An Efficiency Analysis of Defensive Tactics

57 Pages Posted: 26 Jun 2020

See all articles by Ronald J. Gilson

Ronald J. Gilson

Stanford Law School; Columbia Law School; European Corporate Governance Institute (ECGI)

Alan Schwartz

Yale Law School

Date Written: February 12, 2020

Abstract

For thirty five years, courts and scholars have divided over the effects of defensive tactics in the market for corporate control. Strong defensive tactics locate authority to accept a hostile bid in the target’s board. The board can bargain for a higher takeover price than uncoordinated shareholders could realize but high takeover prices may reduce shareholder returns by reducing the likelihood of receiving a bid. The Delaware Courts themselves disagree. The Delaware Chancery Court would locate ultimate decision authority in the target’s shareholders, while the Supreme Court, by permitting strong defensive tactics, allocates extensive power to the target’s board. Though the Supreme Court’s view settles the legal issue in Delaware for now, the normative debate among scholars and decision-makers regarding whether the shareholders or the board should decide remains unresolved.

The Delaware courts ask whether defensive tactics maximize target shareholder welfare: the shareholders’ expected return from acquisitions. But the more important question concerns social welfare: do defensive tactics reduce efficiency in the market for corporate control? Empirical difficulties so far have prevented analysts from answering either the private or social welfare question rigorously. Regarding private welfare, the analyst cannot observe bids a target’s defensive tactics level deterred. Regarding public welfare, the analyst cannot observe how an otherwise identical market would behave under weak and then strong defensive tactics levels.

We address the two empirical questions by creating a structural model that predicts how the market for corporate control performs under varying defensive tactics levels and then testing the model by simulating market performance. A simulation permits us to isolate the effect of different defensive tactics levels. It also permits us to solve for a target’s optimal tradeoff between the increased share of an acquisition’s gain strong defensive tactics can permit a target to capture and the reduced probability of receiving bids in consequence of the acquirer’s reduced gain.

The simulated corporate control market performs poorly, making 15% fewer acquisitions under strong defensive tactics than under weak defensive tactics. Target boards, however, apparently have been faithful fiduciaries for their shareholders, choosing defensive tactics levels that optimize the tradeoff between bid frequency and bid returns. On the other hand, we show, the privately optimal target defensive tactics level greatly exceeds the socially efficient level. Finally, we suggest that some firms’ recent efforts further to strengthen defensive tactics, such as combining a staggered board with a poison pill, reduce both efficiency and target shareholder welfare.

Our results do not support a call for an immediate regulatory response. Initially, we do not rigorously analyze other possible justifications for defensive tactics, such as that they encourage potential targets to take long-term projects that the market may undervalue. Also, simulations raise an external validity question: do the researcher’s assumed simulation parameters capture real world patterns? We argue that our parameters do well on this measure, but a simulated market cannot perfectly capture real world behavior. On the other hand, the magnitude of our results and their consistency with theoretical predictions strongly support our central claim: today’s market for corporate control is so unlikely to maximize the number of value increasing acquisitions that scholars, regulators and courts should revisit the defensive tactics debate.

Keywords: defensive tactics

Suggested Citation

Gilson, Ronald J. and Schwartz, Alan, An Efficiency Analysis of Defensive Tactics (February 12, 2020). Harvard Business Law Review, Vol. 11, No. 1, 2020; Stanford Law and Economics Olin Working Paper No. 548; Columbia Law and Economics Working Paper No. 623. Available at SSRN: https://ssrn.com/abstract=3549527

Ronald J. Gilson

Stanford Law School ( email )

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Columbia Law School ( email )

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European Corporate Governance Institute (ECGI)

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Belgium

Alan Schwartz (Contact Author)

Yale Law School ( email )

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New Haven, CT 06520-8215
United States
203-432-4030 (Phone)
203-432-8260 (Fax)

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