MARTIN LIPTON MEMOS

DOCUMENT INDEX TAB

Conflicts of Interest - Use of Special Committees of Disinterested Directors,

dated August 23, 1976 ................................................................................................ 113

Investment Bankers' Fairness Opinions, dated February 4, 1977 ........................................ 126

Tender Offers; Acquisitions to Block a Takeover, dated May 24, 1977 ............................. 135

Audit Committees, dated May 24, 1977 .............................................................................. 137

Going Private; Long-Form Freezeout Mergers; Delaware Abandons Position that

Appraisal is Exclusive Remedy, dated September 28, 1977 ...................................... 146

Tender Offers; Fiduciary Duties of the Target’s Board of Directors,

dated August 14, 1978 ................................................................................................ 168

Takeover Bids in the Target's Boardrooms 1979............................................................................

Memorandum with respect to Treatment by a Target Company of a Takeover

Proposal, dated January 4, 1979 ................................................................................. 183

Response to Takeover Bids, dated January 28, 1981 .......................................................... 219

Takeovers; Some Recent Experiences And Important Lessons,

dated April 9, 1981 ..................................................................................................... 226

Takeovers: Protecting Shareholders Against Front-End Loaded Tender Offers

and Bust-Up Proxy Fights, dated December 13, 1982 ............................................... 246

Share Purchase Rights Plans (“Poison Pills”), dated November 21, 1985 .......................... 270

The Poison Pill on the First Anniversary of Household,

dated November 19, 1986 .......................................................................................... 291

W/2710550
The Proposed Delaware Takeover Statute, dated June 1, 1987 ........................................... 299

A Second Generation Share Purchase Rights Plan, dated July 14, 1987............................. 305

Proposed Delaware Takeover Defense Stock Redemption Statute,

dated September 2, 1987 ............................................................................................ 308

Takeovers: No Requirement to Auction a Company, dated November 18, 1987 ............... 312

Much Ado About Nothing; the Delaware Takeover Law, dated February 2, 1988 ............ 317

The Takeover Frenzy, dated March 31, 1988 ...................................................................... 323

Delaware Clarifies Fiduciary Duties of Directors in a Takeover Situation,

dated May 21, 1988 .................................................................................................... 335

The Interco Case, dated November 3, 1988......................................................................... 340

Just Say No, dated November 8, 1988 ................................................................................. 341

You Can't Just Say No in Delaware No More, dated December 17, 1988 .......................... 346

A New System of Corporate Governance: The Quinquennial Election of Directors dated

1991..............................................................................................................................

Ten Questions Raised by Paramount, dated February 7, 1994 ............................................ 386

Delaware Corporations Should Eliminate “Dead Hand” Provisions, dated August

28, 1998 ...................................................................................................................... 420

Delaware Supreme Court Affirms Validity of Poison Pills,

dated September 10, 2001 .......................................................................................... 450

Pills, Polls and Professors, dated January 28, 2002 ............................................................. 458

Pills, Polls and Professors Redux, dated January 28, 2002 ................................................. 459

The Business Judgment Rule is Alive and Well, dated June 17, 2003 ................................ 485

Some Thoughts for Boards of Directors, dated January 19, 2004 ....................................... 493

Delaware Chancellor's Opinion in the Disney/Ovitz Case Confirms that the

Business Judgement Rule is Alive and Well, dated August 10, 2005 ........................ 505

Key Issues for Directors, dated December 1, 2005 ............................................................. 510

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Delaware Supreme Court Affirms Disney Case: the Business Judgement Rule
Prevails, dated June 12, 2006 ..................................................................................... 523

Directors Face-to-Face Meetings with Institutional Investors on Corporate

Governance Policies and Practices, dated June 28, 2007 ........................................... 536

A Crisis Is a Terrible Thing to Waste: The Proposed "Shareholder Bill of Rights

Act of 2009" Is a Serious Mistake, dated May 12, 2009 ............................................ 551

Schumer's Shareholder Bill Misses the Mark, dated May 12,

2009..................................................................................................................................... 176

Future of the Board of Directors, dated June 23, 2010 ........................................................ 567

Delaware Court Reaffirms the Poison Pill and Directors’ Power to Block
Inadequate Offers, dated February 16, 2011 .............................................................. 582

Key Issues for Directors 2012, dated November 28, 2011 .................................................. 590

Harvard's Shareholder Rights Project is Wrong, dated March 21, 2012 ............................. 596

Harvard's Shareholder Rights Project is Still Wrong, dated November 28, 2012 ............... 603

Bite the Apple; Poison the Pill; Paralyze the Company; Wreck the Economy, dated February
26, 2013...............................................................................................................................
Current Thoughts About Activism, dated August 8, 2013 .................................................. 612

The Bebchuk Syllogism, dated August 26, 2013 ................................................................ 613

Empiricism and Experience; Activism and Short-Termism; the Real World of

Business, dated October 25, 2013 .............................................................................. 614

A Response to Bebchuk and Jackson’s Toward a Constitutional Review of the

Poison Pill, dated March 13, 2014 ............................................................................. 622

The Delaware Courts and Investment Banks, dated October 29, 2015 ............................... 650

The Delaware Supreme Court Speaks to Boards and the Investment Banks,
dated December 3, 2015 ............................................................................................. 652

A Personal Reflection on Corporate Governance: Is 2015, like 1985, an

Inflection Year? dated December 3, 2015 .................................................................. 653

The New Paradigm for Corporate Governance, dated February 1, 2016 ............................ 658

-3-
The New Paradigm for Corporate Governance, dated March 7, 2016 ................................ 660

Delaware Court of Chancery Appraises Fully-Shopped Company at Nearly 30%

Over Merger Price, dated June 2, 2016 ...................................................................... 663

Corporate Governance: The New Paradigm, dated January 9, 2017 .................................. 674

Promoting Long-Term Value Creation – The Launch of the Investor Stewardship

Group (ISG) and ISG’s Framework for U.S. Stewardship and Governance,
dated January 31, 2017 ............................................................................................... 679

Corporate Governance, dated April 18, 2017 ...................................................................... 682

The Classified Board Duels, dated June 30, 2017 ............................................................... 683

-4-
 WACHTELL, LIPTON, ROSEN & KATZ August 23, 1976

To Our Clients:

Conflicts of Interest - Use of Speciq.l

Committees of Distinterested Directors

The utility of the special committee of disinter-

ested directors to decide how a corporation should act in a
situation where a majority of the directors have a conflict
of interest was recently reaffirmed in Gall v. Exxon Corp.,
CCH Fed. Sec. L. Rep . • 95,675 (S.D.N.Y. Aug. 2, 1976). Exxon
had made what were alleged to be illegal foreign political
contributions of about $59 million. After a shareholder de-
mand that Exxon bring suit against the officers and directors
involved in the contributions to recover the damage to Exxon,
the Exxon Board of Directors appointed a special committee of
directors to consider the question. The special committee
decided not to bring suit. The court held that under the
usual business judgment rule applicable to corporate deci-
sions, the determination of the special committee would not
be subject to review by the court in a shareholder derivative
suit and such suit would be dismissed. In order for the
business judgment-rule to be applicable to such special com-
mittee determinations, the special committee must have actual
decision making authority and the members of the committee
must be truly disinterested.

Other recent examples of the efficacy of the special

committee approach are Lasker v. Burks, CCH Fed. Sec. L. Rep .
• 95,297 (S.n.N.Y. 1975) (determination not to sue m~tual
fund adviser with respect to a bad investment); Schulwolf v.
Cerro Corp., N.Y.L.J. Feb. 15, 1976 p. 6, col. 5 (Sup. Ct.,
N.Y. Co. Feb. 13, 1976) (parent-subsidiary freeze-out merger)
and Puma v. Marriott, 283 A.2d 693 (Del. Ch. 1971) (purchase
of assets from controlling shareholder).
; t The special committee of disinterested directors,
advised by special outside counsel, investment bankers or
other independent-experts, depending upon the issue to be
decided, has proved to be an effective means of meeting the
strike suit attack on corporate conflict transactions. It
warrants wider use.

Martin Lipton'

76-0039
V/ACH7ELL LIPTON ROSEN KATZ

February 1977

Investment Bankers Fairness Opinions

The increasing and expanding use of investment

bankers fairness opinions warrants reexamination of the

premises on which they are based The traditional fairness

opinion evolved primarily from armslength merger transac

tions in which the investment banker acted for the deal

Recently fairness opinions have become significant in

wide range of transactions

Minority shareholder freezeouts

Repurchases from insiders

Second step acquisitions following tender

offers

Conflict mergers and

Armslength mergers

Lawyers and management of corporations recognize that an

investment bankers opinion can be major factor in sustain

ing corporate transaction against attack Indeed in Harriman

E.I duPont de Nemours Co CCH Fed Sec Rep IF 95386

ID.Del 1975 it was argued that it would be violation of

Rule lObS for the controlled party in conflict merger to

negotiate the terms without the assistance of an investment

banker and although the court rejected the argument it is

clear that the court reached its conclusion sustaining the

dupontChristiana merger there in issue primarily on the

basis that the parties did in fact obtain investment bankers

fairness opinions

Where fairness opinion is used in proxy state

ment for business combination governed by Rule 145 the in

vestment banker probably has the status of an expert within

Section lla4 of the 1933 Act As such the investment

banker will be held liable for any misleading statement

opinion or valuation made by it unless it can show that ex

cept for statements made on the basis of other experts it

conducted reasonable investigation and had reasonable

grounds to believe that its statements were true and not

misleading

Where fairness opinion is used in proxy or

information statement not governed by Rule 145 or where

fairness opinion is not communicated to shareholders the

liability standards may differ somewhat from the experts

liability under the 1933 Act However as Sanders

John Nuveen Co 524 F.2d 1064 7th Cir 1975 vacated

From time to time theory has been advanced that an

investment bankers fairness opinion in business combination
proxy statement may make the investment banker participant
in the distribution and therefore an underwriter with full
due diligence responsibility for the proxy statement While
we think that this theory is not well grounded it must be
recognized as potential liability and taken into account
in determining the form of the fairness opinion and the review
procedures used in connection with the fairness opinion
and remanded 96 Ct 1659 1976 and ChrisCraft Industries

Inc Bangor Panta Corp 480 F.2d 341 2d Cir 1975 cert

granted 96 Ct 1505 1976 demonstrate the possibility

that the courts may impose 1933 Act type due diligence standards

in other contexts must be kept in mind

Accordingly specific due diligence program

should be developed for each fairness opinion In this con

nection counsel should be consulted in each case for advice

as to whether the usual procedures should be changed Recent

cases have changed substantially the standards which may ap

ply in reaching fairness opinions and this is an evolving

area of the law See e.g Endicott Johnson Corp Bade

37 N.Y.2d 585 1975 and Del Noce Delyar Corp CCH Fed

Sec Rep 95670 S.D.N.Y 1976

For many years it has been assumed that if

fairness opinion was qualified by use of from financial

standpoint or similar words the investment banker limited

its liability and had no duty to inquire into any aspect

of the transaction other than the traditional economic

matters taken into account in valuing security or

business Whether or not this assumption would stand up

3--
in actual litigation has not been tested However we

believe that it would not be effective in cases where the

investment banker has an advisory role or otherwise assists

in the transaction beyond merely providing an opinion To

the extent that such assumption limits due diligence or

limits the factors taken into account in reaching the opinion

it may be counterproductive and subject both the investment

In Green Santa Fe Industries Inc 533 F.2d 1283

2d Cir 1976 cert granted 95 S.Ct 54 1976 short
form cash merger freezeout transaction was found to vio
late Rule lobS on the basis of substantial undervaluation
lack of corporate purpose and failure of Delaware law to
provide prior notice to minority shareholders The statu
tory notice of the effectuation ofthe shortform merger
had appended to it an investment bankers opinion as to
the price at which stock of the merged subsidiary
would trade under current market conditions The invest
ment banker was alleged to have participated in the parents
Rule lObS violation On the basis that the investment
bankers engagement was limited to valuation of the stock
and compilation of report on the subsidiarys financial
status and on the basis that the investment banker was not
involved in the planning or the effectuation of the short
form merger and had no knowledge of lack of corporate pur
pose the court held that the investment banker was not
participant in the parents Rule lObS violation However
the case arose on motion to dismiss the complaint and the
decision was premised on the absence of allegations as to
the investment bankers participation As practical mat
ter the investment banker does and should participate in
the decision making with respect to this type of transac
tion and it is rarely possible to remain so removed from the
transaction as to meet the criteria on which the court re
lied Therefore it is better for the investment banker to
participate use due diligence and insist that the client
obtain and follow well founded legal advice than to rely
on having expressed only financial opinion If the
investment banker had indeed concerned itself with both
substantive and procedural fairness for freezeout trans
action in all probability its client as well as it would
have escaped liability
banker and its client to needless liability exposure For

example in certain states such as New Jersey there is sub

stantial question whether minority shareholder freezeout

may be effected no matter what the financial terms Fairness

from financial standpoint may be only one element necessary

to sustain such transaction and the investment banker should

take that into account There are cases where the investment

banker has no connection with the transaction other than re

sponding to request for an economic or market valuation In

such cases the investment banker may properly limit its function

but it should be specially careful to describe its limited

role and to guard against its opinion being misused

The broad spectrum of types of transactions in which

fairness opinions may be used makes it not feasible to provide

useful general guidelines Each fairness opinion should be

designed specially for the specific transaction The client

requesting the opinion should be asked to present an engage

ment letter which defines precisely the purpose of the opinion

and the legal standards that govern the transaction The en

gagement letter should be reviewed by counsel for the invest

ment banker The engagement should not be accepted unless

there is agreement as to the scope of the work and the

See Berkowitz Power/Mate Corp 137 N.J Super 36

Sup Ct Ch Div 1975

applicable standards Indemnification including legal ex
penses should be obtained for each engagement The engage

ment letter should reserve the investment bankers control

over the use of the opinion and any summary or description

of the opinion

The following additional procedures should be fol

lowed

The opinion should describe the matters considered

those statements relied upon without investigation those state

ments or matters that have been independently verified and the

inherent limitations if any of any procedures or standards

that have been used

The opinion should set forth any conflicts of

interest and the fee and describe all relations with the

client If the investment banker participated in the negotia

tion of the transaction this should be noted in the opinion

The opinion should be updated to the latest pos

sible date and if that date is prior to the date of the trans

action the opinion should set forth that it is as of specific

date and does not reflect matters thereafter

 Counsel for the investment banker should assist

in the due diligence review and advise as to the kind of back

up material which should be prepared

Independent verification of the key issue e.g

limitation on future growth of the business in repurchase

liquidation value in minority shareholder freezeout should

be made

where key issue is legal the opinion should

state that the investment banker has consulted counsel and re

lied on counsel with respect to such issue

where the opinion is to be used in conflict

transaction the investment banker should be satisfied as to

all the procedures to be used by the client such as committee

of independent directors vote of minority shareholders use

oct appraisers and other experts etc

The investment banker should not accept con

tingent compensation or any other arrangement that would im

peach its independence in rendering fairness opinion

If properly structured and supported by fair

ness opinion from an independent investment banker there

is virtually no corporate transaction no matter how many or

strong the conflicts of interest that cannot be accomplished

The foregoing provides basis for tailoring fairness

opinion for any situation The cardinal point is that the

fairness opinion must be tailored to each situation

standard forms will not work

Martin Lipton

8--
WACHTELL LIPTON ROSEN KATZ
May 24 1977

To Our Clients

Audit Committees

The increasing attention being focused on audit

committees occasions note of an SEC consent order in SEC
Killearn Properties Inc N.D Fla Civ No TCA7567
entered earlier this month which sets forth the SEC concep
tion of the functions of an audit committee The order
provides for an audit committee of three outside directors
having the following duties

should review the engagement of the inde

It
pendent accountants including the scope and general extent
of their review the audit procedures which will be utilized
and the compensation to be paid

It should review with the independent account

ants with
and the companys chief financial officer as well
as with other appropriate company personnel the general pol
icies and procedures utilized by the company with respect to
internal auditing accounting and financial controls The
members of the committee should have at least general
familiarity with the accounting and reporting principles and
practices applied by the company in preparing its financial
statements

It should review with the independent account

ants upon completion of their audit any report or opin
ion proposed to be rendered in connection therewith the
independent accountants perceptions of the companys finan
cial and accounting personnel the cooperation which the
independent accountants received during the course of their
review the extent to which the resources of the com
pany were and should be utilized to minimize time spent
by the outside auditors any significant transactions
which are not normal part of the companys business
any change in accounting principles all signifi
cant adjustments proposed by the auditor any recom
mendations which the independent accountants may have with
respect to improving internal financial controls choice
of accounting principles or management reporting systems

It should inquire of the appropriate company

personnel and the independent auditors as to any instances
of deviations from established codes of conduct of the com
pany and periodically review such policies
WACHTELL LIPTON ROSEN KATZ
24 1977
May

It should meet with the companys financial

staff at least twice year to review and discuss with them
the scope Of internal accounting and auditing procedures
then in effect and the extent to which recommendations
made by the internal staff or by the independent account
ants have been implemented

It should prepare and present to the companys

board of directors report summarizing its recommendation
with respect to the retention or discharge of the independ
ent accountants for the ensuing year

It should have the power to direct and super

vise an investigation into any matter brought to its atten
tion within the scope of its duties including the power to
retain outside counsel in connection with any such
investigation

Lipton
WACHTELL LIPTON ROSEN KATZ May 24 1977

To Our Clients

Tender Offers Acquisitions

to Block Takeover

The Anaconda acquisition of Walworth which created

an antitrust block to Cranes tender offer for Anaconda
provoked shareholder derivative action against the manage
ment of Anaconda under the federal securities laws on Rule
l0b-5 and 14e theories Holding that even if the
Walworth acquisition had no valid corporate purpose and was
in fact for the sole purpose of blocking the Crane tender
offer the management of Anaconda had only committed corporate
waste and breached its fiduciary duties which post Santa Fe
are matters left to state law and do not give rise to fedeil
securities law causes of action the court dismissed the
complaint Altman Knight CCH If96040 S.D.N.Y 1977
After Royal Industries and Milgo it was assumed that an
acquisition or the issuance of shares by target company to
block tender offer would be enjoined in federal court
action If Altman holds up targets may again gamble that
state courts will not enjoin defensive acquisitions or issuances
of shares and there could be resurgence of these defensive
techniques It continues to be our opinion that unless
there is reason for the takeover block acquisition
including blocking the takeover where that in itself is
reasonable business decision under the circumstances it
should not be attempted

Lipton
WACHTELL LIPTON ROSEN KATZ

September 28 1977

To Our Clients

Going Private LongForm Freezeout Mergers Delaware

Abandons Position that Appraisal is Exclusive Remedy

Despite recent cases in other jurisdictions to the

contrary until September 23 1977 it was generally assumed
that Delaware law was that absent fraud or blatant overreach
ing longform cash merger could be used to freezeout the
minority shareholders of subsidiary even though the freeze
out does not serve any corporate or business purpose of the
subsidiary and the minority has no voice in determining
whether the merger will be effected and the sole remedy of
the minority is an appraisal proceeding This was the direct
holding of the Delaware Court of Chancery in Singer Magna
vox Co 367 A.2d 1349 Del Ch 1976 However this deci
sion was reversed by the Delaware Supreme Court which held
that longform merger made for the sole purpose of freez
ing out minority stockholders is an abuse of the corporate
process Civ No 289 Del Sup Ct Sept 23 1977
The facts of the Magnavox case are important for
full understanding of the decision The case arose out of
hostile cash tender offer by North American Philips Corp
NAPC for all the shares of Magnavox at $8 per share at time
when the market price was substantially less than $8 Magna
vox opposed the NAPC tender on the ground that the price was
inadequate in light of the $11 per share book value of Magna
vox After the usual skirmishing management of Magnavox
reached an accomodation twoyear employment contracts at
their then salaries with NAPC which resulted in an increase
in the tender price to $9 per share and withdrawal of oppo
sition to the tender offer The tender offer stated NAPCs
purpose to acquire the entire equity of Magnavox and intent
to acquire any shares outstanding after the tender by merger
or other means The tender offer drew 84% of the Magnavox
shares and NAPC took full control of Magnavox few
months later NAPC caused Magnavox to enter into long
form cash merger agreement at $9 per share The corporate
action by Magnavox on the merger was taken without the use
of committee of independent directors and without an in
WACHTELL LIPTON ROSEN KATZ

dependent investment bankers opinion as to fair value No

corporate or business reason for the merger was advanced
other than the desire of NAPC to eliminate the minority and
to achieve full ownership of Magnavox The merger was sub
mitted to vote of the Magnavox shareholders at special
meeting Since NAPC owned 84% of the shares and did not
agree to vote in accordance with the vote of the minority
the minority vote was meaningless and as practical mat
ter the merger was effected by the sole action of NAPC.

The Chancery Court in Magnavox summarized the

Delaware law with respect to freezeout mergers as
unless minority shareholder could show fraud or blatant
overreaching on the part of the majority in eliminating his
stock interest through merger the merger itself and the
reasons for it were not subject to attack and mer
ger designed primarily to eliminate minority shareholders
was not an improper use of either longform or short
form merger provisions of the Delaware Corporation Law
The Chancery Court rejected the recent federal and state
cases e.g Green Santa Fe md Inc 533 F.2d 1283
2d Cir 1976 reversed 97 Ct 1292 1977 Berkowitz
Power/Mate Corp 342 A.2d 567 N.J Super 1975
Jutkowitz Bourns Civ No 000268 Cal Super Nov 19
1975 that invalidated freezeouts that were not justified
by business or corporate purpose of the subsidiary The
primary basis for rejection was the basic Delaware doctrine
that corporate transaction that is authorized by the
Delware Corporation Law is viewed as an independent trans
action that does not need any extrastatutory justification
motive is not significant if the transaction is specifi
cally authorized by statute In addition the court noted
that Power/Mate and Bourns involved going public high and
going private low and said

Admittedly there seems something funda

mentally inequitable about such stark pro
gression of events and perhaps use of the
Delaware statutes should not be permitted
which would allow those with controlling in
terests who originally sought public partici
pation to later kick out public investors for
the sole reason that they have outlived their
WACHTELL LIPTON ROSEN KATZ

utility to those in control and are made easy

pickings by existing market conditions How
ever if such an exception is to be made it
must wait for another day because according
to the complaint such situation does not
exist here 367 A.2d at 1358

The rationale of the Delaware Supreme Court in

Magnavox was almost directly opposite to that of the Chancery
Court First the Supreme Court held that the parent in
parentsubsidiary merger has fiduciary duty to the minor
ity shareholders of the subsidiary and that this fiduciary
duty cannot be met simply by relegating minority
shareholders to statutory appraisal proceeding In so
holding the Delaware Supreme Court accepted the reasoning
of the Bourns and Power/Mate cases that shareholders
rights are more than the mere assurance of fair value when
the majority shareholder decides to eliminate the minority
interest This reasoning constitutes clear retreat from
the modern investment concept of share ownership in public
corporations back to property right concept

The essence of the Delaware Supreme Court decision

is contained in these paragraphs

We hold the law to be that Delaware Court

will not be indifferent to the purpose of merger
when freezeout of minority stockholders on
cashout basis is alleged to be its sole purpose
In such situation if it is alleged that the
purpose is improper because of the fiduciary
obligation owed to the minority the Court is
dutybound to closely examine that allegation
even when all of the relevant statutory formal
ities have been satisfied

First it within the responsibility of

is
an equity court to scrutinize corporate act
when it is alleged that its purpose violates
the fiduciary duty owed to minority stock
holders and second those who control the
WACHTELL LIPTON ROSEN KATZ

corporate machinery owe fiduciary duty to

the minority in the exercise thereof over
corporate powers and property and the use
of such power to perpetuate control is
violation of that duty

By analogy if not fortiori use of

corporate power to eliminate the minority
is violation of that duty if done without
valid business purpose Accordingly
while we agree with the conclusion of the
Court of Chancery that this merger was not
fraudulent merely because it was accom
plished without any purpose other than
elimination of the minority stockholders
we conclude that for that reason it was
violative of the fiduciary duty owed by the
majority to the minority stockholder

We hold therefore that

merger made for the sole purpose of freez
ing out minority stockholders is an abuse
of the corporate process and the complaint
which so alleges in this suit states
cause of action for violation of fiduciary
duty for which the Court may grant such re
lief as it deems appropriate under the cir
cumstances

What is left of going private after Magnavox

Magnavox involved The

longform merger
longform was necessary because the
parent did not own 90%
or more of the subsidiary The opinion is expressly limited
to longform mergers and clearly does not affect shortform
mergers Therefore Delaware law continues to be that short
form mergers may be accomplished without business purpose
of the subsidiary and absent fraud or blatant overreaching
appraisal is the exclusive remedy of the minority share
holders Accordingly successive tender offers or other
voluntary acquisitions of shares followed by shortform
merger may continue to be used to eliminate minority owner
ship
WACHTELL LIPTON ROSEN KATZ

Magnavox involved cash freezeout not an

equity security merger While the opinion is not clear
based on the repeated use of cashout by the Court it
appears that this is distinction that the Delaware Supreme
Court may accept It is of course much easier to find
or construct business purposes when the minority share
holders continue to have an equity interest in the combined
enterprise

Despite dissent which criticized the failure

the Delaware Supreme Court in Magnavox refused to deal with
the question whether the requisite business purpose is that
of the parent or the subsidiary and instead rendered very
narrow opinion on the conceded fact of no business purpose
This at least leaves open the possibility that Delaware would
accept the elimination of conflicts and benefits of central
ization business purposes accepted in New York in Tanzer Eco
nomic Associates Inc Universal Food Specialties Inc
383 N.Y.S.2d 472 Sup Ct N.Y.Co 1976

The absence of the now customary procedures for

assuring fulfillment of fiduciary duties in conflict situa
tions while not specifically mentioned clearly was the
underlying rationale of the Magnavox decision We believe
that the result would have been different if the merger had
been approved by committee of independent directors upon
the advice of an independent investment banker that the terms
were fair from financial standpoint to the minority share
holders and if the merger was structured so that it would
have been approved only if majority of the minority share
holders voted in favor

While Magnavox makes going private more difficult

in our opinion going private is not dead We think the courts
will continue to recognize the practical business financial
and economic advantages of going private and will continue
to permit going private transactions which are accomplished
with the appropriate safeguards of the rights of the minority
shareholders noted above

Magnavox emphasizes that the minority shareholder

freezeout is the most sensitive of corporate transactions
and should only be undertaken in compliance with procedures
designed to assure the establishment of complete discharge
of the parents fiduciary duty to the minority shareholders
of the subsidiary

Lipton
Wr.!HTELL. LIPTON, ROSEN & KATZ -2- August 5, 1976

7. Filing of Schedule 14D-l. In addition to the SEC and

the target, a Schedule 14D-l would have to be filed with the
appropriate exchange for a listed target or the NASD for an
OTe target.

8. Post-offer purchases. Purchases during the 40 days

after the end of a tender offer would in effect be prohibited
except for a second tender offer at no less than the original
tender price.

9. Creeping tender offers. The SEC has invited' comment on

whether there should be a 40 day rule for pretender offer
purchases.

10. Preemption of state statutes. The SEC has not done

anything affirmatively to preempt the state takeover statutes.
However, philosophically and literally the new rules are
antithetical to the state statutes and bolster the argument
that the Williams Act preempts the state statutes.

M. Lipton
LIPTON ROSEN KATZ

August 14 1978

TO Our Clients

Tender Offers Fiduciary Duties of the Targets

of

been exonerated from lia

The Gerber directors have
bility for their successful defense
against the Anderson
Clayton tender offer Products CCH Fed
Sec Rep 96506 WD
Mich July 19 1978
direct holding on the issue of the liability of
is the first
targets
board if it successfully resists tender offer The court
held that even where the tender offer price is substantial and
there has been no determination that it is unfair or inadequate
the directors of the target may defend on the ground that the
offer violates the securities laws or the antitrust laws and
that such defense does not breach their fiduciary duty to the
shareholders The court said Far from violating the fidu
ciary duty imposed on them Gerbers directors were seeking
protection of statutorily established right It has been
noted moreover that corporate management has an affirmative
duty not to refrain from bringing actions under circumstances
like those present here but to oppose offers which in its
best judgment are detrimental to the company or its stock
holders

The basic holding of the case can be sum

marized as Where directors of target act in good faith
and exercise reasonable business judgment they are free to
reject tender offer and bring litigation to enjoin it even

though the price is not inadequate or unfair

The case also held that failure of the direc

tors of target to entertain proposals for White Knight deals
was not action in connection with any tender offer and there
fore not within Section 14e of the Williams Act that Section
14e is limited to deception and disclosure and does not
determine the fiduciary duties of the directors of target
that integrity of management of raider is material disclo
sure item in tender offer and sensitive payments are disco
verable in detail and must be disclosed with particularity

780052
WACHTELL LIPTON ROSEN KATZ

that wheretender offer is resisted on the ground of illegal

ity and statement is made as to the adequacy or fairness
no
of the price the failure to disclose the opinion of the
targets investment banker that the price is substantial
and market and earnings information was not material omis
sion and that the Williams Act does not impose an affirmative
duty on the directors of target to respond to tender offer

Lipton
Takeover Bids in the Target's Boardroom

By MARTIN LIPTON*

The heightened level of takeover activity during the past five years' has
focused attention on the legal, moral and practical questions faced by the
directors of a company that becomes the target of an unsolicited takeover bid. 2
While as far as is known no director has ever been held liable for the rejection
of a takeover bid, almost every successful takeover defense results in share-
holder lawsuits against the directors of the target.3 Such decided cases as there
*Member, New York Bar. Mr. Lipton's associates, Meyer Koplow and Bruce Rosenblum
assisted in the preparation of this article. Much of what-is said in this article is based on Lipton &
Steinberger, Takeovers & Freezeouts (1978) (reviewed in 34 Bus. Law. 2021), of which Mr.
Lipton is coauthor.
The terms "takeover bid," "target" and "raider" are used in this article for clarity; there is no
pejorative intent.
1. According to the W.T. Grimm Co. 1978 Merger Summary there were 325 acquisition
proposals for public companies announced in 1978, an increase of 22% over 1977. Where the price
was disclosed 24% were $100 million or larger.
2. One commentator has described the director's dilemma as follows:
Attempts by the manager to reconcile the many conflicting interests is impossible. Among
the goals the executive may pursue are 1) the shareholders' receiving a fair price for their
shares, 2) the corporation's obtaining or maintaining good management, 3) the economy's
producing goods and services more efficiently, 4) the general public's becoming better able to
interact with powerful corporate institutions, and 5) his keeping his job. Suggestions that a
corporate executive can always resolve this great dilemma ignore reality. A takeover creating
a large, powerful corporation may give advantage to shareholders and improve economic
efficiency, yet threaten further the ability of the individual to survive in our increasingly
institutionalized society. Stopping a takeover may save the executive's job, maintain good
management, and save individualism, yet cause the corporation to shrivel in the shadow of its
larger competitors and thereby harm the shareholders.
There are no easy answers for management here, no suggested ranking of the relative
importance of the conflicting goals of management, shareholders, and society.
Bowers, It's A Raid! Strategies for Avoiding Takeovers, 3 Wharton Magazine 22, 28 (Summer
1979).
Shareholders of companies that have rejected takeover bids sometimes charge "that most
board members, particularly those from the management side, are only concerned with keeping
their jobs, and will set up any kind of roadblock to keep tender offers from reaching shareholders
directly, regardless of the financial benefits." Feinberg, The Directors' New Dilemma, in The
Takeover Crisis: A Special Report, Institutional Investor, 32, 45 (June 1979). Faced with such
charges, "directors from target companies often say that they're caught in the middle between
their primary duty to shareholders and their ancillary responsibility-though one they believe to
be almost equally important-to the corporation as a whole and its future as a business
enterprise." Id. at 46. See also, Heat on Directors, Barron's, July 30, 1979, at 4, col. I ("it's still
difficult to tell precisely what's expected of a director ... in the event of a tender offer").
3. See e.g., Labaton v.'Universal Leaf Tobacco Co., 77 Civ. 119 (CMM) (S.D.N.Y. Aug. 2,
1979); Panter v. Marshall Field & Co., 80 F.R.D. 718 (1978); Berman v. Gerber Products Co.,
454 F. Supp. 1310 (W.D. Mich. 1978); Grossman, Faber & Miller, P.A. v. Cable Funding Corp.,
[1974-1975 Transfer Binder] Fed. Sec. L. Rep. (CCH) 94,913 (D. Del. 1974). See also, In re
Sunshine Mining Co. Securities Litigation, 77 Civ. 4020 (S.D.N.Y. May 25, 1979) summarized

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102 The Business Lawyer; Vol. 35, November 1979

are sustain the right of the directors of a target to reject a takeover on the
grounds of inadequacy of price,4 illegality of the offer,' illegality of the
acquisition of control of the target by that raider,' and concern with the
impact of the takeover on the employees of the target and the community in
which it operates. 7 However, the debate continues to rage.8 The following are
the principal questions:
1) Must the directors accept any takeover bid that represents a sub-
stantial premium over the current market?
2) When faced with a takeover bid should the directors declare an open
auction and seek to sell the company to the highest bidder?

in 509 Sec. Reg. & L. Rep. (BNA) A-9, which held that even if it were assumed that the directors
of a target were selfishly motivated in rejecting a takeover, there is no shareholder cause of action
under the federal securities laws against the directors; the shareholders' rights are governed by
the applicable state corporation law.
4. See Anaconda Co..v. Crane Co., 411 F. Supp. 1210, 1215 (S.D.N.Y. 1975) ("[Ijt is clear
... that a businessman could make a proper business judgment [on the basis of an investment
banker's report] to recommend rejection of the Crane [tender] offer."); Northwest Industries,
Inc. v. B.F. Goodrich Co., 301 F. Supp. 706, 712 (N.D. II1. 1969) ("[M]anagement has the
responsibility to oppose offers which, in its best judgment, are detrimental to the company or its
shareholders."). Cf. Kaplan v. Goldsamt, 380 A.2d 556, 568 (Del. Ch. 1977); Danziger v.
Kennecott Copper Corp., N.Y.L.J., Dec. 7, 1977 at 7, col. 1, aff'd on the opinion below, 400
N.Y.S.2d 724 (1st Dept. 1977) (both cases holding that directors may rely on investment
banker's reports in determining whether to make an offer to purchase stock at a certain price).
5. E.g., Berman v. Gerber Products Co., supra n. 3, at 1318-23 (target with "legitimate
concerns" about raider's possible violations of securities laws in making offer did not violate
fiduciary duty in bringing action against raider to halt tender offer); Consolidated Amusement
Co. v. Rugoff, [1978 Transfer Binder] CCH Fed. Sec. L. Rep. (CCH) 96,584, at 94,475,
94,478 (S.D.N.Y. 1978); Copperweld Corp. v. Imetal, 403 F. Supp. 579 (W.D. Pa. 1975).
6. E.g., Berman v. Gerber Products Co., supra n. 3; Gulf & Western Industries, Inc. v. Great
Atlantic & Pacific Tea Co., 356 F. Supp. 1066 (S.D.N.Y.), affd, 476 F.2d 687 (2d Cir. 1973);
Allis-Chalmers Manufacturing Co. v. White Consolidated Industries, Inc., 414 F.2d 506 (3d Cir.
1969), cert. denied, 396 U.S. 1009 (1970); Humana, Inc. v. American Medicorp., Inc.,
[1977-1978 Transfer Binder] CCH Fed. Sec. L. Rep. (CCH) 96,286, at 92,823, 92,833
(S.D.N.Y. 1978).
7. See e.g., Herald Co. v. Seawell, 472 F.2d 1081 (10th Cir. 1972). In Herald, the court
expressly held that directors-at least directors of certain kinds of corporations such as
newspapers-have an obligation to "employees, and to the public," in addition to their duty to
stockholders. Thus the directors in that case were justified in averting a takeover which they
believed would have "an adverse impact on the character and quality" of the newspaper, and
would lead to "poor relations with employees .. " Id. at 1092. See also American Rolling Mill
Co. v. Commissioner, 41 F.2d 314 (6th Cir. 1930); Armstrong Cork Co. v. H.A. Meldrum Co.,
285 F. 58 (W.D.N.Y. 1922) (both cases holding that it is within legitimate business purpose of
corporations to make contributions and establish programs for the benefit of employees and the
community in which the corporation operates); Dodd, For Whom Are Corporate Managers
Trustees? 45 Harv. L. Rev. 1145 (1932) ("those who manage our business corporations should
concern themselves with the interests of employees, consumers, and the general public, as well as
of the stockholders"); Blumberg, Corporate Responsibility and the Social Crisis, 50 Boston U. L.
Rev. 157 (1970).
8. See e.g., The Takeover Crisis: Special Report, Institutional Investor, June 1979, at 32;
Wyser-Pratte, Takeover Panel Needed to Protect Shareholders, N.Y.L.J., Jurne 4, 1979, at 25,
col. 5; Fortune, March 12, 1979 at 159 (interview with William Klein II).

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 Takeover Bids in the Target's Boardroom • 103

3) Should the directors consider the impact of the takeover on employ-

ees, customers, suppliers, the community; indeed is national policy a
proper consideration?
4) Do the shareholders of the target have a right to- decide for
themselves no matter what the directors believe to be the best
interests of the target as a business enterprise?
5) May the directors ignore a clear antitrust issue or litigate a minor
antitrust issue; may the directors litigate other issues such as failure
to comply with the disclosure requirements of the federal securities
laws?
6) May the directors adopt a policy that the company will remain an
independent business entity and authorize management to reject any
overtures or feelers?
7) May the directors build an antitakeover fence picketed with shark-
repellent charter amendments and specially lobbied local takeover
laws?
8) May the directors authorize a standstill arrangement with a big
brother who buys 20 percent of the target in order to block a
takeover or authorize a premium purchase of shares of the target
from a potential raider who has accumulated them in the market?
9) Are the management directors of the target so infected with self-
interest that they are disqualified from participating in the ultimate
decision to accept or reject a takeover bid?
10) Must an investment banker opine that a takeover bid is inadequate
to justify rejection by the directors of the target?
11) Should a company and its directors prepare to deal with a takeover
bid, if one were in the future to be made, by consulting in advance
with experienced investment bankers and legal counsel?
12) Is a takeover bid so significantly different from other major business
questions that the usual rules governing directors must be displaced
by rules unique to takeovers?
It is believed that experience and common sense prove that:
1) Directors should not be forced to accept any takeover bid that is at a
substantial premium and the usual rule that directors may accept or

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104 • The Business Lawyer; Vol. 35, November 1979

reject a takeover bid if they act on a reasonable basis and in good

faith should continue.9
2) Takeover bids are not so different from other major business
decisions as to warrant a unique sterilization of the directors in favor
of direct action by the shareholders. 0
Many of the lawsuits and much of the agitation for changes in the existing
rules come from certain arbitrageurs and professional investors whose short-
term perspectives are not in accordance with the long-term interests of other
shareholders and other constituencies of corporations and who do not share
the concern of corporate management with the need for long-term planning in
a high technology economy. 1 It would not be unfair to pose the policy issue as:
Whether the long-term interests of the nation's corporate system and econ-
omy should be jeopardized in order to benefit speculators interested not in
the vitality and continued existence of the business enterprise in which they
have bought shares, but only in a quick profit on the sale of those shares? The
overall health of the economy should not in the slightest degree be made
subservient to the interests of certain shareholders in realizing a profit on a
takeover. Even if there were no empirical evidence that refuted the argument
that shareholders almost always benefit from a takeover (as noted below, the
empirical evidence is to the contrary) and even if there were no real evidence,

9. E.g., Panter v. Marshall Field & Co., supra n. 3; Berman v. Gerber Products Co., supra n.
3; Klaus v. Hi-Shear Corp., 528 F.2d 225, 233-34 (9th Cir. 1975); Heine v. Signal Cos.,
[1976-1977 Transfer Binder] Fed. Sec. L. Rep. (CCH) T 95,898, at 91,311, 91,322 (S.D.N.Y.
1977); Northwest Industries, Inc. v. B.F. Goodrich Co., supra n. 4, at 711-12; Cheff v. Mathes,
199 A.2d 548, 554-56 (Del. 1964); Scott v. Stanton Heights Corp., 131 A.2d 113, 116 (Pa. 1957)
("other considerations ... may weigh in the appraisal of the offer which the ordinarily prudent
businessman would accept than money price alone"). See generally, E. Folk, The Delaware
General Corporation Law, 75-76 (1972).
10. Most modern corporation statutes provide that "the business and affairs of a corporation
shall be managed by the board of directors." N.Y. Bus. Corp. Law § 701. See also, Model Bus.
Corp. Act. § 35; Del. Corp. Law § 141 (a); Ill. Bus. Corp. Act § 33. Directors routinely make the
decision whether or not to enter into contracts or embark on new business ventures. In general,
questions of policy and management are left to the decision of the directors. See generally, Abbey
v. Control Data Corp., (Current) Fed. Sec. L. Rep. (CCH) 96,721 (D. Minn. 1978); 2 W.
Fletcher, Cyclopedia of the Law of Private Corporations § 505. In particular, directors may
borrow money, id. § 515; mortgage and lease property, id. §§ 516, 521; make purchases and sales,
id. §§ 517, 518; issue stock and determine dividends, id. §§ 523, 526; file voluntary proceedings in
bankruptcy, id. § 532; and institute suits, id. § 535. Such decisions may have as great an impact
on the corporation as the decision to oppose a tender offer. See text accompanying nn. 59-60,
infra.
I1. Arbitrageurs such as Bache Halsey Stuart Shields' Guy Wyser-Pratte have been in the
forefront of those suggesting, for example, that shareholders vote on proposed tender offers and
that an independent "takeover panel" oversee offers. See Wyser-Pratte, N.Y.L.J., June 4, 1979,
at 25, col. 5; Feinberg, The Directors' New Dilemma in The Takeover Crisis, supra n. 8, at 45-46.
Takeover battles, particularly those that escalate into "bidding wars," have been a "bonanza" for
arbitrageurs and similar short-term speculators. See, Carborundum Stake May Be Bonanza For
Broker Who Foresaw Bidding War, Wall St. J., Nov. 28, 1977, at 4, col. I; Arbitrage: It's the
Hottest Game in Town. Bus. Week, Jan. 17, 1977, at 71.

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Takeover Bids in the Target's Boardroom 105

but only suspicion, that proscribing the ability of companies to defend against
takeovers would adversely affect long-term planning and thereby jeopardize
the economy, the policy considerations in favor of not jeopardizing the
economy are so strong that not even a remote risk is acceptable.

Role of Directors
Before turning to an analysis of the specific questions, it is helpful to review
briefly the role played by directors in the corporate governance system as it
exists today. Our corporate governance system is structured similarly to our
national government. Ultimate power rests with the shareholders who cannot
act directly but only through their elected representatives-the directors. The
directors are elected annually and both state and federal law provide mecha-
nisms which enable the shareholders either to change the composition of the
board of directors or' to instruct the directors to take action desired by the
shareholders.'2 Directors are considered to owe a fiduciary duty to the
shareholders-that is, they are supposed to act as prudent businessmen, in
good faith and on a reasonable basis to assure that the business of the
corporation is operated for the benefit of its shareholders." Corporation laws
generally permit directors to rely on reports prepared by management and by
outside experts such as lawyers, accountants and investment bankers, in
discharging the directors' duties. 4
In the early years of this century almost the sole focus of the directors of a
corporation was its shareholders. Efforts to broaden the concerns of directors
to include employees, consumers, the community, the environment and the
national welfare have reached full fruition only during the last 20 years. It is
now well settled through legislation and court decisions that corporations:
a) must protect the environment,' 5
16
b) must protect the health and safety of employees,
c) must protect the pensions of employees, 7
d) must produce safe products and replace products found to have
defects, 8

12. E.g., Model Bus. Corp. Act § 28; N.Y. Bus. Corp. Law § 602; Del. Corp. Law § 211(d)
(provisions for special meetings of stockholders). SEC rule 14a-8 requires management to include
in its proxy statements certain kinds of proposals submitted by shareholders.
13. E.g., Singer v. Magnavox Co., 380 A.2d 969 (Del. 1977); Cheff v. Mathes, supra n. 9;
Model Bus. Corp. Act § 35; N.Y. Bus. Corp. Law § 717; Cal. Corp. Code § 309.
14. E.g., Model Bus. Corp. Act. §§ 35, 48; N.Y. Bus. Corp. Law § 717; Del. Corp. Law
§ 141(e).
15. See 42 U.S.C.A. §§ 7401-7642 (1978 Pamphlet) (Environmental Protection Act).
16. See 29 U.S.C. §§ 651-678 (1976) (Occupational Safety and Health Act).
17. See 29 U.S.C. §§ 1001-1381 (1976) (Employee Retirement Income Security Act).
18. See 15 U.S.C. §§ 2051-2081 (1976) (Consumer Product Safety Act).

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106 * The Business Lawyer; Vol. 35, November 1979

e) may make charitable contributions from corporate funds, 19

f) may spend corporate funds, or assign employees to engage in activi-
ties, for the betterment of communities in which the corporation
operates,"
g) may organize political action committees."
The movement to further the interests of the community, employees, the
environment, consumers and perceived national policy at the expense of
maximum profits and maximum benefit to shareholders has not abated. In
addition to the specific legislation and court decisions reflected above, the
concept of federal chartering of major corporations for the purpose of assuring
their adherence to national policy continues to be advanced. 2 Our present
system of corporate governance places the directors at the center of corporate
decisionmaking and has expanded the corporation's responsibilities to safe-
guard interests broader than those of shareholders alone.

Contrary to Popular Belief Shareholders Usually Win When a Takeover Is

Rejected
Central to an analysis of the questions posed at the outset is an examination
of the ultimate effect on shareholders when a corporation rejects a takeover.
Contrary to popular belief on Wall Street, the decision to accept or reject a
takeover is not so heavily weighted in favor of acceptance that as a matter of
experience it can be said that the shareholders are always disadvantaged by
rejection. The 36 unsolicited tender offers that were rejected and defeated by
the target between the end of 1973 and June 1979 (believed to be all such
tender offers filed with the SEC during this period) show that the shares of
more than 50 percent of the targets are either today at a higher market price
than the rejected offer price or were acquired after the tender offer was
defeated by another company at a price higher than the offer price. This is
particularly true with respect to those tender offers that were defeated prior to
1978.23 Eight of the 36-four where on the basis of market price as opposed to
rejected offer price the shareholders of the target won as a result of the
successful defense; and four where on the same basis the shareholders lost-
have been selected as illustrations. While neither these illustrations nor

19. E.g.. A. P. Smith Manufacturing Co. v. Barlow, 98 A.2d 581 (N.J. 1953), appeal
dismissed, 346 U.S. 861; Theodora Holding Corp. v. Hendersen, 257 A.2d 398 (Del. 1969); Cal.
Corp. Code § 802(g); Del. Corp. Law § 122(9), (12); N.Y. Bus. Corp. Law § 202(a)(l2).
Virtually all states have similar provisions. See Blumberg, supra n. 7, at 167, 192-202, 208-10.
20. E.g., American Rolling Mill Co. v. Commissioner, supra n. 7; Huntington Brewing Co. v.
McGrew, 112 N.E. 534 (Ind. App. 1916). See generally, Blumberg, supra note 7.
21. See 2 U.S.C. §441b (1976).
22. See Nader, Green & Seligman, Constitutionalizing the Corporation: The Case for the
Federal Chartering of Giant Corporations (1976).
23. See Exhibit A.

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 Takeover Bids in the Target's Boardroom • 107

Exhibit A distinguishes between cash tender offers and exchange offers and
while the amounts and securities values have not been adjusted to present
values or for interim dividends, it is 4pparent that the basic point is clearly
established: the shareholders of more than 50 percent of the targets are better
off today than if the defeated tender offer had succeeded. The following table
shows the target, the raider, the date the offer was announced, the market
price of the target one month and one week before the announcement, the
price offered and the price at August 10, 1979 for the eight tender offers
chosen as fllustrations:
Market Market Price
I Month t Week Offer August
Target Raider Date Prior Prior Price 10, 1979
Dictaphone Northern Electric 9/24/74 $ 7.12 $ 8.37 $12.00 $28.0024
Foremost McKesson Sharon Steel 5/17/76 15.50 16.62 27.00 24.00
Gerber Products Anderson, Clayton 8/1/77 29.75 32.62 37.00 28.12
Marshall Field Carter Hawley Hale 2/1/78 32.7525 29.62 42.00 17.87
Mead Occidental Petroleum 8/11/78 21.50 23.25 35.00 26.75
Sabine Hamilton Brothers 9/22/76 21.50 22.19 30.00 40.12
Sterndent Cable Funding 2/13/75 8.75 9.25 14.00 21.62
Universal Leaf
Tobacco Congoleum 10/8/76 12.13 11.94 16.25 23.25

There are no readily available studies which show the results of rejected
takeover bids which did not reach the actual tender offer stage. Personal
experience leads to the belief that the Viacom International illustration is not
atypical. In January, 1977 when Viacom was selling for $10 per share, Storer
Broadcasting offered $20 per share for a "friendly" takeover. Viacom rejected
the offer. In August, 1979 the market price of Viacom was more than $30 per
26
share.

24. Acquired by Pitney-Bowes for $28.00 per share in 1979.

25. Prior to a previous offer by Carter Hawley Hale, the market for Marshall Field was $22
per share.
26. Another illustration of the win-some, lose-some nature of takeovers is a comparison of the
offer by United Technologies in 1977 for Babcock & Wilcox with the offer by United
Technologies in 1978 for Carrier. See, United Technologies Makes a Bid For All Babcock &
Wilcox Stock, Wall St. J., March 30, 1977, at 3, col. 1; United Technologies Will Bid $510
Million for Babcock's Stock, N.Y. Times, March 30, 1977, at § IV, p. 1, col. 6; Wall St. J., Nov.
13, 1968, at 30-31 (tombstone announcement of United Technologies' Offer to Purchase;Carrier
offer). The Babcock offer was $42.00 per share as compared to an average 30-day preoffer market
of $32.65. The Carrier offer was $28 as compared to an average 30-day preoffer market of $24.30.
In each case the target was advised by Morgan Stanley that the offer was inadequate. In each case
the target raised an antitrust defense (in each case the Government also brought an antitrust
case) and after several months of legal proceedings, including trial of the antitrust proceedings,
the offer was allowed to be made. See Babcock & Wilcox Co. v. United Technologies Corp., 435
F. Supp. 1249 (N.D. Ohio 1977); Carrier Corp. v. United Technologies Corp., [1978-2 Transfer
Binder] Trade Cas. (CCH) 62,393 (N.D.N.Y. Dec. 6, 1978), affd, [1978-2 Transfer Binder]
Trade Cas. (CCH) 62,405 (2d Cir. Dec. 18, 1978). In the Babcock situation a white knight, J.
Ray McDermott, acquired the target for the equivalent of $65 per share. In the Carrier situation
United acquired Carrier at the original $28 offer price. Babcock built the reactor involved in the
Three Mile Island incident and the McDermott stock issued to Babcock shareholders at a value of
$65 at the end of June 1979 had a market value of $53.25.

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Two further points should be noted in determining the impact of rejection of

a takeover bid on the shareholders of the target. First, the experience of the
past five years shows that the stock n-orket has been valuing most companies
at between 50 percent and 662/3 percent of what they are worth to someone
acquiring control and also that the premiums that acquirors are willing to pay
for companies have been increasing continuously during this period.27 There-
fore unless there has been a material downturn in the business of a target that
has rejected a takeover, even if the market price of its stock has not caught up
with the offer price, there has been no change in the fundamental value of the
target and it could today be sold for more than the rejected offer price.28 The
proper comparison is not between the price of the stock in the market and the
rejected offer price, but between the rejected offer price and the amount that
could be obtained otherwise upon the sale of the entire company. While the
damage suits that have been brought against directors of targets that have
rejected takeovers are premised on the supposed loss to shareholders resulting
from the difference between the offer price and the market price, if the
directors were to be found to have acted wrongly, the proper measure of
damages should not be the difference between the market price and what was
offered, but between what was offered and the true value at that time.29 Only if
it were assumed that the raider was acting contrary to its self-interest and
proposing to pay more than true value, would there have been any damage to
the shareholders of the target that could be recoverable in such a lawsuit.
Second, in about 95 percent of the cases where a company has been acquired
after initially having resisted an unsolicited takeover bid, the shareholders
have ended up with a higher price than the original offer.30 One court has
expressly held that it is appropriate for the target to resist a tender offer by
litigation for the purpose of gaining time to get the best deal possible for the
shareholders."1
Experience does not prove that the shareholders of the target are better off
if the target accepts a takeover bid. Experience shows that from the standpoint
of whether the shareholders win or lose, the decision to accept or reject is
about 50/50 on market price alone and, if sale value today as opposed to
yesterday's rejected offer price is used as the basis of comparison, the

See also, Shareholder Beware! Takeovers Don't Pay, The (London) Sunday Times, Oct. 1,
1978, at 61, col. 1.
27. See Ehrbar, Corporate Takeovers Are Here to Stay, Fortune, May 8, 1979, at 91.
28. See Dictaphone and Sterndent in chart at pp. 132-33, supra. Typically those companies
which become the subject of unsolicited takeover bids are just those which are perceived by the
raider as having bright prospects which are not adequately reflected in the market's current
valuation of the target's shares.
29. Cf Labaton v. Universal Leaf Tobacco Co., supra n. 3.
30. Unpublished study by Goldman, Sachs & Co. of 85 takeover bids during the period
January 1, 1976 to June 8, 1979.
31. See Commonwealth Oil Refining Co. v. Tesoro Petroleum Corp., 394 F. Supp. 267,
274-75 n. I (S.D.N.Y. 1975).

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 Takeover Bids in the Target's Boardroom • 109

shareholders have profited in the overwhelming majority of defeated take-

overs. There is no empirical evidence to support an absolute requirement that
the directors of a target accept any takeover bid. The fact that a raider chooses
for its economic purposes to make a takeover bid does not mean that the
directors of the target have a fiduciary obligation to cause a sale of the
company either to the raider or a white knight which outbids the raider.

Requiring Acceptance of Any Takeover Bid is the Equivalent of Mandating a

Periodic Decision to Sell or Liquidate
There is no logical distinction between a requirement that directors accept
any takeover bid that represents a substantial premium over market and a
requirement that the directors determine annually whether it would be
possible to sell or liquidate the company at a'substantial premium over market
and that, if possible, the directors do so. The fact that a raider has taken the
initiative is no basis for distinction. If the directors have an obligation to sell
whenever a substantial premium is available, it should make no difference who
initiates the activity. Indeed, if that is the rule, the directors should not al'ait a
raider's initiative, but are required to take the initiative themselves. Nor is the
greater certainty created by a takeover bid as compared to the directors'
assessment of what might be realized on sale or liquidation a basis for
distinction. The skill and sophistication demonstrated by the major invest-
ment bankers in finding white knights or auctioning major companies like
Carborundum32 and General Crude 33 prove that the advice of such a banker as
to saleability and price is, for the purpose of this type of assessment by the
directors, as certain as an unsolicited takeover bid made by a third party.
What, then, would be wrong with a requirement for annual assessment by
the directors as to whether the company should be sold or liquidated? First, it
shortens the directors' perspective to the present and forces them to ignore the
long term. It defies common sense and ordinary business practices to mandate
that a company be sold today for a substantial premium even though the
directors believe it could be sold in the future for a larger premium, or that
future market value plus interim dividends have a greater present value than
the premium price now available. Second, a requirement for an annual life or

32. See, Carborundum Stake May Be Bonanza for Broker Who Foresaw Bidding War, Wall
St. J., Nov. 28, 1977, at 4, col. I; Carborundum Deal Created Suspense, N.Y. Times, Nov. 21,
1977, at 60, col. 1. For an account of the Carborundum bidding war see, Control Battle for
Carborundum Emerges as Eaton Enters Picture, N.Y. Times, Nov. 3, 1977, at § IV, p. 1, col. 5;
Eaton Officially Offers $47 a Share for Carborundum, N.Y. Times, Nov. 10, 1977, at § IV, p. 1,
col. 2; Kennecott Offers $66 a Share in Bid for Carborundum, N.Y. Times, Nov. 16, 1977, at
§ IV, p. I, col. 6; Directors Approve Kennecott's Offer for Carborundum, N.Y. Times, Nov. 17,
1977, at § IV, p. 1, col. 4.
33. See, Mobil Oil Said to Prepare Offer for General Crude, N.Y. Times, Mar. 15, 1979, at
§ IV, p. I, col. 1; Would-Be Acquirers Line Up for Change at General Crude, N.Y. Times, Mar.
18, 1979, at § Ill, p. 15, col. 2; Mobil Bids $765 Million For General Crude Oil, N.Y. Times,
Mar. 23, 1979, at § IV, p. I, col. 4.

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death assessment would have a fundamental impact on the way in which

corporations operate. Executives, employees, customers, suppliers and others
dependent on doing business with the company would have no assurance of
continuity. The scramble by each of these constituencies to protect against
sale or liquidation would cause major disruptions in the manner in which
business is now conducted. These disruptions would favor the short term at the
expense of the long-term planning that is essential in a high technology
economy. Third, there is no reason to believe that the experience with
mandated annual life or death assessments would be any different than the
experience with rejection of unsolicited tender offers. In sum, there is no
empirical evidence or logic to support a requirement that sale or liquidation of
the company be treated any differently from any other major business
decision.
In this era of takeovers the directors of a company may find that it is good
business management to take steps to assure employees, suppliers, customers
and communities in which the company operates that the company intends to
continue its current business policies and to that end intends to remain in
independent entity and not be taken over. The adverse reaction of authors and
editors to the Houghton Mifflin 34 and McGraw-Hill 5 takeover attempts
illustrates that this may be particularly appropriate where a company is
heavily dependent on highly paid and mobile employees. These assurances
may take the form of a company policy not to engage in merger discussions;36 a
charter amendment requiring the directors to consider the interests of employ-
ees, customers, suppliers and others when considering a merger or takeover
bid;37 charter amendments designed to deter unsolicited takeover bids; 38 and

34. See, Authors Protest Conglomerate Deal, N.Y. Times, Apr. 20, 1978, at § 111, p. 17, col.
5. The authors' protest was instrumental in thwarting Western Pacific's takeover attempt. After
receiving numerous letters from authors, Western Pacific chairman Howard (Mickey) Newman
came to the conclusion that "I'm going to buy this company and I ain't going to have nothing."
See, The Takeover Crisis, supra n. 8, at 40.
35. See, McGraw-Hill Bid Stirs Editorial Fears, N.Y. Times, Jan. 14, 1979, at 51, col. 3;
Friendly, McGraw-Hilland a Free Press, Wall St. J., Jan. 16, 1979, at 14, col. 4. As was the case
with Western Pacific, American Express was eventually persuaded that McGraw-Hill was a
"people company," and that, given the reaction of authors and editors, "there wasn't going to be
anything left when they took over." See The Takeover Crisis, supra n. 8, at 35.
36. See I Lipton & Steinberger, Takeovers & Freezeouts 69, 290 (1978).
37. McDonald's Corporation recently added charter amendments charging directors with
considering "the social, legal and economic effects on franchises, employees, suppliers, customers
and business" when confronted with a takeover bid. See. McDonald's Proposes increased
Protection Against Takeover Bids, Wall St. J., Mar. 30, 1979, at 10, col. 2. Control Data
Corporation had previously adopted a similar charter amendment. See, Control Data Asks
Holders to Approve Antitakeover Step, Wall St. J., at 17, col. 2; Cuniff, Supplementary Material
from New York Times News Service and the Associated Press, October 12, 1978. The Control
Data charter provision reads as follows:
The Board of Directors of the Corporation, when evaluating any offer of another party to
(a) make a tender or exchange offer for any equity security of the Corporation, (b) merge or
consolidate the Corporation with another corporation, or (c) purchase or otherwise acquire
all or substantially all of the properties and assets of the Corporation, shall, in connection

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 Takeover Bids in the Target's Boardroom * 111

migration to a state with laws that inhibit unsolicited takeovers.39 In addition,

a company may make special provisions in employment contracts, employee
with the exercise of its judgment in determining what is in the best interests of the
Corporation and its stockholders, give due consideration to all relevant factors, including
without limitation the social and economic effects on the employees, customers, suppliers and
other constitutents of the Corporation and its subsidiaries and on the communities in which
the Corporation and its subsidiaries operate or are located.
See Lipton & Steinberger, supra n. 36, at 65-66.
38. One such amendment is a provision requiring a supermajority vote to approve any business
combination with a person owning a specified percentage of the company's shares. See Lipton &
Steinberger, supra n. 36, at 266-71 (1978). The efficacy of such provisions is the subject of
debate. See id. at 266; Securities Week, June 26, 1978, at 9.
Rubbermaid, Inc. coupled a supermajority provision with an amendment giving shareholders
who do not tender shares during an offer the right to submit them for redemption-at the offer
price or the highest market price during the previous 18 months, whichever is higher-should the
raider obtain more than 50% of the company's stock. See, Rubbermaid Seeks Nod From Holders
on Plan to Deter Tender Bids, Wall St. J., Apr. 18, 1978, at 17, col. 2.
See also, Jewelcor Inc. v. Perlman, 397 F. Supp. 221, 231 (S.D.N.Y. 1975) (company's
"defensive strategy in the event of a tender offer" included charter amendments increasing the
number of directors, creating three classes of directors with staggered terms, and requiring a two-
thirds vote for repeal of the above provisions).
39. Three companies responding to a National Association of Accountant's survey stated that
they had made this complicated change. See National Association of Accountants, Takeovers:
The State of the Corporate Defense Art Q8 (1978).
Shark-repellent charter amendments, migration to a state with a strong takeover law and
similar actions, while legal and proper under the circumstances described in the text, may not be
desirable. There is great doubt as to the constitutionality of the state takeover laws. See Great
Western United Corp. v. Kidwell, 439 F. Supp. 420 (N.D. Tex. 1977), aff'd, 577 F.2d 1256 (5th
Cir. 1978), rev'd on other grounds, (Current) Fed. Sec. L. Rep. (CCH) 96,900 (U.S. Sup. Ct.
June 26, 1979). In addition, the SEC requires extensive disclosures with respect to shark-repellent
provisions; its views are set forth in Securities Exchange Act Release No. 15230 (October 13,
1978), reprinted in [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) 81,748. In general, the
SEC requires explicit statements with respect to the negative impact on the shareholders and the
benefits to management. The release details the nature of the disclosures the SEC will demand
with respect to supermajority voting provisions, staggered boards, special classes of voting stock,
and other shark-repellent provisions.
While the SEC release does not establish new disclosure requirements, it does serve to
emphasize the negative aspects of shark-repellent provisions. First, except in rare situations of
companies that would be attractive to bootstrappers, they are not a real practical deterrent to a
takeover attempt. Second, they cast doubt on the legitimacy of rejection of takeover proposals
that might be received in the future. Third, they advertise that the company fears that it is a
takeover candidate. Fourth, they may create a false sense of security. Fifth, there is danger
(particularly where there are large institutional holdings) that they will not receive the requisite
vote and thereby advertise that the shareholders are receptive to a takeover. See, PSA Inc. Is
Winner In Proxy Fight Tied to Curbing Takeovers, Wall St. J., Dec. 15, 1978, at 31, col. 3:
PSA Inc. won a hotly contested proxy fight over management's proposals to discourage
takeovers by 32,455 votes, or fewer than 1% of the 3,339,498 shares eligible to vote on the
issue.
The company, parent of Pacific Southwest Airlines, said it received 1,702,205 affirmative
votes, with 1,148,136 votes cast against. It needed a majority of shares outstanding to make
the changes in its certificate of incorporation. The changes will eliminate cumulative voting
for directors, institute staggered board terms and require an 80% shareholder vote for some
types of mergers involving holders of at least 20% of PSA stock. Under cumulative voting,
each holder has as many votes as the number of his shares multiplied by the number of
directors up for election. He may concentrate, or distribute, these votes and thus can gain
board representation even with a relatively small minority interest.

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benefit plans and material agreements with customers and suppliers to assure
against abrogation or change in the event of a takeover." ° In connection with
the question whether the directors of a target may consider constituencies
other than the shareholders in passing on a takeover bid, it should be noted
that the Carter Administration in connection with proposed legislation
designed to rescue Chrysler Corp. insisted that Chrysler show that its
shareholders, employees, suppliers and others are making maximum sacri-
fices.4 1 If employees, suppliers and others must participate in rescuing a
company from bankruptcy, it is hard to argue that they should be ignored
when the question is a takeover that will benefit the shareholders.

There Is No Requirement to Negotiate or Sell

If we accept the premise that directors should not be compelled either to
assess annually the continuance of the company as an independent entity or
accept any substantial premium opportunity to sell or liquidate, and that it
may be important to the good management of the business of the company to
provide assurances against a takeover, we answer some of the questions with
which we started. It follows that:
1) A company need not have a perpetual "for sale" sign on its front lawn,
i.e., there is no requirement that the management or the directors
engage in acquisition discussions at another person's initiative;42 on
the contrary, a company may have an express policy of continuing as
an independent business enterprise.
2) The directors are not required when faced with a takeover bid to
declare an auction and seek to sell the company to the highest bidder.
PSA also denied a request by the leading opponent of its proposals to review the balloting,
and said it would file the new certificate immediately.
Harold Simmons, who owns about 20% of PSA's stock and led the fight to block the
antitakeover measures, said in a telephone interview from Dallas, "We're definitely going to
challenge; we demand the right to inspect the ballots." He said that "it's unusual" for a
certificate to be filed immediately after such a close vote, and "I'm told by my attorneys that
1% of the votes normally are challengeable," he said.
40. See Freedman v. Barrow, 427 F. Supp. 1129, 1154 (S.D.N.Y. 1976). Placement of
reasonable provisions in such plans and contracts is fully consistent with the directors' fiduciary
duties. Assurance of fair and adequate treatment of officers, employees, customers and suppliers
in the event of a takeover is a major factor in the consideration of any takeover proposal. Such
provisions are not in the category of shark repellents designed to entrench management but are
just the opposite-reasonable provisions designed to protect important constituents of the
company and assure full and fair consideration of the takeover proposal.
41. Financing Unit ofChrysler Sets Receivables Sales, Wall St. J., Aug. 13, 1979 at 3, Col. 1:
"Treasury Secretary G. William Miller made clear last week that the burden is on the company to
produce a workable plan, including the 'substantive contributions or concessions' that are to be
made by the auto-maker's management, employees, bankers, stockholders and others."
42. Such discussions are often misperceived by the potential acquiror and result in unwanted
takeover offers. Disclosure of such discussions (usually "leaks") may have the same type of
unsettling effect on employees, customers, suppliers and communities as an unsolicited takeover
bid.

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 Takeover Bids in the Target's Boardroom • 113

3) A company may make special provisions, such as full vesting and

immediate cash-out in the event of a change of control, in its
employee stock option and other benefit plans to protect the benefi-
ciaries in the event of a takeover.
4) A company may attempt to discourage takeovers through such tactics
as shark-repellent charter amendments and lobbies for takeover laws
that have the same effect.

A Shareholder Referendum Is Not the Answer

Assuming that a raider makes a firm takeover offer at a substantial
premium, must the directors ignore questions as to the adequacy of the price,
the legality of the acquisition, the impact on employees, customers, suppliers,
communities and national policy and let the shareholders decide for them-
selves?
In pursuing this discussion it will be assumed that the holders of a majority
of the shares of the target would accept the offer. This has been the experience
in almost every tender offer during the past five years. One prominent
exception was the 1976 tender offer by Airco for Unitek at a 30 percent
premium which resulted in Airco acquiring less than 22 percent of the Unitek
shares. 3 Only a few substantial companies in addition to Unitek have been
successful in convincing their shareholders not to accept a tender offer. The
failure of management to convince shareholders not to accept a tender offer is
the result of several factors. First, the special dynamics of a tender offer are
such that the decision of shareholders is almost always a foregone conclusion
-they will tender, therefore, it is misleading to speak of a free shareholder
choice at all. The existence of an offer to acquire a controlling interest in a
company makes it almost impossible for a shareholder in the target to
prudently retain his shares unless he does so for the purpose of exchanging
them in a promised subsequent tax-free exchange. Once a raider has acquired
control-and target shareholders must assume that the raider will acquire
control-it is highly unlikely that shareholders will receive a higher price than
that initially offered: since there is no possibility of a competing offer at a
higher price, the public trading market (if one still exists) will have been
capped at the price offered in the tender offer and the raider is not likely to
offer more for the target's shares once it has achieved control. Retaining the
target's shares in the face of a tender offer will bring the shareholder no
benefit. He is likely to be forced out through a merger at a later date for the
43. See Wall St. J., May 10, 1976, at 16 (tombstone announcement of Airco Offer to Purchase
at $30 per share). Airco received only 15% of Unitek's shares in response to the tender offer. See,
Airco Acknowledges It Failed in Attempt to Acquire Unitek, Wall St. J., June 8, 1976, at 42, col.
2. Through subsequent purchases, Airco increased its holdings to 21.7%. See Wall St. J., March
22, 1977, at 21, col. I. Morethan a year after the Airco offer at $30 per share Unitek was acquired
by Bristol-Myers for $59.14 per share in a negotiated merger; another example of the sharehold-
ers winning by the rejection and defeat of a takeover.

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114 • The Business Lawyer; Vol. 35, November 1979

same price he could have realized upon the initial offer. 4 The outcome of a
shareholder referendum conducted in the form of a tender offer cannot
realistically be said to reflect a careful appraisal of the merits or demerits of
the offer. Each individual shareholder must look to his own interest and must
pragmatically assume that most other shareholders will tender with the result
that the nontendering shareholder will be left in a minority, illiquid invest-
ment position. Thus, any uncoerced decision against acceptance of a tender
offer can only be made at the board of directors level.
The second factor which accounts for acceptance of tender offers by
shareholders is the shift of equities from individuals to professional investment
managers during the last 30 years; a shift that has closely paralleled the
growth of institutions such as pension funds, private foundations and mutual
funds. Today, practical control, i.e., 20 percent to 50 percent of the stock of a
large number of major corporations is held by professional investors. As
predicted by A.A. Berle, we have now reached the tertiary stage of capitalism.
Control of American business passed from the founder-shareholders to the
professional managers who held sway until the 1970s and now, at least in the
sense of ability to control in the event of a tender offer or proxy contest, to the
professional managers of pension funds, foundations and mutual funds.4 5 In
addition to the holdings of the institutional investors, professional and
amateur arbitrageurs will frequently purchase 10 percent to 50 percent of the
shares of a target. While some of the arbitrage stock comes from the
institutions, it is not infrequent that the institutions and arbitrageurs together
quickly end up with a greater than 50 percent interest in a target and thus
have the ability to determine its destiny. It is rare for a target to survive as an
independent company after such a situation develops.
The only interest of the arbitrageur is in a quick sale at a profit. Some of the
institutions may have a longer investment perspective, but in the competition
to demonstrate performance among professional investment managers, the
lure of improving performance and the ability of tax-exempt funds to realize
gains without incurring any tax almost always results in a decision to sell even
when there is no more attractive long-term investment available. Frequently
this decision to sell is motivated in part by a desire to avoid becoming a
minority holder-often with a loss of market liquidity-in a target that will be
controlled by the raider. This is so even where the control is less than 50%.

44. See e.g., Singer v. Magnavox Co., supra n. 13. See also Borden & Weiner, An Investment
Decision Analysis of Cash Tender Offer Disclosure, 23 N.Y.L. Sch. L. Rev. 553 (1978);
Schwartz, Response: Some Thoughts on the Directors' Evolving Role, 30 Hast. L. Rev. 1405,
1406 n. 1 (1979).
45. See generally Berle, The Modern Corporation Revisited, 64 Colum. L. Rev. 1410 (1964);
Berle & Means, The Modern Corporation and Private Property (1932); W. Cary, Corporations
229-37 (4th ed. unabridged 1969). See also Wellman v. Dickinson, [Current] Fed. Sec. L. Rep.
(CCH) 96,918 (S.D.N.Y. July 9, 1979).

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 Takeover Bids in the Target's Boardroom * 115

In sum, an unsolicited tender offer is often successful not because a majority

of the shareholders of the target determine that it is a good acquisition, but
because the dynamics of a tender offer trigger motivations by different
minority segments of the shareholder body, such as those who:
a) believe that once the raider gets control it will probably move to
obtain 100% ownership and it is unlikely that they will be able to
realize any more for their shares than the takeover price;
b) need to show performance;
c) desire to avoid a loss of market liquidity;
d) believe that the raider is not a good manager;
e) desire not to be a minority shareholder in a controlled company;
f) have a tax incentive to sell;
g) fear poor treatment on a second step freezeout by the raider;
that in aggregate creates an ad hoc consortium of sellers of a majority of the
shares of the target. The United Technologies Corporation tender offer for
Carrier illustrates this point.46 The tender offer, which was vigorously opposed
and litigated by Carrier, was oversubscribed even though United Technolo-
gies had initially announced its willingness to negotiate a merger at a higher
price than the tender offer price.
Even in the face of such an ad hoc consortium, the necessity from
technological, social and economic standpoints for long-term planning by
business requires a policy decision in favor of not mandating decisions that
ignore or penalize long-term planning. Rather than forcing directors to
consider only the short-term interests of certain shareholders, national policy
requires that directors also consider the long-term interests of the sharehold-
ers and the company as a business enterprise with all of its constituencies in
addition to the short-term and institutional shareholders. There would be a
compelling argument for this result even if experience had proven that all
takeovers turned out better for the shareholders of the target if they sold at the
takeover price. Since experience proves that the decision to sell or remain
independent is not clear, and that even when measured by comparing the
rejected offer price with the market price, in more than 50 percent of the
rejected takeovers the shareholders did better by the target remaining
independent. There is no reason to remove the decision on a takeover from the
reasonable business judgment of the directors. On the contrary, the policy
considerations are overwhelmingly in favor of specific recognition that the
directors not only have the right to make takeover decisions based on their

46. See discussion in n. 26, supra.

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116 * The Business Lawyer; Vol. 35, November 1979

reasonable business judgment, but that macrosocioeconomic issues must be

considered along with the long-term interests of the shareholders and the
company as a business enterprise.
If the shareholders are dissatisfied with the directors' rejection of a takeover
bid, they have the right, through the normal proxy machinery, to replace the
directors or to instruct the directors to accept a takeover bid. This right,
however, should not be translated into an absolute requirement that the
directors pass to the shareholders the direct right to accept or reject any
takeover bid. To do so would be the equivalent of mandating sale whenever an
unsolicited takeover bid is made.
The proponents of direct reference to the shareholders point out that the
usual procedure on a merger is for the directors to approve the merger
agreement and refer the matter to a shareholder vote. 7 The proponents argue
by analogy that substantially the same procedure should be followed with
respect to unsolicited takeover bids and the directors should have the right, if
they are so minded, to issue strong advice to reject the takeover. In the case of
a merger, however, nonapproval by the directors means that it is not
submitted to the shareholders. There is not, and there should not be, any
requirement that, just because a raider requests approval or nonopposition by
the directors of the target, they accede to the request without making the same
study and determination they would make in the case of a negotiated merger.
Where the only issue in a tender offer is price, our present legal structure
permits a raider, after compliance with the applicable federal and state laws,
to short-circuit acceptance by the directors of the target and to make its offer
directly to the shareholders of the target. The shareholders then have the
power, independent of the directors, to determine whether or not to accept the
offer. Even under the most far-reaching of the state takeover statutes, no
tender offer has been blocked on the question of price.48 The decisions are
uniform that where there is a cash tender offer, the state will not determine
what is a fair premium but will leave that determination to the shareholders.4 9

47. E.g., Model Bus. Corp. Act § 73; N.Y. Bus. Corp. Law § 903; Del. Corp. Law
§ 251(b), (c).
48. The general attitude of the state securities commissions has been to "rely on the market
mechanism to assure fairness as to cash tender offers .. " In re EZ Paintr Corp., [1971-1978
Transfer Binder] Blue Sky Rep. (CCH) 71,063, at 67,318 (Wisc. Comm'r Sec., 1973).
49. See n. 43, supra; In re Elkhart Lake's Road America, Inc., 3 Blue Sky Rep. (CCH)
71,410 (Wisc. Comm'r Sec., 1977) ("We will not substitute our subjective evaluation of the
shares' worth for that of the market"); In re Proposed Acquisition of CNA Financial Corp. by
Loews Corp., Findings, Conclusions and Recommendations, Hearing No. 1522 (111.Dept. Ins.
July 30, 1974) (" 'fairness' is an elusive concept at best and the decision of each stockholder ... to
sell or hold his securities is as good an evaluation as any"); In re Hein-Weiner Corp., 3 Blue Sky
L. Rep. (CCH) 71,448, at 68,473, 68,479 (Wisc. Comm'r Sec., 1979) ("It is not the province of
the Commissioner to determine whether a proposed takeover offer is desirable from a social or
economic standpoint or whether the interests of the state or local community, or the employees or
management of the target company, might be adversely affected by a successful takeover"). See
generally Lipton & Steinberger, supra n. 36, at 254-58.

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 •
Takeover Bids in the Target's Boardroom 117

If that is the law and that is what has happened, why the issue? Primarily,
because price is rarely the only issue. Most major takeovers raise other issues
such as:
a) antitrust,"
b) regulatory approval,51
c) disclosures (actually failures to make material disclosures) by the
raider,"
d) conflict of interest by those advising or financing the raider,"
54
e) impact on constituencies other than the shareholders of the target,
f) poor quality of the raider's securities in an exchange offer. s5

50. E.g., Berman v. Gerber Products Co., supra n. 3; Babcock & Wilcox Co. v. United
Technologies Corp., supra n. 26; Carrier Corp. v. United Technologies Corp., supra n. 26.
51. See e.g., Babcock & Wilcox Co. v. United Technologies Corp., supra n. 26 (question of
need for approval of Nuclear Regulatory Commission). Examples of offers raising potential
regulatory problems include the 1977 offer by Northwest Industries, Inc. for The Coca-Cola
Bottling Company of Los Angeles (possible need for FCC approval; see Lipton & Steinberger,
supra n. 36, at 170), the American Express offer for McGraw-Hill (possible need for FCC
approval; see, American Express Gets a Loan, New York Times, Jan. 12, 1979, at § IV, p. 1, col.
4; McGraw-Hill Replies to Suit, N.Y. Times, Jan. 25, 1979, at § IV, p. 5, col. 6), and the recent
attempts to buy National Airlines (possible need for CAB approval; see, Airline Files to Control
National Air, N.Y. Times, July 29, 1978, at 23, col. 3; Separate Study Set on Eastern Air's Bid
For National Air, Wall St. J., Dec. 22, 1978, at 8, col. I). See generally Lipton & Steinberger,
supra n. 36, at 169-72.
52. E.g., Berman v. Gerber Products Co., supra n. 26; Jewelcor Inc. v. Pearlman, supra n. 38,
at 233.
53. E.g., Humana, Inc. v. American Medicorp, Inc., supra n. 6 (alleged conflict of interest of
investment banker); Washington Steel Corporation v. TW Corp., Civ. No. 79-0166 (3d Cir. July
20, 1979) (alleged breach of fiduciary duty by financing bank). During the recent American
Express bid for McGraw-Hill, McGraw-Hill asserted that there were conflicts of interest as a
result of both the President of Amex' service on the McGraw-Hill board of directors, and the
participation of McGraw-Hill's bank, Morgan Guaranty Trust Company, in the financing of the
offer. See, McGraw Rift: Focus on Role of a Director. N.Y. Times, Jan. 18, 1979, at § IV, p. 1,
col. 3; McGraw-HillPuts Outside Directors in Legal Limbo, Wall St. J., Feb. 2, 1979, at 12, col.
3; McGraw-Hill Bid Raises Questions on Bank's Role, N.Y. Times, Jan. 23, 1979, at § IV, p. 1,
col. 1; Some Banks Accused of Conflicts of Interest in Hostile Takeovers, Wall St. J., Mar. 16,
1979, at 1, col. 6.
54. E.g., Herald Co. v. Seawell, supra n. 7 (impact of newspaper takeover on employees and
the community). See also text accompanying nn. 30-31 supra (adverse reaction of authors and
editors to attempted takeovers of Houghton Mifflin and McGraw-Hill).
55. E.g., Humana, Inc. v. American Medicorp, Inc., supra n. 6, at 92,823, 92,824; In re Pabst
Brewing Co., 3 Blue Sky L. Rep. (CCH) 71,415, at 68,354, 68,359-64 (Wisc. Comm'r Sec.,
June 6, 1978). During the recent exchange offer by Occidental Petroleum for Mead, Mead
contended that the Occidental securities offered in exchange were a "bad investment". See The
Takeover Crisis, supra n. 8, at 35.
At a recent NACD conference, NACD President 1. Cummings advised directors to consider,
when faced with a tender offer, such price related factors as whether the current market price was
depressed and whether a better bid might be expected, and such non-price related factors as the
effect of the offer on joint ventures, financing arrangements, and relationships with customers,
suppliers, creditors and employees. See, Heat on Directors,supra n. 2, at 4.

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In a negotiated merger these issues are sorted out in the screening and
negotiating stages. One or more of these issues frequently cause the demise of
a merger that both parties desire. In an unsolicited tender offer there is no
opportunity to fully evaluate and negotiate them and, as noted above, the
dynamics of the tender offer, as distinguished from the negotiated merger
where there is an opportunity for careful advance consideration by the
directors, assisted by counsel, accountants, investment bankers and other
experts, often resulting in the holders of a majority of the shares of the target
being coerced into accepting the tender offer without full exploration and
consideration of the issues. In addition the directors of the target must take
into account the impact on the target if they fail to take action to block a
tender offer which they believe is or may be illegal and such tender offer is in
fact subsequently enjoined or otherwise determined to have been illegal. 6 The
failure of the target to attempt to defeat a tender offer which is later blocked
by government or other action may result in loss of key employees, disaffection
of customers and suppliers and other problems, with the result that the
business of the target is damaged and the shareholders never get the opportu-
nity to sell at the tender offer price. One possible result of such a situation
might be a large arbitrage position, sufficient to determine control of the
target, that is dumped by the arbitrageurs and purchased by a new raider, at a
low price, who then is able to take over the target at a lower price than could
have been obtained if the target was able to seek a buyer. The target of an
unsolicited tender offer must successfully litigate or be faced with a fait
accompli in much less time than a reasonable study of the same questions
takes in a negotiated merger." Thus the directors of the target are faced with
two basic questions beyond price:

56. See nn. 59 and 65, infra.

57. Wachtell, Special Tender Offer Litigation Tactics, 32 Bus. Law. 1433 (1977), describes
the lightning-fast timetable which governs in tender offer litigation:
You are operating in a pressure atmosphere where you have constant surprise. You have
very little turnaround time. The company goes running for counsel: help us. You have to
commence litigation immediately. You have to get out your deposition notices. You have to
make your motions for expedited discovery. You have to set up your teams for taking what
could be two or three sets of simultaneous depositions, often in different cities. You have to be
prepared to flow all the information you're getting from depositions and documents into
affidavits and briefs almost simultaneously with the taking of the depositions and the review
of the documents. You have to be scheduling your applications for temporary restraining
orders, stays, preliminary injunctions and the like. You are essentially compressing into a
span of four, five or six days what would normally be months and months, if not years, of
typical big case litigation, including analysis of antitrust ramifications, industry studies,
competitive lines of products and the like. It is unique.

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 Takeover Bids in the Target's Boardroom • 119

Should (or must) they consider the legality and other policy aspects of
the takeover (or an aborted takeover) or merely close their eyes and leave
it to the shareholders and the government?5"
Should (or must) they consider the impact of the takeover (or an
aborted takeover) on constituencies other than the shareholders and is
this an independent justification for rejection?
After five decades of continuous efforts both to raise the consciousness of
directors with respect to antitrust, disclosure and other issues of national
policy, and to impose on corporations and their directors obligations to
employees, customers and communities, it is impossible to contemplate a rule
that would vitiate these concerns when the question is solely whether the
shareholders may have an opportunity immediately to realize a premium over
the current market price for their shares. It can be argued that the directors

58. E.g., when the directors of Reliance Electric Co. were recently confronted with a proposed
tender offer by Exxon Corp. they decided neither to endorse nor oppose the offer, maintaining that
"the stockholders of Reliance should determine for themselves whether to accept the offer if and
when made by Exxon." See, Reliance Electric Doesn't Oppose Exxon's Proposal, Wall St. J.,
June 13, 1979, at 6, col. 1. In contrast, the board of Carrier Corp. fought United Technologies'
proposed tender offer by, among other things, filing an antitrust action. See Carrier Corporation's
Notice of Special Meeting of Stockholders, July 5, 1979. The government did indeed seek to
enjoin the Exxon offer for Reliance. The following excerpt from an affidavit Felix G. Rohatyn
submitted on behalf of Reliance in FTC v. Exxon Corp., No. 79-1975 (D.C.D.C. 1979) illustrates
the point made in the text that the impact on the target of a determination that a tender offer is
illegal may be severe:
6. We believe that if the purchase of the shares is not consummated by Exxon there will
be extremely confused trading in Reliance stock for an indefinite period. There is likely to be
heavy selling which would result in a drastic reduction of the price of Reliance stock. In such
a market, Reliance would be unable to make a satisfactory equity offering of the type which
had been an integral part of its financing program. This would make it necessary for Reliance
to achieve its refinancing, qt least at the first stage, entirely through a debt placement. This
would be significantly more costly to Reliance because of the inability of Reliance to improve
its equity base. In addition, Reliance would have reduced flexibility in future financial
planning. As the costs to the Company increase, Reliance's ability to compete effectively
would be negatively affected.
7. During the period following collapse of the proposed acquisition the volatile trading in
Reliance's stock would create a high level of probability that a third party, possibly foreign,
could obtain control of the Company by purchasing stock at distressed prices. The mere fact
that Reliance had experienced a substantial change in the composition of its shareholder
body and had been identified as a desirable acquisition target would increase the probability
that it would not be able to remain an independent entity following a failure to complete the
proposed acquisition by Exxon.
8. It is also apparent that if the purchase of the shares is not completed and litigation
continues, Reliance will be injured by the continuing uncertainty which will not only plague
its financial planning but will undoubtedly harm its ability to attract and retain qualified
personnel. As long as there is uncertainty about the future ownership and control of
Reliance, its management will lack both direction and incentive in planning and implement-
ing Reliance's future activities. As the uncertainty continues, Reliance will inevitably lose
ground as an effective entity in its areas of operation; a company in limbo cannot remain an
effective competitor.
Also see n. 61, infra.

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should and must consider these issues, 9 which are not for the shareholders to
decide directly any more than decisions to produce the Edsel, introduce Crest,
buy the Xerox patents, compete with IBM, or file a bankruptcy petition were
questions for direct answer by the shareholders of Ford, Procter & Gamble,
Haloid, GE, and W.T. Grant. A takeover bid is no different than any other
fundamental business decision. Many corporations annually or periodically
face decisions with respect to capital expenditures, new product introductions,
adoption of new processes, termination or disposition of businesses or bank-
ruptcy, 0 that may have as significant an impact on the market value of the
corporation as a takeover bid. As long as matters such as capital expenditures,
discontinuances of businesses and bankruptcy are for the reasonable business
judgment of the directors, there is no reason to put acceptance or rejection of a
takeover bid on any different basis.6 If the shareholders do not like the
directors' decisions, they have the right and power to change the directors.
What the Directors Should Do
If we accept the premises that the directors of a target do not have an
absolute duty to accept a takeover bid and that there is no absolute require-
ment that the question be referred for direct action by the shareholders, we are
left only with the questions as to how the directors of a target should approach
a takeover bid.
I) Are the management directors disqualified?
2) Should the independent directors or a committee of independent
directors obtain separate legal and investment banking advice?
3) Must an investment banker be consulted or may the directors reach
their own decision? .
4) May the directors litigate any legal issues that may exist, even minor
issues?
5) If the directors determine that the takeover is not in the best interests
of the target, may they acquire a company that would create an
antitrust or regulatory problem for the raider, issue additional shares

59. See e.g., Gould v. American-Hawaiian Steamship Co., F.2d 761, 776-77 (3d Cir. 1976)
(even disinterested directors are liable for failure to act to prevent violation of securities laws).
60. See n. 10, supra.
61. The courts have recognized in analogous areas that, even in extreme cases, the directors,
not the shareholders, must make the business decisions for the corporation. See e.g., Burks v.
Lasker, 99 S. Ct. 1831 (1979) (committee of independent directors can stop derivative suit
against other directors); Abbey v. Control Data Corp., supra n. 10 ("most important corporate
decisions are to be made by the corporation's board of directors," and thus committee of
independent directors can make decision to terminate derivative suit against other directors);
Auerbach v. Bennett, No. 323 (N.Y. July 9, 1979) (decision by committee of independent
directors to terminate derivative action is beyond judicial inquiry under the business judgment
doctrine).

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 Takeover Bids in the Target's Boardroom • 121

of the target to a big brother or purchase shares of the target at a

premium for the purpose of defeating the takeover?
6) What standard should govern the directors' determination?
There are some takeover bids so devoid of antitrust or other legal issues and
so attractive in price that no competent director would reject them. There are
some takeover bids-particularly partial offers and exchange offers-that are
so bad that only a negligent director would fail to oppose them. Our problem
rests not with the extreme takeover bids which are so rare that they do not
warrant special rules, but with the vast majority of takeover bids as to which
reasonable men may differ as to price or the other issues. As to these, so long
as the directors act in good faith and on a reasonable basis, their decision to
accept or reject a takeover bid should not be subject to being second guessed.
As noted above, as far as is known ho director has ever been held liable for the
rejection of a takeover bid and, if the guidelines set forth below are followed, it
is hoped that none ever will.
Since we are dealing with takeovers which by definition are within a broad
band of discretion, and since some might believe that there are conflicts
between management's self-interest in preserving the independence of a target
company and the directors' decision to accept or reject a takeover bid, it may
be helpful to follow those procedures which in other areas have proven to
eliminate or minimize conflicts and produce well founded objective decisions.
Thus:
A) Management (usually with the help of investment bankers and
outside legal counsel) should make a full presentation of all of the
factors relevant to the consideration by the directors of the takeover
bid, including:
(1) historical financial results and present financial condition
(2) projections for the next two to five years and the ability to fund
related capital expenditures
(3) business plans, status of research and development and new
product prospects
(4) market or replacement value of the assets
(5) management depth and succession
(6) can a better price be obtained now
(7) timing of a sale; can a better price be obtained later
(8) stock market information such as historical and comparative
price earnings ratios, historical market prices and relationship
to the overall market, and comparative premiums for sale of
control
(9) impact on employees, customers, suppliers and others that
have a relationship with the target

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(10) any antitrust and other legal and regulatory issues that are
raised by the offer
(11) an analysis of the raider and its management and in the case of
a partial offer or an exchange offer pro forma financial
statements and a comparative qualitative analysis of the busi-
ness and securities of both companies.
B) An independent investment banker or other expert should opine as to
6
the adequacy of the price offered and management's presentation. 1
C) Outside legal counsel should opine as to the antitrust and other legal
and regulatory issues in the takeover and as to whether the directors
have received adequate information on which to base a reasonable
63
decision.
D) If a majority of the directors are officers or otherwise might be
deemed to be personally interested, other than as shareholders, a
committee of independent directors, although not in theory neces-
sary, from a litigation strategy standpoint may be desirable. 64 The
exigencies and pressures of a takeover battle are such that it is
desirable to avoid proliferation of committees, counsel and invest-
ment bankers. The target will be best served if it is advised by one
investment banker and one outside law firm.
E) It is reasonable for the directors of a target to reject a takeover on any
one of the following grounds:
(1) inadequate price
(2) wrong time to sell
(3) illegality
(4) adverse impact on constituencies other than the shareholders

62. See e.g., Kaplan v. Goldsamt, supra n. 4, at 568 (to extent that directors relied on
responsible investment banker's reports, individuals cannot be held accountable for improper
conduct); Danziger v. Kennecott Copper Corp., supra n. 4, at 7, col. I, aff'don the opinion below,
400 N.Y.S.2d 724 (reliance on investment banker's report evidence of directors' thorough
consideration of transaction). The investment banker's opinion must be adequately prepared,
however. In In re Royal Industries, Inc., [1976-1977 Transfer Binder] Fed. Sec. L. Rep. (CCH)
95,863 (C.D. Cal. 1976), the court held that it was misleading for the target to include in a press
release the statement that it had been "guided" in its decision to reject the offer by an investment
banker's report, because the report had been prepared "virtually overnight and without the
necessary time and deliberation for a fair evaluation . "I.Id. at 91, 139-40.
See generally Lipton & Steinberger, supra n. 36, at 291-92.
63. Cf., Tannenbaum v. Zeller, 552 F.2d 402, 416-29 (2d Cir.), cert. denied, 434 U.S. 934
(1977) (in finding that directors of mutual fund did not breach fiduciary duty by decision to
forego recapture of brokerage commissions, court stressed that "every administrative, judicial
and legislative development pertaining to recapture" had been brought to board's attention, and
stressed need for advice of outside counsel). See also Leech & Mundheim, The Outside Director
of the Public Corporation 27 (1976).
64. See n. 51, supra.

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 •
Takeover Bids in the Target's Boardroom 123

(5) risk of nonconsummation65

(6) failure to provide equally for all shareholders
(7) doubt as to quality of the raider's securities in an exchange
offer.
Once the directors have properly determined that a takeover should be
rejected they may take any reasonable action to accomplish this purpose,"
including litigation," complaints to governmental authorities,68 the acquisi-
69
tion of a company to create an antitrust or regulatory problem for the raider,

65. Directors may properly take into account that even if the price is right, if the partner is
wrong because of legal or other problems, the takeover may be enjoined or abandoned by the
raider and the target may have suffered serious damage through employee, customer, or supplier
disaffections without the shareholders having enjoyed the premium they thought they would get.
This isa major factor in negotiated deals where one of the very early, if not first, steps is to
determine whether antitrust or other legal problems make the merger impractical. It is even more
important in takeover situations. See n. 59, supra.
66. See Northwest Industries, Inc. v. B.F. Goodrich Co., supra n. 4, at 712-13
("[Management has the responsibility to oppose offers which, in its best judgment, are
detrimental to the company or its stockholders.... After [making a carefully considered decision]
the company may then take any step not forbidden by law to counter the attempted capture");
Berman v. Gerber Products Co., supra n. 3, at 1323.
67. See n. 66, supra.
68. Cf., Leech & Mundheim, supra n. 63, at 25-27:
Despite ...obstacles to effective outside director action, it nevertheless may be desirable
to establish a committee of outside directors whose major function would be to determine,
from time to time, whether continuation of the fight against the tender offer makes sense.
Management would inform the committee about its reasons for contesting the tender offer
and about any other relevant facts. The committee would also meet separately with the
company's investment bankers and outside counsel. The separate meetings with the outside
professional consultants should help give the committee a sense of the available information
on which the conclusion to continue the fight is based. Moreover, the need to deal with the
outside directors and to answer their questions should remind the outside consultants of their
responsibility to the corporation and place on them the burden of furnishing full information
to the committee.
The committee of outside directors may also have to consider whether it will meet
separately with representatives of the offeror.
As set forth in the text we do not accept the Leech and Mundheim position. Indeed, we do not
believe that a takeover bid presents the type of self-interest conflict that warrants abstention by
the management directors or deference to an independent committee. See, Tyco Laboratories,
Inc. v. Kimball, 444 F. Supp. 292 (E.D. Pa. 1977): "Thus, this Court is required to decide whether
the directors' interest in retaining control allows for the corporation, as represented by its
shareholders, to be substituted for the board of directors, in the formula for determining whether
there has been a deception under section 10(b). This Court finds that the directors' interest in
retaining control is not a sufficient interest to permit this Court to change the formula."
69. E.g., Anaconda Co. v. Crane Co., supra n. 4; Altman v. Knight, 431 F. Supp. 309
(S.D.N.Y. 1977). But see, Royal Industries, Inc. v. Monogram Industries, Inc., supra n. 62, at
91,131, 91,136-37 ("If a tender offer target makes a defensive acquisition whose compelling
reason or sole, controlling or primary purpose is to block a tender offer, the acquired company or
its management violate ... their fiduciary duties to their shareholders .... ")

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the issuance of shares to a big brother," or the premium purchase of shares of

the target from the raider.71
While in theory there should be no distinction in judicial treatment of the
various tactics that may be selected by a target to defeat an unsolicited
takeover, the courts appear to be forging a pragmatic distinction. Where the
target asserts its legal rights through litigation and complaints to government
authorities the stahdard seems to be the business judgment rule." Where the
target issues stock to a big brother, buys a company to create an antitrust
block, purchases its shares from a raider at a premium or takes similar action,
the standard seems to be a primary purpose rule-the action will be sustained
unless the primary purpose was to keep the management in office rather than
to serve the best interests of the company and its shareholders.73 It may be
argued that where the primary purpose test has been applied, the cases really
turned on the courts' belief that the directors had not acted in good faith or on
a reasonable basis, but rather than reach those issues, the court based the
decision on the primary purpose test. Even where the courts have found a
defensive tactic to have been improper and held the management directors
who had a personal interest liable therefor, they have refused to find any
liability on the part of the outside directors who did not benefit.74 Where the
directors have made a reasonable good-faith decision to reject the takeover on
one or more of the bases set forth above, the business judgment rule should
apply equally to any and all defensive tactics.

The Directors Meet

The process of consideration by a board of directors of a takeover bid is
illustrated by the minutes of a recent meeting of the Board of Target
Corporation.
A special meeting of the Board of Directors of Target Corporation was
held at the office of the Corporation at 10:00 A.M. on June 25, 1979. All of the
directors were present. Also present were Mr. Thomas Thompson, Executive
Vice President-Finance; Mr. Karl Freeman, Executive Vice President and
General Counsel; Messrs. Robert Sachs and Stephen Redhill of Sachs,

70. See e.g., Northwest Industries, Inc. v. B.F. Goodrich Co., supra n. 4; Klaus v. Hi-Shear
Corp., supra n. 9. But see Applied Digital Data Systems, Inc. v. Milgo Electronic Corp., 425 F.
Supp. 1145 (S.D.N.Y. 1977) (target's sale of unissued shares for the purpose of defeating tender
offer violates § 14(e) if done without a valid business purpose).
71. E.g., Heine v. The Signal Cos., supra n. 9; Cheff v. Mathes, supra n. 9.
72. E.g., Berman v. Gerber Products Co., supra n. 3, at 1319-23; Humana, Inc. v. American
Medicorp, Inc., supra n. 6, at 92,823, 92,833; Anaconda Co. v. Crane Co., supra n. 4.
73. E.g., Cheff v. Mathes, supra n. 9, at 554-56; Anaconda Co. v. Crane Co., supra n. 4, at
1219-20; Podesta v. Calumet Industries, Inc., [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH)
96,433, at 93,549, 93,551-57 (N.D. Ill. 1978); Royal Industries, Inc. v. Monogram Industries,
Inc., supra n. 62, at 91,131, 91,135-38; Klaus v. Hi-Shear Corp., supra n. 9, at 233-34. See
generally Fleischer, Tender Offers: Defenses, Responses and Planning 83-85, 147-52 (1978).
74. E.g., Consolidated Amusement Co. v. Rugoff, supra n. 5, at 94,475, 94,485-86. See also
Cheff v. Mathes, supra n. 9, at 553 (discussing lower court decision).

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 Takeover Bids in the Target's Boardroom • 125

Morgan & Co., the Corporation's investment banker; Messrs. Joseph Lipton
and Martin Flom of Skadden & Wachtell, special counsel to the Corporation,
and Mr. Richard Martens of Cromwell & Polk, special counsel to Sachs,
Morgan & Co.
"The Chairman stated that the business of the Special Meeting was
consideration of the June 20, 1979 proposal by Raider Inc. to acquire all of the
shares of the Corporation for $75 per share in cash. He noted that prior to the
announcement of the June 20 proposal the market price of the shares was $40
and that the current market price is $68. He stated that this was one of the
most serious matters that the Board of Directors of the Corporation had ever
faced. He suggested that the Board take as much time as it deemed
appropriate and said that arrangements had been made to continue the
meeting through the day and thereafter if the Board so desired. He also
expressed the desire that each director reach his or her own individual
judgment and that no director feel in any way obligated to agree with the
management of the Corporation. He requested that each director feel free to
comment on the June 20 proposal and the presentations of the financial and
legal advisers and that each director feel free to raise questions at any time.
"The Chairman stated that since 9 of the 13 directors were not employed by
the Corporation and he and the other officer-directors did not feel any
personal conflict of interest, it was management's recommendation that the
June 20 proposal be considered by the Board as a whole and that it was not
appropriate to establish a special committee of outside directors for that
purpose. Mr. Freeman stated that in his opinion and that of Skadden &
Wachtell there is no legal requirement that the Board delegate consideration
of the June 20 proposal to a special committee or that the Corporation retain
investment bankers and legal counsel who have had no prior relationships with
the Corporation. The Board concurred unanimously in the management
recommendation.
"The Chairman and Mr. Thompson then presented and explained in detail
a summary of the Corporation's financial position, earnings and future
prospects, a copy of which was distributed to each director. At the conclusion
of this report, the Chairman stated that he and the management of the
Corporation had complete confidence in both the short-range and the long-
range future of the Corporation; that they believe this is not the time to sell or
merge the Corporation; that they believe Raider is not the appropriate partner
for the Corporation; and that they believe that if the Corporation were to
accept the June 20 proposal, there would be serious legal questions with
respect to a combination of the Corporation and Raider that would result in
long delay before consummation, with a high risk of nonconsummation of the
combination because of legal or regulatory prohibition, and that in the
interim, the business of the Corporation would have been seriously adversely
affected by the uncertainties created by the unresolved situation.

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126 • The Business Lawyer; Vol. 35, November 1979

"The Chairman then asked Robert Sachs of Sachs, Morgan & Co. to report
to the Board with respect to Sachs, Morgan's opinion of the June 20 proposal.
Mr. Sachs introduced his partner, Stephen Redhill, who had participated with
him since June 20 in a continuing study of the Corporation and Raider's
proposal. Mr. Sachs also introduced Richard Martens, partner of Cromwell
& Polk, special counsel to Sachs, Morgan. Mr. Sachs described in detail the
study that had been performed by Sachs, Morgan, including the extensive
work done for the Corporation prior to the assignment to study the June 20
proposal, and the Sachs, Morgan firm meeting held to discuss the June 20
proposal.
"Mr. Sachs stated that in the opinion of Sachs, Morgan, the June 20
proposal is inadequate from a financial viewpoint. Mr. Sachs further stated
that in the opinion of Sachs, Morgan, this is not the appropriate time to
undertake the sale or merger of the Corporation.
"Mr. Sachs then explained the analyses and procedures followed by Sachs,
Morgan in reaching its conclusion. Director Pell asked Mr. Sachs to describe
in more detail the factors that Sachs, Morgan studied and the methodology
employed in reaching its opinion. Mr. Sachs gave a lengthy and detailed
answer in which he described the various procedures followed by Sachs,
Morgan and referred to the various work sheets that had been used in the
Sachs, Morgan analysis of comparable acquisitions and the relative price
earnings ratios reflected by such acquisitions. Mr. Sachs referred to several
recent transactions and stated that in those transactions in which the acquired
company had a return on equity comparable to that of the Corporation, the
average price earnings ratio of the acquisition price was approximately 15
which would result in a substantially higher price for the Corporation than
$75. Mr. Sachs noted that in several instances of recent transactions where the
acquired corporation had a return on equity approximately 75 per cent of that
of the Corporation, the acquisition price was at an average price earnings ratio
that also would result in a price for the Corporation in excess of $75 per share.
Mr. Sachs noted that the Corporation ranked 29 among the Standard and
Poor's 425 industrial companies with respect to return on capital and that the
consistency between the Corporation's forecasts and actual results (indeed,
that results regularly exceeded forecasts) were highly favorable factors in
merger valuation and negotiation.
"Director Smith asked whether Sachs, Morgan had delivered to the
Corporation the analyses and other information used by it in its study of the
Corporation and Raider's proposal. Mr. Sachs stated that these were internal
working documents of Sachs, Morgan and not in form for delivery to the
Corporation, although they were present at the meeting and he would be
pleased to have the directors look at them and ask questions with respect to
them.

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 Takeover Bids in the Target's Boardroom * 127

"Director Tubbs asked Mr. Sachs whether Sachs, Morgan had taken into
account the public policy aspects of a sale of the Corporation to Raider. Mr.
Sachs replied that Sachs, Morgan confined its analysis to the financial aspects
and that its opinion was based only on its judgment with respect to the present
financial condition and future prospects of the Corporation and its judgment
with respect to the timing and manner by which the optimum sale price could
be achieved, if it were determined to sell or merge.
"Director Stone requested that Mr. Sachs explain the Sachs, Morgan view
of the Corporation from an investment standpoint. Mr. Sachs replied that
Sachs, Morgan believes the Corporation to be one of the best investment
opportunities available today. Based on the recent history of the Corporation,
Sachs, Morgan's opinion of the Corporation's management and personnel and
Sachs, Morgan's opinion of the various businesses in which the Corporation is
engaged, Sachs, Morgan believes that the Corporation will experience better
than average growth and market acceptance in the 1980's. Mr. Sachs stated
that if no takeover proposal had been made at this time and Sachs, Morgan
had been consulted with respect to whether the Corporation should seek a sale
or merger, Sachs, Morgan would have advised the Corporation that this is not
the time so to do. Mr. Sachs added that Sachs, Morgan was very impressed
with the planning and budgeting procedures followed by the Corporation and
that Sachs, Morgan has confidence in the Corporation's projections of future
earnings.
"Director Peters asked whether Sachs, Morgan had reached a determina-
tion as to what would be a fair price for the Corporation at this time. Mr.
Sachs stated that Sachs, Morgan had not made such a determination but that
Sachs, Morgan is of the opinion that a price higher than $75 per share could
be obtained at this time. Mr. Sachs also noted that Sachs, Morgan believes
that there are several companies that would be interested in acquiring the
Corporation for more than $75 per share and that if the Corporation
.experiences three more years of sustained growth, as predicted, the value of
the Corporation would be greatly enhanced.
"The Chairman asked Mr. Joseph Lipton to report on the opinion of
Skadden & Wachtell. Mr. Lipton introduced his partner, Martin Flom. Mr.
Lipton reviewed the opinion of Skadden & Wachtell, a copy of which had
previously been furnished to each director. Mr. Lipton also reviewed in detail
the legal issues inherent in a combination of Raider and the Corporation and
described why his firm felt that there was a substantial likelihood that those
problems would preclude the consummation of such a combination even if the
Corporation were to accept the June 20 proposal. Mr. Lipton concluded by
stating that the decision as to whether to accept or reject the June 20 proposal
was one that the directors should make based on their own judgment; that the
directors had before them an adequate basis on which to make the decision;
and that while it should be assumed that if the directors were to reject the June

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128 • The Business Lawyer; Vol. 35, November 1979

20 proposal, they would be named as defendants in shareholder lawsuits, they

would in his firm's opinion be acting entirely properly and within the law and
would not ultimately be held liable for such rejection.
"Director Lawton asked Mr. Lipton whether the Board could take the
position that it would not pass on the matter and make no recommendation to
the shareholders. Mr. Lipton replied that while on a narrow legal basis there
was no requirement that the Board take a position, in his opinion the issue is so
fundamental that the Board should take a position and that the Board should
either accept or reject the June 20 proposal. Mr. Lipton stated that the Board
should take all the time it felt appropriate to study and discuss the issue.
"Director Tubbs asked whether there were any precedents sustaining the
rejection of an acquisition proposal on the sole ground that there were serious
issues as to legality of a combination of the two companies. Mr. Lipton
referred to the Gerber case and described the court's decision in detail.
"Director Pell asked whether in the opinion of counsel it would be illegal to
accept the June 20 proposal. Mr. Lipton replied that his firm had not opined
on the issue of whether it would be illegal for the Board to accept the June 20
proposal; that, if the Board deemed, based upon counsel's opinion, that the
offer raised serious questions of legality, the issue of whether the Board would
nonetheless be entitled to accept the proposal could not be said to be free from
doubt. He said that the Board could take such serious legal questions and the
consequent risks of nonconsummation of the proposed transaction into ac-
count in reaching its overall business judgment determination as to whether to
accept or reject the June 20 proposal.
"Director Pell asked Mr. Lipton whether in the opinion of counsel the
directors had an adequate basis on which to reach a decision at this time or
whether the decision should be postponed. Mr. Lipton stated that the decision
itself and the time of the decision were solely for determination by the Board:
it was for the Directors to decide in their reasonable judgment how much time
was appropriate for them to consider the matter. As previously stated, it was
the opinion of counsel that the Board, if it should determine to go forward with
its decision, presently had an adequate basis on which to make such decision.
Mr. Lipton pointed out that the Board might wish to consider the potential for
misunderstanding by shareholders and the public of any delay in reaching a
decision and the impact on the market. The Chairman and several other
directors voiced concern as to the effect of delay upon employee morale as
well.
"Director Tubbs asked whether there were any issues which should be
considered by the Board that had not been mentioned. The Chairman stated
that he viewed employee morale and the impact on the Corporation of a
nonconsummated transaction with Raider to be of great significance. He
stated that the greatest risk of a transaction with Raider would be a collapse of
employee morale and, if ultimately there were to be no transaction with

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 •
Takeover Bids in the Target's Boardroom 129

Raider, as he believed would be the case, the Corporation would have been
seriously damaged without the shareholders having received the $75 price.
"Director Jones stated that on financial grounds he felt the long range
interest of the Corporation would be best served by rejecting the June 20
proposal. Additionally, he expressed deep concern about the conduct of
Raider in making its proposal in that Raider had obtained 80 percent of the
funds necessary for the acquisition from the Fifth National Bank which is the
principal bank for the Corporation and which had confidential information
about the Corporation and that Raider had just prior to making the proposal
attempted to hire the former Chairman of the Corporation as a consultant.
Director Jones stated that he was so troubled by the ethics of Raider that he
believed that Raider was not a company with which the Corporation should
negotiate or contract. Director Jones noted that the nonconsummation of the
transaction with Raider would be harmful to the Corporation in that he
believed that going forward with such transaction would have a serious
adverse effect on suppliers, customers and others on whom the Corporation is
dependent for both products and sales.
"The Chairman noted that, although some shareholders had been quoted in
support of the proposal, the Corporation had also received a number of letters
from shareholders who were opposed to an acquisition of the Corporation by
Raider.
"Director Jones asked whether if there was a new offer by a company other
than Raider, would the Board consider it. The Chairman stated that it was his
opinion that any bona fide offer must be considered by the Board and that if
any such offers were presented to him he would refer them to the Board. The
Chairman further stated that while he believes that it is important to its
business that the Corporation remain an independent entity, if a new offer was
extremely attractive from a financial standpoint, came from a responsible
company with good employee, customer, supplier and community relation-
ships, and there was a relatively low risk of nonconsummation of the
transaction, it would be his recommendation that such an offer be carefully
considered. The Chairman expressed his belief that an offer from the right
company under the right circumstances might be understood and accepted by
the employees, suppliers and customers and accordingly, there could be
circumstances where an acquisition would present only minimal risk of harm
to the Corporation and its shareholders if such a transaction were not
consummated.
"Director Tubbs stated that he felt that he had all of the information and
opinions necessary for him to reach a conclusion and that it appeared to him
that the other directors felt the same way.
"Director Tubbs moved that the June 20 proposal be rejected and this
motion was seconded by Director Jones. The Chairman requested legal

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130 • The Business Lawyer; Vol. 35, November 1979

counsel to state such resolution for consideration by the Board, which Mr.
Freeman did. The Chairman asked whether there was any further discussion.
"The Chairman called for a vote and the following resolution was unani-
mously adopted by an individual poll of the directors:
"RESOLVED that based on the advice of the Corporation's manage-
ment, legal counsel and investment bankers, the Board of Directors has
determined that the proposal by Raider to acquire the Corporation for
$75 cash per share of common stock as set forth in Raider's letter to the
Board of Directors, dated June 20, 1979, is not in the best interests of the
Corporation and its shareholders and that the Chairman of the Board is
authorized and directed to inform Raider that such proposal has been
rejected by the Board of Directors.
"There being no further business the meeting was adjourned at 4:00 P.M."

Conclusion
The answers to the questions with which we started are:
1) Directors are not required to accept any takeover bid that
represents a substantial premium over market.
2) When faced with a takeover bid the directors are not required to
declare an open auction and sell the company to the highest
bidder.
3) The directors should consider the impact of the takeover on
employees, customers, suppliers, and the community. National
policy is a proper consideration.
4) If the directors believe that a takeover is not in the best interests
of the company as a business enterprise, there is no requirement
that the takeover bid be submitted by the directors to the
shareholders.
5) The directors may not ignore clear legal issues. The directors may
litigate any issue which they reasonably believe to be pertinent.
6,7,8) A company may have a policy of remaining an independent
business entity. The directors may implement that policy with
shark-repellent charter amendments, standstill agreements, pre-
mium purchases from potential raiders, specially lobbied local.
takeover laws, and special provisions in employee benefit plans
and material contracts.

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 Takeover Bids in the Target's Boardroom • 131

9) While the management directors are not disqualified from partic-

ipating in the decision to accept or reject a takeover bid,
procedures should be followed that assure both the appearance
and the actuality of a good faith decision on a reasonable basis.
10,11) The advice of an investment banker as to the financial issues and
legal counsel as to the legal issues is desirable. Prior consultation
with investment bankers and legal counsel who have experience
with mergers and takeovers so that the company and its directors
are adequately prepared to deal with a takeover bid, if one should
happen, is also desirable.
12) The business judgment rule applies to takeovers in the same
manner as it applies to other major business decisions.
•) The fear of lawsuits should not deter directors from rejecting a
takeover that they believe not to be desirable.

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132 • The Business Lawyer; Vol. 35, November 1979

Defeated Tender Offers 1974 to June 1979*

Target Offering Company

(a) Missouri Portland Cement Co. Cargill, Inc.

ICM Realty Cabot, Cabot & Forbes Land trust
Towle Manufacturing Co. Nortek, Inc.
Funding Systems Corp. Equimark Corp.
(b) Latrobe Steel Co. Eastmet Corp.
(c) Dictaphone Corp. Northern Electric Co., Ltd.
RSC Industries, Inc. Hoskins Manufacturing Co.
(Armada Corp.)
(d) Sterndent Corp. Magus Corp. (Cable Funding Corp.)
(e) Vail Associates, Inc. Contran Corp.
(f) Inspiration Consolidated Copper Anglo-American Corp. of S. Africa
(g) GSC Enterprises, Inc. Sierra Capital Corp., Clyde Engle,
Robert Weston
Boyertown Burial Casket Co. Amedco, Inc.
National Paragon Corp. R. T. French Co.
Craddock-Terry Shoe Corp. Caressa, Inc.
Pargas, Inc. Empire Gas Corp.
(h) Unitek Corp. Airco, Inc.
Foremost McKesson Inc. Sharon Steel Corp.
(i) Braden.Industries, Inc. Valley Industries, Inc.
(j) Sabine Royalty Corp. Hamilton Brothers Corp.
Universal Leaf Tobacco Co., Inc. Congoleum Corp.
Baird-Atomic Xonics
Sonesta International Hotel Corp. Loews Corp.
Sonesta International Hotel Corp. Minneapolis Shareholders Group
Gerber Products Co. Anderson, Clayton & Co.
(k) Detroit International Bridge Wesco Financial Corp.
(1) Pabst Brewing Co. APL Corp.
(m) Electro-Nite Co. Yates Industries, Inc.
Property Trust of America Federated Reinsurance Corporation
Marshall Field & Co. Carter Hawley Hale Stores, Inc.
(n) Rowan Companies, Inc. CBI Industries, Inc.
Mead Corp. Occidental Petroleum Corp.
Wurlitzer Co. Xcor International Inc.
McGraw-Hill Inc. American Express Inc.
Ludlow Corporation AMBG Corporation
(o) Chicago Rivet & Machine Co. Mite Holdings Inc.
(p) Sunshine Mining Co. Hunt International Resources Corp.
F. W. Woolworth Co. Brascan Ltd.

*See p. 134 for footnotes to above exhibit

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 Takeover Bids in the Target's Boardroom • 133

EXHIBIT A
Market Price Market Price
One Mo. One Week Offering Market Price
Announcement Before Ann. Before Ann. Price Premium Aug. 10, 1979
12/19/73 $18.40 $17.80 $19.20 1.348x $30.000(t)
2/4/74 14.87 16.87 13.50 0.800 11.375
2/20/74 7.00 7.25 11.50 1.586 28.250
3/15/74 2.62 2.62 3.00 1.145 2.500
6/7/74 6.25 6.25 11.00 1.760 14.280(t)
9/24/74 7.12 8.37 12.00 1.434 28.000(t)
12/19/74 1.00 0.87 2.00 2.299 3.125

2/13/75 8.75 9.25 14.00 1.514 21.625

4/28/75 5.75 6.62 10.00 1.511 11.250
5/28/75 34.25 31.75 32.00 1.008 33.000(t)
6/12/75 1.00 1.25 1.50 1.200 1.150(t)

12/22/75 10.50 10.50 16.00 1.524 1.500(q)

3/24/76 8.50 8.50 12.75 1.500 2.375
4/7/76 6.75 6.75 9.50 1.407 10.375
5/5/76 13.00 15.37 18.50 1.204 18.500
5/7/76 24.00 23.12 30.00 1.298 59.140(t)
5/17/76 15.50 16.62 27.00 1.625 24.000
6/29/76 5.12 4.75 7.25 1.526 7.000(r)
9/22/76 21.50 22.19 30.00 1.352 40.125(s)
10/8/76 12.13 11.94 16.25 1.362 23.125(s)
1/27/77 2.38 2.50 4.00 1.600 6.375
4/6/77 3.00 3.25 7.00 2.154 12.000
7/1/77 5.25 5.25 7.00 1.333 12.000
8/1/77 29.75 32.62 37.00 1.134 28.125
9/29/77 17.00 17.25 20.00 1.159 25.000(t)
10/20/77 25.25 24.25 40.00 1.649 12.875
12/14/77 7.75 7.75 10.00 1.290 14.250
1/19/78 5.12 4.75 6.00 1.263 6.188
2/1/78 32.75 29.62 42.00 1.418 17.875
7/3/78 17.75 22.37 24.50 1.095 27.875
8/11/78 21.50 23.25 35.00 1.505 26.750
9/25/78 11.75 18.50 22.00 1.189 8.875
1/9/79 24.12 24.37 34.00 1.395 26.625
2/9/79 12.37 13.12 19.00 1.448 16.125
2/12/79 22.00 28.62 31.00 1.083 20.375
2/14/79 11.12 12.87 15.00 1.166 14.375
4/9/79 22.00 23.25 35.00 1.505 25.875

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 •
134 The Business Lawyer; Vol. 35, November 1979

FOOTNOTES:
(a) Subsequently acquired by H. K. Porter Company through a $26 per share tender offer in Jan-
uary 1976 and a merger in which each share of Missouri Portland received $30 principal
amount of 10% subordinated debentures. Missouri stock split 5-4 in January 1974.
(b) Subsequently acquired by merger by LSC, Inc. (The Timken Company) in January 1975 at
the rate of .48 shares of Timken per share of Latrobe, valued at $14.28 per share.
(c) Subsequently acquired by PB Holding Corp., a subsidiary of Pitney-Bowes Inc., in December
1978 at $28 per share.
(d) Cooper Laboratories Inc. obtained approximately 22% in November 1978 by open market
purchases. Merger discussions are continuing concerning Cooper's $28 offer for the rest of
Sterndent's common. Cooper revised the offer in August 1979 from $28 cash to $3 cash and
$25 in 10% 20-year notes.
(e) Goliad Oil and Gas Co. acquired 400,000 shares in September 1976 at $14 per share.
(f) Subsequently acquired by Hudson Bay Mining and Smelting, an indirect subsidiary of Anglo
American, in July 1978 for $33 per share.
(g) Subsequently acquired by merger by 13 dissident shareholders including Engle and Weston
in October 1977 at the rate of $1.15 face value of 81/% capital notes per share.
(h) Subsequently acquired by Bristol-Myers in November 1977 at the rate of 1.733 shares of
Bristol-Myers for each share of Unitek, valued at $59.14 per share.
(i) Valley Industries obtained approximately 23% pursuant to its offer, increasing its holdings to
28%. Braden partially liquidated in January 1977 with a liquidating distribution of $7.52.
(j) Rejected a tender offer by Hamilton Brothers Petroleum Corp. for $60 a share in September
1976. Sabine signed a letter of intent for a tax-free merger, but negotiations broke down on
price.
(k) Wesco obtained approximately 14.3% pursuant to its offer, increasing its holdings to 24.9%.
Subsequently, Central Cartage Co. and Fallbridge Holdings Ltd. acquired approximately
49.5% in open market purchases and offered $25 per share for the remainder. The offer is cur-
rently enjoined.
(1) Price represents principal amount of 10% debenture offered in exchange for each Pabst
share.
(m) Yates obtained approximately 8.1% pursuant to its offer, increasing its holdings to 20.8%.
(n) Schlumberger acquired approximately 18% in October 1978 by open market purchases.
(o) Mite Corporation had agreed to make a tender offer for $31 a share in February 1979, but
withdrew the offer in March 1979.
(p) Hunt International Resources Corp. had owned 28% since October 1977. Sunshine Mining
Co. repurchased these shares in June 1979 subsequent to an unsuccessful takeover bid in
March 1979.
(q) Last bid recorded on May 23, 1979.
(r) Last bid recorded on March 13, 1979.
(s) Offer price and market prices prior to offer reflect two-for-one stock split.
(t) Represents value of final tender offer or merger.

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WÀCHTELL, LIPTON, ROSEN & KATZ

January 4, 1979

Memorandum with respect to Treatment by

a Target Company of a Takeover Proposal

The following outlines the legal and practical

considerations in the case of a takeover proposal or attempt:
1. There is no legal requirement that a target
discuss acquisition or engage in acquisition negotiations
wi th anyone who proposes such discussions or negotiations.
There is no duty to negotiate even when a prospective ac-
quiror indicates that it would offer a large premium if the
target would agree to an acquisition.
2. The target should not permit the raider to
misperceive the target's intentions. Many takeover attempts
are attributable to the failure of the target to reject firmly
and uneauivocally the first approach. The target's equivoca-
tion misleads the raider into believing that it has a chance
for a negotiated acquisition. The raider then invests time
and effort in studying and developing a. proposal and the
management of the raider commi ts its prestige to accomplish-
ing the acquisition. When the target does finally reject, the
raider loses sight of the problems of a takeover attempt and
proceeds with a tender offer where, if there had been an early
clear-cut rejection, the raider would have abandoned the
effort.
3. There is no requirement for public announcement
by a target of rejected approaches requesting acquisition
discussions. (However, there should be no insider trading at
times when the insiders know that acquisition approaches are
being made and rejected.)

4. If a raider makes a specific firm acquisition

proposal, it should be considered by the target's board of
directors and, except under special circumstances, such
proposal should be announced publicly.

5. The target's board of directors .has no duty to

accept an acquisition proposal or to take a position on a
takeover attempt. There is no case that has held the direc-
tors of a target liable for the rejection of an acquisition
proposal or the defeat of a takeover attempt.

6. When considering an acquisition proposal or

takeover attempt, the directors of a target must act in good
faith and on a reasonable basis. The target's management
and/or investment banker should put together the financial
and business information (including management's five-year
WACHTELL. LIPTON, ROSEN & KATZ

projections and management's valuation of the target's assets

on the basis of what they could be sold for) appropriate for
consideration by the target's board of the adequacy of the
price proposed by the raider.

7. It is reasonable for the directors of a target

to reject an acquisition proposal or to seek to defeat a take-
over attempt on anyone of three bases:
(a) the price is inadequate in that it does
not reflect the value of the target if the target were to
determine to seek to be acquired or to liquidate, or

(b) the belief that the timing is wrong and

that a better deal could be obtained in the future, if
then desired, or

(c) illegality, e.g., the acquisition would

violate the anti trust or other laws or the takeover
attempt violates the disclosure or other provisions of
the federal securities or other laws.

Even if the price is adequate or unusually high and there is

no determination that the timing is wrong, the target has an
absolute right to reject an offer or seek to defeat a takeover
attempt if the acquisition would violate the antitrust or
other laws.

8. In addition to the above bases for rejection

of an acquisition proposal, it is reasonable for the directors
of a target to refuse to consider an acquisition proposal that
is uncertain or conditioned in an unusual manner or that is
for less than all of the outstanding shares of the target.
9. While there is no legal requirement that the
directors of a target obtain the advice of an investment
banker or legal counsel, reliance by the directors of a tar-
get on the advice of an independent investment banker and
independent legal counsel has been held, in a number of cases,
to establish the requisite good faith and reasonable basis for
rejection of an acquisition proposal or action to defeat a
takeover attempt. With respect to rejection on the basis of
illegali ty, except in a very clear case, the opinion of
counsel should be obtained.
Attached is an excerpt from Lipton & Steinberger,
Takeovers and Freezeouts, which discusses and cites some of
the case law on which this memorandum is predicated.

Martin Lipton

-2-
(\

290 6.3.-6.3.2.

6.3. Resonding to pre-offer takeover attempts.

6.3.1. Friendly approach. As long as it is acting in good
faith, the management and board of directors of a target have no
legal duty to engage in discussions or to negotiate with respect to
the sale of the target, but management should advise the board
of diectors of any approaches. See Berman v. Gerber Products
Co., supra. Friendly discussions are frequently misunderstood by
the potential raider, and the termination of such discussions often
reults in a hostile offer. Such discussions should .therefore be
avoided and, assuming such is the fact, management should be
authoried to inform any prospective raider that the taget is not
for sae and there is no interest in discussing the subject. Advance
preparation of the board of directors and management in ths
regar is highly desirable. See generaly Management's Responsi-
bility, supra.
6.3.2. Ber-hug approaches. Although management has a
duty to brig fir proposal to the board, and the board has the
duty to consider carefully such proposals, there is no legal duty
to sell the target. The response to a proposal can var depending
on the particular circumstances, and may range from outright
rejecton to discussions and/or negotiations. Northwest Industries,
Inc. v. B.F. Goodrich Co., supra at 712 ("management has re-
sponsibilty to oppose offers which, in its best judgment, are detri-
menta to the company or its stockholders"); Selama-Dindings
Plantations, Ltd. v. Durham, 216 F. Supp. 104 (S.D. Ohio 1963),
af d, 337 F .2d 949 (6thCir. 1964 ) (depending upon circum-
staces, dictors have duty to investigate potential raider and to
advi shareholders); Berman v. Gerber Products Co., supra at
93,958 (target has afirative duty not to refra from bringing
. action to enjoin tender offer on antitrt and securties law dis-
closur grounds even though target's investment baner has ad-
vised that offer price is substantial). See alo Cummings v. United
Artiss Theatre Circuit, Inc. 237 Md. 1, 204 A.2d 795 (Md. Ct.
App. 1964). The board of diectors should prevent an acquisition
by those who it may have reason to know would loot or mismanage
the asets of the target. Insranhaes Corp. v. Northern Fiscal
Corp.,.....-3_li_S-iPP~_:i4JE.D.
~..,..._--,. Pa. 1940)._ In a decision uoholdisr
(

6.3.2. 291

an acquisition by a target to defeat a takeover, a federal ditrict

cour in llinois said
(MJanagement has the responsibilty to oppose offers which,
in its best judgment, are detrimental to the company or to
its stockholders. In arrving at such a judgment, manage-
ment should be scrupulously fai . . . (and their J informed
opinion should result from that strct imparialty which is
required by their fiduciar duties. After takg these steps,
the company may then take any step not forbidden by law
to counter the attempted capture. Northwest Indus., Inc. v.
B.F. Goodrich Co., 301 F. Supp. 706, 712-13 (N.D. ll.
1969 )
Careful preparation of the board for consideration of a taeover
offer is necesar; frequently it is desirable to have an investment
banets.opinon as to the adequacy of the offer. See Kaplan v.
Gold$am, supra; at 6.2.8.2, to the effect that the cour will not
second guess a good faith decision by the board as to value. If the
board's decision is made in good faith and is reasonably based on
~ the facts presented, there is no liabilty for rejection of a takeover
) offer. Danziger v. Kennecott Copper Corp., supra, although in-
volving the converse situation-the propriety of directors authori-
ing a tender offer--emonstrates the value of an independent in-
vesent banets opinon in a tender offer situation. Danziger
involved an attempt by Kennecott shareholders to enjoin prelim-
inary the Kennecott tender offer for Carborudum. The essence
of the shareholders' claim was that the Kennecott directors, in
reachig a quick . decision to offer for Carborundum at an aggregate
price of nearly $600,000,000 (a price far in excess of Carborun-
dum's book value and hitorical market price), "failed to thor-
oughy investigate the relevant factors and consider the best in-
terets of Kennecott. . . . In the few days available to the (directors J
to stdy the matter, they cannot possibly have given the tye of
detailed attention and study to such. an importt acquiition that
. the law requies." In response, the cour stated:
Kennecott's opposing papers include an extensive and
detaied report on the proposed purchase. Th analytcal
report was prepared by the First Boston Corporation, an
.------------
independent financial adviser, at the request of Kennecotts
 boar of dictors. Firt Boston recommended the pur-
chase. Thus, it is clear that Kennecott did thoroughly in-
vestigate the relevant factors and considered its own inter-
es before deciding to make the tender offer. Kennecott
explai that the $66 per share price was calculated to
outbid another offeror which had previously made an offer
of over $60 per shar. . . .
(The New York Business Corporation Law J imposes a
duty on corporate diectors to discharge their duties "in
go faith and with that degree of dilgence, care and ski
which ordary prudent men would exercise under similar
ciumces in lie positions." On the papers submitted,
ther is no showig that Kennecott's diectors departed
frm th high standar in reaching their decision to offer
to purhase Carborudum shares. It appears that the direc-
. tors. were thorough in their deliberations despite the rela-
tively short period of tie avaiable for the decision-making.
pres.
But see Royal Indusries, Inc. v. Monogram Indusries, Inc., supra,
i
in which the Cour found that a target's pres release, which stated
reject the offer by
. that the taget was "guided" in its decision to

an invesent bankets report, was misleading because it failed to

stte that the investment baner had prepared such report "vir-
tualy overnght and without the necear time and deliberation
for fai evaluation" and because, in any event, the board's decision
to oppoe was not "guided" by the investIent banets report but
rather by the s~lf interest of the target's management and directors.
To avoid the Royal Indusries problem, it is desirable that the
company's investment baner keep up to date on the company
so that it can render a considered opinion on short notice if the
. nee ar. See 6.1.2(c). But see Elfenbein v. Braunschweiler,
Bench Opinion, 75 Civ. 2202 (S.D.N.Y. June 2, 1978) and dis-
c~on at 8.4.2.
6.3.3. Resnding to accumulations through open-maret
and other purcha. Pre-offer accumulations have the purposes,
among others, of recouping the raidets expenses in the event the
rader is topped by a competig offeror, and, if such purchases
ar sufciently lare, of discouragig other suitors of the target.
In addition, in certin C'les open-market and other accumulations
-_._----- ._-_.~--~_.._-----_._._."._---_._-- -- _. ...

have resulted in an actal shift in control of the target or have

given the raider additional leverage with the target. Typicallitiga-
tion attacks the radets disclosure of "investment" intent, raies
the usal antitrt and margi claims and aleges a "creeping
tender offer." See 1.5.2 and 2.3.1.7.
6.3.4. Public anouncement of the raders approach. The
question of whether the target must make a public announcement
of the raidets approach depends upon varous factors. If the pro-
posal has meaningful conditions or is otherwe "if", a strong
arguent can be made that no disclosure by the target is required.
If, however, the proposal does not have meaningful conditions and
specifes a price, it would appear that disclosur is required. In any
event, taget and inider tradig is prohibited pending anounce-
ment or reolution of the question whether there wi be a "real"
offer. No anouncement need be made of invitations to negotiate.
In Berman v. Gerber Products Co., supra, the cour said that over-
tues that ar not firm offers ar not material inormation that is
required to be disclosed under Section 14(e). See discussion of
anouncement of specific offers at 6.4.1.
For a general discussion of disclosure obligations by public
companies, see SEC v. Texas Gulf Sulphur Co., 401 F.2d 833
(2d Cir. 1968), cert. denied, 404 U.S. 1005 (1971); and SEC v.
Geon Industries, Inc., supra (condemng selective disclosur of
preliinar negotiations relating to potential merger of Geon but
exprely I10ting that the holding did not mean that public dis-
closue of preliminar negotiations is either necessar or appro-
priate); see also Freund, Selected Acquisition Problems under
Rules lOb-5 and lOb-6 and under Section 16(b), in Mundheim,
Fleischer & Vandegr ed., Eighth Annual Insitute on Securities
Regulation (1977). The NYSE Company Manual and Amex
Company Guide each conta gudelines with respect to disclosure
obligations of listed companes, see discussions at 4.1.1 and 4.2.1,
repectively.
6.3.5. Considerations in reondig to taeover attempts.
The Willam Act does not compel the board of directors of a
taget to take a position with repect to an offer. Berman v. Gerber
Products Co., supra. Under state law the management of a target
company must act in accordance with what it reasonably believes
294 6.3.5.

to be the best interests of the target's shareholders. The decision

is esentially an economic and financial one and the board of
the taget must act in an objective. maner toward that end. The
recommendation of a course of conduct by truly independent out-
side adviors, e.g., investment baners and/or independent direc-
tors, is most helpful in sustaining target company decisions (see
6.3.2). Among the factors to be considered in responding to a
taeover attempt are: .'
(a) the adequacy of the offering price given the present
value and future eargs prospects of the target;
(b) the nature of the consideration offered by the raider,
e.g., cash or securties (and the value and prospects of such se-
curties) ;
(c) whether the raider is seeking all of the target's stock or
only a porton, and if it is a paral offer, what the effect wil be on
remaig sharholders (e.g., market liquidity' and price; effect
on relationships with customers and suppliers and, consequently,
on taget's business; future prospects of a "freezeout"), see 6.5.2.5;
(d) whether ths is the right time to sell the target (a reason-
able good faith decision as to ting is a sufcient basis in and
of itself on which to reject a takeover offer) ;
(e) thê avaiabilty of other alternatives (See 8.4.2 with
repect to the factors to be taken into account by the investment
baIer adviing the board, all of which are appropriate for the
board to independently consider); and
(f) the legalty of the takeover offer (in Berman v. Gerber
Products Co., supra, the cour held that the target had an absolute
right to litigate the takeover offer which the board of the target in
good faith believed to violate the securties and antitrut laws).
Management may wish to delay the raidets tender offer in order
to gai tie to negotiate a defensive merger or White Knght
tender offer. See Commonwealth Oil Refining Co. v. Tesoro Petro-
leum Corp., supra, and Jewelcor, Inc. v. Pearlman, supra. How-
ever, it should be noted that Grossman, Faber & Miler P.A. v.
Cable Funding Corp., CCH Fed. Se. L. Rep~ f 94,913 (D. Del.
1974), a pre-Green decision, held that if taget company manage-
ment engages in a campaign to defeat one tender offer and inure the
succe of a competig tender offer for personal reasons, rather than
in the best interests of the target and its shareholders, such conduct
...._----------------...__..- _._---_._-_...
6.3.5.-6.3.6. 295

might be deemed a scheme to defraud within Rule 10b-5 as well as a

breach of common law fiduciar duty. See alo Klaus v. Hi-Shear
Corp., supra; and Del Noce v. Delyar Corp., CCH Fed. Sec. L.
Rep. If 95,670 (S.D.N.Y. 1976). With respect to disclosures of
the target in connection with an attempt to defeat competing tender
offers, see SEC v. Thermal Power Co., supra. Among other things,
the complait in Thermal Power sets fort the proposition that
where management recommends one offer over a competing offer,
faiur to disclose advantages flowing to members of management
by vie theref is a violation of Rule 10b-5 and Section 14(e).
Specifcaly, the SEC aleged a faiure to diclose that the president
of the target had reached an agreement with the "favored" offeror
to reta his position following. the recommended exchange offer
and that the target's directors who recommended a tax-free ex-.
change offer over competlng cash tender offers had a low tax
basis in their stock as compared to the tax basis of the target's
public shareholders.

6.3.6. "Rule of reaon." In Monogram Industries, Inc. v.

Royal Industries, Inc., Civ. No. 76 3356-R (C.D. Cal. Nov. 17,
1976 and Dec. 13, 1976), the cour held that improperly moti-
vated defensive maneuvers may be prelinary enjoined as viola-
tions of Setion 14 (e) and/ or breaches of fiduciar duty. Th
decision was presaged by such cases as Anaconda Co. v. Crane
Co., supra; Grossman, Faber & Miler P.A. v. Cable Funding

Green. '
Corp., supra; and Condec Corp. v. Lunkenheimer, supra. Note,
however, that the Section 14(e) basis is questionable in light of

In Monogram, the cour preliary enjoined Royal from:

(a) holding a meetig of stockholders to vote on pro-
posed amendments to Royal's charer to increase to 90%
the percentage stockholder vote required to effect a busi-
nesscombination with the holder of 30% or more of Royal's
stock;
(b) acquig another corporation which had an anti-
trt action pending agaist Monogr and which Royal
aleged to be a competitor of Monogr;
( c) makg any payments under the acceleration fea-
tu of Royal's deferred compensation plan, which plan
 ,,

(
.-----n-296
6.3.6.-6.4.1.

had been adopted severa year prior to the Monogram

tender offer and provided for imediate payment of sub-
stantial sums if an offeror acquired more than 25 % of
Royal's stock in a traction not approved by a majority
of Royal's board of dirctors;
(d) prosecutig Royal's most recently commenced law-
suit againt Monogram in the Delaware Cour of Chancery,
which suit was one of a total of nine initiated by Royal in
the six and one hal weeks since Monogram anounced its
intention to make the offer; and
(e) commencing or fmancing any additional litigation
related to Monogram's tender offer, other than in the
United States Distrct Court for the Central District of Cali-
forn where most of the tender offer litigation was being
conducted.
The cour, findig that the proposed charer amendment, the
propsed acquisition and the acceleration features of the deferred
compensation plans all had as their "sole, primar, contrQllig,
pricipal and compellg purose" the blocking of tender offers
and .the maitenance of Royal's officers and directors in their
positions, stated that the proposed charer amendment and acqui-
sition rased "serious questions" as toviolations of Section 14( e)
and breach of fiduciar duty, and the acceleration proviions con-
sttuted a breach of fiduciar duty. The cour held that Royal, by
commencing the litigation in Delaware to avoid prosecution of a
related suit in the Central District of California (see Royal I ndus-
tries, Inc. v. Monogram Industries, Inc., supra) and to promote
vexatious litigation, had violated Section 14 ( e), and that furher
litigation relating to the offer, other than in the Central Distrct of
Calornia, would be vexatious and unnecessary costly. "-
In determining a defensive strategy, it must be remembered that,
!!~~~ain Ci~C~!~~~~~!__~ti~~_~ay_~ out _ to _!'~ less.

- 'u n .. "-- __._.._______________ ____._.____n_______ "___._______.

WACHTELLLIPTONSROSENKATZ January 28 1981

To Our Clients

Response to Takeover Bids

Attached is the edited version of the update

of my article on Response to Takeover Bids as it will

appear in the April issue of The Business Lawyer

Lipton
 1/2 3/8

TAKEOVER BIDS IN THE TARGETS

BOARDROOM AN UPDATE AFTER ONE YEAR

By Martin Lipton

Last year in Takeover Bids in the Targets Board

room1 this author argued that

the business judgment rule applies to the

consideration by the board of directors of target of

an unsolicited takeover
.2
bid

there is no requirement that the board of

directors of target submit to the shareholders any

unsolicited takeover bid on the contrary company can

have an express policy of continuing as an independent

entity3

once the board of directors has in good faith

and on reasonable basis determined to reject take

over bid the target may take any reasonable action to

accomplish this purpose4

there is no real difference between the busi

ness judgment rule and the primary purpose test the

test courts often say is violated when they determine

that defensive action was improper because it was

 for the primary purpose of keeping management in office

as applied to the rejection of or defending against

takeover bid where the primary purpose test has

been applied the cases really turned on the courts

belief that the directors had not acted in good faith or

on reasonable basis rather than philosophical

distinction between the two standards.5

year ago there was little direct judicial authority to

support these positions During the past year several sig

nificant decisions have been rendered which provide that

support Additionally several commentators have aligned

themselves with the positions taken in Takeover Bids

Judicial Developments

In Panter Marshall Field Co.6 stockholder

action attacking the rejection of takeover proposal and the

defensive measures i.e lawsuit and acquisition program

taken by the board of directors to foreclose the takeover

the court held that the business judgment rule governs the

consideration of takeover bid by the board of directors of

target The court said

Directors of publicly owned corporation do

not act outside of the law when they in good
faith decide that it is in the best interest
of the company and its shareholders that it
remain an independent business entity Having
 so determined they can authorize management
to oppose offers which in their best judg
ment detrimental
are to the company and its
shareholders 7/

The court agreed with the view set forth in Takeover Bids

that where directors reach their decision to reject take

over bid after full consideration of all of the interests

affected by the proposal and after receiving antitrust and

securities law advice from outside counsel they can not be

held to have breached their fiduciary duties The court also

applied the business judgment rule in evaluating the pro

priety of acquisitions by the target which were alleged to

have been made for the purpose of creating an_antitrust

impediment to the takeover

As to the acquisitions which defendants

authorized management to make
each was consummated after defendants con
sidered business projections by management
received the advice of lawyers and experts
and consulted with accountants and investment
bankers Despite great deal of straining
with financial data reports and statistics
plaintiffs have not produced evidence which
could prove that any of these acquisitions
were unsound business ventures 8/

In Johnson Trueblood9 plaintiffs owning 47

percent of the outstanding shares of financiallytroubled

closelyheld corporation alleged that defendants owners of

the remaining 53 percent interest in order to retain control

of the corporation breached their fiduciary duty by refusing

plaintiffs offers to make loans and to purchase additional

stock and instead caused the corporation to enter into

transactions which were less advantageous to the corporation

but which retained the defendants control The district

court had instructed the jury that the business judgment rule

protects directors decision involving retention of control

so long as other rational business reasons supported the

decision and that the rule is rebutted only by showing that

the directors sole or primary purpose was to retain control

The plaintiffs appealed arguing that they only needed to

prove that control was motive in the directors decision in

order to rebut the business judgment rule The Third Circuit

held that under Delaware law the business judgment rule

applied and that plaintiff

at minimum must make showing that

the sole primary motive of the defendant
or
was to retain control If he
makes showing the
burden then shifts to the defendant to
show that the transaction in question had valid
corporate business purpose 10/

The Third Circuit said that to permit the business judgment

rule to be overcome by mere showing that control was

purpose of challenged action would in effect destroy the

rule since realistically corporate directors are always

motivated at least in part by the desire to retain office

even when acting on business questions which do not have

direct impact on control The Third Circuit also said that

the business judgment rule validates actions arguably taken

for the benefit of the corporation despite the desire to

retain office by the directors who authorized those actions.11

In the latter part of 1980 the Second Circuit

decided two cases which also support the positions taken in

Takeover Bids

In Treadway Companies Inc Care Corporation12

Treadway had sold large block of its common stock to Fair

Lanes Inc selected as white knight to rescue Treadway

from threatened takeover by Care The sale was made to

facilitate proposed Treadway-Fair Lanes merger and to

defeat the attempt by Care owner of onethird of the Tread

way stock to take control of Treadways board of directors

at the upcoming annual meeting The district court had

enjoined the voting of Fair Lanes Treadway shares on the

ground that Treadways primary motivation in consummating the

sale was to protect its incumbent management against Cares

takeover effort The Second Circuit reversed ruling that

Care had not established any basis under New Jersey law

construed in light of general corporation law including the

law of Delaware for overturning the business judgment of

the Treadway directors

 The Second Circuit stated that the business judg
ment rule which presumes that directors have acted prop
erly13 applies both to the determination that threat

ened takeover would be detrimental to the target and to

the choice of particular defensive measures including the

issuance and sale of stock to oppose such detrimental

takeover Thus party challenging defensive transaction

has the burden of proving that the directors of the target

acted in bad faith or in furtherance of their own interests

or for some other improper purpose.14 Even if that party

carries its burden the directors action is still protected

if they show that they approved the challenged transactions

for proper corporate purpose and not merely for the direc

tors selfish purposes.15 The directors need not also

prove that the actual terms of the transactions were fair

The Second Circuit further made clear that the substance of

the directors deliberations will not be scrutinized once it

is apparent that business judgment was in fact exercised

Since the conduct of the Treadway directors which

was complained of would have led to change of control of

Treadway and consequently to the severance of the directors

controlling relationship with Treadway the Second Circuit

decision left open the question whether the same reasoning

would be applied where the transactions were for the purpose

of keeping target an independent company with the manage

ment and directors of the target continuing in office This

question was answered in CrouseHinds Co InterNorth Inc.16

with the Second Circuit holding that the mere fact that the

directors of target will retain control by authorizing

transaction an exchange offer to assure consummation of

defensive acquisition to defeat takeover bid does not

remove the protection of the business judgment rule or shift

the burden of proof to the directors The district court in

Crouse-Hinds had read Treadway as holding that where the

directors of target would retain office as the result of

defensive action to defeat takeover the burden of proof

shifted to the directors The Second Circuit rejected the

district courts interpretation of Treadway

We find no basis in the present case for

the district courts conclusion that Inter
North carried its burden of demonstrating
selfinterest or bad faith on the part of the
CrouseHinds directors As his starting point
the district judge gave his consideration to
the decision in Treadway in which we found
that because the Treadway directorsj other
than the chairman were not to remain in of
fice after the merger perpetuation of their
control could hardly have been their motiva
tion for actions in furtherance of the mer
ger Unfortunately the district judge
inferred from this that quite different
proposition must also be true that i.e
if the directors are to remain on the board
after the merger perpetuation of their con
trol must be presumed to be their motivation
This inference has no basis in either law or
logic Treadway did not disturb the normal
 requirement that complaining shareholder
present evidence of the directors interest
in order to shift the burden of proof to
them

In short when the

tender offeror has
presented the target company with an obvious
reason inadequacy of price possible
illegality or interference with an existing
contract to oppose the tender offer the
offeror cannot on the theory that the tar
gets management opposes the offer for some
other unstated improper purpose obtain an
injunction against the opposition without
presenting strong evidence to support its
theory We find no such evidence here 17/

With respect to the speed with which the CrouseHinds board

of directors reached its debision to oppose the InterNorth

tender offer the Second Circuit said

The fact that the initial decision to oppose

the was made in four days
does not prove that either that decision or
the subsequent transaction stemmed
from control motivation Such decisions
are required to be made promptly and
are normally made quickly and the district
court recognized that this decision was not
made without CrouseHinds having consulted
its expert advisers in an effort to be ob
jective We note further that the
transaction which is of course the precise
target of the counterclaims was not entered
into until eleven days after announcement of
the 18/
 The Second Circuit decisions in Treadway and Crouse

Hinds were adumbrated in its earlier decision in Rodman

Grant Foundation19 in which the Second Circuit indicated

that strong showing of an entrenchment of management

motivation would be necessary to overcome the normal judicial

reluctance to secondguess the business decisions of board

of directors In Rodman the plaintiffs alleged that proxy

material soliciting stockholder approval of purchases by the

company of large amounts of its own stock failed to disclose

that the principal if not the sole reason for the

repurchases was to entrench managements control of the

company.2 In affirming the district courts finding that

full disclosure of the repurchases had been made the Second

Circuit said that the effect of the stock purchases on

company control was selfevident from the very size of the

transaction involving as it did over ten percent of the

outstanding common stock.21 The Second Circuit agreed

with the lower courts holding that corporate control is

recognized to be of universal interest to corporate officers

and concluded that the absence of some ulterior

wrongful design hinging upon socalled entrenchment the

directors were not required to put forth in the proxy mater

ials an analysis of their otherwise obvious interest in

control 22
company

-it
 In addition in Lewis McGraw23 the Second

Circuit held that shareholders may not maintain cause of

action for damages under section 14e of the Williams Act

where proposed tender offer is defeated and never in fact

made The court explained

element of cause of action under

14e is showing that there was misrepre
sentation upon which
the target corporation
shareholders relied ChrisCraft Industries
Inc Piper Aircraft Corp 480 F.2d 341
2d Cir cert denied 414 U.s 910 1973
emphasis supplied In instant case the
the targets shareholders simply could not
have relied upon McGrawHills statements
whether true or false since they were never
given an opportunity to tender their shares 24/

II Commentators Views

In the 1980 edition to Fleischer Jr Tender

25
Offers Defenses Responses and
Planning1
the author

agrees with the rationalization of the business judgment rule

and primary purpose test put forward in Takeover Bids and

states

In fe4 cases the courts have applied both

the primary purpose test and the business
judgment rule without discussing how the two
differ if at all These cases should not be
dismissed as aberrational for although the
primary purpose test is stricter sounding
than the business judgment rule it may well
be that there is no real distinction between
the two All courts no matter which test
they apply seem to review the entire environ
ment of the transaction and ask the same
questions Why did the directors act What
factors did the1 take into account How

10
 carefully did they exercise
their business
judgment Moreover hard to see how
it is
these questions could be answered in such
way as to lead to liability under one test
and not the other Where the facts show that
the primary purpose of board in opposing an
offer is to perpetuate itself in power it
would be inconsistent for court to find
that they had acted in good faith and had
exercised reasonable business judgment
Conversely most courts seem to decide
whether the primary purpose of the board was
to achieve corporate goal or to maintain
itself in power by examining the alleged
business reason for the action taken by the
board Only if the justification is implaus
ible will the court hold that the boards
primary purpose was improper In short it
seems that both the business judgment rule
and the primary purpose test essentially
demand no more than that directors act in
good faith and with due care like reason
able businessmen

number of other commentators have also supported

the positions set forth in Takeover Bids Shortly after Take

over Bids was published Securities and Exchange Commission

Chairman Harold Williams noted his agreement but also argued

that the decision with respect to takeover bid should be

made by committee of independent directors of the target

It is my view that court in reviewing

such wellmonitored fullyconsidered and
documented special committee
independent
directors determination to
reject and resist
an acquisition or tender offer bid should
and would give substantial deference to that
decision and to any legal and ethical acts to
resist the bid which are reasonably commen
surate to the existing threat to the corpora
tions and its shareholders interests pro
vided that the acts themselves are not incon
sistent with the corporations viability 26/

_11i_
-a

The difference between Chairman Williams position and the

position taken in Takeover Bids is that Chairman Williams

would have special committee of independent directors in

every case while Takeover Bids argues that such committee

should be resorted to only in the rare case where there is

very significant conflict of interest involving majority of

the directors of the target Thus Takeover Bids recommends

If majority of the directors are officers

or otherwise might be deemed to be person
ally interested other than as shareholders
committee of independent directors al
though not in theory necessary from liti
gation strategy standpoint may be desirable
The exigencies and pressures of takeover
battle are such that it is desirable to avoid
proliferation of committees counsel and
investment bankers The target will be best
served if it is advised by one investment
banker and one outside law firm 27/

Chairman Williams also endorsed the position taken in Take

over Bids that in reviewing takeover the directors of

target may properly consider the adverse impact of the

takeover on employees suppliers customers the public

and the national economy.28

While some commentators argue for stricter stan

dards29 it may be assumed that the weight of authority

will be in accord with Treadway and CrouseHinds which is

exactly where it should be.3 As noted in Takeover Bids

the history of takeover decisions is no different than the

12
history of new product decisions.31 There are both Edsels

and Xeroxes It would be as impractical for the courts to

secondguess takeover decisions as it would be to secondguess

new product decisions

Takeover Bids analyzed the 36unsolicited tender

offers that were rejected and defeated by the target between

the end of 1973 and June 1979 and showed that in more than

50% of the cases as of August 1979 the shareholders were

better off than if the tender offer had been successful

At the end of November 1980 this was true in an even higher

percentage of the defeated tender offers In addition to

the examples provided by defeated tender offers there are

numerous examples of other situations where the shareholders

of target have benefitted from the targets decision to

reject or avoid takeover

In January 1977 Viacom rejected $20

takeover bid reflecting premium of 95 percent

over the then market price of $10.25 by Storer

Broadcasting at the end of November 1980 Viacom

was at $57.25

In October 1978 Freeport Minerals purchased

for $14.00 reflecting premium of 19 percent over

the then market price of $11.78 about 10% of its

13
shares from Denison Mines which had accumulated

the shares through market purchases at the end of

November 1980 Freeport Minerals was at $61.25

In June 1978 Bache purchased for $10.50

reflecting premium of 26 percent over the then

market price of $8.13 about 7.5 percent of its

shares from certain private investors who had

accumulated the shares through market purchases at

the end of November 1980 Bache was at $23.63

In January 1979 BunkerRamo entered into

standstill agreement whereby Fairchild Industries

purchased from Martin Marietta 20.6 percent of

BunkerRamos shares at $23.50 reflecting

premium of 32 percent over the then market price of

$17.88 at the end of November 1980 BunkerRamo

was at $39

In April 1978 ASARCO entered into

standstill agreement whereby Bendix purchased

from ASARCO 14.2 percent of its shares at $23

reflecting premium of 22 percent over the then

market price of $18.88 at the end of November

1980 ASARCO was at $48.32

14
 Since it received so much attention the American

Express offer for McGrawHill is worthy of special note

Many arbitrageurs and professional investors felt that the

$40 per share offer reflecting 50 percent premium over the

preoffer market price of $26 mandated acceptance While

the decision of the McGrawHill directors to reject the

offer was publicly criticized by those investors and attacked

in several shareholder lawsuits within less than two years

the directors decision was completely vindicated with the

shares selling in the market for more than the $40 offer

price When taxes and current control premiums are consid

ered the benefit of the directors decision to the McGraw

Hill shareholders becomes even more dramatic Thus the

McGrawHill case which when the bid was made was argued by

some to be the one which would establish that targets

board did not have discretion to reject takeover bid has

become cogent evidence of the validity of the premises of

Takeover Bids not just in court but also in the market

place.33

III Procedure to be Followed by the Board of Directors

The cases decided during the past year emphasize

the point made in Takeover Bids as to the importance of the

procedure to be followed by the board of directors of

target in considering takeover bid The new tender offer

15
rules adopted by the SEC in November 1979 also highlight this

point through the rules requirement that targets board

consider and respond to tender offer34 and that the

target disclose the reasons for the boards decision Thus

what was said in Takeover Bids warrants repetition

Management usually with the help of invest

ment bankers and outside legal counsel
should make full presentation of all of
the factors relevant to the consideration
by the directors of the takeover bid in
cluding

historical financial results and pres

ent financial condition

projections for the next two to five

years and the ability to fund related
capital expenditures

business plans status of research and

development and new product prospects

market or replacement value of the

assets

management depth and succession

can better price be obtained now

timing of sale can better price

be obtained later

stock market information such as his

torical and comparative price earnings
ratios historical market prices and
relationship to the overall market and
comparative premiums for sale of con
trol

impact on employees customers sup

pliers and others that have relation
ship with the target

16
10 any antitrust and other legal and
regulatory issues that are raised by
the offer

11 an analysis of the raider and its man

agement and in the partial
case of
offer or an exchange offer pro forma
financial statements and comparative
qualitative analysis of the business
and securities of both companies

An independent investment banker or other

expert should opine as to the adequacy of
the price offered and managements presen
tat ion

Outside legal counsel should opine as to

the antitrust and other legal and regula
tory issues in the takeover and as to
whether the directors have received
adequate information on which to base
reasonable decision

If majority of the directors are offi

cers or otherwise might be deemed to be
personally interested other than as
shareholders committee of independent
directors although not in theory neces
sary from litigation strategy stand
point may be desirable The exigencies
and pressures of takeover battle are
such that it is desirable to avoid prolif
eration of committees counsel and invest
ment bankers The target will be best
served if it is advised by one investment
banker and one outside law firm

It is reasonable for the directors of

target to reject takeover on any one of
the following grounds

inadequate price

wrong time to sell

illegality

adverse impact on constituencies other

than the shareholders

17
 risk of nonconsummation

failure to provide equally for all

shareholders

doubt as to quality of the raiders

securities in an exchange offer

Once directors have properly determined

the
that takeover should be rejected they -inay
take any reasonable action to accomplish this
purpose including litigation complaints to
governmental authorities the acquisition of
company to create an antitrust or regula
tory problem for the raider the issuance of
shares to big brother or the premium pur
chase of shares of the target from the raider 35/

18
 Footnotes

Member of the New York Bar Mr Liptons associate han

Reich assisted in the preparation of this article Mr

Lipton has participated in several of the matters mentioned

in this article

Lipton Takeover Bids in the Targets Boardroom 35 Bus

Law 101 1979 Takeover Bids

Id at 131

Id at 130

Id at 123

Id at 124

486 Supp 1168 N.D Ill 1980 appeal docketed No

801375 7th Cir March 21 1980

Id at 1186 In an amicus brief submitted to the Seventh

Circuit on the appeal of the Marshall Field case the SEC has

taken the position that if the management of company adopts

policy that it will resist any and all takeover efforts be

cause the management believes that the company should remain

independent then such policy would be material disclosure

item While it is not clear whether the SEC position would

require disclosure only in the face of proposed tender

offer as in the Marshall Field case or generally even in

-i-
the absence of tender offer or takeover proposal as

practical matter the literal SEC position is not very mean

ingful in that very few companies would decide to reject any

and all tender offers no matter what the price and no matter

what the circumstances of the company Most companies follow

general policy of preferring to remain independent This

is valid and legal policy It does not in any way negate

the good faith of the board of directors As set forth in

Takeover Bids absent such policy companies would constantly

be in play boards of directors would spend an inordinate

amount of time considering takeover or liquidation proposals

they would have serious employee customer supplier and

community relations problems and longrange planning would

be very difficult Takeover Bids supra n.1 at 10910 It

is reasonable business judgment for the management and board

of directors of company to take the position that the com

pany wishes to remain independent and will not pursue takeover

or liquidation proposals This position does not require

special disclosure However if company adopts polfcy to

resist any and all takeovers no matter what the price and no

matter what the circumstances then special disclosure may be

required In addition in order for such position to meet

the business judgment rule it would be necessary for the

board of directors to have reached that position on justi

11
fiable basis i.e the goodfaith belief that the business

of the company would be affected adversely in the absence of

such position Where business is heavily dependent on

maintaining stable relations with employees customers sup

pliers or others such goodfaith belief might possibly be

demonstrated Each such situation musb be approached on

casebycase basis

486 Supp at 1194

629 F.2d 287 3d Cir 1980 vacated on other grounds 629

F.2d 302 3d Cir 1980 per curiam

10 Id at 293

11 Id at 292

12 Fed Sec Rep CCII 97603 2d Cir

1980 rehearing denied Fed Sec Rep CCII

97705 2d Cir 1980 Treadway

13 Id at 98210

14 Id

15 24 at 98211

16 No 807865 2d Cir Nov 14 1980 Crouse

Hinds

iii
17 Id at 307311

18 Id at 310 n.24

19 608 F.2d 64 2d Cir 1979 Rodman

20 Id at 70

21 Id at 71

22 Id

23 619 F.2d 192 2d Cir 1980 cert denied 49 TJ.S.L.W

3332 1980

24 619 F.2d at 195 similar result was reached in

Marshall Field supra n.6 at 119091 Query the effect

of SEC Rule 14d2b Fed Sec Rep CCII 24282A

25 Fleischer Jr Tender Offers Defenses Responses

and Planning 884 1980 edition

26 Speech by Chairman Harold Williams Securities and

Exchange Commission Tender Offers and the Corporate Directors

reprinted in Transfer Binder Fed Sec Rep

CCII 82445 at 82881 speech before the Seventh Annual

Securities Regulation Institute San Diego Cal Jan 17

1980

-iv-
WACHTELL LIPTON ROSEN KATz April 1981

To Our Clients

Takeovers Some Recent Experiences

And Important Lessons

Takeovers in the $2S billion range are possible Prior

to this year it was assumed that companies with
generally
market value in excess of $1 billion were relatively
safe from nonnegotiated takeover The Seagram offer
for St Joe and the Socal bearhug of Amax show that this
assumption is no longer valid

While there are white knights for $2S billion deals who
can act in 1020 days it is axiomatic that it is much
more difficult to find white knight for $2S billion
deal than for the $100 million to $1 billion deals that
were typical during the past years Therefore advance
preparation is essential Potential white knights should
be identified and the financial information necessary for
white knight negotiations should be kept current Natural
resource companies should keep their reserve reports and
appraisals up to date Close coordination between
company and its investment banker is essential Whether
or not advance contact with potential white knight
is desirable is question for individual determination
and no generalization is possible We continue to
believe that it carries significant risk of provoking
undesired takeover proposals

Cash selftender offers and preferred stock exchange

offers are more likely to be effective in defeating
tender offers for large companies than for small com
panies With small companies unless such transactions
result in majority of the stock being in friendly
hands the net effect is to make the overall cost of
the takeover lower and thus make it easier rather than
more difficult With the larger companies this is not
significant factor Also it is unlikely that the
arbitrage of $2S billion takeover will exceed 10% of
the targets shares Therefore the Street does not
control the destiny of the target If the target has
good story and the institutions can be induced to
maintain their investment positions restructuring of
the capitalization of the target can be effective
WACHTELL LIPTON ROSEN KATz
April 1981

raider who Springs tender offer without prior con

tact with the target is most unlikely to be able to in
duce the target to enter into discussions with the raider
Where the raider is prepared to negotiate higher price
the way to achieve negotiations is through an increase in
the offer price at the right time Failure to do so
leaves too much room for white knights and foregoes an
opportunity to change the psychology of the situation
The shibboleth enjoining bidding against oneself really
has no place in takeover situation The best time for
such move is after litigation victory or just prior
to meeting of the targets board raider normally
cannot litigate its way to successful takeover

The NYSE 181/2% rule requiring on pain of delisting

shareholder vote to issuance of more than
approve
181/2% of companys stock negates one of the most
effective takeover defenses Frequently target is
able to place 2535% of its stock in friendly hands at

price in excess of the takeover bid but is prevented

from doing so by the NYSE rule Where the targets board
of directors on the advice of the targets investment
bankers determines that such placement is in the best
interests of the shareholders there is no legal reason
not to go forward Delisting is one of the elements to
be considered by the board but should not be overriding
in the boards determination NYSE listed companies
would be well advised to seek repeal of the NYSE 181/2%
rule The rule was adopted prior to the current wave of
takeover activity and operates against the shareholders
best interests rather than to protect them as originally
intended

Despite dicta to the in the St Joe case

contrary
liquidation at price substantially higher than the
takeover bid is viable alternative and is legal and
proper It is the diametric opposite of entrenchment
of management It can and should be used in appro
priate situations

Executive incentive plans and severance arrangements

should be amended to protect executives in the event of
takeover If this is not done prior to takeover bid
there is danger that it will not be understood as being
appropriate and in the best interests of the company and
its shareholders These amendments have become fairly
standard and have been adopted by large number of
companies

Lipton
WACHTELL LIPTON ROSEN KATZ

December 13 1982

To Our Clients

Takeovers Protecting Shareholders Against Front

Loaded Tender Offers and BustUp Proxy

the past year we have been recommending

For that
corporations consider protecting against frontend loaded
tender offers by amending their charters to include require
ment that the second step in hostile takeover be for cash
at the same price as the first step

We have also been recommending that corporations

protect against raiders who purchase to 20 of the stock
of target in the market and then seek to have the target
ransom the shares or run to white knight in order to avoid
proxy fight in which the raider will seek control on the
promise of takeover liquidation selftender special
dividend or other transaction that would presumably enhance
the value of the stock of the target

As the annual meeting season approaches we renew

those recommendations Frontend loaded takeovers and bust
up proxy fights are not in the best interests of shareholders
Given the present frequency of these transactions we believe
every corporation should consider our recommendations In
that connection it should be noted that our recommendations
are not shark repellants they will not deter an all cash
bid for all of the shares of corporation but they do deter
the types of raids they are designed to protect against It
should also be noted that while there is significant possi
bility that many institutional shareholders will not vote for
our recommendations if there is any possibility of obtaining
the requisite vote there is at present almost no downside
risk to seeking shareholder approval These amendments re
flect strength rather than weakness and sophistication rather
than naivete The large number of corporations that will
submit these types of charter amendments to shareholders in
1983 and the current absence of significant takeover activity
with almost no likelihood of imminent revival indicate that
even the failure to obtain the requisite vote is not going to
attract takeover proposals In essence this is window period
in which the potential benefits of our recommendations far out
weigh any detriments We think that almost all corporations
should attempt to take advantage of this opportunity

Lipton

01
WAcHTELL LIPTON ROSEN KATZ November 21 1985

To Our Clients

Share Purchase Rights Plans

Poison Pills

Rights Plan is legal Rights Plan is within the business

judgment of the board of directors As the Supreme Court of Dela
ware says in Moran Household Intl No 37 Nov 19 1985

here we have defensive mechanism adopted to ward off

possible future advances and not mechanism adopted in
reaction to specific threat This distinguishing
factor does not result in the Directors losing the pro
tection of the business judgment rule To the contrary
preplanning for the contingency of hostile takeover
might reduce the risk that under the pressure of
takeover bid management will fail to exercise reason
able judgment Therefore in reviewing preplanned
defensive mechanism it seems even more appropriate to
apply the business judgment rule

Rights Plan does not change the fiduciary standards to be

followed by the board of directors in deciding whether to accept
or reject takeover bid In the words of the Supreme Court of
Delaware the board will be held to the same fiduciary standards
any other board of directors would be held to in deciding to adopt
defensive mechanism the same standard as they were held to in
originally approving the Rights Plan
Plan is
Rights reasonable defense against abusive takeover
tactics In words of the Supreme Court of Delaware
the the direc
tors reasonably believed Household was vulnerable to coercive acqui
sition techniques and adopted reasonable defensive mechanism to
protect itself

Rights Plan does not cause decline in the price of the stock
of company that adopts it Numerous investment banker studies of
stock prices before and after adoption show no attributable decline

Rights Plan should be adopted before company becomes target

Takeover entrepreneurs and speculators hate Rights Plans and are

continuing their campaign to outlaw them Witness the attached Wall
Street Journal editorial While Rights Plans do not prevent all take
overs they do protect against abusive takeover tactics and they do
deter bustup bootstrap twotier junk bond takeovers Naturally
those who profit from these takeovers at the expense of American
business workers and communities and whose wildly speculative ac
tivities threaten our entire economic system oppose anything that
restricts their activities There is no stronger argument for imple
menting Rights Plan now

Lipton
 THE WALL STREET JUURNAL THURSDAY NUVMM.K iSSb

Et Tu Delaware

The Delaware has This view of the business judgment

tiny state of As we have argued before share
en in the world rule is precisely the problem with the
titan corporate holders should have to approve any
For 50 has been the state courts decision Managers get the defensive tactic
years it
by managers
because of the rule because courts
of choice for incorporations protection Shareholders Know Best Nov
its corporate charter and courts have assume they are meeting their fidu An SEC study last month found that

catered to the needs of the market Its ciary duties to shareholders One of
do not even ask sharehold
managers
rules are aimed at efficiency these duties is the pledge not to act
legal ers to approve poison pills that seri

and investors feel most safe going self-interestedly at the expense of the
ously jeopardize the chances of take
with Delaware company Until company But as Seventh Circuit
over no doubt because the sharehold
Court of Appeals Judge Frank Easter-
now ers wouldnt approve New owners
On Tuesday the Delaware Su brook and University of Chicago law think they can run things more profit
Prof Daniel Fischel have in
preme Court upheld ruling giving argued ably and so are willing to pay dearly
law-review there
management nearly carte blanche always
to articles is
for the right to control the firm The

force poison pills down the throats of conflict when there is possible markets which make billions
capital
shareholders These anti-takeover pro takeover Managers are fighting to
available for effect
takeovers are in

visions in owner keep their jobs but it might be in the

discourage changes disciplining corporate managers The
ship which means that shareholders interests of shareholders to get new result is better- run corporations
will not be able to count on the mar set of managers The Delaware Chan So why is Delaware helping to stop
let for corporate control to ensure cery Court recently voided poison takeovers One be
reason may that

that managers perform well The re pill adopted by Revlon Inc in its un choose where
managers to incorpo
be fewer takeovers more en successful takeover defense but only
sult will rate and will go to the state that best
trenched managements and it is not because lockup was made in the
helps them keep their jobs But this is
too much fear could eventually heat of takeover battle instead of in
to shortsighted view Investors want
lead to European-style ossification of advance of battle as in Household In to invest in that will
corporations
the nations economy ternational make them money They will not want
The case Moran vs Household In The Delaware courts are losing to invest in Delaware-based corpora
ternational upholds the use of flip- of the fact that corporation is tions if that means there is little
sight
over rights plan This provision gives based on set of contracts between chance of profitable takeover This
of
shareholders the right to buy $200 shareholders and managers including would be problem for Delaware
acquirers stock for $100 upon that managers will act in the best in which has been getting almost of 20
.erger the threat to potential terests of shareholders But we sus its revenues from incorporation fees

raiders is in no uncertain terms that

pect most Household International and franchise taxes
the takeover wont pay Although Sir shareholders agree with Mr Moran There is way for the Delaware
James Goldsmith overcame similar that the poison pill is lousy idea Legislature to keep the states envi

provision adopted by Crown Zeller Proof is that the directors had consid able record as place to incorporate
bach John Moran director and ma- ered asking shareholders to and collecting incorporation rev
approve keep
jor shareholder of Household Interna fair amendment poison pill enue The state lawmakers might con
price
tional opposed the poison pill because that requires in excess of majority sider changing the corporate charter

the major effect is to decrease radi shareholder approval of hostile take to make it harder for managers to dis

cally the chances of takeover over that involves buying only some poison without exposing
pense pills

The court said the rights plan is shares at premium but backed off these strategies to shareholder ap
indeed preventive mechanism to from the idea when proxy solicita proval
ward off future advances But the di tion consultant reported that share
rectors could adopt the plan and in holders vote no
might
voke the business judgment rule to The trial heard evidence that
court
themselves from any share
protect shareholders get an average 30%
holder suits This rule says that man price premium when there is tender

agers should be left free to make busi offer and the SEC filed brief on be
ness decisions good and bad without
half of Mr Moran warning that the
the courts constantly second-guessing would shareholders of
plan deprive
them Even when it comes to fighting an to consider
opportunity virtually
takeovers the Delaware court says all hostile tender offers Yet the Del
boards duty is no different from
aware Supreme Court endorsed the

any other responsibility it shoulders trial courts view that shareholders

and its decisions should be no less en do contractual
not possess right to
the otherwise
titled to respect they receive takeover bids Shareholders
be accorded the realm of
would in
do have right to expect that man
business judgment agers wont entrench themselves
VACHTELL LIPTON ROSEN KATZ

June 1987

To Our Clients

The Proposed Delaware Takeover Statute

The Delaware Bar is considering introducing take

over statute similar to the Indiana statute upheld by the
Supreme Court in the CTS case

The Delaware statute would be applicable to all

Delaware corporations without regard to where they are head
quartered or where their shareholders reside

There is still an open question as to whether ap

plicability of the statute will require shareholder vote
or only board action

The Delaware statute will lengthen the tender offer

period from 20 business days to 50 calendar days The
tradeoff for the additional time is mandatory shareholder
vote on the tender offer vote that management will lose
unless it presents restructuring alternative that provides
greater value to the shareholders

Further the mere existence of the statute will

enable raiders to argue that it is the principal test for
tender offer and that defenses designed to keep company
independent should be held to higher legal standard than
at present

The statute would be greatly improved by the addi

tion of two provisions

Only those shareholders who were such on the

date raider first disclosed that it might seek control are
eligible to vote This would eliminate arbitrageurs making
the vote sure thing

An express recognition of the holding of the

Delaware Supreme Court in the tJnocal case that in consider
ing takeover bid the directors of the target may take into
account constituencies other than the shareholders such as
employees customers suppliers creditors and the community
at large

Delaware should be urged to make these additions

Lipton

87-0047
qTELL UPTON ROSEN KATZ

July 14 1987

To Our Clients

Second Generation Share Purchase Rights Plan

In the four years since we developed it the share

purchase rights plan poison pill has proved to be the

most effective protection against abusive takeover tactics

It has been upheld by most courts that have considered it

It has been adopted by over 400 companies But the dynamics

of takeovers have changed the takeover frenzy continues and

it is necessary to develop new means to deal with new take

over tactics and the attacks by institutional investors on

what they deem to be interference with shareholder determi

nation of takeover matters We believe that we have devel

oped new plan designed to cope with the new problems We

recommend that consideration be given to substituting it for

the original plan

In addition to the attacks on the basic legality of

the pill raiders have argued so far without success

that the directors of target that is protected by pill

have special fiduciary duty to redeem the pill to permit

cash offer for all the outstanding shares of the target

7-00 68
tHTELL UPTON ROSEN KATZ

Apart from legal attacks on the pill during the

1987 annual meeting season certain institutional investors

proposed proxy resolutions asking for shareholder referen

dum on the adoption of the pill While the resolutions

attracted on the average only 20% of the outstanding shares

and were in every case defeated the institutions are plan

ning an expanded proxy campaign in 1988 Also the SEC

continues its opposition to the pill and several of the

takeover reform bills now pending in Congress would curb the

use of the pill

The market price of the shares of many companies

that adopted pill in 1985 or 1986 has appreciated substan

tially since the pill was adopted and therefore the exer

cise price of the rights could be reevaluated with view to

increasing it to accord with current market prices and the

companys current prospects

In light of the foregoing this is clearly an

appropriate time to reexamine the pill

The pill is made more effective by adding flipin

at the 20% acquisition threshold This will prevent

raider from sweeping the street or otherwise acquiring con

trol through market purchases or partial tender offer It

also protects the shareholders in case where the raider

avoids the effect of the flipover by not doing second

HTELL LIPTON ROSEN KATZ

step merger after acquiring control We believe that the

special shareholder meeting procedure described below

resolves previous questions about the judicial reaction to

the flipin

The shareholder democracy and fiduciary duty

arguments are answered by providing for shareholder vote

if nonabusive takeover is proposed To accomplish this

we have added new provision that if bidder who does not

hold more than 1% of the shares of the company and therefore

is not greenmailer or free rider seeking to profit by

putting the company in play proposes to acquire all of the

shares of the company for cash at fair price and has

financing or financing commitments then the company will

if requested by the bidder hold special shareholder meet

ing to vote on resolution requesting the board of direc

tors to accept the bidders proposal prospective bidder

who holds more than 1% could not avail itself of this provi

sion unless it sold down to 1% before making the request

The bidder would have to furnish an investment bankers

opinion addressed to the shareholders of the company that

the price proposed by the bidder is fair The bidder would

also have to bear onehalf of the companys costs of the

special shareholder meeting

CHTELL LIPTON ROSEN KATZ

In connection with the special shareholder meeting

the bidder could submit any information it wished for

inclusion in the companys proxy statement and could mail

its own proxy material if it so desired The company could

include any information it wished in its proxy material

including information relating to the fairness of the

price proposed by the bidder and information about any

alternative transactions There would be no restriction on

the board of directors determining that the company should

remain independent and unrestructured and concurrently with

the proxy solicitation for the special shareholder meeting

asserting any litigation or other defenses the company

wishes We recognize that obtaining an injunction against

tender offer is made more difficult by providing for the

special shareholder meeting in that the courts will be

reluctant to stop tender offer that the shareholders are

about to vote upon however we think this is fair trade

off for the protections of the new pill Nor would there be

any restriction on the bidder pursuing whatever takeover

tactics including litigation to invalidate the pill or

require the board of directors to redeem it it wishes

To assure sufficient time to consider the bidders

proposal and to seek and evaluate alternatives and to pre

pare the proxy material but also to avoid undue delay the

special shareholder meeting would be required to be held not

CHTELL LIPTON ROSEN KATZ

later than 120 days nor earlier than 90 days after the bid

ders request except that if the bidders request is

received after an annual or special shareholder meeting has

been scheduled the meeting requested by the bidder could be

held not later than 120 days after the earlier scheduled

meeting We recognize that the meeting procedure permits

the vote to be heavily influenced by arbitrageurs and the

bidder and its allies who purchase after the announcement

of the bidders proposal but before the record date How

ever absent statutory authority there is substantial

question as to the legality of record date prior to the

first announcement of the bidders proposal and it would

raise other legal questions to restrict purchases by the

bidder after it makes its request or to deprive the bidder

of voting rights on those purchases

If majority of the companys outstanding shares

vote in favor of the resolution at the special shareholder

meeting the pill would be redeemed so as to permit consum

mation of the bidders proposal or competing better pro

posal If following an approving vote the company does not

enter into cash merger agreement with the bidder and

there would be no obligation to do so the bidder could

make tender offer unaffected by the pill provided the

tender offer is for all the shares at cash price not less

than the price the shareholders voted upon The bidder

CHTELL LIPTON ROSEN KATZ

might actually start its tender offer when it makes the

request for the special shareholder meeting or at any time

thereafter If the bidder does so it could structure the

timing so that it consummates its tender offer immediately

following the meeting

To the extent that the new pill channels takeover

activity into the special shareholder meeting procedure it

will be more effective than the original pill in

discouraging abusive takeover tactics and will provide more

time for target to deal with the cash offer for all shares

against which there is today no practical defense other than

drastic restructuring The new pill recognizes the

realities of market dominated by institutional investors

and regulatory system that tolerates junkbondfinanced

corporate raiders who are able to put almost any company

into play and whose activities invariably result in bust-

up of the target whether by the raider white knight or

the target itself in restructuring The new pill does not

prevent takeovers Like its predecessor it protects against

the worst takeover abuses it gives all parties reasonable

period of time in which to make decisions on such funda

mentally important question as takeover and it

strengthens the ability of the board of directors of tar

get to obtain the best result for the shareholders

ICHTELL LIPTON ROSEN KATZ

We recognize that the new pill assures raider

that it can obtain shareholder vote on proposed take

over and therefore might be said to promote takeovers

However as practical matter raider can obtain share

holder vote or the pragmatic equivalent of shareholder

vote on proposed takeover apart from the special share

holder meeting provisions in the new pill For most major

public companies with substantial institutional ownership

there is no absolute takeover defense other than management

control of majority of the voting stock Therefore those

companies and their shareholders are best served by pill

that provides the most effective protection against takeover

abuses and removes much of the profit incentive for raider

putting company in play On balance we believe that if

universally adopted the new pill would decrease substan

tially hostile takeover activity

The new pill borrows from the special shareholder

meeting concept of but is more balanced than the Indiana

type control share acquisition statute recently upheld by

the Supreme Court in the CTS case The new pill would

reduce the pressure for Delaware and other states to enact

the Indianatype statute with all of its drawbacks Unlike

the new pill the Indianatype statute does not deter

raiders from freeriding or seeking greenmail by accumulat

ing an up to 20% position and then putting the target in

CHTELL UPTON ROSEN KATZ

play To avail itself of the special shareholder meeting

the bidder cannot hold more than 1% when it requests the

meeting and can buy more than 1% only after the share

holders of the target have been protected by public dis

closure of the bidders proposal However prior to the

vote at the special shareholder meeting neither the bidder

nor anyone else could cross the pills 20% threshold with

out triggering the nonredeemability and flipin provisions

of the pill at that level

The Indianatype statute does not protect share

holders from twotier offers partial offers unfair second

step freezeout mergers and being locked into minority

positions The new pill prevents or protects against all of

these abuses

The Indianatype statute provides only 50 days to

evaluate an offer and to seek and evaluate alternatives

period that is clearly inadequate for the creation and ac

complishment of complex restructuring or the search for

and negotiation of an alternative acquisition and the prep

aration and SEC clearance of the requisite proxy material

The new pill does not affect the bidders voting rights or

otherwise prevent tender offer by the bidder from being

completed in the 20 business day period set under the

Williams Act Therefore the pill is not inconsistent with

CHTEL.L LIPTON ROSEN KATZ

the Williams Act and does not create the sort of preemption

question that is thought to limit Indianatype statutes to

the 50day period The new pill only establishes 90 to

120 day period if bidder desires to avail itself of the

special shareholder meeting procedure If the bidder does

not elect to avail itself of this procedure subject to the

other provisions of the pill it may proceed with tender

offer open market accumulation or bear hug just as it would

at present

As in the case of the original pill and most sig

nificant legal innovations there can be no assurance that

all courts will agree that the new pill is legal It is our

opinion that it is legal and that it is within the business

judgment of the board of directors to substitute the new

pill for the original pill

We are advising our clients to consider substitut

ing the new pill for their existing pill and in that con

nection where appropriate to set the exercise price of the

new rights to reflect the current market price of the common

stock Companies that have first generation pills can in

most cases amend such pills to add the second generation

pill provisions without redeeming their pills However the

substitution of new exercise price in place of the exist

ing exercise price of companys rights would require that

CHTELL UPTON ROSEN KATZ

the original pill be redeemed and the new issued

pill in the

same manner as the original pill

Lipton

10
CHTELL LIPTON ROSEN KATZ
September 1987

To Our Clients

Proposed Delaware Takeover Defense Stock Redemption Statute

Introduction

proposed amendment to the Delaware corporate law

would permit Delaware corporations to redeem common stock

held by persons who intend to greenmail them or put them in

play at the lesser of the fair value of the common stock or

the average price paid by the acquiror during the previous

year This proposal may provide Delaware corporations with

useful takeover defense in some situations but we are

concerned it will not be effective In any event it is not

sufficient to protect corporations and their shareholders

against abusive takeover tactics and junk bond bust-up

takeovers It is hoped that this proposal will not divert

Delaware from enacting meaningful takeover legislation We

recommend that Delaware adopt the New York type statute that

deters bustup takeovers and the Ohio type statute that

affirms the right of company to remain independent

Section 151b of the Delaware General Corporation

Law now permits corporation which has governmental

license or franchise to conduct its business conditioned

upon some or all of the holders of its stock possessing

87-0077
CHTELL LIPTON ROSEN KATZ

prescribed qualifications to have charter provision pro

viding that its stock is subject to redemption by the corpo

ration to the extent necessary to prevent the loss of such

license or franchise or to reinstate it The proposal would

expand Section 151 to permit redemption by the corporation

whenever twothirds majority of the independent outside

directors and twothirds majority of the full board con

clude that the holder intends to obtain shortterm

gain from greenmail or to cause the corporation to enter

into transaction that is not in the longterm interests of

the corporation and its stockholders or that the hold

ers ownership of the stock is causing or is likely to cause

material adverse impact on the corporations business or

prospects including the impairment of the corporations

relationships with its customers or its ability to maintain

its competitive position These expanded redemption provi

sions would be applicable to all Delaware corporations which

did not opt out of its coverage by charter amendment

The text of the proposed amendment is attached as

an appendix It is loosely based upon provision in the

Connecticut insurance laws that makes the stock of Connecti

cut insurers subject to redemption at its fair price if the

board of directors determines that the stockholder being

redeemed fails to meet the prescribed licensing qualifica

tions or otherwise fails to obtain necessary regulatory

approvals
CHTELL LIPTON ROSEN KATZ

Potential Risks

There is danger that directors will be exposed to

personal liability In view of the exposure to personal

damage suits seeking substantial amounts boards of direc

tors would be extremely reluctant to exercise the redemption

power The directors would face not an amorphous class

litigation but highlymotivated action by an individual

who would be able to show an actual readily determinable

loss Furthermore boards decision to redeem would be

attacked as breach of its duty of loyalty and accord

ingly board members would not be shielded from liability

for monetary damages even if the corporations charter had

been amended to conform with the recent Delaware legislation

regarding director and officer liability only further

and highly unlikely amendment to the Delaware law elimi

nating any liability for wrongful redemption such as by

making appraisal the exclusive remedy could fully protect

directors

The market effect of the proposal is unknown

Potential redemption at the average price paid if stock

holder including institutional holders were to support or

Damages could be measured by the difference between the

redemption price and the market price on the date of redemp
tion or the difference between the redemption price and
premium price subsequently paid upon change of control
plus carrying costs and related fees and expenses
CHTELL LIPTON ROSEN KATZ

join in proposal to restructure or merge company is

such an extreme penalty that it might depress the trading

price and affect the marketability of companys stock

The reaction of institutional investors and the effect on

the market would have to be considered by board in deter

mining whether to propose charter amendment to opt out of

the statute

In view of the current interest in one shareone

vote and the SECs all holders rulemaking response to

Unocals exclusionary selftender offer it seems inevitable

that Delaware forced redemption statute would generate

substantial controversy at the SEC and in Congress and could

even impel Congress to seek to preempt broad range of

state statutes in this area

Insufficient Defense to Current Takeover Abuses

The Supreme Court of Delaware has held that board

of directors of target company has the right in the

proper exercise of its fiduciary duty to reject takeover

bid and seek to preserve the companys independence What

is needed is statutory approach to assist boards of direc

tors to protect their companies and shareholders from inade

quate or illtimed takeovers

CHTELL LIPTON ROSEN KATZ

The redemption proposal standing alone does not

provide sufficient protection Raiders will simply adjust

their tactics to avoid the reach of the statute They will

disclaim any intent to seek greenmail or destabilize the

corporation for shortterm gain and claim that their only

purpose is an acquisition at premium price Indeed

Boone Pickens who in recent weeks has disclosed accumula

tions or intentions to accumulate positions in Boeing

Singer and Newmont has now proposed to acquire all of

Newmont after having accumulated 9.9% of its stock If

Pickens were simultaneously to disclose both his acquisition

proposal and his accumulation then notwithstanding his

history and the tJnocal cases characterization of his past

actions one could not be certain that the proposed statute

would protect directors who were to authorize redemption

of his Newmont shares

Recommended Approach

Hence even if the redemption statute were to be

adopted it should be part of broader package The Dela

ware legislature should consider adopting the approach

enacted by seven states including New York This approach

establishes fiveyear freeze on secondstep mergers

CHTELL LIPTON ROSEN KATZ

between company and 10% stockholder unless approved by

the board of directors before the acquisition of the 10%

stake Unlike the redemption proposal this statute

addresses the junk bond bustup takeover by denying the

raider the ability to reach the assets of the target to

repay the takeover financing

We also recommend that the Delaware legislature

adopt the portion of the Ohio statute that permits board

faced with takeover bid to consider range of factors

including the interests of the corporations employees

suppliers creditors customers and communities which it

serves as well as the longterm interests of the corpora

tion and its shareholders

Unlike the precedents provided by the New York and

Ohio statutes for our recommended approach the Connecticut

insurance company statute is weak precedent for the

redemption proposal The Connecticut statute can be distin

guished by the long tradition of extensive state regulation

of insurance companies including the universal requirement

that state agency approve transfers of control defined

to mean stock positions of as little as 5% Furthermore

like the very narrow redemption power presently permitted

While New York established 20% threshold for an

interested stockholder we recommend the 10% threshold
adopted by New Jersey and four other states
CHTELL LIPTON ROSEN KATZ

under Delaware law to be included in corporate charters the

basis for the redemption power in the Connecticut statute is

linked to the qualifications to be licensed which affects

the fundamental ability of regulated corporation to oper

ate as going concern There is no precedent for such

redemption power in the case of industrial or service corpo

rations generally

Drafting Issues

Determination of intention to greenmail or put

company into play As noted above this standard may be

ineffective against raider who takes precautions to avoid

its reach Since this basis for redeeming the raiders

stock depends upon the subjective intent of the raider it

will be difficult for board to redeem the stock of

raider who expressly disclaims such intent unless such

raiders mere presence as shareholder can reasonably be

said to materially adversely impact the corporation Fur

thermore while it is appropriate for board of directors

in determining what course of action to take to consider

the longterm interests of the corporation and its stock

holders this proposal would authorize board to redeem the

stock of anyone whether greenmailer an arbitrageur or

CHTELL LIPTON ROSEN KATZ

long-term stockholder who supports corporate

restructuring who seeks shortterm gain In this

respect it is so extreme that one may expect the courts to

construe it narrowly

Pricing redemption price formula that is based

upon the fair value of the stock as determined by the board

but limited to no more than the average price paid by the

raider in the last year may well be viewed as overly harsh

On the other hand marketpricebased redemption provi

sion by giving the raider the benefit of the increase in

market price that his actions have generated would obvi

ously be less effective deterrent than the costbased

model One possible compromise would be redemption price

based upon the market price prior to the first public dis

closure of the raiders position or proposal

Procedures The proposed statute is silent on the

procedures for redemption The provisions of the Connecti

cut statute should be considered Connecticut provides for

written warning to the raider prior to board action and

30day notice period of the redemption date although upon

the corporation setting aside the redemption price the

As proposed the statute would subject to redemption the

shares held by institutional investors who support proxy
fight by group proposing new slate of directors who
would approve restructuring
CHTELL LIPTON ROSEN KATZ

rights of the raider terminate with respect to such shares

other than to receive the redemption price and dividends to

the redemption date The Connecticut statute also provides

that court appraisal of the value of the redeemed shares is

the shareholders exclusive remedy Only if Delaware were

to adopt this approach would the directors be fully pro

tected from liability

Limitations on other corporate repurchases The

proposed redemption statute may unduly limit the boards

authority to repurchase shares under circumstances that in

the boards view justify price higher than the statutory

redemption price Read in conjunction with present Section

l60a2 which prohibits the purchase of shares that are

redeemable at the corporations option for more than the

redemption price the proposed statute could preclude

corporation from repurchasing its shares at price above

the redemption price under circumstances which would not be

considered greenmail As such it may prevent perfectly

legitimate transactions

Effective Date While the statute is drafted to be

effective as of the announcement of its consideration it is

unclear what this means It is also not clear whether it is

proper to make subject to redemption shares acquired before

statute becomes effective The Connecticut statute

CHTELL LIPTON ROSEN KATZ

applies to shares the beneficial ownership of which is ac

quired after the effective date

Conclusion

Delaware should as soon as possible enact legisla

tion to protect against takeover abuses The best protec

tion would be provided by combination of New York type

statute that imposes fiveyear prohibition on second

step merger following an unapproved acquisition of 10% of

the targets shares and statutory recognition of the right

of directors of the target to reject takeover on the basis

of longterm interests as well as shortterm interests of

the corporation and its shareholders including the possi

bility that these interests may be best served by the con

tinued independence of the corporation

Lipton
G.A Katz
M.W Schwartz
E.S Robinson
G.J Shrock

10
HTELL LIPTON ROSEN KATZ

Appendix

Text of Proposed Delaware Redemption Statute

Unless the certificate otherwise provides any

stock held by an existing stockholder may be redeemed by
the corporation if twothirds majority of the indepen
dent outside directors and twothirds majority of the
entire board of directors conclude that the ownership of
the corporations stock by such stockholder is intended
to cause the corporation to repurchase the stock owned
by such stockholder or to cause the corporation to take
action or enter into transaction or series of transac
tions intended to provide such stockholder with short
term financial gain under circumstances where such two
thirds majorities determine that the best longterm
interests of the corporation and its stockholders would
not be served by taking such action or entering into
such transactions or series of transactions at that
time or determine that such ownership is causing or
reasonably likely to cause material adverse impact
including but not limited to loss or threat of loss
of any license or franchise from governmental agency
to conduct its business loss or threat of loss of any
membership in national securities exchange impairment
of relationships with customers or impairment of the
corporations ability to maintain its competitive posi
tion on the business or prospects of the corporation

This section shall not apply to and no power to

redeem pursuant to this section shall be conferred on
any corporation the board of directors of which does not
contain at least two independent outside directors

Any stock redeemed pursuant to this section may be

redeemed for consideration in the form of cash property
or rights including securities of the same or another
corporation having value equal to the fair value of
such stock as determined by the board of directors but
in no event greater than the average price per share
paid for all of the stock of the corporation held by the
stockholder whose stock is redeemed which stock has
been acquired during the year preceeding the determina
tion multiplied by the number of shares redeemed In
the absence of actual fraud the judgment of the direc
tors as to the value of the consideration for the re
deemed stock shall be conclusive

A-l
HTELL LIPTON ROSEN KATZ

The Court of Chancery is hereby vested with the

exclusive jurisdiction to determine the validity of any
redemption of stock pursuant to this section

This Act shall be effective as of of an

nouncement of consideration of amendment

A-2
HTELL LIPTON ROSEN KATZ

November 18 1987

To Our Clients

Takeovers No Requirement to Auction Company

In definitive and extremely significant

decision the Delaware Supreme Court in the Newmont case has
held that there is no requirement that the directors of
target company auction the company to the highest bidder The
directors have the right to reject the takeover bid and
determine to keep the company independent In evaluating
takeover bid the directors may consider

the inadequacy of the bid

the nature and timing of the offer

questions of illegality

the impact on constituencies other than the

shareholders

the risk of nonconsummation and

the basic stockholder interests at stake

including the past actions of the bidder in other
takeover contests

The decision also makes clear that company may

have policy of remaining independent and take reasonable
action to implement that policy

Lipton

87-0095
WACPITELL LIPTON ROSEN KATZ

February 2 1988

To Our Clients

Nuch Ado About Nothing The Delaware Takeover Law

The much discussed arid heavily lobbied Delaware

takeover statute today became law with a December 23 1987
effective date

The statute is quite simple If someone crosses

the 15threshold without the approval of the board of
directors of the target it is barred from a business
combination with the target for three years unless

1 it jumps from below 15 to at least 85 of

the target s stock in a tender offer excluding from the
denominator shares controlled by the target s management or

2 it obtains the approval of two thirds of the

shares it does not own

It will be a rare situation where a tender offer

will not attract 85 of the target s non management
controlled stock Only where a single large holder or a
group holds about 10 or more and is prepared to not accept
the tender and risk becoming a minority shareholder will
the 85 threshold not be obtained If there is a large
holder with 10 to the 15
bidder may follow an alternative
strategy and tender for only 51 instead of 100 and state
its intention to follow the tender with a cash merger on the
assumption that since the remaining shareholders will not
want to continue as minority shareholders in a company now
controlled by the bidder the bidder can obtain the approval
of two thirds of the remaining shares

Sincedelay before a raider can effect a

the
squeezeout merger only three years it is easy in
is
today s markets to structure bank or junk bond financing
that will permit the raider to follow either of the
strategies described above and not be in default if it
should fail to achieve either the 85 or two thirds goal
15 threshold before the statute is triggered
The
leaves ample room for raiders to continue to accumulate a 10
to 15 position and then put the target in play This has
been and continues to be virtually a no lose proposition for
raiders Either the raider acquires the target at the

C03265
WAcHTELL LIPTON RosEN KATZ

raider s price and then profits by busting it up or the

target restructures or finds a white knight at a price that
gives the raider a large profit

The Delaware law does deter two tier bids where

the raider s financing will not accoriinodate a three year
delay before the raider can squeezeout the remaining
shareholders However this form of abusive takeover had
become obsolete long before Delaware started to consider
adopting a takeover statute

Since the Delaware statute does not displace other

protections against abusive takeovers such as the poison
pill the statute may be summed up as innocuous and there is
no reason why Delaware corporations should opt out of it

M Lipton

O32.66
WACHTELL LIPTON RosEN KATZ March 31 1988

To Our Clients

The Takeover Frenzy

1988 has witnessed an amazing resurgence of take

over activity Less than six months after the October 19

market crash takeover activity is higher than at any time

before the crash So far this year more than 72 billion of

takeover bids have been announced twice that of this time

last year There is no one explanation for the renewed

takeover frenzy However it is possible to identify a num

ber of factors that contribute Some of the factors overlap

and some are more significant than others In combination

they explain today s takeover activity

Cultural changes There is no longer any cultural

barrier to a hostile takeover bid Corporate raiders are

glorified on the covers of magazines and on television

This year has seen JP Morgan act for a Swiss company

Hoffman LaRoche in a tender offer for Sterling Drug a

long time Morgan banking client Shearson Lehman Hutton join

as an equity partner with a British company to make a hos

tile bid for Koppers General Electric a pillar of the

Business Roundtable and the corporate establishment make a

hostile bid for a small appliance manufacturer Roper

Emhart a major company in Hartford Connecticut become the

first company in a close business community like Hartford to

c031
WACHTELL LIPTON RosEN K rz

make a hostile bid for another company in the same cominu

flity the spread of takeover activity to continental Europe

and the concommitant willingness of European companies to

make hostile bids in the US and the beginning of Japanese

participation with the Bridgestone white knight bid of 80

per share 2.6 billion for Firestone after a hostile bid

of 58 per share 1.9 billion by Pirelli and Michelin

Director attitudes Boardroom attitudes have

changed Management is no longer restrained by fear that

directors will look askance at a proposal to make a hostile

bid Many companies believe that if they are not taking

over others and not increasing their size and leverage they

will become targets To remain independent they have become

raiders Target directors are less willing to fight to

remain independent and seem more concerned to avoid being

embarrassed by a charge of failure to maximize shareholder

values than to preserve independence

Availability of financing First Boston developed

the bridge loan to compete with Drexel Burnham s junk

bonds Now all the investment banks provide bridge loans to

be refunded with junk bonds and the major commercial banks

are competing with the investment banks to provide takeover

financing A fair estimate of the aggregate equity funds

for acquisitions held by the scores of leverage buyout funds

Cu3 I I
WACHTELL LIPTON ROSEN KATZ

many started since October 19 is more than 25 billion

Leveraged at five to one which is quite low compared to the

ten to one in many recent transactions the 25 billion

would support 125 billion of acquisitions Money to

finance takeovers is available in unlimited amounts

Cheap dollar and cheap companies The decline in

the dollar against the yen and the European currencies

lower market prices post October 19 and lower price earnings

ratios for US companies than for those of most non US

companies makes US companies cheap This has created a

unique opportunity for non US companies to bid for US

companies such as the tender offers this year by Hoffman

LaRoche for Sterling Drug BAT Industries for Farmers Group

Campeau for Federated Department Stores Pirelli for

Firestone Beazer for Koppers and Hachette for Grolier The

US is still the safest safe haven and there is still a

great desire by foreigners to diversify into the US

Strength of US economy The October 19 crash did

not at least not yet result in a recession It merely

lowered stock market prices to a level where they became

attractive to corporate strategic buyers The economy today

appears strong with more concern about inflation than reces

sion Inflation encourages acquisitions in that assets

appreciate in value and the debt incurred to buy the assets

decreases in value

3
WACHTELL LIPTON ROSEN KATZ

Retreat of the raiders return of the strategic

yers For several years prior to 1988 takeovers were

dominated by corporate raiders and their junk bond financed

boot strap bust up takeovers The 1987 change in the tax

law eliminating devices which allowed a raider to liquidate

a target on a tax favored basis has reduced the incentive

for bust up takeovers and in many cases results in a price

advantage to a buyer who does not plan to resell a signifi

cant part of the acquired assets Similarly an internal

restructuring of a company has become more competitive in

price with a bust up takeover Thus the bust up raiders

have taken to the sidelines They still go on to the

playing field but not so often This has brought back the

strategic buyers Less competition from raiders lower mar

ket prices post October 19 and fear that the next Admin

istration may be restrictive of takeovers have combined to

make hostile bidders of acquirors who previously would

undertake only a negotiated acquisition

Institutional investor control With the ownership

of a majority of the shares of most major companies in the

hands of institutional investors it has become virtually

impossible to defend against a takeover The institutions

have become activists in opposing takeover defenses voting

for Corporate raiders in proxy fights and forcing companies

to auction themselves to the high bidder One is hard

4
IQ
WACHTELL LIPTON RosEN KATZ

pressed to name even one company which during the past three

years became the target of a cash tender offer for all of

its shares and managed to remain independent and unrestruc

tured Today institutional investors are not just insisting

on a takeover premium when a company is put in play they

are actively promoting takeovers

Permissive attitude of the regulators and the

courts The SEC FRB ICC CAB FCC and the Administration

generally favor takeovers oppose legislation that would

restrict takeovers and enforce the law or refuses to

enforce the law in a manner that favors the raider over the

target There is a sharp tilt of the playing field in favor

of the raider The only effective brakes on takeover activ

ity the poison pill and state takeover statutes are

under constant attack by the SEC and the Administration

The courts have caught takeover fever and do not hesitate to

second guess directors who are seeking to preserve the inde

pendence of their company Whereas once the main focus of

takeover litigation was the target s effort to enjoin the

raider today it is the raider s efforts to enjoin a re

structuring defense by the target

Market encouragement of leverage The standards

for the ratio of debt to equity have reversed so substan

tially that where once it was thought too risky to have debt

5
cj3 Vll
WACHTELL LIPTON RosEN KATZ

greater than half of equity today debt ten times equity is

applauded The highly leveraged company is accorded a pre

mium price in the market The stub shares of highly lever

aged restructured companies sell at prices not based on

earnings or assets but as calls on what the earnings might

be in five years or more The premium for leverage is a

major factor in promoting takeovers Indeed the market

today so deeply discounts unleveraged future growth that

there is a significant disincentive to invest in research

and development and new plants and equipment

The attraction of LBO5 The LBO gives management a

greater equity stake than the customary stock incentives in

most public companies For professional managers there is a

great attraction to getting away from worrying about

quarter to quarter earnings performance and instead being

able to manage with the objective of maximizing cash flow

Many managers today believe that if a company is subject to

being raided there is no reason not to be preemptive and

attempt a leveraged buyout With the huge amount of LEO

capital available there is great momentum behind the LEO

movement It has become a major factor in the rationaliza

tion of American business It continues to grow at a very

rapid pace

6
WACHTELL LIPTON ROSEN F ATZ

The takeover infrastructure Almost every large

Company has an acquisition staff All the major law firms

and accounting firms have merger and acquisition depart

ments Takeovers are the most profitable investment banking

activity So profitable that the major commercial banks

have developed large merger and acquisition departments to

compete with the investment banks Boutique investment

banking firms are springing up and large and small all the

firms want to be merchant bankers with direct equity partic

ipation in takeovers The expanding infrastructure is a

driving force in expanding takeover activity

Decline of community and union opposition The

days of the Bartlesville prayer meetings and the Pittsburgh

union demonstrations are gone Today except for the attack

by the state of Pennsylvania and the city of Pittsburgh on

Shearson Lehman for participating as an equity partner with

Beazer in its hostile bid for Koppers communities rarely

come forward to protest the takeover of local companies

Indeed as illustrated by the efforts of the United Airlines

and PanAm unions to takeover those companies unions have

become raiders

Takeovers have become a world wide phenomenon The

current resurgence following the October 19 crash is ex

plained by some on the basis of one or two factors At any

7
WACHTELL LIPTON ROSEN KATZ

One point in time one or two factors may be dominant How

ever after 15 years of world wide growth of takeovers the

conclusion is inescapable they are not a temporary aber

ration They reflect a universal fundamental aspect of pub

lic ownership of major business entities in democractic

Societies The debate as to whether takeovers are good or

bad whether they enhance efficiency whether they impede

long term planning whether they create dangerous levels of

leverage whether they are essential counterbalances to

trade deficits will continue Respected opinion is lined

up on either side of each issue However one feels about

these issues the fact is takeovers have become a major

aspect of the free world economies

M Lipton

8
WACHTELL LIPTON ROSEN KATZ

May 21 1988

To Our Clients

Clarifies Fiduciary
of Directors in Takeover

The recency of the takeover phenomenon and the hap

penstance nature of takeover litigation results in an

absence of body of judicial opinions that would enable

comprehensive synthesis of the law governing the fiduciary

duties of the directors of company faced with takeover

This has resulted in much confusion Some have argued that

the courts have abandoned the traditional business judgment

rule in takeover situations Some have argued that the

directors of takeover target have only one duty to act

as auctioneers and get the highest price obtainable

In the past year there have been number of cases

reaffirming the application of the business judgment rule to

takeover decisions by directors These cases have rejected

the argument that the only question is the shortterm inter

ests of the shareholders The courts have now made it clear

that the directors of takeover target may properly deter

mine to reject the takeover bid and decide to remain an

02923
WACHTELL LIPTON ROSEN KATZ

independent company and in reaching that decision may

take into account the adequacy of the bid timing factors

risk of nonconsummation effect on employees customers

sup pliers and communities and the past history of the

bidder

Now one of the most troublesome questions also has

been laid to rest Some had read the and

cases to mean that the directors of company who had deter

mined to sell the company had an absolute duty to get the

highest possible price and that in this circumstance there

was no room for the exercise of discretion In the

case decided on May 19 the Delaware Chan

cery Court said it

is certainly incorrect to assert that

recognized duty on the part of
directors when corporation is for
sale to get the highest available
price Rather the duty can only be to
try in good faith in such setting to
get the best available transaction for
the shareholders Directors are not
insurers

The court went further and laid to

rest the fear that the case undercut the business

judgment rule the court saying

In my opinion where disinterested

board in good faith considers the signif
icance of the decision called for the
available information of which it and its

02924
VVACATELL LIPTON ROSSN KATZ

advisors are aware and the time con

straints imposed upon it and in those
circumstances the board makes decision
that it is in the best interests of the
corporation to act that decision itself
is entitled to the benefits of the busi
ness judgment rule

Lipton

02
WACHTELL LIPTON ROSEN KATZ November 1988

To Our Clients

Interco

The Tuesday November decision in the

case came as surprise If it is affirmed by the Delaware
Supreme Court which yesterday scheduled an appeal for No
vember 30 it could be the death knell for restructuring as
response to cash tender offer for all the shares of
company which the board of directors determines is inade
quate
The Delaware Chancery Court in held that
the company could not use its poison pill as shield
against the inadequate offer until it had completed the dis
tribution to its shareholders of the dividend to be paid as
part of its restructuring Rather the Court said after
the restructuring plan has been developed and adopted the
pill must be redeemed so that the tender offer could go for
ward before the distribution This despite the fact that
the Court found no fault with the restructuring plan and no
reason to doubt that the Interco board reasonably concluded
that the hostile tender offer was inadequate and that the
restructuring plan was preferable Further there was no
finding of entrenchment indeed the restructuring plan
did not roll up managements shareholdings into blocking
position and Interco was as much subject to takeover after
the restructuring as before

While the Court in the case pays lip ser

vice to the doctrines that companies do not have to have
permanent for sale signs and that an auction sale is not the
only response target of hostile cash bid for all its
shares can make the practical effect of the decision is
just that believe it flies in the face of the Delaware
Supreme Court decisions in the and cases If
it is not reversed by the Delaware Supreme Court it will be
dagger aimed at the hearts of all Delaware corporations
and further fueling of the takeover frenzy

The case and the failure of Delaware to

enact effective
an takeover statute raise very serious
question as to Delaware incorporation New Jersey Ohio and
Pennsylvania among others are far more desirable states
for incorporation than Delaware in this takeover era Per
haps it is time to migrate out of Delaware

02 839
IQ LIPTON ROSEN KATZ

It should be noted that press reports to the con

trary notwithstanding the case did not cast any
doubt on the legality of the poison pill The pill remains
the most effective means of dealing with abusive takeover
tactics But unless is reversed by the Delaware
Supreme Court its benefits to targets and their shareholders
will be significantly curtailed

Lipton

C02E40
WACHTELL, LIPTON, ROSEN & KATZ

November 8, 1988

To Our Clients:

J
Court of
In the

Chancery
Pendorsed
case,

the
Say

decided

"just say no"

yesterday,

response
the

to
Delaware

a cash

tender offer for all shares that the target’s board acting in

good faith and on a reasonable basis determined to be inadequate.

The Court said that the target’s "exploration of alternatives m

go on indefinitely" and a poison pill may be kept in place to

protect

Court read
the

the I
target’s ability to

case (now
continue

on appeal
the

to
exploration.

the Delaware
The

Supreme

P
Court) as holding that a pill must be redeemed only when the

target has selected an alternative and the tender offer is

"arguably comparable" to the alternative. The decision

did not take into account the spin-off alternative Pillsbury

announced yesterday and the bidder for Pillsbury is going back to

the Court to argue that since an alternative valued in the

market at less than the cash bid -[ has now been selected, the

Court should now order the pill redeemed.

M. Lipton
 WACHTEL-L-. LIPTON, ROSEN Ôc KATZ

December 17, 1988

(
\

To Our Ci ients :
You Can't Just Sav No
In Delaware No More

The Pillsbury decision yesterday fulfills the threat to

Delaware corporations presaged by the Interco decision. In
Pillsbury a single Delaware judge substituted his judgment for the
business judgment of the Pillsbury Board of Directors and
sentenced Pillsbury to death as an independent company. The death
sentence was passed despite the fact that the Pillsbury Board was
not found to be acting in bad faith or negl igently and despite the
fact that the Pillsbury Board, on the advice of independent
investment bankers, had determined that the takeover bid on the
table was inadequate and was asking for $5 per share more as the
price for a negotiated merger.

The Pillsbury decision confirms the fear that the

Delaware judges have abandoned the Business Judgment Rule in
takeover cases and will substitute their business judgment for
that of a target company's board of directors, even though the
board is acting in good faith and on a reasonable basis.

The effect of the Pillsbury decision will be disastrous

for American business and the American economy. It will fuel the
takeover frenzy. It guarantees that any highest cash bid for all
the shares of a company will result in the bidder acquiring the
target. It even threatens the effective use of the poison pill as
a means of achieving the time and circumstances necessary for a
target's board to obtain the highest value for the shareholders.
The Pillsbury decision means that the constant threat of takeover
will be ever present for Delaware corporations, and, to survive,
they will have to satisfy the demands of institutional investors
and arbitrageurs for short-term stock price performance by
increasing their leverage to dangerous levels and decreasing
research, development and capital investment to levels that will
ul timately destroy their ability to compete in world markets.

The Pillsbury decision shows that Delaware either does

not understand, or does not care about, the long-range
macroeconomic problems of the takeover frenzy and the concomitant
deequitization of American business and its forced refocus on
short-range stock market performance. Unless Delaware acts
quickly to correct the Pillsbury decision, the only avenues open
to the half of major American companies incorporated in Delaware
will be federal legislation of the type now being considered by
the Treasury Department or leaving Delaware for a more hospitable
state of incorporation.
 WACHTELL, LIPTON. ROSEN Ôc KATZ

While the institutional investors and speculators who

~
profit from the pillsbury decision and the takeover frenzy will
likely oppose a company lowering its takeover profile by leaving
Delaware, the necessary votes are probably obtainable (witness
Time and Inco) if the migration is accompanied by a special
dividend or reasonable restructuring. In this connection, a
company should consider a dividend of Share Price Protection
Preferred Stock.

M. Lipton

- 2 -
 A New System of Corporate Governance:
The Quinquennial Election of Directors
Martin Lipton and Steven A. Rosenblumt

INTRODUCTION

Corporate governance is a means, not an end. Before we can

speak intelligently about corporate governance, we must define its
goals. In much of the recent academic literature on corporate gov-
ernance, however, the goals are either ill-defined or assumed with-
out examination. Academic writers commonly assume that a corpo-
rate governance system should be designed primarily to ensure
that the actions of a corporation's managers and directors accu-
rately reflect the wishes of its stockholders.' This assumption rests
in turn on the premise that stockholders, as owners of the corpora-
tion, have the intrinsic right to dictate the corporation's course and
receive its profits. Once this premise is accepted, the recognition of
the separation of ownership and management as the central char-
acteristic of the modern public corporation2 leads inexorably to the
conclusion that the central goal of corporate governance is to disci-
pline managers, that is, make managers conform their actions to
the desires of stockholders.
This line of academic analysis has coincided with the rise of
hostile takeovers. Ignoring the quite varied sources and motiva-
tions of hostile acquirors, academic writers have embraced the hos-
tile takeover as the free-market device to rid corporations of bad
managers and give stockholders their entitled profit in the pro-

t Members of the Firm of Wachtell, Lipton, Rosen & Katz, New York. The authors'
colleague, Yvonne M. Dutton, assisted in the preparation of this Article.
I See, for example, Frank H. Easterbrook and Daniel R. Fischel, The ProperRole of a
Target's Management in Responding to a Tender Offer, 94 Harv L Rev 1161, 1191, 1201
(1981) (managerial passivity in response to takeovers best serves stockholder interests);
Ronald J. Gilson and Reinier Kraakman, Reinventing the Outside Director: An Agenda For
Institutional Investors 31-32, 38, 46-48 (John M. Olin Program in Law and Economics,
Stanford University Law School, 1990) (on file with U Chi L Rev) (proposing a corps of
professional outside directors dependent on institutional stockholders, not management, for
their positions); Louis Lowenstein, What's Wrong with Wall Street: Short-term Gain and
the Absentee Shareholder209-18 (Addison-Wesley, 1988) (institutional stockholders should
nominate 20-25 percent of board, to encourage their participation in corporate governance).
2 See generally Adolf A. Berle and Gardiner C. Means, The Modern Corporationand
Private Property (Harcourt, Brace & World, rev ed 1968).
 The University of Chicago Law Review [58:187

cess.3 Accordingly, these writers have proposed corporate govern-

ance rules designed to ensure that corporate managers and direc-
tors cannot impede a hostile takeover.
Upon examination, however, the unspoken premises of this
body of academic literature are seriously flawed. First, there is no
basis for the assumption of intrinsic rights and entitlements in the
corporate structure. The Anglo-American corporate form is a crea-
tion of the state, conceived originally as a privilege to be conferred
on specified entities for the public good and welfare. While the cor-
porate form became more widely available as the economy de-
manded it, and is now generally available to any business, it re-
mains a legal creation. As with any legal construct, we must justify
the rules governing it on the basis of economic and social utility,
not intrinsic rights. If alteration of those rules benefits the eco-
nomic system and, in the long run, the corporations themselves,
notions of "intrinsic rights" should not stand in the way.
Second, the academic literature has vastly overstated the ben-
efits of the hostile takeover. Even if one accepts the priority of dis-
ciplining managers, the hostile takeover has proven a particularly
destructive and inefficient means of such discipline. Hostile take-
overs have not led managers to manage more effectively or to cre-
ate more successful business enterprises. Instead, together with the
increasing dominance of institutional stockholders, hostile takeover
activity has led to an inordinate focus on short-term results and a
dangerous overleveraging of the American and British economies,
the ill effects of which are only beginning to emerge.
The present lull in hostile takeover activity provides an oppor-
tunity to reexamine our system of corporate governance relatively
free of the high emotions of the 1980s. But the need for reexamina-
tion remains pressing. While the pace of hostile takeover activity
has slowed, reflecting in part the current recession, hostile take-
overs remain very much a part of the corporate landscape and
managerial thinking. Moreover, the growing power of institutional
stockholders, and their increasing willingness to exercise that

I See, for example, Easterbrook and Fischel, 94 Harv L Rev at 1198 (cited in note 1)
(managerial passivity in response to tender offers forces managers to put stockholder wealth
ahead of their desires to protect their own positions); Lucian A. Bebchuk, The Case For
FacilitatingCompeting Tender Offers, 95 Harv L Rev 1028 (1982) (supporting a rule of
auctioneering, rather than passivity, in which incumbent management solicits competing
bids); Ronald J. Gilson, A StructuralApproach to Corporations:The Case Against Defen-
sive Tactics in Tender Offers, 33 Stan L Rev 819, 878-79 (1981) (proposing a rule that limits
management's ability to interfere with stockholders' decision to accept or reject tender
offers).
1991] QuinquennialElection

power, create pressures on corporate managers as great as those

imposed by the last takeover wave. With the early corporate gov-
ernance agenda of institutional stockholders focusing on opposition
to takeover defenses and promotion of short-term profits, it is im-
perative that we reach a collective judgment as to the appropriate
goals of corporate governance and the best means of meeting those
goals.
This Article rejects the approach, which we will refer to as the
"managerial discipline model," that assumes that conformity to
stockholder wishes and protection of hostile takeovers are the pri-
mary goals of corporate governance. Instead, this Article argues
that the ultimate goal of corporate governance is the creation of a
healthy economy through the development of business operations
that operate for the long term and compete successfully in the
world economy. Corporate governance is a means of ordering the
relationships and interests of the corporation's constituents: stock-
holders, management, employees, customers, suppliers, other
stakeholders and the public. The legal rules that constitute a cor-
porate governance system provide the framework for this ordering.
This Article argues that the legal rules, the system of corporate
governance, should encourage the ordering of these relationships
and interests around the long-term operating success of the corpo-
ration. For it is this goal that will ultimately be the most beneficial
to the greatest number of corporate constituents, including stock-
holders, and to our economy and society as a whole.
The system of corporate governance we propose places partic-
ular emphasis on the need for cooperation between managers and
their principal institutional stockholders. The relationship between
managers and stockholders is a problematic one in the modern
public corporation, one that is dominated alternately by apathy
and confrontation. The academic focus on the discipline of manag-
ers threatens to exacerbate the confrontational side of the relation-
ship. What is needed is a system that will lead managers and
stockholders to work cooperatively towards the corporation's long-
term business success.
Part I of this Article examines the premises and flaws of the
managerial discipline model of corporate governance. Part II exam-
ines the interest of the corporation in its long-term success as a
business enterprise, and the harm to corporate and national inter-
ests inflicted by the short-termism that has resulted from changes
in the nature of stock ownership and the rise in hostile takeover
activity. Part III considers alternative approaches to corporate gov-
ernance exemplified by the Japanese and German systems, and
 The University of Chicago Law Review [58:187

suggests some of the practical constraints in implementing these

approaches in the United States and United Kingdom economies.
Part IV proposes a new corporate governance system for the
United States and the United Kingdom, designed to balance the
need for a long-term orientation with the need for managerial ac-
countability. This proposal would replace annual elections of direc-
tors with quinquennial elections; bar nonconsensual changes in
control between elections; provide major stockholders with direct
access to the corporate proxy machinery in connection with the
quinquennial election; provide for a detailed five-year report,
which would be independently evaluated by an outside advisor, an-
alyzing the corporation's prior five-year performance and setting
forth its prospective five-year plan; and tie significant management
compensation awards, as well as significant penalties, to the corpo-
ration's performance against the five-year plan.

I. THE MANAGERIAL DISCIPLINE MODEL

The academic community has generally embraced the manage-

rial discipline model of corporate governance, which seeks to con-
form managerial behavior to the wishes of the corporation's stock-
holders and to prevent managers and directors from impeding
hostile takeovers. 4 Judicial norms, for the most part, have also fol-
lowed the view of the supremacy of the stockholder in the corpo-
rate structure. 5 Within the last few years, statutory and case law,
largely at the urging of non-academic commentators, has begun to
give legal recognition to the importance of long-term planning and
non-stockholder constituencies in the health of corporations and
the corporate economy." This recognition, however, has been spo-

For examples of the academic view, see sources cited in notes 1 and 3.
8 For examples of the judicial view, see Dynamics Corp. of America v CTS Corp., 794
F2d 250, 256 (7th Cir 1986) (primary criterion for judging legality of poison pill is "the goal
of stockholder wealth maximization"), rev'd on other grounds, 481 US 69 (1987); Revlon Inc.
v MacAndrews & Forbes Holdings, Inc., 506 A2d 173, 182, 184 n 16 (Del 1986) (after decid-
ing to sell company, directors may only consider interests of the stockholders); Dodge v
Ford Motor Co., 204 Mich 459, 170 NW 668, 684 (1919) ("A business corporation is organ-
ized and carried on primarily for the profit of the stockholders.").
' For examples of commentators' views, see Martin Lipton, Corporate Governance in
the Age of Finance Corporatism, 136 U Pa L Rev 1, 35-43 (1987); William H. Steinbrink,
Management's Response to the Takeover Attempt, 28 Case W Res L Rev 882 (1978);
Nicholas F. Brady, Secretary of the Treasury, Remarks before the Business Council (Feb
22, 1990) (on file with U Chi L Rev). For examples of judicial decisions, see Paramount
Communications, Inc. v Time Inc., 571 A2d 1140, 1153 (Del 1989) (In evaluating a takeover
bid, directors need not maximize short-term stock price and may consider "'the impact on
"constituencies" other than shareholders ... .' ") (quoting Unocal Corp. v Mesa Petroleum
Co., 493 A2d 946, 955 (Del 1985)); TW Services, Inc. v SWT Acquisition Corp., [1989
1991] QuinquennialElection

radic and non-systematic, and has engendered much criticism from

academic circles. 7
In this Part, we analyze three intellectual underpinnings of the
managerial discipline model: the paradigm of the stockholder as
property owner; the notion that managers are self-interested and
require external discipline in order to run their companies well;
and the view that the hostile takeover is an effective instrument of
discipline. We conclude that' each of these concepts is deeply
flawed, and that the managerial discipline model is thus inade-
quate as the basis for a system of corporate governance.

A. The Stockholder as Property Owner

The managerial discipline model of corporate governance rests
in large part on the paradigm of the stockholder as owner of the
corporation, standing in much the same relationship to the corpo-
ration as the owner of any item of private property stands to that
property." One of the fundamental principles of a capitalist legal
system is that the owner of private property may do with that
property as he wishes, so long as he does not harm third parties.
Once one accepts the premise that stockholders own the corpora-
tion in the same manner as they own any other private property,

Transfer Binder] Fed Secur L Rptr (CCH) 94,334 at 92,173 (Del Chanc 1989) (directors
need not pursue immediate maximization of share value by redeeming rights plan at ex-
pense of long-term business plan).
Chancellor William T. Allen of the Delaware Chancery Court noted in a recent speech,
"The assumption that we want corporation law to more perfectly align manager action with
shareholder interest is fundamental to the traditional legal view of the domain of corpora-
tion law. But that assumption was tested in the takeover setting in the 1980s and guess
what? As George Gershwin put it, it ain't necessarily so." William T. Allen, Competing Con-
ceptions of the Corporationin American Law 9 (Rocco J. Tresolini Lecture in Law, Lehigh
University, Oct 29, 1990) (on file with U Chi L Rev). Because about 50 percent of the major
public companies are incorporated in Delaware, the Delaware courts, more than any others,
have been compelled to be the judicial arbiters of the corporate governance debate. Chancel-
lor Allen, in his decisions and speeches, has demonstrated a keen understanding of corpo-
rate governance issues and the ramifications of judicial decisions on the business and poli-
cies of corporations. Together with the Delaware Supreme Court, he has fashioned a series
of decisions, including the Time and TW Services cases cited above, that have enabled
boards of directors to blunt, if not defeat, some of the ill effects of the takeover wave of the
1980s.
See, for example, Easterbrook and Fischel, 94 Harv L Rev at 1190-92 (cited in note 1)
(criticizing the view of some commentators that, in responding to a tender offer, the target
board should consider the interests of various non-investor groups); Gilson, 33 Stan L Rev
at 862-65 (cited in note 3) (rejecting the argument that responsiveness to non-stockholder
constituencies justifies management discretion in preventing tender offers).
0 See, for example, Frank H. Easterbrook and Daniel R. Fischel, Takeover Bids, Defen-
sive Tactics, and Shareholders' Welfare, 36 Bus Law 1733, 1733 (1981) ("corporations exist
and conduct their affairs for the benefit of the shareholders").
 The University of Chicago Law Review [58:187

the conclusion that the wishes of the stockholders must be the par-
amount focus of the corporation follows, constrained only by the
limitation on injuring third parties embodied in concepts such as
environmental or products liability tort principles. From this start-
ing point, the descriptive observation that separation of ownership
and management is the central characteristic of the modern public
corporation leads to the normative conclusion that the primary
goal of corporate governance is to ensure that managerial actions
conform to the wishes of stockholders. If the corporation is simply
private property for the stockholders to do with as they please, the
directors and managers of the corporation should, ideally, be no
more than implementers of the stockholders' desires.
This line of reasoning, however, suffers from two major flaws.
First, the corporation, particularly the modern public corporation,
is not private property like any other private property.9 Rather, it
is the central productive element of the economies of the United
States and the United Kingdom. The health and stability of these
economies depends on the ability of corporations to maintain
healthy and stable business operations over the long term and to
compete in world markets.' 0 The corporation affects the destinies
of employees, communities, suppliers, and customers. All these
constituencies contribute to, and have a stake in, the operation,
success, and direction of the corporation. Moreover, the nation and
the economy as a whole have a direct interest in ensuring an envi-
ronment that will allow the private corporation to maintain its
long-term health and stability. Rules of corporate ownership and
governance must take account of many more interests than do the
rules governing less complex property.
The origins of the public corporation reinforce this contrast
with ordinary private property. Corporations came into being in
England and the United States as quasi-public entities, granted
legislative charters to serve specific public as well as private pur-
poses." Companies such as the British East India Company and

' Professor Berle divides property into two classifications: (1) consumption property
and (2) productive property-"property devoted to production, manufacture, service or
commerce, and designed to offer, for a price, goods or services to the public from which a
holder expects to derive a return." Berle and Means, The Modern Corporationat xi (cited
in note 2).
"0Capitalism, The Economist 5, 6 (May 5, 1990) ("Capitalism") ("The proper 'micro'
in microeconomics is the individual firm. How well it does, multiplied by thousands and
millions of times, determines how well the economy does.").
Berle and Means, The Modern Corporationat 120 (cited in note 2). For an overview
of the corporation in American law, see generally Lawrence M. Friedman, A History of
American Law 511-25 (Simon & Schuster, 2d ed 1985).
1991] Quinquennial Election

the Hudson Bay Company were political instrumentalities as well

as profit-making enterprises. 1 2 Legislatures granted charters to
early American corporations so that religious, educational, and
charitable organizations could hold property and act as indepen-
dent legal entities. Later charters established banks, canal compa-
nies, aqueduct companies, and other businesses essential for trade
and city development. 13 General incorporation statutes did not be-
come predominant until the late nineteenth century. 4 This au-
thorization of general incorporation rights reflected a policy choice
to encourage the general aggregation of capital by freeing the
owner/stockholders from the risk of unlimited liability.
Given the corporation's origins as a historical and legal con-
struct created for specific public policy reasons, the state naturally
may choose to condition the use of the corporate form upon com-
pliance with rules that advance societal goals, even if those goals
clash with stockholder interests. For example, corporations must
observe laws governing polluting, worker safety, child labor, the
right of workers to unionize, foreign corrupt practices, product
safety, and a host of other corporate behavior that affects society
at large. There is no a priori reason why rules of corporate gover-
nance should not similarly take account of public purposes. To the
extent there is an intrinsic nature to the corporation, it is more
akin to that of a citizen, with responsibilities as well as rights, than
to that of a piece of private property.
Second, the managerial discipline model tends to ignore or dis-
miss the implications for corporate governance of the changing na-
ture of corporate ownership. Just as the corporation is not analo-
gous to ordinary private property, neither is the stockholder in the
modern public corporation analogous to the owner of ordinary pri-
vate property. The stockholder owns an interest in a share of
stock, a financial investment granting no direct control over the
properties, equipment, contract rights, organizational structure,
and other elements that make up the corporation itself. That share
may entitle the stockholder to a percentage of the profits and

12 Samuel Williston, History of the Law of Business CorporationsBefore 1800, 2 Harv

L Rev 105, 108-11 (1888).
13 James Willard Hurst, The Legitimacy of the Business Corporationin the Law of the

United States 1780-1970 13-20 (Virginia, 1970); Ronald E. Seavoy, The Origins of the
American Business Corporation,(1784-1855) 5-7 (Greenwood, 1982). See also Liggett Co. v
Lee, 288 US 517, 545 (1933) (Brandeis dissenting) (early charters granted only when neces-
sary to procure some specific community benefit).
14 See Berle and Means, The Modern Corporation at 126-27 (cited in note 2) (discuss-
ing the appearance of the early general incorporation statutes).
 The University of Chicago Law Review [58:187

residual value of the corporation, but the stockholder's intrinsic

ownership interest is a financial interest, on which there is a return
in the form of dividends or appreciation in trading price, rather
than the "use and enjoyment" interest of the owner of a piece of
personal property.
Moreover, unlike the stockholder/manager of the nineteenth
century corporation or the modern incorporated proprietorship,
the stockholder of the modern public corporation does not behave
as a traditional owner of property. The stockholder/managers of a
closely held corporation have an interest in developing the corpo-
ration, nurturing its business, preserving its strength, and ensuring
its future. Their shares are not publicly traded and are usually not
traded at all. In contrast, the stockholder/investors of the modern
publicly held corporation view the corporation more as the holder
of a betting slip views a racehorse. 5 Just as the bettor does not
really care about the fate of the racehorse as long as it provides
him a financial payoff, so too the stockholder/investor does not re-
ally care about the fate of the corporation as long as the stock gen-
erates a profit.
The paradigm of the stockholder as the owner of private prop-
erty, then, does not provide a compelling basis for the managerial
discipline model of corporate governance. The economic and politi-
cal justifications for our -legal rules of private property do not
transfer automatically to the rules governing the relationship be-
tween stockholder and corporation.' 6 It is simply not a sufficient or
compelling answer to the question of why the desires of stockhold-
ers must be the paramount and controlling focus of the corporation
to say that the stockholders are the owners of the corporation. Of
course, stockholders deserve a prominent voice in corporate gov-
ernance. 7 Indeed, the proposal for a revised corporate governance
system advanced in Part IV looks to stockholders to provide real
and ultimate control over the corporation's direction. But the or-
dering of relationships among corporate constituents that is corpo-
rate governance cannot blindly follow the maxim that stockholders
own the corporation and must be free to do with it as they please.

16 Capitalism at 8 (cited in note 10).

16 As Chancellor Allen states, "The premise of 'ownership' simply assumes but does not
justify an answer." Allen, Competing Conceptions of the Corporationin American Law at
15 (cited in note 6).
17 Professors Gilson and Kraakman assert that "managerialist rhetoric" views the insti-

tutional investor as less than a real stockholder, and one whose interests "may be appropri-
ately ignored." Gilson and Kraakman, Reinventing the Outside Directorat 1 (cited in note
1). This argument is a straw man.
1991] QuinquennialElection

Rather, we must examine, justify, and if necessary modify our cor-

porate governance system in terms of its impact on stockholders,
the corporation and its other constituents, and the health of our
economic system and society as a whole.

B. The Need for External Discipline

The managerial discipline model assumes that managers are
inherently self-interested and that, left to their own devices, they
will act selfishly and to the detriment of the corporation and its
other constituencies, particularly the stockholders.18 This bias,
however, is simply unfounded. In our experience, most managers
and directors act diligently and in good faith to develop and main-
tain the business success of the corporations they manage or di-
rect.'9 Only the rare manager or director steals, whether literally or
figuratively, from the corporation for personal gain. Certainly, the
problem does not warrant the obsession of many academic writers
with the issue. Of course, diligence and good faith do not ensure
good or successful management. But the kind of discipline contem-
plated by the managerial discipline model, primarily the threat of
takeover or replacement, is directed at the misperceived problem
of managerial selfishness, not managerial ability.
Proponents of the managerial discipline model tend to view
any action taken by managers that conflicts with the wishes of the
stockholders as evidence of managerial self-interest. Thus, they
characterize the adoption of antitakeover devices as management
entrenchment,2 0 and business acquisitions that hurt short-term
earnings as managerial self-aggrandizement. 21 In so doing, they ig-
nore the possibility that, to the extent these actions conflict with
the wishes of stockholders, the divergence may simply reflect dif-

"SSee, for example, Easterbrook and Fischel, 94 Harv L Rev at 1169-70 (cited in note
1) (discipline necessary because some managers "will find it advantageous to shirk responsi-
bilities, consume perquisites, or otherwise take more than the corporation promised to give
them"); Gilson, 33 Stan L Rev at 836 (cited in note 3) (managers "can be expected, if other-
wise unconstrained, to maximize their own welfare rather than the shareholders' ").
19See also Jay W. Lorsch, Pawns or Potentates: The Reality of America's Corporate
Boards 30 (Harvard Business School Press, 1989) ("America's boards are made up of, by
and large, responsible and dedicated directors who take their duties seriously.").
"I See, for example, Easterbrook and Fischel, 94 Harv L Rev at 1175 (cited in note 1)
(To protect their salaries and status, managers of target company "may disguise a policy of
resistance to all offers as a policy of searching for a better offer than any made so far.").
"1See, for example, Michael C. Jensen and Kevin J. Murphy, CEO Incentives-It's
Not How Much You Pay, But How, Harv Bus Rev 36, 45 (May-June 1990) ("Executives are
invariably tempted to acquire other companies and expand the diversity of the empire, even
though acquisitions often reduce shareholder wealth.").
 The University of Chicago Law Review [58:187

fering perspectives as to the appropriate direction and business

plan of the corporation. While a stockholder seeking a short-term
premium may object to takeover impediments, antitakeover provi-
sions can be a quite rational tool for a board of directors seeking to
preserve the corporation in the face of an attempted takeover that
is likely to be detrimental to the long-term health of its business.
Similarly, while a stockholder with a short-term investment hori-
zon may object to a business combination that initially hurts the
corporation's earnings per share, the business combination may re-
flect the good faith judgment of the corporation's directors and
managers that the step is necessary to position the corporation to
prosper over the long term.
The managerial discipline model also dismisses the substantial
common law and statutory legal strictures already in place that ad-
dress overt self-dealing or self-interestedness. Transactions with
the corporation in which a director or manager has a personal fi-
nancial interest receive close scrutiny.2 2 Insider trading rules 23 and
short-swing profit recovery 24 guard against the misuse of informa-
tion in stock trading by directors and managers. Moreover, sub-
stantial existing financial and social incentives motivate directors
and managers to seek the business success of the corporations they
direct or manage. Incentive compensation based on appreciation of
the stock of the corporation, or based on increasing earnings and
exceeding budget targets, provides managers with financial rewards

22 See, for example, Fliegler v Lawrence, 361 A2d 218, 221 (Del 1976) (where defend-
ants stood on both sides of transaction, burden was on dbfendants to demonstrate transac-
tion's intrinsic fairness to the acquiring firm and its stockholders); AC Acquisitions Corp. v
Anderson, Clayton and Co., 519 A2d 103, 111 (Del Chanc 1986) (board with financial inter-
est in transaction adverse to corporation bears burden of proving the transaction's intrinsic
or objective fairness); Guth v Loft, Inc., 23 Del Chanc 255, 5 A2d 503, 510 (1939) (rule
demands of a director the most scrupulous observance of his duty to "refrain from doing
anything that would work injury to the corporation, or to deprive it of profit or advantage
which his skill and ability might properly bring to it, or to enable it to make in the reasona-
ble and lawful exercise of its powers"). In addition to case law, approximately three-quarters
of the states have enacted statutory provisions governing contracts with interested directors.
See, for example, 8 Del Code Ann § 144 (1990).
2 Section 10(b) of the Securities Exchange Act of 1934, 15 USC § 78j (1988), and Rule
10b-5 promulgated thereunder, require that an insider who possesses material nonpublic
information about a company make appropriate disclosure of the information or abstain
from trading in the company's stock. See In re Cady, Roberts & Co., 40 SEC 907, 911
(1961).
24 Section 16(b) of the Securities Exchange Act of 1934, 15 USC § 78p(b), provides for a
rule of strict liability, entitling an issuer to recover any profits realized by a director, officer,
or beneficial owner of ten percent of an issuer's outstanding stock, from the purchase or sale
of any equity security of the issuer.
1991] QuinquennialElection

tied to the success of the corporation.2 5 An executive's social sta-

tus, and the respect of fellow executives, typically depend in large
part on the success of the corporation he or she manages. Indepen-
dent directors' reputations, and to some extent their opportunities
to serve on other boards, are tied to the business success of their
corporations.2 6
The managerial discipline model's emphasis on reining in
managerial self-interest is thus just as flawed as its emphasis on
conforming the actions of managers to the desires of the stockhold-
ers. The greater problem, or challenge, is to design a system that
gives managers the opportunity and the incentive to work in part-
nership with stockholders and the corporation's other constituen-
cies in improving the long-term business performance of the corpo-
ration. The quinquennial proposal advanced in Part IV addresses
this problem.

C. Hostile Takeovers as an Instrument of Discipline

Academic proponents of the managerial discipline model of
corporate governance tend to embrace the hostile takeover as the
primary instrument of managerial discipline. They argue that bad,
inefficient, or self-interested managers, or managers who fail to
heed the wishes of the stockholders, will find themselves vulnera-
ble to a hostile takeover. If the state does not permit incumbent
management to interfere with stockholders' freedom to accept
tender offers, the argument continues, the fear of a hostile take-
over will make bad managers good, inefficient managers efficient,
and self-interested managers responsive to stockholder desires.2 7 In

The quinquennial proposal set forth in Part IV suggests tying these financial incen-
tives to the performance of the corporation over five-year periods as part of the effort to
reorient the corporation towards long-term business performance. See Part IV.E.
26 See Eugene F. Fama, Agency Problems and the Theory of the Firm, 88 J Pol Econ
288, 294 & n 3 (1980) (discussing market for outside directors: "Like the professional
outside director, the welfare of the outside auditor depends largely on 'reputation.' "). But
see Gilson and Kraakman, Reinventing the Outside Director at 22-23 & nn 41-42 (cited in
note 1) (arguing that no effective market for outside directors exists). While perhaps not as
developed as the market for outside auditors, our experience is that reputation is important
in creating opportunities for outside directors.
17 See, for example, Gilson & Kraakman, Reinventing the Outside Director at 12-13
(cited in note 1) (mere threat of hostile offer is likely to improve target management); Eas-
terbrook and Fischel, 94 Harv L Rev at 1169 (cited in note 1) ("tender bidding process
polices managers whether or not a tender offer occurs"); ALI, Principlesof Corporate Gov-
ernance: Analysis and Recommendations part VI at 98 (Tent Draft No 10, 1990)
("[T]ender offers are mechanisms through which market review of the effectiveness of man-
agement's delegated discretion can operate."). See also Finneganv Campeau Corp., 915 F2d
824, 831 (2d Cir 1990) ("Congress realized 'that takeover bids should not be discouraged
 The University of Chicago Law Review [58:187

practice, however, the hostile takeover is not a particularly effec-

tive or efficient means of motivating or disciplining managers.
The enthusiasm for the hostile takeover as the primary instru-
ment of managerial discipline rests heavily on the efficient capital
markets theory that has dominated the academic literature over
the last two decades. This theory holds, in essence, that the market
price of a corporation's stock at any given time accurately reflects
all available information about the corporation and its anticipated
future income stream. Accordingly, the argument continues, the
market can neither undervalue nor overvalue a corporation's
worth.2 8 The willingness of an acquiror to pay a premium to the
market price, then, necessarily implies that the acquiror can in-
crease the value of the corporation by managing the assets better,
thus demonstrating the inefficiency of the existing management.
In recent years, however, the efficient capital markets theory
has become increasingly discredited, especially since the stock
market crash of October 1987.29 A growing body of economic litera-
ture now accepts that the stock market can and does misprice par-
ticular stocks, groups of stocks, and even stocks in general for ex-
tended periods of time.30 The new literature recognizes the great
degree of subjectivity, and even irrationality, among investors who
set the demand for and the price of stocks. 31 Recent literature also

because they serve a useful purpose in providing a check on entrenched but inefficient man-
agement.' ") (quoting legislative history of the Williams Act, S Rep No 90-550, 90th Cong,
1st Sess 3 (1967)).
28 See, for example, Easterbrook and Fischel, 36 Bus Law at 1734 (cited in note 8)

("[T]he notion that stock is priced in the market at less than its true value is implausible.");
Werner F.M. De Bondt and Richard H. Thaler, A Mean-Reverting Walk Down Wall Street,
3 J Econ Persp 189, 189 (1989) ("Few propositions in economics are held with more fervor
than the view that financial markets are 'efficient' and that the prices of securities in such
markets are equal to their intrinsic values.").
29 Andrei Shleifer and Lawrence H. Summers, The Noise TraderApproach to Finance,

4 J Econ Persp 19, 29 (1990) ("[S]tock in the efficient markets hypothesis-at least as it has
traditionally been formulated-crashed along with the rest of the market on October 19,
1987," when "a 22 percent devaluation of the American corporate sector" occurred in one
day.).
30 See Stephen F. LeRoy, Efficient Capital Markets and Martingales, 27
J Econ Lit
1583, 1616 (1989) ("The most radical revision in efficient-markets reasoning will involve
those implications of market efficiency that depend on asset prices equaling or closely ap-
proximating fundamental values. The evidence suggests that, contrary to the assertion of
this version of efficient markets theory, such large discrepancies between price and funda-
mental value regularly occur."); E. Victor Morgan and Ann D. Morgan, The Stock Market
and Mergers in the United Kingdom 74 (David Hume Institute, 1990) ("There are powerful
reasons for believing that equity markets, in the UK and elsewhere, are unlikely to be fun-
damental-valuation efficient but, in view of the difficulty of testing and the paucity of fac-
tual evidence, the question must remain open.").
31 See, for example, Shleifer and Summers, 4 J Econ Persp at 19-20 (cited in note 29)
1991] Quinquennial Election

examines the effects on pricing of varying levels of information

among investors, varying investor time horizons, varying evalua-
tions of future prospects and risks, and the greater cost and risk of
32
arbitraging long-term mispricing than short-term mispricing.
Moreover, tax and accounting effects can cause a corporation's
stock to be underpriced in the market compared to its worth to an
acquiror. These factors all support the conclusion that the public
market may often undervalue the shares of a corporation relative
to the worth an acquiror would place on the shares, even in the
absence of any efficiency gains from the acquisition.
Professors Shleifer and Summers suggest that another source
of takeover activity may be the ability of an acquiror to realize
gains from a "breach of trust" with the corporation's other constit-

("Our approach rests on two assumptions. First, some investors are not fully rational and
their demand for risky assets is affected by their beliefs or sentiments that are not fully
justified by fundamental news. Second, arbitrage-defined as trading by fully rational inves-
tors not subject to such sentiment-is risky and therefore limited."); Gavin C. Reid, Effi-
cient Markets and the Rationale of Takeovers 19-23 (David Hume Institute, 1990) (describ-
ing "bubbles," in which "prices rise rapidly without apparent good reason, trading volumes
accelerate, and prices finally crash," and "fads," in which "social convention or fashion
makes certain assets desirable"); De Bondt and Thaler, 3 J Econ Persp at 199-200 (cited in
note 28) (discussing how "faulty risk perceptions," "a tendency to overreact to recent earn-
ings trends," and "biased" immediate price reaction to negative events may result in market
undervaluation of a corporation's shares: "For companies that experience a series of 'bad
events,' the price correction may take several years.").
32 See Jean A. Crockett, Takeover Attempts, Economic Welfare, and the Role of

Outside Directors (Rodney L. White Center for Financial Research, Wharton School of Fi-
nance, 1989) (on file with U Chi L Rev) (stock prices can undervalue corporations because of
information imperfections and short-term investment horizons); Lynn A. Stout, Are Take-
over Premiums Really Premiums? Market Price, Fair Value, and CorporateLaw, 99 Yale L
J 1235, 1295 (1990) (heterogeneous investor valuations create a downward sloping demand
curve for a corporation's shares, which implies that takeover premiums "may be natural
market phenomena rather than evidence of efficiency gains from acquisitions"); Andrei
Shleifer and Robert W. Vishny, The New Theory of the Firm: Equilibrium Short Horizons
of Investors and Firms, 80 Am Econ Rev Pap & Proc 148 (1990) (greater cost of arbitrage in
long-term assets compared to short-term assets results in greater mispricing of long-term
assets in equilibrium).
33 Tax rules (particularly the tax deductibility of interest payments and non-deductibil-
ity of dividend payments) and accounting conventions (particularly the capitalization of ac-
quisition costs in contrast to the current charge for the costs of starting a new business,
research and development, and introducing new products) encouraged the acquisitions and
leveraging of the last decade and require reexamination, although we do not undertake that
task here. See Crockett, Takeover Attempts at 5-6 (cited in note 32) ("When we look at the
impact on the economy as a whole, the increment in after-tax earnings for the surviving firm
[in a leveraged transaction] must be offset against the loss to the Treasury and ultimately
the taxpayers. The effect is primarily an income transfer hard to justify on equity grounds.
Furthermore, it is possible that the overall economy will suffer if the higher leverage leads to
a higher rate of bankruptcies or serious financial difficulties in the next recession.").
 The University of Chicago Law Review [58:187

uents 4 They point out that a corporation enters into implicit con-
tracts with constituents such as employees and suppliers. In some
circumstances, these implicit contracts may become a liability, but
incumbent managers remain committed to upholding them be-
cause of the trust relationship between the managers and stake-
holders. "In these cases ousting the managers is a prerequisite to
realizing the gains from the breach .... The resulting wealth gains
show up as the takeover premia."3 5 To the extent such breaches of
trust account for the takeover premium, the takeover represents a
wealth transfer and not an efficiency gain. In this manner, "hostile
takeovers can be privately beneficial and take place even when
36
they are not socially desirable.
A number of other factors also contributed to the hostile take-
over explosion of the 1980s. For example, the relative ease of ob-
taining acquisition financing and leveraged buyout fund capital al-
lowed acquirors to make risky acquisitions with little of their own
money invested, and thus little downside risk to themselves. 37 The
ease of obtaining financing also extended to takeover arbitrageurs,
who facilitated hostile transactions. 8 And the arrogance and ego of
corporate raiders, seeking to do a bigger or better deal than the
one just announced in the financial press, may also have helped
fuel the takeover wave.3 9 In sum, it is simply wrong to suggest that

3'Andrei Shleifer and Lawrence H. Summers, Breach of Trust in Hostile Takeovers, in

Alan J. Auerbach, ed, Corporate Takeovers: Causes and Consequences 33 (Chicago, 1988).
See also J. Mark Ramseyer, Takeovers in Japan: Opportunism, Ideology and Corporate
Control, 35 UCLA L Rev 1, 63 (1987) ("A hostile acquisition enables a firm's shareholders to
renege on the bargain they initially struck with their managers. In so doing, a hostile acqui-
sition enables the shareholders to appropriate the bulk of any organizational rent the firm
earns, even when that rent results from joint investments by shareholders and managers.").
14 Shleifer and Summers, Breach of Trust in Hostile Takeovers, in Auerbach, ed, Cor-
porate Takeovers at 41 (cited in note 34).
Id at 34.
3 See, for example, Richard L. Stern and Edward F. Cone, Scarlett O'Hara comes to
Wall Street, Forbes 37 (Sept 21, 1987) (investment banks, commercial banks, and insurance
companies fight to finance LBOs); Sarah Bartlett, Need A Quick Billion or Two? Just Ask
Your Banker, Bus Week 98 (Oct 26, 1987) (big banks providing loans for mergers and LBOs
quickly and in huge amounts); Robert L. Messineo, Proposed SEC Rules May Impact LBO
Funds, NY L J 5 (Sept 21, 1989) ($20 billion committed to LBO funds is used to finance
sizeable transactions on an expeditious basis).
18See, for example, Allan Sloan, An Extra Slice of the Pie, Forbes 32 (Feb 9, 1987)
(leading takeover arbitrageur Ivan Boesky, together with Drexel Burnham Lambert, raised
$350 million in equity and $660 million in debt for Boesky's takeover arbitrage partnership).
19See Reid, Efficient Markets and the Rationale of Takeovers at 34 (cited in note 31)
("[I]s it not possible that 'noise trading' is also going on, with pathological propensities to
'do a deal' over-riding considerations of net benefit, and thus of efficiency?").
1991] QuinquennialElection

bad, inefficient, or self-interested management is the sole or pri-

mary source of this takeover activity.
The anecdotal evidence supports this conclusion. In recent
years, well-managed corporations have been just as likely as poorly
managed corporations to become the target of a hostile takeover.
For example, AMR Corporation (the parent of American Airlines)
became the subject of a takeover attempt by Donald Trump, al-
though the chairman of AMR is generally recognized as the best
manager in the airline industry.4 0 Georgia-Pacific Corporation ac-
quired Great Northern Nekoosa Corporation even though Great
Northern Nekoosa's return to stockholders for the prior ten years
41
exceeded that of Georgia-Pacific and the industry as a whole.
42
Georgia-Pacific's stock price and earnings have since declined.
Even noted raider Sir Gordon White, Chairman of Hanson Indus-
tries, in defending hostile takeover activity, notes: "There are a
large number of companies which are regarded, by and large, as
well run. Of course, these companies can be taken over as the re-
sult of a hostile bid but the shareholders can and do demand a
43
very high price.
If poor or inefficient management is not the primary impetus
for hostile takeovers, it follows that takeovers do not generally mo-
tivate managers to manage better or more efficiently. Rather, the
hostile takeover motivates managers to combat the undervaluation
of their stock by leveraging the corporation, avoiding investments
that do not immediately add to reported earnings, selling assets, or
otherwise boosting short-term earnings, regardless of the possible
harm to the corporation over the long term.4 4 Even to the extent

4 See Judith H. Dobrzynski, Why Even Well-Run Companies Can Be Easy Prey, Bus
Week 56 (Oct 23, 1989); Erik Hedegaard, Fasten Your Seatbelt, Bob, It's Going to be a
BUMPY Year, M Inc. 61 (Jan 1991) ("American Airlines' Robert Crandall is considered the
best in the business.").
41See Great Northern Nekoosa Corporation Letter to Shareowners (Nov 13, 1989), filed
with the Securities and Exchange Commission as Exhibit 15 to Great Northern Nekoosa
Corporation Schedule 14D-9 (on file with U Chi L Rev).
11 Jacqueline Bueno, Georgia-PacificEarnings, Stock Price Take a Tumble, Atlanta
Bus Chron 3A (Sept 3, 1990). The authors' law firm represented AMR and Great Northern
Nekoosa in these takeover matters. While these two examples do not demonstrate that all
takeovers are bad, they do undercut any close linkage between takeovers and incentives for
competent management.
4'Sir Gordon White, Why Management Must Be Accountable, Financial Times § 1 at
11 (July 12, 1990).
4 See, for example, Richard Lambert and Anatole Kalestsky, Jam Today Is What
Shareholders Want, Financial Times § 1 at 21 (July 12, 1989) ("The last-ditch defence
against hostile takeovers has thus been for existing managements to steal the raider's thun-
der by arranging a leveraged buy-out and recapitalisation themselves .... Ironically, in
many cases it is the existing management, rather than the outside raider, that ultimately
1
ads a company up with greater debts and becomes the more ruthless liquidator."); Chris-
 The University of Chicago Law Review [58:187

mismanagement does contribute to hostile takeover activity, the

threat of a hostile takeover is far more likely to create an attitude
of defensiveness on the part of managers than to create an open-
ness to the kind of change and new ideas that might serve to im-
prove business performance.4 5 Some hostile takeovers may replace
bad managers with new ones who may or may not be better. But
the threat of a hostile takeover is unlikely to improve the perfor-
mance of bad managers. 46 Finally, as we discuss in Part II, hostile
takeovers and related short-termism have imposed substantial an-'
cillary societal costs.
In sum, the managerial discipline model of corporate govern-
ance is not compelling. We must turn, then, to the examination of
the corporation's proper place in our economy and society, the
challenges for corporate governance, and the question of how best
to reconcile the interests of the corporation's various constituents
and our economy and society as a whole.

II. THE INTEREST OF THE CORPORATION IN ITS LONG-TERM

SUCCESS AND THE SOCIETAL COST OF SHORT-TERMISM

In this Part, we offer an alternative to the managerial disci-

pline model. We argue that the corporation has an independent
interest in its own long-term business success. Classical economic
theory suggests that this interest, multiplied by many individual

topher Farrell, The Bills Are Coming Due, Bus Week 84 (Sept 11, 1989) (USG Corp. "beat
back a takeover raid last year through a $2.2 billion recapitalization .... USG has slashed its
research-and-development staff and expenditures in half, nearly halved capital spending,
cut its work force from 21,000 to 16,000, reduced the management ranks by 10%, and sold
assets worth $600 million-including highly profitable Masonite Corp .... Competitors
smell blood.").
4" John C. Coffee, Jr., Regulating the Market for CorporateControl: A CriticalAssess-
ment of the Tender Offer's Role in Corporate Governance, 84 Colum L Rev 1145, 1242-43
(1984) (The work of Douglas McGregor and "a legion of other social scientists" suggests that
"management will be more effective if it creates an environment that stresses support and
encouragement rather than constant threats of dismissal .... In this view, the constructive
deterrent value of the takeover lies more in its ability to function as the corporate guillotine,
amputating swiftly and finally an inefficient management, and less in its general deterrent
effect as a motivating force by which marginal managements are spurred to greater effort.").
46 Melvin Aron Eisenberg, The Structure of CorporationLaw, 89 Colum L Rev 1461,
1497-99 (1989) (threat of a takeover may make some managers more efficient, but"'the take-
over market neither adequately aligns the interests of managers and shareholders, nor ade-
quately addresses the problem of managerial inefficiency"); Coffee, 84 Colum L Rev at 1192-
95 (cited in note 45) (capital market is only an effective monitor in cases of massive manage-
rial failure); Michael L. Dertouzos, Richard K. Lester and Robert M. Solow, Made in
America: Regaining the ProductiveEdge 39 (MIT, 1989) ("Only an extraordinary optimist
could believe, for example, that the current wave of takeover activity is an efficient way to
deal with the organizational deficiencies of American industries.").
1991] QuinquennialElection

firms, is also society's interest and therefore supplies the proper

organizing principle of corporate governance. The ascendancy of
the institutional stockholder and the hostile takeover, however,
creates an emphasis on short-term results that makes it increas-
ingly difficult for the corporation to maintain the long-term focus
necessary to its own and society's well-being. The efficient capital
markets theory that underlies academic support for takeovers, and
that dismisses the distinction between short-term and long-term
interests, has become increasingly discredited. The short-term bias
imposed by institutional stockholders and takeover activity is real,
and this short-term bias has substantial corporate and societal
costs. In this context, the priorities of the managerial discipline
model threaten to exacerbate the problems of short-termism. In-
stead, our rules of corporate governance require the sort of funda-
mental reform that will align the interests of all corporate constitu-
ents toward the long term.

A. The Interest of the Corporation as a Business Enterprise

At the most basic level, the corporation is no more than a spe-

cific legal form of business enterprise. It is a concatenation of fac-
tors of production-property, equipment, employees, contract
rights, and the like-organized to produce goods and services effi-
ciently. To the extent that the enterprise is able to attract and re-
tain consumers of its products or services who are willing to pay
the enterprise more than it costs to produce the products or ser-
vices, the enterprise will make a profit. The greater the amount of
goods or services the enterprise can sell, and the greater the differ-
ence between what the consumer is willing to pay and what the
goods or services cost to produce, the greater the profit that inures
to the enterprise. Viewed in this light, the corporate enterprise has
an independent interest of its own in the successful operation of its
business, with success measured in terms of present and expected
profit. The notion of "the best interest of the corporation" refers
to this interest in the present and continuing vitality of the
enterprise. 7
Classical economic theory looks to the profit interest of propri-
etors to ensure the health of business enterprises and, in turn, of

47 TW Services, Inc. v SWT Acquisition Corp., [1989 Transfer Binder] Fed Sec L Rptr
(CCH) 94,334 at 92,178 (Del Chanc 1989) ("[D]irectors... may find it prudent (and are
authorized) to make decisions that are expected to promote corporate (and shareholder)
long run interests, even if short run share value can be expected to be negatively affected.").
 The University of Chicago Law Review [58:187

the national economy.48 This theory holds that the profit motive
drives each proprietor to produce better goods and services more
efficiently than his competitors. As long as private actors have vir-
tually complete freedom to use their resources as they wish, classi-
cal economic theory's invisible hand will cause the best and most
efficient producers to flourish, direct each factor of production to
its best and most efficient use, and lead the economy as a whole to
thrive. This is the basis on which the legal and social system justi-
fies granting free rein to the individual's economic self-interest.
This theory, however, originated in a time when most proprie-
tors owned and managed their own enterprises. 49 Proprietor and
enterprise shared identical interests; by making the enterprise
more successful and profitable, the proprietor reaped a personal
profit. Moreover, the enterprise typically represented the bulk of
the proprietor's economic wealth. The proprietor could not simply
set it aside and turn to some other investment or pursuit without
losing much of his wealth. Accordingly, self-interest dictated that
the proprietor seek to develop and maintain the long-term operat-
ing success of the enterprise.
The separation of ownership and management dramatically al-
ters this theoretical model. No longer does the profit motive of the
corporate owner, with her highly liquid stake and betting-slip
mentality, automatically promote the long-term health of the en-
terprise. Nor does the self-interest and profit motive of the man-
ager, typically insulated from risk by her small ownership stake
and by limited liability, automatically create the most efficient and
profitable corporation possible.
The managerial discipline model focuses sharply on the poten-
tial divergence between managers' interests and the corporation's
interest. But, in so doing, it fails to recognize or consider the impli-
cations of the potential divergence between stockholders' interests
and the corporation's interest. Indeed, most of the academic litera-
ture defines the interest of the corporation in terms of the desires
of stockholders, thereby assuming away the potential divergence.5 0
As discussed above, however, there is no intrinsic reason that the
conformity to the wishes of the stockholders must be the central

46 Adam Smith, The Wealth of Nations Book 4, ch 2 at 419-20 (Methuen, 6th ed 1950)
(originally published 1776).
40 Id. See also Berle and Means, The Modern Corporationat 303-08 (cited in note 2).
See, for example, Easterbrook and Fischel, 36 Bus Law at 1733 (cited in note 8)
("The purpose of corporations law is to establish organizing principles under which share-
holders may conduct the enterprise for their own benefit.").
1991] QuinquennialElection

goal of the corporation. 51 Rather, the justification for granting free

rein to owner or stockholder self-interest, and defining that self-
interest as the interest of the corporation, rests on the classical
economic model in which the stockholder/owner/proprietor links
her long-term economic well-being to the long-term health of the
business enterprise. As and when the underpinnings of this model
change, the conclusions and policy decisions generated by the
model must be reexamined.
An obvious example of the need to reexamine the model and
make periodic adjustments is provided by the development of anti-
trust laws in the United States and the United Kingdom. These
laws, responding to the modern corporation's ability to distort
markets through monopolization or anticompetitive pricing, re-
present an effort to realign the market into conformity with the
assumptions of the classical model. Similarly, the separation of
ownership and management, and the changing nature of owner-
ship, have undermined the invisible hand model. A corporate gov-
ernance system based on this model accordingly becomes problem-
atic. Ultimately, the corporate governance system must realign the
interests of the corporation's stockholders, managers, and other
constituencies to promote the long-term health of the business en-
terprise. Only then will the pursuit of private interest again serve
the public interest as posited by classical economic theory.

B. Short-Termism and the Bias of Institutional Stockholders

The growing dominance of institutional shareholdings, and the

structure within which institutional stockholders now operate, has
virtually ensured the divergence of the interests of stockholders
and those of the corporation. Institutions now hold more than 45
percent of total equities in the United States, and approximately
52 percent of equity in the 500 largest companies . 5 The concentra-
tion of institutional ownership in the United Kingdom is even
greater, exceeding 63 percent.5 3 Institutional stockholders have lit-
tle incentive or inclination to behave like traditional owners in the
classical economic model-that is, to work actively towards the

81 See Part I.A.

Carolyn Kay Brancato, The Pivotal Role of InstitutionalInvestors in Capital Mar-
kets: A Summary of Economic Research at the Columbia InstitutionalInvestor Project 21
and Table 7 (Center for Law and Economic Studies, Columbia University School of Law,
1990) (on file with U Chi L Rev).
"' See William Taylor, Can Big Owners Make a Difference?, Harv Bus Rev 70 (Sept-
Oct 1990).
 The University of Chicago Law Review [58:187

long-term operating success of the corporation. They tend to focus

instead on the current market price of the corporation's stock.
Most institutional stockholders will support a hostile takeover, a
sale of assets, a leveraging recapitalization, or any other transac-
tion that boosts the immediate price of the corporation's stock.
The critique of short-term bias is a critique not of the motives
or integrity of institutional stockholders, but of the system that
has failed to respond to the changing nature of stock ownership.
While proposing a corps of professional directors to be nominated
and elected by institutional stockholders, Professors Gilson and
Kraakman recognize that institutional stockholders currently have
little opportunity or incentive to take an interest in the long-term
54
business development of the corporations whose stock they own.
However, they would accept the short-term bias of institutional
stockholders and seek to guarantee that the board of directors, in
the name of heeding the wishes of stockholders, reflects this bias.
In contrast, this Article suggests that the corporate governance
system must attempt to counteract this short-term bias and realign
the interests of stockholders with the interest of the corporation as
an ongoing business enterprise.
Several constraints operate on the institutional stockholder to
produce a short-term bias. First, as their stock portfolios have
grown in size, institutional stockholders have increasingly lost the
ability to assess adequately the business performance of each port-
folio company.5 5 For these stockholders, the market price of the
corporation's stock has become the only important valuation mea-
sure for the corporation, and any step that boosts the short-term
price of a portfolio company's stock has become viewed as intrinsi-
cally desirable.
Second, institutional stockholders assess the performance of
the investment managers who control their stock portfolios over a
short time frame, typically quarter to quarter or year to year, on
the basis of the change in the portfolio's market value during the
specified time period.56 The investment manager trying to out-
perform the market average in each quarter or each year will al-

" Gilson & Kraakman, Reinventing the Outside Director at 6-8 (cited in note 1).
Id at 6-7 (growth of funds under the management of institutional investors whose
investment strategy is simply to track the general performance of the market reflects the
inability or unwillingness of those stockholders to track the performance of individual cor-
porations); Taylor, Harv Bus Rev at 72 (cited in note 53) ("Of the $40 billion in equities
owned by the New York funds [three pension funds for retired state and local employees],
$30 billion are in indexed portfolios.").
51 See Dertouzos, Lester, and Solow, Made in America at 62 (cited in note 46) (fund
19911 Quinquennial Election

ways have an incentive to accept, even seek, a short-term premium

for a portfolio stock.5 7 This competition among investment manag-
ers exacerbates a situation analogous to the "prisoner's dilemma,"
in which cooperation produces optimal results but rational, self-
interested behavior does not.58 Even if the investment manager un-
derstands that stockholders as a whole would be better off encour-
aging and promoting the long-term business development of all
corporations, he will still accept, even seek, short-term premiums
on his portfolio stocks in an effort to outperform competing invest-
ment managers in any given quarter or year.
Finally, the institutional stockholder faces liability constraints.
The typical institutional stockholder has a fiduciary duty to the 59
beneficiaries of its portfolio and must act solely in their interest.
While fiduciary status does not intrinsically require a short-term
orientation, to the extent the courts and government agencies such
as the Department of Labor have accepted the managerial disci-
pline model's short-term bias, the institutional stockholder may
fear exposure to liability if it fails to seek or accept the short-term
premium for its portfolio shares.6 0

managers rapidly turn over stock holdings since judged on current value of investment port-
folio). See also Lipton, 136 U Pa L Rev at 7-8 (cited in note 6).
11 See Crockett, Takeover Attempts at 8 & n 8 (cited in note 32) (short time horizons
of institutional stockholders result from "emphasis ...placed on short-term performance in
evaluating and rewarding fund managers").
" See generally Anatol Rapoport and Albert M. Chammah, Prisoner's Dilemma: A
Study in Conflict and Cooperation (Michigan, 1965).
, The Department of Labor (DOL) views the Employee Retirement Income Security
Act of 1974 (ERISA), 29 USC §§ 1001 et seq (1988), as requiring plan fiduciaries to consider
only the economic interests of the plan participants and beneficiaries in the shares held by
the plan when deciding whether to tender shares in a tender offer. While the DOL has
stated that plan fiduciaries may weigh the long-term value of the target company in this
decision, it also warns that it will monitor plan fiduciaries to ensure that they do not violate
ERISA's requirements and are aware of the liability that can result from any such viola-
tions. See PressBriefing on ERISA and Takeovers, in 6 Pension & Profit Sharing (Prentice-
Hall) 135,649 at 136,971 (1989). See also David George Ball, Assistant Secretary, Pension
& Welfare Benefits Administration, The Importance of Corporate Governance (speech to
United Shareholders' Association, Sept 17, 1990) (on file with U Chi L Rev). In practice, the
DOL's statements have resulted in pressure on plan fiduciaries to tender their shares for the
immediate premium, in order to avoid liability for incorrectly assessing the long-term value
of the target corporation and its prospective return to stockholders.
60 See, for example, statement of David Walker, Assistant Secretary of Labor, in 6 Pen-
sion and Profit Sharing at 136,971 (cited in note 59) (plan fiduciaries must look solely to
economic interests of the pension plan, with purpose of maximizing retirement income for
beneficiaries); Thomas Gilroy and Brien D. Ward, The InstitutionalInvestor's Duty Under
ERISA to Vote Corporate Proxies, in Proxy Contests, InstitutionalInvestor Initiatives,
Management Responses 1990 853, 866 (PLI, 1990) (DOL generally claims that ERISA's
prudence requirement "obligates the fiduciary to consider only economic factors that affect
the value of the plan's investment. For example, the decision to vote for a shareholder initi-
 The University of Chicago Law Review [58:187

Commentators outside of academic circles have for some time

noted the problem of short-termism.6 Because of the influence of
the efficient capital markets theory, however, the academic litera-
ture has tended to ignore the problem. Under the efficient capital
markets theory, the short-term price of a stock reflects the present
value of the corporation's long-term results. Adherents of this the-
ory thus define out of existence the distinction between short-term
2
and long-term values or investor orientations.
It is only with the recent undermining of the efficient capital
markets theory 3 that the academic literature, particularly the eco-
nomic literature, has begun to examine the effects of short-term
biases and short-term investment horizons. Professors Shleifer and
Vishny, for example, have demonstrated that the short time hori-
zons of arbitrage investors, who focus on short-term assets because
they are relatively less expensive to arbitrage, may result in severe
market underpricing of a corporation's equity. This phenomenon
in turn imposes a short time horizon on managers, who avoid long-
term investments that depress share prices over the short term and
that thus make the corporation vulnerable to hostile takeover.6
They conclude that the "clustering" of arbitrage on the trading of
short-term assets "leads to systematically more accurate pricing of
short-term assets than of long-term assets, even though efficient
capital allocation and managerial evaluation might be better
served by the opposite bias."6 5
Other academic writers identify additional sources of short-
term pressures and biases. Stephen LeRoy points to the recent
literature on cognitive psychology for the proposition that stock-
holders "systematically overweight current information and under-
weight background information, 66 thus producing an artificially

ative in the belief that it will support management's commitment to stimulate job growth in
a targeted sector of the economy may, in the DOL's view, violate [the fiduciary duty].").
ERISA provides that a plan fiduciary is "personally liable" for any breach of fiduciary duty.
ERISA § 409(a), 29 USC § 1109(a). This provision may be enforced either by a plan partici-
pant or beneficiary or by the Department of Labor. ERISA § 502(a)(2), 29 USC §
1132(a)(2).
61 See, for example, John G. Smale, What About Shareowners' Responsibility?,Wall St
J 24 (Oct 16, 1987) ("by focusing on the short term, our publicly held business enterprises
will see their competitive position decay"); Alan Greenspan, Takeovers Rooted in Fear,
Wall St J 28 (Sept 27, 1985) ("Excessively high discount factors place a disproportionate
share of the value of a company's stock on near-term earnings and dividend flows.").
82 See note 28 and accompanying text.
63 See notes 29-32 and accompanying text.
Shleifer and Vishny, 80 Am Econ Rev Pap & Proc at 148 (cited in note 32).
66 Id at 153.
66 LeRoy, 27 J Econ Lit at 1616 (cited in note 30).
1991] Quinquennial Election

high discount rate for future earnings estimates. Jeremy Stein cites
"informational asymmetry" as leading to undervaluation of pro-
ductive assets that do not contribute to current earnings, forcing
managers to take short-term steps such as selling the asset or
7
leveraging against it in order to "signal" the value of the asset.1
The anecdotal evidence, particularly in connection with the re-
action of share prices to short-term earnings, also supports the
view of a short-term bias in the market. Recent examples include
Tambrands Inc., whose share price dropped precipitously on the
announcement of a capital spending and marketing program that
caused analysts to reduce 1990 and 1991 earnings estimates. An
investment banker explained, "'Some of their marketing programs
were just a little more long-term in nature' than had been ex-
pected. . . . 'Some analysts were expecting more immediacy in
terms of earnings growth.'-"68 Similarly, Motorola Inc.'s share
price plunged following the announcement of lower-than-expected
earnings for the third quarter of 1990, due primarily to substantial
research and development expenses, notwithstanding the fact that
Motorola's historical strategy of investing for the future had
"helped move it from an old-line television and radio maker in the
1950s and 1960s into a global leader in wireless communications." 69
An 83-year old investment manager, who had been investing in
Motorola since 1955, said he had seen the mistake before: "'I have
never tried to pinpoint the exact amount of quarterly earnings
ahead,' he said. 'That's not important to me.' ,,7o Given the domi-
nance of institutional shareholdings, these market reactions are
clearly an indication of the institutional stockholders' response to
these short-term earnings declines. A report on Warren Buffett's
investment in Wells Fargo Corporation highlighted the scarcity of
long-term institutional investors when it quoted a broker who said,
"Buffett is a long term investor with a three to five year time hori-
'71
zon-a time frame that most institutional investors can't afford.
Disagreeing with the assertion that institutional shareholders
hold a short-term perspective, a study commissioned in the United

67 Jeremy C. Stein, Takeover Threats and ManagerialMyopia, 96 J Pol Econ 61, 62-63
(1988).
43 Lourdes Lee Valeriano, Estimates Lowered for Tambrands; Share Price Sags, Wall
St J A10 (Nov 16, 1990).
"' Robert L. Rose, Motorola Profit Report Depresses Stock, Wall St J A8 (Oct 10,
1990).
70 Id.
7' Buffett's Stake in Wells Fargo Doesn't Mean Stock's Bottomed, Portfolio Letter 3

(Oct 29, 1990).

 The University of Chicago Law Review [58:187

Kingdom by the Institutional Fund Managers' Association argues

that managers and directors themselves generate a short-term out-
look, in part because they wrongly believe that institutional inves-
tors share this bias. 72 While evidence of the actual short-term bias
of institutional stockholders is strong, the adverse consequences of
short-termism may flow just as easily from a perceived short-term
bias. To the extent the quinquennial proposal outlined in Part IV
can promote a continuing dialogue between managers and institu-
tional stockholders, any misperceptions that exist can be
minimized.
The focus on the short term has come at the expense of the
long-term planning, investment and business development of the
corporation. When managers seek to boost the short-term earnings
and stock price, the easiest expenditures to forego are investments
in the future. Thus, corporations have sacrificed research and de-
velopment expenses, capital expenditures, market development,
and new business ventures, simply because they promise to pay off
only in the long term.73 David Walker of the Bank of England
points to "an attitude that attention to the longer run is a luxury
and risk that can be indulged only within tight limits, especially by
companies that see themselves as potential takeover targets. 1 4 In-
stead, managers channel resources to projects expected to produce
immediate results, or to financial measures, such as stock repur-
chase programs, designed to boost short-term earnings. The long-

72 Paul Marsh, Short-Termism on Trial 50-53 (Institutional Fund Managers' Associa-

tion, 1990).
" See R & D Spending Growth Continues to Slow, Res Tech Mgmt 2 (Mar-Apr 1990)
(period from 1980-85 saw annual rate of increase in American corporate research and devel-
opment spending of 8.2%, while period from 1985-90 shows real increases averaging less
than one-fifth that rate); NSF Implicates LBOs in Corporate R&D Cuts-Others Not So
Sure, Res Tech Mgmt 2 (May-June 1989) (National Science Foundation's 1987 survey indi-
cates that acquisitions, mergers, and other restructurings hurt the research and develop-
ment performance of those industries in which they occurred); Bronwyn H. Hall, The Im-
pact of Corporate Restructuring on Industrial Research and Development, in Martin Neil
Baily and Clifford Winston, eds, Brookings Paperson Economic Activity: Microeconomics
1990 85, 123 (Brookings, 1990) ("Regardless of whether one believes that leverage is effi-
ciency enhancing or that it leads to a decline in productive investment, the link between
leverage and reduced R & D spending has been established."). But see Margaret Menden-
hall Blair, A SurprisingCulprit Behind the Rush to Leverage, Brookings Rev 19 (Winter
1989/90) (citing high real interest rates, rather than short-term bias, as chief deterrent to
new investment and chief cause of shift to debt financing). It is unclear, however, whether
interest rates would have been so high during the 1980s but for the speculative binge of
which the takeover and leveraging wave was a part.
"' David Walker, Capital Markets and Industry, Bank of England Q Bull 573 (Dec
1985), quoted in Morgan and Morgan, The Stock Market and Mergers in the United King-
dom at 94-95 (cited in note 30).
1991] Quinquennial Election

term adverse effect of these measures on the ability of our corpora-

tions to compete against business enterprises whose ownership
structures, and whose countries' economies, promote investment in
the future is apparent and becoming more severe.
In his monumental study of global competition, Michael E.
Porter identifies the growth of institutional investors in the United
States to a position of dominance over the major business corpora-
tions as the most significant factor in the decline of American
industry:
Unlike institutional investors in nearly every other advanced
nation, who view their shareholdings as nearly permanent and
exercise their ownership rights accordingly, American institu-
tions are under pressure to demonstrate quarterly apprecia-
tion. Pension consultants have grown up that collect fees by
assisting funds in changing asset managers whose recent per-
formance is deemed inadequate. Asset managers, in turn, re-
ward their employees based on the appreciation of their port-
folio in the last quarter or year. With a strong incentive to
find companies whose shares will appreciate in the near term
and incomplete information about long-term prospects, port-
folio managers turn to quarterly earnings performance as per-
haps the single biggest influence on buy/sell decisions.

Managers have become preoccupied with heading off take-

overs through boosting near-term earnings or restructuring.
While restructuring has often led to beneficial sales of un-
derperforming assets, cost cutting, and sometimes the weeding
out of poor managements, the completion of restructuring
starts the same pressures running again. The taking on of sub-
stantial debt in the course of restructuring, with proceeds
paid to shareholders instead of invested in the business as was
the case in highly leveraged Japanese companies, often leads
to risk aversion and a slowing of true strategic innovation. 5
The focus on the short term has also led to the overleveraging
of our economy. 76 The last decade saw an unprecedented wave of

75 Michael E. Porter, The Competitive Advantage of Nations 528-29 (Macmillan,

1990).
11 See Farrell, Bus Week at 84 (cited in note 44) (There "is growing evidence that steep
leverage is beginning to hobble management, a worrisome trend because Corporate America,
in this decade, has retired nearly $500 billion in equity while piling on almost $1 trillion in
debt."). While determining the "right" level of debt is difficult, the leveraging wave of the
last decade is particularly disturbing in that, historically, in times of economic expansion,
 The University of Chicago Law Review [58:187

leveraged transactions, in the form of debt-financed acquisitions,

leveraged buyouts, and leveraged recapitalizations. These transac-
tions resulted in large measure from the demand for short-term
stock premiums, regardless of the long-term consequences. In the
rush to profit from leveraging or breaking up the corporation, ac-
quirors and stockholders ignored the long-term implications of
these actions. Leveraged transactions allow the acquiror to pay a
premium to acquire a corporation using the corporation's own as-
sets as collateral. They allow the corporation to boost short-term
value by paying stockholders a large special dividend, or to boost
short-term stock prices by repurchasing a large portion of its stock.
But these leveraged transactions also exacerbate the need to cut
expenditures and future investments in order to produce short-
term cash flow, and leave our corporations less able to weather eco-
nomic downturns. The bankruptcies and workouts now in the news
are the legacy of these leveraged transactions."
The increasing activism of institutional stockholders may well
worsen the corporations' preoccupation with the short term. Influ-
ential groups such as the Council of Institutional Investors, the
California Public Employees' Retirement System (CalPERS), and
the United Shareholders' Association have historically promoted
takeovers. Organized by these groups, large numbers of institu-
tional stockholders have increasingly embarked on proxy voting
agenda designed to remove takeover defenses and other impedi-
ments to takeover premiums.7 While takeover defenses have no
intrinsic merit, they often provide the only means by which a cor-

debt levels have decreased, providing a cushion for the next downturn. See Henry Kaufman,
The Great Debt Overload Will Keep the Recovery Feeble, Fortune 23 (Dec 31, 1990) ("The
credit quality of American corporations deteriorated throughout the just-ended business ex-
pansion. That is unprecedented; normally the financial condition of business improves when
the economy grows.").
77 See Business FailuresIncrease 14.5% in First9 Months, Wall St J B2 (Nov 2, 1990)
(recent report by Dun & Bradstreet indicates that United States business failures rose
14.5% in the first nine months of 1990, to 43,836); Sharon Reier, A Banquet for Fat Cats:
Bankruptcy, Financial World 36 (Oct 16, 1990) (blaming LBOs for the fact that the past
two years have produced 13 of the nation's 25 largest bankruptcies, accounting for close to
$50 billion in assets); Daniel Wise, Workouts, Bankruptcy Work Replacing Junk Bonds
Practices,NY L J 1 (Nov 2, 1989); Fred R. Bleakley, Many Firms FindDebt They Piled On
in 1980s Is a Cruel Taskmaster, Wall St J Al (Oct 9, 1990) (belt tightening engendered by
debt load is forcing cutbacks in capital expenditures, new ventures, and new product lines,
and could deepen the unfolding slump in the United States economy).
78 See Investor Responsibility Research Center, Inc., Major 1990 Corporate Govern-

ance Shareholder Proposals (Feb 20, 1990) (on file with U Chi L Rev) (listing by sponsor
proposals to redeem rights plans, opt out of state antitakeover laws, prohibit greenmail, ban
golden parachutes, reduce supermajority requirements, etc.).
1991] QuinquennialElection

poration and its directors and managers can seek to protect the
long-term business needs of the enterprise against the pressure for
short-term premiums. To the extent these defenses are removed
without taking steps to reorient the stockholders' perspective to
the long term, the ill effects of the current short-term bias will be
exacerbated.
Similarly, CalPERS and the United Shareholders' Association
have proposed comprehensive revisions of the SEC's proxy rules,
intended to increase the role of institutional investors in the proxy
process and corporate governance.79 Any reform in this area, how-
ever, must be part of a larger effort to reorient stockholders toward
a long-term perspective. Otherwise, the increased activism of insti-
tutions in the proxy process is likely to promote a continued short-
term outlook, with all its negative consequences."0

C. Hostile Takeovers and Short-Termism

The hostile takeover wave of the last decade both caused and
resulted from stockholders' short-term bias. A dominant stock-
holder population anxious to accept a takeover premium encour-
ages the hostile acquiror with the likelihood that a premium bid
will succeed or that a higher bid will prevail, allowing the first po-
tential acquiror to profit on shares of the corporation it purchased
prior to making its bid. Moreover, the short-term bias tends to re-
sult in greater discounting by the market of the long-term profits
of the firm, leaving the market valuation of the corporation well
below the true value of the enterprise. The acquiror is thus able to
make a bid that is below the corporation's value (measured in
terms of the future income streams but discounted at a lower rate
than that typically produced by the short-term bias). Yet the bid,

"' See letter from CalPERS to Linda C. Quinn, Director, Division of Corporation Fi-
nance, Securities and Exchange Commission (Nov 3, 1989), reprinted in InstitutionalInves-
tors: Passive Fiduciariesto Activist Owners 454 (PLI, 1990); letter from United Sharehold-
ers' Association to Edward H. Fleischman, Commissioner, Securities and Exchange
Commission (Mar 20, 1990), reprinted in id at 485. Compare letter from The Business
Roundtable to Linda C. Quinn, Director, Division of Corporation Finance, Securities and
Exchange Commission (Dec 17, 1990) (on file with U Chi L Rev) (opposing revisions to the
proxy rules).
80 Philip R. Lochner, Jr., Commissioner, Securities and Exchange Commission, Improv-
ing Corporate Governance for the Nineties: The Role of InstitutionalInvestors and Proxy
Reform 6 (speech to City Club, Sept 20, 1990) (on file with U Chi L Rev) (If proposed proxy
reforms are adopted and provide institutional stockholders with greater power to influence
boards, institutions might "use their newfound muscle ... to break up and sell off compa-
nies in order to yield higher short-term returns.").
 The University of Chicago Law Review [58:187

so long as it is at a premium to the market, is likely to be well

received by stockholders.
At the same time, takeover activity has fueled the short-term
orientation of institutional stockholders. Takeover premiums pro-
vide the fast return on financial equity investments that institu-
tional stockholders desire. Support of hostile takeover activity has
provided a focal point for the expression of short-term interests,
exemplified by the spate of stockholder-sponsored proxy proposals
in opposition to rights plans and other takeover defenses.8 1 And
the threat of hostile takeovers fuels the pressure on directors and
managers to increase short-term earnings and cash flow, regardless
of the impact on long-term business planning and development.
The hostile takeover activity of the last decade has also im-
posed severe dislocations and costs on the corporation's non-stock-
holder constituencies. A hostile takeover often brings with it staff
reductions and layoffs. It may involve selling off operating units or
shutting down offices or operations. These actions frequently harm
the communities affected. 2 The hostile takeover may also contract
the relevant product market, causing disruptions or dislocations
for customers and suppliers. These costs, while not by themselves
dispositive, add further weight to the case for corporate govern-
ance reforms that will discourage the reemergence of takeover
mania.

D. The Interests of Other Constituencies

Largely in response to the impact of hostile takeover activity

on the corporation's non-stockholder constituencies, twenty-nine
state legislatures have enacted legislation permitting boards of di-
rectors to consider and act on the interests of these various corpo-

81See Investor Responsibility Research Center, Inc., Major 1990 Corporate Govern-
ance Shareholder Proposals (cited in note 78); Emile Geylein and Richard Koenig, Pension
Funds Plot Against Takeover Law, Wall St J C1 (Apr 5, 1989) (describing attempts of three
large pension funds, through stockholder proposals, to cause corporations to opt out of Dela-
ware antitakeover statute).
82 See, for example, Susan C. Faludi, Safeway LBO Yields Vast Profits but Extracts a
Heavy Human Toll, Wall St J Al (May 16, 1990) (following Safeway's defensive LBO,
63,000 workers and managers were laid off); George Anders, Morgan Stanley Found A Gold
Mine of Fees By Buying Burlington, Wall St J Al (Dec 14, 1990) (highly leveraged takeover
of Burlington Industries, Inc., to rescue the company from the advances of corporate raider
Asher Edelman, resulted in the selling off of twenty of Burlington's businesses and the
shrinking of Burlington's work force from 44,000 before the bid to 27,500 several years
later); Shleifer and Summers, Breach of Trust in Hostile Takeovers in Auerbach, ed, Corpo-
rate Takeovers at 50-51 (cited in note 34) (describing community costs to Youngstown, Ohio
'l-owing acquisitions of Youngstown Sheet and Tube and Lykes Steamship Company).
1991] Quinquennial Election

rate constituencies. 83 Some have criticized these statutes on the

basis that they call upon directors to set social policy, a task be-
yond the directors' proper powers."4 Constituency statutes, how-
ever, should not be viewed as giving directors a mandate to make
social policy. Rather, they merely permit directors to take into ac-
count the interest and role of non-stockholder constituencies in the
corporation's long-term vitality. Suppliers, customers, employees
and communities all prosper in the long run if the enterprise pros-
pers in the long run: suppliers retain a strong consumer of their
products, customers retain a strong producer of desired goods or
services, employees retain a healthy employer, and communities
retain a vital contributor to their economic and fiscal health. Con-
stituency statutes empower a board of directors to consider these
interests in adopting a "just say no" response to a takeover bid: if
the board determines that it best serves the corporation's long-
term interests to remain independent, it can refuse to remove im-
pediments to the bid.
Constituency statutes, then, are best understood as a means of
permitting boards of directors to consider the interests of the cor-
poration as a business enterprise, rather than solely the desires of
the stockholders. They respond to the divergence of the stockhold-
ers' interests and the corporation's interests resulting from the sep-
aration of ownership and management and from the dominance of
institutional ownership. They are, however, at best a stopgap
measure. The real need is for a realignment of the interests of
stockholders and corporations around the long-term health of the
business enterprise. In the next Part, we seek better models for
carrying out this task.

8 The concept that the interests of non-stockholder constituencies should be taken

into account in the takeover context was developed in academic literature and case law prior
to the enactment of constituency statutes. See, for example, Martin Lipton, Takeover Bids
in the Target's Boardroom, 35 Bus Law 101, 130 (1979); Unocal Corp. v Mesa Petroleum
Co., 493 A2d 946, 955 (Del 1985). For examples of constituency statutes following this con-
cept, see Ill Ann Stat ch 32, § 8.85 (Smith-Hurd Supp 1990); NJ Stat Ann § 14A: 6-1 (West
Supp 1990); NY Bus Corp Law § 717 (Law Co-op Supp 1989); 15 Pa Cons Stat Ann §
1721(c) (Purdon Supp 1990).
88 See, for example, Committee on Corporate Laws, Other ConstituenciesStatutes: Po-

tentialfor Confusion, 45 Bus Law 2253, 2270 (1990) ("[A]Ilocations of wealth (which essen-
tially a balancing of the interests of various constituencies would be) are political decisions"
which are "beyond the general pale of [directors'] perceived mandate from society.") (em-
phasis in original). See also Amanda Acquisition Corp. v Universal Foods Corp., 877 F2d
496, 500 & n 5 (7th Cir 1989) (Easterbrook) (no policy need to protect non-stockholder
corporate constituencies, because acquiror is no more likely than incumbent management to
injure these constituencies).
 The University of Chicago Law Review [58:187

III. THE REALIGNMENT OF INTERESTS: LESSONS FROM

HOME AND ABROAD

A long-term view on the part of stockholders and managers is

necessary to permit public corporations in the United States and
the United Kingdom to invest in the future, maintain their vital-
ity, and compete in the world economy.8 5 Corporations must be
permitted to sacrifice some immediate value to investments in cap-
ital assets, research and development, new ventures, or market
share. To the extent the corporation is not permitted to invest in
the future, it will inevitably lose customers and profits to those
corporations that are permitted to do so."6 In this Part, we discuss
elements of the Japanese and German systems of corporate gov-
ernance, and the "patient capital" approach of American investor
Warren Buffett, to demonstrate the advantages of long-term
emphasis.

A. The Need for a Long-Term View

The long-term health of the business enterprise is ultimately
in the best interests of stockholders, the corporation's other con-
stituencies, and the economy as a whole. The institutional stock-
holder typically invests in a large number of stocks whose overall
performance, like that of index funds, tends to mirror the perform-
ance of the market and the economy."7 Moreover, the large institu-

" Brady, Remarks before the Business Council at 2 (cited in note 6) (American corpo-
rations "can't innovate and produce the products needed to capture world markets by focus-
ing on results one quarter at a time."); Alan 0. Sykes, Corporate Takeovers-the Need for
FundamentalRethinking 21 (David Hume Institute, 1990) ("The inevitable consequence of
'City' short-termism is long-term damage to the City on the back of far greater long-term
damage to the [United Kingdom's] corporate sector as a whole."); Lord Alexander of
Weedon, Q.C., Chairman of National Westminster Bank'and former Chairman of the City
Takeover Panel, The Changing Nature of Finance 9 (speech for the Lombard Association
60th Anniversary Dinner, Oct 4, 1990) (on file with U Chi L Rev) ("Concern about takeovers
may inhibit medium- to long-term planning and, as some say, research and development.
The future of companies may undoubtedly be settled on the basis of short-term
considerations.").
88 See, for example, John J. Curran, Hard Lessons from the Debt Decade, Fortune 76
(June 18, 1990) ("Says Douglas Watson, head of industrial ratings at Moody's Investors
Service: 'I've been seeing signs that once a company leverages, it invites predatory behavior
from its rivals.' For example, most major supermarket chains are stocked to their fluorescent
lights with debt. Thus they're in no shape to respond as A&P, one of the few grocers with a
clean balance sheet, aggressively expands into their markets.").
" Gilson and Kraakman, Reinventing the Outside Directorat 6-8 (cited in note 1) (in-
stitutional investors increasingly "hold the market," whether through indexing or simply by
virtue of the size of their portfolios, thereby eliminating the likelihood of benefits from ac-
tive trading).
1991] QuinquennialElection

tional stockholder is a long-term investor in the market as a whole.

Unless it divests itself of equities altogether, it will have an equity
stake in a substantial portfolio of corporations regardless of how
long it maintains a stake in any one corporation. To the extent the
economy as a whole thrives over the long term, the portfolio should
thrive, regardless of the performance of, or the availability of take-
over premiums for, any individual stock.
Professors Gilson and Kraakman cite several studies for the
proposition that takeovers provide long-term benefits to stockhold-
ers. "[O]n average," they claim, "target shareholders lose signifi-
cantly when offers are defeated and the company is not subse-
quently acquired by an alternative bidder .... [T]he data resolves
the charge that a favorable orientation to premium tender offers
reflects a short-term orientation."'8 It is unclear, however, why one
should limit the sample to companies "not subsequently acquired
by an alternative bidder." The corporation that defeats a takeover
bid retains the value of control, on which it may realize a premium
by selling the corporation at any time. The corporation that is ac-
quired, of course, loses the asset of control.
More importantly, all the studies cited by Professors Gilson
and Kraakman necessarily measure stock market effects within the
existing system of corporate governance. In the current environ-
ment, corporations that successfully defeat a takeover attempt (as
well as corporations seeking to avoid a takeover attempt) may take
steps to boost short-term earnings or value whether or not these
steps are in the long-term interests of the corporation. The studies
cannot measure the benefits of a new system that would encourage
all the corporation's constituencies to work toward the long-term
success of the corporate enterprise. It may well be rational under
the current system for any individual investment manager to focus
on short-term results, 9 but the short-term bias remains irrational
for the economy as a whole.
The takeover activity of the last decade did not enhance the
development of productive assets. Instead, it produced a reshuf-
fling of assets, large gains to the sponsors of and advisors to the
reshuffling, large gains (and losses) to the arbitrageurs who bet on
the outcome of the transactions, substantial societal dislocations,
and a legacy of heavy debt burdens."' In some cases takeovers did

88 Id at 11 & n 16.
See text at notes 55-60.
90 Lester C. Thurow, Let's Put CapitalistsBack into Capitalism,Sloan Mgmt Rev 67,

68 (Fall 1988) (lack of productivity growth during takeover era demonstrates that acquisi-
 The University of Chicago Law Review [58:187

shift assets to more efficient uses, but the studies that claim take-
overs generally have this positive effect tend to measure very short
time spans, not long-term effects. 91 Even some proponents of hos-
tile takeovers doubt that they are the best way to bolster the long-
term health and productivity of our corporate economy.92 The
healthy economies of Japan and Germany result in large part from
93
effective, stable management and long-term capital investment.
Unless the corporate governance systems of the United States and
the United Kingdom can engender a similar long-term orientation,
the relative health of American and British corporations, and the
relative wealth of their stockholders, will inevitably erode.
The following illustrations are not intended to imply that ei-
ther the Japanese or German corporate regime can or should be
transplanted to the American or British corporate setting. Rather,
these examples are meant to demonstrate successful alternatives to
the managerial discipline model of corporate governance.

B. Japan and Germany

There are many reasons for the economic health and success
of Japan and Germany relative to the United States and the
United Kingdom. 4 It is not possible, of course, to determine pre-

tions are a redistributive activity, not a productive activity); Stout, 99 Yale L J 1235 (cited
in note 32) (takeover premiums may be a natural market phenomenon rather than evidence
of efficiency gains).
91 See, for example, Gregg A. Jarrell, James A. Brickley, and Jeffrey M. Netter, The
Market for Corporate Control: The Empirical Evidence Since 1980, 2 J Econ Persp 48, 66
(1988) ("premiums in takeovers represent real wealth gains, and are not simply wealth redis-
tributions"); Michael C. Jensen, The Takeover Controversy: Analysis and Evidence, Mid-
land Corp Fin J 6, 6 (1986) (attributing takeovers to "productive entrepreneurial activity
that improves the control and management of assets and helps move assets to more produc-
tive uses").
92 See, for example, Gilson and Kraakman, Reinventing the Outside Director at 14
(cited in note 1) ("the hostile takeover is an expensive and inexact tool for monitoring man-
agers that is better suited for correcting mistakes than preventing them").
93See Evan Herbert, How Japanese Companies Set R&D Directions, Res Tech Mgmt
28 (Sept-Oct 1990) (Japanese corporate governance system enables corporations to suffer
prolonged losses until R&D pays off); Brian O'Reilly, America's Place in World Competi-
tion, Fortune 80 (Nov 6, 1989) (In 1987, Japan's capital spending was approximately 22
percent of GDP, West Germany's was approximately 17 percent of GDP, and the United
States' and the United Kingdom's were approximately 13 percent of GDP.).
9' Factors that have been cited include higher levels of saving, lower costs of capital,
and cultural work ethics. See generally G.C. Allen, The Japanese Economy (St. Martin's,
1981) (emphasizing the importance of political and social factors in Japan's economic
growth); Porter, The Competitive Advantage of Nations at 368-82 (cited in note 75) (educa-
tion, research, and worker commitment, as well as corporate governance structure and na-
ture of capital markets, contributed to German economic success).
1991] QuinquennialElection

cisely the degree to which any given factor has contributed to this
success. Many commentators agree, however, that an important
factor is their corporate governance schemes.9 5 At a minimum, Ja-
pan and Germany provide notable examples of alternatives to the
managerial discipline model of corporate governance, chosen by
two countries whose modern economies have been among the most
successful in the world. Japan and Germany have created systems
akin to what has been termed "proprietor-capitalism," the sort of
capitalism envisioned by classical economic theory, in which stock-
holders are knowledgeable and actively involved in ensuring the
quality of management.9 s These systems stand in contrast to the
"punter-capitalism" of the United States and the United King-
dom, in which stockholders typically remain uninvolved in assess-
ing and developing the business operations and management of
their corporations, except when it comes to the opportunity to re-
ceive the short-term premium of a takeover. 7

1. Japan: Control through the keiretsu.

The Japanese model centers around the keiretsu, a voluntary
grouping of firms and financial institutions with cross-sharehold-
ings and business relationships:
[Members of the keiretsu] hold non-controlling stock in each
other's firms. In addition, shares are owned by banks and life
insurance companies with the expectation of assured long-
term business relationships. In Japan, corporations and finan-
cial institutions together hold about two-thirds of all stock
listed on all exchanges. Often the majority of shares in a cor-
poration are collectively owned by members of the same in-
dustrial group or keiretsu.98
This cross-shareholding, together with major shareholdings by the
corporation's lenders, provides stability and a long-term orienta-
tion for Japanese corporations, leaving roughly 25 percent of

91 See, for example, Capitalism at 17 (cited in note 10); Sykes, CorporateTakeovers at

12-13 (cited in note 85); Dertouzos, Lester, and Solow, Made in America at 61-62 (cited in
note 46); Brady, Remarks before the Business Council (cited in note 6); Jonathan
Charkham, The American Corporationand the Institutional Investor: Are There Lessons
From Abroad? Hands Across the Sea, 1988 Colum Bus L Rev 765, 766.
98 Capitalism at 7 (cited in note 10).
97 Id.

" Aron Viner, Mergers, Acquisitions and Corporate Governance in Japan, in Joseph
C.F. Lufkin and David Gallagher, eds, InternationalCorporateGovernance 27 (Euromoney
Books, 1990).
 The University of Chicago Law Review [58:187

shares available for everyday trading. 99 The concentration of

shareholdings creates a monitoring body that can assess the busi-
ness performance of the corporation and its managers. 10 0 But the
business relationships among the keiretsu, primarily lending, cus-
tomer, and supplier relationships, ensure the alignment of interests
around the long-term business health and vitality of the corpora-
tion. This structure insulates the management of Japanese corpo-
rations against the short-term pressures felt by managers in the
United States and the United Kingdom.' 0 '

2. Germany: Control through bank intermediation.

While quite different from that of Japan, the German corpo-
rate governance structure leads to the same result. Stock owner-
ship of public corporations in Germany is largely through bank in-
termediaries that vote the shares they hold for others. Voluntary
delegation of voting rights to portfolio-managing banks is the norm
among private investors, except for major stockholders. For widely-
held corporations these banks account for over 90 percent of voting
rights, with the three largest banks controlling the voting rights of
over 40 percent of all shares.0 2 The banks also own shares in their
own right and often hold seats on corporate supervisory boards,

99 Capitalism at 17 (cited in note 10). See also Tony Shale, Reawakening the Sleeping
Giant, Euromoney 14, 17 (Nov 1990) ("of the 1,612 companies presently listed on the Tokyo
Stock Exchange, 1,100 belong to keiretsu groupings and account for 78% of market
capitalisation").
100 See Ramseyer, 35 UCLA L Rev at 49-50 (cited in note 34) (Japanese shareholders
have greater incentive to monitor managers as they generally hold large blocks of stock due
to the cross-shareholding practices in Japan. In addition, Japanese banks have proved to be
effective monitors of the corporations with which they have ongoing financial dealings.).
101 See id at 21-32 (Several factors combine to make hostile acquisitions in Japan a
relatively unprofitable, and therefore, rare occurrence: (1) the practice of cross-shareholding
in corporation stocks increases the cost of obtaining a controlling block of shares; (2) the
higher leverage of Japanese firms gives the lending bank the ability to bargain with the
potential acquiror for a portion of the gains; and (3) the absence of a provision in Japanese
law allowing the acquiror to cash out minority shareholders after the bid permits sharehold-
ers to free-ride on any efficiency gains resulting from the acquisition.). See also Martin Lip-
ton, Paying the Price of Takeover Money 34, Manhattan, inc. (May 1989) (quoting a 1988
speech by Masaaki Kurokawa, the chairman of Nomura Securities International: "Japanese
top management need not concentrate on short-term-profit schemes for the sole purpose of
appeasing its investors. In the United States, by contrast, each quarter's profit statement
brings around renewed panic ot exaltation, as investors concentrate on short-term results
rather than long-term profit and investment. Japan's separation of management and inves-
tors, however, allows freer investment in long-term physical assets, which, of course, contrib-
utes to Japan's strong economic performance.").
102 Hermann H. Kallfass, The American Corporation and The Institutional Investor:
Are There Lessons From Abroad? The German Experience, 1988 Colum Bus L Rev 775,
782-83.
1991] Quinquennial Election

adding to their enormous power.10 3 Like the keiretsu, the German

structure insulates management from short-term pressures. It con-
centrates the control of shareholdings within a group capable of
effective monitoring, but oriented toward the long-term business
health of the corporation.104

3. Applicability of the Japanese and German examples.

Even if we favored the full-scale transplantation of the Japa-
nese or German models into the Anglo-American corporate envi-
ronment, which we do not, we recognize that present antitrust and
banking statutes would forbid it and that the American and Brit-
ish political systems would probably reject the concentration of
corporate power in such small groups. 105 But some of the concepts
of the Japanese and German structures can be applied to the
American and British systems. Professors Gilson and Kraakman
describe the Japanese and German structures as the "banker
model." They dismiss the banker model as "inapposite to the cir-
cumstances of the American institutional investor," claiming that
it "unifies, rather than bridges, ownership and control."'1 6

103Id at 783 ("It is hardly possible for private investors to effectively control the exer-
cise of voting rights by banks, and in practice they do not do so. This enables banks to
pursue their own interests when exercising voting rights, for instance, voting with a view to
their lending or investment business."); Dirk Schnalenbach, FederalRepublic of Germany,
in Lufkin and Gallagher, eds, InternationalCorporateGovernance at 109, 111 (cited in note
98) ("As a general rule the banks tend to exercise their power in support of management
which... will often make shareholder activism and attempts by shareholders to maximise
shareholder value in a way which is contrary to the present policy of management, seem
futile.... In their role as lenders the banks prefer a long-term increase in the substance of
the company rather than the distribution of high yield dividends.").
104 See, for example, Kallfass, 1988 Colum Bus L Rev at 790-91 (cited in note 102)
("Bank representatives are thus involved in filling positions on managing boards and in
making important business decisions. The resulting stability of control reduces the pres-
sures on managers, freeing them to pursue medium to long-term corporate objectives.");
Porter. The Competitive Advantage of Nations at 376 (cited in note 75) ("Sustained com-
mitment to the business is reinforced by the nature of German capital markets. Many com-
pany shares are held by banks and other long-term holders, who often play a prominent role
on boards. . . .The concern for quarterly earnings, in preference to actions required to
sustain the long-term position, has been all but absent, in contrast to the United States.");
Andrew Fisher, Banks Facing Up to Foreign Competition, The Banker 22, 39 (Apr 1987)
("The country's two biggest banks, Deutsche and Dresdner, played important roles in the
nursing back to health of Germany's largest shipping group, Hapag-Lloyd.... At AEG, the
electrical and electronics giant now controlled by Daimler-Benz, banks were also instrumen-
tal in preventing a collapse into bankruptcy.").
105 See Gilson and Kraakman, Reinventing the Outside Directorat 28 & n 52 (cited in
note 1) (noting political and cultural barriers to use of Japanese and German structures in
the United States and United Kingdom).
106 Id at 27.
 The University of Chicago Law Review [58:187

The German banks and the Japanese keiretsu, however, con-

stitute monitors, not managers, of the public corporation. Owner-
ship and management remain separate, but the structure of stock
ownership ensures the alignment of the interests of the managers
and stockholders around the long-term interests of the business
enterprise, and creates a stockholder presence capable of shielding
management from short-term pressures and monitoring managerial
performance. There is no reason that the systems of the United
States and United Kingdom cannot be reconstructed, by far less
radical means, to serve the. same goals: alignment of stockholder
and corporate interests around the long-term health of the corpo-
ration as a business enterprise, insulation of management from
short-term financial pressures, and effective monitoring of the
long-term business performance of the corporation's managers.

C. Leveraged Buyouts
In the United States and the United Kingdom, the replace-
ment of public with private ownership structures, particularly
through leveraged buyouts (LBOs), has become a common means
of reuniting ownership and management, and has been cited as a
means of improving corporate efficiency.10 7 Substantial equity
stakes for managers, active monitoring by the LBO sponsor/inves-
tor, and freedom from the preoccupation with reported quarterly
earnings and takeover defenses often combine to cause substantial
improvement in the newly private corporation's business opera-
tions.10 8 The financial incentives and risks for the management of
the post-LBO corporation can motivate quite effectively: the man-
ager who takes personal loans, perhaps even mortgages his house,
to participate in the equity of a buyout has a more direct financial
stake in the corporation's success than the manager who is insu-
lated from personal financial risk.

107 Michael C. Jensen, Eclipse of the Public Corporation,Harv Bus Rev 61, 65 (Sept-
Oct 1989) ("[T]hese organizations' resolution of the owner-manager conflict explains how
they can motivate the same people, managing the same resources, to perform so much more
effectively under private ownership than in the publicly held corporate form."); Frank H.
Easterbrook and Daniel R. Fischel, Corporate Control Transactions, 91 Yale L J 698, 706
(1982) (when firms go private they eliminate or substantially reduce the separation of own-
ership and control).
108 See, for example, Brett Duval Fromson, Life After Debt: How LBOs Do It, Fortune
91 (Mar 13, 1989) (describing how O.M. Scott & Sons, Borg-Warner, and other companies
substantially improved their operating performances in response to the pressures and op-
portunities created by LBOs).
1991] QuinquennialElection

The current recession demonstrates, however, that LBOs also

entail enormous risks for corporations and the economy as a whole.
Overleveraging engendered by the LBO wave has left many corpo-
rations in 'dire straits as the economic growth of the 1980s has
slowed or reversed. 10 9 Even those newly private corporations that
are not facing bankruptcy often find that massive debt and inter-
est payments siphon off the cash they need to invest in productive
uses. The debt burden of the LBO arguably forces managers to
operate efficiently in order to meet their payments. 110 But LBO
debt imposes a decidedly short-term discipline. Lenders in an
LBO, unlike the lender/stockholders of the German and Japanese
systems, are attracted by the initial transaction fees and seek a
quick repayment of their loans."' The LBO thus replaces the
short-termism of the institutional stockholder and the hostile take-
over with the short-termism caused by the need to pay down debt
quickly.
Even proponents of the LBO as a promoter of efficiency recog-
nize that "the LBO capital structure is simply inappropriate ...
for large numbers of public corporations that require the cash flow
flexibility to fund [research and development] or to compete in
growing markets.""' 2 Moreover, the corporation taken private in
an LBO typically goes public again within a matter of a few
years." 3 Indeed, taking the LBO company public is the only way
the LBO investor can realize the 30-40 percent annual equity re-
turns promised by LBO sponsors. Returns at that level depend on
high leverage and quick resale of the equity. Thus, the LBO does
not offer a widely applicable, long-term answer to the problems of
corporate governance.

D. Patient Capital
A more promising model for the United States and the United
Kingdom is the "patient capital" philosophy exemplified by War-
ren Buffett and Berkshire Hathaway, of which Mr. Buffett is chair-
man. Like the LBO sponsor and management investor, Mr. Buffett

109See sources cited in note 77.

110 Jensen, Harv Bus Rev at 66-67 (cited in note 107).
"I See Staff of House Subcommittee on Oversight and Investigations of the Committee
on Energy and Commerce, 101st Cong, 1st Sess, Leveraged Buyouts and the Pot of Gold:
1989 Update 148 (Committee Print, 1989) (testimony of L.W. Seidman, FDIC Chairman)
(substantial origination fees and selling fees are significant inducements to banks' competi-
tion to lend for LBOs).
"' Gilson and Kraakman, Reinventing the Outside Directorat 25-26 (cited in note 1).
113See Louis Lowenstein, Management Buyouts, 85 Colum L Rev 730, 731 (1985); Les-
lie Wayne, 'Reverse LBO's' Bring Riches, NY Times DI (Apr 23, 1987).
 The University of Chicago Law Review [58:187

serves the role of a knowledgeable and motivated monitor for the

companies in which he and his company invest. But he invests in
unleveraged companies and has a time horizon far beyond that of
the typical LBO investor. He treats "almost all [Berkshire
Hathaway's] investments as long-term ownership commit-
ments. "' 114 Mr. Buffett says: "[W]e have no interest at all in selling
any good businesses that Berkshire owns, and are very reluctant to
sell sub-par businesses as long as we expect them to generate at
least some cash and as long as we feel good about their managers
and labor relations." ' 1 5
This investment strategy has produced astonishing results.
Berkshire Hathaway's return has far exceeded that of the market
and almost any investment manager: "Since Mr. Buffett took over
Berkshire, $10,000 invested in its shares has grown to be worth
116
about $1.5 m[illion], a compound growth rate of 23% a year."
The patient capital approach teaches that long-term investment in
successful business enterprises can provide a highly attractive re-
turn, over a much longer period, when contrasted with a preoccu-
pation with short-term results and takeover premiums. As The
Economist concludes, "Whenever a typical money manager claims
that at least his betting-slip ways produce results, remind him gen-
tly of Warren Buffett.""' 7

IV. THE QUINQUENNIAL PROPOSAL

In this Part we describe our proposal for reform of the Ameri-
can and British corporate governance systems. This proposal, the
quinquennial system, seeks to make stockholders and managers
think and act like long-term owners by combining the patient capi-
tal approach of Warren Buffett, the long-term monitoring ap-
proach of the Japanese and German ownership structures, and the
financial incentives for managers of the LBO. The quinquennial
system would permit the delegation of control of the corporation to
its managers for sufficiently long periods of time to allow them to
make the decisions necessary for the long-term health of their cor-
poration. At the same time, it would force managers to develop
and justify their long-term plans for the corporation, and would
evaluate and compensate managers based on their ability to imple-

Capitalism at 15 (cited in note 10).

"' Id (quoting statements of Warren Buffett in Berkshire Hathaway Annual Report to
Stockholders).
11 Id.
117 Id at 16.
1991] QuinquennialElection

ment those plans successfully. The system would motivate stock-

holders, directors and managers to work cooperatively towards the
long-term business success of the corporation. And, if it ultimately
became necessary, it would allow stockholders to remove incompe-
tent or venal management and to force the sale or restructuring of
the corporation if that is determined, after sufficient time and
study, to be the best alternative.
The first section of this Part sketches the broad outlines of the
quinquennial system. Succeeding sections provide a detailed
description of each element of the proposal: the operation of stock-
holder meetings, the use of the proxy machinery, public reporting
requirements, managerial compensation, rules governing takeovers,
and the role of outside directors. The final section discusses the
steps necessary to implement the system. We have presented the
basic concept of the quinquennial system before. " 8 Here we pre-
sent it in fully developed form, as a response to the concerns out-
lined in the preceding Parts.

A. The Quinquennial Concept

The essence of the quinquennial proposal is to convert every
fifth annual meeting of stockholders into a meaningful referendum
on essential questions of corporate strategy and control, and to
limit severely the ability of stockholders to effect changes in con-
trol between quinquennial meetings. Stockholders would elect di-
rectors for five-year terms. Directors seeking reelection would
stand on the corporation's record for the past five years and its
strategic plan for the next five years. Stockholders would base
their determination of whether to oppose incumbent directors, and
focus any challenge they determined to mount, on the same issues.
Between these quinquennial election meetings, stockholders could
remove directors only for personal illegal conduct or willful malfea-
sance, or if the corporation were guilty of such conduct. The board
would have to consent to any takeover between quinquennial
meetings. Potential acquirors could, however, make unsolicited ac-
quisition proposals in conjunction with the quinquennial meeting,
in which case the meeting would become a referendum on the pro-
posals. In connection with the quinquennial meeting, any stock-
holder or group of stockholders owning five percent or more of the

18 Martin Lipton, An End to Hostile Takeovers and Short-Termism, Financial Times

§ 1 at 21 (June 27, 1990); Martin Lipton, Quinquennial Election of Directors:A Proposal
for Discussion, Wachtell, Lipton, Rosen & Katz Memorandum to Clients (Apr 9, 1990) (on
file with U Chi L Rev).
 The University of Chicago Law Review [58:187

corporation's outstanding shares, or shares having a market value

of five million dollars or more, would have the same access as the
incumbent board to the corporate proxy machinery, in support of
any candidates they wished to nominate. This access would include
corporate payment of proxy contest expenses to the same extent as
incumbent expenditures.
In the year of the quinquennial meeting, within 75 days after
the corporation's fiscal year ends, the corporation would send to its
stockholders a detailed report on its performance over the prior
five years compared to its strategic plan, together with industry
averages and other relevant data. The report would also detail the
corporation's projections for the next five years, the assumptions
underlying those projections, expected returns on stockholder in-
vestment, and the management compensation plan. At the same
time, an investment bank, accounting firm, or other outside advi-
sor selected by the board would send stockholders a detailed, inde-
pendent evaluation of both the corporation's performance for the
prior five years and its projections for the next five years. Stock-
holders would have 60 days after the mailing of the report and
evaluation to decide whether they wish to nominate candidates for
election as directors.
Because the quinquennial proposal would eliminate coercive
takeovers, it would also eliminate the panoply of private takeover
defenses and state legislation. It would make moot the issue of
whether and the extent to which directors can consider non-stock-
holder constituencies: decisions on takeover bids would lie in the
hands of the stockholders at the quinquennial meetings, and would
be at the discretion of the board between meetings. It would also
affirm the "one-share, one-vote" provisions currently embodied in
Rule 19c-4 under the Securities Exchange Act.119 In sum, it would
make the quinquennial election a true, unobstructed stockholders'
referendum on the corporation's performance and plans.
The quinquennial system would strengthen the board's inde-
pendence by requiring a majority of outside directors. The system
would look to outside directors to provide an effective monitoring
function over the operations of the corporation. The increased

119 17 CFR § 240.19c-4 (1990) (Rule 19c-4 seeks to deter corporate action, including
issuance of new class of securities, which "[has] the effect of nullifying, restricting, or dispa-
rately reducing the per share voting rights" of existing common stock shareholders.). But
see The Business Roundtable v SEC, 905 F.2d 406 (DC Cir 1990) (Rule 19c-4 invalidated
because SEC exceeded its authority under the Securities Exchange Act of 1934 in adopting
the Rule.).
1991] Quinquennial Election

ability of stockholders to replace directors at the quinquennial

meeting would lead directors (and, at the directors' insistence,
managers) to work far more closely with major stockholders than
they typically now do. To avoid the risk of replacement at the
quinquennial meeting, directors would carefully monitor the corpo-
ration's progress against its long-term plan and maintain a close
dialogue with stockholders with respect to the corporation's ongo-
ing performance. Meanwhile, the five-year period between elec-
tions, and the extremely limited ability to replace directors other-
wise, would leave stockholders with little choice but to work
cooperatively with directors during the five-year period, within a
structure that focuses all parties on the long-term business per-
formance of the corporation.
Lack of information for outside directors, as well as lack of
time or expertise to evaluate corporate information, often limits
directors' ability to monitor managerial performance. 12 0 The five-
year report would lower the information barrier for directors as
well as stockholders, and encourage managers and outside advisors
to consult more often with outside directors on the corporation's
performance and direction. Many corporations today present their
directors with an in-depth annual review by management and
outside advisors of the corporation's business plan and objectives,
its historical success or failure in meeting these objectives, and the
steps it plans to take in the future. The quinquennial system
would encourage this type of healthy in-depth analysis.
The quinquennial system would make the corporation's five-
year performance, including its success in meeting its five-year
plan, the sole basis for incentive compensation. It would eliminate
the annual or biannual incentive awards now common. Managers
would receive substantial rewards, well in excess of current com-
pensation levels, only if the corporation met or exceeded its goals.
Given the increased demands on their time and resources, outside
directors would receive more compensation than they now gener-
ally do, with an incentive system similar in concept to
management's.
The quinquennial system would benefit the corporation's
other constituencies, which prosper if the enterprise's business op-

120 See, for example, Lorsch, Pawns or Potentates at 55-58 (cited in note 19); Gilson
and Kraakman, Reinventing the Outside Director at 22 (cited in note 1). See also William
L. Cary and Melvin A. Eisenberg, Cases and Materials on Corporations 215-16 (Founda-
tion, 5th ed 1980).
 The University of Chicago Law Review [58:187

erations prosper over the long term. 1 21 Moreover, by eliminating

hostile takeovers and removing the pressure for excessive leverag-
ing, the quinquennial system would ameliorate the societal disloca-
tions that resulted from the takeover and leveraged buyout wave of
122
the last decade.
At the outset, we suggest limiting the quinquennial system to
large corporations, such as the Standard and Poor's 500 or the
Business Week 1000, which are more heavily held by institutional
investors. After experience with these corporations, the quinquen-
nial system could then apply to a broader group.
The quinquennial proposal would not entrench directors or
managers. It is not designed to prevent changes in corporate con-
trol, but rather to channel nonconsensual changes in control into a
more healthy forum. The primary defect of the takeover activity of
the past decade is not that it allowed for the replacement of direc-
tors and managers, but that it forced an external, short-term focus
on companies, directors, managers, and their stockholders. The
quinquennial system, by making the corporate proxy machinery
available to substantial stockholders who wish to nominate a com-
peting slate of directors, would actually enhance the ability of
stockholders to replace incumbent directors and to change corpo-
rate strategy. But it would provide this opportunity within a
framework that permits the corporation to carry out long-term
plans, and permits stockholders to assess their results before de-
ciding whether they are satisfied with their directors' performance.
Removal and replacement of directors would occur by means of an
orderly stockholder vote, based on full information. The quinquen-
nial framework would thus prevent the hurried decisionmaking im-
posed on corporations and their stockholders in the context of hos-
tile takeover battles123 and would eliminate the type of abusive,
coercive takeover activity prevalent in recent years.
The remainder of this Part dvelops in more detail the ele-
ments of the quinquennial proposal and the rationale underlying
each element.

121 See Part II.D.

122 See Parts II.B. and I.C.
122 See 17 CFR § 240.14e-1(a) (1990) (tender offer may be completed in as little as
twenty business days). This is hardly a time frame within which to decide intelligently the
destiny of the enterprise.
1991] QuinquennialElection

B. The Quinquennial Meeting

1. Rationale for five-year terms.
The five-year period between election meetings affords direc-
tors and managers some measure of freedom from the short-term
focus now imposed on them by institutional stockholders' pressure
for quarterly results and the ever-present takeover threat. Like the
four-year terms of American presidents and the six-year terms of
senators-as opposed to the two-year terms served by members of
the House of Representatives-it encourages a focus on long-term
policy decisions. 1 4 Yet the period is short enough that directors
and managers would feel an ongoing need to report to stockholders
on their plans and progress. The period is also short enough to
permit development of a realistic business plan for presentation to
stockholders in connection with the election meeting; five years is a
common yardstick for business planning today. Annual meetings of
stockholders would continue for matters other than election of
directors.
The five-year time period would also give institutional stock-
holders enough time to evaluate managers and directors and to
plan an effort to replace ineffective directors. Free access to the
corporate proxy machinery and to detailed business information,
in connection with the quinquennial meeting, would enable institu-
tional stockholders to monitor effectively and knowledgeably. The
election of a competing slate of directors would become a realistic
and practical alternative for dissatisfied stockholders, giving direc-
tors and managers a powerful incentive to work cooperatively with
stockholders throughout the period between quinquennial
elections.

2. Limited exceptions to the five-year rule.

The five-year period would not be wholly inflexible. As noted
above, the quinquennial proposal contemplates that directors
would be removable by stockholders during the five-year interim in
extreme cases of individual or corporate misconduct or illegality. It
would also be possible to provide an "escape valve" for the unusual
case where the corporation is doing so poorly that five years might
be too long a period to wait for directors to come up for reelection.

124 See Gary C. Jacobson, The Politics of CongressionalElections 87-91, 216-18 (Little,

Brown, 2d ed 1987); M. Kent Jennings and L. Harmon Zeigler, eds, The ElectoralProcess
28-29, 37-38 (Prentice-Hall, 1966) (noting flaws in political system produced by fact that
incumbent Representatives usually conduct perpetual campaigns).
 The University of Chicago Law Review [58:187

For example, the holders of 20 percent of the corporation's shares

could be allowed to call an election meeting during the five-year
interim if the corporation failed to achieve at least 80 percent of its
five-year projections for two consecutive years. Any such meeting
would be subject to the same requirements as the quinquennial
meeting: major stockholders would have access to the corporate
proxy machinery, and the corporation would issue a detailed report
together with the advisors' evaluation of that report.
But any exceptions to the five-year rule must operate only in
truly exceptional circumstances, or the system would not promote
the long-term perspective that is its goal. For example, there
should be no exception to the five-year rule for an acquisition pro-
posal from a third party. The incumbent board would consider any
proposal made between elections and accept or reject it as the
board determines appropriate. The board's determination with re-
spect to the acquisition proposal might become an issue at the next
quinquennial meeting, but not before.

C. Access to Corporate Proxy Machinery

1. The need to ensure meaningful elections.
The most commonly cited obstacles to effective corporate de-
mocracy are the ability of management to control the corporate
proxy machinery and the cost to any one stockholder or group of
stockholders of amassing the information necessary to evaluate the
performance of managers and directors properly. 12 5 The efforts of a
single investor or a group of stockholders to evaluate the corpora-
tion's business or run a proxy contest may benefit all stockholders,
but there is no effective means to eliminate free riders and dis-
tribute the costs among all stockholders. 26 Corporate elections
therefore tend to produce a realistic challenge to incumbent direc-
tors only in the context of takeover battles, fueling the contention
of proponents of the managerial discipline model that hostile take-
27
overs are needed to discipline managers and directors.

12 See, for example, Eisenberg, 89 Colum L Rev at 1474-75 (cited in note 46); Jeffrey
N. Gordon, Ties that Bond: Dual Class Common Stock and the Problem of Shareholder
Choice, 76 Cal L Rev 3, 43-44 (1988).
12 See, for example, Eisenberg, 89 Colum L Rev at 1478-79 (cited in note 46); Jeffrey
N. Gordon, The Mandatory Structure of Corporate Law, 89 Colum L Rev 1549, 1575-76
(1989).
127 See Edward Jay Epstein, Who Owns the Corporation?13 (Priority, 1986) (Corporate
elections are "procedurally much more akin to the elections held by the Communist party of
North Korea" than real democratic elections because "they normally provide only one slate
1991] Quinquennial Election

Corporate elections need not be a sham, however. The quin-

quennial meeting structure removes the chilling effect of an ever-
present takeover threat on long-term planning. Once election con-
tests are no longer simply another short-term coercive takeover
tactic, they can become a meaningful referendum on the corpora-
tion's business plans and performance. The combination of free ac-
cess to the corporate proxy machinery, and the provision of the
detailed information contemplated by the five-year report, dis-
cussed in greater detail below, would effect this restructuring. It
would also eliminate the free rider problem, by allocating the costs
of the information gathering and the proxy process to the corpora-
tion and thus, effectively, to all stockholders.
The quinquennial proposal would grant free access to the cor-
porate proxy machinery in connection with the quinquennial meet-
ing to any stockholder or group of stockholders with at least five
percent of the outstanding shares, or shares having an aggregate
market value of five million dollars or more. These thresholds are
high enough to exclude "gadfly" stockholders, but low enough not
to impede the serious, substantial stockholder who wishes to pro-
pose nominees or a slate of directors in an election contest. Access
to the corporate proxy machinery would include the corporation's
payment of the challenger's proxy expenses, up to the amount that
the incumbent directors spend on the proxy contest. This would
place institutional stockholders on the same footing as the corpora-
tion's board with respect to nomination and election of corporate
directors, thereby radically improving the ability of these stock-
holders to participate meaningfully in the selection of directors.
The quinquennial proposal does not, however, anticipate the
frequent, wholesale replacement of directors every five years. The
very credibility of the quinquennial election would lead directors
and managers to develop a working relationship with the corpora-
tion's major stockholders. And once the stockholders are placed in
a structure that promotes a focus on the long-term business opera-
tions of the corporation, they will be more inclined, except in ex-
treme cases, to try to influence the incumbent directors and man-
agers rather than risk the disruption to business operations of a
wholesale change in senior personnel.
The quinquennial proposal would also eliminate SEC Rule
14a-8, which generally allows any holder of $1,000 worth of a cor-
poration's stock to require inclusion of a proposal in the corpora-

of candidates."). See also Easterbrook and Fischel, 94 Harv L Rev at 1170-74 (cited in note
1).
 The University of Chicago Law Review [58:187

tion's proxy statement.12 While intended to promote stockholder

interest in corporate governance, in practice this rule has become
the tool of gadflies who seek to promote special interests. 12 9 Stock-
holders may espouse any cause they wish, but the corporate proxy
machinery is rarely the appropriate forum for such expression.
More recently, institutional investors have also used Rule 14a-
8 to address voting procedures and takeover-related issues and de-
fenses. The last few years have seen a spate of proposed stock-
holder resolutions dealing with rights plans, confidential voting,
and golden parachutes.'3 0 The quinquennial proposal would largely
supersede this agenda by eliminating takeover defenses and limit-
ing nonconsensual changes of control to the quinquennial meeting,
at which major stockholders or groups of stockholders would have
full and free access to the corporate proxy machinery. Moreover,
the availability of the quinquennial meeting as a realistic means
for institutional stockholders to replace directors would increase
responsiveness to institutional concerns during the interim periods.
Rule 14a-8, accordingly, would become unnecessary.

2. Proxy access only desirable as part of fundamental reform.

Access to the corporate proxy machinery as contemplated by
the quinquennial system is desirable only in conjunction with the
other elements of the proposal. Granting substantial stockholders
free access (including coverage of reasonable expenses) to the cor-
porate proxy machinery, without reorienting those stockholders
away from a strictly short-term perspective, would only exacerbate
the short-term pressures and detrimental effects of the takeover
activity of recent years. If stockholders continue to view their in-
vestment as a gambling chip and any takeover premium as a jack-
pot, then the stockholders' increased ability to nominate and elect
their own directors would only worsen the problems of short-
termism.

17 CFR § 240.14a-8 (1990).

129 See, for example, Jesse H. Choper, John C. Coffee, Jr., and C. Robert Morris, Jr.,
Cases and Materials on Corporations647 (Little, Brown, 3d ed 1989) (rule recently used to
address issues relating to discrimination, nuclear power, pollution, and divestment from
South Africa).
130 John J. Gavin, Changes in Corporate Control and Governance Communicated
through Proxy Power, in InstitutionalInvestors: Passive Fiduciariesto Activist Owners 91,
95-96 (PLI, 1990) (215 governance proposals submitted by institutional investors and voted
upon at annual meetings in 1989); Dennis J. Block and Jonathan M. Hoff, EmergingRole of
The InstitutionalInvestor, NY L J 5 (Apr 12, 1990) (listing confidential voting, repeal of
poison pills, and golden parachutes as top three subjects of governance proposals).
1991] QuinquennialElection

Professors Gilson and Kraakman, for example, propose the de-

velopment of a class of professional directors elected by and re-
sponsible to institutional stockholders, suggesting that these direc-
tors could be recruited and monitored by a clearinghouse initiated
by one of the existing "shareholders' rights" groups such as the
Council of Institutional Investors or United Shareholders' Associa-
tion.' 3 ' These organizations, however, have been particularly vocal
in their short-term orientation and pro-takeover bias. 3 2 Gilson and
Kraakman's proposal ignores the pressing need for directors to
adopt a long-term measure of performance or success. Unless the
orientation of institutional stockholders shifts away from the short
term, then directors beholden to these stockholders will simply re-
present a potent constituency seeking a fast return. If selling or
busting up the corporation generates this return, so much the bet-
ter. Only when these stockholders redefine the success of their in-
vestment in terms of long-term operating returns, rather than
takeover or other short-term premiums, will increasing their power
to influence directors and managers promote the long-term health
of the corporation.

D. The Five-Year Report

Institutional stockholders typically lack the resources to inves-

tigate and evaluate the performance of each company in their port-
folios, limiting their ability to participate effectively in corporate
governance. 3 3 The five-year report contemplated by the quin-
quennial proposal would reduce the need for investigation by pro-
viding detailed information on the corporation's performance and
business plans. The critique of the five-year report by independent
advisors would fulfill the evaluation function, minimizing the need
for stockholders to expend their own resources in order to judge
the validity of the corporation's own report.

13! Gilson and Kraakman, Reinventing the Outside Director at 39-42 & n 71 (cited in
note 1). For example, Professor Gilson was co-chairman of the USX Corporation share-
holder committee, formed by corporate raider Carl C. Icahn "to press for the rapid sale or
spinoff of the USX Corporation's steel business." Gregory A. Robb, Icahn Group to Urge
USX Sale of Steel Unit, NY Times D5 (Nov 15, 1990).
132 See text at notes 78-80.

133 See, for example, Jensen, Harv Bus Rev at 66 (cited in note 107) (too costly for

institutional investors to become involved in major decisions and long-term strategies of the
companies in which they invest); John Plender, The Limits to InstitutionalPower, Finan-
cial Times § 1 at 20 (May 22, 1990) (institutional stockholders in the United Kingdom lack
industry-specific expertise and information needed to play a role in corporate strategy).
 The University of Chicago Law Review [58:187

1. The corporation's report.

The quinquennial proposal contemplates that the corporation
would continue to issue annual reports as currently required for
public corporations. In the quinquennial year, however, the corpo-
ration would issue a far more thorough document, resembling the
"blue book" evaluation of the corporation typically prepared by a
corporation's investment banker or management consultant. First,
it would review the corporation's performance for the prior five
years against the five-year plan set forth in its prior five-yeai re-
port, and against the performance of other companies in the corpo-
ration's industry, the market in general, and any other relevant in-
dices. A narrative description would evaluate the performance,
explain trends, and review the reasons for the corporation's operat-
ing successes and failures.
The report would also detail the corporation's five-year busi-
ness plan, including projections, the assumptions underlying them,
the factors likely to affect whether the projections are met, and the
corporation's ability to control or influence these factors. These
projections should not raise liability concerns in light of the federal
safe-harbor rules that protect companies against claims of securi-
ties fraud in connection with projections made in good faith.""
The SEC might also promulgate special safe-harbor provisions for
the five-year report.
The report would discuss the return on investment if the cor-
poration's projections were met, and the dividend stream antici-
pated by the corporation. If the corporation plans to retain earn-
ings instead of paying them out as dividends, the report would
discuss the anticipated uses of these funds. The report would also
contain a narrative description of the corporation's five-year stra-
tegic plan, the steps the corporation intends to take to accomplish
its goals, and the anticipated short-term and long-term implica-
tions of the plan for the corporation's financial results.
Some may be concerned that the five-year plan would set goals
that could prove too easy to meet in the event of an economic up-
swing that begins after the plan is drafted.' 35 Each five-year re-
port, however, would compare historical performance not only
against the corporation's plan, but also against the performance of
other companies in the industry, the market in general, and other
relevant measures. These requirements, together with the advisor's

131 17 CFR § 230.175 (1990); 17 CFR § 240.3b-6 (1990).

115 Sykes, Corporate Takeovers at 43-44 (cited in note 85).
1991] QuinquennialElection

independent report and the likelihood of a continuing dialogue

among directors, managers, and stockholders throughout the five-
year period, would ensure that managers and directors made every
effort to exceed their targets if general economic and other condi-
tions permit.

2. The independent advisor's evaluation.

The separate advisor's report would address the concern that

institutional investors might not be able to judge an acceptable
five-year plan."3 6 The advisor selected by the board to report to
the stockholders could be an investment banking firm, consulting
firm, or similar entity that provides other services to the corpora-
tion, or a firm engaged solely for the purpose of rendering the eval-
uation. The advisor's appointment by a board with a majority of
outside directors, its direct relationship and responsibility to stock-
holders, and the importance of its reputation for integrity would
work to assure the independence and quality of the advisor's re-
port. If additional assurance of independence is desired, the advi-
sor could be appointed by a committee, such as the audit commit-
tee, consisting entirely of outside directors. Moreover, institutional
stockholders would quickly determine which advisors' evaluation
reports were worthwhile and would lead corporations to select
these advisors. Given these practical safeguards, there is no need to
disqualify advisors who have prior working relationships with the
corporation. These firms may be the most familiar with the corpo-
ration and its operations, and therefore the most logical and capa-
ble candidates to perform the evaluation.
While the advisor would be free to include such information in
the evaluation as the advisor believed necessary, at a minimum the
evaluation would: (1) review the previous five years' performance
by the corporation, assessing the successes and failures of the cor-
poration and the comparative performance of other corporations,
both in the industry and in general; (2) comment on management's
explanation of the corporation's performance; (3) review the pro-
jections in the corporation's report, as well as the assumptions un-
derlying the projections and the factors likely to affect the corpora-
tion's ability to meet the projections; (4) assess the corporation's
ability to meet the projections; (5) evaluate the corporation's stra-
tegic plan for the next five years; and (6) comment on the stock-

136 Id at 44.
 The University of Chicago Law Review [58:187

holder investment objectives likely to be met by successful imple-

mentation of the plan.
The advisor would have the benefit of the same safe harbor as
the corporation, and would be permitted a customary indemnifica-
tion from the corporation, which would exclude acts of negligence.
As in the case of independent accountants evaluating a firm's fi-
nancial reports, possible liability for negligence, 13 7 and, more im-
portantly, the concern for reputation, would motivate care by the
advisor.

3. Benefits of the report and evaluation.

The report and evaluation would encourage stockholders to
view their shares as a stake in the operating performance of the
corporation rather than as a mere financial instrument. Along with
the long-term orientation imposed by the quinquennial election of
,directors, the .report and evaluation would give institutional stock-
holders the means to understand the strategic direction and corpo-
rate objectives of their portfolio companies, and to intervene or sell
their shares if they differ with these plans.3 8
The discipline of the five-year report would also improve the
quality of annual reporting. Stockholders would demand annual
reports that analyze where the corporation stands within the five-
year framework, the causes and consequences of any discrepancies
between performance and projections, and what changes, if any,
are necessary for the business plan. Managers and directors inter-
ested'in retaining their positions at the quinquennial meeting

MSee, for example, Schneider v Lazard Freres & Co., 159 AD2d 291, 552 NYS2d 571
(1990) (investment bankers who advised a Special Committee of the board of directors in a
sale-of-control context could be liable in negligence to the company's stockholders). For crit-
icism of the court's holding, see Herbert M. Wachtell, Eric M. Roth, and Andrew C. Hous-
ton, Investment Banker Liability to Shareholders in the Sale-of-Control Context, NY L J 1
(Mar 29, 1990); John C. Coffee, Jr., New York's New Doctrineof 'Constructive Privity', NY
L J 5 (Jan 25, 1990). See also Rachel Davies, Bidders Can Sue in Takeover Case, Financial
Times 33 (Oct 30, 1990) (reporting on 1990 English Court of Appeal decision holding that
the financial advisors and auditors of a company may be liable to an unwanted takeover
bidder for allegedly negligently prepared financial statements and forecasts issued before
and during the pendency of the bid, on which the bidder could foreseeably rely in deciding
whether to make or increase its offer).
"SS For excellent suggestions on how to reform corporate reporting, see generally Peter
N. McMonnies, ed, Making CorporateReports Valuable (Kogan Page, 1988) (urging reports
that encourage a long-term perspective). The study, prepared by the Institute of Chartered
Accountants of Scotland, notes the need for an increased level of independent assessment of
corporate reports. The study suggests, as is contemplated by the quinquennial proposal,
that the assessor's role be expanded far beyond the role of the typical outside accountant in
the current corporate reporting scheme. Id at 84.
1991] QuinquennialElection

would naturally provide this sort of useful information in the in-

terim years.
The expanded information contained in the five-year report
and evaluation, and the improved quality of annual reporting,
would enable analysts to better assess the performance and pros-
pects of each corporation, and would increase investor confidence
in the expected performance of an investment. Perceived invest-
ment risk to stockholders should decline in turn, resulting in a
lower risk premium and a lower cost of capital to the corporation.
The additional information would also assist stockholders in more
closely matching their investment objectives to the objectives of
the corporations in which they invest, thereby further reducing the
risk premium and the cost of equity capital. Ultimately, the quin-
quennial proposal would bring institutional investor knowledge in
the United States and the United Kingdom closer to the level now
seen in Japan and Germany. This could bring the return on equity
demanded by investors in our markets, and the cost of capital,
more in line with that of the Japanese and German markets.1 39
Some corporations may argue that the requirements of the
five-year report are too onerous, or that wide distribution of pro-
jections or the advisor's evaluation would damage the corporation.
Well-managed corporations, however, should welcome the five-year
reports and the quinquennial proposal as a whole. Most well-man-
aged corporations today develop, at least internally, detailed stra-
tegic plans and five-year projections. Any corporation seeking fi-
nancing must go through such a process; a well-managed
corporation and its management should want to develop a detailed
long-term strategic plan and measure its performance against this
plan.
Nor can the argument that publication of projections and stra-
tegic plans would harm the corporation withstand analysis. On the
basis of information already available to them, most good analysts
can develop projections for the corporations they follow. These
projections do not produce the same investor confidence as man-
agement's own projections, but they typically come very close to
what the corporation itself would prepare. The quinquennial pro-
posal does not require disclosure of trade secrets or competitively

139 See, for example, Short-termism,part 20, The Economist 76 (June 30, 1990) (cost of

capital is higher in United States and United Kingdom than in Japan and Germany); Gary
Hector, Why U.S. Banks Are In Retreat, Fortune 95 (May 7, 1990) (from 1983 to 1988 the
cost of capital for United States companies was twice that of competitors in Japan and West
Germany).
 The University of Chicago Law Review [58:187

vital business information. Sophisticated investors understand, and

the five-year report would emphasize, that projections constitute a
framework, not a crystal ball. Even with such a qualification, how-
ever, the framework set forth in the projections and the strategic
plan would be of great value in assessing the performance and di-
rection of the corporation.
The real objection of some corporations is likely to be their
reluctance to establish a concrete framework against which to
judge management's performance or to have management publicly
critiqued by an outside advisor. Yet an effective system of corpo-
rate governance depends on the ability to evaluate the business
-performance and direction of the corporation and its management.
The corporation least willing to expose itself to such an evaluation
probably needs it most.

E. Management Compensation
1. Compensation linked to performance.
The revision of compensation structures would reinforce the
long-term time horizon contemplated by the quinquennial system
by directly aligning the managers' personal financial interests with
the long-term success of the corporation. Financial incentives and
risks for managers in leveraged buyouts contribute significantly to
the performance of those buyouts that succeed. 40 And the dissatis-
faction of many managers who want a more significant share of any
increase in value generated by the business success of the corpora-
tion fuels strong management interest in participating in these
buyouts. 4 '
Today, managerial compensation is not adequately related to
the long-term results of the corporation's business operations. Ob-
servers note the "dearth of financial incentives for top manage-
ment to make the costly and risky decisions that can promise sub-
stantial long-term payoffs for the shareholders."' 42 They also
complain that high levels of managerial compensation persist in

140 George Anders, Leaner and Meaner Leveraged Buy-Outs Make Some Companies
Tougher Competitors, Wall St J -Al (Sept 15, 1988) (financial risks at stake in LBO force
management to be more aggressive). See also Jensen, Harv Bus Rev at 69 (cited in note
107).
141 Capitalism at 12 (cited in note 10); Sykes, Corporate Takeovers at 11-12 (cited in
note 85).
142 Graef S. Crystal, Cracking the Tax Whip on C.E.O.'s, NY Times Mag 48 (Supple-

ment on the Business World, Sept 23, 1990); see also Sykes, Corporate Takeovers at 11-12
(cited in note 85); Jensen and Murphy, Harv Bus Rev at 39 (cited in note 21).
1991] Quinquennial Election

corporations whose performance is poor, effectively rewarding

managers for corporate failure. 143 To the extent a large portion of
an executive's compensation is set regardless of the corporation's
success, the executive lacks any financial motive to improve the
business performance of the corporation. Incentive compensation
plans tied to the corporation's annual performance, or performance
over even shorter time periods, reinforce the problems of short-
termism.14
The quinquennial proposal would link significant financial
risks and rewards for managers to corporate performance against
the corporation's five-year goals. Managers would receive no bo-
nuses or stock awards based on any. shorter time period.1 45 The
specific compensation plan for each corporation would be part of
the quinquennial plan submitted to stockholders. It could also be
subject to evaluation by a compensation consultant, in a manner
similar to the advisor's evaluation of the five-year business plan.

2. An illustrative plan for compensation.

One possible plan would allocate ten percent of the corpora-

tion's shares to management, contingent on at least a twelve-per-
cent increase in the market price of the corporation's shares, com-
pounded over the five-year period (a net increase of 76 percent).
The actual increase in market price in any given year would be
irrelevant; the plan would look only to the five-year average. Man-
agers would receive half the ten-percent stake if the price increase
met the twelve-percent target, and an additional one percent of the
corporation's shares for each additional one percent per year mar-
ket price increase above twelve percent, up to the maximum ten
percent if the compound growth rate for the five years reached or
exceeded 17 percent. The shares would then vest in equal install-
ments over the next five years, thus limiting the possibility of man-

"" Crystal, NY Times Mag at 48, 54 (cited in note 142); Jensen and Murphy, Harv Bus
Rev at 39 (cited in note 21); White, Financial Times at 11 (cited in note 43).
...Dertouzos, Lester, and Solow, Made in America at 62 (cited in note 46) ("A chief
executive whose compensation is a strong function of his company's financial performance
in the current year is naturally going to stress short-term results. Indeed, some executive-
compensation schemes may encourage managers to adopt an even shorter time horizon than
the capital markets do.").
I'l A number of writers have similarly suggested the need to enhance the financial re-
wards to managers of corporations achieving successful long-term business results while cre-
ating a meaningful financial penalty if the corporation's long-term business performance is
poor. See sources cited in note 142. See also Porter, The Competitive Advantage of Nations
at 529 (cited in note 75).
 The University of Chicago Law Review [58:187

agement "loading" the first five-year period at the expense of the

future. If the corporation did not meet the targeted compound in-
crease in stock price, but otherwise achieved its five-year goals,
managers could receive a specified cash bonus. If the corporation
fell short of its five-year goals, managers would receive no incentive
compensation and no increase in base salary. This compensation
plan would encourage successful managers to stay with the corpo-
ration, much as the incentive arrangements with managers of
leveraged buyout corporations require them to stay on for a mini-
mum period of time. While the time frame for realizing the finan-
cial reward would be relatively long, the size of the potential re-
ward would be sufficiently great to lead managers to accept the
14 6
plan.
The quinquennial proposal would also prohibit employment
arrangements that inhibit the ability to replace managers in con-
junction with the quinquennial meeting, or that create personal in-
centives in conflict with the focus on the successful long-term busi-
ness operations of the corporation. Thus, for example, the
corporation could not enter into employment contracts with its
managers that extend beyond the quinquennial term. Nor could it
offer golden parachutes. 14 1 However, broad-based severance poli-
cies that provide for severance payments regardless of whether
there has been a change of control would be permitted.
Management compensation and employment arrangements
would thus complement the quinquennial system's reorientation of
the corporation's constituencies around the corporation's long-term
business success. This system would remove the structural impedi-
ments to the ability of managers to manage for the long term,
while the financial reward structure would create positive incen-
tives to adopt a long-term personal time horizon.

F. The Prohibition on Takeovers and Elimination of Takeover

Defenses
The quinquennial election would be the sole means of accom-
plishing nonconsensual changes of control. Between meetings, di-

"0 See CEO Roundtable on CorporateStructure and Management Incentives, 3 Conti-

nental Bank J Applied Corp Fin 6, 20 (Apr 1990) (Richard Sim, chief executive officer of a
company that grants stock options that cannot be exercised for five years, commented, "Un-
less they're in it for the long haul, they will get discouraged and quit; and that's, quite
frankly, just the way I want it.").
"'7 "Golden parachute" as used here refers to severance contracts providing for large
payments to executives who are fired or leave under other specified circumstances following
a change of control or sale of the corporation.
1991] QuinquennialElection

rectors would not be removable except for criminal conduct or will-

ful misfeasance. In addition, no stockholder could acquire more
than ten percent of a corporation's stock without the board's con-
sent. The would-be acquiror therefore could not purchase a con-
trolling stake in a corporation and then coerce a "consensual"
change of control, making the next quinquennial election a fait
accompli.
Correspondingly, the quinquennial system would prohibit
takeover defense devices and repeal takeover-related state legisla-
tion. It would thus eliminate share purchase rights plans, 4 ' stag-
gered boards, 4 ' supermajority "fair price" provisions, 50 standstill
provisions,' 5' control share acquisition statutes, 52 and business
combination moratorium statutes. 53 It would reinstate the sub-
stance of SEC Rule 19c-4, limiting the ability of public corpora-
tions to issue equity with disproportionate voting rights. 5 4

I'l Such plans deter control acquisitions not approved by the corporation's board of
directors by making inexpensive new shares available to current shareholders other than the
acquiror, diluting the acquiror's stake and increasing the leverage of the board in responding
to an unsolicited acquisition attempt. Share purchase rights plans were first developed by
one of the authors as a response to abusive takeover tactics. In the context of the quinquen-
nial system's restrictions on changes in control, the protections afforded by rights plans
would be unnecessary.
149 In these arrangements, one-third of the board typically comes up for reelection each
year. Under Delaware law, members of a staggered board may only be removed for cause,
unless the charter provides otherwise. 8 Del Code Ann §§ 141(d), (k) (1990).
150 These provisions, found in many corporate charters and some state statutes, impose
a supermajority voting requirement on mergers, sales of assets, liquidations, and recapitali-
zations between the corporation and an "interested person" (typically defined as a 10-20
percent stockholder) unless the transaction meets specified price requirements. See, for ex-
ample, Ill Ann Stat ch 32, § 7.85 (Smith-Hurd 1990).
5I Under these provisions a stockholder agrees to vote with management at election
meetings, or agrees not to contest management's proposals or nominees, in exchange for
some corporate concession or as a condition to the corporation's sale of newly issued securi-
ties to the stockholder.
152 Control share acquisition statutes provide that shares acquired in a "control share
acquisition," defined as the direct or indirect acquisition of shares constituting voting power
in the target corporation of at least 20 percent, 333 percent, or 50 percent, automatically
lose their voting rights unless a majority of the disinterested holders of each class of stock
approves. See, for example, Ind Code Ann §§ 23-1-42-1 to 21-1-42-11 (West 1989); CTS
Corp. v Dynamics Corp. of America,. 481 US 69 (1987) (upholding constitutionality of Indi-
ana statute).
1 New York's statute prohibits certain in-state corporations from entering into a busi-
ness combination, including certain self-dealing transactions as well as mergers and consoli-
dations, with a 20 percent stockholder for five years after the 20 percent threshold is
crossed, unless the board grants approval in advance of the 20 percent acquisition. NY Bus
Corp Law § 912 (Law Co-op Supp 1989). See also Amanda Acquisition Corp. v Universal
Foods Corp., 877 F2d 496 (7th Cir 1989) (Easterbrook) (upholding constitutionality of simi-
lar Wisconsin statute).
'" See note 119.
 The University of Chicago Law Review [58:187

The quinquennial proposal would also repeal all constituency

statutes. Because hostile takeovers could only occur as a result of
stockholder balloting at the quinquennial meeting and, absent bad
faith, self-dealing, or fraud, the board's decision to accept or reject
a takeover proposal in the interim would not be subject to review,
the board would not have to face the issue of whether it: could le-
gally consider the interests of non-stockholder constituencies in re-
sponding to a takeover attempt. Board, management, and stock-
holders would focus not on the threat of takeovers, but rather on
the long-term business success of the corporation, an orientation
that itself protects the interests of non-stockholder
constituencies.' 5 5
The elimination of hostile takeovers and takeover defenses
would channel all nonconsensual changes of control into the quin-
quennial meeting. This would allow stockholders to focus more
clearly on the rationale for any proposed change of control, its
likely consequences and its desirability. Stockholders could make a
considered decision free of coercion from the acquiror or interfer-
ence from the incumbent board or management, making it less
likely that institutional investors would replace good managers
simply to get a takeover premium. The quinquennial meeting
would become an effective referendum on the business and invest-
ment sense of the proposed change of control. To the extent more
than one bidder emerged at the quinquennial meeting, the corpo-
ration could establish auction procedures, and the courts could de-
velop rules on permissible postponements of the meeting in re-
sponse to material developments.'
The elimination of takeover battles between quinquennial
meetings would also dramatically reduce the amount of manage-
ment time and and other corporate resources now spent on
preventing takeovers and developing takeover-related protections.
The quinquennial system would insulate directors and managers
for- substantial enough periods to permit them to develop their fu-
ture plans, while at the same time creating a periodic forum in
which the directors would be totally uninsulated and subject to re-
call by the stockholders. While it is possible that the quinquennial
meeting could become a focal point for hostile takeover activity,
the closer relationship between managers and institutional stock-

See Part II.D.

1 See MA Basic Four, Inc. v Prime Computer Inc., CA No 10868 (Del Chanc, June
13, 1989) (permitting board to postpone contested election meeting in light of material
changes in challengers' takeover bid shortly before scheduled date of meeting).
.1991] QuinquennialElection

holders that the quinquennial system fosters would reduce the

likelihood of frequent takeover battles. At worst, the quinquennial
system would still free the corporation for substantial periods from
preoccupation with the threat of a takeover.
The quinquennial proposal would not permit incumbent direc-
tors or management to spend corporate funds in litigation or simi-
lar challenges to an opposing slate of directors. The SEC through
the federal proxy rules, not incumbent management through pri-
vate litigation, would police false or misleading statements in the
opposing sides' proxy materials. The SEC has policed proxy fights
quite diligently. 1 57 Whatever additional enforcement benefit pri-
vate litigation might add, the principle of neutrality toward quin-
quennial changes in control that underlies the quinquennial system
could not permit one side of the proxy contest to use corporate
funds to litigate against the other in a litigation initiated by the
incumbents. Incumbents could, however, use corporate funds to
defend litigation initiated by the opposition.
Eliminating the takeover battleground should remove much of
the current friction between managers and institutional stockhold-
ers, which is often centered around takeover battles and antitake-
over defenses. Institutional stockholders have mounted anti-poison
pill stockholder resolution campaigns. Incumbent boards have
adopted a panoply of takeover defenses. Legislatures have enacted
antitakeover legislation. Stockholders complain that directors are
simply trying to entrench themselves. Managers complain that
stockholders only care about takeover premiums. The whole de-
bate engenders a degree of distrust and hostility that undermines
the necessary spirit of patience and partnership essential for long-
term operating success in today's business world.
Under the quinquennial system, institutional stockholders
would have to take at least a five-year perspective, or dispose of
their investment. Incumbent directors would have to justify the
five-year performance and plans of the corporation or risk being
voted out of office at the quinquennial meeting. The frequency of
the incumbent directors' vulnerability would diminish, but the vul-
nerability, when it arises, would be heightened due to the existence
of easily measured goals and the elimination of takeover defenses.
The net result would be that the focus of directors, managers and

See David A. Sirignano, Review of Proxy Contests by the Staff of the Securities and
Exchange Commission, in Proxy Contests, Institutional Investor Initiatives,and Manage-
ment Responses 261, 263 (PLI, 1990) (SEC staff acts to "assure that the security holders
receive the information they are entitled to under the proxy rules and are not misled.").
 The University of Chicago Law Review [58:187

stockholders would merge on the corporation's long-term business

success.
Mergers, acquisitions, and other business combinations would
remain possible during the interim between quinquennial meet-
ings. The incumbent board would retain its duty to examine and
evaluate any bona fide acquisition or merger proposal in the con-
text of the corporation's strategic plan. If the directors were to ap-
prove an acquisition involving the issuance of securities with more
than 25 percent of the corporation's voting power, they would sub-
mit the transaction to the corporation's stockholders. 15 If the di-
rectors were to reject a merger or acquisition, however, the stock-
holders' only recourse would be to replace them at the next
quinquennial meeting. Because of the unfettered ability of stock-
holders to approve a change in control at the quinquennial meet-
ing, directors would not be liable for rejecting an acquisition pro-
posal in the interim, except in cases of bad faith, fraud or self-
dealing.
The quinquennial system would remove a significant barrier to
negotiated transactions, particularly stock-for-stock transactions
that make strategic sense and that avoid the dangerous levels of
debt that takeover activity has engendered. Directors are currently
reluctant to pursue equity mergers for fear they will put the com-
pany "in play" and result in the corporation being forced to accept
an undesirable business combination. 159 By barring nonconsensual
takeovers except at the quinquennial meeting, the new system
should eliminate such fears. Moreover, the focus on strategic direc-
tion that the quinquennial system promotes will likely encourage
corporations to give careful consideration to the role strategic ac-
quisitions, mergers, or combinations might play in the develop-

"' For examples of similar trigger mechanisms, see ALI, Principlesof Corporate Gov-
ernance § 1.32 at 46-47, 101 (cited in note 27); New York Stock Exchange, Listed Company
Manual § 312.03(c) (July 1989); American Stock Exchange, Company Guide § 712 (May
1990); NASDAQ, Notice to Issuers (Oct 16, 1990) (announcing amendment to Schedule D,
Part I, Section 5(i) of the By-Laws of the National Association of Securities Dealers, Inc.,
calling for stockholder approval of any issuance of stock in connection with a merger' or
acquisition equal to 20 percent or more of outstanding voting shares).
1 See Paramount Communications, Inc. v Time Inc., 571 A2d 1140 (Del 1989). Al-
though the court held that the preplanned equity merger between Time and Warner could
proceed, Time was forced to defend itself at great expense against the hostile advances of
Paramount. See generally Laura Landro, David B. Hilder, and Randall Smith, Time Inc.'s
Stock Soars $44 a Share as Wall Street Bets Paramount's Offer Will Derail Merger With
Warner, Wall St J A3, 12 (June 8, 1989) (Paramount's chief executive officer "told analysts
that Time 'put itself up for sale' by handing over 60% ownership to Warner shareholders in
the proposed Time-Warner merger."). The authors' law firm represented Warner in this
transaction.
1991] QuinquennialElection

ment of the corporation's business. The quinquennial system

might have a slight chilling effect on riskier acquisitions that, if
unsuccessful, would threaten the corporation's ability to meet its
five-year goals. On the whole, this chill is as likely to be a positive
as a negative consequence.

G. The Role of Outside Directors

1. Incentives for effective monitoring.
The quinquennial proposal would require that a majority of
each public corporation's board be composed of directors otherwise
unaffiliated with the corporation. Thus, the quinquennial system,
like the current system of corporate governance, looks to the
outside director as the primary monitor of the business perfor-
mance of corporate managers. But the quinquennial proposal
would make the outside director more vulnerable to replacement
by stockholders. Incumbent directors now rarely lose their seats in
a proxy fight, except in the context of a tender offer or acquisition
proposal. Critics therefore charge that outside directors are not re-
sponsive to stockholders because they owe their jobs to manage-
ment.6 0 With the greatly enhanced ability of stockholders to chal-
lenge incumbent directors at the quinquennial meeting, directors
who are unresponsive to stockholders would likely lose their seats.
Outside directors would have an increased incentive to perform an
effective monitoring role.
These directors' ability to monitor would also increase. Some
have pointed to the lack of business information given to outside
directors, and the lack of time and expertise to evaluate this infor-
mation, as major obstacles to the performance of outside directors
as effective business monitors. 16 1 The five-year report and evalua-
tion contemplated by the quinquennial proposal, the expanded an-
nual reporting and internal reviews it is likely to engender, and the
continuity of a five-year term, would help to remove these barriers.
The framework established by the five-year report should also give
further impetus to the growing practice of regular, detailed inter-
nal and outside advisor reviews, with the entire board, of the cor-
poration's performance, projections, and strategic plan. Directors

140 See Gilson and Kraakman, Reinventing the Outside Director at 21 (cited in note 1).
See also Victor Brudney, The Independent Director-HeavenlyCity or Potemkin Village?,
95 Harv L Rev 597, 610 & n 39 (1982) (independent directors are rarely appointed without
prior approval of management).
1I Lorsch, Pawns or Potentatesat 84-88 (cited in note 19). See also Coffee, 84 Colum L
Rev at 1202-03 (cited in note 46).
 The University of Chicago Law Review [58:187

would insist on the sort of interim reporting and analysis that will
help them push the corporation toward its five-year goals, and jus-
tify any deviation.
Experience in the last few years shows that directors are very
responsive to a proxy fight or even the threat of a proxy fight. Sev-
eral recent proxy fights/consent solicitations have led to conces-
sions by, or the ultimate sale of, the target corporation. For exam-
ple, BTR plc's combined proxy contest and tender offer for Norton
Company resulted in the sale of Norton to a third-party bidder;
Georgia-Pacific Corporation's proxy contest and tender offer for
Great Northern Nekoosa Corporation resulted in the sale of Great
Northern to Georgia-Pacific; Gemini Partners' proxy contest and
consent solicitation to take over the board of directors of Healthco
International, Inc. resulted in the appointment of three Gemini
nominees to the Healthco board and the pending sale of Healthco
to a third party; and the threat by Chartwell Associates to com-
mence a proxy fight with Avon Products to nominate four new di-
rectors who would seek to sell the company resulted in Avon giving
the dissidents two seats on the board and a stronger voice in run-
ning the company.' 62 The quinquennial meeting, and the knowl-
edge that institutional stockholders would have access to the cor-
porate proxy machinery to challenge directors with whom they are
dissatisfied, would strengthen the unity, and thus the power, of the
outside directors in taking an active role in monitoring the corpo-
ration's business performance. In this manner, the remaining barri-
ers to effective monitoring by outside directors would be lowered.
Given the outside directors' heightened monitoring role, the
quinquennial proposal would limit the number of boards on which
an outside director could serve to three, and would increase their
compensation. In addition to an increase in base compensation, the
outside director-like managers-would participate substantially
in stock-based incentive compensation tied to the corporation's
five-year performance. Such provisions would further motivate the
corporation's outside directors to fulfill their role as monitors of
the corporation's long-term direction and business performance,

162 Randall Smith, Storming the Barricades With a Proxy, Wall St J C1 (May 10,
1990); Healthco to Give Gemini Partners L.P. 3 Seats on New Board, Wall St J C8 (Sept
21, 1990). See also Phillip A. Gelston, New Developments in Proxy Contests, in Tenth An-
nual Institute:Proxy Statements, Annual Meetings and Disclosure Documents 651 (Pren-
tice-Hall, 1988) (citing examples of proxy contests to promote a policy of selling or restruc-
turing the company). The authors' law firm represented Norton in its proxy contest with
BTR, and Healthco in its proxy contest with Gemini.
1991] Quinquennial Election

and would meet the complaint of some institutional investors as to

the minimal share ownership of most outside directors.

2. The perils of special-interest directors.

Professors Gilson and Kraakman argue that traditional
outside directors cannot be effective monitors of managerial per-
formance because, through the nomination process and through so-
cial ties, they are tied too closely to the management they monitor,
and because they are too independent of stockholders. 1' 3 The first
part of this argument reflects a view that managers and directors
must have an adversarial relationship in order for the monitoring
function to be successful. In fact, the opposite is true. The direc-
tor-manager relationship must be a cooperative one, not an adver-
sarial one, in order to be effective. While the adversarial director or
board may have the ultimate threat of firing to enforce their poli-
cies, the likelihood of full and successful responsiveness by manag-
ers to the views of directors is much greater when the manager is
motivated by respect and friendship than when motivated by
1 64
fear.
The second part of the argument reflects the view that an
outside director cannot be responsive to a corporate constituency
without being nominated by, or specially designated to represent,
that constituency. The quinquennial proposal responds to this con-
cern by aligning the interests of the various corporate constituen-
cies-stockholders, managers, employees, and the corporation it-
self-around the corporation's long-term business success.
It is not necessary, and indeed it would be divisive, to elect
separate classes or groups of directors to represent the various cor-
porate constituencies, or to have any constituency have a separate
special right to nominate or advise on the nomination of direc-
tors.16 5 A board monitors best when it works as a cohesive whole,
each director viewing himself as representing all constituencies. 6
Once the corporation's various constituencies all center on the
long-term health of the enterprise as their common goal, then
traditional outside directors would have ample incentives to work
cooperatively with inside directors, management, stockholders, and

11 See Gilson and Kraakman, Reinventing the Outside Directorat 21 (cited in note 1).
...See note 45 and accompanying text.
"' Compare Gilson and Kraakman, Reinventing the Outside Director (cited in note 1)
(recommending election of professional outside directors by, and beholden to, institutional
stockholders).
"' Lorsch, Pawns or Potentates at 41-54 (cited in note 19) (the more directors explic-
itly agree about in whose interests they are governing, the more they will feel empowered as
a group).
 The University of Chicago Law Review [58:187

the other constituencies to improve the corporation's operating

performance. For similar reasons, it is not necessary that the chair-
man of the board be someone other than the chief executive
16 7
officer.

H. Implementation
The best way to implement the quinquennial system would be
through a comprehensive legislative package, adopted in the
United States by Congress and the state legislatures and abroad by
Parliament in the United Kingdom, or by a Directive of the Euro-
pean Economic Community to all its member states, including the
United Kingdom. 68 This comprehensive approach would require
the corporate world and the institutional investor world in each
country to work together toward adoption of the new system. In
this Section, we discuss the roles that various groups in the United
States could play to make the quinquennial proposal a reality. We
then briefly discuss the implementation of the quinquennial propo-
sal in the United Kingdom.

1. Congress.
The best hope for coordinated nationwide implementation lies
with federal legislation. This legislation could take one of three
forms: a) a substantive federal corporation law that would essen-
tially replace existing state law; b) legislation that mandates the
quinquennial concept but leaves specific implementation to the
states; or c) legislation that complements, but does not mandate,
implementation at the state level.
We favor the second approach. While a federal law of corpora-
tions is within the power of Congress,6 9 such radical change is un-
necessary. There is no need to transfer the responsibility for, and
the burden of, corporation law as a whole to the federal govern-
ment and judiciary. On the other hand, non-mandatory legislation
would encourage but not ensure uniform adoption of the quin-

17 But see id at 184-85 & n 5 (proposing separation of the offices of chairman of the

board and chief executive officer).

168 EEC legislation may take several forms, including Regulations and Directives. Regu-
lations are immediately binding and directly applicable to all member states. Directives
bind member states to achieve certain specific results. The results can be achieved in many
ways, usually by enacting the appropriate legislation in that member state.
10 See, for example, Donald E. Schwartz, A Case for Federal Chartering of Corpora-
tions, 31 Bus Law 1125, 1146 (1976) (substantial federal interest in operation of large corpo-
rations would overcome any Tenth Amendment objection to federal chartering of
corporations).
1991] Quinquennial Election

quennial proposal. While adoption on a state-by-state basis would

have some beneficial effect, the quinquennial system would work
best as a national solution.
Federal legislation mandating the quinquennial system, but
leaving implementation to the states, would ensure nationwide
adoption of the quinquennial system, while preserving state con-
trol and administration of corporation laws. This legislation would
require that within a specified period of time (perhaps two years),
each state amend its corporation law to provide for the quinquen-
nial election of directors; the prohibition of nonconsensual changes
in control between election meetings; the abolition of takeover de-
fenses and repeal of state antitakeover legislation; access to the
corporate proxy machinery for major stockholders; publication of
the quinquennial report and evaluation; and guidelines for permis-
sible corporate compensation schemes. We also suggest interim leg-
islation providing for a temporary moratorium on takeovers be-
tween the introduction and adoption of quinquennial legislation.
This moratorium addresses the concern that the pendency of the
quinquennial legislation might prompt a destructive surge in hos-
170
tile takeover activity.
Federal legislation would implement directly, or delegate to
the SEC, necessary revisions to federal proxy and general disclo-
sure laws and rules, the reinstatement of SEC Rule 19c-4, and the
repeal of SEC Rule 14a-8. States would maintain whatever other
provisions of corporation law they desired, as long as those provi-
sions did not threaten to undercut the quinquennial system. States
would also remain responsible for administering their own corpora-
tion laws, and state courts would continue to interpret and enforce
those laws.
Historically, it has been difficult to achieve the necessary con-
sensus for federal legislation affecting takeovers. 17 1 As a first step
toward overcoming this difficulty, Congress could create an advi-
sory panel including representatives of both the corporate and the
institutional investor worlds. Congress could require the panel to
report back shortly with a fully developed legislative proposal sup-
ported by both groups. Alternatively, the Treasury Department's
task force on corporate governance could undertake to achieve the
necessary consensus.

170 See Sykes, Corporate Takeovers at 44 (cited in note 85).

171 See, for example, Thomas G. Donlan, Twice Shy: Congress Unlikely to Try Another
Anti-Buyout Bill, Barron's 15 (May 1989).
 The University of Chicago Law Review [58:187

2. States.
If federal legislation initially proves impossible, the next-best
alternative would be implementation by individual states. While
federal law historically has governed disclosure requirements and
proxy procedures, the quinquennial system's proposals in these ar-
eas do not conflict with existing federal law and thus could be en-
acted by the state. The prohibition on nonconsensual changes in
control between election meetings is the only element of the quin-
quennial system that would raise serious constitutional questions if
enacted without federal authorization. In light of the obviously le-
gitimate state interest in the quinquennial proposal as a whole,
however, enactment of this provision by states should survive any
constitutional challenge. 1 2 Moreover, even if states could not con-
stitutionally ban nonconsensual changes in control between elec-
tion meetings, they could accomplish much the same purpose by
prohibiting removal of directors between quinquennial meetings or
limiting the voting rights attached to shares acquired in excess of a
specified percentage of outstanding shares without the approval of
the corporation's directors.
State-by-state implementation would begin in states with
small populations of major public corporations. A variety of com-
peting constituencies and political forces, similar to those found on
the national level, tend to operate in Delaware and other states
where large numbers of major corporations are incorporated. If
these forces block development of the consensus necessary to
achieve federal legislation, they would probably also block passage
of legislation in these key states. In a state where a limited number
of major corporations are incorporated, however, those corpora-
tions and their corporate constituencies could combine to secure
enactment of the quinquennial system by the state legislature.
Success of the system in a few such states would facilitate its wider
adoption.
The first step in this process would be for one or a group of
the major corporations in a state to work with the state bar groups
to develop a legislative proposal. The corporations would also so-
licit input and support from any of its major stockholders who de-
sired to participate in the process. Support of a legislative corpo-

172 See CTS Corp. v Dynamics Corp. of America, 481 US 69 (1987) (Indiana's interest
in protecting its corporations and regulating their internal affairs outweighed any extraterri-
torial effects of control share acquisition statute); Amanda Acquisition Corp. v Universal
Foods Corp., 877 F2d 496, 503, 506 (7th Cir 1989) (following CTS in upholding constitution-
ality of Wisconsin's business combination statute).
1991] Quinquennial Election

rate governance proposal by many of the state's large corporations,

their major stockholders, and the state bar groups would virtually
guarantee passage.

3. The Securities and Exchange Commission.

Development of the federal proxy and disclosure provisions of
the quinquennial system would fall naturally within the domain of
the SEC. Congress could delegate to the SEC the job of developing
detailed rules governing the five-year report and the advisor's eval-
uation, just as the SEC has historically developed disclosure and
reporting rules under existing securities laws. 173 The SEC would
also develop rules governing the access of major stockholders to
the corporate proxy machinery just as it currently develops and
enforces the federal proxy rules."7 4
The SEC could take the lead in implementation of the quin-
quennial proposal by developing and advising on federal or state
legislative proposals for such implementation. The staff of the SEC
has extensive experience with a number of the issues raised by the
quinquennial proposal. Representatives of the SEC could serve on
the congressional advisory panel charged with developing a federal
legislative proposal. Alternatively, the SEC could work with the
Treasury task force, or conduct an independent study of the pro-
posal and offer recommendations for improving it.

4. Corporations and institutional investors.

Corporations and institutional investors would serve primarily
as advocates for adoption of the quinquennial system. Through
public statements, private discussion and legislative lobbying, they
could play a key role in developing political support for the propo-
sal. Those who opposed the proposal could engage in similar ef-
forts, encouraging proponents to either accommodate or rebut sig-
nificant objections.
Business groups such as The Business Roundtable and the
National Association of Manufacturers, institutional stockholder
groups such as the Council of Institutional Investors, and major
public investment funds such as CalPERS, provide preexisting ve-

173 See, for example, 17 CFR §§ 240.13a-1, 240.13a-11 and 240.13a-13 (1990) (requiring

annual, quarterly, and other reports on prescribed forms); 17 CFR § 240.13d-1 (1990) (re-
quiring disclosure of beneficial ownership in excess of five percent of a corporation's shares);
17 CFR § 239.11 to 239.34 (1990) (setting forth forms prescribing disclosure requirements
for registration statements under the Securities Act of 1933).
17, 17 CFR §§ 240.14a-1 to 240.14a-102 (1990).
 The University of Chicago Law Review [58:187

hicles for discussion of the quinquennial proposal. The identifica-

tion of these groups with fixed positions in the corporate govern-
ance debate, however, may create obstacles to constructive dia-
logue. Accordingly, we also encourage discussion among individual
corporate leaders and institutional stockholders. The congressional
advisory panel, or any other legislatively appointed panel or com-
mission, would provide an appropriate forum for such discussion.

5. The United Kingdom.

Parliament could enact the, entire quinquennial system

through a comprehensive amendment to the Companies Act, the
principal regulatory statute governing public companies in the
United Kingdom. 175 The extensive relationships among industry,
merchant banks, institutional stockholders, and governmental
agencies such as the Bank of England-for example, in their roles
on the City Panel on Takeovers and Mergers' 7 6-would permit
these groups to work together toward implementation of the new
system. Alternatively, the United Kingdom's role as a member of
the EEC may make it more appropriate to implement the quin-
quennial system through an EEC Directive to member states. This
approach' would be analogous to federal legislation in the United
States mandating enactment of the quinquennial system but leav-
ing implementation to the states.
As in the United States, the key would be to gain the support
of both the corporate world and the institutional investor world.
Recognition of the corporate governance problem is high in the
United Kingdom, and the perceived need for reform is great. The
quinquennial system responds to the concerns voiced in the United
Kingdom by participants in the corporate governance debate; ac-
cordingly, adoption of the system may be possible.

1'7 Companies Act 1985, II Palmer's Company Law T A-051 at 1011 (1985). See also

Companies Act 1989, II Palmer's Company Law I A-110 at 1509 (1989) (incorporating
amendments that reflect, among other things, certain EEC directives).
17' The Takeover Panel is a non-statutory body that regulates takeovers through its
interpretations of the City Code on Takeovers and Merges, an industry code containing
general principles and specific rules relating to takeovers. Members of the Takeover Panel
include representatives of merchant banks, investment fund managers and institutional in-
vestors, professional accountants, the Bank of England, the Securities Association, the Stock
Exchange and the Confederation of British Industry. See generally Tony Shea, Regulation
of Takeovers in the United Kingdom, 16 Brooklyn J Intl L 89 (1990); Lord Alexander of
Weedon, Q.C., Takeovers: The Regulatory,Scene, 1990 J Bus Law 203.
1991] Quinquennial Election

CONCLUSION

The intensity of the corporate governance debate in the

United States and the United Kingdom reflects a deep-seated con-
cern with the present system. Virtually all participants in the de-
bate recognize that the present system will not meet our needs in
the 1990s and beyond. We cannot afford to repeat the financial
chaos of the 1980s or the crises that inevitably follow such a specu-
lative frenzy. While corporate governance is only one factor in de-
termining the success of our business corporations, it is a key fac-
tor. It is imperative that we rebuild the corporate governance
system to promote the long-term health of the corporations that
form the backbone of our free-market economy.
At the theoretical level, this task entails rejection of
the mana-
gerial discipline model of corporate governance, which places
stockholder wishes, stockholder profit, and the promotion of take-
overs on an undeserved pedestal. This model encourages the sort
of short-term obsessions that continually undermine the ability of
American and British companies to compete in world markets over
the long term. In place of the managerial discipline model we pro-
pose a theory centered on the corporation's own interest in its
long-term business success. This interest, when multiplied many
times over, in classical economic theory mirrors the interest of all
corporate constituencies and society as a whole.
At the practical level, we urge adoption through the coordi-
nated efforts of many actors-state and federal, public and pri-
vate-of a quinquennial system of corporate governance. This sys-
tem would reserve essential decisions of corporate control and
strategy for stockholders to decide every five years, in a meeting
dedicated to rational and unfettered consideration of the corpora-
tion's long-term interests. Not all aspects of the quinquennial sys-
tem would find favor with corporations or with institutional stock-
holders; it is not designed to meet the wishes of either. But it
would meet the needs of our economies, and lead both corporations
and institutions to act in the national interest.
Wachtell, Lipton, Rosen & Katz

February 7, 1994

To Our Clients:

Ten Questions Raised by Paramount

The Paramount decision issued by the Delaware Supreme Court last Friday
answers a number of questions that come up in structuring an acquisition or responding to a
takeover bid:

1. Question. If the sale of a company is for cash, or securities other than

voting stock in a public company that does not have a control group, what standard should be
followed by the board of directors.

Answer. The Paramount decision holds that in a sale of control context

the directors of the company have one primary objective — “to secure the transaction
offering the best value reasonably available for the stockholders.” See Question 5 below.

2. Question. Did Paramount hold that the poison pill is illegal?

Answer. No. Paramount did not invalidate the pill. To the contrary it
cites approvingly the Household decision in which the pill was first sustained by the
Delaware Supreme Court.

3. Question. Can the target of a hostile takeover bid still just say no?

Answer. Yes. The Paramount decision expressly states that it does not
apply to a situation where a company is following its own strategic plan and has not
initiated a takeover situation. Where the target of a hostile bid wishes to consider
rejecting the bid and remaining independent it is critical that the board of directors follow
the correct process and have the advice of an experienced investment banker and legal
counsel. The Paramount decision lists the key considerations for the board weighing an
acquisition or a takeover:

(a) the offer’s fairness and feasibility,

(b) the proposed financing,
(c) the consequences of the financing,
(d) questions of illegality,
(e) the risk of nonconsummation,
(f) the bidder’s identity, prior background and other business experiences,
and
(g) the bidder’s business plans for the company and their effects on all
stockholder interests.
 4. Question. If it is not a sale of control but rather a common stock merger
with the combined company being a true public company, can you have no-shop and lock-up
provisions?

Answer. Yes. The Paramount decision is expressly limited to the

situation of a sale of control. It does not apply to the merger of two companies that
results in a public company without a control group. However, the Paramount decision
does have much to say about the reasonableness of no-shop and lock-up provisions. In
light of the Paramount decision a no-shop provision that is limited to the company not
initiating discussions with third parties but does not restrict responses to third party
initiatives is indicated. A lock-up option or bust-up fee should also be reasonable in
amount and not so material as to foreclose a third party bid. The decision indicates that a
combination of a lock-up stock option and a bust-up fee that is not capped at an aggregate
reasonable amount is likely to be held invalid. Also questionable are a put alternative to
a lock-up stock option as is an alternative permitting noncash exercise. While it can be
argued that the Paramount decision discussion of lock-up options, bust-up fees and no-
shop provisions is limited to sale of control situations, the underlying theme of the
decision signals caution. This is an area where more may well be less and too much may
taint the independence of the board and jeopardize the deal.

5. Question. Is there any way to do a deal that is viewed as a sale of control

without shopping or conducting an auction?

Answer. Yes. If on the basis of well considered expert advice the board
determines it is more likely to get the best value reasonably available by not shopping or
auctioning, then the board can authorize the transaction. In this situation the board
should document the basis for its determination and should avoid any no-shop, lock-up
option of bust-up fee provision that would impede a third party from competing. In the
past the Delaware courts have approved a subsequent “market check” as a substitute for
shopping prior to entering into an agreement and the Paramount decision does not reject
that approach.

6. Question. In evaluating competing bids involving securities can the board

decide that it prefers one security over the other?

Answer. Yes, but only within reasonable limits. The Paramount decision
says, “a board of directors is not limited to considering only the amount of cash involved,
and is not required to ignore totally its view of the future value of a strategic alliance. . . .
When assessing the value of non-cash consideration, a board should focus on its value as
of the date it will be received by the stockholders. Normally, such value will be
determined with the assistance of experts using generally accepted methods of valuation.”
(Emphasis added)

7. Question. Does the Paramount decision change the role or duties of the
directors?

-2-
 Answer. No. The court in the Paramount decision cited with approval the
prior Delaware cases which basically say that in acquisition transactions the directors
must be especially diligent. The decision goes on to say “the role of outside, independent
directors becomes particularly important because of the magnitude of a sale of control
transaction and the possibility, in certain cases, that management may not necessarily be
impartial.”

8. Question. Can a company enter into a merger of equals (that is not a sale
of control) in which neither company gets a premium?

Answer. Yes. The language in the Paramount decision that the

shareholders of the acquired company must get a premium for the sale of control is
expressly limited to the sale of control situations and does not apply to a merger of
equals.

9. Question. If a company enters into a strategic merger that is not a sale of

control in which the company gets a premium and a third party makes a hostile takeover bid for
the company at a higher value to its shareholders, can the company cancel the merger and reject
the hostile bid?

Answer. Yes, in theory, but as a practical matter there may be so much

shareholder pressure that the company will be forced into the auction mode and be forced
to accept the highest bid.

10. Question. In a transaction where it is permitted to use a bust-up fee, what

is a reasonable amount?

Answer. The Paramount decision rejects an “unreasonable” bust-up fee

but does not give guidance as to what is reasonable. Prior precedent and the Paramount
decision’s rejection of a $100 million bust-up fee as unreasonable when considered
together with a lock-up option with a value of more than $400 million in a $10 billion
transaction, provides some basis for the view that a bust-up fee of up to 2% is sustainable.

M. Lipton

-3-
 August 28, 1998

Delaware Corporations Should Eliminate “Dead Hand” Provisions

As we noted in our memorandum dated August 11, 1998, in Carmody v. Toll

Brothers, the Delaware Chancery Court recently indicated that “dead hand” provisions in rights
plans in their “pure” form -- those that deny the winner of a proxy fight the ability to redeem a
rights plan for an indefinite period after control of the board of directors changes -- will be found
invalid under Delaware law. In light of this decision, we understand that plaintiff law firms that
pursue stockholder litigation are considering targeting Delaware corporations who have rights
plans with dead hand provisions. If stockholder litigation is commenced and the rights plan is
subsequently amended, the plaintiffs in the stockholder litigation may claim that they are entitled
to receive compensation for causing the amendment.

Therefore, we recommend that any Delaware corporation that has a dead hand
provision in its rights plan proactively amend the plan to eliminate the dead hand provision before
stockholder litigation arises. In Toll Brothers, the Chancery Court limited its ruling to pure dead
hand provisions, thereby suggesting that dead hand provisions with a limited time period could be
valid. However, we recommend that any limited dead hand provision be adopted only in response
to a specific threat to the ability of the corporation to obtain the best available deal for its
stockholders.

M. Lipton
D. A. Katz

181257v2
 September 10, 2001

Delaware Supreme Court

Affirms Validity of Poison Pills

The Delaware Supreme Court has affirmed the rejection by the Court of Chancery
of a series of technical attacks against poison pill rights plans (see our memorandum of October
12, 2000). Fittingly, the opinion was authored by Justice Walsh who, then a Vice Chancellor,
rendered the first decision upholding rights plans in the Household case over 15 years ago.
Leonard Loventhal Account v. Hilton Hotels Corp., Del. Supr., No. 584, 2000 (Sept. 6, 2001).

The Supreme Court affirmed on the basis of stare decisis, emphasizing the “need
for stability and continuity in the law and respect for court precedent.” In turning back the
attacks on various elements of the plan, the Court stressed thatHousehold had addressed the
fundamental question — “whether a board of directors had the power to adopt unilaterally a
rights plan the effect of which was to interpose the board between the shareholders and the
proponents of a tender offer” — and that it would not entertain even contentions not explicitly
passed upon in Household that could not be harmonized with that basic holding. The Court’s
analysis makes clear that the courts ought not consider challenges to the validity of rights plan
provisions that would undercut Household’s basic holding.

M. Lipton
T.N. Mirvis
P.K. Rowe

W/591971v1
M. Lipton.

Shareholder Rights Plan draft in support of the “poison pill”; Univ. Chicago Law School
symposium; request for comments; January 28, 2002

Wachtell, Lipton, Rosen & Katz

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 Forthcoming, University of Chicago Law Review (2002)
Working Draft, January 2002

Pills, Polls and Professors Redux

Martin Lipton*

September of this year will mark the twentieth anniversary of the

publication of my memorandum recommending that companies adopt the poison
pill, which I invented in the summer of 1982 to deal with the takeover abuses that
emerged in the 1970s and had become endemic by the end of the decade. The pill
prevents a hostile tender offer from being consummated unless and until the board
of directors of the target redeems the pill. The pill does not prevent a proxy fight
to remove and replace a board of directors that refuses to redeem the pill. It was
and is a fundamental aspect of the pill that a proxy fight is the only way in which
a raider can override a well-founded decision of the board to reject and block a
takeover bid. Now Professor Lucian Bebchuk urges, in his brilliantly presented
paper, that basic state corporation law be changed to allow a raider to demand a
shareholder referendum whenever a board refuses to redeem a pill.1 This
proposal is one of several that have been advanced over the years to deny the
board of a target the ability to craft a strategy to protect corporate interests in the
context of a hostile takeover bid. In a rough chronological sequence, the pro-
takeover, anti-board-of-directors arguments have been:
1. The law should deny the board the power to be anything but
passive in the face of a takeover bid.2

*
Partner, Wachtell, Lipton, Rosen & Katz, New York City. I am grateful to my colleagues
Laura A. McIntosh, Erin E. Quinn and Paul K. Rowe for their significant contributions to this
paper, and to William T. Allen, Andrew R. Brownstein, John A. Elofson, Daniel A. Neff,
Gregory N. Racz, Eric S. Robinson, Steven A. Rosenblum, William D. Savitt, Warren R.
Stern, Herbert M. Wachtell and Jeffrey M. Wintner for their helpful comments.
1
See L. Bebchuk, The Case for Shareholder Voting and Against Board Control in Corporate
Takeovers (Wkg. Draft Jan. 2002); see also L. Bebchuk & A. Farrell, A New Approach to
Takeover Law and Regulatory Competition, 87 Va. L. Rev. 111 (2001).
2
See F. Easterbrook & D. Fischel, The Proper Role of a Target’s Management in Responding
to a Tender Offer, 94 Harv. L. Rev. 1161 (1981).

1
 2. The law should deny the board the power to frustrate the takeover
bid but permit the board to advise the shareholders as to fairness
and to seek a higher bid.3
3. The pill is illegal.4
4. A pill should require shareholder approval before it is effective.5
5. Shareholders can initiate and adopt a bylaw amendment that forces
redemption of the pill and precludes adoption of a pill.6
6. Given that at least Delaware will probably hold that the
shareholder bylaw overruling the pill is not legal, shareholders
should initiate and adopt bylaw amendments that do not directly
overrule the pill, but make a takeover easier and takeover defense
more difficult.7
7. Professor Bebchuk’s proposal to change the law to permit a bidder-
initiated referendum to remove the pill and all other takeover
defenses, which would be binding on all the shareholders if it
received the support of a majority of the outstanding shares of the
target.8

3
See L. Bebchuk, The Case for Facilitating Competing Tender Offers, 95 Harv. L. Rev. 1028
(1982); R. Gilson, A Structural Approach to Corporations: The Case Against Defensive
Tactics in Tender Offers, 33 Stan. L. Rev. 819 (1981); see also European Parliament and
Council Directive on Company Law Concerning Takeover Bids (Joint Text Approved by the
Conciliation Committee on June 6, 2001).
4
See Amalgamated Sugar Co. v. NL Indus., Inc., 644 F. Supp. 1229 (S.D.N.Y. 1986)); Moran
v. Household Int’l, Inc., 500 A.2d 1346 (Del. 1985) (in which appellants argued that the board
of directors did not have the power to adopt the poison pill and that the board may not usurp
shareholders’ right to receive hostile tender offers); Bank of New York Co. v. Irving Bank
Corp., 536 N.Y.S.2d 923 (N.Y. Sup. Ct. 1988), aff’d without op., 533 N.Y.S. 2d 411 (Table)
(N.Y. App. Div. 1st Dep’t 1988); see also R. Helman & J. Junewicz, A Fresh Look at Poison
Pills, 42 Bus. Law. 771 (1987).
5
See J. Gordon, “Just Say Never?” Poison Pills, Deadhand Pills, and Shareholder-Adopted
Bylaws: An Essay for Warren Buffett, 19 Cardozo L. Rev. 511, 549 (1997).
6
See Int’l Bhd. of Teamsters Gen. Fund v. Fleming Cos., Inc., 975 P.2d 907 (Okla. 1999); R.
Gilson, Unocal Fifteen Years Later (And What We Can Do About It), Columbia Law School
Wkg. Paper No. 177 (June 2000); Gordon, supra note 5, at 549.
7
See J. Coates & B. Faris, Second-Generation Shareholder Bylaws: Post-Quickturn
Alternatives, 56 Bus. Law. 1323 (2001).
8
See supra note 1; cf. infra note 65.

2
 This paper discusses the development of the law — primarily Delaware
law — governing takeovers, and against that background, rebuts Professor
Bebchuk’s referendum proposal. In a way, this paper is the culmination of my
efforts over a twenty-year period in courts, legislatures and academic publications
to counter those who would hang a permanent “For Sale” sign on all public
companies. I have sought to preserve the ability of the board of directors of a
target of a hostile takeover bid to control the target’s destiny and, on a properly
informed basis, to conclude that the corporation remain independent. I have never
been able to understand the persistent refusal of those academics who would hang
a “For Sale” sign on public corporations to recognize (i) that there are very
significant costs to corporations in being managed as if they are continuously for
sale, and (ii) that there is simply no evidence at all that the damage, if any, that the
anti-pill academics attribute to the pill is greater than those costs.
Prior to the 1960s, there was little academic discussion or judicial or
legislative focus on the legal rules that should apply to the response by a
corporation to a takeover bid. With the increase in takeover activity in the 1970s,
the topic became a growing concern for lawyers who advised target corporations,
but there was still no direct, cogent case law and no meaningful academic debate.
From the outset it was clear that there were three constituencies with prime
interests in any rule-shaping debate: (1) the shareholders, (2) the corporation as
an operating entity, and (3) the employees and other stakeholders. Within each
group there were gradations of interests, and the groups and interests overlapped
and sometimes collided. In this period, the role of the board of directors and the
grounds on which it was to act in responding to a hostile takeover bid were
nebulous and had yet to be definitively determined.
In an effort to distill clarity from this confusion, in 1979 I wrote what
became the seminal article in the ensuing debate. In Takeover Bids in the
Target’s Boardroom,9 I argued, based on my experience during the 1960s and
1970s in advising boards of directors of corporations that were the targets of
hostile takeover bids, that the directors should be governed by the business
judgment rule and that in exercising their judgment they should be able to take
into account the interests of employees, communities and other constituents, as
well as the long-term (and not just the short-term) interests of the shareholders.
This position was quickly rejected by academics opposed to an active
board role in the hostile takeover context, who argued for the so-called “Rule of
Passivity,” relegating directors to the role of passive observers proscribed from
any action other than giving advice to the shareholders. A classic series of
articles ensued,10 with the courts deciding the debate in favor of the business

9
M. Lipton, Takeover Bids in the Target’s Boardroom, 35 Bus. Law. 101, 130 (1979).
10
See, e.g., Herzel et al., Why Corporate Directors Have a Right to Resist Tender Offers, 3
Corp. L. Rev. 107 (1980); F. Easterbrook & D. Fischel, Takeover Bids, Defensive Tactics,
and Shareholders’ Welfare, 36 Bus. Law. 1733, 1750 (1981) (arguing that decisions as to
tender offers do not involve management of the corporation’s affairs in any meaningful sense

3
judgment rule.11 This exchange of articles reflected a fierce public policy debate.
The new breed of hostile bids was, on the one hand, wreaking havoc with
expectations of managers, employees and communities, and, on the other,
enriching the raiders and a new class on Wall Street: the bankers who advised,
financed or arbitraged takeovers. The pro-takeover forces found theoretical
support for their position among a group of economists who adhered to the
efficient market theory, which was argued to offer support for the proposition that
shareholder wealth could be maximized by outlawing most forms of takeover
defense. Starting from the premise that share prices at all times accurately reflect
the intrinsic value of a corporation, efficient market theory partisans contended
that the willingness of a bidder to offer a premium price reflects the bidder’s
ability to manage the assets better or more efficiently. At the same time, they
contended that board reluctance to accept a premium price necessarily reflects an
instinct of self-preservation rather than conviction that the tender price is
inadequate. Defenses, in this view, serve only to entrench incumbents and
necessarily to harm shareholders.
The opponents of the efficient market theory pointed out that corporations
were not chartered by the states solely to maximize shareholders’ short-term
gains, and that large corporations could not function in an environment where
they were continuously “for sale.”12 The aggregate costs to all shareholders of all
______________________________________________________
and can be made by the shareholders); Easterbrook & Fischel, supra note 2, at 1191, 1198,
1201 (defending their proposal of director passivity in response to tender offers by
distinguishing between board’s role in tender offers and its role in other situations); M.
Lipton, Takeover Bids in the Target’s Boardroom: A Response to Professors Easterbrook
and Fischel, 55 N.Y.U. L. Rev. 1231 (1980); Gilson, supra note 3, at 878-79 (arguing that in
the face of a tender offer, management of the target company should take no action other than
to: (1) disclose information bearing on the value or attractiveness of the offer, and (2) seek
out alternative transactions which it believes may be more favorable to target shareholders);
M. Lipton, Takeover Bids in the Target’s Boardroom: An Update After One Year, 36 Bus.
Law. 1017 (1981); Bebchuk, supra note 3, at 1054 (arguing that although incumbent
management should be barred from actions that obstruct any tender offer, management should
diligently seek a higher offer); M. Lipton & A. Brownstein, Takeover Responses and
Directors’ Responsibilities: An Update, ABA National Institute on the Dynamics of
Corporate Control, Dec. 1983, at 7 (noting that boards must consider the nature of a takeover
bid and its effect on the corporate enterprise, including the adequacy of the price, the nature
and timing of the offer, the impact on constituencies other than shareholders, the risk of
nonconsummation, and the quality of the securities being offered in the exchange); see also
M. Lipton, Boards Must Resist, N.Y. Times, Aug. 9, 1981, at 2F; M. Lipton, Takeover Abuses
Mortgage the Future, Wall St. J., Apr. 5, 1985.
11
See Johnson v. Trueblood, 629 F.2d 287 (3d Cir. 1980); Crouse-Hinds Co. v. InterNorth,
Inc., 634 F.2d 690 (2d Cir. 1980); Panter v. Marshall Field, 646 F.2d 271 (7th Cir. 1981);
Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del. 1985); Kahn v. MSB Bancorp, Inc.,
1998 WL 409355 (Del. Ch. 1998), aff’d, 734 A.2d 158 (Del. 1999).
12
Corporation law is designed to protect the “long-term value of capital committed
indefinitely to the firm,” W. Allen, Ambiguity in Corporation Law, 22 Del. J. Corp. L. 894,

4
public companies if they had to operate on this basis would far exceed the costs, if
any, in the long run to the shareholders of companies that successfully resist
unsolicited takeovers. Those who did not accept the relevance of the efficient
market theory to the regulation of takeovers also pointed out, drawing on a
growing body of economic literature, that inefficiencies in the market could exist
at any given point in time, meaning that share prices did not always reflect
intrinsic values.13
Those in favor of takeover defenses further argued that a central
assumption of efficient market theory proponents — that shareholder responses to
tender offers are necessarily informed decisions that rationally reflect the
supposed “best” interests of all shareholders collectively — is not true. Tender
offers are not the functional equivalents of free votes, since the decision not to
tender (whether into an all-cash, all-shares offer or a two-tier, front-end-loaded
offer) carries with it economic risks and detriments; not knowing whether the
mass of other shareholders will tender or not, the individual holder faces the
classic “prisoner’s dilemma” and is effectively stampeded into tendering. The
proponents of takeover defenses also observed that many hostile bids were
opportunistic attempts to buy assets on the cheap, and that there was no empirical
evidence that such takeovers were always (or ever) good for the economy.14
______________________________________________________
896-97 (1997), and does not share the short-term horizon of takeover arbitrageurs. See also
M. Lipton and S. Rosenblum, A New System of Corporate Governance: The Quinquennial
Election of Directors, 58 U. Chi. L. Rev. 187 (Winter 1991).
13
See M. Lipton & S. Rosenblum, supra note 12.
14
See, e.g., M. Lipton, Corporate Governance in the Age of Finance Corporatism, U. Pa. L.
Rev. 1, 23 (Nov. 1987) (“The advent of the highly leveraged takeover, and the defensive
responses to it, have forced companies to focus on short-term profitability rather than on
capital investment, long-term planning, research, and development”); J. Charkham, Keeping
Good Company: A Study of Corporate Governance in Five Countries, 219, 229 (1994)
(arguing that putting great emphasis on shareholders’ immediate values may result in
competitive disadvantage compared to other nations’ systems that take a longer-term view); J.
Pound, The Promise of the Governed Corporation, Harv. Bus. Rev., Mar.-Apr. 1995, at 91,
91 (“Many takeover bids themselves represent flawed decisions by the acquirer”); E. Spencer,
The U.S. Should Stop Playing Poker with Its Future, Bus. Week, Nov. 17, 1986, at 20, 20
(arguing that Wall Street has adopted the view that “the higher the stock price, the better the
management has done its job,” leading managers “to put short-term earnings growth before
such interests as market development, product quality, research and development, and
customer and employee satisfaction”); Williams, It’s Time for a Takeover Moratorium,
Fortune, July 22, 1985, at 133, 136 (in which former SEC Chairman Harold Williams
commented that takeover activity has resulted in a loss in management effectiveness that
“works against corporate and national productivity, the wages of employees, and returns to
stockholders. It undermines our economy and our society.”); R. Stern & E. Cone, Scarlett
O’Hara Comes to Wall Street, Forbes, Sept. 21, 1987, at 37, 37-38 (reporting competition to
provide financing for leveraged acquisitions and suggesting that valuations were driven up to
insupportable levels); see also A. Boyer, Activist Shareholders, Corporate Directors, and
Institutional Investment: Some Lessons from the Robber Barons, 50 Wash. & Lee L. Rev.

5
Moreover, the view that directors were only capable of acting in their self-interest
was unsupported by empirical evidence and inconsistent with the assumptions
underlying the structure of American corporate law.15
State legislatures around the country resolved this debate squarely in favor
of directorial discretion. Between 1968 and 1982, laws designed to slow or halt
the wave of opportunistic takeover activity were enacted in 37 states.16 Thus, by
the early 1980s, both the legislatures and the courts had emphatically rejected the
view that directors should be passive in the face of takeover bids.17 But in 1982,
by a razor-thin margin, the United States Supreme Court invalidated the “first
generation” of anti-takeover statutes in Edgar v. MITE Corp.18 Now there was
nothing to delay the consummation of a tender offer beyond the Williams Act’s
twenty business days. Increasingly, boards turned to creative attempts to release
short-term value by selling pieces of the business or turning to a “white knight,”
but these alternative transactions were often difficult to achieve on the truncated
timeline of the Williams Act minimum tender period.
The MITE decision coincided with the decision of most institutional
investors that they would not vote for charter amendments designed to deter or
regulate hostile takeovers, and also with the federal courts’ picking up on an
earlier decision by Judge Henry Friendly in which he treated with great
skepticism suits brought by targets raising antitrust, disclosure and similar claims
to enjoin hostile bids.19 This left the playing field heavily tipped in favor of the
corporate raiders and peddlers of junk bonds. In September 1982, I published a
______________________________________________________
977, 1004-05 (1993) (explaining that as LBOs increased and junk bonds became popular, a
new group of investors entered and expanded the market for low-grade debt).
15
See, e.g., Del. Gen. Corp. L. § 141(a) (providing that the business and affairs of every
Delaware corporation shall be managed by a board of directors). This is an eminently
sensible state of affairs; among other advantages, directors have much better (non-public)
information and far lower costs of communication than do shareholders.
16
State Takeover Laws, Investor Responsibility Research Center Inc., at Appendix B-5 (Mar.
1998).
17
See supra note 11.
18
457 U.S. 624, 632-34 (1982) (plurality opinion concluding that the Williams Act struck a
careful balance between the interests of offerors and target companies, and that any state
statute that “upset” this balance was pre-empted).
19
See Missouri Portland Cement Co. v. Cargill, Inc., 498 F.2d 851 (2d Cir. 1974), cert.
denied, 419 U.S. 883 (1974); see, e.g., Scientific Computers, Inc. v. Edudata Corp., 599 F.
Supp 1092, 1098 (D. Minn. 1984); American General Corp., et al. v. NLT Corp., et al., 1982
WL 1332, *25 (S.D. Tex.) (quoting Cargill for the statement that “‘district judges should take
arguments of serious harm to a corporation due to jitters in executive suites with a fair amount
of salt’”); Raybestos-Manhattan Inc. v. Hi-Shear Indus., 503 F. Supp. 1122, 1134 (E.D.N.Y.
1980) (citing Cargill for the proposition that “[t]he Second Circuit has warned district courts
to look skeptically on Clayton Act claims raised by target management who become vigilant
enforcers of the antitrust laws only when a tender offer threatens their control”).

6
memorandum describing the “Warrant Dividend Plan.”20 The “warrant” of the
Warrant Dividend Plan was a security that could be issued by the board of
directors of a target company (before or after it was faced with an unsolicited bid)
that would have the effect of increasing the time available to the board to react to
an unsolicited bid and allowing the board to maintain control over the process of
responding to the bid. Beginning at the end of 1982, in various forms it was used
successfully by targets of hostile bids to gain time and maximize shareholder
value. Six months later, in 1983, the plan was given its unfortunate nickname by
an investment banker who had nothing to do with its creation. When asked by a
Wall Street Journal reporter what to call a security — modeled on the Warrant
Dividend Plan — issued on my advice by Lenox, Inc. to defend against a hostile
tender offer, this banker responded flippantly, “a poison pill.”21
By whatever name, the pill’s arrival was remarkably timely. As the tide of
junk-bond-financed, bootstrap bids, sometimes linked to two-tier, front-end-
loaded tenders, rolled on in the mid-1980s, there was increasing recognition that
something was needed to redress the balance between the corporate raider and the
board of the target. The pill met precisely that need. Nevertheless, the
introduction of the pill was viewed as a radical innovation by those who believed
that directors should play no active role in the hostile takeover context, and the
attacks on the pill’s validity were unrelenting.22
The increasing use of the pill in 1984-85 set the stage for a decisive
confrontation between the forces advocating a free hand for corporate raiders and
those supporting the traditional model of the corporation and the business
judgment rule. The question remained: Who would act as the decision-maker?
At the federal level, Congress had shown no interest in adopting a statutory
framework for regulating takeovers beyond the Williams Act; and by 1983 the
federal impulse for further regulation, even at the Securities and Exchange
Commission level, had petered out. The United States Supreme Court in Santa
Fe Industries, Inc. v. Green had extinguished the ability of federal judges to
federalize substantive takeover law through the securities laws.23 On the other

20
M. Lipton, Memorandum: Warrant Dividend Plan (Sept. 15, 1982) (on file with author).
21
F. Allen and S. Swartz, Lenox Rebuffs Brown-Forman, Adopts Defense, Wall St. J., June
16, 1983, at 2.
22
See, e.g., Helman & Junewicz, supra note 4 (suggesting that the poison pill may be invalid
or financially inconsequential); J. Shub, Shareholder Rights Plans: Do They Render
Shareholders Defenseless Against Their Own Management?, 12 Del. J. of Corp. L. 991
(1987) (arguing that a board’s unilateral adoption of a poison pill usurps the right of
shareholders to decide whether to sell their stock to a purchaser); K. Master, Poison Pill
Takeover Defense Stirs Controversy, Uncertainty, Legal Times, August 29, 1983, at 1; R.
Ferrara and W. Phillips, Opposition to Poison Pill, Legal Times, Oct. 15, 1984; G. Stevenson,
A Poison Pill That’s Causing a Rash of Lawsuits, Bus. Wk., Apr. 1, 1985, at 54.
23
430 U.S. 462, 479 (1977) (“Absent a clear indication of congressional intent, we are
reluctant to federalize the substantial portion of the law of corporations that deals with

7
hand, the Court’s opinion in MITE had limited the ability of state legislatures to
impose their own statutory regulation in the area.24 Meanwhile, increasing
corporate reliance on defensive tactics — and the increasingly shrill objections of
their opponents — created a pressing practical need for dependable legal ground
rules. The state courts were left as the only institutional actors with the power and
will to fashion a comprehensive resolution.
In 1985, the Delaware Supreme Court decided four cases — Trans
Union, Unocal,26 Revlon27 and Household28 — that created the framework that
25
has governed takeover law ever since. The key choices Delaware made in 1985
were the following:
(1) In Trans Union, Delaware decisively rejected the efficient market
theory and not only permitted, but required, directors to make takeover-related
decisions based on an informed view of the “intrinsic” value of the corporation —
not the value assigned by the stock market.29
(2) In Unocal, citing with approval a later version of my 1979 article,
Takeover Bids in the Target’s Boardroom,30 Delaware accepted the utility and
appropriateness of “takeover defenses” and the board of directors’ discretion to
deploy such defenses, but announced that henceforth they would be reviewed
under an enhanced business judgment rule — a tougher and objective “reasonable
in relation to the threat posed” test, rather than the pre-existing subjective
business judgment rule.31
(3) In Revlon, Delaware required directors to maximize short-term
value once they decided to sell a company for cash; and conversely, Delaware
______________________________________________________
transactions in securities, particularly where established state policies of corporate regulation
would be overridden.”).
24
See supra note 18 and accompanying text. The states were, however, active in reversing
several federal court rulings that the pill was invalid under state corporate statutes. Every
court ruling invalidating pills was legislatively overturned. See, e.g., N.Y. Bus. Corp. Law §
505(a)(2) (legislatively overturning a July 1988 New York State Supreme Court decision
invalidating Irving Bank’s flip-in poison pill, see Irving Bank Corp., 536 N.Y.S.2d 923); N.J.
Rev. Stat. Ann. § 14A:7-7 (legislatively overturning an August 1986 New York federal
district court case applying New Jersey corporate law, which invalidated NL Industries’ flip-
in poison pill, see Amalgamated Sugar Co., 644 F. Supp. 1229).
25
Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985) (hereinafter Trans Union).
26
493 A.2d 946.
27
Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). The
Delaware Supreme Court decided Revlon in 1985, although its opinion was issued in 1986.
28
500 A.2d 1346.
29
488 A.2d at 875-76.
30
See 493 A.2d at 955 (citing Lipton & Brownstein, supra note 10).
31
493 A.2d at 954-55, 957.

8
decided that it would not require directors to maximize short-term value outside
this one, relatively narrow situation. Delaware companies were not required to be
for sale twenty-four hours a day, seven days a week, and directors could agree to
friendly stock mergers without putting the company “in play” or having to
“auction” the company.32
(4) In Household, Delaware permitted boards to adopt the poison pill
as a structural defense to a takeover bid. Household recognized that the pill gave
boards the power to “just say no” until such time as the shareholders (if they so
wished) replaced the incumbent directors, and established that judicial review of a
board’s use of the poison pill would be subject to the enhanced business judgment
rule standard of Unocal.33
Clearly, these four crucial decisions represented a set of compromises.
Delaware accepted neither the pleas of corporate constituencies for continued
application of the deferential business judgment rule to takeover defense, nor
endorsed the demands of corporate raiders and academics who sought to outlaw
takeover defense. Instead, Delaware chose a middle ground: Takeover defenses
were permitted, but they were to be judged, in common law fashion, under a fact-
intensive, case-by- case analysis in which the directors would effectively bear the
burden of showing not merely their good faith but also the “reasonableness” of
their chosen response.
Put to the practical test during the half-decade of intense hostile takeover
activity that ensued, the new Delaware paradigm has worked well. Contrary to
the fears of both sides, Unocal and its siblings did not usher in a period in which
every takeover defense was either condemned automatically or rubber-stamped.
A review of some of the major cases of that period demonstrates the suppleness of
the standard and the discriminating manner in which it was applied.34

32
MacAndrews & Forbes Holdings, Inc. v. Revlon, Inc., 501 A.2d 1239, 1248 (Del. Ch.
1985). Although this implication of Revlon was reasonably clear from the opinion, the
efficient market partisans refused to acknowledge it as Delaware doctrine until the Delaware
Supreme Court had the opportunity to make it an express holding four years later in
Paramount Communications, Inc. v. Time Inc., 571 A.2d 1140, 1150 n.12 (Del. 1989)
(hereinafter Time-Warner) (a corporate board of directors, the court found “is not under any
per se duty to maximize shareholder value in the short-term, even in the context of a
takeover”; moreover, the court stated that “[i]t is not a breach of faith for directors to
determine that the present stock market price of shares is not representative of true value”).
33
See 500 A.2d at 1357.
34
See, e.g., Ivanhoe Partners v. Newmont Mining Corp., 535 A.2d 1334 (Del. 1987)
(upholding special dividend issued to facilitate a “street sweep” to defeat a two-tier offer);
Robert M. Bass Group, Inc. v. Evans, 552 A.2d 1227 (Del. Ch. 1988) (enjoining restructuring
adopted in response to unsolicited bid); AC Acquisitions v. Anderson Clayton, 519 A.2d 103
(Del. Ch. 1986) (enjoining recapitalization adopted in response to hostile bid).

9
 Of the quartet of 1985 decisions, the one that proved to have the greatest
practical impact was undoubtedly Household.35 The pill changed everything.
Instead of twenty business days, boards now had sufficient time to consider,
respond to and craft alternatives to unsolicited bids. And, contrary to the
arguments of the plaintiffs in Household,36 the pill actually revived the
importance of proxy contests as a means of determining a corporation’s future.
Indeed, the Delaware courts rarely receive the credit they deserve for having been
right in rejecting the supposed factual, empirical arguments made by the pill’s
opponents in Household as to the predicted effect of the pill on proxy contests.
Professors and experts were paraded in the Court of Chancery to testify, among
other things, that validation of the pill in Delaware would suppress proxy
contests.37 Both the Court of Chancery and the Delaware Supreme Court refused
to let themselves be persuaded by these “experts” –– and of course with hindsight
we can see that the pill simply did not usher in the parade of horribles predicted
by its opponents. As the Chancery Court correctly predicted, the pill did not spell
the doom of proxy contests.38 A recent review of the economic literature on the
shareholder-wealth effects of takeover defenses was undertaken by Professor
John Coates.39 He concluded:
Delaware courts should take some comfort from the
fact that they resisted strong academic arguments
and political efforts that attempted to push them to
dramatically repudiate pills and other structural
defenses. The empirical case against defenses
remains unproven, and, without empirical support,
the theoretical case against defenses is not as

35
See G. Stevenson, A Poison Pill That’s Causing a Rash of Lawsuits, Bus. Week, Apr. 1,
1985, at 53 (“This is probably the single most important corporate law case to come before
the courts in years. Legal challenges [to the pill] have proliferated [throughout the United
States]. But the [Household] case in Delaware is the crucial one. Because so many
companies are incorporated there, and because the court is widely respected, its decision will
set the tone for rulings in other state and federal courts.”).
36
Plaintiffs in Household argued that the pill’s restriction upon individuals or groups from
first acquiring more than 20% of shares before waging a proxy contest would reduce the
potency of proxy contests. See 500 A.2d at 1351. Even the SEC filed an amicus curiae brief
in support of this argument. Id. at 1346.
37
See 490 A.2d at 1079.
38
See 490 A.2d 1059, 1080 (Del. Ch. 1985) (“On the evidence presented it is highly
conjectural to assume that a particular effort to assert shareholder views in the election of
directors or revisions of corporate policy will be frustrated by the proxy feature of the Plan.”).
39
J. Coates, Empirical Evidence on Structural Takeover Defense: Where Do We Stand?, 54
U. of Miami L. Rev. 783 (2000).

10
 compelling as it might have seemed to hostile
commentators [in 1989].40
The new rules crafted by the Delaware courts in the four 1985 decisions
met with wide acceptance. Corporate raiders did not abandon the market for
corporate control;41 corporations did not seek to reincorporate out of Delaware in
order to avoid the new regime; and litigators increasingly chose the Delaware
state forum over federal and non-Delaware state courts when there was a need for
adjudication. Interestingly, the pill even became a standard feature in initial
public offering charters, a context in which management entrenchment is virtually
absent.42
But the 1985 Delaware rules were controversial enough — and perceived
as insufficiently sensitive to the realities of corporate life — to provoke a
legislative reaction in other states. It is a signal fact that, despite Delaware’s
primacy as a corporate domicile and despite some academic criticism of Delaware
as too protective of management,43 the Delaware regime has not been broadly
embraced by the other states. Instead, a number of states enacted legislation that
to a greater or lesser extent rejected the Delaware compromise as too favorable to
corporate raiders and hostile bids,44 too suspicious of the motives of directors,45

40
Id. at 797. In view of this conclusion by Professor Coates, it is difficult to understand his
seeming endorsement of shareholder-initiated bylaws that would curtail defenses against
hostile takeovers. See Coates & Faris, supra note 7.
41
As the Delaware Supreme Court noted in 1989, “the spate of takeover litigation . . . readily
demonstrates that such ‘poison pills’ do not prevent rival bidders from expressing their
interest in acquiring a corporation . . . . Because potential bidders know that a pill may not be
used to entrench management or to unfairly favor one bidder over another, they have no
reason to refrain from bidding if they believe that they can make a profitable offer for control
of the corporation.” Barkan v. Amsted Indus., Inc., 567 A.2d 1279, 1287 (Del. 1989).
42
See R. Daines, Does Delaware Law Improve Firm Value?, NYU Center for Law and
Business, Wkg. Paper No. CLB-99-011, available at http://papers.ssrn.com/paper.
taf?abstract_id=195109 (1999).
43
There is a growing body of academics who view Delaware corporation law as, on balance,
highly successful. See, e.g., R. Romano, The Genius of American Corporate Law (Wash.,
D.C.: AEI Press, 1993); R. Daines, supra note 42; M. Kahan, Paramount vs. Paradox:
Delaware Supreme Court Jurisprudence, 19 J. Corp. L. 587 (1994); M. Kahan and E. Rock,
How I Stopped Worrying and Love the Pill (unpublished manuscript, on file with authors).
44
See, e.g., Ind. Code Ann. §§ 23-1-35-1(f) (West Supp. 1990) (Standards of Conduct for
Directors), which rejects the Unocal compromise as being “inconsistent with the proper
application of the business judgment rule under this article. Therefore, the general assembly
intends . . . to protect both directors and the validity of corporate action taken by them in the
good faith exercise of their business judgment after reasonable investigation.” Id. When the
Supreme Court upheld Indiana’s control share acquisition statute in CTS Corp. v. Dynamics
Corp. of America, 481 U.S. 69 (1987), the Court ushered in a new era in state activism

11
and too unresponsive to the legitimate interests of non-shareholder constituencies
such as employees and communities. No American jurisdiction went further than
Delaware and adopted rules, either by statute or judge-made law, that restrict
takeover defenses more tightly than Delaware. No American jurisdiction has ever
adopted a framework for takeover law based on the efficient market theory or
gone farther than Delaware in that direction.
If anything, after 1985 there was a growing realization that the extreme
simplicity of the world view of the anti-board partisans — that there was no place
for any interference with the presumed “right” of shareholders to sell the company
at any time to a bidder opposed by the board, and that directors should therefore
be “passive instrumentalities” — was neither an accurate description of reality nor
a desirable goal. Moreover, in 1987, the United States Supreme Court, which in
1982 had rejected states’ efforts to regulate takeovers through so-called “first
generation” statutes, effectively switched sides and endorsed “second generation”
statutes in CTS Corp.46 The 1987 market “break,” and the 1990 collapse of
Drexel Burnham Lambert, the most prominent financier of hostile bids in the
1980s, further damaged the prestige and persuasiveness of the efficient market
theory.
It is perhaps outside the terms of academic argument, but nonetheless
suggestive, to recall the subsequent careers of the bidders whose takeover
proposals were opposed by boards in some of the high-profile cases of the 1980s.
For example, the board of Macmillan, Inc. was harshly criticized by the Delaware
courts for opposing Robert Maxwell’s 1988 bid for the company. But in light of
the revelations of dishonesty, corporate looting and other wrongdoing that
followed Maxwell’s presumed suicide in 1991, does the Macmillan board now
look quite so unreasonable in preferring a 20" per share lower bid from
Maxwell’s rival Henry Kravis? While the Maxwell and Macmillan transaction is
perhaps the most thought-provoking example, is there anything in the subsequent
business careers of such raider icons of the 1980s as Boone Pickens, Carl Icahn,
Paul Bilzerian and Robert Campeau that suggests that corporate law should have
been redesigned to put these people in charge of important enterprises and large
pools of assets?
In 1988, Delaware adopted its own “second generation” statute. This
enactment is Delaware’s only major legislative response to the takeover issue, and
______________________________________________________
regarding takeovers. See also, e.g., 805 ILCS 5/8.85 (Ill.); N.J. Rev. Stat. Ann. § 14A:7-7;
N.Y. Bus. Corp. Law § 717(b); Ohio Rev. Code Ann. § 1701.59(E).
45
Unocal assumed that the “perks” of outside directorship are substantial enough to cause
independent directors to be less trustworthy in making takeover-related decisions than
garden-variety business decisions. See 493 A.2d at 958. I am aware of no research or
evidence on this point. It is certainly not self-evident.
46
481 U.S. 69 (holding that the Indiana control share acquisition statute was a legitimate
exercise of state authority, and that it did not conflict with federal tender offer regulation).

12
clearly represents a further rejection of the efficient market theory. Under Section
203,47 directors have the statutory power effectively to block potential transfers of
control to substantial shareholders by refusing to approve a transaction. While
this power is not absolute, it can be overridden only by a very high
“supermajority” of 85% of the shareholders; Section 203 is in effect a statutory
pill that can be neutered by a tender offer that attracts 85% of the shares. Like the
1985 cases, Section 203 is another Delaware compromise, but clearly one that
recognizes that directors should have a major role in determining the
corporation’s fate in a takeover situation.
Events of the 1990s have further demonstrated the wisdom of the
Delaware compromise. The coercive, highly leveraged, and often destructive
attributes of the 1980s takeover market have faded from view. Secure in their
ability to resist hostile bids, directors have used this authority to enhance
shareholder value. And directors can use this same power to resist a transaction
they reasonably believe to be insufficient or unduly speculative — a power of no
mean significance, wielded for the protection of the interests of shareholders and,
indeed, every corporate constituency. Confirming the position I first advanced in
1979 in Takeover Bids in the Target’s Boardroom, the American Law Institute —
in Principles of Corporate Governance — endorsed Delaware’s takeover
jurisprudence as a model for the nation.48

47
Del. Gen. Corp. L. § 203.
48
American Law Institute, Principles of Corporate Governance § 6.02 (1994).
§ 6.02 Action of Directors That Has the Foreseeable Effect of
Blocking Unsolicited Tender Offers:
(a) The board of directors may take an action that has
the foreseeable effect of blocking an unsolicited tender offer
[§ 1.39], if the action is a reasonable response to the offer.
(b) In considering whether its action is a reasonable
response to the offer:
(1) The board may take into account all
factors relevant to the best interests of the corporation and
shareholders, including, among other things, questions of legality
and whether the offer, if successful, would threaten the
corporation’s essential economic prospects; and
(2) The board may, in addition to the analysis
under § 6.02(b)(1), have regard for interests or groups (other than
shareholders) with respect to which the corporation has a legitimate
concern if to do so would not significantly disfavor the long-term
interests of shareholders.
(c) A person who challenges an action of the board on
the ground that it fails to satisfy the standards of Subsection (a) has

13
 In the same vein, it warrants notice that Delaware’s two major structural
features with respect to takeover law — the poison pill and Section 203 — have
not given rise to significant case law since the Household case. While the
Household Court announced in 1985 the standard — Unocal — under which pill
decisions were to be reviewed, there have been only three Delaware Chancery
Court decisions requiring a board of directors to redeem a pill, two of which were
later disapproved by the Delaware Supreme Court in Time- Warner.49 The only
case in which a board of directors was found to have breached its fiduciary duties
in connection with its application of Section 203 involved the improper waiver of
the protections of Section 203 by the directors of a majority-owned subsidiary.50
The absence of such case law strongly suggests that both the pill and Section 203
are being utilized responsibly by Delaware boards and that the system they uphold
is a healthy one.51 After twenty years, I can confidently say that the pill has been
used; it has not been abused.
______________________________________________________
the burden of proof that the board’s action is an unreasonable
response to the offer.
(d) An action that does not meet the standards of
Subsection (a) may be enjoined or set aside, but directors who
authorize such an action are not subject to liability for damages if
their conduct meets the standard of the business judgment rule
[§ 4.01(c)].
49
The Chancery Court decisions in City Capital Assocs. Ltd. P’ship v. Interco., Inc., 551
A.2d 787 (Del. Ch. 1988) and Grand Metro. PLC v. Pillsbury Co., 558 A.2d 1049 (Del. Ch.
1988) were disapproved by the Delaware Supreme Court in Time- Warner, 571 A.2d 1140.
The only other Chancery Court decision requiring a target to redeem a poison pill was in the
context of a completed auction of the company in which the two highest bids were on the
table and the court found that no corporate purpose would be served by maintaining a poison
pill to preclude the possible consummation of a $90.25 per share bid in favor of a $90.05 deal
supported by the target. Mills Acquisition Co. v. Macmillan Inc., C.A. No. 10168 (Del. Ch.
Oct. 17, 1988, revised Oct. 18, 1988), rev’d on other grounds, 559 A.2d 1261 (Del. 1989).
50
In re Digex, Inc. S’holders Litig., Consol. C.A. No. 18336 (Del. Ch. Dec. 13, 2000).
51
The work of Professor Robert Daines demonstrates that Delaware’s post-1985 legal regime
has not reduced returns to shareholders. See Daines, supra note 42, at 26. As Professor
Daines summarizes his conclusions:
. . . Delaware corporate law improves firm value and
facilitates the sale of public firms. Using Tobin’s Q as an
estimate of firm value, I find Delaware firms are worth
significantly more than similar firms incorporated
elsewhere. The result is robust to controls for firm size,
diversification, profitability, investment opportunity and
industry. Delaware firms also receive significantly more
takeover bids and are significantly more likely to be
acquired. Firms with strong incentives to choose valuable
legal regimes are likely to incorporate in Delaware when

14
 Nevertheless, for reasons that are not supported by history or practice,52
the academic community and activist investors have not been satisfied with the
Delaware solution and the present state of the law.53 The leading spokesperson
for doing away with the pill, Professor Ronald Gilson, argues that shareholders
should be permitted to adopt a bylaw that repeals a poison pill previously adopted
by the corporation and that prohibits the corporation from adopting a pill in
response to a hostile takeover bid.54 Professor Gilson would go back to the 1979-
82 debate and essentially come down on the side of the Rule of Passivity.
Without the pill there is no effective defense against a hostile takeover, and
Professor Gilson would doom all targets to being acquired by a raider or a white
knight. A full explication of Professor Gilson’s thesis and my refutation are
available in my response to his article.55 It also should be noted that in a reply to

______________________________________________________
they go public. These results suggest that corporate law
affects firm value.
Id. at 1. Professor Daines’s study, while starting from the premise of the efficient market
theory, nonetheless shows none of the dysfunctional or shareholder-wealth-damaging effects
complained of by others.
52
See, e.g., J.P. Morgan & Co., Median Control Premiums: Pill v. No Pill, July 1997 (study
of 300 U.S. transactions from 1993 through 1997 (representing all transactions over $500
million in which a majority interest was purchased) finding that the median takeover premium
paid for companies that had a rights plan in place was nearly 10% higher than for companies
that did not have one. J.P. Morgan further found that in hostile deals during the period from
1988 through 1997, the takeover premium paid was 14% greater for companies with rights
plans in place); Georgeson & Co. Inc., Georgeson Research, Mergers & Acquisitions, Poison
Pills and Shareholder Value / 1992-1996, Nov. 1997 (hereinafter Georgeson Study) (study of
319 takeover transactions over $250 million between 1992 through 1996, finding that
premiums to acquire companies that had shareholder rights plans six months prior to the first
bid were on average eight percentage points higher than premiums paid for target companies
without rights plans); R. Comment & G.W. Schwert, Poison or Placebo? Evidence on the
Deterrence and Wealth Effects of Modern Antitakeover Measures, 39 J. Fin. Econ. 3, 31 tbl. 4
(1995) (confirming premium results); J. Coates, supra note 39 (affirming that there is no
evidence that the poison pill has ever detracted from shareholder economic welfare).
53
In 1984, total United States merger and acquisition activity was $196 billion; it grew to
$1.7 trillion in 2000, and with the market decline in 2001, fell to $800 billion, but still four
times the 1984 volume. Merger and acquisition activity as a percent of market capitalization
has averaged 10% since 1985 and averaged 12% in 1998-2000. Clearly the pill and takeover
defenses have not had an adverse effect on the volume of change of control transactions.
Source: Thompson Financial Securities Data.
54
See Gilson, supra note 6.
55
See M. Lipton & P. Rowe, Pills, Polls and Professors: A Reply to Professor Gilson, New
York University Center for Law and Business, Wkg. Paper CLB-01-006 (Apr. 2001),
available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=268520 (forthcoming in the
Feb. 2002 Delaware Journal of Corporate Law).

15
my response,56 Professor Gilson essentially acknowledges that his fight is not
against the pill’s being used to support a “just say no” response to a hostile
takeover bid, but instead against a theoretical construct that the pill permits a “just
say never” defense. He argues that the marketplace, in the form of shareholder
pressure on the board of directors, has prevented the pill from being an absolute
bar to a takeover, and therefore the pill does not function as designed. As the
creator and principal proponent of the pill, I think it fair to say that the pill was
neither designed nor intended to be an absolute bar. It was always contemplated
that the possibility of a proxy fight to replace the board would result in the
board’s taking shareholder desires into account, but that the delay and uncertainty
as to the outcome of a proxy fight would give the board the negotiating position it
needs to achieve the best possible deal for all the shareholders, which in
appropriate cases could be the target’s continuing as an independent company.
The pill and the proxy contest have proved to yield the perfect balance, both
hoped for and intended, between an acquiror and a target. A board cannot say
“never,” but it can say “no” in order to obtain the best deal for its shareholders. If
Professor Gilson’s price for entente cordiale is a concession that a “design flaw”
in the pill forecloses it from being used to achieve the never-intended result of
enabling a board of directors to totally and permanently ignore the will of the
shareholders and “just say never,” the Gilson Theatre of the Twenty Years’ Pill
Wars can now be closed.
A new participant in the debate, Professor John Coates, recognizing that
Delaware would not embrace the Gilsonian views and would strike down the
bylaw Professor Gilson proposes, has advanced three bylaws that he believes
might stand a better chance to pass the test of legality in Delaware.57 Activist
shareholder groups are presently attempting to implement variations of the Coates
approach.58 Although discussion of the legality of these bylaws is outside the
scope of this article, there is a serious question of their validity, as even Professor

56
R. Gilson, Lipton & Rowe’s Apologia for Delaware: A Short Reply (Dec. 2001)
(unpublished manuscript, on file with author).
57
See Coates & Faris, supra note 7; cf. supra note 39.
58
See, e.g., Providence Capital, Inc. Press Release, Sept. 20, 2001, available at
http://providencecapitalnyc.com (announcing a seminar on a Director Nomination By-law
Amendment, in which board members would be disqualified from being renominated if they
fail to abide by precatory shareholder votes to eliminate poison pills). Note, however, that
these bylaws may not be legal. See L. Hamermesh, Corporate Democracy and Stockholder-
Adopted By-Laws: Taking Back the Street?, 73 Tul. L. Rev. 409, 437 & nn.121-124, 483 &
n.314 (1998) (asserting that bylaws addressing specific business decisions are invalid).
Hamermesh argues that the “statutes creating the general authority to adopt by-laws may not
be construed to permit stockholders to adopt by-laws directly limiting the managerial power
of the board of directors.” Id. at 419. He concludes that in the short term, investors will
continue to press forward with bylaw initiatives, but in the long term, state legislation will
likely be enacted to limit stockholders’ power to do so. Id. at 492.

16
Coates acknowledges — namely, that the bylaws are in essence conduct-
regulating rather than qualification bylaws.59
Professor Bebchuk, who in 1982 was an advocate of the “Rule of
Passivity,” modified to permit the target’s board to seek a white knight, now
accepts the poison pill and acknowledges the right of the board of directors to
deploy it in defense of a hostile takeover bid. However, he rejects the
fundamental premise of Delaware law and the Household case that if shareholders
are dissatisfied with the directors’ response to a takeover bid, their remedy is to
vote out the incumbent board and replace it with one that will redeem the pill and
sell the corporation to the raider or a white knight. Rather, his solution is to
change the law to provide that whenever a corporation becomes the target of a
hostile bid, the board must submit it to a shareholder referendum. He proposes
that if a majority of the outstanding shares vote in favor of the bid, the board must
remove the pill and all other structural takeover defenses.60
As originally proposed in 1982, and as approved in the Household
decision, the pill contemplated that a board of directors could not ignore the will
of the shareholders with respect to a takeover offer.61 The pill was structured so
that it would not interfere with the right of the shareholders to vote to replace the
board and would not impede a raider from instituting a proxy fight to replace the
board.62 Professor Bebchuk acknowledges in his current work that the fact that
the pill requires hostile bidders to prevail in a proxy contest — what he calls the
“critical consequence of the pill” — is indeed desirable.63 However, he wants it
in the form of a bidder-initiated referendum on the bid, and not on the
composition of the board, and at whatever time a bidder determines.64

59
See L. Hamermesh, supra note 58.
60
See Bebchuk & Farrell, supra note 1.
61
“When the Household Board of Directors is faced with a tender offer and a request to
redeem rights, they will not be able to arbitrarily reject the offer.” 500 A.2d at 1354.
62
See, e.g., Leonard Loventhal Account, 780 A.2d at 249 (“[A] rights plan would not have the
unauthorized effect of restricting stockholders’ rights to conduct a proxy contest.”) (citing
Household, 500 A.2d at 1355-56); see also In re Gaylord Corp. S’holders Litig., 753 A.2d
462, 470 (Del. Ch. 2000) (“[T]he fact that a company has a poison pill in place is less
significant because the proxy fight can operate as a substitute for a tender offer.”); Stahl v.
Apple Bancorp, Inc., Fed. Sec. L. Rep. (CCH) ¶ 95,412 (Del. Ch. Aug. 9, 1990).
63
L. Bebchuk & O. Hart, Takeover Bids vs. Proxy Fights in Contests for Corporate Control,
The Harvard John M. Olin Discussion Paper Series (first draft Feb. 1999; last revised Oct.
2001), available at http://www.law.harvard.edu/programs/olin_center, at 4.
64
Similarly, the European Commission’s Committee of Company Law Experts has concluded
that “a rule should be introduced, which allows the bidder to break-through mechanisms and
structures which may frustrate a bid, as defined in the articles of association and related
constitutional documents …. The threshold for exercising the break-through right should not
be set at a percentage higher than 75% of the risk-bearing capital of the company….” See
Report of the High Level Group of Company Law Experts on Issues Related to Takeover Bids,

17
 For the past year, proponents of Professor Bebchuk’s referendum proposal
have been citing the fourteen-month resistance by Willamette to a hostile takeover
bid by Weyerhaeuser as an example of abuse of the pill and staggered board
combination. Weyerhaeuser’s first bid was $48 per share, which it subsequently
unilaterally raised to $50 per share prior to commencing a proxy fight.
Willamette’s position was that Weyerhaeuser was attempting to acquire it at an
inadequate price that did not reflect its true value. Willamette continued to resist
after shareholders replaced a third of the board with nominees of Weyerhaeuser
committed to a sale of the company and after 64% of the shares were tendered to
the all-cash, all-shares offer.65 This gave the pill traducers their best argument —
that the combination allows a determined board to deny the will of the
shareholders not for one year, but for two. However, this argument evaporated
after Weyerhaeuser increased its offer from $50 per share to $55 per share and
finally to $55.50 per share, which the Willamette board finally accepted as being
in the best interests of its shareholders.66 The Weyerhaeuser-Willamette deal is
no less than a shining example of how a staggered board and poison pill operate
to the benefit of shareholders.67 The agreed-upon price of $55.50 represents a
______________________________________________________
at 7. However, in explaining their conclusion, the European Commission’s Committee of
Company Law Experts noted in a recent report that U.S. boards of directors are subject to
much greater pressure to maximize shareholder value than are their European counterparts.
See Report of the High Level Group of Company Law Experts on Issues Related to Takeover
Bids, Jan. 10, 2002, at 20, 21, 40. Among the factors cited in support of this proposition by
the Committee of Company Law Experts are the following: U.S. boards of directors are
judged by their performance in the capital markets; they are subject to pressure from
institutional investors; their behavior is painfully public due to disclosure rules and media
attention; they may be replaced in a successful proxy contest; and it is relatively easy for
shareholders to bring derivative suits against them. Id. at 40-41. Further, the Committee
argues that the existing U.S. anti-takeover measures arose largely in response to a potential
raider’s ability to bid for only a portion of a company’s outstanding shares; in Europe, a
bidder is required to offer to purchase all outstanding shares at an equitable price. Id. at 41.
65
See J. Carlton and R. Sidel, Willamette Agrees to Be Bought by Weyerhaeuser, Wall St. J.,
Jan. 22, 2002; see also S. Holmes, It’s Time for Willamette to Give In to Weyerhaeuser, Bus.
Week, Jan. 14, 2002, at 30.
66
See D. Hassler, Weyerhaeuser To Buy Willamette for $7.78 Billion in Cash, Debt,
Bloomberg News, Jan. 21, 2002; B. Virgin, Weyerhaeuser Finally Wins; Willamette Gives In,
Agrees To Be Bought by Rival for $55.50 a Share, Seattle Post-Intelligencer, Jan. 2, 2002, at
A1 (including a timeline of events in Weyerhaeuser’s bid for Willamette).
67
BTR Corporation’s 1990 acquisition of Norton Corporation provides another illustration
that a staggered board affords a board of directors the leverage and time it may need in order
to negotiate effectively with a potential acquiror. In BTR-Norton, shortly before the annual
meeting of Norton at which BTR’s nominees were up for election, Governor Dukakis signed
a bill amending the Massachusetts corporation law to mandate that all Massachusetts
corporations have a staggered board unless the board determines otherwise. Due to this
timely intervention, the Norton board was able to negotiate an additional $15 per share for its
shareholders.

18
16% increase over Weyerhaeuser’s initial bid, and an 11% increase in deal value
even after the conclusion of the first proxy fight. Those who would credit
shareholder choice for the outcome overlook the fact that in the absence of the
staggered board and poison pill, Willamette shareholders would have “chosen”
$48 per share before they ever had the opportunity to receive $55.50.68
Willamette is typical of the experience of the past twenty years, during
which very few companies have remained independent after a tender offer
combined with a proxy fight to replace the board. The largely theoretical
possibility of continued resistance after loss of a proxy fight that worries
Professor Bebchuk and his followers does not in any way warrant a change in
basic corporate law, which has long permitted shareholders to enjoy a staggered-
board charter that protects against changes in management predicated on short-
term events.69 There are strong policy reasons to assure that management has
sufficient time to demonstrate the validity of its strategic plan — indeed, I have
argued that this period should be five years, with a referendum on the
management’s performance and the possibility of a hostile takeover only at the
quinquennial election.70
There have been a number of instances in which an unsolicited bid has
been coupled with a proxy fight to remove the target’s board and replace it with a
board committed to redeeming the target’s pill.71 In some cases, the target was
acquired by the original bidder, and in others, the target sought a white knight and
was acquired at a higher price than that offered by the raider that initiated the
68
Fifty-one percent of the outstanding shares had been tendered into Weyerhaeuser’s $48-per
share offer as of the February 2, 2001 expiration date. See Weyerhaeuser Extends an Offer,
N.Y. Times, Feb. 2, 2001, at C14.
69
Of the 5,000-plus U.S. public companies that responded to the 2001-2002 NACD Public
Company Governance Survey, 57% have a classified board. See National Association of
Corporate Directors, 2001-2002 NACD Public Company Governance Survey, Nov. 2001, at
14. Further, the survey reveals that “[n]early three-quarters of the initial public offering
companies tracked in 2001 had classified boards.” Id. Also, the pill has been adopted by
thousands of public companies and has become an essential, commonplace element of the
fabric of corporate governance, with no adverse impact on share prices or merger activity.
Academic prescriptions for change would upset widespread and settled expectations and
practices, and therefore should carry a particularly heavy burden of persuasion.
70
See Lipton & Rosenblum, supra note 12.
71
The poison pill has decisively shifted the battle for corporate control from the arena of the
coercive tender offer to that of the proxy contest. When confronted with a poison pill, a
hostile suitor may be forced to make its case by means of a proxy solicitation if it wishes to
persuade target shareholders that it is truly in their best interests to accept the offer. Two
well-known examples are Georgia-Pacific Corporation’s 1989 battle to acquire Great
Northern Nekoosa Corporation and AT&T’s 1990 fight to acquire NCR. In each case, the
target board resisted a takeover, the acquiror commenced or announced the intention to
commence a proxy contest, and the merger ultimately was consummated at a significantly
higher price per share than that initially offered by the acquiror.

19
process. In very few instances has a target with a staggered board suffered a first-
round loss — had a third of the board replaced with the raider’s nominees — and
continued to refuse to surrender its independence. In all other cases, after a first-
round loss, or even before, when it became clear that the shareholders would vote
to replace a third of the board, the target negotiated a deal. In light of this
experience, there does not appear to be any compelling need to change the law to
mandate a shareholder referendum whenever a raider demands it.
By contrast, Professor Bebchuk’s proposal carries with it significant
dangers. As a practical matter, his proposal, like Professor Gilson’s and like the
1981 Rule of Passivity proposal, would put a “For Sale” sign on all public
corporations. Though the difference between a bid-and-referendum and a bid-
and-proxy fight may be seen as one of degree, a referendum would create the
critical problem of an open invitation for unsolicited bids. The acquiror would
have the assurance of a vote on the bid, with little chance for the target to do
anything other than declare an auction. Further, the costs of operating as if it
were always for sale would be highly detrimental to a company. In general, a
company that becomes the target of an unsolicited takeover bid must institute a
series of costly programs to protect its business during the period of uncertainty as
to the outcome of the bid. To retain key employees, in the face of the usual rush
of headhunters seeking to steal away the best employees, expensive bonus and
incentive plans are put in place. To placate concerned customers and suppliers,
special price and order concessions are granted. Communities postpone or
reconsider incentives to retain facilities or obtain new facilities. The company
itself postpones major capital expenditures and new strategic initiatives.
Creditors delay commitments and seek protection for outstanding loans. All of
this imposes enormous costs on the target, which are not recovered no matter
what the outcome of the takeover bid; if the bidder is successful, the bidder and its
shareholders bear these costs; if the target remains independent, the target and its
shareholders bear them. The poison pill alleviates some, but not all, of these
concerns and related costs. To change the law to remove the protections of the
pill and not protect the target against these costs is unthinkable.
Professor Bebchuk’s attempt to draw support from the decision of the EU
to adopt a referendum-type regulation of unsolicited takeover bids is not well-
founded. The EU specifically recognizes that its approach is based on a
dramatically different set of economic conditions from those in the U.S.72
Further, the EU approach parallels closely the “no frustration” of bids approach of
the U.K. Takeover Panel. There is no evidence that corporate performance and
corporate governance in the U.K. is superior to that in the U.S. Indeed, it is
universally recognized that that is not the case.73

72
See supra note 64.
73
The Committee of Company Law Experts recognizes that it is in effect hanging a “For
Sale” sign on all EU public companies and that EU takeover rules will be virtually the
opposite of those in the U.S. The Committee believes that, at this stage of the EU markets

20
 Professor Bebchuk’s proposal also raises fundamental issues of
inconsistency with the existing corporate law allocation of responsibility between
the shareholders and the board of directors. Professor Bebchuk would permit
either a takeover bid combined with a referendum or a merger proposal that
bypasses the target’s board and is submitted directly to the target’s shareholders.
He would permit both cash and securities to be offered. No new financial,
economic or jurisprudential reason is advanced to support this radical change in
the law. As matters now stand, it is an essential part of the statutory framework of
Delaware law and of most, if not all, of the other states that both the directors and
shareholders agree to a sale of the company before it can occur.74 In short,
Delaware law requires that the board make a considered determination of the
fairness of a bid before referring to shareholders the question of whether to keep
the pill or other takeover protections in place. Under the Delaware statute, there
is no contemplation of a control change unapproved by a board of directors. The
“shareholder choice” provided by the statute is the right to choose representatives
periodically, not the right of perpetual self-governance through instant polls or
plebiscites. Directors have a duty to insure that the shareholders get a fair price,
and “shareholder choice” independent of the board is not part of the law of
mergers and acquisitions. The shareholders’ right is to elect or replace the board
of directors or to accept or reject a board recommendation.
As the law now stands, when faced with a takeover bid, a board has the
duty to determine whether such bid is at a fair price and in the shareholders’ best
interests.75 This is not a burden to be taken lightly. Under Unocal76 and
Unitrin,77 a board of directors may not merely “assert” that the underlying long-
term value of the corporation exceeds the bid on the table;78 in the two cases in
which a “just say no” defense was actually tried in court, the directors were
required to show, through detailed presentations and expert testimony, that their
position was reasonable and based on appropriate information.79 If a board either
______________________________________________________
and company consolidation, its recommendations — not the U.S. approach — are what is
right for the EU. There is no doubt that, when the EU rules go into effect, there will be a
significant increase in EU takeover activity. See Report of the High Level Group of Company
Law Experts on Issues Related to Takeover Bids, supra note 65, at 38-44.
74
Except for a “short-form merger” involving a 90% owned subsidiary. See Del. Gen. Corp.
L. § 253.
75
See Trans Union, 488 A.2d 858.
76
493 A.2d 946.
77
Unitrin v. American General Corp., 651 A.2d 1361 (Del. 1995).
78
Professor Gilson appears to misunderstand the substantive nature of the directors’ duty to
consider a takeover bid. See Gilson, supra note 6, at 13-14.
79
See Amanda Acquisition Corp. v. Universal Foods Corp., 877 F.2d 496 (7th Cir. 1989);
Moore v. Wallace, 907 F. Supp. 1545 (D. Del. 1995).

21
does not believe the takeover bid to be in the best interests of the shareholders, or
is unable to make such a decision, it may not, consistent with its fiduciary duty
under Trans Union,80 Household81 and Quickturn/Mentor Graphics,82 redeem the
pill to permit the bid to go forward. It is inconsistent with existing Delaware law
for a board, absent a board decision that the bid is fair, to delegate to shareholders
in a referendum the fiduciary decision of whether to keep the pill or other
takeover protections in place.
There is simply no reason to take the diametric turn in the law urged by
Professor Bebchuk. And even if there were, Professor Bebchuk drastically
underestimates the number and complexity of the conditions that would need to
be applicable to such a referendum in order to protect the corporation and its
shareholders from abusive bids. First, there would have to be assurance that the
purpose of the bid is to acquire the target rather than to put it in play to profit from
a topping bid. This could be accomplished by requiring that the bid represent a
premium over the current market price equal to not less than the average of recent
comparable acquisition premiums as set forth in an opinion of a recognized
financial advisor. Here there would also be two subsidiary issues: Should the
target be able to dispute the premium analysis, and should the referendum be
denied to a bidder that has acquired more than 1% of the outstanding shares of the
target within the twelve months prior to the bid?
Second, the bid could not be overly conditional. Here the principal
question is the degree of material adverse change that would warrant the bidder’s
terminating the bid and walking away. This is a matter that has recently been
contested in connection with negotiated takeovers.83 To protect the target and its
shareholders, the adverse change condition would have to be triggered only for
truly material, unforeseen events that have a long-term impact and that are
company-specific as distinguished from industry-wide or macroeconomic
events.84

80
488 A.2d 858.
81
500 A.2d 1346.
82
Quickturn Design Sys., Inc. v. Shapiro, 721 A.2d 1281 (Del. 1998); Mentor Graphics Corp.
v. Quickturn Design Sys., Inc., 2001 WL 1018749 (Del. Ch. Aug. 16, 2001).
83
Two of the most highly publicized transactions of 2001 include Tyson Foods’ acquisition
of IBP, see, e.g., H. Henryson, ‘IBP v. Tyson’ Teaches Valuable Lessons, N.Y.L.J., July 26,
2001, at 1, and WPP Group’s acquisition of Tempus Group, see, e.g., J. Eaglesham, Ruling
Sets High Hurdle for ‘MAC Clauses’: The Takeover Panel Has Left Little Room for
Maneuver, Fin. Times (London), Nov. 7, 2001, at 24. Both Tyson and WPP tried to walk
away from their deals on the basis of material adverse change conditions in the merger
agreements. In each case, a court ruled that the intervening events cited by the acquiror did
not constitute sufficient justification for terminating the merger agreement and ordered that
the merger be consummated.
84
Indeed, after the Tyson case, more attention than ever is being paid to material adverse
condition provisions in merger agreements. “What might have been boilerplate before may

22
 Third, the obviously necessary condition that the bidder obtain regulatory
approval raises another difficult issue: How far should the bidder have to go to
obtain regulatory approval, and how much time should be allowed for it to do so?
Since the bidder initiates a unilateral process that it knows will be very disruptive
and costly to the target, the bidder would have to be required to use its best
efforts, including agreeing to any divestitures, business restrictions or
expenditures that are necessary to obtain regulatory approval. If it failed to do so,
the bidder would be obligated to the target for liquidated damages in an amount
equal to a percentage of the offer price sufficient to compensate for the damages
caused by the disruption.85 This could, for example, equal five percent of the
aggregate bid. If the time period during which regulatory approval is being
sought is more than six months, and thereafter the raider fails to get the approval,
the liquidated damages could be increased by, say, one percent per month to
compensate for the greater damage inflicted on the target by the longer period of
disruption from uncertainty as to the future of the target. Even with further
compensation, it would be necessary to specify a final expiration date that could
not be greater than, say, nine months. A related issue is the limitation on the
bidder’s ability to negotiate with regulators, who would be aware of the strictures
imposed by the statutory referendum procedure.
A fourth set of issues involves the proposed consideration. Where all or
part of the bid consideration is cash, the bidder would be required to furnish
assurance that it has the cash on hand or a loan commitment from a major
financial institution that is not qualified by a material adverse change condition
that is different from the material adverse change condition in the bid.
______________________________________________________
now be a point of negotiations.” J. Seiberg, A Legal Beef, Tyson’s Big MAC Attack on IBP
Reshaped M&A Law, The Daily Deal, Jan. 18, 2002, at 15 (quoting L. Hamermesh).
85
The ill-fated attempt by General Electric Co. to acquire Honeywell International Inc. in
2001 is a situation that received a great deal of attention in which the failure to obtain
required regulatory approvals doomed a merger. GE made an unsolicited $55 per share
proposal to Honeywell while the Honeywell board of directors was concluding a special
meeting called to approve an extensively negotiated merger with United Technologies at $50
per share. See, e.g., N. Anthony, Honeywell’s Path to Deal Now Subject to Question, Star
Trib. (Minn.), Oct. 29, 2000, at 1D. The GE merger agreement was signed within two days of
the proposal’s having been made. But though the U.S. Department of Justice would have
permitted the merger, the European Competition Commission rejected GE’s divestiture
proposal as insufficient, and the parties ultimately canceled their merger agreement. See, e.g.,
N. Stoll & S. Goldfein, A Tale of Two Regulators, N.Y.L.J., July 17, 2001, at 3. Upon
termination of the merger agreement, GE agreed to pay Honeywell $100 million to cover
expenses related to the merger. See Honeywell International; Merger with GE Off, Appliance
Mfr., Nov. 1, 2001, at 18. However, on October 2, 2001, the day that GE and Honeywell
announced the termination of their merger agreement, Honeywell stock closed at $38.05 per
share, 30% lower than the $55 per share value of the GE deal and a total of more than $13
billion lower than the GE bid, and more than $9 billion lower than the United Technologies
bid.

23
 Where all or part of the bid consideration is securities, the bidder would be
required to make the bid through a registered securities dealer. The securities
dealer would have “underwriter” liability under Section 11 of the Securities Act
and would be expected to perform customary due diligence. Underwriter’s
liability and due diligence are not perfect safeguards, but they represent the
minimum protection that should be afforded to the target’s shareholders against
the pitfalls of Professor Bebchuk’s argument that the market effectively
determines the value of the bid to the target’s shareholders, who need only
compare the pre-bid share price and the value of the bid.86 After all, in almost
every case, it would be impossible for all the target’s shareholders to convert all
the securities received in the bid into cash at the price on the day the tender offer
is consummated. Moreover, shareholders lack information that careful due
diligence might reveal; a year ago, for example, Enron stock providing a 20% or
better premium would have been considered a “great deal” by the shareholders of
most target companies.87
Bidders and the banks that finance and advise them will undoubtedly have
trouble with these protections for the target and its shareholders. The difficulty of
achieving an appropriate balance between the interests of a bidder and those of
the target and its shareholders in designing such a bid and referendum structure
illustrates that mergers, acquisitions, takeovers and proxy fights and the legal
rules applicable to them are complex, with many interdependent variables. That
is why, instead of a system of inflexible statutory rules, we have developed a
system of negotiation — with the target board and the bidder as the primary
negotiating counterparties. It is important to preserve the board’s role as the best
negotiator on behalf of the shareholders and not leap headlong into a new regime
that has the potential to be seriously disruptive to business and the economy. But
to be an effective negotiator — and the record shows that, on balance, boards
have been88 — the board needs the fundamental power of any successful
negotiator: the ability to “just say no” and walk away. The poison pill provides
that power, which is why the pill is legal and why it enables directors to do their
job effectively.
* * *
It was to protect against tender offers structured by raiders with terms that
were inimical to the interests of shareholders, or which under certain
circumstances would become inimical to shareholders, that I developed the poison
pill. I put that tool in the hands of the board of directors as the only corporate

86
See Bebchuk & Hart, supra note 63.
87
A comprehensive summary of Enron’s dramatic collapse is set forth in A Chronology of
Enron’s Recent Woes, Wall St. J., Jan. 16, 2002.
88
See Georgeson Study, supra note 52.

24
organ that could act to protect both the corporation and the shareholders, with
those actions subject to the power of a court to ensure that they met the business
judgment rule test. As the foregoing discussion of the type of conditions that
would be necessary to protect targets and their shareholders in a referendum
regime demonstrates, the shareholders would be at a serious disadvantage if they
did not have such statutory conditions or the board to negotiate terms on their
behalf.
As the pill approaches its twentieth birthday, it is under attack from three
groups of professors, each advocating a different form of shareholder poll, but
each intended to eviscerate the protections afforded by the pill. The Gilsonians
urge the shareholders to approve a bylaw amendment invalidating the pill; the
Coatesites would have the shareholders amend bylaws to accomplish the
equivalent of invalidating the pill; and the Bebchukers would preserve the pill just
long enough for the shareholders to invalidate it in a concurrent tender offer and
referendum. Upon reflection, I think it fair to conclude that the three schools of
academic opponents of the pill are not really opposed to the idea that the
staggered board of the target of a hostile takeover bid may use the pill to “just say
no.” Rather, their fundamental disagreement is with the theoretical possibility
that the pill may enable a staggered board to “just say never.” However, as the
recent Willamette situation and almost every other in which a takeover bid was
combined with a proxy fight show, the incidence of a target’s actually saying
“never” is so rare as not to be a real-world problem. While each of these
professors’ attempts to undermine the protections of the pill is argued with force
and considerable logic, none of their arguments comes close to overcoming the
cardinal rule of public policy — particularly applicable to corporate law and
corporate finance — “If it ain’t broke, don’t fix it.”

25
 June 17, 2003

The Business Judgment Rule is Alive and Well

Two widely reported recent cases from influential courts have refocused attention
on the question of whether an independent director who is not alleged to have engaged in self-
dealing may face personal liability because of his failure to prevent harm to the corporation. Walt
Disney Co. Derivative Litigation, No. 15452 (Del. Ch. May 28, 2003);Abbott Laboratories
Derivative Litigation, 325 F.3d 795 (7th Cir. Mar. 28, 2003). In fact, while these two decisions are
examples of the heightened scrutiny that all board conduct is subject to in the post-Enron climate,
the fundamental principles governing independent director liability have not changed. Each of
these cases involve allegations that the directors failed to engage even in normal everyday levels of
deliberation and decision-making, and there is no reason to think that directors who do use
common sense and appropriate diligence are any more exposed to personal liability today than
previously. The Business Judgment Rule is alive and well.
In shareholder litigation arising out of Disney’s $140 million severance payment to
its former President, Michael Ovitz, the Delaware Court of Chancery addressed allegations that
Disney’s outside directors first failed to obtain basic information about the Ovitz contract (i.e., its
potential cost in the event of termination), and then, after the directors knew Ovitz was leaving,
allowed Eisner, who was alleged to be Ovitz’ long-time personal friend, to single-handedly arrange
for Ovitz to receive termination benefits beyond those he was entitled to.
The Court found simply that these allegations, if proved, stated a claim on which
plaintiffs could recover. The complaint described a company where board process on this issue
had completely broken down, in that the Disney directors did not “exercise any business judgment
or make any good faith attempt to fulfill the[ir] fiduciary duties.” The Court noted that “[i]f the
board had taken the time or effort to review [the company’s] options [with respect to Ovitz’
termination], perhaps with the assistance of expert legal advisors, the business judgment rule might
well protect its decision.” The problem at Disney was that there was (at least as alleged) simply no
process, no inquiry and no decision.
[T]he facts alleged in the new complaint suggest that the defendant directors
consciously and intentionally disregarded their responsibilities, adopting a “we
don’t care about the risks” attitude concerning a material corporate decision. . .
.[T]he alleged facts, if true, imply that the defendant directors knew that they were
making material decisions without adequate information and without adequate
deliberation, and that they simply did not care if the decisions caused the
corporation and its stockholders to suffer injury to loss.
In the Abbott opinion, the Seventh Circuit dealt with allegations that the
independent directors on the board of Abbott stood by and did nothing during a six year period in
which the FDA repeatedly served notice of safety violations at one of Abbott’s major divisions.
The Seventh Circuit found that shareholder plaintiffs stated a claim by alleging “that the board
knew of the problems and decided no action was required.” The key to the Court’s decision was
its view that the allegations, if proved, showed that the directors failed to act “in conscious
disregard of a known risk” and that a “systematic failure of the board to exercise oversight” had
occurred:

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 We find that six years of noncompliance, inspections, [FDA] warning
letters, and notice in the press, all of which then resulted in the largest civil fine
ever imposed by the FDA and the destruction and suspension of products which
accounted for approximately $250 million in corporate assets, indicate that the
directors’ decisions to not act were not made in good faith. . .
The lessons of Disney and Abbott are plain, but they do not include a change in the
legal standards governing director conduct. In both cases, the courts were required by the
procedural posture of the case to assume all of the plaintiffs’ allegations would be proved at trial.
And both cases do indicate that what might in the past have been characterized as a breach of the
duty of care may now be considered a breach of the duty of good faith, with potential negative
consequences for indemnity and insurance. But the following bed-rock principles remain true:
–– Independent board members remain fully protected by the business
judgment rule when they make corporate decisions with the exercise of due care. Due care
means that directors have acted to assure themselves that they have the information required to
take, or refrain from taking, action; that they devote sufficient time to the consideration of such
information; and that they obtain, where useful, advice from experts and counsel. Neither Disney
nor Abbott suggests that the advisors usually employed to assist the board need to be supplemented
with new ones simply because the board is reviewing conduct of the company’s senior
management. Nor is there any implication that a special committee of independent directors is
necessary, or for that matter even desirable, where there is no conflict involved.
–– Neither Disney, Abbott or any other decision imposes liability on directors
who were unaware of issues which subsequently resulted in losses. Both cases involve clearly
apparent “red flags” and problems that were reported in the media..
–– Neither case contemplates director liability where a well-functioning
oversight function was in place. In Abbott, the Court inferred that after six years of repeated
notices of regulatory non-compliance, the board should have concluded that internal controls were
insufficient.
–– Cases like Disney and Abbott highlight the importance of the board-level
record of events. Minutes that accurately convey the time and effort directors devote to decision-
making, even where the outcome is to take no action, are essential to responding to claims that the
board has not been doing its duty.
In sum, there is no doubt that the courts are applying a high level of scrutiny to
allegations of board misconduct, including failure to exercise oversight where there was clear
indication of need for it. But the courts also continue to recognize that, if large public
companies are to attract experienced persons who will not be petrified into excessive risk-
aversion by the possibility of personal liability, independent directors must be given
adequate judicial protection for their decisions where the record shows that they took the
time to deliberate and to exercise oversight.

Martin Lipton
Paul K. Rowe

-2-
 January 19, 2004

Some Thoughts for Boards of Directors

The attached paper reflects advice I have been giving to directors and boards
concerned about a growing overemphasis on process as a result of the post-Enron reforms
embodied in Sarbanes-Oxley, new SEC regulations and new stock exchange rules. Compliance
with the new regulations and rules is not that difficult. Process should not, and need not,
overwhelm attention to the business of the company, and the new regulations and rules should
not, and need not, deter the CEO and the directors from pursuing entrepreneurial opportunities.
The business judgment rule is alive and well. The primary focus should be on performance of
the business and maximizing shareholder value, not on process.

Martin Lipton

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W/806558v1
 August 10, 2005

Delaware Chancellor's Opinion in the Disney/Ovitz Case

Confirms that the Business Judgment Rule is Alive and Well

Yesterday’s decision in the Disney/Ovitz case is an important, and welcome,

reaffirmation of fundamental concepts underlying our corporate law. Delaware Chancellor
Chandler found that the Disney directors did not breach their fiduciary duties in the 1995 hiring
and 1996 termination of Michael Ovitz. The opinion focused carefully on the core question of
whether the directors had acted in good faith in what they believed to be the corporation’s best
interests. The opinion illustrates that no special legal duties or enhanced judicial scrutiny are
attached to often difficult and sensitive decisions about executive compensation, hiring and
severance – either on the part of the officers and directors charged with responsibility for making
these decisions, or the incoming or departing executives themselves.

Importantly, the decision means that the current emphasis on improved

governance practices will not boomerang into new bases of personal liability for officers and
directors by seeping into, and distorting, long-standing fiduciary duty requirements. The
Business Judgment Rule is alive and well. The Chancellor forcefully stated that aspirational
“best practices” are not synonymous with legal requirements that result in liability, and that the
protection from liability accorded directors who act honestly is essential to maximizing
shareholder and societal value:

“Unlike ideals of corporate governance, a fiduciary’s duties do not

change over time. How we understand those duties may evolve and become
refined, but the duties themselves have not changed, except to the extent that
fulfilling a fiduciary duty requires obedience to other positive law. This
Court strongly encourages directors and officers to employ best practices, as
those practices are understood at the time a corporate decision is taken. But
Delaware law does not—indeed, the common law cannot—hold fiduciaries
liable for a failure to comply with the aspirational ideal of best practices. . . .

Fiduciaries are held by the common law to a high standard in

fulfilling their stewardship over the assets of others, a standard that
(depending on the circumstances) may not be the same as that contemplated
by ideal corporate governance. Yet therein lies perhaps the greatest strength
of Delaware’s corporation law. Fiduciaries who act faithfully and honestly
on behalf of those whose interest they represent are indeed granted wide
latitude in their efforts to maximize shareholders’ investment. Times may
change, but fiduciary duties do not. Indeed, other institutions may develop,
pronounce and urge adherence to ideals of corporate best practices. But the
development of aspirational ideals, however worthy as goals for human
behavior, should not work to distort the legal requirements by which human
behavior is actually measured. Nor should the common law of fiduciary
duties become a prisoner of narrow definitions or formulaic expressions. . . .

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W/952341v1
 Even where decision-makers act as faithful servants, however, their
ability and the wisdom of their judgments will vary. The redress for failures
that arise from faithful management must come from the markets, through
the action of shareholders and the free flow of capital, and not from this
Court. Should the Court apportion liability based on the ultimate outcome of
decisions taken in good faith by faithful directors or officers, those decision-
makers would necessarily take decisions that minimize risk, not maximize
value. The entire advantage of the risk-taking, innovative, wealth-creating
engine that is the Delaware corporation would cease to exist, with disastrous
results for shareholders and society alike. That is why, under our corporate
law, corporate decision-makers are held strictly to their fiduciary duties, but
within the boundaries of those duties are free to act as their judgment and
abilities dictate, free of post hoc penalties from a reviewing court using
perfect hindsight. Corporate decisions are made, risks are taken, the results
become apparent, capital flows accordingly, and shareholder value is
increased. ”

M. Lipton
T.N. Mirvis
P.K. Rowe

-2-
 December 1, 2005
Key Issues for Directors
The following is an updated list of key issues for directors:
1. Anticipating attacks by activist hedge funds seeking strategy changes by the company to boost the
price of the stock, and developing business, financial and legal strategies to avoid or counter them.
2. Recognizing the explosive nature of the executive compensation question, developing specially tai-
lored executive compensation programs to minimize criticism, properly documenting the discussions
and decisions of the compensation committee, and disclosing fully all elements of the compensation.
At the same time, cutting through the public and political gadflies’ criticism of executive compensa-
tion to enable the company to attract and retain the best available executives and reward outstanding
performance.
3. Understanding that Sarbanes-Oxley and other post-Enron reforms should not cause the board to
overreact to the new requirements and procedures by concentrating on process and compliance to the
exclusion of the fundamental function of the board to advise on strategy and to monitor performance.
The decision in the Disney case revitalized the business judgment rule and alleviates the concern
raised by the Enron and WorldCom settlements that the post-Enron reforms would create new crite-
ria for director liability.
4. Developing and following due diligence procedures designed to establish the due diligence defense
to personal liability claims predicated on misstatements or omissions in SEC filings. It was weak-
ness of their due diligence defense that led to the personal liability settlements by the Enron and
WorldCom directors.
5. Striking the right balance in responding to shareholder corporate governance initiatives, accepting
those that do not interfere with management of the business and rejecting those that limit the power
of the CEO and the board. Majority voting, which has received very significant shareholder support,
is an example of a proposal that should be accommodated. Limits on executive compensation and
splitting the role of Chairman and CEO are examples of proposals that should be resisted. The effort
being led by some academics to impose management by referendum must be resisted, if the corpo-
rate system as we know it is to be preserved.
6. Regularly reviewing that the CEO and senior management are setting “tone at top” that stresses pro-
fessionalism, integrity, transparency, legal compliance and high ethical standards.
7. Creating the appropriate relationships between the board as a whole and the audit, compensation and
nominating-governance committees so that the work of the committees is not duplicated by the
board, but the significant actions of the committees are understood by the board as a whole and are
integrated into the overall work of the board.
8. Resisting the trend to having the audit committee or a special committee of independent directors
investigate almost all whistle-blower complaints, recognizing how disruptive such investigations are,
and being judicious in deciding what really warrants investigation. When an investigation is war-
ranted, resorting to outside advisors only when there is a real conflict or real need for special exper-
tise, and continuing to obtain professional advice from the company’s officers and regular advisers.
Martin Lipton
W/983602v1
 June 12, 2006

Delaware Supreme Court Affirms Disney Case:

the Business Judgment Rule Prevails

In a unanimous and masterful decision, the Delaware Supreme Court has affirmed
the Court of Chancery’s rejection of all the stockholder claims challenging the conduct of the
Disney directors in the 1995 hiring and 1996 termination of Michael Ovitz (see our
memorandum of August 10, 2005).

Justice Jacobs’ opinion for the Court is a welcome demonstration that the
Delaware courts remain unrattled by the on-going corporate governance debate on executive
compensation, succession planning and severance. The opinion hews to settled and fundamental
doctrine, and powerfully depicts how little the stockholders’ challenges implicated any legal
nuances but, rather, failed because under the Business Judgment Rule director decision-making
is protected from second guessing by the presumption that the directors acted on an informed
basis and in good faith — a presumption that can be overcome only by a factual showing that
the directors breached their duties of care and loyalty or acted in bad faith. The opinion is
welcome reassurance that the drumbeat of the stockholder activist and academia attacks will not
change the fundamental protections that Delaware has always accorded director business
decisions.

On the question of the directors’ “duty of good faith,” the Supreme Court rejected
the argument that decision-making without adequate information and deliberation amounts to
bad faith. Contrawise, the Court explained that “bad faith” could result from two different forms
of behavior: activities motivated by an actual intent to do harm (“substantive bad faith”); or
“intentional dereliction of duty, a conscious disregard for one’s responsibilities.” Importantly,
the Court emphasized that gross negligence, even including failure to inform one’s self of
material facts, cannot constitute bad faith. The Court’s discussion of the “duty of good faith”
signals an effort to limit that concept, and prevent its wholesale employment as the key to unlock
the long-standing protections afforded directors under Delaware law.

The Delaware Supreme Court’s opinion closes a potentially worrisome chapter in

the ongoing development of fiduciary duty law with a note that should be comforting to those
concerned about the potential spill-over of the oft-rancorous corporate governance debates into
the realm of legal rule and liability standards: that the Delaware courts remain steadfast in
drawing the necessary distinctions between “best practices” and liability-producing behavior,
and in eschewing what may sometimes seem the popular fix in favor of the well-tested legal
doctrines that have encouraged risk-taking and creation of stockholder value. The opinion
likewise reflects that the Delaware courts recognize the reality that the corporate boardroom is at
times not a perfect laboratory or even a law school classroom.

M. Lipton
T.N. Mirvis
P.K. Rowe

If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1429.
W/1040126
 June 28, 2007

Directors Face-to-Face Meetings with

Institutional Investors on Corporate Governance Policies and Practices

While corporate governance activists are applauding today’s announcement by

Pfizer “that members of its Boards of Directors will invite its largest institutional shareholders to
a meeting where they will have an opportunity to provide comments and perspective on the
company’s governance policies and practices including executive compensation,” this is another
example of corporate governance run amuck. Since 2002 there has been a steady escalation of
demands by corporate governance activists to increase shareholder power over the business
decisions of boards of directors. With academic support from Prof. Lucian Bebchuk of the
Harvard Law School, activists are seeking to impose prospective and retrospective referenda on
basic decisions by boards of directors.

There is no justification for revolutionizing corporate law and corporate practices

so that shareholders replace directors as the fundamental arbiters of corporate policy. Basic
corporate law and corporate practices, as they have developed and evolved over the past 50
years, is the only proven vehicle for organizing and deploying capital on the large and dynamic
scale of the modern United States economy. It should not be overturned by desperate attempts to
appease deconstructionist activists.

Martin Lipton

If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1487.
W/1151976v1
 May 12, 2009

A Crisis Is a Terrible Thing to Waste:

The Proposed “Shareholder Bill of Rights Act of 2009” Is a Serious Mistake
By Martin Lipton, Jay W. Lorsch and Theodore N. Mirvis 1

A few weeks ago, Senator Schumer announced his intention to introduce the
Shareholder Bill of Rights Act of 2009. The central stated goal of the Act — “to prioritize the
long-term health of firms and their shareholders” and create “more long-term stability and
profitability within the corporations that are so vital to the health, well-being, and prosperity of
the American people and our economy” — is commendable. That goal represents a significant
break from the agendas of many self-proclaimed governance experts who, in actuality, have
sometimes hijacked the banner of “good governance” to amp up stockholder power in a
campaign to press Corporate America away from attention to and investment in the long term.

Short-termism is a disease that infects American business and distorts

management and boardroom judgment. But it does not originate in the boardroom. It is bred in
the trading rooms of the hedge funds and professional institutional investment managers who
control more than 75% of the shares of most major companies. Short-termist pressure bred by
stockholder power demanded unsustainable ever-increasing (quarterly) earnings growth, possible
only via the shortcut of over-leverage and reduced investment, and the dangerous route of
excessive risk. Stability and financial strength to weather economic cycles were sacrificed for
immediate satisfaction. That short-termist pressure, in the view of many observers, contributed
significantly to the financial and economic crises we face today.

Thus, the legislation’s purpose — to restore the long-term stability of the firm as
the ultimate goal of corporate governance — is a salutary and important guidepost.

But the suggested provisions of the Act threaten to encourage the opposite of its
stated goal. The Act proposes to enhance stockholder power and thereby would fuel the very
stockholder-generated short-termist pressure that, in the view of many observers, contributed
significantly to the financial and economic crises we face today. The Act would implement, by
federal mandate, a series of yet further empowerments of stockholders: it would require annual
stockholder advisory votes on executive compensation, facilitate a federal requirement that
stockholders be granted access to every corporation’s proxy to nominate their own candidates to
boards of directors, end staggered boards at all companies, require that all directors receive a
majority of votes cast to be elected, and order that all public companies split the CEO and board
chair positions.

1
Jay W. Lorsch is the Louis E. Kirstein Professor of Human Relations at the Harvard Business School.
Martin Lipton and Theodore N. Mirvis are partners at the New York law firm of Wachtell, Lipton, Rosen
& Katz.

If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1476.
W/1409786
 Increased stockholder power is directly responsible for the short-termist fixation
that led to the current crises. The bulk of the specific provisions suggested would increase
stockholder power. Stockholder power has already substantially increased over the last twenty
years. Concomitantly, our stock markets have become ever-increasingly institutionalized. The
undeniable fact is that the true “investors” are now professional money managers who are
inherently short-term (even quarterly) focused. That “stockholder” pressure pushed companies
to generate high financial returns at levels that were not sustainable, with management’s
compensation being tied to producing such returns (at stockholder urging). The increase in
stockholder power and stockholder pressure to produce unrealistic profits fueled the pressure to
take on increased risk. As the government arguably relaxed regulatory checks on excessive risk
taking (or, at minimum, did not respond with increased prudential regulation), the increased
stockholder power and pressure for ever higher returns contributed significantly to the current
financial and economic crises. That pressure became all the more irresistible as it combined with
increased stockholder power to oust or discipline managers and directors — power available to
enforce the stockholder and activist investor agenda of ever higher short-term returns.

Furthermore, substantial concerns arise as to whether it is sound to seek to address

corporate governance at the federal level in a “one size fits all” mandate, and whether the
subjects proposed to be addressed in the Act would, in fact, advance or detract from the goal of
re-establishing the long-term outlook necessary for sustained economic health and growth. In
particular, the Act raises significant issues for all constituencies concerned with realigning
proper corporate governance to facilitate long-term focus and avoiding counterproductive federal
intrusion into corporate law traditionally reserved for the states.

1. The corporate governance subjects proposed to be addressed by the Act

have traditionally been the province of state law. That model allows for the exploration of a
variety of mechanisms, careful evolution, and the development of considerable state legislative
and judicial expertise. It is not apparent that replacement of the Brandeisian state “laboratories”
with federally mandated rules is sound. Indeed, it seems fair to say that moving corporate
governance issues like executive compensation onto the national legislative agenda has not
produced thoughtful consideration, but rather has promoted divisive and counterproductive
controversy.

2. Beyond that, the federal mandate suggested by the Act is a “one size fits
all” fiat that does not respond to the differing needs of different firms or industries. One model
of governance for all companies is no more possible than one management structure or one
organizational culture. Working out the optimal mix of power allocation between corporate
management, boards, stockholders, employees and other relevant stakeholders requires nuanced
balance that is inconsistent with federal dictates on a handful of subjects. Good corporate
governance requires a holistic approach. It is not readily achievable by picking out and
addressing a few topics. Getting corporate governance correct requires attention to all its
aspects, and is ill-served by hard and fast rules imposed on certain points (e.g., ending all
classified board structures, separating CEO-Chairman positions at all public firms, mandating
the creation of yet another committee at all public companies).

-2-
 3. Importantly, the states have proven themselves responsive to legitimate
calls for reform. Delaware has recently amended its corporate statute to permit corporate boards
or stockholders to provide for stockholder access to the company’s proxy materials for director
elections. Delaware, New York and other states have recently amended their laws to facilitate
the adoption of majority voting policies for director elections. These state-based initiatives have
proceeded thoughtfully, and undoubtedly will produce continued refinement in other states. It
would not seem warranted to short circuit these developments by newly federalizing these
aspects of corporate governance.

4. Radically altering the respective federal-state roles would seem

particularly ill-advised in light of the fact that many of the issues raised in the proposed
legislation are already being significantly addressed by voluntary action taken by public
companies. The number of companies electing all directors annually has dramatically increased
in recent years (reportedly, 64% of S&P 500 and 50% of S&P 1,500 companies now elect all
directors each year). Some form of majority voting on directors is now reportedly utilized for
75% of corporate boards. Of the S&P 500, nearly 40% now have split the Chair/CEO roles, and
95% have an independent lead director or the practical equivalent. Corporate boards are already
at least 80% comprised of independent directors in 90% of the cases. The TARP legislation has
already caused stockholder votes on executive compensation at the hundreds of stockholder
meetings held this year by companies accepting TARP funds. Over 20 additional public
companies have agreed to hold such advisory votes annually.

5. Perhaps most fundamentally, the legislation’s stated ultimate goal of

prioritizing “long-term health” and stability of our corporate economic system would be
undermined by the proposed specific provisions of the Act. It is essential to recognize that the
key contributors to the current crises were the coincidence of increased stockholder pressure for
high returns and weakened prudential regulation. Government policy makers appear to have
determined that reinstituting sensible prudential regulation (at the federal as well as even
international level) is a necessary part of the fix. But enhancing stockholder power — the
direction taken in the proposed Stockholder Bill of Rights Act — would exacerbate, not
alleviate, an important part of the underlying dynamic that caused the current crises. That course
is a serious mistake, especially when the government has done nothing to either encourage (or
require) that money managers — the real “stockholders” today — think and act on a long-term
basis.

While there can be no claim of a consensus on the point, thoughtful corporate

governance observers have recognized the direct causal relationship between the current crises
and stockholder-generated short-termism driving over-leverage and excessive risk-taking in
pursuit of unsustainable returns, coupled with under-investment in the long term. The November
10, 2008 Statement on the Global Financial Crisis by the International Corporate Governance
Network declared that “[i]t is true that shareholders sometimes encouraged companies, including
investment banks, to ramp up short-term returns through leverage,” and that: “Institutional
shareholders must recognize their responsibility to generate long term value on behalf of their
beneficiaries, the savers and pensioners for whom they are ultimately working. Pension funds
and those in a similar position of hiring fund managers should insist that fund managers put
sufficient resources into governance that delivers long term value.” It is certainly time for the

-3-
entire corporate governance movement to recognize that the true interest of the American
investor is long-term value creation and stability.

Accordingly, it is submitted that realization of the Act’s goal of long-term

stability and profitability warrants the embrace of pragmatic measures that would promote long-
term value, instead of going along with yet further stockholder empowerment in the absence of
any effort to encourage the essential long-termist perspective. Time-phased shareholder voting
structures that would provide long-term shareholders a greater number of votes per share should
become a permissible option. Quinquennial rather than annual or triennial elections of corporate
board members should be revisited. Institutions should discontinue the practice of compensating
fund managers based on quarterly performance. Corporate America should discontinue the
practice of issuing quarterly earnings guidance as recommended by the Aspen Institute’s
Corporate Values Strategy Group and as adopted by General Electric and other prominent
companies.

The stockholder-centric view exemplified by the heyday of stockholder activism,

and embedded in the proposed Act, cannot be the cure for the very short-termist disease it
spawned. One vivid and undeniable lesson of the current financial crisis is that not only
stockholders are impacted in a meltdown. Employees who devote their lives to building
stockholder value are a very painful example. Communities, suppliers, creditors, indeed, the
whole range of constituencies who support the creation and maintenance of stock value, are
likewise impacted and have a legitimate stake in the governance and reform debate.

There is no simple panacea. The drivers of short-termism have gained

considerable momentum in recent years, and shareholder activists have entrenched many
corporate governance mandates that exacerbate these pressures – measures that Senator
Schumer’s proposed Act would not alleviate and may indeed foster. Board members who
approve poison pills, classified board structures, supermajority voting requirements and other
safeguards against the pressures of hostile takeovers and short-termism face a considerable risk
of a “withhold the vote” or “vote no” campaign when they stand for reelection. Influential proxy
voting advisory firms carefully monitor companies for any deviations from corporate governance
alleged “best practices” and punish disobedient directors with adverse vote recommendations.

It is time to use the opportunity for fresh thinking that the current crisis affords to
reconsider fundamental changes that could restore the ability of boards and managers to run
America’s companies for our long-term best interest. Short-termism has become deeply
ingrained. Inertia is a powerful force. But it may be that the astounding losses we have now
seen are enough of a stimulus to steer us back. Companies, directors, managers, shareholders,
regulators, other market participants, and political leaders should embrace pragmatic measures
that promote long-term value, instead of going along with a new frenzy of shareholder activism
and misguided corporate governance reforms built on that failed model. This crisis would be a
terrible thing to waste.

-4-
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 Chairman & CEO Peer Forum
Board Leadership in a New Regulatory Environment
New York Stock Exchange

Future of the Board of Directors

Martin Lipton
June 23, 2010

In an effort to think about the board of directors of the future, we need to start
with what we expect the board to do today and the rules we have set governing how directors are
selected, how they function and how they relate to shareholders – not only the legal rules but also
the aspirational “best practices” that we have allowed to influence corporate and director
behavior. We also need to look at how corporate management and boards are perceived by the
media, the public and elected officials in the post-financial crisis era.

We expect boards to:

• Choose the CEO, monitor his or her performance and have a detailed succession plan in
case the CEO becomes unavailable or fails to meet performance expectations.

• Provide business and strategic advice to management and approve the company’s long-
term strategy.

• Determine the company’s risk appetite (financial, safety, reputation, etc.) and monitor the
management of those risks.

• Monitor the performance of the corporation and evaluate it against the economy as a whole
and the performance of peer companies.

• Monitor the corporation’s compliance with legal and regulatory requirements and respond
appropriately to “red flags.”

• Take center stage whenever there is a proposed transaction that creates a seeming conflict
between the best interests of stockholders and those of management, and sometimes even
when the conflict is more imagined than real, including takeovers.

• Set the standards of social responsibility of the company, including human rights, and
monitor performance and compliance with those standards.

• Oversee government and community relations.

W/1633396v2 06/21/10 2:43 PM

 • Determine executive compensation.

• Interface with shareholders.

• Plan for and deal with crises.

• Approve the company’s ethical standards and programs and take responsibility for “tone at
the top.”

• Monitor and evaluate the board’s own performance and seek continuous improvement.

We require the board to be made up of a majority of independent directors. While

the rules of the stock exchanges require only a majority, the guidelines of many institutional
investors and governance advisory organizations have specified a “substantial” majority or a
specific percentage. In fact, many major corporations today have boards whose only non-
independent director is the CEO, or that have only one other director who is not independent.
Further, the definition of independence is periodically adjusted by governance activists and
advisory organizations to be more stringent than the definition in the stock exchanges rules.

It is interesting to note that it is not at all clear that director independence is the
fundamental keystone of “good” corporate governance. The world’s most successful economy
was built by companies that had few, if any, independent directors. It was not until 1956 that the
NYSE recommended that listed companies have two outside directors and it wasn’t until 1977
that they were required to have an audit committee of all independent directors. In 1966 when
the Standard Oil Company added outside directors, the New York Times reported that it would
require the board to rethink its schedule of meeting every day at 11 AM.

Independence became the touchstone during the takeover era of the 1970’s-
1980’s. Governance theorists were so convinced that any takeover bid at a premium to market
was desirable that they viewed takeover defense with deep suspicion and deemed it a result of
structural conflict – as if only managers intent on keeping their jobs could justify not selling the
company whenever and however a takeover bid was made. The antidote seemed obvious to
those who considered all management incapable of seeing beyond their own personal interests:
populating boards with men and women with as little connection to the enterprise as possible,
and demonizing any board that saw itself as something more than just auctioneers. The ideal

-2-
became a board with as little or no true “skin in the game” in the sense of a felt connection to the
business and its long-term viability, continuity and success.

In addition to independence, we think directors should have relevant business

experience, leadership ability and the strength of character to challenge management. Finally,
we seek gender and ethnic diversity; availability and commitment such that few if any board and
committee meetings are missed; and willingness to serve for compensation that does not fully
reflect the scope of the expected commitment and the exposure to litigation and reputational
damage when something goes wrong.

At the same time as we have set these stringent expectations for performance and
personal qualifications, we have allowed the playing field on which the board of directors
performs to tilt in favor of shareholders who seek short-term profits rather than long-term
growth. To quote the title of a brilliant speech Vice Chancellor Leo Strine of the Delaware Court
of Chancery gave at Stanford University last month, “One Fundamental Corporate Governance
Question We Face: Can Corporations Be Managed For The Long Term Unless Their Powerful
Electorates Also Act And Think Long Term?”

Underlying the academic thinking about corporate governance is the “agency

theory” first put forth by Adolph Berle in 1931. Ever since, academic writers have embraced the
concept that shareholders are the true owners or “principals” of the company, and that corporate
directors are their “agents,” with the duty to maximize shareholder wealth and carry out the
shareholders’ directions. As Profs. Jay Lorsch and Rakesh Khurana of the Harvard Business
School said in an interesting paper on executive compensation published this year,

“Few ideas about business have been as quickly and widely embraced not only by
directors and executives, but also by the bankers, consultants, and lawyers who advise
them, as well as by the Delaware Court of Chancery. Prominent business organizations
switched from advocating a “stakeholder view” in corporate decisionmaking to
embracing the “shareholder” maximization imperative. In 1990, for instance, the
Business Roundtable, a group of CEOs of the largest U.S. companies, still emphasized in
its mission statement that “the directors’ responsibility is to carefully weigh the interests
of all stakeholders as part of their responsibility to the corporation or to the long-term
interests of its shareholders.” By 1997, the same organization argued that ‘the paramount
duty of management and of boards of directors is to the corporation’s stockholders; the
interests of other stakeholders are relevant as a derivative of the duty to the
stockholders.’”

-3-
 The combined effect of the agency theory, Sarbanes-Oxley, the stock exchange
governance rules, SEC regulations, the Institutional Shareholder Services Company (ISS) and
the Council of Institutional Investors (CII) pressure and the corporate governance provisions of
the pending financial industry regulation bill is to exalt short-term shareholder interests over that
of all the other stakeholders—and of the American economy and the American public. The
assumption that empowering shareholders and promoting their interests will lead to better
performance and more efficient management of corporations, and that shareholder interests are
therefore aligned with those of other stakeholders, is contradicted by the short-term trading
objectives of many of the major institutional investors and hedge funds. It was the taking of
undue risks in an effort to meet the short-term profits demands of shareholders that was a root
cause of the financial crisis.

I might note that in 1979, I published a widely cited article arguing that the
stakeholder theory—not the agency theory—should determine the board’s fiduciary duties.
Although fiercely attacked by the Chicago School of Law and Economics academics, my article
was relied upon by the Delaware Supreme Court in 1985 in the famous Unocal case and has
subsequently been embraced by legislation in more than 30 states and enshrined in the new
British corporation law. Notwithstanding what is now established law permitting boards to reject
short-term goals in favor of long-term objectives, institutional and activist investors, and their
advisors like ISS, continue to vote for short-term while paying lip service to long-term.

With this as background, we turn to the question of the day, “what will the board
look like and how it will operate in the future.” Here let me emphasize that these are general
thoughts applicable to major public corporations and are in no way intended to be a checklist of
best practices or legal requirements. Contrary to the course currently being pursued by
Congress, the SEC and the governance activists, one size does not fit all and it is bad policy to
impose check-the-box governance.

The Directors. There will continue to be a substantial majority of independent

directors on corporate boards. There will be significant gender and ethnic diversity. While we
will not prescribe percentages for gender diversity, we will be somewhere between (a) the new
UK Corporate Governance Code: “The search for board candidates should be conducted, and
appointments made, on merit against objective criteria and with due regard for the benefits of

-4-
diversity on the board including gender” and (b) the stronger Australian Stock Exchange
proposal requiring disclosure of specific diversity objectives and their achievement and (c) the
40% female quota imposed by law in Norway and actively being considered or adopted in other
European countries.

The trend to smaller boards will be reversed in order to have a sufficient number
of independent directors for the audit, nominating and compensation committees and to add
directors who have special expertise and are not necessarily independent. For example, the
financial crisis called attention to directors of financial institutions who did not have the
expertise to fully understand the risks of complicated derivatives and other hi-tech financial
instruments. To remedy the situation, the banking regulators are now insisting that experienced
bankers be added to the boards. At Citigroup, Diana Taylor, former N.Y. State Banking
Superintendent, became a director last year and last month it was reported that she would chair
the nominating and governance committee. Also at Citi, Robert Joss, a former Wells Fargo
director and Stanford University Business School dean, became a director and paid consultant.
While he does not qualify as an independent director, his appointment to the board makes his
experience and expertise available at board and committee meetings as a director and not just as
an outside consultant.

A separate risk committee has been mandated for financial institutions and, even
if not mandated for non-financial companies, will likely become common at companies where
risk plays a significant role. The BP Gulf of Mexico spill, and BP’s acknowledgment that it was
not prepared for it, followed a BP Houston refinery explosion in 2005 that resulted in a special
review, by a committee chaired by James Baker, that criticized the BP board for not properly
monitoring the risk of that type of accident. To assist boards and committees with evaluating
and monitoring risks and other specialized issues, there will be greater resort to obtaining
opinions of expert consultants. Boards will have regular tutorials by both company employees
and outside experts. Board retreats for two or three days will have longer agendas to fulfill the
need for director education about specialized issues.

It should be noted that while our courts, even in cases involving multi-billion-
dollar losses by financial institutions, have continued to adhere to the customary Caremark-case
standard for determining whether directors have met their duties of care, earlier this month, the

-5-
European Commission, in a consultation paper seeking comments on options to improve
corporate governance in financial institutions, suggested strengthening “legal liability of
directors via an expanded duty of care”. The possibility that higher standards of care for
directors of financial institutions could be extended to all corporations is real. Specialized
committees, use of expert consultants, tutorials and expanded director education programs will
go a long way to enable boards to meet even a strengthened duty of care.

Looking out even further into the future, the time demands of board service will
result in more use of modern conferencing and communication technology so that travel time is
reduced, committees can meet conveniently apart from meetings of the whole board and special
meetings with outside consultants can be convened whenever needed. In dealing with important
issues and crises, companies will have very frequent special meetings and resort widely to
outside experts.

As a result of the increased time demands of board service and the need for larger,
more diverse boards with special expertise, director recruiting will become an increasingly
critical challenge for many corporations.

Executive Compensation. Shareholder advisory voting on executive

compensation will be effective for the next proxy season. “Say on Pay” is here and will
continue. Combined with new SEC disclosure rules and greater resort to independent
compensation consultants, we will have achieved the unfortunate result of transferring the
fundamental role of the board to establish executive compensation to institutional investors and
ISS and CII and their compatriots.

Ann Yeager, Executive Director of the CII, in a memo, “Red Flags for Say-on-
Pay Voting,” posted on the Harvard Law School Forum on Corporate Governance and Finance
Regulation, refers to the adoption of say on pay at more than 300 companies in 2010 and goes on
to list 10 principal and 15 subsidiary red flags (problematic pay practices) of concern to CII. In
effect, a 25 item checklist that boards and compensation committees are instructed to follow on
pain of the CII advising its members to vote against the company’s compensation program.

Separation of Chairman and CEO. While separation of Chairman and CEO roles
is not mandated by the pending financial industry regulation bill, the bill does require disclosure

-6-
of whether the roles are split—something the SEC has already required companies to discuss in
proxy statements. In light of the strong support for separation in the activist governance
community and the implicit endorsement by Congress and the SEC, pressure through
shareholder proxy resolutions will continue to grow. It is reasonable to assume that in a few
years separation will be more widespread.

Shareholder Control. While the financial industry regulation bill no longer

requires the stock exchanges to adopt majority voting rules, it continues to authorize the SEC to
adopt proxy access. In addition, SEC rules permit proxy resolutions designed to induce or force
the company to (a) dissolve takeover defenses, (b) make it easier for shareholders to call special
shareholder meetings, (c) authorize shareholders to act by written consent instead of a
shareholder meeting and conduct campaigns to obtain full control and (d) enable shareholders to
shape director nominating procedures and CEO succession planning. Together with NYSE rules,
effective this year, that eliminated broker discretionary voting in uncontested elections, activist
institutional shareholders will be more able to heavily influence, if not dictate business actions,
policies and strategies at most major public companies. This raises the ultimate questions:

• Will we be able to attract the qualified directors we need in light of the limitation on their
ability to take actions and adopt policies that shareholders seeking short-term gains object
to?

• Will the pressure for short-term performance lead to the “Eclipse of the Public
Corporation” a 1989 prognostication by famed Harvard economist, Michael Jensen?

• Will the pressure for short-term gain result in business decisions that so adversely affect
stakeholders and the economy that the government becomes intrusive in the management
of public corporations other than financial institutions?

While these are reasonable ruminations, I think that they will not come to pass.
What will come to pass is that companies and their advisors will adjust to the reality of the new
governance regime and the lives of CEOs and boards of directors will become more challenging.
And, hopefully, we will over time realize the drawbacks of conceptualizing corporate
governance as primarily a means to discipline managers, to arbitrarily limit the compensation of
executives and to provide convenient ways for institutional and activist shareholders to dictate
corporate policy in order to achieve their short-term profit interests. Instead, we should
recognize that the purpose of corporate governance must be to encourage management and

-7-
directors to develop policies and procedures that enable them to best perform their duties (and
meet our expectations), while not putting them in a straight jacket that dampens risk-taking and
discourages investing for long-term growth and true value creation.

-8-
 February 16, 2011

Delaware Court Reaffirms the Poison Pill and

Directors’ Power to Block Inadequate Offers

Almost thirty years ago, our Firm announced there was a way—the poison pill—
to level the playing field between corporate raiders and a board of directors acting to protect the
interests of the corporation and its shareholders. Despite great skepticism about the pill in the
legal and banking communities, the Delaware Supreme Court in 1985 agreed with us and
affirmed that directors, in the exercise of their business judgment, could properly use the pill to
protect the corporation from hostile takeover bids.

Since then, many have continued to criticize the pill, and hostile bidders and
plaintiffs’ lawyers have continued to litigate to constrain its use. Yesterday, in a historic
decision, the Delaware Court of Chancery rejected the broadest challenge to the pill in decades.
Air Products & Chemicals, Inc. v. Airgas, Inc., C.A. No. 5249—CC (Del. Ch. Feb. 15, 2011).
The decision reaffirms the vitality of the pill. It upholds the primacy of the board of directors in
matters of corporate control under bedrock Delaware law. It reinforces that a steadfast board,
confident in management’s long-term business plan, can block opportunistic bids. We
represented the target, Airgas, and its board of directors.

The conduct of the Airgas board, the Chancellor concluded, “serves as a

quintessential example” of these fundamental principles: if directors act “in good faith and in
accordance with their fiduciary duties,” the Delaware courts will continue to respect a board’s
“reasonably exercised managerial discretion.” Directors may act to protect the corporation, and
all of its shareholders, against the threat of inadequate tender offers. And they may act to protect
against the special danger that arises when raiders induce large purchases of shares by
arbitrageurs who are focused on a short-term trading profit, and are uninterested in building
long-term shareholder value.

The Chancellor could not have been clearer that “the power to defeat an
inadequate hostile tender offer ultimately lies with the board of directors.” And it is up to
directors, not raiders or short-term speculators, to decide whether a company should be sold:
“a board cannot be forced into Revlon mode any time a hostile bidder makes a tender offer that is
at a premium to market value.” The Chancellor concluded: “in order to have any effectiveness,
pills do not—and can not—have a set expiration date.” The poison pill lives.

Martin Lipton Marc Wolinsky

Kenneth B. Forrest Stephanie J. Seligman
Theodore N. Mirvis George T. Conway III
Daniel A. Neff David A. Katz
Eric M. Roth

If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1418.
W/1742362
 November 28, 2011

Key Issues for Directors 2012

For a number of years, as the new year approached, I have prepared a one-page list
of the key issues for boards of directors that are newly emerging or will be especially important in
the coming year. Each year, the legal rules and aspirational best practices for corporate governance
matters, as well as the demands of activist shareholders seeking to influence boards of directors,
have increased. So too have the demands of the public with respect to health, safety, environmental
and other socio-political issues. In The Spotlight on Boards, I have published a list of the roles and
responsibilities that boards today are expected to fulfill. Looking forward to 2012, it is clear that in
addition to satisfying these expectations, the key issues that boards will need to address include:

1. Working with management to navigate the dramatic changes in the domestic and
world-wide economic, social and political conditions, in order to remain competitive and successful.

2. Coping with the increase in regulations and changes in the general perception of
business that have followed the financial crisis. Once it was said, “The business of America is
business.” Today, it could be said, “The business of America is government, and a dysfunctional
government at that.”

3. Dealing with populist demands, such as criticism of executive compensation and risk
management, in a manner that will preempt increased regulation and avoid escalation of activist
demands while at the same time furthering the best interests of the corporation.

4. Organizing the business, and maintaining the collegiality, of the board so that each of
the increasingly time-consuming matters that the board is expected to oversee receives the
appropriate attention of the directors.

5. Working with management to encourage entrepreneurship, appropriate risk taking,

and investment to promote the long-term success of the company, despite the pressures for short-
term performance.

6. Retaining and recruiting directors who meet the requirements for experience,
expertise, diversity, independence, leadership ability and character, and providing compensation for
directors that fairly reflects the significantly increased time and energy that they must now spend in
serving as board members.

7. Developing an understanding of shareholder perspectives on the company, as well as

coping with the escalating requests of union and public pension funds and other activist
shareholders for meetings to discuss governance and business proposals.

8. Developing an understanding of how the company and the board will function in the
event of a crisis. Most crises are handled less than optimally because management and the board
have not been proactive in planning to deal with crises, and because the board cedes control to
outside counsel and consultants.

Martin Lipton

If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1443.
W/1878032
 March 21, 2012

Harvard’s Shareholder Rights Project is Wrong

The Harvard Law School Shareholders Rights Project (SRP) recently issued joint press releases
with five institutional investors, principally state and municipal pension funds, trumpeting SRP’s
representation of and advice to these investors during the 2012 proxy season in submitting proposals to
more than 80 S&P 500 companies with staggered boards, urging that their boards be declassified. The
SRP’s “News Alert” issued concurrently reported that 42 of the companies targeted had agreed to
include management proposals in their proxy statements to declassify their boards – which reportedly
represented one-third of all S&P 500 companies with staggered boards. The SRP statement
“commended” those companies for what it called “their responsiveness to shareholder concerns.”

This is wrong. According to the Harvard Law School online catalog, the SRP is “a newly
established clinical program” that “will provide students with the opportunity to obtain hands-on
experience with shareholder rights work by assisting public pension funds in improving governance
arrangements at publicly traded firms.” Students receive law school credits for involvement in the SRP.
The SRP’s instructors are two members of the Law School faculty, one of whom (Professor Lucian
Bebchuk) has been outspoken in pressing one point of view in the larger corporate governance debate.
The SRP’s “Template Board Declassification Proposal” cites two of Professor Bebchuk’s writings,
among others, in making the claim that staggered boards “could be associated with lower firm valuation
and/or worse corporate decision-making.”

There is no persuasive evidence that declassifying boards enhance stockholder value over the
long-term, and it is our experience that the absence of a staggered board makes it significantly harder for
a public company to fend off an inadequate, opportunistic takeover bid, and is harmful to companies that
focus on long-term value creation. It is surprising that a major legal institution would countenance the
formation of a clinical program to advance a narrow agenda that would exacerbate the short-term
pressures under which American companies are forced to operate. This is, obviously, a far cry from
clinical programs designed to provide educational opportunities while benefiting impoverished or
underprivileged segments of society for which legal services are not readily available. Furthermore, the
portrayal of such activity as furthering “good governance” is unworthy of the robust debate one would
expect from a major legal institution and its affiliated programs. The SRP’s success in promoting board
declassification is a testament to the enormous pressures from short-term oriented activists and
governance advisors that march under the misguided banner that anything that encourages takeover
activity is good and anything that facilitates long-term corporate planning and investment is bad.

Staggered boards have been part of the corporate landscape since the beginning of the modern
corporation. They remain an important feature to allow American corporations to invest in the future and
remain competitive in the global economy. The Harvard Law School SRP efforts to dismantle staggered
boards is unwise and unwarranted, and – given its source – inappropriate. As Delaware Chancellor Leo
Strine noted in a 2010 article: “stockholders who propose long-lasting corporate governance changes
should have a substantial, long-term interest that gives them a motive to want the corporation to
prosper.”

Martin Lipton
Theodore N. Mirvis
Daniel A. Neff
David A. Katz
If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1443.
W/1924937
 November 28, 2012
Harvard’s Shareholder Rights Project is Still Wrong
A small but influential alliance of activist investor groups, academics and trade unions continues
– successfully it must be said – to seek to overhaul corporate governance in America to suit their particu-
lar agendas and predilections. We believe that this exercise in corporate deconstruction is detrimental to
the economy and society at large. We continue to oppose it.
The Shareholder Rights Project, Harvard Law School’s misguided “clinical program” which we
have previously criticized, today issued joint press releases with eight institutional investors, principally
state and municipal pension funds, trumpeting their recent successes in eliminating staggered boards and
advertising their “hit list” of 74 more companies to be targeted in the upcoming proxy season. Coupled
with the new ISS standard for punishing directors who do not immediately accede to shareholder pro-
posals garnering a majority of votes cast (even if they do not attract enough support to be passed) – which
we also recently criticized – this is designed to accelerate the extinction of the staggered board.
While the activist bloc likes to tout annual elections as a “best practice” on their one-size-fits-all
corporate governance scorecards, there is no persuasive evidence that declassifying boards enhances
shareholder value over the long term. The argument that annual review is necessary for “accountability”
is as specious in the corporate setting as it is in the political arena. In seeking to undermine board stew-
ardship, the Shareholder Rights Project and its activist supporters are making an unsubstantiated value
judgment: they prefer a governance system which allows for a greater incidence of intervention and con-
trol by fund managers, on the belief that alleged principal-agent conflicts between directors and investors
are of greater concern than those between fund managers and investors. Whether these assumptions and
biases are correct and whether they will help or hurt companies focus on long-term value creation for the
benefit of their ultimate investors are, at best, unknown. The essential purpose of corporate governance is
to create a system in which long-term output and societal benefit are maximized, creating prosperity for
the ultimate beneficiaries of equity investment in publicly-traded corporations. Short-term measurement
and compensation of investment managers is not necessarily consistent with these desired results. Indeed
the ultimate principals of investment managers – real people saving for all of life’s purposes – depend not
on opportunism, shareholder “activism” or hostile takeovers, but rather on the long-term compound
growth of publicly-traded firms.
As we have said, it is surprising and disappointing that a leading law school would, rather than
dispassionately studying such matters without prejudice or predisposition, choose to take up the cudgels
of advocacy, advancing a narrow and controversial agenda that would exacerbate the short-term pressures
under which U.S. companies are forced to operate. In response to our critiques, the activists resort to ad
hominem attacks, suggesting that, “as counsel for incumbent directors and managers seeking to insulate
themselves from removal” we “advocate for rules and practices that facilitate entrenchment.” The fact is
that the board-centric model of corporate governance has served this country very well over a sustained
period. A compelling argument should be required before those corporate stewards who actually have
fiduciary duties, and in many cases large personal and reputational investments in the enterprises they
serve, are marginalized in favor of short-term-oriented holders of widely diversified and ever-changing
portfolios under the influence of self-appointed governance “experts.” Indeed a just published compre-
hensive study by a distinguished group of professors at the London School of Economics demonstrates
that the statistical analyses relied on by these experts are seriously flawed and that the shareholder-centric
governance they are trying to impose was a significant factor in the poor performance by a large number
of banks in the financial crisis.
Martin Lipton
Daniel A. Neff
Andrew R. Brownstein
Adam O. Emmerich
David A. Katz
Trevor S. Norwitz
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 February 22, 2013

Bite the Apple; Poison the Apple; Paralyze the Company; Wreck the Economy

The activist-hedge-fund attack on Apple—in which one of the most successful,

long-term-visionary companies of all time is being told by a money manager that Apple is doing
things all wrong and should focus on short-term return of cash—is a clarion call for effective ac-
tion to deal with the misuse of shareholder power. Institutional investors on average own more
than 70% of the shares of the major public companies. Their voting power is being harnessed by
a gaggle of activist hedge funds who troll through SEC filings looking for opportunities to de-
mand a change in a company’s strategy or portfolio that will create a short-term profit without
regard to the impact on the company’s long-term prospects. These self-seeking activists are aid-
ed and abetted by Harvard Law School Professor Lucian Bebchuk who leads a cohort of academ-
ics who have embraced the concept of “shareholder democracy” and close their eyes to the real-
world effect of shareholder power, harnessed to activists seeking a quick profit, on a targeted
company and the company’s employees and other stakeholders. They ignore the fact that it is
the stakeholders and investors with a long-term perspective who are the true beneficiaries of
most of the funds managed by institutional investors. Although essentially ignored by Professor
Bebchuk, there is growing recognition of the fiduciary duties of institutional investors not to seek
short-term profits at the expense of the pensioners and employees who are the beneficiaries of
the pension and welfare plans and the owners of shares in the managed funds. In a series of bril-
liant speeches and articles, the problem of short-termism has been laid bare by Chancellor Leo E.
Strine, Jr. of the Delaware Court of Chancery, e.g., One Fundamental Corporate Governance
Question We Face: Can Corporations Be Managed for the Long Term Unless Their Powerful
Electorates Also Act and Think Long Term?, and is the subject of a continuing Aspen Institute
program, Overcoming Short-Termism.

In his drive to enhance the shift of power over the management of companies
from directors to shareholders, Professor Bebchuk has announced that he is pursuing empirical
studies to prove his thesis that shareholder demand for short-term performance enforced by ac-
tivist hedge funds is good for the economy. We have been debating director-centric corporate
governance versus shareholder-centric corporate governance for more than 25 years. Because
they are inconvenient to his theories, Professor Bebchuk rejects the decades of my and my firm’s
experience in advising corporations and the other evidence of the detrimental effects of pressure
for short-term performance. I believe that academics’ self-selected stock market statistics are
meaningless in evaluating the effects of short-termism. Our debates, which extend over all as-
pects of corporate governance, have of late focused on my effort to obtain early disclosure of
block accumulations by activist hedge funds and my endorsement of an effort to require institu-
tional shareholders to report their holdings two days, rather than 45 days, after each quarter. It is
in the context of these efforts, opposed by the activists who benefit from lack of transparency,
that Professor Bebchuk has announced his research project.

If Professor Bebchuk is truly interested in meaningful research to determine the

impact of an activist attack (and the fear of an activist attack) on a company, he must first put
forth a persuasive (or even just coherent) theory as to why the judgments as to corporate strategy

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and operations of short-term-focused professional money managers should take precedence over
the judgments of directors and executives charged with maximizing the long-term success of
business enterprises. There is nothing persuasive about his view, whether as theory or experi-
ence. Furthermore, he must take into account the following:

1. As to all companies that were members of the Fortune 500 during the period January 1,
2000 to December 31, 2012, what was the impact on the price of the shares of a company
that missed the “street estimate” or “whisper number” for its earnings for a quarter and
what adjustment did each of those companies make to its capital expenditures, investment
in research and development and number of employees for the balance of the year of the
miss and the following year.

2. For companies that are the subject of hedge fund activism and remain independent, what
is the impact on their operational performance and stock price performance relative to the
benchmark, not just in the short period after announcement of the activist interest, but af-
ter a 24-month period.

3. Interviews with the CEO’s of the Fortune 500 as to whether they agree or disagree with
the following statements:

a) From the Aspen paper, “We believe that short-term objectives have eroded
faith in corporations continuing to be the foundation of the American free
enterprise system, which has been, in turn, the foundation of our economy.
Restoring that faith critically requires restoring a long-term focus for
boards, managers, and most particularly, shareholders—if not voluntarily,
then by appropriate regulation.”

b) From a 2002 interview with Daniel Vasella, CEO of Novartis in Fortune

Magazine, “The practice by which CEOs offer guidance about their ex-
pected quarterly earnings performance, analysts set ‘targets’ based on that
guidance, and then companies try to meet those targets within the penny is
an old one. But in recent years the practice has been so enshrined in the
culture of Wall Street that the men and women running public companies
often think of little else. They become preoccupied with short-term ‘suc-
cess,’ a mindset that can hamper or even destroy long-term performance
for shareholders. I call this the tyranny of quarterly earnings.”

Martin Lipton

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 August 8, 2013

Current Thoughts About Activism

A long-term oriented, well-functioning and responsible private sector is the country’s

core engine for economic growth, national competitiveness, real innovation and sustained em-
ployment. Prudent reinvestment of corporate profits into research and development, capital pro-
jects and value-creating initiatives furthers these goals. Yet U.S. companies, including well-run,
high-performing companies, increasingly face:

• pressure to deliver short-term results at the expense of long-term value, whether through
excessive risk-taking, avoiding investments that require long-term horizons or taking on
substantial leverage to fund special payouts to shareholders;

• challenges in trying to balance competing interests due to excessively empowered special

interest and activist shareholders; and

• significant strain from the misallocation of corporate resources and energy into mandated
activist or governance initiatives that provide no meaningful benefit to investors or other
critical stakeholders.

These challenges are exacerbated by the ease with which activist hedge funds can, with-
out consequence, advance their own goals and agendas by exploiting the current regulatory and
institutional environment and credibly threatening to disrupt corporate functioning if their de-
mands are not met. Activist hedge funds typically focus on immediate steps, such as a leveraged
recapitalization, a split-up of the company or sales or spinoffs of assets or businesses that may
create an increase in the company’s near term stock price, allowing the activist to sell out at a
profit, but leave the company to cope with the increased risk and decreased flexibility that these
steps may produce.

The power of the activist hedge funds is enhanced by their frequent success in proxy
fights and election contests when companies resist the short-term steps the hedge fund is advo-
cating. These proxy contest successes, in turn, are enabled by the outsized power of proxy advi-
sory firms and governance reforms that weaken the ability of corporate boards to resist short-
term pressures. The proxy advisory firms are essentially unregulated and often demonstrate a
bias in favor of activist shareholders. They also tend to take a one-size-fits-all approach to poli-
cy and voting recommendations without regard for or consideration of a company’s unique cir-
cumstances. This approach includes the potential for across-the-board “withhold votes” from
directors if the directors fail to implement any shareholder proposal receiving a majority vote,
even if directors believe that the proposal would be inconsistent with their fiduciary duties and
the best interests of the company and its shareholders. Further complicating the situation is the
fact that an increasing number of institutional investors now invest money with the activist hedge
funds or have portfolio managers whose own compensation is based on short-term metrics, and
increasingly align themselves with the proposals advanced by hedge fund activists. In this envi-
ronment, companies can face significant difficulty in effectively managing for the long-term,

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considering the interests of employees and other constituencies, and recruiting top director and
executive talent.

Although there is no single solution to these problems, the following perspectives and
actions may help to restore a more reasonable balance:

• Recognize that the proper goal of good governance is creating sustainable value for the
benefit of all stakeholders, rather than reflexively placing more power in the hands of ac-
tivist hedge funds or often-transient institutional shareholders who are themselves meas-
ured by short-term, quarterly portfolio performance;

• Resist the push to enact legislation, regulations or agency staff interpretations that place
more power in the hands of activist hedge funds and other investors with short-term per-
spectives, and that thereby weaken the ability of corporate boards to resist such short-
term pressures; and

• In any new legislation or regulation that is enacted, provide appropriate protections to

companies, as opposed to focusing only on new rights for shareholders who already have
significant leverage to pressure companies.

Some specific examples of possible steps to implement these general principles may in-
clude the following:

• SEC Commissioner Daniel Gallagher recently questioned whether “investment advisors

are indeed truly fulfilling their fiduciary duties when they rely on and follow recommen-
dations from proxy advisory firms” and expressed “grave concerns” about institutional
investors engaging in “rote reliance” on proxy advisory firms’ advice. He attributed this
in part to the unintended consequences of two SEC staff no-action letters from 2004,
which he noted were not approved by the Commission and did not necessarily represent
the views of the Commission or the Commissioners, that had “unduly increased the role
of proxy advisory firms in corporate governance” by “essentially mandating the use of
third party opinions.” New Commission-level guidance could replace these staff interpre-
tations and, instead, encourage proxy voting based on individual evaluation of each
company and its long-term best interests. Other agencies may also wish to keep in mind
this illustration of unintended and undesired outcomes as appropriate.

• Activist shareholders take advantage of Securities Exchange Act Rule 14a-8 to force the
inclusion, year-after-year and notwithstanding prior failures, of corporate governance and
business-related shareholder proposals in public company proxy statements that have lit-
tle connection to effective governance or the creation of long term shareholder value.
These proposals can be misused to exert leverage over companies, and dealing with the
deluge distracts from the business and requires significant time and resources. Rule 14a-
8 should be revisited to raise the bar on inclusion of shareholder proposals. This could
include more substantial and longer-term ownership requirements to be eligible under
Rule 14a-8, and exclusion of proposals in subsequent years that did not obtain a truly
meaningful level of support (current rules prohibit a company from excluding a repeat

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 proposal the following year unless 97% of the shares reject it the first time or 90% of the
shares reject it at least three times, standards that are far too low).

• Proxy advisory firms, such as Institutional Shareholder Services (ISS) and Glass, Lewis
& Co., have disproportionate influence over voting decisions made by every public com-
pany’s institutional shareholder base and regularly support activist shareholders and
hedge funds. Their recommendations and analyses may also contain material inaccura-
cies, and companies have little visibility into the preparation of these reports and the
proxy advisory firms’ methodologies. We believe that the proxy advisory firms should be
held to reasonable standards to ensure transparency, accuracy and the absence of con-
flicts and that the special regulatory treatment given to these firms should end.

• Activist hedge funds have recently exploited loopholes in existing SEC rules under Sec-
tion 13(d) of the Securities Exchange Act to accumulate significant, control-influencing
stakes in public companies rapidly without timely notice to the market. These techniques
are facilitated by the widespread use of derivatives, advanced electronic trading technol-
ogy and increased trading volumes. Many non-U.S. securities markets have already tak-
en action to address the risks of such rapid, undisclosed accumulations. A rulemaking
petition, pending before the SEC since March 2011, would close the derivatives loophole
and require acquirers of 5% stakes to disclose such positions to the public within one day,
instead of the current ten-day window established forty years ago. We believe approval
of this rulemaking petition will help curb abuses and bring the rules current with con-
temporary practices and technologies.

• Companies face significant difficulty engaging with their institutional shareholder base
because the current reporting regime does not provide timely information to companies as
to who their shareholders are. A second rulemaking petition pending before the SEC,
submitted in February 2013, requests that the SEC shorten the deadline for institutional
investors to report their positions on Forms 13F from 45 days to two business days after
quarter-end and increase the frequency with which shareholders report their position.
The petition also supports reform of the Section 13(d) stock accumulation rules. We be-
lieve approval of this rulemaking petition will promote market transparency and facili-
tate engagement between companies and shareholders.

• Harvard Law School Professor Lucian Bebchuk has established the Harvard Law School
Shareholder Rights Project to promote corporate governance that facilitates activist hedge
fund attacks on companies. He has also published several articles and editorials arguing
that activist attacks are beneficial to the targeted companies and should be encouraged.
His articles and editorials are widely used by activist hedge funds and institutional share-
holders to justify their actions. We believe that the statistics Professor Bebchuk uses do
not establish the validity of his claims that activist attacks are beneficial nor justify his
uncritical embrace of activists. We believe that attacks, and the threat of attacks, by ac-
tivist hedge funds and pervasive activism have significant implications for the broader
economy and our nation’s competitiveness and are major contributors to unemployment
and slow growth of GDP. We believe that the recent studies by:

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 Professor Pavlos E. Masouros, Corporate Law and
Economic Stagnation: How Shareholder Value and
Short-Termism Contribute to the Decline of the
Western Economies

Professor Lynn Stout, The Shareholder Value Myth:

How Putting Shareholders First Harms Investors,
Corporations, and the Public

Professor Colin Mayer, Firm Commitment: Why

the corporation is failing us and how to restore
trust in it

Professor David Larcker and Brian Tavan, A Real

Look at Real World Corporate Governance

reflect the true effects of activism and that it is in the national interest to reverse the legisla-
tion and regulation that promotes activism.

Martin Lipton
Steven A. Rosenblum
Sabastian V. Niles

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 August 26, 2013

The Bebchuk Syllogism

Empirical studies show that attacks on companies by activist hedge

funds benefit, and do not have an adverse effect on, the targets over the five-year peri-
od following the attack.

Only anecdotal evidence and claimed real-world experience show

that attacks on companies by activist hedge funds have an adverse effect on the targets
and other companies that adjust management strategy to avoid attacks.

Empirical studies are better than anecdotal evidence and real-world

experience.

Therefore, attacks by activist hedge funds should not be restrained but

should be encouraged.

Harvard Law School Professor Lucian A. Bebchuk is now touting this syllogism and his
obsession with shareholder-centric corporate governance in an article entitled, “The Long-Term Effects of
Hedge Fund Activism.” In evaluating Professor Bebchuk’s article, it should be noted that:

There is heavy reliance in the article on Tobin’s Q (i.e., a ratio of market value to book
value, with book value intended to serve as a proxy for replacement value) to measure the performance of
the targets of activist attacks, and the article presents the data in a way that makes the statistical analysis
appear favorable to Professor Bebchuk’s argument. The article highlights the average Q ratio for compa-
nies subject to activist attack in the following five years. Since averages can be skewed by extreme re-
sults (as the article acknowledges), focusing on the median outcome would be more appropriate. Indeed,
the article presents median results, but does not reference in the text that the median Q ratio for each of
the first four years following the attack year is lower than the median Q ratio in the year of the activist
attack. Only in year five does the median Q ratio exceed the Q ratio in the attack year. While the article
fails to disclose the average holding period of the activists in the study, it is undoubtedly less than five
years. So it seems quite speculative, at best, to credit activists with improvements in Q ratios that first
occur for the median company only in the fifth year after the attack.

Beyond the highly questionable conclusions Professor Bebchuk draws from his Tobin’s
Q statistics, there is also the fundamental question of whether Tobin’s Q is a valid measure of a compa-
ny’s performance. A 2012 paper by Olin School of Business Professor Philip H. Dybvig, “Tobin’s q
Does Not Measure Firm Performance: Theory, Empirics, and Alternative Measures,” points out that To-
bin’s Q is inflated by underinvestment, so a high Q is not evidence of better company performance.
Companies that forego profitable investment opportunities—including as a result of pressure from activ-
ists to return capital to investors or defer investments in R&D and CapEx—can actually have higher Q
ratios while reducing shareholder value that would have been generated by those investments. In addi-
tion, the use of book value as a proxy for replacement value introduces complications from different ac-
counting decisions, including the timing of write-downs, depreciation methods, valuation of intangibles
and similar decisions that can significantly distort a company’s Q ratio. The other metric that Professor
Bebchuk relies on in his article—return on assets (ROA)—is highly correlated with Tobin’s Q (indeed,
both ratios use the same denominator, and the numerators are substantially related), and thus his ROA
statistics suffer from these same shortcomings and add little to the analysis.

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 Further undermining the validity of the empirical analysis, the article acknowledges but
fails to control for the fact that 47% of the activist targets in the dataset cease to survive as independent
companies throughout the measurement period. The study sheds no light on whether the shareholders of
those companies would have realized greater value from other strategic alternatives that had a longer-term
investment horizon, whether those companies were pressured to sell on account of the activist attack (as
other empirical work has argued), or whether shareholder gains from activism are largely driven by the
cases that result in sales of control.

Lastly, Professor Bebchuk concedes that his analytical methodology provides no evi-
dence of causation, and thus simply misses the crux of the debate: whether activists can impair long-term
value creation. Favorable results would arise under his approach whenever managements of the target
companies pursue value-enhancing strategies, even those that run counter to the activists’ pressures or
were being initiated even before the activist appeared. In addition, improving economic, market, industry
and company-specific conditions would also contribute to favorable results independent of activist pres-
sure. Professor Bebchuk also states that the targets in his dataset “tend to be companies whose operating
performance was below industry peers or their own historical levels at the time of [activist] intervention”;
if true, it is plausible that many companies improved from a historical or cyclical trough position in spite
of—rather than as a result of—activist pressures.

These defects, among others, are sufficient in and of themselves to raise serious doubts
about the conclusions that Professor Bebchuk draws from his empiricism. But there is a more fundamen-
tal flaw in Professor Bebchuk’s syllogism: it rejects and denies the evidence, including anecdotal evi-
dence and depth of real-world experience, that he acknowledges in the article comes from a “wide range
of prominent writers . . . significant legal academics, noted economists and business school professors,
prominent business columnists, important business organizations, and top corporate lawyers.”

No empirical study, with imperfect proxies for value creation and flawed attempts to iso-
late the effects of activism over a long-term horizon influenced by varying economic, market and firm-
specific conditions, is capable of measuring the damage done to American companies and the American
economy by the short-term focus that dominates both investment strategy and business-management
strategy today. There is no way to study the parallel universe that would exist, and the value that could be
created for shareholders and other constituents, if these pressures and constraints were lifted and compa-
nies and their boards and managements were free to invest for the long term. The individuals who are
directly responsible for the stewardship and management of our major public companies—while commit-
ted to serious engagement with their responsible, long-term shareholders—are nearly uniform in their de-
sire to get out from under the short-term constraints imposed by hedge-fund activists and agree, as do
many of their long-term shareholders, that doing so would improve the long-term performance of their
companies and, ultimately, the country’s economy.

Reflecting on Professor Bebchuk’s article and failed syllogism, one is reminded of Mark
Twain’s saying, “There are three kinds of lies: lies, damned lies and statistics.”

Martin Lipton
Steven A. Rosenblum
Eric S. Robinson
Karessa L. Cain
Sabastian V. Niles

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 October 25, 2013

Empiricism and Experience; Activism and Short-Termism; the Real World of Business

Harvard Law School Professor Lucian Bebchuk believes that shareholders should be
able to control the material decisions of the companies they invest in. Over the years, he has written
numerous articles expressing this view, including a 2005 article urging that shareholders should
have the power to initiate a shareholder referendum on material corporate business decisions. In
addition to his writings and speeches, Prof. Bebchuk has established and directs the Shareholder
Rights Project at Harvard Law School for the purpose of managing efforts to dismantle classified
boards and do away with other charter or bylaw provisions that restrain or moderate shareholder
control of corporations (see “Harvard’s Shareholder Rights Project is Wrong” and “Harvard’s
Shareholder Rights Project is Still Wrong”). In addition, Prof. Bebchuk has been at the forefront in
arguing to the SEC that, despite the specific action of Congress in 2010 to empower the SEC to
adopt a rule to require fair and prompt public disclosure of accumulations of shares by activist
hedge funds and other blockholders, the SEC should not do so because it would limit the ability of
activist hedge funds to attack corporations. In short, Prof. Bebchuk believes that shareholders
should have the power to control the fundamental decisions of corporations – even those
shareholders who bought their shares only a few days or weeks before they sought to assert their
power, and regardless of whether their investment objective is short-term trading gains instead of
long-term value creation.

While there is no question that almost every attack, or even rumor of an attack, by an
activist hedge fund will result in an immediate increase in the stock market price of the target, such
gains are not necessarily indicative of real value creation. To the contrary, the attacks and the
efforts by companies to adopt short-term strategies to avoid becoming a target have had very serious
adverse effects on the companies, their long-term shareholders, and the American economy. To
avoid becoming a target, companies seek to maximize current earnings at the expense of sound
balance sheets, capital investment, research and development and job growth. Indicative of the
impact of shareholder pressure for short-term performance is the often cited comment by then-
Citigroup CEO Chuck Prince in the July 9, 2007 Financial Times: “When the music stops, in terms
of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up
and dance.” Many commentators have cited pressure to boost short-term performance metrics as
one of the causes of the 2008 fiscal crisis, such as Lynne Dallas in her 2012 article in the Journal of
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Corporation Law (“[t]he financial crisis of 2007-2009 was preceded by a period of financial firms
seeking short-term profit regardless of long-term consequences”) and Sheila Bair in her last speech
as FDIC chairman in 2011 (“the overarching lesson of the crisis is the pervasive short-term thinking
that helped to bring it about”). Virtually all of the academic and government studies of the fiscal
crisis have concluded that shareholder pressure was a contributing cause.

In August of this year, Prof. Bebchuk released an article describing what he

characterized as empirical evidence that attacks by activist hedge funds do not harm companies and
their long-term shareholders (see “The Long-Term Effects of Hedge Fund Activism”). I released a
paper pointing out serious deficiencies in the methodology, analysis and conclusions that Prof.
Bebchuk used and I cited an academic study questioning his statistics, an empirical study to the
contrary and real-world experience and anecdotal evidence that activism and its concomitant short-
termism destroy long-term value and damage the American economy (see “The Bebchuk
Syllogism”; see also “Current Thoughts About Activism” and “Bite the Apple; Poison the Apple;
Paralyze the Company; Wreck the Economy”). Apparently, my paper touched a raw nerve. In an
attempt to resuscitate his promotion and justification of attacks by activist hedge funds, Prof.
Bebchuk has published a new paper (“Don’t Run Away from the Evidence: A Reply to Wachtell
Lipton”) accusing me of running away from the evidence; a serious accusation, but demonstrably
untrue. Let’s take a look at some of the evidence (empirical, experiential, and overwhelming) that
supports my views.

Empirical Evidence

It should be noted that Prof. Bebchuk’s claim that “supporters of the myopic activists
view have failed to back their view with empirical evidence or even to test empirically the validity
of their view” is patently false. In fact, numerous empirical studies over the years have produced
results that conflict with those Prof. Bebchuk espouses. These other studies generally find that
activism has a negative effect or no effect on long-term value, particularly when controlling for the
skewing impact of a takeover of the target (which generally occurs at a premium regardless of
whether the target is the subject of activism). This fact compels a careful assessment and critical
review of his study to determine why his results differ from many prior studies – something I
attempted to provide in my previous paper. I have provided below a brief, and admittedly
incomplete, sampling of such studies.

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 Director Contests and Firm Performance

● According to Jonathan Macey and Elaine Buckberg in their 2009 “Report on Effects of Proposed
SEC Rule 14a-11 on Efficiency, Competitiveness and Capital Formation,” there are “[s]everal
studies [that] establish that when dissident directors win board seats, those firms underperform
peers by 19% to 40% over the two years following the proxy contest.”

● One of those studies is David Ikenberry and Josef Lakonishok’s “Corporate Governance Through
the Proxy Contest” (published in the Journal of Business in 1993), which reviewed 97 director
election contests during a 20-year period in order to examine the long-term performance of targeted
firms subsequent to a proxy contest. Their findings were striking: “When the incumbent board
members successfully retain all board seats, cumulative abnormal returns are not significantly
different from zero over the next 5 years. Yet, in proxy contests where dissidents obtain one or
more seats, abnormal returns following resolution of the contest are significantly negative. Two
years following the contest, the cumulative abnormal return has declined by more than 20%. The
operating performance of these same firms during the postcontest period is also generally consistent
with the pattern observed using stock returns.”

● Michael Fleming obtained similar results when looking at instances where a dissident obtains
board representation in “New Evidence on the Effectiveness of the Proxy Mechanism,” a 1995
Federal Reserve Bank of New York research paper. Reviewing a sample of 106 threatened proxy
contests between 1977 and 1988, Fleming found statistically significant negative returns of -19.4%
in the 24 months following the announcement of a contested election for the 65 firms in his sample
where dissidents won board seats – either as a result of a shareholder vote or a settlement. Fleming
found that the majority of gains resulting from threatened proxy contests were “attributable to firms
which [we]re acquired within one year of the outcome of the proxy contest,” suggesting that the
gains were due to payment of a takeover premium (consistent with Greenwood and Schor’s findings
described below), not from operating improvements or governance changes.

● Lisa Borstadt and Thomas Zwirlein found very similar results in “The Efficient Monitoring Role
of Proxy Contests: An Empirical Analysis of Post-Contest Control Changes and Firm
Performance,” published in Financial Management in 1992. These authors examined 142
exchange-traded firms involved in proxy contests for board representation over a 24-year period.
They found the following: “A dissident victory in the proxy contest does not necessarily translate

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into superior corporate performance. Positive abnormal returns over the proxy contest period are
realized by firms in which the dissidents win the proxy contest and the firm is subsequently taken
over. In contrast, no abnormal performance over the contest period is observed for the firms in
which the dissidents win but the firm is not subsequently taken over. For these firms, large negative
(although insignificant) cumulative returns are observed in the postcontest period.”

Shareholder Proposals and Firm Performance

● In “Investor Activism and Takeovers,” published in the Journal of Financial Economics in 2009,
Robin M. Greenwood and Michael Schor examined Schedule 13D filings by portfolio investors
between 1993 and 2006 to investigate the effect of activist interventions on stock returns. They
found the following: “[A]ctivism targets earn high returns primarily when they are eventually taken
over. However, the majority of activism targets are not acquired and these firms earn average
abnormal returns that are not statistically distinguishable from zero. . . . Thus, the returns associated
with activism are largely explained by the ability of activists to force target firms into a takeover,
thereby collecting a takeover premium.”

● In “Pension Fund Activism and Firm Performance,” published in the Journal of Financial and
Quantitative Analysis in 1996, Sunil Wahal reviewed 356 “targetings” by the nine most active funds
between 1987 and 1993. “Targetings” included both proxy proposals and nonproxy targeting, and
were typically initiated by sending a letter to the target firm (either publicly or privately) followed
by a telephone call from the activist fund. Wahal found that, while pension funds “are reasonably
successful in changing the governance structure of targeted firms,” these changes have no impact on
stock performance. According to Wahal, “targeting announcement abnormal returns are not
reliably different from zero,” and “[t]he long-term abnormal stock price performance of targeted
firms is negative prior to targeting and still is negative after targeting.” Wahal also found that
“accounting measures of performance do not suggest improvements in operating or net income
either; accounting measures of performance also are negative prior to and after targeting.”

● Two studies released by the U.S. Chamber of Commerce in partnership with Navigant
Consulting reviewed shareholder proxy proposals between 2002-2008 and 2009-2012, respectively,
for impact on firm performance. The studies, published in May 2009 and May 2013, both focused
on shareholder proposals that were identified as “Key Votes” by the AFL-CIO in annual surveys
during the respective time periods, including proposals reflecting board declassifications, proxy

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access and director removal policies. In the first study, “Analysis of the Wealth Effects of
Shareholder Proposals – Volume II,” Joao Dos Santos and Chen Song reviewed 166 shareholder
proposals between 2002-2008 and found “no evidence of a statistically significant overall short-run
or long-run improvement and some indication of a long-run decrease in market value for the firms
in our sample.” In the second study, “Analysis of the Wealth Effects of Shareholder Proposals –
Volume III,” which reviewed 97 shareholder proposals between 2009-2012, Allan T. Ingraham and
Anna Koyfman came to similar conclusions: “We . . . find no conclusive or pervasive evidence that
the shareholder proposals assessed in this study improve firm value or result in an economic benefit
to pension plans and plan participants. Given that the proxy process imposes costs on both firms
and shareholders, and given that there are no proven benefits in terms of corporate performance, the
overall net benefit of these initiatives is likely negative.”

● Andrew K. Prevost and Ramesh P. Rao studied the impact of shareholder activism by public
pension funds in their paper “Of What Value Are Shareholder Proposals Sponsored by Public
Pension Funds?” (published in the Journal of Business in 2000), examining a total of 73 firms that
received shareholder proposals during the period of 1988-1994. They came to the following
conclusions: “Firms that are subject to shareholder proposals only once during the sample period
experience transitory declines in returns, but firms that are subject to repeat shareholder proposals
experience permanent declines in market returns. . . . Long-term changes in operating performance
corroborate the event study results: firms targeted only once exhibit positive but insignificant long-
term results, while those targeted repeatedly show strong declining performance.”

● Jonathan M. Karpoff, Paul H. Malatesta and Ralph A. Walkling reviewed 522 shareholder
proposals at 269 companies between 1986 and 1990 to determine the impact of shareholder
proposals on firm performance in “Corporate Governance and Shareholder Initiatives: Empirical
Evidence,” published in the Journal of Financial Economics in 1996. After finding that “proposals
are targeted at poorly performing firms,” they concluded that, notwithstanding this fact, the
“average effect of shareholder corporate governance proposals on stock values is close to, and not
significantly different from, zero.” In fact, “[s]ales growth declines for firms that receive proposals
in relation to sales growth for control firms,” “[c]hanges in operating return on sales are not
significantly larger for proposal firms than their controls, and are not significantly related to the
persistence or intensity of proposal pressure, or to the sponsors’ identity,” and “[c]hange in
operating ROA are not related to the pressure’s intensity or sponsors’ identity.”

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● In “Less is More: Making Institutional Shareholder Activism a Valuable Mechanism of
Corporate Governance,” published in the Yale Journal on Regulation in 2001, Yale Law School
professor Roberta Romano conducted a review of the corporate finance literature on institutional
investors’ corporate governance activities, involving seven different empirical studies and a total of
over 4,500 individual shareholder proposals. She found that the shareholder proposals had “little or
no effect on targeted firms’ performance” over the time periods considered in the studies and
proposed that improvements might be achieved if the rules were revised “to require proposal
sponsors either to incur the full cost of a losing proposal or a substantial part of the cost.”

● It is particularly noteworthy that CalSTRS, one of the major public employee pension funds and
one of the leaders in proxy voting and investing in activist hedge funds, has recently reported that
its aggregate investments in activist funds as of October 2012 trailed the United States public equity
market, as shown by this chart from its annual report.

If activist funds fail to achieve attractive returns for their own investors, it raises the question
whether pension funds and other fiduciary investors are actually promoting the best interests of the
beneficiaries of the funds they manage when they invest in activist funds, given the fact that activist
funds promote short-termism with its attendant costs to the rest of the market and to the economy as

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a whole (see Leo E. Strine’s “One Fundamental Corporate Governance Question We Face: Can
Corporations Be Managed for the Long Term Unless Their Powerful Electorates Also Act and
Think Long Term,” published in The Business Lawyer in November 2010). This month the UK
Law Commission published a consultation paper responding to a government request, based on the
Kay Review discussed below, “To evaluate whether fiduciary duties (as established in law or as
applied in practice) [of investment intermediaries] are conducive to investment strategies in the best
interests of the ultimate beneficiaries. We are asked to carry out this evaluation against a list of
factors, balancing different objectives, including encouraging long-term investment strategies
[emphasis supplied] and requiring a balance of risk and benefit.”

Takeover Defenses and Firm Value

● Approaching the question from another perspective, William C. Johnson, Jonathan M. Karpoff
and Sangho Yi investigated the impact of takeover defenses on firm value in “The Bonding
Hypothesis of Takeover Defenses: Evidence from IPO Firms” (April 29, 2013 working paper,
available at http://papers.ssrn.com/abstract=1923667). Looking at a sample of 1,219 firms that
went public between 1997 and 2005, the authors tested the “bonding hypothesis of takeover
defenses” – that is, the theory that “takeover defenses increase the value of managers’ commitments
to maintain their promised operating strategy and not to opportunistically exploit their
counterparties’ investments in the IPO firm,” which, “in turn, encourages the firm’s counterparties
to invest in the business relationship, yielding benefits for the IPO firm.” The authors reported the
following findings:

(1) IPO firms deploy more takeover defenses when they have large customers,
dependent suppliers, or strategic partners;

(2) The IPO firm’s value is positively related to its use of takeover defenses,
particularly when it has large customers, dependent suppliers, and/or strategic
partners;

(3) The IPO firm’s subsequent operating performance is positively related to its
use of takeover defenses, particularly when it has large customers, dependent
suppliers, and/or strategic partners;

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 (4) When the IPO firm announces its intention to go public, its large customers
experience a change in share values that is positively related to the IPO firm’s
use of takeover defenses; and

(5) After the IPO, the longevity of the IPO firm’s business relationship with its
large customer is positively related to its use of takeover defenses.

According to the authors, these results are explained by the fact that “takeover defenses … help to
economize on the cost of building and maintaining value-increasing trading relationships between
the IPO firm and its counterparties.” As a result, “at IPO firms whose values depend heavily on
their relationships with customers, suppliers, and strategic partners, takeover defenses appear to
increase value by bonding the IPO firm’s commitment to these relationships.”

● In “The Impact of Antitakeover Amendments on Corporate Financial Performance” (published in

The Financial Review in 2001), Mark S. Johnson and Ramesh P. Rao examined a sample of 649
antitakeover amendments adopted between 1979 and 1985 to determine the impact of the passage of
antitakeover amendments on firm share price. Contrary to the management entrenchment
hypothesis, the authors found that “antitakeover amendments are relatively benign events that do
not significantly impact managerial behavior,” and that “antitakeover amendments are not
associated with deleterious effects to shareholders in terms of their impact on various fundamental
firm performance measures.”

Managerial Behavior and Pressures to Achieve Short-Term Performance

● Jie He and Xuan Tian’s “The Dark Side of Analyst Coverage: The Case of Innovation”
(forthcoming in the Journal of Financial Economics) examined the effect of analyst coverage on
firm innovation to investigate how the pressure to achieve short-term performance impacts
managerial behavior. The short-term pressures exerted by activist investors are often no different
than those generated by stock analysts, and in many instances activist investors merely piggyback
on stock analyst commentary when they launch attacks. Examining a sample of 25,860 firm-year
observations relating to U.S. listed firms during the period of 1993-2005, He and Tian explored the
“innovation output” of firms (as measured in terms of the number of (i) patent applications filed in a
given year that are eventually granted and (ii) non-self citations each patent receives in subsequent
years) in relation to the intensity of analyst coverage (as measured by the average number of

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earnings forecasts issued for the firm each month). The authors found that “an exogenous average
loss of one analyst following a firm causes it to generate 18.2% more patents over a three-year
window than a similar firm without any decrease in analyst coverage” and that “an exogenous
average loss of one analyst following a firm leads it to generate patents receiving 29.4% more non-
self citations than a similar firm without any decrease in analyst coverage.” He and Tian
determined that this evidence “is consistent with the hypothesis that analysts exert too much
pressure on managers to meet short-term goals, impeding firms’ investment in long-term innovative
projects.”

● Natalie Mizik published similar findings in “The Theory and Practice of Myopic Management,”
featured in the Journal of Marketing Research in 2010. In this study, Mizik reviewed the operating
performance, marketing spending, R&D spending and stock price performance of 6,642 firms
between 1986 and 2005 to assess the financial consequences of the practice of cutting marketing
and R&D spending to inflate short-term earnings. In order to isolate firms that were potentially
engaging in “myopic management,” Mizik filtered for firms that simultaneously reported greater-
than-normal profits, lower-than-normal marketing expenses and lower-than-normal R&D spending.
Mizik then compared the stock performance of these “potentially myopic” firms against the
performance of “nonmyopic” firms. Potentially myopic firms initially experienced much better
stock performance than the firms that failed to meet performance expectations. However, after four
years, “the portfolio of potentially myopic firms ha[d] a negative return of -15.7%, far below the
return to the two nonmyopic benchmark portfolios (29.2% and 13.3%) and the S&P 500 return of
21.6%.” Mizik concludes that “[m]yopic management might have some short-lived benefits – it
leads to higher current-term earnings and stock price – but it damages the long-term financial
performance of the firm because the initial gains are followed by greater negative abnormal
returns.”

● Aleksandra Kacperczyk’s “With Greater Power Comes Greater Responsibility?” (published in

the Strategic Management Journal in 2009) tested the effect of takeover protection on the amount
of corporate attention paid to shareholders and non-shareholding stakeholders, respectively.
Looking at a sample of 878 firms between 1991 and 2002, Kacperczyk found that “an exogenous
increase in takeover protection leads to higher corporate attention to community and the natural
environment, but has no impact on corporate attention to employees, minorities and customers,” and
that “firms that increase their attention to stakeholders experience an increase in long-term

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shareholder value,” measured over the two-year and three-year periods following the increase in
takeover protection.

● Other empirical studies have shown that pressure from investors with short investment horizons
can influence management to engage in financial misreporting. In “Institutional Ownership and
Monitoring: Evidence from Financial Misreporting” (published in the Journal of Corporate
Finance in 2010), Natasha Burns, Simi Kedia and Marc Lipson examined a sample of firms that
restated their earnings between 1997 and 2002, finding that ownership by “transient institutions”
(those with short investment horizons) are positively related with an increase in the likelihood and
severity of an accounting restatement. The authors concluded that “[i]t is precisely these
institutions, which trade frequently and therefore are likely to focus management attention on short-
term reported performance, that provide incentives to manipulate earnings.”

● Another relevant study coming out of the financial crisis examined whether the corporate
governance characteristics of banks impacted the likelihood of banks requiring government
“bailout” support during the financial crisis. In “Shareholder Empowerment and Bank Bailouts” (a
2012 working paper), Daniel Ferreira, David Kershaw, Tom Kirchmaier and Edmund Schuster
created a “management insulation” index ranking the degree of banks’ management insulation
based on their charter and by-law provisions and on the provisions of the applicable state corporate
law that make it difficult for shareholders to oust management. They found that, in a sample of
U.S. commercial banks, banks in which managers are “fully insulated” from shareholders were
roughly 19 to 26 percentage points less likely to receive state bailouts than banks whose managers
were subject to stronger shareholder rights. The authors explained that “[b]ank shareholders may
have incentives to increase risk taking beyond the socially-optimal level” and that, “in search for
higher returns, bank shareholders had incentives to push their banks towards less traditional banking
activities.”

● In his article “Do Institutional Investors Prefer Near-Term Earnings Over Long-Run Value?”
(published in Contemporary Accounting Research in 2001), Brian Bushee examined a sample of
10,380 firm-years between 1980 and 1992 to determine whether institutional investors exhibit
preferences for near-term earnings over long-run value. Bushee found that “the level of ownership
by institutions with short investment horizons (transient institutions) and by institutions held to
stringent fiduciary standards (banks) is positively (negatively) associated with the amount of value

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in near-term (long-term) earnings.” Bushee found no evidence that banks “myopically price” firms
by overweighting short-term earnings potential and underweighting long-term earnings potential.
However, in transient institutions “high levels of transient ownership are associated with an over-
(under-) weighting of near-term (long-term) expected earnings and a trading strategy based on this
finding generates significant abnormal returns. This finding supports the concerns that many
corporate managers have about the adverse effects of an ownership base dominated by short-term-
focused institutional investors.”

● The above result is consistent with an earlier empirical study by Bushee that examined the
influence of shareholder demographics on earnings management by managers. In “The Influence of
Institutional Investors on Myopic R&D Investment Behavior,” published in the Accounting Review
in 1998, Bushee investigated whether institutional investors create or reduce incentives for
corporate managers to reduce investment in research and development to meet short-term earnings
goals. Examining a sample of all firm-years between 1983 and 1994 with available data, Bushee
found that “a high proportion of ownership by institutions exhibiting transient ownership
characteristics (i.e., high portfolio turnover, diversification, and momentum trading) significantly
increases the probability that managers reduce R&D to boost earnings.” Bushee believed that
“[t]his result supports the widely-argued view that short-term-oriented behavior by institutions
creates pressures for managers to sacrifice R&D for the sake of higher current earnings” among
those firms with high levels of transient ownership.

● William Pugh, Daniel Page and John Jahera, Jr.’s “Antitakeover Charter Amendments: Effects
on Corporate Decisions” (published in the Journal of Financial Research in 1992) tested whether
managers adopt a longer-term investment strategy after their firm passes antitakeover charter
amendments. Examining a sample of firms that adopted antitakeover charter amendments between
1978 and 1985, the authors found that “firms increase spending on fixed capital as a percentage of
both sales and assets the year of passage and for several years thereafter,” and that overall results
with respect to R&D expenditures “appear to support the managerial myopia hypothesis.”

● A recent survey of 1,038 board members and executives by McKinsey & Company and the
Canada Pension Plan Investment Board found startling levels of short-term orientation among
corporate executives. As reported in the Wall Street Journal on May 22, 2013, this study found the
following:

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 - Sixty-three percent of business leaders indicated the pressure on their senior
executives to demonstrate strong short-term financial performance has increased
in the past five years.

- Seventy-nine percent of directors and senior executives said they felt the most
pressure to demonstrate strong financial performance over a time period of less
than 2 years. Only 7% said they felt pressure to deliver strong financial
performance over a horizon of 5 or more years.

- However, respondents identified innovation and strong financial returns as the

top two benefits their company would realize if their senior executives took a
longer-term view to business decisions.

- Yet, almost half of respondents (44%) said that their company's management
team currently uses a primary time horizon of less than 3 years when they
conduct a formal review of corporate strategy. Seventy-three percent said this
primary time horizon should be more than 3 years and 11% said the horizon
should be more than 10 years.

● The McKinsey findings are consistent with an earlier study published in the Financial Analysts
Journal in 2006. In “Value Destruction and Financial Reporting Decisions,” John Graham,
Campbell Harvey and Shiva Rajgopal described the results of a survey of 401 senior financial
executives. Going a step further than the McKinsey study, the authors asked executives if they
would be willing to sacrifice long-term value in order to smooth earnings. An “astonishing 78%
admit[ted] they would sacrifice a small, moderate or large amount of value to achieve a smoother
earnings path.”

Short-Termism and Macroeconomic Productivity

● The problems discussed above have larger implications than simply the performance of
individual firms. In his 2012 book, Corporate Law and Economic Stagnation: How Shareholder
Value and Short-Termism Contribute to the Decline of the Western Economies, Pavlos Masouros
used macroeconomic data to show that the shift in corporate governance toward shareholder
interests and increasing short-termism in France, Germany, the Netherlands, the UK and the US
have contributed to low GDP growth rates in those countries since the early 1970s. Masouros

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outlined the unfolding of a “Great Reversal in Corporate Governance” whereby the primacy of
shareholder value in the corporate governance pecking order was established, as well as a “Great
Reversal in Shareholdership” where the average holding period of shares rapidly decreased, both of
which contributed to a dramatic increase in the average equity-payout ratio of firms and a decrease
in the average capital retention and reinvestment of profits by firms. Masouros’ prescription for
ameliorating this trend away from capital reinvestment is what he calls “Long Governance” –
moving toward a system where shareholders are infused with incentives that would allow them to
develop long-term horizons that would align their interests with other constituencies and increase
companies’ incentives to invest in future productivity.

● In “The Kay Review of UK Equity Markets and Long-Term Decision Making,” published by the
UK Department for Business Innovation and Skills in July 2012 (the “Kay Review”), John Kay
examined how the structure of the UK equity markets encourages short-termism and discussed the
impact on UK businesses and investors. Kay started with the observation that “[a]s a percentage of
GDP, research and development expenditure by British business has been in steady decline” and
proceeded to explore why this was the case. He then identified a fundamental misalignment of the
interests of the UK asset management industry and the ultimate principals, the companies which use
equity markets and the individual UK “savers” who provide funds to them: “Returns to beneficial
owners, taken as a whole, can be enhanced only by improving the performance of the corporate
sector as a whole. Returns to any subset of beneficial owners can be enhanced, at the expense of
other investors, by the superior relative performance of their own asset managers. Asset managers
search for alpha, risk adjusted outperformance relative to a benchmark. But savers collectively will
earn beta, the average return on the asset class.” This misalignment exists because “the time
horizons used for decisions to hire or review investment managers are generally significantly
shorter than the time horizon over which the saver, or the corporate sponsor of a pension scheme, is
looking to maximize a return.” Kay pointed out that “[c]ompetition between asset managers to
outperform each other by anticipating the changing whims of market sentiment … can add nothing,
in aggregate, to the value of companies … and hence nothing to the overall returns to savers.”
Predictably, the short-term incentives of asset managers flow down to corporate managers, many of
whom are incentivized “to make decisions whose immediate effects are positive even if the long run
impact is not” and “whose consequences are likely to be apparent within a short time scale.” After
describing the problem in great detail, Kay presented a series of recommendations that he believed
“will help to deliver the improvements to equity markets necessary to support sustainable long-term

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value creation by British companies,” including the recommendation that “regulation must be
directed towards the interests of market users – companies and savers – rather than the concerns of
market intermediaries.” The applicability of Kay’s analysis to American equity markets is obvious.

The Evidence of Experience

No matter how much Professor Bebchuk attempts to denigrate what he calls “anecdotal”
evidence, the experiences of those with “boots on the ground” must be taken into consideration in
combination with the empirical evidence sampled above. Take, for example, some of the
statements below from leaders who have firsthand experience with the short-term pressures faced
by public company managers and directors.

● Bill George, a professor at Harvard Business School, former chief executive of the medical
device company Medtronic, and currently a director of Goldman Sachs and Exxon Mobil, recently
said in his August 2013 New York Times article, Activists Seek Short-Term Gain, Not Long-Term
Value: “While activists often cloak their demands in the language of long-term actions, their real
goal is a short-term bump in the stock price. They lobby publicly for significant structural changes,
hoping to drive up the share price and book quick profits. Then they bail out, leaving corporate
management to clean up the mess. Far from shaping up these companies, the activists’ pressure for
financial engineering only distracts management from focusing on long-term global
competitiveness.”

● Warren Buffet and 27 other highly regarded businesspeople, academics, investment bankers and
union leaders expressed concerns about short-termism in “Overcoming Short-Termism: A Call for
a More Responsible Approach to Investment and Business Management,” a 2009 Aspen Institute
policy statement. In this paper, these leaders voiced concern that “boards, managers, shareholders
with varying agendas, and regulators, all, to one degree or another, have allowed short-term
considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the
corporation,” and that this trend toward short-term objectives has “eroded faith in corporations
continuing to be the foundation of the American free enterprise system.” In particular, they noted
that “the focus of some short-term investors on quarterly earnings and other short-term metrics can
harm the interests of shareholders seeking long-term growth and sustainable earnings, if
managements and boards pursue strategies simply to satisfy those short-term investors,” which
“may put a corporation’s future at risk.”

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● Dominic Barton, global managing director of McKinsey & Company, described the problem in
“Capitalism for the Long-Term,” a 2012 McKinsey publication: “[E]xecutives must do a better job
of filtering input and should give more weight to the views of investors with a longer-term, buy-
and-hold orientation. . . . If they don’t, short-term capital will beget short-term management through
a natural chain of incentives and influence. If CEOs miss their quarterly earnings targets, some big
investors agitate for their removal. As a result, CEOs and their top teams work overtime to meet
those targets. The unintended upshot is that they manage for only a small portion of their firm’s
value. When McKinsey’s finance experts deconstruct the value expectations embedded in share
prices, we typically find that 70 to 90 percent of a company’s value is related to cash flows expected
three or more years out. If the vast majority of most firms’ value depends on results more than
three years from now, but management is preoccupied with what’s reportable three months from
now, then capitalism has a problem.”

● Daniel Vasella, former chairman and CEO of Novartis AG, spoke firsthand about the pernicious
effects of the pressure created by such short-term expectations in a 2002 Fortune article: “Once
you get under the domination of making the quarter – even unwittingly – you start to compromise in
the gray areas of your business, that wide swath of terrain between the top and bottom lines.
Perhaps you’ll begin to sacrifice things (such as funding a promising research-and-development
project, incremental improvements to your products, customer service, employee training,
expansion into new markets, and yes, community outreach) that are important and that may be vital
for your company over the long term.”

A Proposal for Effective Shareholder Engagement

In laying out the evidence above, I do not mean to say that all forms of investor engagement are
bad. To the contrary, I believe that collaborative interaction between boards and long-term
shareholders can help increase the effectiveness of boards. Consider the observations of John Kay
in the Kay Review. Kay encouraged “effective engagement” between asset managers and the
companies they invest in. However, he did not hold all forms of engagement equal, arguing instead
that all participants in the equity investment chain should act according to the principles of what he
calls “stewardship”: “Our approach, which emphasizes relationships based on trust and respect,
rooted in analysis and engagement, develops and extends the existing concept of stewardship in
equity investment. This extended concept of stewardship requires that the skills and knowledge of

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the asset manager be integrated with the supervisory role of those employed in corporate
governance: it looks forward to an engagement which is most commonly positive and supportive,
and not merely critical.” Kay recommends that company directors “facilitate engagement with
shareholders, and in particular institutional shareholders such as asset managers and asset holders,
based on open and ongoing dialogue about their long-term concerns and investment objectives.”
But, importantly, he also emphasizes that directors should “not allow expectations of market
reaction to particular short-term performance metrics to significantly influence company strategy.”

I support Kay’s views on what constitutes “effective engagement” and believe

shareholder collaboration with management and directors along these lines could be a value-
enhancing development for many companies both in the short-run and long-run.

Standing Firm, Not Running Away

As to Professor Bebchuk’s allegation, I think it is clear that, far from “running away”
from the evidence, my views and my colleagues’ views are supported by many highly respected
academics, policymakers, investors and business leaders whose empirical analyses and real-world
experiences show that most activist interventions contribute to managerial short-termism and harm
the innovation and growth potential of American companies. It is also clear that empirical evidence
must be considered in context with other forms of evidence, including macroeconomic analysis,
real-world experience and common sense, to determine if it tells a story that makes sense in the real
world.

Martin Lipton

With thanks to:

Steven A. Rosenblum
Eric S. Robinson
Karessa L. Cain
Sabastian V. Niles
William T. Clayton

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 March 13, 2014

A Response to Bebchuk and Jackson’s

Toward a Constitutional Review of the Poison Pill

In a recent paper, Professors Lucian Bebchuk and Robert Jackson have extended
Professor Bebchuk’s extreme and eccentric campaign against director-centric governance into a
new realm—that of the Constitution of the United States. They claim that “serious questions”
exist about the constitutionality of the poison pill—or, more precisely, “about the validity of the
state-law rules that authorize the use of the poison pill.” It is likely, they argue, that these state-
law rules violate the Supremacy Clause of the Constitution, and are thus preempted, because they
frustrate the purposes of the Williams Act, the 1968 federal statute that governs tender-offer
timing and disclosure.

Bebchuk and Jackson cite leading academic textbooks and articles that either
recognize the preeminence of the poison pill in takeover defense or demonstrate the weakness of
preemption challenges to state takeover statutes. The scholars authoring these books and
articles, we are told, “overlooked” or “ignored” the obvious fact that poison pills may delay
tender offers for lengthy periods of time. Bebchuk and Jackson profess “surpris[e]” that the
constitutional issue they discuss “has received little attention, or even notice, from
commentators,” and assert that it is rather a shocking “oversight” that, despite a “large literature”
on Williams Act preemption, “commentators and practitioners” have devoted “little attention to
the question of whether the state-law rules with the most powerful antitakeover effect—the rules
authorizing use of the poison pill—are preempted.”

And, as far as courts are concerned, Bebchuk and Jackson claim that their discovery of
the pill’s unconstitutionality is utterly brand new: “litigation based on … a claim” that “state-
law poison-pill rules may well be preempted has not yet been pursued.” Bebchuk and Jackson
definitively declare that “no court has ever expressly considered a preemption challenge to the
validity of state-law poison-pill rules.” (Emphasis added.) It is for this reason, they insist, that
“the courts have not yet resolved” the question. Were a preemption challenge to the poison pill
to be brought now for the first time, they argue, courts would likely look to whether the pill
permits “tender offerors … a meaningful opportunity to successfully acquire the target and
whether shareholders are given an opportunity to evaluate the merits of tender offers.” This test,
they posit, the pill would fail.

Bebchuk and Jackson’s paper is tendentious and misleading—and, in material

respects, simply wrong. It is not a work of serious scholarship. It is an attempt at advocacy, but
fails even at that. From their paper, a reader would never know

 that, in 1985, in the landmark Household litigation that established the validity of
the poison pill, the Delaware Supreme Court expressly rejected the plaintiff’s
argument that, were it construed to allow the pill, Delaware law would be
preempted by the Williams Act;

 that, in an important decision in 1995, the United States Court of Appeals for the
Fourth Circuit rejected a bidder’s preemption challenge to a statute that not only

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 authorized poison pills, but also cloaked directors’ decisions regarding pills with
the powerful protections of a traditional, plain-vanilla, no-heightened-scrutiny
business-judgment rule;

 that this Fourth Circuit decision not only explicitly rejected Bebchuk and
Jackson’s “meaningful opportunity” standard, but also held that a state’s “decision
to allow management access to a set of defensive mechanisms in the takeover
situation”—including, and especially, the pill—in no way “frustrates the Williams
Act’s goal of investor protection,” and is thus not preempted, even if those
defensive mechanisms “work to give target management an advantage in the
tender offer context”;

 that, in the leading decision addressing Williams Act preemption challenges to

state antitakeover laws, the United States Court of Appeals for the Seventh Circuit,
in an opinion by Judge Frank Easterbrook, rejected such a challenge in part
because “firms issue and state law enforces poison pills” and other “devices [that]
make tender offers unattractive ([or] even impossible)”—and stated that “[n]one of
these devices could be thought preempted by the Williams Act”;

 that, in the same decision, the Seventh Circuit held that “rules governing the inter-
nal affairs of corporations … are not preempted by the Williams Act,” that
“investors have no right to receive tender offers,” and that, “[m]ore to the point[,]
… the Williams Act does not create a right to profit from the business of making
tender offers”;

 that the Seventh and Fourth Circuit decisions represent the law on Williams Act
preemption today; and

 that the district court decisions from which Bebchuk and Jackson derive their
“meaningful opportunity” standard are based upon an overly expansive and now
discredited view of Williams Act preemption that commanded the support of, at
most, only three members of the Supreme Court some 32 years ago.

Bebchuk and Jackson’s article thus conveys a fanciful vision of Williams Act
preemption standards that in no way reflects the true state of the law today. To set the record
straight, we set forth here a short history of Supremacy Clause challenges to takeover statutes
and to the poison pill.

The Supremacy Clause, the Williams Act,

and the Act’s History and Purpose

The Constitution’s Supremacy Clause provides that “[t]his Constitution, and the Laws
of the United States made in Pursuance thereof … shall be the supreme Law of the Land; and the
Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State
to the Contrary notwithstanding.” It thus renders a state law ineffective—preempted—whenever
that law conflicts with a federal statute.

2
 Whether state law is preempted by federal law turns on Congress’s intent and purpose
in enacting the federal law. Preemption can occur in several ways. Congress can expressly
preempt state law by explicitly barring state law from applying to a particular matter. State law
can also be impliedly preempted. Implied preemption occurs when a state law directly conflicts
with federal law—when it is impossible to comply with the requirements of both state and
federal law. It also occurs when federal law has so occupied the field, so pervasively regulated a
particular subject, that application of state law must be precluded. Finally, implied preemption
occurs when a challenged state law “stands as an obstacle to the full accomplishment and
execution of the full purposes and objectives of Congress.”

It is on this last prong of preemption that Bebchuk and Jackson hang their hats. They
argue that, in enacting the Williams Act in 1968, Congress sought to “give tender offerors a
‘meaningful opportunity for success,’” and to “set[] a floor”—a substantive floor—“for the level
of protection shareholders must receive in connection with tender offers.” As a result, they say,
“current state-law poison pill rules” should be declared preempted because “these rules give
hostile offerors no practical opportunity for success,” as “they allow incumbents to block a
hostile offer from shareholder consideration for long periods of time,” and because the “state-law
rules today empower directors to adopt arrangements that permit incumbents, rather than
investors, to decide whether shareholders may accept a tender offer.”

These arguments are premised upon a gross overreading of the Williams Act. The
Williams Act does not give hostile offerors a substantive right to have their offers succeed, and
does not even give shareholders a right to receive such offers. And it does not remotely betray
any intent to overturn any state law, statutory or decisional, that addresses the fiduciary duties of
directors in matters relating to corporate control—or, for that matter, any substantive aspect of
the relationships among shareholders, directors, and the corporation.

To the contrary, the Williams Act was a simple and narrow law. It was also
commendably short, barely over four pages long; so that the reader can see it for himself or
herself, we link to it here. It regulates only the process of tender offers. It thus addresses the
disclosures that offerors must make, and when they must make them. It addresses the timing of
offers—how long stockholders must have to withdraw their tendered shares. It addresses the
terms of permissible offers, requiring bidders to pay the same price to all tendering shareholders,
and requiring, in the event of oversubscription in partial offers, purchases to be prorated among
all who tendered shares. Finally, the law contains a broad antifraud provision governing
disclosures and practices in connection with tender offers.

Just as nothing in the law’s text suggests that state fiduciary-duty law is to be
disturbed, nothing in the legislative history does either. That history is also short and clear; for
the reader’s convenience, we have posted the relevant House and Senate reports here and here.
The legislative history makes clear that Congress in 1968 was concerned with unfair tactics of
hostile offerors—in particular, the then-burgeoning practice of “Saturday night special” tender
offers, by which bidders would suddenly launch a quickly expiring offer over a weekend in order
to coerce and stampede shareholders into tendering. As the Supreme Court explained in Piper v.
Chris-Craft Industries, quoting the floor statement of a Senate cosponsor:

3
 The legislative history thus shows that Congress was intent upon regulating
takeover bidders, theretofore operating covertly, in order to protect the shareholders of
target companies. That tender offerors were not the intended beneficiaries of the bill
was graphically illustrated by the statements of Senator Kuchel, cosponsor of the
legislation in support of requiring takeover bidders, whom he described as “corporate
raiders” and “takeover pirates,” to disclose their activities.
“Today there are individuals in our financial community who seek to reduce
our proudest businesses into nothing but corporate shells. They seize control of
the corporation with unknown sources, sell or trade away the best assets, and later
split up the remains among themselves. The tragedy of such collusion is that the
corporation can be financially raped without management or shareholders having
any knowledge of the acquisitions. … The corporate raider may thus act under a
cloak of secrecy while obtaining the shares needed to put him on the road to a
successful capture of the company.”

Despite this overarching concern about “corporate raiders” and “takeover pirates”
engaging in “financial rape[]” under a “cloak of secrecy,” Congress nevertheless was, as the
Court put it in Piper, “plainly sensitive to the suggestion that the measure would favor one side
or the other in control contests.” And that is why Congress chose to pass only a limited measure
governing the process of tender offers—in particular, disclosure. As the Court in Piper
explained, the Williams Act’s sponsors

made it clear that the legislation was designed solely to get needed information to the
investor, the constant focal point of the committee hearings. Senator Williams
articulated this singleness of purpose, even while advocating neutrality:
“We have taken extreme care to avoid tipping the scales either in favor of
management or in favor of the person making the takeover bids. S. 510 is
designed solely to require full and fair disclosure for the benefit of investors.”

In short, as the Supreme Court explained in Rondeau v. Mosinee Paper Corp., “[t]he
purpose of the Williams Act is to insure that public shareholders who are confronted by a cash
tender offer for their stock will not be required to respond without adequate information
regarding the qualifications and intentions of the offering party.” As a result, nothing about the
Williams Act suggests that Congress intended in any way to regulate or restrict the substantive
powers of directors to respond to takeover bids, or to otherwise displace the state law that
controls a corporation’s internal affairs. To the contrary, as far as those matters were concerned,
and apart from matters of disclosure, Congress sought to be neutral and evenhanded—it chose to
leave the balance between targets and bidders, as established by state law, alone.

Justice White’s Misreading of the Williams Act

in Edgar v. MITE Corp.

In arguing the contrary, Bebchuk and Jackson rely on an opposing view of the
Williams Act that was suggested over 30 years ago by only three Justices of the Supreme
Court—a view that has never commanded a majority. In 1982 in Edgar v. MITE Corp., the
Supreme Court addressed a constitutional challenge, under the Commerce and Supremacy

4
Clauses, to a so-called “first generation” takeover statute. The challenged Illinois law prohibited
tender offers for the shares of any firm with substantial shareholdings in Illinois unless the offer
were approved as fair by the Illinois secretary of state. The Seventh Circuit had struck the law as
both violating the Commerce Clause and preempted by the Williams Act.

By a vote of 6 to 3, the Supreme Court affirmed—but only reached the Commerce

Clause challenge. The Court did not render any holding on the Williams Act preemption claim.
In an opinion on behalf of only himself, Chief Justice Burger, and Justice Blackmun, however,
Justice White wrote that, in his view, the Illinois law conflicted with the Williams Act and thus
violated the Supremacy Clause as well. Expressing an expansive view that Bebchuk and Jackson
today seek to resurrect, Justice White argued that the “policy of neutrality” and
“‘evenhandedness’” embodied in the Williams Act meant that “Congress intended to strike a
balance [among] the investor, management, and the takeover bidder.” In other words, Justice
White argued that Congress intended to strike and enforce its own evenhanded balance between
targets and bidders—and not simply that Congress sought to be neutral and evenhanded as to the
balance already struck by state law. Justice White’s view represents a stunningly capacious, and
ultimately insupportable, view of the purposes of the Williams Act: as one court of appeals later
crisply explained, “it is a big leap from saying that the Williams Act does not itself exhibit much
hostility to tender offers to saying that it implicitly forbids states to adopt more hostile
regulations.”

Six Justices in MITE did not join in Justice White’s leap. Three Justices declined to
address the merits at all, finding the case nonjusticiable because it was either moot or unripe.
One Justice declined to address preemption because it was unnecessary to do so in light of the
Court’s Commerce Clause holding. Two Justices, however, squarely rejected Justice White’s
idiosyncratic interpretation of the Williams Act. Justice Stevens refused to join that approach
because he was “not persuaded … that Congress’ decision to follow a policy of neutrality in its
own legislation is tantamount to a federal prohibition against state legislation designed to provide
special protection for incumbent management.” And Justice Powell “agree[d] with Justice
Stevens that the Williams Act’s neutrality policy does not necessarily imply a congressional
intent to prohibit state legislation designed to assure—at least in some circumstances—greater
protection to interests that include but often are broader than those of incumbent management.”

Even though Justice White’s views of the Williams Act failed to convince a majority,
bidders and others immediately seized on those views to launch further attacks on other takeover
laws and defensive measures. In fact, in 1984, in Moran v. Household International, Inc.—the
landmark Delaware litigation establishing the validity of the poison pill—the plaintiffs, citing
Justice White’s opinion, expressly argued in both the Delaware Court of Chancery and the
Delaware Supreme Court that, were it construed to authorize the pill, Delaware law would be
preempted by the Williams Act because it would “upset[] the neutrality between a tender offeror
and target management which Congress sought to establish through the Williams Act.” The
plaintiffs even received support from an amicus brief filed by the Securities and Exchange
Commission, which stopped short of arguing that Delaware law would be preempted, but
nonetheless asserted that the pill was “a practice more extreme than” takeover statutes and would
“frustrate the shareholder choice that Congress and the Commission have viewed as being in the
shareholder interest.” For its part, in its seminal decision, the Delaware Supreme Court rejected
the preemption challenge to the pill, and held that the directors’ actions in approving the pill

5
“provide[d] an insufficient nexus to the state for there to be state action which may violate the …
Supremacy Clause.”

Second-Generation Takeover Laws Are Upheld:

CTS Corp. v. Dynamics Corp. of America

Justice White’s commodious view of the Williams Act’s preemptive scope fared no
better with his colleagues in CTS Corp. v. Dynamics Corp. of America, a 1987 decision that
represents the Supreme Court’s only other encounter with takeover defense. CTS presented
Commerce Clause and Supremacy Clause challenges to a “second generation” takeover statute—
an Indiana statute that provided that a bidder’s shares lose their voting power unless either the
target’s directors approved the acquisition, or the target shareholders not affiliated with the
bidder or management did so. The Seventh Circuit struck down this law as well, again on both
Commerce Clause and preemption grounds.

This time, however, the Supreme Court reversed, and upheld the statute by a 6-to-3
vote. Justice White dissented—and was the only Justice who argued that the Indiana law was
preempted. Justice Powell’s opinion for the Court squarely rejected the preemption claim. In
doing so, the Court pointedly noted that Justice White’s “opinion in MITE did not represent the
views of a majority of the Court”—that it was joined “only by Chief Justice Burger and by
Justice Blackmun,” and that “[t]wo Justices disagreed with Justice White’s conclusion.” As a
result, the Court emphasized, “we are not bound by its reasoning.” The CTS Court nevertheless
applied its understanding of Justice White’s approach in MITE for the sake of argument—and
found that “the Indiana Act passes muster even under the broad interpretation of the Williams
Act articulated by Justice White in MITE.” As a result, in rejecting the bidder’s preemption
argument in CTS, the Court did not issue a definitive holding on the Williams Act’s overall
preemptive scope.

Still, the Court’s opinion in CTS made a number of statements that made clear its
skepticism about expansive Williams Act preemption—and in particular, its respect for the
states’ historic and traditional prerogative in establishing principles of corporate law. “[I]f it
were construed to pre-empt any state statute that may limit or delay the free exercise of power
after a successful tender offer,” the Court observed, “the Williams Act would pre-empt a variety
of state corporate laws of hitherto unquestioned validity.” As examples, the Court cited
staggered boards and cumulative voting—both of which could serve to “delay … the ability of
offerors to gain untrammeled authority over the affairs of the target corporation.”

All of this strongly cut against preemption, in the Court’s view:

The longstanding prevalence of state regulation in this area suggests that, if Congress
had intended to pre-empt all state laws that delay the acquisition of voting control
following a tender offer, it would have said so explicitly. [Emphasis added.]

And, quite notably, the Court in CTS also observed that the Indiana statute was
designed to protect shareholders against coercive tender offers in which stockholders are forced
to tender for fear of receiving diminished value in a back-end, second-step transaction. That aim,

6
the Court noted, was quite consonant with, and not contrary to, the policies underlying the
Williams Act:

The desire of the Indiana Legislature to protect shareholders of Indiana corporations

from this type of coercive offer does not conflict with the Williams Act. Rather, it
furthers the federal policy of investor protection. [Emphasis added.]

Williams Act Preemption After CTS:

the “Meaningful Opportunity” Test

Given the Supreme Court’s obvious misgivings about preemption of state corporate
law, virtually all Williams Act preemption challenges to takeover statutes thereafter failed—
other than those involving first-generation state takeover statutes, or state statutes imposing
disclosure obligations that specifically “intrude[d] upon” the Williams Act’s scheme “for
regulating disclosure” and thus created “an ‘actual conflict between federal and state law’” on
“disclosure regulation.”

Most of the post-CTS cases involved challenges brought in 1988 and 1989 to “third
generation” takeover statutes, such as Section 203 of the Delaware General Corporation Law.
Generally speaking, these third-generation takeover statutes—also known as “business
combination” laws—prohibit a would-be acquirer from engaging in a back-end merger with a
target if the acquirer purchases a certain threshold percentage of the target’s stock without first
obtaining the approval of the target’s board. These laws were consistently found to be consonant
with the Williams Act and thus constitutional.

Some courts reached this conclusion by following the approach that the Supreme
Court took in CTS: they assumed the validity of Justice White’s capacious view of the Williams
Act, but found the preemption claims to be meritless anyway. Thus, for example, in a leading
case addressing Delaware’s Section 203, RP Acquisition Corp. v. Staley Continental, Inc., the
federal district court in Delaware applied Justice White’s “‘broad interpretation’” “for the sake of
argument,” and, given its conclusion that “Section 203 survives [that] standard,” saw no need to
“explore what narrower standard the CTS court might have approved.” RP Acquisition, and
other district court cases like it, went on to apply a standard that Bebchuk and Jackson now argue
should doom the poison pill—the “meaningful opportunity for success” test. The third-
generation laws were not preempted by the Williams Act, these courts held, because hostile
bidders still had a meaningful opportunity for success.

Judge Easterbrook’s Landmark Opinion in

Amanda Acquisition v. Universal Foods

But these cases, decided in 1988 and 1989, did not provide the final word on the
question of Williams Act preemption. To the contrary, that word comes from two seminal court
of appeals decisions that decisively rejected the “meaningful opportunity for success” test—and
effectively put to rest Justice White’s erroneous view of the Williams Act. These appellate
decisions leave no doubt today that state laws governing poison pills are entirely constitutional.
Indeed, both of the decisions so stated, and one of the two expressly so held.

7
 The first was the Seventh Circuit’s powerful decision in 1989 in Amanda Acquisition
Corp. v. Universal Foods Corp.—a case that our Firm briefed, argued, and won. Amanda
Acquisition rejected a bidder’s constitutional challenges to Wisconsin’s third-generation takeover
law. Interestingly enough, the opinion’s author was none other than Judge Frank Easterbrook—a
former University of Chicago law professor who, as a corporate law scholar, had published an
article that directly attacked our Firm’s views on the role that directors should and must properly
play in protecting companies from hostile takeover bids. Then-Professor Easterbrook’s article
famously took the extreme position that directors’ fiduciary duties should prohibit any and all
defensive tactics, and instead should require directors to be entirely passive in response to all
hostile bids. Needless to say, he was no friend of takeover statutes, or of the pill. In fact, in
Amanda Acquisition itself, as a matter of policy, he strongly criticized both.

But even Judge Easterbrook recognized that the Williams Act, and the Constitution,
did nothing to preclude them. “Skepticism about the wisdom of a state’s law,” he wrote, “does
not lead to the conclusion that the law is beyond the state’s power.” Reviewing MITE and CTS,
he noted that “[p]reemption has not won easy acceptance among the Justices for several
reasons.” Among these, he explained, was “the traditional reluctance of federal courts to infer
preemption of ‘state law in areas traditionally regulated by the States.’” That reluctance was of
particular significance here, he observed, because “[s]tates have regulated corporate affairs,
including mergers and sales of assets, since before the beginning of the nation.”

As for the Williams Act, Judge Easterbrook’s opinion for the Seventh Circuit went on
to observe that, “[t]o say Congress wanted to be neutral between bidder and target … is not to
say that it also forbade the states to favor one of these sides.” “Nothing in the Williams Act says
that the federal compromise among bidders, targets’ managers, and investors is the only
permissible one.” “Every law has a stopping point,” the court added, and the Williams Act’s
stopping point was that it merely “regulates the process of tender offers: timing, disclosure,
proration if tenders exceed what the bidder is willing to buy, best-price rules.” And that was
why, Judge Easterbrook explained, the Supreme Court had upheld the Indiana second-generation
vote-sterilization provision that was at issue in CTS: in the Williams Act, “Congress said
nothing about the voting power of shares acquired in tender offers.”

Most importantly, the Seventh Circuit explained how CTS made clear that the
Williams Act could not be deemed to preempt state laws “governing the internal affairs of
corporations,” no matter what effect those laws might have on takeover bids:

CTS observed that laws affecting the voting power of acquired shares do not
differ in principle from many other rules governing the internal affairs of corporations.
Laws requiring staggered or classified boards of directors delay the transfer of control
to the bidder; laws requiring [a] supermajority vote for a merger may make a
transaction less attractive or impossible. Yet these are not preempted by the Williams
Act, any more than state laws concerning the effect of investors’ votes are preempted
by the portions of the Exchange Act regulating the process of soliciting proxies.
Federal securities laws frequently regulate process while state corporate law regulates
substance. Federal proxy rules demand that firms disclose many things, in order to
promote informed voting. Yet states may permit or compel a supermajority rule (even

8
 a unanimity rule) rendering it all but impossible for a particular side to prevail in the
voting. Are the state laws therefore preempted?

The court went on to list other defensive practices and devices that were permissible under state
law and simply could not “be thought [to be] preempted by the Williams Act or the proxy rules.”
The list included poison pills:

How about state laws that allow many firms to organize without traded shares?
Universities, hospitals, and other charities have self-perpetuating boards and cannot be
acquired by tender offer. Insurance companies may be organized as mutuals, without
traded shares; retailers often organize as co-operatives, without traded stock; some
decently large companies (large enough to be “reporting companies” under the ’34
Act) issue stock subject to buy-sell agreements under which the investors cannot sell
to strangers without offering stock to the firm at a formula price; Ford Motor Co.
issued non-voting stock to outside investors while reserving voting stock for the
family, thus preventing outsiders from gaining control (dual-class stock is becoming
more common); firms issue and state law enforces poison pills. All of these devices
make tender offers unattractive (even impossible) and greatly diminish the power of
proxy fights, success in which often depends on buying votes by acquiring the equity
to which the vote is attached. None of these devices could be thought preempted by
the Williams Act or the proxy rules. If they are not preempted, neither is
[Wisconsin’s takeover law]. [Emphasis added.]

Judge Easterbrook concluded that “[o]nly if the Williams Act gives investors the right
to be the beneficiary of offers could Wisconsin’s law run afoul of the federal rule.” But this
interpretation was entirely a nonstarter: “No such entitlement can be mined out of the Williams
Act.” Indeed:

Investors have no right to receive tender offers. More to the point … the Williams Act
does not create a right to profit from the business of making tender offers.

As a result, the court concluded that “events leading bidders to cease their quest do not
conflict with the Williams Act any more than a state law leading a firm not to issue new securi-
ties could conflict with the Securities Act of 1933.” Because “Wisconsin leaves [the tender
offer] process alone,” the Seventh Circuit concluded, “its law may co-exist with the Williams
Act.” The bidder petitioned for certiorari in Amanda Acquistion, but the Supreme Court refused
to hear the case.

The Fourth Circuit in WLR Foods: A Williams Act

Challenge to the Pill Is Explicitly Rejected

When Amanda Acquisition came down, we wrote to our clients that Amanda
Acquisition “should end constitutional doubts” about state takeover laws that addressed the
internal governance of domestic corporations. That prediction turned out to be quite accurate.
So trenchant was the Seventh Circuit’s analysis, that constitutional challenges to such takeover
laws virtually ceased after Amanda Acquisition. Nonetheless, one of the very few post-Amanda

9
challenges actually resulted in another important court of appeals decision—one that explicitly
addressed and rejected a preemption challenge to the poison pill.

That decision came from the Fourth Circuit in 1995. WLR Foods, Inc. v. Tyson
Foods, Inc. presented a constitutional challenge to four Virginia statutes. According to the
bidder, Tyson Foods, the four laws, operating together, “impermissibly restrict[ed] the ability of
a bidder to effect a takeover of a Virginia corporation.” Two of the statutes were takeover
laws—one, a second-generation vote-sterilization statute akin to the Indiana law upheld in CTS,
and the other, a third-generation business-combination law resembling the Wisconsin statute
affirmed in Amanda Acquisition.

The third challenged provision was Virginia’s “Poison Pill Statute,” Va. Code Ann.
§ 13.1–646. That law explicitly authorizes Virginia corporations to create shareholder rights
plans. It also provides that “[a]ny action or determination by the board of directors with respect
to the issuance, the terms of or the redemption of [a rights plan] shall be subject to the provisions
of § 13.1–690 and shall be valid if taken or determined in compliance therewith.” In turn,
Section 13.1–690, referred to in the pill statute, was the fourth provision challenged by Tyson.
And it was none other than Virginia’s codification of the business judgment rule—not the
modern Delaware version, but rather the traditional, historic, pre-Unocal, pure business-
judgment rule, which protects directors from liability for any good faith business judgment,
without regard to whether it involves matters of corporate control, and with no heightened
scrutiny for those matters.

Thus, by challenging both Virginia’s statute authorizing pills and its no-heightened-
scrutiny business-judgment rule as it applies to pills, Tyson brought the very challenge that
Bebchuk and Jackson now erroneously say has never been brought: to borrow words from their
article, the court in WLR Foods v. Tyson Foods “expressly considered a preemption challenge to
the validity of state-law poison-pill rules.” What is more, the preemption challenge in WLR
Foods could not have been made in a posture more favorable to Bebchuk and Jackson’s position:
not only were the Virginia “state-law poison-pill rules” challenged in conjunction with two
potent antitakeover laws, but those “state-law poison-pill rules” were also considerably more
forgiving of directors than Delaware’s, as the Virginia regime commands the application of the
pure, traditional, no-heightened-scrutiny business-judgment rule. No better test case for
Bebchuk and Jackson’s thesis could possibly be found.

Yet both the district court and the court of appeals in WLR Foods rejected the
preemption claim. And quite emphatically so. Quoting Amanda Acquisition, the Fourth Circuit
held that “‘[n]othing in the Williams Act says that the federal compromise among bidders,
targets’ managers, and investors is the only permissible one.’” As a result,

Congress did not forbid the result that Virginia has achieved with the statutory scheme
in the instant case. The fact that Congress, when it created the Williams Act, did not
intend to create an advantage for target management in the takeover situation, does not
necessarily mean that Congress meant to prevent the states from allowing management
an advantage which is not unfair to investors.

10
And so the Fourth Circuit concluded that the Virginia statutory scheme was necessarily
constitutional, because it did not interfere with the Congress’s effort through the Williams Act to
provide shareholders with additional disclosure:

The means by which the Williams Act achieves its purpose of protecting investors
is by requiring disclosure of information in order to allow shareholders to make an
informed decision and to prevent coercion in the tender offer context; Tyson has not
shown that the Virginia statutes controvert the purpose of the Williams Act by
removing protection from investors, for example, by keeping information from the
shareholders. In fact, Tyson has not shown that the shareholders in this case were
deprived of any relevant information. The goal of neutrality between bidder and
target, emphasized by Tyson, is not so central to the purpose of the Williams Act that
the Act should be held to preempt a group of state statutes that regulate the balance
between a target and a bidder, but do not disadvantage the shareholders or prevent
them from gaining access to pertinent information.

In so holding, the Fourth Circuit went on to disapprove the “meaningful opportunity

for success” test that had been suggested by some earlier district-court decisions, and that,
decades later, Bebchuk and Jackson now seek to exhume. The court of appeals cogently
explained why this test lacked any foundation in the Williams Act:

We, like the district court, reject the meaningful opportunity for success test. As
stated above, the purpose of the Williams Act is to protect independent investors from
bidders and management by ensuring that the investors have access to information.
The statute does not, however, have as an independent purpose the creation of an
environment for bidders that is conducive to takeovers. Tyson attempts to use the
“meaningful opportunity for success” test to shift the focus of the Williams Act from
protection of investors to protection of bidders. However, the Williams Act is simply
not designed to protect a company in Tyson’s position; “the Williams Act does not
create a right to profit from the business of making tender offers.”
The four Virginia statutes may work to give target management an advantage in
the tender offer context. The preemption question we address here, however, is
whether Virginia’s decision to allow management access to a set of defensive
mechanisms in the takeover situation frustrates the Williams Act’s goal of investor
protection. We hold that it does not. [Emphasis added.]

And with that, the court of appeals dispensed with Tyson’s claim that Virginia’s director-friendly
poison-pill rules were preempted by the Williams Act. As in Amanda, the bidder petitioned for
certiorari—and once again, the Supreme Court refused to take the case.

Conclusion

Bebchuk and Jackson are wrong that to say that the pill has never been argued to
violate the Supremacy Clause, and wrong to say that no court has ever addressed such a
preemption challenge. But they are right that “commentators and practitioners” have devoted
“little attention” to the question of the pill’s constitutionality. The reason for this is the same

11
reason that preemption challenges to state takeover laws virtually disappeared a quarter-century
ago: those challenges are utterly meritless. They are meritless because the Williams Act
governs procedure, not substance; disclosure, and not fiduciary duties; and because it evinces no
Congressional intent, explicitly or implicitly, to supplant the states’ historic authority to set rules
governing the internal affairs of corporations that the states themselves have created. As we
argued in our brief in Amanda some 25 years ago, the “protection [of investors] is achieved in
the Williams Act through disclosure, not through obliteration of the internal affairs doctrine or of
the role of directors in corporate governance.” And at the end of the day, as we explained almost
30 years ago in our brief in Household, the arguments for preemption prove too much—they
would extensively “federalize matters traditionally committed to state law,” and “would render
constitutionally suspect all of the judicial decisions upholding corporate steps [that] block
takeover attempts.”

There has never been any doubt, and never will be: The pill, and the state-law doc-
trines permitting it, entirely comport with the Williams Act and the Constitution of the United
States.

Martin Lipton
Michael W. Schwartz
Theodore N. Mirvis
George T. Conway III
Jeffrey M. Wintner
William Savitt

12
 October 29, 2015
The Delaware Courts and the Investment Banks
A doctrinal innovation in Delaware law that first appeared a year ago is threatening to mature
into a full-on trend: through the tort of “aiding-and-abetting” fiduciary breach, the Delaware courts,
accepting the invitation of the stockholder-plaintiffs’ bar, have begun to take on the task of regulating
the M&A advisory function of investment banks. In October 2014, the Court of Chancery awarded
stockholder plaintiffs $76 million in damages against an investment bank for aiding and abetting
breaches of the duty of care by the directors of Rural Metro, an ambulance company that was sold for
a 37% premium in 2011 and was bankrupt by the time of trial. The novel theory of the decision was
that conflicted bankers dispensed self-interested advice, which left Rural Metro’s directors unin-
formed and hence induced them to breach their duty of care in approving the sale. Although the di-
rectors were not liable for the breach (because they had settled and were exculpated at any rate), the
court found that the bankers were.
Rural Metro initially appeared to be an outlier, driven by bad facts. But the Court of Chan-
cery has recently applied the Rural Metro analysis in a variety of procedural and factual settings. In
the course of these decisions, the court has suggested that certain banker conflicts may be unwaiv-
able, even if independent directors believe that a waiver reflects sound business judgment, and that
independent directors may breach their duty of care by failing to investigate a bank’s representation
that it does not have a material conflict.
Among the difficult policy and doctrinal questions raised by this line of decisions: Can aid-
ing-and-abetting, which is historically akin to civil conspiracy, fairly be extended to regulate banker
conduct? Does imposing aiding-and-abetting liability based on exculpated director conduct under-
mine the Delaware legislature’s determination to authorize charter provisions that exculpate directors
from liability for breaches of the duty of care and the stockholders’ vote to adopt such provisions?
Does the use of tort principles to allow stockholder plaintiffs to directly challenge the work of bank-
ers impair the ability of boards and financial advisors to privately order their affairs through contract?
Does recognizing this new form of banker liability induce courts to find due care violations by direc-
tors that would seem unjustified were the reviewing court being asked to hold directors themselves
personally liable? What are the unintended consequences—to duty-of-care doctrine, to litigation
incentives, to the character and price of financial advice, to banker indemnification practices, to the
role of other advisors—of this doctrinal departure?
The Delaware Supreme Court has now heard argument in Rural Metro, and its decision, ex-
pected in the coming months, will likely answer some of these questions. In the meanwhile, the cas-
es suggest practical lessons for dealmakers. The first is that disclosure matters: under the Supreme
Court’s recent KKR Financial ruling, approval of a transaction by a fully informed stockholder elec-
torate requires deferential judicial review and will likely lead to dismissal of aiding-and-abetting
claims based on a breach of the duty of care. Directors should also consider more detailed inquiry
into their investment banks’ dealings with potential transaction partners and more searching exami-
nation of their bankers’ advice. And banks must take account not only of the potential for exposure,
and consider internal conflict processes to limit it, but also of the much greater likelihood, conflicts
aside, that they and their work product will be targeted by the stockholder-plaintiffs’ bar in any case.
We hope that the Delaware Supreme Court’s decision will enable us to give definitive advice
to boards of directors and their bankers and other advisors that will foreclose this type of litigation.
Martin Lipton
Theodore N. Mirvis
William Savitt

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 December 3, 2015

The Delaware Supreme Court Speaks to Boards and the Investment Banks

The Delaware Supreme Court earlier this week issued its much anticipated
decision in the Rural Metro appeal. RBC Capital Markets, LLC v. Jervis, No. 140, 2015 (Del.
Nov. 30, 2015). The opinion canvasses many important areas of Delaware fiduciary duty
doctrine applicable to directors and the aiding and abetting liability exposure of investment
bankers advising on transactions. The Supreme Court’s decision is its first statement on the
subject of banker conflicts and conduct since a series of recent Court of Chancery opinions
sparked a debate about whether, and how, Delaware is breaking new ground in examining and
potentially regulating the conduct of bankers and their conflicts (see The Delaware Courts and
the Investment Banks, our memorandum of October 29, 2015).

The Supreme Court’s opinion represents a carefully balanced intervention into

that debate. The opinion contains clear messages for both boards and bankers.

To boards:

“[D]irectors need to be active and reasonably informed

when overseeing the sale process, including identifying and
responding to actual or potential conflicts of interest. But, at the
same time, a board is not required to perform searching and
ongoing due diligence on its retained advisors in order to ensure
that the advisors are not acting in contravention of the company’s
interests, thereby undermining the very process for which they
have been retained. A board’s consent to a conflict does not give
the advisor a ‘free pass’ to act in its own self-interest and to the
detriment of its client. Because the conflicted advisor may, alone,
possess information relating to a conflict, the board should require
disclosure of, on an ongoing basis, material information that might
impact the board’s process.”

“A board’s consent to the conflicts of its financial advisor

necessitates that the directors be especially diligent in overseeing
the conflicted advisor’s role in the sale process.”

“For instance, the board could, when faced with a

conflicted advisor, as a contractual matter, treat the conflicted
advisor at arm’s-length, and insist on protections to ensure that
conflicts that might impact the board’s process are disclosed at the
outset and throughout the sale process.”

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To bankers:

“[W]e do not adopt the Court of Chancery’s description of

the role of a financial advisor in M & A transactions. In particular,
the trial court observed that ‘[d]irectors are not expected to have
the expertise to determine a corporation’s value for themselves, or
to have the time or ability to design and carryout a sale process.
Financial advisors provide these expert services. In doing so, they
function as gatekeepers.’ Although this language was dictum, it
merits mention here. The trial court’s description does not
adequately take into account the fact that the role of a financial
advisor is primarily contractual in nature, is typically negotiated
between sophisticated parties, and can vary based upon a myriad of
factors. Rational and sophisticated parties dealing at arm’s-length
shape their own contractual arrangements and it is for the board, in
managing the business and affairs of the corporation, to determine
what services, and on what terms, it will hire a financial advisor to
perform in assisting the board in carrying out its oversight
function. The engagement letter typically defines the parameters
of the financial advisor’s relationship and responsibilities with its
client. … As became evident in the instant matter, the conflicted
banker has an informational advantage when it comes to
knowledge of its real or potential conflicts. … Adhering to the trial
court’s amorphous ‘gatekeeper’ language would inappropriately
expand our narrow holding here by suggesting that any failure by a
financial advisor to prevent directors from breaching their duty of
care gives rise to an aiding and abetting claim against the advisor.”

This is a welcome opinion that offers important practical guidance to bankers and
boards. The decision makes clear that informed boards of directors can, in the exercise of their
business judgment, retain conflicted investment advisors and that, if appropriate procedures are
followed, neither the board nor the bankers will face liability for breach of fiduciary duty. The
decision also reaffirms that contractual arrangements between companies and financial advisors
will generally be respected. The decision thus provides a constructive pathway for well-
counseled companies and well-counseled advisors to work through the issues of potential
conflict that from time to time inevitably arise in the M&A context.

Martin Lipton
Theodore N. Mirvis
William Savitt
Ryan A. McLeod

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 December 3, 2015

A Personal Reflection on Corporate Governance: Is 2015, like 1985, an Inflection Year?

In an October 2015 paper, I posed the question: Will a New Paradigm for Corpo-
rate Governance Bring Peace to the Thirty Years’ War? As we approach the end of 2015, I
thought it would be useful to note some of the most cogent recent developments on which the
need, and hope, for a new paradigm is based. These developments include, among other things,
the accumulation of a critical mass of academic research that discredits the notion that short-
termism, activist attacks and shareholder-centric corporate governance tend to create rather than
destroy long-term value.

In January a Report of the Commission on Inclusive Prosperity, co-chaired by

Lawrence Summers and Ed Balls, identified activism and short-termism as being a threat to the
American economy and society. The report noted that reforming corporate governance and mov-
ing away from quarterly reporting are critical:

“An additional reason for the absence of inclusive prosperity [ine-

quality] is the changing nature of corporate behavior. Business leaders,
government officials, and academics have pointed out that corporations
have shifted their traditional focus on long-term profit maximization to
maximizing short-term stock-market valuations.

The effects of short-termism are damaging to the economy as a

whole. A firm that invests for the long term will make more investments in
future productivity, whether that’s developing lifesaving medicine; build-
ing or buying newer, more efficient machinery; or paying for training for
its workforce. All of these investments show up immediately as expenses
on the balance sheet and reduce profits in the current quarter but raise fu-
ture productivity of the firm. Incentivizing a continuing short-term focus
lowers future output, reduces long-term competitiveness, and diminishes
future worker productivity and the higher wages that it can bring.

To provide greater macroeconomic and financial stability and to

raise productivity, it is essential that markets work in the public interest
and for the long term rather than focusing only on short-term returns.”

At various times during the year, BlackRock, State Street and Vanguard (the ma-
jor managers of index funds that together hold, on average, about 15% of the shares of most sig-
nificant U.S. public companies) issued statements that they would support the long-term plans of
companies against activist attacks and they would withhold support of activists who primarily
seek to force companies into share buybacks and extraordinary distributions. In May, these three
institutional investors supported DuPont in its proxy fight with Trian. See Winning a Proxy
Fight – Lessons from the DuPont-Trian Vote and Some Lessons from BlackRock, Vanguard and
DuPont—A New Paradigm for Governance.

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 During 2015, five important papers were published by prominent economists, law
professors, a renowned jurist and The Conference Board, each of which points out serious flaws
in the so-called empirical evidence and policy arguments being put forth to justify short-termism,
attacks by activist hedge funds and shareholder-centric corporate governance.

Emiliano Catan and Marcel Kahan, The Law and Finance of Anti-
Takeover Statutes,

Yvan Allaire and François Dauphin, The Game of ‘Activist’ Hedge Funds:
Cui bono?

John C. Coffee, Jr. and Darius Palia, The Wolf at the Door: The Impact of
Hedge Fund Activism on Corporate Governance,

The Conference Board, Is Short-Term Behavior Jeopardizing the Future

Prosperity of Business?

Leo Strine, Jr., Chief Justice of the Supreme Court of Delaware, Securing
Our Nation’s Economic Future: A Sensible, Nonpartisan Agenda To In-
crease Long-Term Investment And Job Creation In The United States

For an earlier critique of the defects in the so-called empirical evidence, see The Bebchuk Syllo-
gism.

In addition, last month, K.J. Martijn Cremers, Erasmo Giambona, Simone M.

Sepe, and Ye Wang published the results of an impressive econometric study, Hedge Fund Activ-
ism and Long-Term Firm Value, that indicates that hedge fund activism more likely destroys
long-term value rather than creates it. Their results show that prior studies—of the type Harvard
Law School Professor Lucian Bebchuk relies on to validate his policy arguments in favor of un-
fettered attacks by activist hedge funds—do not warrant the credibility claimed for them.

The aforementioned studies and papers build on the growing body of academic
and policy research focused on this critical issue, including many other insightful studies that
seriously undermine the credibility of shareholder-centric governance and its concomitant short-
termism and hedge fund activism.

In a paper I presented at an August meeting of the World Economic Forum, Is Ac-

tivism Moving In-House, I quoted Laurence Fink, Chairman and CEO of BlackRock:

“It is critical, however, to understand that corporate leaders’ duty of care

and loyalty is not to every investor or trader who owns their companies’
shares at any moment in time, but to the company and its long-term own-
ers. Successfully fulfilling that duty requires that corporate leaders engage
with a company’s long-term providers of capital; that they resist the pres-
sure of short-term shareholders to extract value from the company if it
would compromise value creation for long-term owners; and, most im-
portantly, that they clearly and effectively articulate their strategy for sus-

-2-
 tainable long-term growth. Corporate leaders and their companies who
follow this model can expect our support.”

I concluded by expressing hope that activism would continue to move in-house at the major in-
stitutional investors and, as this new paradigm for corporate governance becomes pervasive, the
influence of hedge fund activists and ISS and Glass Lewis will shrink and be replaced by the pol-
icies, evaluations and decisions of the major institutions. While this will be a welcome relief
from the short-termism imposed by hedge fund activists, it raises a new fundamental question—
how will the institutions use their power? In an article in Fortune discussing the ramifications of
the outcome of the DuPont-Trian proxy fight, Ram Charan posed the following question:

“As the biggest asset managers gain more power and exercise it more
freely, they bear a heavy responsibility. They may influence employment,
national competiveness, and economic policy for better or for worse.
They can ensure a balance between short-term and long-term corporate
goals, and between value creation and societal needs. They can keep suc-
cession planning near the top of every company’s agenda. How they will
discharge their responsibility remains to be seen….”

I believe that the influence of the major institutional investors will be more favorable to the Na-
tion’s economy and society than the current hedge fund activism and pressure for quarterly per-
formance. Hopefully, the institutional investors will follow through on what they are saying
about encouraging long-term investment and implement fully the new paradigm.

Martin Lipton

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 February 1, 2016

The New Paradigm for Corporate Governance

Since I first identified a nascent new paradigm for corporate governance with leading
major institutional investors supporting long-term investment and value creation and reducing or
eliminating outsourcing to ISS and activist hedge funds, there has been a steady stream of
statements by major investors outlining the new paradigm. In addition, a number of these investors
are significantly expanding their governance departments so that they have in-house capability to
evaluate governance and strategy and there is no need to outsource to ISS and activist hedge funds.
The following is a summary consolidation of what these investors are saying in various forums.

Clearly articulated plans are necessary to gain and keep the support of these
investors. A company should not leave an opening for an activist with a more attractive long-term
plan.

Board participation in the development and approval of strategy should be

effectively communicated in letters to these investors, annual reports and proxy statements. The
description should include the major issues debated by the board and how they were resolved.

A company should recognize that ESG and CSR issues and how they are
managed are important to these investors.

A company should develop and communicate its procedures for engagement by

management and directors with these investors. In addition, a company should facilitate direct
engagement with directors by these investors who request it.

A company should support national policies that are designed to achieve long-
term value creation. A company should support major investment by government in
infrastructure, a rational tax policy that encourages long-term strategies and other policies that
encourage and support long-term growth on both a company and a macro basis.

These investors do not favor stock repurchases at the expense of long-term

investment.

These investors recognize that there is no need for quarterly earnings guidance, if
a company has a clearly articulated long-term strategy. These investors also recognize that
quarterly guidance is inconsistent with the long-term investment strategies that they are
encouraging.

In addition to the statements by, and actions of, these leading institutional investors,
similar views are being expressed by The Conference Board, The Brookings Institution, The Aspen
Institute, Focusing Capital on the Long Term (an organization formed to promote long-term
investment), the chief economist of the Bank of England and numerous others. In addition, recent
academic research has revealed the methodological fallacies in the so-called “empirical evidence”
use by the academics who have argued that unrestrained attacks by activist hedge funds create long-
term value for the targets of their attacks, thereby strengthening the ability of these institutions to
refuse to support activist attacks on portfolio companies. A recent article by Professor John Coffee
of the Columbia Law School and the February 1, 2016 Letter from Larry Fink of BlackRock to the
CEOs of the S&P 500 are must reads.

Martin Lipton

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 March 7, 2016

The New Paradigm for Corporate Governance

In my February 1, 2016 note, “The New Paradigm for Corporate Governance,” I

called attention to the growing evidence that the leading institutional investors were developing a
new paradigm for corporate governance. In the new paradigm, these institutions would engage
with a company and its independent directors to understand its long-term strategy and ascertain
that the directors participated in the development of the strategy, were actively monitoring its
progress and were overseeing its execution.

In a February 26, 2016 letter to board members, State Street Global advisors said:

Unless we make independent long‐term thinking and leadership the driving force
behind a board’s mission, no amount of change to management incentives,
investor behavior or the like will be sufficient to ensure a focus on the long term.
Boards need to look beyond the traditional measures of corporate success such as
the quarterly earnings report and accomplishments since the last board meeting.
Short‐term performance matters, but it should be assessed in the context of a
company’s long‐term goals. Given a company’s stated objectives for the next 5,
10 or 20 years, did management execute as well as possible? Did the company
meet its milestones and exceed its benchmarks?

We recognize that the role of a board has become more complex and demanding
as the challenges companies face in a competitive global economy marked by
technological disruption have intensified. Many boards lack the experience and
expertise to engage effectively and critically with management with regard to a
company’s long‐term planning. Board recruitment becomes an even more critical
function when viewed through the lens of long‐term focus. That is all the more
reason that boards should continually self‐assess the skills and experience of their
board members and seek to continually enhance their capabilities by addressing
any skill, experience or other gaps.

Martin Lipton

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 June 2, 2016

Delaware Court of Chancery Appraises Fully-Shopped Company

at Nearly 30% Over Merger Price

In an appraisal decision issued this week, the Delaware Court of Chancery held that the
fair value of Dell Inc. was $17.62 per share—almost four dollars over and nearly 30% more than
the price paid in the 2013 go-private merger. In re Appraisal of Dell Inc., C.A. No. 9322-VCL
(Del. Ch. May 31, 2016). The result reflects the remarkable view that “fair value” in Delaware
represents a price far higher than any buyer would have been willing to pay and that the merger
price derived from an admirable sales process should be accorded no weight.
In 2012 Michael Dell informed the company’s board that he wished to pursue a
management-led buyout. In response, the board formed a special committee, which embarked on
a year-long process culminating in the approval of a merger agreement under which Mr. Dell and
a private equity firm paid $13.75 per share—a 25% premium over the pre-announcement
unaffected share price of $10.88 and a 37% premium over the trailing 90-day average. Over the
course of its pre-signing auction and very public post-signing go-shop, the committee contacted
over 60 potential merger partners. In view of this robust sales process, the Court of Chancery
previously refused to entertain the customary avalanche of fiduciary duty litigation challenging
the deal. As this week’s opinion reiterated, the company’s careful process “would easily sail
through [a fiduciary duty challenge] if reviewed under enhanced scrutiny.”
The court nevertheless accorded that process no deference in deciding that the company’s
appraised “fair value” was billions more than the market price. Finding that the company’s
investors were “focused on the short term,” the decision concluded that there was “a significant
valuation gap between the market price of the Company’s common stock and the intrinsic value
of the Company.” The merger market was likewise irrelevant in appraising the transaction, the
court reasoned, because financial sponsors like private equity firms “determine[] whether and
how much to bid by using an LBO [leveraged buyout] model, which solves for the range of
prices that a financial sponsor can pay while still achieving particular IRRs,” or internal rates of
return. While some aspects of the decision focused on the fact that the transaction was a
management buyout, much of its reasoning appears to apply to financial buyers generally. The
court thus concluded that “what the sponsor is willing to pay diverges from fair value because of
(i) the financial sponsor’s need to achieve IRRs of 20% or more to satisfy its own investors and
(ii) limits on the amount of leverage that the company can support and the sponsor can use to
finance the deal.”
The decision may turn out to be an outlier, as other Chancery decisions have held that the
merger price—including in private equity deals—is the most reliable indicator of fair value. In
the meanwhile, however, proponents of appraisal arbitrage will tout the Dell result to encourage
the flow of even greater funds into the practice.
For their part, private equity firms should be expected to ask whether they face routine
appraisal exposure in Delaware, no matter how robust the auction, and therefore seek out
alternative transaction structures to cap and price their risk (or exit the market entirely).
Consider, for example, the acquisition of a Delaware company with 1 billion shares trading at
$12 per share, for a total valuation of $12 billion, where a private equity buyer is willing to pay
$16 billion in total to acquire the target. Assume further that the buyer’s reserve price easily

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topped the competitors and the seller succeeds in extracting the full amount the buyer is willing
to pay through a robust auction. A private equity buyer in this situation, concerned that a court
will rely on the logic of Dell and award a 30% increase over the merger price to dissenting
shares, is likely to consider transactional alternatives to mitigate the risk. To cap its appraisal
exposure, the private equity buyer might insist on a provision in the merger agreement allowing
it to walk away if a small fraction of the shares—1 or 2 percent—perfect appraisal rights. This
approach is likely to be unpalatable to selling boards, however, and creates substantial risk that
the buyer will exit the transaction when the appraisal cap is exceeded. Alternatively, a buyer
might choose a higher appraisal cap of 10% of the shares, but augment that approach by reducing
its offer to create a reserve for the eventual appraisal award for the 100 million dissenting shares.
In this scenario, if the reserve is based on the Dell result, the buyer’s top offer price would be
only $15.53 per share (instead of $16), with the excess reserved for a payoff to the appraisal
arbitrageurs of $20.19 per share. This outcome would result in a wealth transfer of $423 million
from the public stockholders to the arbitrage firms.
Either way, however, there is a substantial risk that public stockholders lose out—
whether by losing a value maximizing deal altogether or through value leakage to appraisal
arbitrageurs. Accordingly, it is very much open to question whether the Dell dynamic will
incentivize transactions that maximize value to stockholders and a market for corporate control
that promotes managerial accountability.

Martin Lipton
Theodore N. Mirvis
William Savitt
Ryan A. McLeod

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 January 9, 2017

Corporate Governance: The New Paradigm

At the invitation of the International Business Council of the World

Economic Forum, I prepared The New Paradigm: A Roadmap for an Implicit
Corporate Governance Partnership Between Corporations and Investors to
Achieve Sustainable Long-Term Investment and Growth. I presented The New
Paradigm at the August 2016 meeting of the IBC and it was unanimously approved
by those in attendance. The IBC is now seeking signatures from all participants in
its January 2017 meeting to The Compact for Responsive and Responsible
Leadership: A Roadmap for Sustainable Long-Term Growth and Opportunity.
The Compact includes key features of The New Paradigm. Endorsement and
adherence by business corporations, institutional investors and asset managers to
The Compact and The New Paradigm will substantially alleviate short-term
pressures and will promote sustainable long-term investment and growth. I believe
this is a unique opportunity to make a real difference. I recommend endorsement
and adherence to The Compact and The New Paradigm, not just by those attending
the IBC meeting, but by all corporations, institutional investors and asset
managers.

Martin Lipton

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 January 31, 2017

Promoting Long-Term Value Creation – The Launch of the Investor Stewardship Group
(ISG) and ISG’s Framework for U.S. Stewardship and Governance

A long-running, two-year effort by the senior corporate governance heads of major

U.S. investors to develop the first stewardship code for the U.S. market culminated
today in the launch of the Investor Stewardship Group (ISG) and ISG’s associated
Framework for U.S. Stewardship and Governance. Investor co-founders and signatories
include U.S. Asset Managers (BlackRock; MFS; State Street Global Advisors; TIAA
Investments; T. Rowe Price; Vanguard; ValueAct Capital; Wellington Management);
U.S. Asset Owners (CalSTRS; Florida State Board of Administration (SBA);
Washington State Investment Board); and non-U.S. Asset Owners/Managers (GIC
Private Limited (Singapore’s Sovereign Wealth Fund); Legal and General Investment
Management; MN Netherlands; PGGM; Royal Bank of Canada (Asset Management)).

Focused explicitly on combating short-termism, providing a “framework for

promoting long-term value creation for U.S. companies and the broader U.S. economy”
and promoting “responsible” engagement, the principles are designed to be independent
of proxy advisory firm guidelines and may help disintermediate the proxy advisory
firms, traditional activist hedge funds and short-term pressures from dictating corporate
governance and corporate strategy.

Importantly, the ISG Framework would operate to hold investors, and not just
public companies, to a higher standard, rejecting the scorched-earth activist pressure
tactics to which public companies have often been subject, and instead requiring
investors to “address and attempt to resolve differences with companies in a
constructive and pragmatic manner.” In addition, the ISG Framework emphasizes that
asset managers and owners are responsible to their ultimate long-term beneficiaries,
especially the millions of individual investors whose retirement and long-term savings
are held by these funds, and that proxy voting and engagement guidelines of investors
should be designed to protect the interests of these long-term clients and beneficiaries.
The divergent needs and time horizons of these ultimate beneficiaries have long been
emphasized by Chief Justice Leo Strine (see, for example, Justice Strine’s provocative
article, Can We Do Better by Ordinary Investors? A Pragmatic Reaction to the Dueling
Ideological Mythologists of Corporate Law), and implicates the new theory of corporate
governance espoused by Professors Zohar Goshen and Richard Squire. While the ISG
Framework is not intended to be prescriptive or comprehensive in nature, with
companies and investors being free to apply it in a manner they deem appropriate, it is
intended to provide guidance and clarity as to the expectations that an increasingly large
number of investors will have not only of public companies, but also of each other.

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 Key highlights of the ISG Stewardship Framework for Institutional Investors and
the ISG Corporate Governance Framework for U.S. Listed Companies are outlined
below. The ISG has also supplemented each of these high-level principles with
examples of illustrative implementation. Many of the principles in the ISG Frameworks
will be familiar to those who have recognized the emergence of, and supported, The
New Paradigm: A Roadmap for an Implicit Corporate Governance Partnership Between
Corporations and Investors to Achieve Sustainable Long-Term Investment and
GrowthNew Paradigm for Corporate Governance, sought to adapt their communication,
engagement and governance practices to reflect the New Paradigm and tracked the
heightened expectations and scrutiny placed on public company boards.

Stewardship Framework for Institutional Investors

• Principle A: Institutional investors are accountable to those whose money they

invest.

• Principle B: Institutional investors should demonstrate how they evaluate

corporate governance factors with respect to the companies in which they invest.

• Principle C: Institutional investors should disclose, in general terms, how they

manage potential conflicts of interest that may arise in their proxy voting and
engagement activities.

• Principle D: Institutional investors are responsible for proxy voting decisions and
should monitor the relevant activities and policies of third parties that advise them
on those decisions.

• Principle E: Institutional investors should address and attempt to resolve

differences with companies in a constructive and pragmatic manner.

• Principle F: Institutional investors should work together, where appropriate, to

encourage the adoption and implementation of the Corporate Governance and
Stewardship principles.
Corporate Governance Framework for U.S. Listed Companies

• Principle 1: Boards are accountable to shareholders.

• Principle 2: Shareholders should be entitled to voting rights in proportion to their
economic interest.

• Principle 3: Boards should be responsive to shareholders and be proactive in

order to understand their perspectives.

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 • Principle 4: Boards should have a strong, independent leadership structure, which
may be evidenced by an independent chair or a lead independent director.

• Principle 5: Boards should adopt structures and practices that enhance their
effectiveness.

• Principle 6: Boards should develop management incentive structures that are

aligned with the long-term strategy of the company.
ISG’s goals are ambitious, seeking to have “every institutional investor and asset
management firm investing in the U.S.” sign the framework and incorporate the
stewardship principles in their proxy voting, engagement guidelines and practices. It
should be noted that while the ISG guidelines emphasize the need for a framework to
promote long-term value creation, the current version does not specifically commit
investors to support long-term investment but does express the view that it “is the
fiduciary responsibility of all asset managers to conduct themselves in accordance with
the preconditions for responsible engagement in a manner that accrues to the best
interests of stakeholders and society in general, and that in so doing they’ll help build a
framework for promoting long-term value creation on behalf of U.S. companies and the
broader U.S. economy.”

The Framework is intended to be effective January 1, 2018 and apply to the 2018
proxy season; nevertheless, as companies conduct off-season and in-season shareholder
engagement and finalize their 2017 proxy statement disclosures and associated annual
letters to shareholders from the Board and/or management, they may wish to incorporate
into their communications some of the themes highlighted in the ISG Framework and
benchmark their disclosures and practices against the Framework.

Martin Lipton
Steven A. Rosenblum
Karessa L. Cain
Sabastian V. Niles
Sara J. Lewis

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 April 18, 2017

Corporate Governance

In a brilliant must-read article in the May-June 2017 issue of the

Harvard Business Review, Joseph L. Bower and Lynn S. Paine show the fallacies
of the economic theories and statistical studies that have been used since 1970 to
justify shareholder-centric corporate governance, short-termism and activist attacks
on corporations. They demonstrate the pernicious effect of the agency theory
promoted by Milton Friedman (1970) and Michael Jensen and William Meckling
(1976), a theory still endorsed today by a majority of academic economists and
lawyers who write about and teach corporate governance. The Bower and Paine
rejection of hedge fund activism is telling.

The activists’ claim of value creation is further clouded by indications that some
of the value purportedly created for shareholders is actually value transferred from other
parties or from the general public. Large-sample research on this question is limited, but
one study suggests that the positive abnormal returns associated with the announcement
of a hedge fund intervention are, in part, a transfer of wealth from workers to
shareholders. The study found that workers’ hours decreased and their wages stagnated
in the three years after an intervention. Other studies have found that some of the gains
for shareholders come at the expense of bondholders. Still other academic work links
aggressive pay-for-stock-performance arrangements to various misdeeds involving harm
to consumers, damage to the environment, and irregularities in accounting and financial
reporting.

We are not aware of any studies that examine the total impact of hedge fund
interventions on all stakeholders or society at large. Still, it appears self-evident that
shareholders’ gains are sometimes simply transfers from the public purse, such as when
management improves earnings by shifting a company’s tax domicile to a lower-tax
jurisdiction—a move often favored by activists, and one of Valeant’s proposals for
Allergan. Similarly, budget cuts that eliminate exploratory research aimed at addressing
some of society’s most vexing challenges may enhance current earnings but at a cost to
society as well as to the company’s prospects for the future.

Hedge fund activism points to some of the risks inherent in giving too much
power to unaccountable “owners.” As our analysis of agency theory’s premises suggests,
the problem of moral hazard is real—and the consequences are serious. Yet practitioners

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 continue to embrace the theory’s doctrines; regulators continue to embed them in policy;
boards and managers are under increasing pressure to deliver short-term returns; and
legal experts forecast that the trend toward greater shareholder empowerment will persist.
To us, the prospect that public companies will be run even more strictly according to the
agency-based model is alarming. Rigid adherence to the model by companies uniformly
across the economy could easily result in even more pressure for current earnings, less
investment in R&D and in people, fewer transformational strategies and innovative
business models, and further wealth flowing to sophisticated investors at the expense of
ordinary investors and everyone else.

To counter short-termism and activism, Bower and Paine embrace the

corporation-centric/constituency theory of governance. They argue that the
corporation and its board of directors have a fiduciary duty not just to its
shareholders, but to its employees, customers, suppliers and to the community.
This is the theory I argued in Takeover Bids in the Target’s Boardroom (1979) and
regularly since in a lone series of articles and memoranda. While Bower and Paine
say:
The new model has yet to be fully developed, but its conceptual foundations can
be outlined. . . . [T]he company-centered model we envision tracks basic corporate law
in holding that a corporation is an independent entity, that management’s authority comes
from the corporation’s governing body and ultimately from the law, and that managers
are fiduciaries (rather than agents) and are thus obliged to act in the best interests of the
corporation and its shareholders (which is not the same as carrying out the wishes of even
a majority of shareholders). This model recognizes the diversity of shareholders’ goals
and the varied roles played by corporations in society. We believe that it aligns better
than the agency-based model does with the realities of managing a corporation for
success over time and is thus more consistent with corporations’ original purpose and
unique potential as vehicles for projects involving large-scale, long-term investment.

in fact the corporation-centric theory—that the directors have a fiduciary duty to

the corporation and all of its stakeholders—is reflected in a number of state
corporation laws. Perhaps the most cogent example is the Pennsylvania Business
Corporation Law which provides:

A director of a business corporation shall stand in a fiduciary relation to the corporation

and shall perform his duties as a director, including his duties as a member of any
committee of the board upon which he may serve, in good faith, in a manner he
reasonably believes to be in the best interests of the corporation and with such care,

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 including reasonable inquiry, skill and diligence, as a person of ordinary prudence would
use under similar circumstances.

In discharging the duties of their respective positions, the board of directors, committees
of the board and individual directors of a business corporation may, in considering the
best interests of the corporation, consider to the extent they deem appropriate:
The effects of any action upon any or all groups affected by such action, including
shareholders, employees, suppliers, customers and creditors of the corporation, and upon
communities in which offices or other establishments of the corporation are located.
The short-term and long-term interests of the corporation, including benefits that
may accrue to the corporation from its long-term plans and the possibility that these
interests may be best served by the continued independence of the corporation.
The resources, intent and conduct (past, stated and potential) of any person
seeking to acquire control of the corporation.
All other pertinent factors.

While wider adoption and strengthening of laws like the Pennsylvania

statute would provide some more ability to boards of directors to temper short-
termism and resist attacks by activist hedge funds, voting control of corporations
will remain in the hands of the major institutional investors and asset managers.
To achieve a truly meaningful change and effectively promote long-term
investment, corporations and institutional investors and asset managers will need to
endorse and adhere to The New Paradigm: A Roadmap for an Implicit Corporate
Governance Partnership Between Corporations and Investors to Achieve
Sustainable Long-Term Investment and Growth (2016) promulgated by the World
Economic Forum or A Synthesized Paradigm for Corporate Governance, Investor
Stewardship, and Engagement (2017) based on it and on The Principles of the
Investor Stewardship Group (2017). The alternative would be legislation,
something that both corporations and investors should assiduously avoid.

Martin Lipton

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 June 30, 2017

The Classified Board Duels

Professor Lucian Bebchuk has engaged in two rounds of law-review-

article duels with Professor Martijn Cremers and Professor Simone Sepe over
classified boards. The weapons were statistics (and common sense). Cremers and
Sepe wore the classified-board-stakeholder colors; Bebchuk, the agency-model-
shareholder-democracy colors. Cremers’ and Sepe’s riposte was decisive.

The field for these duels was chosen by Bebchuk in 2011 when he
chartered the Harvard Law School Shareholder Rights Project (the “Harvard
Project”). Bebchuk described the Harvard Project as an academic program
designed to “contribute to education, discourse, and research related to efforts by
institutional investors to improve corporate governance arrangements at publicly
traded firms.” In practice, it worked to eliminate the classified-board moat
protecting companies from short-termism and attacks by activist hedge funds.
Over the course of three academic years from 2011 to 2014, the Harvard Project
submitted declassification proposals to 129 companies, resulting in 102
declassifications.

Bebchuk’s Harvard Project sparked sharp criticism. Former SEC

Commissioner Daniel Gallagher’s and Stanford Professor Joseph Grundfest’s Did
Harvard Violate Federal Securities Law? The Campaign Against Classified
Boards of Directors (2014) argued that it “relie[d] on the categorical assertion that
staggered boards are associated with inferior financial performance” and that the
proposals omitted disclosure of significant, conflicting research.

Scholars with sharpened statistics followed suit. Cremers’ and Sepe’s

The Shareholder Value of Empowered Boards (2016), as well as their follow-on
piece Staggered Boards and Long-Term Firm Value, Revisited (2017) coauthored
with Lubomir Litov, employed lengthy time-series studies showing that
classification (declassification) is associated with an increase (decrease) in firm
value. These studies exposed the limitations of prior cross-sectional studies:
namely Bebchuk’s The Costs of Entrenched Boards (2005), which succumbs to the
reverse causality fallacy. They provided “no support for the entrenchment view.”
In light of their findings, the authors urged policy reform to make classification
boards quasi-mandatory, exclude shareholder declassification proposals and
impose a supermajority requirement on board declassification proposals. They
believed this reform would “restore a board’s ability to credibly commit
shareholders to long-term value creation, which is in their own and society’s best
interests.”
If your address changes or if you do not wish to continue receiving these memos,
please send an e-mail to [email protected] or call 212-403-1443.
W/2937616
 Cremers and Sepe then turned to the Harvard Project. Board
Declassification Activism: The Financial Value of the Shareholder Rights Project
(2017) treated the Harvard Project as a “quasi-natural experiment” to again
measure value implications of classifications. These data provided a source of
exogenous variation, useful to avoid the flaws in prior cross-sectional studies,
because the Harvard Project plausibly had “a direct, causal impact” on
classification decisions. And the results remained the same. They found that
Harvard Project targets that declassified declined in value, more so than non-
Project targets, and that such declines appeared “directly attributable to . . .
declassification.” Further, these results were especially strong for firms with large
research and development investments. Consistent with recent studies, they
concluded that “classified boards may serve a positive governance function in
some companies, thus challenging the ‘one-size-fits-all’ approach to board
declassification exemplified by the [Harvard Project] and, more generally, most
activist investors and proxy advisory firms.”

In Recent Board Declassifications: A Response to Cremers and Sepe

(2017), Bebchuk and Alma Cohen contend that, “appropriately interpreted,”
Cremers’ and Sepe’s 2017 study contradicts their own 2016 study because it
“provide[s] some significant evidence that declassifications are beneficial and no
evidence that they are value-reducing.” Bebchuk and Cohen focus on non-Project
declassifications, which they believe are more important than Project
declassifications (reasoning that the Harvard Project was limited in time and
scope), and claim that firm values did not decline after non-Project
declassifications. They turn only briefly to Project declassifications, finding that
the results do not “provide a basis for concluding that [such] declassifications
reduced value.” Bebchuk and Cohen conclude that the results “fail to provide any
basis for opposing declassifications,” which justifies the apparent retreat from the
policy proposal in the 2016 article (i.e., the relatively weaker language in the 2017
article).

In response to Bebchuk and Cohen, Cremers’ and Sepe’s Board

Declassification Activism: Why Run Away from the Evidence? (2017) reiterates
their findings and argues that Bebchuk’s and Cohen’s critique is unwarranted
because, put simply, it ignores the evidence. That is, the critique essentially
disregards the main result that firm values declined after Project declassifications;
cherry-picks data, sidestepping or downplaying key results; draws conclusions on
statistically and economically insignificant results, defying the “basic econometric
precept that no inferences can be drawn when results lack statistical significance”
and incorrectly focuses on non-Project declassifications while failing to interpret
them in connection with Cremers’ and Sepe’s prior studies. Finally, Cremers and

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Sepe show that their 2017 study reinforces, and not belies, their policy proposal
with new data: a $90 to $149 billion decline in value associated with Project
declassifications that their policy would have mitigated “if not altogether
prevented.”

The costs of Bebchuk’s actions are real. He has exposed hundreds of

major U.S. companies to short-term pressures and attacks by activist investors to
the detriment of those companies, their shareholders and, more generally, the
economy. With the growing recognition by major institutional investors, asset
managers and academics that short-termism and activism are antithetical to the
interests of all stakeholders, including shareholders, and society generally, one
hopes that Bebchuk and his cohorts would cross the Charles River and join their
Harvard Business School colleagues, Jay Lorsch, William George, Joseph Bower
and Lynn Paine in supporting long-term investment and rational, not shareholder-
only, governance. In a recent article, Bower and Paine sum up the damage done by
one-size-fits-all, shareholder-centric governance:

To us, the prospect that public companies will be run even more
strictly according to the agency-based model is alarming. Rigid
adherence to the model by companies uniformly across the economy
could easily result in even more pressure for current earnings, less
investment in R&D and in people, fewer transformational strategies
and innovative business models, and further wealth flowing to
sophisticated investors at the expense of ordinary investors and
everyone else.

Martin Lipton
Daniel Bulaevsky

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