Why Defer to Managers? A Strong-Form Efficiency Model
Richard E. Kihlstrom
University of Pennsylvania - Finance Department
Michael L. Wachter
University of Pennsylvania Law School - Institute for Law and Economics
U of Penn, Inst for Law & Econ Research Paper No. 05-19
We compare the efficiency with which management discretion and shareholder choice regulate hostile tender offers. This is the first paper in a long running debate that rigorously compares these legal rules to analyze both the critical informational assumptions and the interplay of those assumptions with principles of financial market efficiency. A critical innovation of our model is its focus on an informed management's choice among alternative corporate policies under the protection of the business judgment rule, but where agency costs exist. We assume that corporate assets and reinvestment opportunities are efficiently priced by financial markets, but that markets never learn the value of foregone investments. In this case, shareholder choice may create an agency problem whereby managers forego positive net present value investments that increase the risk of a hostile bid. We are able to determine analytic conditions under which the expected cost of this agency problem exceeds that of the standard agency problem usually identified with management discretion.
Number of Pages in PDF File: 58
Keywords: corporate takeovers, corporate governance, management discretion, shareholder choice, market efficiency
JEL Classification: G34
Date posted: September 20, 2005
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