the protection of an other constituencies provision, the entire amount of the premium--in this case $10 per share--would go to the target shareholders. However, the fact that target management also must be induced to approve, or at least not actively oppose, the takeover means that acting as rationally self- interested persons, the target managers will try to maximize their individual economic situations. Inevitably, a portion of that $10 premium is allocated to target management and may be given in many forms, including golden parachutes or promises from the raider to keep target management in place. This transfer of a portion of the premium from target shareholders to target management reduces target shareholder welfare.

For example, suppose that the raider's highest possible premium is $10 per share, represented by P minus P3, where D is the raider's demand for the target stock absent an other constituencies statute (see Figure B). D2 represents the raider's demand for the target stock with an other constituencies statute, and D3 is the initial demand for the target stock. The triangle ABC represents the target shareholder's surplus without the other constituencies provision. Triangle CEF represents target shareholder's surplus with an other constituencies statute. The area ABFE represents the target shareholder's surplus loss attributable to the presence of an other constituencies statute; it also represents target management's surplus. Thus, the amount represented by ABFE is the amount transferred from target shareholders to target management.

Figure B

TABULAR OR GRAPHIC MATERIAL SET FORTH AT THIS POINT IS NOT DISPLAYABLE

IV. Conclusion

The check on corporate management's discretion in rejecting a tender offer is vastly diminished by the combination of the business judgment rule and other constituencies statutes. The economic consequences resulting from the combination of the business judgment rule and other constituencies statutes will lead to fewer takeovers and will weaken the efficient market for corporate control. In addition, target shareholders likely will see a portion of the takeover premium transferred to target management in exchange for target management's agreement not to invoke the protections of other constituency statutes.

Oregon's other constituencies statute awaits its big test. Will the Willamette Industries Board of Directors seek the protection of the other constituencies provision to enrich themselves at the expense of their shareholders? Or will Weyerhaeuser's takeover attempt be rebuffed, keeping jobs and taxes flowing to nonshareholder constituencies in Oregon at the expense of Willamette's shareholders? These questions remain unanswered. One conclusion is clear: state legislatures in general should take a hard look at their other constituencies statutes.

As this analysis indicated, the cost of this form of anti-takeover legislation is simply too great to justify its continued existence. The corporation exists for the benefit of its shareholders. Other constituencies statutes are simply a rude form of provincialism that do not protect the nonshareholder parties they are intended to protect. Instead of protecting nonshareholder constituencies, these statutes act as a subterfuge for management, allowing them to extract gains rightfully belonging to the corporation's shareholders. Corporate managers act as Janus did, purportedly looking to the interests of shareholder and nonshareholder constituencies at the same time. However, in the end, only target managers benefit from their two-faced role. Every state that has enacted such a statute should conduct a simple cost-benefit analysis and determine if the benefit of increasing manager wealth is worth the damage caused to shareholders, nonparty constituencies, and the U.S. capital market. The answer appears to be self- evident, for a modern-day Janus can only look in one direction--toward the best interests of his shareholders.

Footnotes:

1 Or. Rev. Stat. § 60.357(5) (1999).

2 August 28, 2000, www.weyerhaeuser.com

3 Id. (offer rejected by board on September 8, 2000).

4 Brian J. Black, Corporate Strategies: War of Wills in Timber Country, 18 Bus. J. Portland, Mar. 23, 2001, at 12.

5 Id.

6 Or. Rev. Stat. § 60.357(5).

7 Id.

8 Nike is the other Fortune 500 company, employing 14,975 employees. Willamette Industries, Inc., 2000 Annual Report, at 16.

9 Let Weyerhaeuser Fail in Its Campaign, Albany Democrat-Herald, Mar. 5, 2001, available at http://www.dhonline.com.

10 Letter from Willamette Board of Directors Letter to Weyerhaeuser Board of Directors Shareholders, May 9, 2001, available at http:// www.sec.gov/Archives/edgar/data/106535/000095015701000248/000950157-01-000248- 0001.txt.

11 1983 Pa. Laws 92 (codified as 15 Pa. Cons. Stat. Ann. § 1715(a) (1999)).

12 See James J. Hanks, Jr., Playing With Fire: Nonshareholder Constituency Statutes in the 1990s, 21 Stetson L. Rev. 97, 103 (1991).

13 See Michael Bradley et al., Challenges to Corporate Governance: The Purposes and Accountability of the Corporation in Contemporary Society: Corporate Governance at a Crossroads, 62 Law & Contemp. Probs., Summer 1999, at 28 n.134. The following statutes permit directors to consider the interests of nonshareholder constituencies in any appropriate context: Conn. Gen. Stat. § 33-756(d) (1997) (mandating consideration of non-shareholder constituencies); Fla. Stat. ch. 607.0830(3) (Supp. 1999); Ga. Code Ann. § 14-2-202(b)(5) (Supp. 1998); Haw. Rev. Stat. § 415-35(b)(1)-(4) (1997); Idaho Code § 30-1702 (1996); 805 Ill. Comp. Stat. 5/8.85 (West 1993); Ind. Code 23-1-35-1(d) (1995); Iowa Code § 491.101B (1991); Me. Rev. Stat. Ann. tit. 13-A, § 716 (West Supp. 1998); Mass. Gen. Laws Ann. ch. 156B, § 65 (West Supp. 1998); Minn. Stat. § 302A.251(5) (Supp. 1999); Miss. Code Ann. § 79-4-8.30(d) (1998); Nev. Rev. Stat. § 78.138(3) (1994); N.J. Stat. Ann. § 14A:6-1(2) (West Supp. 1998); N.M. Stat. Ann. 53-11-35(D) (Michie 1997); N.Y. Bus. Corp. Law § 717(b) (McKinney Supp. 1999); N.D. Cent.Code § 10-19.1-50(6) (Supp. 1997); Ohio Rev. Code Ann. § 1701.59(E) (Anderson 1993); Or. Rev. Stat. § 60.357(5) (Supp. 1999); 15 Pa. Cons. Stat. § 515 (1995); Wis. Stat. § 180.0827 (1992); Wyo. Stat. Ann. § 17-16-830(e) (Michie 1997).

The following statutes permit directors to consider the interests of nonshareholder constituencies in the context of transactions for corporate control: Ala. Code § 10-2B-11.03(c) (1994); Ariz. Rev. Stat. § § 10- 2702, 10-1202(c) (1996) (sale of assets); Ark. Code Ann. § 4-27- 1202(C) (Michie 1996) (sale of assets); Colo. Rev. Stat. § § 7-106- 105(7) (reverse splitting of shares), 7-111-103(3), 7-114- 102(3) (1998) (authorization of dissolution after issuance of shares); Ky. Rev. Stat. Ann. § § 271B.11-030(2)(b), 271B.12-020(3) (Banks-Baldwin 1989) (sale of assets); La. Rev. Stat. Ann. § 12:92(G) (West 1994); Mo. Ann. Stat. § 351.347 (West 1991); Mont. Code Ann. § § 35-1-815(3), 35-1- 823(3) (1997) (sale of assets); N.H. Rev. Stat. Ann. § § 293-A:11.03(c), 293-A:12.02(c) (Supp. 1996) (sale of assets); N.C. Gen. Stat. § § 55-11- 03(c), 55-12-02(c) (1990) (sale of assets); R.I. Gen. Laws § 7-5.2-8 (1992); S.C. Code Ann. § § 33-11-103(c), 33-12-102(c) (Law. Co-op. 1990) (sale of assets); S.D. Codified Laws 47-33-4 (Michie 1991); Tenn. Code Ann. § 48-103-204 (1995); Tex. Bus. Corp. Act Ann. art. 5.03 (West Supp. 1999); Utah Code Ann. § 16-10a-1103(3) (1995); Vt. Stat. Ann. tit. 11A, § § 11.03(c), 12.02(c) (1997) (sale of assets); Va. Code Ann. § 13.1-718(C) (Michie 1993); Va. Code Ann. § 13.1-724(C) (Michie Supp. 1998) (sale of assets); Wash. Rev. Code § § 23B.11.030(3), 23B.12.020(3) (1994) (sale of assets).

The following states and territories do not have specific legislation regarding consideration of the interests of nonshareholder constituencies: Alaska, California, Delaware, District of Columbia, Kansas, Maryland, Michigan, Nebraska, Oklahoma, Puerto Rico, Virgin Islands, and West Virginia.

14 Smith v. Van Gorkum, 488 A.2d 858, 872 (Del. 1985), quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984), overruled by Brehm v. Gisher, 746 A.2d 244 (Del. 2000).

15 Van Gorkum, 488 A.2d. at 881.

16 164 N.E. 545, 546 (N.Y. 1928).

17 Aronson, 473 A.2d at 812 (emphasis added).

18 Frank H. Easterbrook & Robert R. Fischel, The Proper Role of a Target's Management in Responding to a Tender Offer, 94 Harv. L. Rev. 1161, 1163 (1981); see e.g., Lewis v. McGraw, 619 F.2d 192 (2d Cir. 1980); Panter v. Marshall Field & Co., 486 F. Supp. 1168 (N.D. Ill. 1980) (involving a shareholder's suit against management for defeating a tender offer with a more than one-hundred percent premium over the stock price prior to the takeover attempt); Berman v. Gerber Prod. Co., 454 F. Supp. 1310, 1329 (W.D. Mich. 1978).

19 Conn. Gen. Stat. Ann. § 33-756(d) (West 1997).

20 Hanks, supra note 12, at 103-05.

21 Or. Rev. Stat. § 60.357(5) (1999).

22 See id.

23 Hanks, supra note 12, at 103, quoting Minn. Stat. § 302A.251(5) (2000).

24 Hanks, supra note 12, at 106.

25 James S. Mofsky & Robert D. Rubin, Eighth Annual Baron De Hirsch Meyer Lecture Series--Introduction: A Symposium on the ALI Corporate Governance Project, 37 U. Miami L. Rev. 169, 182 (1983).

26 Herbert B. Mayo, Investments: An Introduction 178 (3d ed. 1991).

27 Id. at 175-77.

28 Id. at 178.

29 Id. at 179.

30 Lynn A. Stout, The Unimportance of Being Efficient: An Economic Analysis of Stock Market Pricing and Securities Regulation, 87 Mich. L. Rev. 613, 687 (1988).

31 See generally Eugene F. Fama, Efficient Capital Markets: A Review of Theory and Empirical Work, 25 J. Fin. 383, 383-416 (1970) (providing an overview of efficient capital markets); Christopher Paul Saari, Note, The Efficient Capital Market Hypothesis, Economic Theory and the Regulation of the Securities Industry, 29 Stan. L. Rev. 1031, 1034-57 (1977) (arguing for a semi-strong form of efficient capital markets) (the Securities and Exchange Commission (SEC) aids the EMH by requiring disclosure from so-called reporting companies under the 1934 Securities and Exchange Act and, in the takeover context, under the Williams Act, 15 U.S.C.S. § 78n (2000)).

32 Stout, supra note 30, at 686.

33 Richard W. Jennings et al., Securities Regulation: Cases and Ma-terials 185 (8th ed. 1998) ("The current eligibility rules [for form S-3] require the aggregate market value for the voting stock held by non-affiliates to be $75 million or more (for a primary offering of stock for cash....").

34 Stout, supra note 30, at 686.

35 Ohio Rev. Code Ann. § 1701.59(E) (West 1994).

36 624 N.E.2d 1118 (Ohio Com. Pl. 1992).

37 Id. at 1120.

38 Larry E. Ribstein, Takeover Defenses and the Corporate Contract, 78 Geo. L.J. 71, 147 (1989).

39 15 Pa. Cons. Stat. Ann. § 1715(a) (1999).

40 Id.

41 Henry N. Butler, Economic Analysis for Lawyers 88 (1988).

42 See Easterbrook & Fischel, supra note 18, at 1197.

43 See Abrahamson v. Waddell, 624 N.E.2d 1118, 1120 (Ohio Com. Pl. 1992).

44 See Smith v. Van Gorkum, 488 A.2d 858, 875 (Del. 1985).

45 Easterbrook & Fischel, supra note 18, at 1173.

46 Id. at 1170.

47 Id. at 1173.

48 Jack Hirshleifer & David Hirschleifer, Price Theory and Applications 322 (6th ed. 1992).

49 See Hirshleifer & Glazer, supra note 48, at 300.

50 Id.

51 Holding expenditures on inputs A and B constant, the level of expenditure is reflected on the isocost curve CC and not the isoquant curve of QQ.

52 To convert the improved production attributable to the raider's minimization of input costs into a dollar figure, one would take the difference in production (X1-Y1), multiplied by the price of a unit of production. Thus, the equation (X1-Y1)(P) equals the increased revenues attributable to optimizing the mix of inputs.

53 The raider will necessarily incur some expense in identifying the inefficient target company; but while this may reduce the premium the raider would be willing to pay for the target company, it would not be reflected in the production function.

54 Butler, supra note 41, at 743.

55 Id.

56 Id .

57 Id.

58 Guhan Subramanian, A New Takeover Defense Mechanism: Using an Equal Treatment Agreement as an Alternative to the Poison Pill, 23 Del. J. Corp. L. 375, 399 (1998).

59 Easterbrook & Fischel, supra note 18, at 1175.

60 Andrei Shliefer and Lawrence H. Summers, Breach of Trust in Hostile Takeovers, in Corporate Takeovers: Causes and Consequences 20-21 (2d ed. 1987).

61 Ribstein, supra note 38, at 149.

62 Id.

63 Id. at 149-50.

64 Easterbrook & Fischel, supra note 18, at 1192.

65 Ribstein, supra note 38, at 149.

66 Or. Rev. Stat. § 60.357(5) (1999).

return to Publications main page