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Uncle Sam and the Hostile Takeover—A Commentary by Jonathan Macey ’82

The following commentary was published in The Wall Street Journal on March 21, 2011.

Uncle Sam and the Hostile Takeover
By Jonathan Macey ’82

Conflicts between a public company's top management and shareholders are seldom more intense than when an activist investor emerges with plans to make a substantial investment in the company's stock. These investors sometimes are hedge funds or "value investors" like Warren Buffett. Whoever they are, after they take a huge stake in the target company they have strong incentives to agitate vigorously for reforms that will increase the value of their investments.

Shareholders benefit from the reforms of corporate governance initiated by these activist investors. So does the economy generally, because the overall economy performs better when companies perform better. But managers are not so fond of this process because activist investors push incumbent senior managers hard to improve their performance. Occasionally they even fire them.

Since incumbent managers sometimes lose to activist investors in fair corporate elections, their preferred strategy for dealing with them is to hire legal talent and team up with friendly regulators to make new rules and to concoct anti-takeover devices like poison pills.

For example, J.C. Penney adopted a poison pill last October, soon after learning that the hedge fund Pershing Square Capital Management and the publicly traded Vornado Realty Trust had acquired a sizeable position in the company. The particular poison pill it adopted would dilute the voting rights of the two activist investors' shares if they further increased their holdings or attempted a takeover of the company by giving other shareholders the right to buy J.C. Penney shares at half-price.

The takeover process is currently governed by a 1968 law called the Williams Act, which is designed to balance the legitimate interests of outside bidders with the interests of incumbent management. Investors have the right to accumulate a sufficient block of stock in a potential target company so that they can be taken seriously by management. And managers have the time to respond to activist investors in order to convince shareholders that there is no need for a shake-up at the company.

But in the decades since the Williams Act was passed, the balance increasingly has come to favor targets as courts, lawyers and the SEC have erected more roadblocks like the poison pill. This is why returns to bidders have been slowly declining and returns to targets have been rising. This is also why the market for corporate control is relatively moribund, particularly when compared to the robust markets of the past.

The way to evaluate the balance of power between bidders and targets is to compare the market returns of bidders with the returns to targets in corporate acquisitions. If the returns to bidders and targets are roughly equal, then the balance of power between the two groups is roughly equal. But if the distribution of returns to bidders and targets is lopsided, then the balance of power is lopsided as well.

Dozens of empirical studies have compared these returns, and the evidence is clear. The returns to the shareholders of public companies that make takeover bids approximates zero, while the returns to the shareholders of target companies are consistently in double digits. Activist investors like hedge funds, often privately held and more nimble than public companies, are the last bidders who still may be able to make money in the market for corporate control—at least for now.

Under Section 13(d) of the Williams Act, investors are free to acquire stock in a target company, but after they acquire a 5% stake, 13(d) gives them just 10 days before they must make public filings with the SEC. But last week Wachtell, Lipton, Rosen & Katz—a law firm that has long represented corporations fighting takeovers, and whose partner Martin Lipton invented the poison pill in the 1980s—proposed an amendment to the regulation that would replace the "10-day window" with a single day.

Since the target company's stock price jumps significantly when these public filings are made, this rule change to the Williams Act would make activist investments prohibitively expensive by increasing the price that these investors would have to pay for all shares acquired just one day after the 5% threshold is passed.

The rule change, in short, would shift the balance of power in the market for corporate control decisively toward entrenched managements and away from bidders and shareholders.

An obscure provision in the Dodd-Frank Act opens the door for the current proposed rule change. This provision authorizes the SEC to establish a disclosure deadline that is shorter than the traditional 10-day window.

In its letter to the SEC proposing the rule change, the Wachtell law firm mentioned its concern that Pershing and Vornado were able to acquire more than 25% of J.C. Penney's stock before having to make an SEC filing within the 10-day window last October. In January, J.C. Penney agreed to give Pershing and Vornado seats on its board. Yet it is hard to see how this has harmed shareholders. J.C. Penney's stock price increased 60% from the date of its first mandated disclosure. It is now up almost 80%.

Proponents of the new rule ignore the fact that as a practical matter, one cannot gain voting control of a public company within the existing 10-day window. Consequently, the existing rule is serving its purpose: Management still has the opportunity to make its case to the shareholders.

Proponents also argue that changes in technology and other advances have made it possible for investors to buy shares and to file reports with the SEC in less time than before. The better argument is that investors should be allowed to benefit from these technological advances before new regulation destroys this opportunity.

Mr. Macey is a professor at Yale Law School and a member of the Hoover Institution Task Force on Property Rights.