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STATE UNIVERSITY Ll

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This is to certify that the

dissertation entitled

RESOLV I NG FOREGONE CORPORATE OPPORTUN I T I ES

presented by

Elvin Carroll Lashbrooke, Jr.

has been accepted towards fulfillment
of the requirements for

Ph.D. Finance

degree in

 

 

v M‘
7 Major piofe%/

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MSU i: an Affirmative Action/Equal Opportunity Institution 0- 12771

 

 

LIBRARY
MIChigan State
University

 

 

 

PLACE IN RETURN BOX to romovo this chockout from your "cord.

TO AVOID FINES rotum on or botoro dot. duo.

DATE DUE DATE DUE DATE DUE

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

MSU lo An Affirmative ActlonlEquol Opportunlly lnotltwon
MUM-9.1

 

RESOLVING FOREGONE CORPORATE OPPORTUNITIES

BY
Elvin Carroll Lashbrooke, Jr.

A DISSERTATION
Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Finance and Insurance

1993

ABSTRACT
RESOLVING FOREGONE CORPORATE OPPORTUNITIES
3)!
Elvin Carroll Lashbrooke, Jr.

Empirical studies show that stock prices are depressed
when a corporation announces an equity issue. One
ramification of this phenomenon is that managers acting in
the best interests of existing shareholders will not finance
positive net present value projects with equity issues if
the firm does have not sufficient slack or debt capacity to
do so. Consequently, the value of the firm is not
maximized, and there is a misallocation of resources. One
solution to this problem--the spin-off of positive net
present value projects is analyzed in the context of the
legal environment.

A spin-off generally entails registration of the stock
of the subsidiary corporation, and disclosure is required
under federal and state law. In the legal context,
disclosure of the inside material information resolves the
asymmetric information problem at the heart of the
misallocation.

The dissertation examines how the market reacts to
spin-off announcements and the motivation of managers
deciding to spin-off assets.

Analysis of the market reaction to the 158 spin-offs in

the sample shows that (1) prior to the announcement date

debt-equity ratios increase, (2) the higher the ratio of
current assets to current liabilities, the higher the
abnormal returns, (3) the higher (lower) the market value of
the firm to the book value of the firm, the lower (higher)
the abnormal returns, and (4) firms having market value of
the firm to book value of the firm ratios below the sample
mean ratio value had higher abnormal returns than firms
having market value of the firm to book value of the firm
ratios below the mean ratio value These findings are
consistent with the theory predictions.

Finally, it is observed that following a spin-off
managers of firms with high debt-equity ratios contract and
retrench their firms whereas managers of firms with low
debt-equity ratios expand their firms. This behavior is

consistent with the theory prediction.

Copyright by
ELVIN CARROLL LASHBROOKE , JR.
1993

To my loving wife, Meg, for her unwavering support.

ACKNOWLEDGEMENTS

I wish to thank Dr. Michael A. Mazzeo, Chair of my
Dissertation Guidance Committee, for his guidance and
valuable assistance in the preparation of this dissertation.
I also wish to thank the other members of the committee, Dr.
Richard R. Simonds, Dr. John L. O'Donnell, and Dr. Dale L.
Domian for their assistance. In addition, I wish to thank
the two outside reviewers, Professor Robert Prentice of The
University of Texas at Austin and Professor Thomas Bowers of
Indiana University. Finally, I wish to thank Dean Richard
J. Lewis and Associate Dean James F. Rainey for their
support.

vi

TABLE OF CONTENTS

I. Introduction to the Problem . . . . . . . . . . 1
II. Literature Review . . . . . . . . . . . . . . . 27
III. Possible Solutions . . . . . . . . . . . . . . . 33
IV. Spin-off and Equity Carve Out Solutions . . . . 42
A. Financial . . . . . . . . . . . . . . . . . . 43

B. Public Offerings of Securities . . . . . . . 53

1. Federal Regulation . . . . . . . . . . . 53

a. Registration . . . . . . . . . . . 53

b. Liability . . . . . . . . . . . . . 65

2. State Regulation . . . . . . . . . . . . 71

C. Conclusion . . . . . . . . . . . . . . . . . 73

V. Empirical Studies . . . . . . . . . . . . . . . 76
A. Database . . . . . . . . . . . . . . . . . . 76

B. Wealth Effects and Prior Studies . . . . . . 78

C. Analysis of Market Reaction to Spinoffs . . . 80

D. Motivation of Managers . . . . . . . . . . . 86
VI. Conclusions . . . . . . . . . . . . . . . . . . 89

Appendix A. Assumption of in the old Shareholders

Best Interests . . . . . . . . . . . . . 92
A. Separation of Ownership and Control . . . . . 94
B. The Parting of the ways . . . . . . . . . . . 97

1. The Fiduciary Relationship . . . . . . . 100

vii

viii
2. Business Judgment Rule . . . . . . . . . 111

3. Social Responsibility and Third Party
Beneficiaries . . . . . . . . . . . . . 115

C. Conclusions and Remedies . . . . . . . . . . . 122

Appendix B. Merger and Tender Offer Solutions . . . . 128
A. Financial Aspects . . . . . . . . . . . . . . 135

B. Legal Aspects . . . . . . . . . . . . . . . . 151

1. General Antifraud . . . . . . . . . . . 152

a. Federal . . . . . . . . . . . . . . 152

b. State . . . . . . . . . . . . . . . 162

2. Tender Offers and the Williams Act . . . 166

3. State Regulation of Takeovers . . . . . 184

C. Conclusion . . . . . . . . . . . . . . . . . 188
Appendix B.1. Fair Price Statute . . . . . . . . . . 191
List of References . . . . . . . . . . . . . . . . . . 199

List of Cases . . . . . . . . . . . . . . . . . . . . 204

Table

Table
Table

Table

Table

LIST OF TABLES

Distribution of 158 Sample Spinoff
Announcements by Year 1979-91 . . . . . .

Table of Prediction Errors . . . . . . .
Significance of Division at the Mean . .

Multiple Regression MVBV; and Cqu
onSPEowhereN=137. . . . . . . . . . .

Regression of Debt-Equity Ration of
Year_l on the Percentage Change in the
Total Assets in Yearb . . . . . . . . . .

77

79

82

84

88

Figure 1.

LIST OF FIGURES

Debt to Equity Ratios for Years Prior
to the Announcement Period . . . . .

85

I. Introduction to tho Problem

Basic finance theory says that managers should maximize
the value of the corporation by investing in all positive
net present value projects thereby maximizing the value of
the firm and maximizing the wealth of the shareholders. We
suspect, however, that managers do not take advantage of all
positive net present value opportunities. Several
explanations, such as price depression of equity issues and
agency costs, have been offered for this phenomenon.

Empirical studies show that stock prices are depressed
when a corporation announces an equity issue. Masulis and
Korwar,l Asquith and Mullins,2 Rolodny and Suhler,3 and
Mikkelson and Partch‘ report such a phenomenon. One
explanation of this phenomenon is asymmetric (inside)
information and the assumption or belief that managers act
in the best interests of the existing (old) shareholders.
Managers have information that shareholders and investors do

not have. When making an investment decision managers have

 

‘ 8- Masulis and A- Korwar. Seasgnsd_£gui§2_9fferingsi_
' , J. Of FINANCIAL ECONOMICS 15,
91-113 (1986).

2 P. Asquith and D. Mullins, Jr., Eggity_1§§ug§_and
Qifering_pilu§igg, J. OF FINANCIAL ECONOMICS 15, 61-90
(1970).

3 R- Kolodny and 0- Sublet. Changes_in_sanital
, J. OF

FINANCIAL RESEARCH 8, 127-136 (1985).

‘ W. Mikkelson and M. Partch, yalnatign_fiffeg;§_gf
' , J. OF FINANCIAL

ECONOMICS 15, 31-60 (1986).

2
information concerning the values of the projects and assets
in place that is unavailable to others. The possession of
inside information coupled with managers acting in the best
interests of the existing shareholders results in a
suboptimal investment policy.

A firm's value consists of the value of the assets in
place plus growth opportunities. Under traditional
financial theory, managers should invest in all projects
that have a positive net present value (NPV>0). This
process maximizes the value of the firm. Evidence that the
market does indeed follow the traditional valuation model
was supplied by McConnell and Muscarella in 1985.5 They
found that announcements of unexpected increases (decreases)
in capital expenditure resulted in positive (negative)
impacts on the market value of the corporation.

If managers pass up growth opportunities, they are not
maximizing the value of the firm, and resources are
misallocated. However, managers may not always maximize the
value of the firm as discussed by Jensen and Meckling‘ hi
their seminal paper on agency costs.

This dissertation explores why managers might pass up

positive net present value projects and, consequently, not

 

5 J. McConnell and C. Muscarella, e ta
1"! 0 ‘ | ‘ 011 (I. -t‘ 0 9‘ °qu, J.

OF FINANCIAL ECONOMICS 14, 399-422 (1995).
‘ H-C- Jensen and W- Hecklinq. W

1111-8 a-11a 0 10196 01 1 11° -- a- 1, J.
Of FINANCIAL ECONOMICS 3, 305-360 (1976) [Hereinafter
referred to as Jensen and Meckling (1976)].

3

maximize the value of the firm and proposes possible
solutions to the problem. Solutions to finance problems
tend to be restricted to finance without regard for the
legal environment surrounding the problem. Consequently,
there is no systematic study of the interaction between
finance theory and the law. None of the financial solutions
is a totally satisfactory solution to the problem.
Something appears to be missing from the model. One
important missing element is the legal environment. This
dissertation is intended to be a theoretical paper with
emphasis on trying to explain the conflict between finance
theory and observed behavior in the context of the legal
environment. Similar in style to Roll's Critique of the
CAPM, this dissertation compares observed behavior with
theory and examines the inconsistencies, considers why these
inconsistencies may be important and what causes them, and
how they might be resolved. This dissertation places the
finance problem of inefficiencies resulting from under-
investment in its legal environment. The relationship
between finance theory and the law is examined, and both
legal and finance solutions are proposed.

The analysis utilizes the Myers and Maj luf7 model
described below and examines the legal ramifications Of the

assumptions and results.

 

7 S.C. Myers and N.S. Majluf, o te nci nd
1 ‘1H‘1 3‘ 1 01: 11111'1'11 1-_ ‘ 1 01H.- '1 1g
Ingestgr§_ng_ngt_nayg, J. Of FINANCIAL ECONOMICS 13, 187-221
(1984) [Hereinafter referred to as Myers and Majluf (1984)].

4

Myers and Majluf create a single period model that
shows that under certain conditions firms may pass up
positive net present value projects if they must issue
equity to finance them. Consider a firm which has a single
asset in place and an investment opportunity which must be
financed in whole or in part by issuing equity. The firm
does not have sufficient cash or other marketable securities
on hand to finance the project. Further, there are no
taxes, transaction costs, or other market imperfections.
Investors are rational. Myers and Majluf assume asymmetric
information and that managers act in the best interest of
Old shareholders who are assumed to be passive, i.e.,
shareholders do not rebalance their portfolios in response
to the firm's actions.

The Myers and Majluf model is a three date model. At
t=-1, both the market and managers have the same
information. At t=0, managers receive information
concerning the value of the asset in place and project that
is unknown to the market. At t-+1, the market receives the
information that managers received at t=0. The value of the
asset in place at t--1 is the expected future value, A=E(A),
where the distribution of A is the possible values of the
asset in place at t-O. Management information received at
t=0, is the updated estimate 'a' which is the realization of
A. Similarly, the net present value (NPV) of the project at
t=-1 is §=E(§), where 3 represents the possible NPV's of the

project at t=0. Management receives the updated estimate,

5

b, at t-O. Both a and b are assumed to be non-negative. S,
the amount of slack (cash and equity securities) on hand, is
known by both the market and managers. Equity is issued if
OSSSI, where I is the amount of investment needed to finance
the project.

Myers and Majluf show that managers will issue equity
and invest only if

S+as[P/(P+E)](E+S+a+b),

where P is the "Old shares” market value if stock is issued
and E=I-S. The old shareholders' share of the firm with
investment must be greater than or equal to the value of the
firm without investing in the project. If this condition
does not obtain, then managers will pass up the positive net
present value project and not maximize the value of the
firm.

The problem may be seen easily by use of an
illustration. Assume that there are two states of nature
that can occur and are equally likely. The true state of

nature is known to management at t=0 but not to investors

 

 

until t=+1.
State 1 State 2
Asset in Place a = 150 a = 50
Project NPV b - 20 b - 10

 

 

 

Further assume that the corporation has no cash but

does have $10 in marketable securities so that slack, S,

6
equals $10. The amount of investment needed to finance the
project is $200. The amount of equity needed to be issued
to finance the project is the amount of the investment minus
the amount of slack.
E=I-SIZOO-10=19O.
If the corporation were to issue equity securities to

finance the project regardless of which state occurs,

F=S+A+fi=1o+[(150+50)/2]+[(20+10)/2]=125.
If state 1 were to occur, the value of the corporation,
\h=E+S+a+b=l90+lO+1SO+20=370.
The market value is the market value of the old
shareholders' stock, P, plus the market value of the new
equity, E.
Since the value of the corporation in state 1 is $370,
the old shareholders' aliquot share is
[p/ (P+E) 1 ov1-[125/ (125+190) J ~37O=146.83 .
The new shareholders' aliquot share of the corporation is
[E/ (P+E) 1 -v,-(190/315) -37O=223 . 17.
Likewise, if state 2 were to occur, the value of the
corporation,
. \h=E+S+a+b-190+10+50+10=260.
The old shareholders' aliquot share is
[p/ (P+E) 1 -v,-[125/ (125+19O) ] -260-103 . 17 .
The new shareholders' aliquot share is
[E/ (9+3) ] ovz-[190/315] ~260=156.83.

Note that the stock is correctly priced to old shareholders

and new investors.
F-k(146.83+103.17)-125, and
E=%(223.17+156.83)-190.

Now, consider the payoffs to the old shareholders.

 

 

Issue 8 Invest Do Nothing
Payoffs to Old S/M (E-190) (E=0)
State 1 146.83 150
State 2 103.17 50

 

 

 

The optimal strategy is for managers not to issue and
invest if state 1 occurs but to do so if state 2 occurs.
However, if investors know the strategy, not issuing and
investing signals state 1 while issuing and investing
signals state 2. Consequently, investors will adjust, and

the equilibrium payoffs are

 

 

Issue 8 Invest Do Nothing
Payoffs to Old S/H (E=190) (E=0)
State 1 -- 150
State 2 60 ---

 

 

 

Managers will not issue and invest if state 1 occurs, and
because investors know it, the market value of the stock, if
issued, is now determined as

F=S+A+§=1o+g(60)+§(150)=115.
This represents a loss of $10 over the ex ante price of
$125. Consequently, managers will forgo investment in the

positive net present value project to protect the value of

the old shareholders stock.

The Myers and Majluf model may be generalized without
changing the result. For simplicity, consider only three
stakeholder groups--managers, old shareholders, and new
investors (the market). The assumption that managers act in
the best interest of all of the old shareholders could be
modified to act in the best interest of the controlling
shareholder(s) without changing the results.

The updated estimate of the value of the firm's asset,
a, is always non-negative because of the limited liability
attribute of corporations. In the absence of fraud or
watered stock, shareholder losses are limited to the value
the corporation's assets; shareholders receive the maximum
of zero or the residual value, if positive. There are no
restrictions on the sign of the net present value of the
real investment Opportunity, b.

The value of the firm at the initial point is the sum
of the slack plus the value of the asset in place, V°=S+a.
The value of the firm if the project is undertaken and
financed with an equity issue is the sum of the market value
of the new equity plus the slack plus the updated estimates
of the values of the asset in place and the project,

VI,- (E+S+a+b) .
Of which the old shareholders aliquot share of V, is
[P/(P+E)](E+S+a+b)
and the new shareholders aliquot share of V, is

[E/(P+E)](E+S+a+b).

9
It is important to note that the total value of the firm
does not change. What changes is the aliquot shares of the
different stakeholders.

The conflict among the stakeholders is as follows:
managers will want to maximize the value of the firm by
accepting the project if NPVrb>0. Old or initial
shareholders will want to have at least the same value in
the new enterprise as in the old, i.e.,

[P/ (P+E) 1v,zv,,
or restated,
[P/(P+E)](E+S+a+b)zs+a.
New shareholders will want their value in the new enterprise
to at least equal the value of the stock, i.e.,
[3/ (P'l'E) 1V,ZE.
or restated,
[E/(P+E)](E+S+a+b)zE.

In other words, old shareholders will want to undertake

the project only if
[E/(P+E)](S+a)S[P/(P+E)](E+b)
which is equivalent to
E+bz(E/P)(S+a);
while new shareholders (or investors) will only buy if
[E/ (P+E) ] (3+3) ZIP/ (P+E) ] (FWD)
which is equivalent to
E+bs(E/P)(S+a).
These conditions can Obtain simultaneously only at

E+b-(E/P)(S+a)

10
which implies that the stock must be fairly priced in the
market. If it is either undervalued or overvalued, one or
the other of the stakeholders would object. Old
shareholders would want to issue new equity if the stock is
overvalued while new investors would balk. New investors
want to buy if the stock is undervalued while old
shareholders would object to the issue. Managers will want
to issue stock if expected NPV>0. This by itself conveys no
information to the shareholders or investors about the value
of the stock. However, managers also want to maximize the
value of the firm in other ways. This implies that managers
will want to issue stock if expected NPV>0 and the stock is
overvalued. If the stock is undervalued, the value of the
firm is reduced below fair market value (FMV) so managers
will not issue stock. This is in the best interests of the
old shareholders.

Investors know that managers would issue stock only if
expected NPV>0 and the stock is overvalued. Issuing stock
sends a negative message to the market which causes stock
prices to fall. Managers are aware of this and will not
issue stock to finance the project even though NPV>0 to
protect the stock value.

In balancing the interests of the old shareholders,
managers, and investors, managers will make a suboptimal
investment decision if equity must be issued to finance the
project. The optimal investment decision under asymmetric

information is made if 321 in which case managers and

11
shareholders benefit from undertaking a NPV>0 project and
investors have no immediate stake in the outcome.

If debt is issued to finance the project, the managers
will invest in the expected NPV>0 project since it would be
in the best interest of managers and the shareholders.
Again, new shareholders or investors have no immediate stake
since no new equity will be issued. The interests of the
bondholder-stakeholder group is protected contractually;'
otherwise, they are at risk. The law provides little
protection to bondholders outside of bankruptcy other than
enforcing protective or restrictive covenants’ of the bond
contract or indenture.

It is not necessary that b>0. The model can explain
agency costs associated with managers investing in NPV<0
projects because they have a vested interest in the project
or are engaged in empire building. Assume managers expect
b<0. Because of the asymmetry of information, only the
managers know the value of b. Under this condition,
investors would be even more leery of an equity issue and
would either not buy or require a substantial discount.
Again, an equity issue sends a negative signal to the

market. Old shareholders would object to accepting NPV<0

 

' Trust Indenture Act of 1939, 15 U.S.C. s 77aaa et
seq.

9 See American Bar Association, COMMENTARIES ON MODEL
DEBENTURE INDENTURE PROVISIONS (1971) for a description of
the many different restrictions and covenants used in bond
contracts.

12
projects if they knew about them. Moreover, the condition
E+b=(E/P)(S+a) would still have to hold. In balancing the
interests of managers, investors, and old shareholders,
managers wanting to invest in NPV<0 projects would issue new
equity only if the stock is overvalued. Investors would not
want to buy under these conditions, however, if they knew
them. Managers would have no incentive to issue new equity
if the stock is undervalued, and old shareholders would
object. The net result of balancing the interests of all
stakeholder groups is that no equity will be issued to
finance the project.

As in the case b>0, managers would undertake the
project if 821. In this case, there are no competing
shareholder or investor interests. If the managers
consistently undertake NPV<0 projects they run the risk of
shareholder opposition or become candidates for takeover.
If S<I, debt financing would avoid problems with equity
investors although it increases the risk of bankruptcy.
However, shareholder opposition would be reduced because
agency costs of monitoring the managers would be shifted to
the bondholders who can protect themselves, and indirectly
the shareholders, contractually.

Thus, the model explains the observed phenomenon that
managers prefer internal financing to outside, and if they
must go outside, debt is preferred to equity. The model
also accounts for suboptimal investment and some agency

costs.

13

Myers and Majluf (1984) assume that the project
evaporates if the firm does not take advantage of it at
t=0.10 Parenthetically, they assert that they could just as
well assume that delay reduced the project's net present
value. Whether their assumption is correct or not can be
ascertained by extending their model to a two-period model
and examining it.

An investment will be bypassed in the first period and
undertaken in the second period only if

[P/ (P+E) 1 (E+S+a+b,)<s+as[p/ (P+E) ] (E+s+a+b,) ,
if the value of the asset in place, a, is held constant or
if the value of the asset in place is allowed to vary over
time only if
[P/ (P+E) ] (E+S+a1+b,) <S+a,, and
[P/ (P+E) ] (E+S+a,+b2) >S+a,.

where aiis the updated estimate of the asset in place in
period i known to management but not the market in said
period and biis the updated estimate of the value of the

 

w Contra, Lucas and MCDonald created a dynamic,
infinite horizon model of a corporation's equity issue
decision. They assumed short-term asymmetric information
and that managers act in the interests of the shareholders
as did Myers and Majluf. They hypothesized that overvalued
firms will issue equity to finance a NPV>0 project
immediately, whereas an undervalued firm will delay issuing
equity to finance a NPV>0 project. Simulations of their
model produced the familiar pattern around equity issue
announcement dates. Prior to the announcement date stock
prices on average exhibited an extended positive abnormal
return, but immediately following the announcement, stock
prices fell significantly. D. Lucas and R. McDonald, Equity
I§§BsE_QBQ_§§QQK_EIIQ£_DIDAIIEE1 3- OF FINANCE 45: 1019-1043
(1990).

14
project in period 1 known to management but not the market
in said period. The old shareholders' value in the firm
without investment must be greater then their aliquot share
of the firm with investment in the first period for there to
be no investment; however, for there to be investment in the
second period the old shareholders' value in the firm must
be less than or equal to their aliquot share of the firm
with investment in the second period.

Myers and Majluf, in effect, assert that in every case

S+a>[P/ (P+E) ] (E+S+a+b,) >[p/ (P+E) ] (E+S+a+b2)
if the value of the asset in place is held constant or
S+a‘>[P/ (IN-E) ] (E+S+a,+b,) and
S+a2> [P / (P+E) ] (E+S+a2+bz)
if the value of the asset in place is allowed to vary over
time.

An argument can be made that projects do indeed go
stale. If the project is postponed one period, the net
present value will be reduced since it is one period farther
away and must be discounted back one additional period.
There may be a strategic component in the value of the
project concerning product mix, marketing, competition, or
timing that is lost if the project is postponed. Postponing
the project may increase the risk. More uncertainty will
alter the distributions of the values of the asset in place
and project. The increased risk will increase the
capitalization rate and yield a lower net present value.

Another way to view the situation is to consider the

15
right to postpone as a call option which expires in the
second period. The value of the project in the first period
is the net present value of the project plus the value of
the call option. In the second period the value of the
project is just the net present value of the project. Even
if the net present value of the project remained constant,
the value of the project is reduced by the value of the call
option which is positive; hence, the project is worth less
thereby supporting Myers and Majluf’s claim.

Nonetheless, a2 and b, are updated estimates of expected
values of the distributions of the values of the asset in
place and project respectively in period two and may exceed
al and bi due to economic or other conditions. In which
event, holding the amount of slack, S, constant,

(1) [P/ (P+E) ] (E+S+a,+b,) < [P/ (P+E) ] (E+S+a,+b2) <S+al<S+a2, or
(2) [P/ (P+E) ] ( E+S+a1+b,) <S+al<S+a,s[P/ (P+E) ] (E+S+a2+b,) , or
(3) S+al<S+azs[P/ (P+E) ] (E+S+a,+b,) <[P/ (P+E) ] (E+S+a,+b,) , or
(4) [P/ (P+E) ] (E+S+a,+b,) <S+al< [P/ (P+E) ] (E+S+a2+b,) <S+a2, or
(5) S+a15 [P/ (P+E) ] (E+S+al+b,) <S+azs[P/ (P+E) ] (E+S+a2+b2) , or
(6) S+a,s [P/ (P+E) 1 (E+S+a,+b,) < [9/ (9+2) ] (E+s+a,+b,) <S+a,.

In cases (1) and (4) the project would be abandoned in
period one; however, in case (2), investment in the project
should be postponed until period two. .In cases (3), (5),
and (6), the investment is made in period one, so there is
no postponement issue. The point here is that Myers and
Majluf’s assumption does not hold in all cases. In case

(2), the value of the corporation is maximized and Old

 

16

shareholders are satisfied by postponing the investment
until period two.

Now suppose that b2>b, and a,<a, still holding the amount
of slack, S, constant, the alternatives are:
(1) S+a2< [P/ (P+E) 1 (E+S+a,+b,) <[P/ (P+E) J (E+S+a2+b,) <S+a,, or
(2) s+a,<[p/ (P+E) 1 (E+S+a2+b2) <[P/ (P+E) 1 (E+S+a,+b,) <S+a,, or
(3) [P/ (P+E) 1 (E+S+a,+b() < [P/ (P+E) 1 (E+S+a2+b2) <S+a2<S+aU or
(4) [P/ (P+E) ] (E+S+a2+bz) < [P/ (P+E) ] (E+S+a,+b,) <S+a2<S+a,, or
(5) [P/ (P+E) ] (E+S+a,+b,) <5+32<3+81$IPI (P+E) ] (E+s+a2+b2) , or
(6) [P/ (P+E) 1 (E+s+a,+b,)<s+a,<s+a,s[1>/ (9+3) 1 (E+s+a,+b,) , or
(7) [P/ (P+E) 1 (E+s+a,+b,) <S+az< [p/ (P+E) 1 (E+S+a2+b,) <s+aiI , or
(8) [P/ (P+E) 1 (E+S+a,+b,) <S+a,<[P/ (P+E) ] (E+S+a1+b,) <S+au or
(9) S+a2<S+a,<[P/ (P+E) 1 (E+s+a,+b,) <[P/ (P+E) 1 (E+S+a2+b2) , or
(10) S+a2<S+al< [P/ (P+E) 1 (E+S+a2+b,) < [P/ (P+E) 1 (E+S+a,+bl) , or
(11) S+a,<[p/ (P+E) 1 (E+s+a,+b,) <S+a,<[P/ (P+E) 1 (E+s+a,+b,) , or
(12) S+a2< [P/ (P+E) 1 (E+s+a,+b,)<s+a,<[1>/ (P+E) 1 (E+S+a,+b1) .
No investment would be made in either period in cases (3),
(4), and (8). In cases (6), (9), (10), and (12) investment
would be made in period one. Investment would be bypassed
in period one but made in period two in cases (1), (2), (5),
(7), and (11). Again, Myers and Majluf's assumption does
not hold in all cases. In four of these cases, (3), (4),
(5), and (7), the value of the corporation is maximized and
old shareholders are satisfied by postponing the investment
until period two. In one-half of these cases involving a

reduction in the value of the asset in place in period two,

 

 

17
management is forced to re-evaluate the investment decision
in period two.

If we now assume that the value of the project
decreases in period two, b,>b,, and that the value of the
asset in place increases in period two, a,>a,, while holding
the amount of slack, S, constant then
(1) S+a,<[P/ (P+E) I (E+S+al+bl) < [P/ (P+E) J (E+S+az+b2) <5+azr or
(2) s+a,< [p/ (P+E) 1 (E+S+a,+b,) < [p/ (P+E) 1 (E+S+a,+b,) <S+a2, or
(3) [P/ (P+E) ] (E+S+a,+b,) <[P/ (P+E) ] (E+S+a,+b,) <S+a1<S+a2, or
( 4) [P/ (P+E) ] (E+S+a2+b2) <[P/ (P+E) ] (E+S+a,+b1) <S+a1<S+a2, or
(5) [P/ (P+E) 1 (E+S+a,+b,) <s+a,<s+a,s[p/ (9+3) 1 (E+S+a2+b2) , or
(6) [P/ (P+E) ] (E+S+a2+b2) <S+a,<S+a,s[P/ (P+E) ] (E+S+a,+bl) , or
(7) [P/ (P+E) 1 (E+S+a,+b1)<s+a,<[P/ (P+E) 1 (E+S+a2+b,) <S+a,, or
(8) [P/ (P+E) ] (E+S+a2+b2) <S+ai< [P/ (P+E) ] (E+S+a(+bl) <S+a2, or
(9) S+a1<S+a2< [P/ (P+E) 1 (E+s+a,+b,) < [p/ (P+E) 1 (E+s+a2+b2) , or
(10) S+a1<S+a2< [p/ (P+E) 1 (E+S+a2+b2) < [P/ (P+E) 1 (E+S+a,+b1) , or
(11) S+a1< [P/ (P+E) ] (E+S+a,+b!) <S+a2< [P/ (P+E) ] (E+S+a2+b2) , or
(12) s+a,< [p/ (P+E) 1 (E+s+a,+b,) <S+a2< [P/ (P+E) 1 (E+S+a,+b,) .

The investment is made in period 1 in cases (1), (2), (6),
(8), (9), (10), (11), and (12). No investment is made in
either period in cases (3), (4), and (7). Postponement
results in investment in period two only in case (5), but
still rejects the Myers and Majluf assumption.

Finally, assume that the values of both the asset in
place and the project decline in period two, b1>b2 and al>a2,

while holding the amount of slack, S, constant then

 

 

18
(1) [P/ (P+E) ] (E+S+a,+bl) >[P/ (P+E) ] (E+S+a2+b2) >S+a1>S+a,, or
(2) [P/ (P+E) 1 (E+s+a,+b,) >s+a,>S+a,>[P/ (P+E) 1 (E+S+a2+b2) , or
(3) S+a1>S+a2>[P/ (P+E) 1 (E+s+a,+b,) >[P/ (P+E) 1 (E+S+a2+b2) , or
( 4) S+ai>[P/ (P+E) ] ( E+S+a1+b‘) >[P/ (P+E) ] (E+S+a,+b2) >S+a2, or
(5) [P/ (P+E) 1 (E+S+a,+b,) >s+a,>[F/ (P+E) 1 (E+S+a,+h,) >S+a2, or
(6 ) S+a1>[P/ (P+E) 1 (E+S+a,+b,)>s+a,>[1>/ (P+E) 1 (E+S+a,+b,) .
Investment is made in period one in cases (1), (2), and (5).
NO investment is made in either period in cases (3) and (6).
The project is postponed until period two in caSe (4). The
assumption fails to hold in case (4). In no scenario does
the assumption hold in all cases.

In the examples above the amount of slack was held
constant, but the amount of slack could vary from period to
period. Slack could be a function of interest paid on the
cash deposits, dividends paid on the market securities held,
dividend policy on the corporation's own stock, income from
the asset in place, capital gain or loss on the market
securities held, and internal expenses. Slack could
increase as a result of interest received on the cash
deposits, dividends received on the market securities, or
capital gains on the market securities. Slack could
decrease with dividends paid, capital losses on the market
securities, or operating expenses causing a net operating
loss. For the sake of simplicity, it is assumed that slack
varies exogenously to illustrate the point.

Assume that S,>S, and that a, and b, exceed al and b1

respectively due to economic or other conditions. In which

19
event,
(1) [P/ (P+E) 1 (E+s,+a,+b,) < [P/ (P+E) 1 (E-t-Sz+a2-1-bz)<Sl-1-a1<82+a2
(2) ' [p/ (P+E) 1 (E+S,+a,+b,) <s,+a,<s,+a,s [P/ (P+E) 1 (E+s2+a2+b2)
(3) S,+a,<s,+a,s [P/ (P+E) 1 (E+s,+a,+b,) < [P/ (P+E) 1 (E+s,+a,+bz)
(4 ) [P/ (P+E) 1 (E+s,+a,+b,) <S‘+a,< [Pl (P+E) 1 (E+Sz+a2+b2) <s2+a2
(5) s,+a,s [P/ (P+E) ] (E+Sl+a,+b1) <s,+a,s [P/ (P+E) ] (E+Sz+a2+b2)
(6) S,+a,s [P/ (P+E) 1 (E+S,+a,+b1) < [P/ (P+E) 1 (E+Sz+a2+bz<sz+a2)
In cases (1) and (4) the project would be abandoned in
period one; however, in case (2), investment in the project
should be postponed until period two. In cases (3), (5),
and (6), the investment is made in period one, so there is
no postponement issue. Again Myers and Majluf's assumption
does not hold in all cases. In case (2), the value of the
corporation is maximized and old shareholders are satisfied
by postponing the investment until period two.

Now assume that the values of both the asset in place
and the project decline in period two, b,>bz and a1>a2, and
Sl>sz, then
(1) [P/ (P+E) 1 (E+S,+a,+b1) >[P/ (P+E) 1 (E+S,+a,+b,) >Sl+a1>Sz+a2
(2) [P/ (P+E) 1 (E+S,+a,+b,) >s,+a,>s,+a,> [P/ (P+E) 1 (E+s,+a,+b2)

(3) s,+a,>S,+a,> [p/ (P+E) 1 (E+s,+a,+b,) > [P/ (P+E) 1 (E+S,+a2+b2)
(4) s,+a,> [p/ (P+E) 1 (E+s(+a,+b,) >[p/ (P+E) 1 (15:+s,+ai,+n,)>sz+a2
(5) [P/ (P+E) ] (E+S,+a1+b,) >S‘+a,>[P/ (P+E) ] (E+S,+a2+b2) >Sz+a2
(6) 51+31>IPI (P+E) ] (E+S1+al+b1) >Sa+a2>[P/ (P+E) ] (E+Sz+a2+b2)
Investment is made in period one in cases (1), (2), and (5).

No investment is made in either period in cases (3) and (6).

20

The project is postponed until period two in case (4). The
assumption fails to hold in case (4).

For the remaining four cases 51(52 and a,>a2 and b1<b2,
Sl<S2 and a,>a2 and b,>b,, S,>S2 and a‘>a,, and bl<bz, and S,>S2 and
ai>a2 and b,>b,, there are twenty-four different cases. In
all four, S1+a,>s,+a, or S,+a¢28,+a, and E+S,-1-a,+b,<E~1-sz-I»a2-1-b2 or
E+Sl+al+b121'114-82-1-a2-1-bz depending on the magnitude of the
individual elements.
(1) sz+azs [P/ (P+E) 1 (E+sl+a(+b() s [P/ (P+E) 1 (E+s,+a,+b,) ss,+al
(2) sz+azs [P/ (P+E) 1 ( E+Sz+a1+b,) s [P/ (P+E) 1 (E+S,+a,+bl) ssl+a1
(3) [Pl (P+E) 1 (E+s,+a,+b,) s [P/ (P+E) 1 (E+s,+a,+h,) ss,~1»azss,+al
(4) [P/ (P+E) 1 (E+s,+a,+b,) s [P/ (P+E) 1 (E+s,+a,+b,) ss,+a,,ss,+al
(5) [Pl (P+E) ] (E+Sl+al+b‘) ssz+a2581+a,s[P/ (P+E) ] (E+Sz+a2+b2)
(6) [P/ (P+E) ] (E+S,+a2+b2) SSz+azssI+als [P/ (P+E) ] ( E+S1+a1+b!)
(7) [P/ (P+E) 1 (E+s,+a,+b,)ss,+azs[1>/ (P+E) 1 (E+s,+a,+b2) ssl+a1
(8) [P/ (P+E) ] (E-I-Sz-l-az-i-bz) $82+a25[P/ (P+E) ] (E+S‘+a‘+b1) 5814-31
(9) s,+a,s [P/ (P+E) 1 (E+s,+a,+b,) s [P/ (P+E) 1 (E+s,~11112+b,)ssz+a2
(10) S,+a,s [Pl (P+E) 1 (E+Sz+a,+h2) s[P/ (P+E) 1 ( E+Sl+a1+b,) 5824a2
(11) [P/ (P+E) ] (E+Si+al+b1) S[P/ (P+E) ] (E+Sz+a2+b2) SS1+a1552+a2
( 12) [P/ (P+E) 1 (E+sz+a2+bz) s [P/ (P+E) 1 (E+s,+a,+b,) ssl+alssz+a2
(13) [P/ (P+E) 1 (E+s,+a,+b,) ssl+a,ssz+azs [P/ (P+E) 1 (E+Sz+a2+b2)
(14) [P/ (P+E) ] (E+Sz+a2+b,) ss,+a,ss,+a,s [P/ (P+E) ] (E+Sl+a1+b!)
(15) [P/ (P+E) ] (E-t-Sl-t-al-l-bl) SSl+OIS[P/ (P+E) ] (E+Sz+a2+b2) SSz+a2
(16) [P/ (P+E) 1 (E+s,+a,+bz) ss,+a15[P/ (P+E) 1 (E+s,+a,+b() ss,,+a2
(17) sz+a25 [P/ (P+E) 1 (E+s1+a,+b,)ss,+a,s[P/ (P+E) 1 (E+Sz+a2+b2)

(18) s,+a,s [P/ (P+E) 1 (E+s,+a,+b,) ssl+als [P/ (P+E) 1 (E+s,+a,+b,)

 

 

 

21
( l9) s1+a15[9/ (P+E) 1 ( E+S1+a1+b,) SS,+a¢S[P/ (P+E) 1 (E+S,+a2+b2)
(20) SI+a1$[P/ (P+E) 1 (E+S,+a,+b2) 5324-815 [P/ (P+E) 1 (E+S,+a1+bl)
(21) 32+32551+31$ [Pl (P+E) ] (E+sl+al+bl) SIP/ (P+E) ] (E+Sz+az+b2)
(22) S,+a,ss,+a,s [9/ (P+E) 1 (E+Sz+a2+bz) s [9/ (P+E) 1 (E+Sl+al+b,)
(23) s,+a,ss,+a,s [P/ (P+E) ] ( B+S1+a1+bl) S[P/ (P+E) ] (E+Sz+a2+bz)
(24) S,+a,ss,+a,s[ (9/9+E) 1 (E+s,+a,+h,) 5(9/ (9+9) 1 (E+s,+a,+b,)
No investment would be made in either period in cases (3),
(4), (8), (11), (12), and (15). Investment would be made in
period one in cases (6), (9), (10), (14), (16), (18), (19),
(20), (21), (22), (23), and (24). Investment would be
postponed until period two in cases (1), (2), (5), (7),
(13), and (17).

Myers and Majluf's assumption does not hold whether the
amount of slack is held constant or allowed to vary from
period to period.

An illustration of case 13 , where S‘<s,, a,<a2, and b1>b2,
provides some insight into the problem. Consider a two-
period model using the framework and numbers for period 1
from the one-period illustration above.

 

Asset in Place State 1 State 2

 

Period 1 150 50
Period 2 155 53

 

 

 

 

 

Project (NPV>0) State 1 State 2

 

Period 1 20 10
Period 2 18 8

 

 

 

 

22

Note that the project becomes stale, bu>b21 and bn>bn,
and the value of the asset in place increases in value as a
result of economic conditions such as increased market
share. Assume that S,=10, as in the one-period illustration
and that S,=15, as a result of an increase in market value
of the marketable securities held as slack. Il=200 and
13=202 as a result of increased costs. The amount of equity
needed to be issued is

E,=I,-s,-2oo-1o-19o, and
32:12-32-202-15-187 .
Therefore,
91=s,+A,+§,=10+100+15=125, and
9,=S,+A2+§,-15+104+13-132 .

In period 2, if state 1 occurs, old shareholders'

aliquot share of the corporation's value, Vfi, computed as
E,+S,+a,,+b,,=187+15+155+18=375
is
[92/ (P2+Ez) 1 -v,1=[132/ (132+187) 1 o375=155. 17.
If state 2 occurs in period 2, old shareholders' aliquot
share of the value of the corporation, Vh, computed as
E2+sz+an+bn-187+15+53+8=263
is
[9,/(9,+E,)1-v,,=(132/319) 0263=108.83 .

The payoff matrix for old shareholders in period 1 is

 

23

 

 

 

Period 1 Issue 8 Invest Do Nothing

Payoffs to Old S/H (E-190) (E-O)
State 1 146.83 150
State 2 103.17 50

 

The payoff matrix for old shareholders in period 2 is

 

 

 

Period 2 Issue 8 Invest DO Nothing

Payoffs to Old S/H (E-187) (E=0)
State 1 155.17 155
State 2 108.83 53

 

 

 

Recall from the one-period model that managers did not

issue and invest in the first period.

The optimal strategy

in this case of the two-period model is not to issue and

invest in period 1 if state 1 occurs but to issue and invest

if state 2 occurs.

Since this signals investors that state

2 occurred, the payoffs were adjusted downward, and,

consequently, managers did not issue and invest regardless

of state.

In period 2, the optimal strategy is to invest

regardless of which state occurs.

However, if investors

believe that managers are following the same strategy as in

period 1, the payoff matrix is adjusted as follows:

 

 

 

Period 2 Issue 6 Invest Do Nothing

Payoffs to Old S/H (E=187) (E=0)
State 1 -- 155
State 2 26 ---

 

 

 

 

 

24

This adjustment results in a market value of

9,--15+!5 (155) +35 (26) =105 . 5
whereas the ex ante value of the corporation is $132. This
represents a loss of $26.50 because of the misleading signal
of period 1 strategy when in fact the same strategy is not
being employed in both periods. Because of the false signal
managers should not issue and invest if operating in the
best interests of the old shareholders.

If investors know managers' strategy in both periods,
no information is conveyed by issuing and investing in
period 2 because managers will issue and invest in period 2
regardless of which state occurs. The ex ante value of $132
is not affected. In this case, with full disclosure of
managers' strategy, managers should issue and invest because
the old shareholders' stock value is not affected.

This set of circumstances raises the question of
whether or not any reliable information can be consistently
signalled in both periods. Extension of Myers and Majluf's
model to a two-period model undercuts their equilibrium
solution based on the issue and invest signal. If the
signal is not reliable from period to period or conveys no
information, no equilibrium solution can be determined and
the only reliable value is the ex ante market value at t=0.

One solution may be to couple the assumption that
managers act in the best interest of the old shareholders
with a condition that the stock be overvalued in the market.

In this case, no investment would be made in period 1 acting

25
in the best interest of the old shareholders, and no
investment would be made in period 2 unless state 2 occurred
in which event the stock is overvalued. Investors knowing
this strategy would place a value of $105.50 on the old
shareholders' stock if managers issued and invested instead
of the true value of $108.83; consequently, managers would
not issue and invest in period 2 either.

Even in a two period model, the basic problem remains.
Managers acting in the best interest of the old shareholders
may forgo investment in positive net present value projects
if the old shareholders' aliquot share of the firm value
with investment is less than the value of the firm without
investment. Because the signal may not be consistent from
period to period or convey no information, the asymmetric
information aspect of the problem remains to be solved by
other means.

Pure financial solutions are discussed in Chapter II
which is a review of the relevant finance literature
attempting to solve the Myers and Majluf model problem.

None of the financial solutions is a satisfactory solution
to the problem. Something is missing from the model. One
important missing element is the legal environment. Several
possible solutions to the problem utilizing both legal and
financial aspects are presented in Chapter III. Chapter IV
discusses the spin-Off and equity carve out solution with
particular attention to asymmetric information. An analysis

of the assumption that managers act in the best interests of

26
the Old shareholders is presented in Appendix A. Appendix B
discusses the merger and tender offer solution with
particular attention to the asymmetric information problem.
Chapter V presents empirical evidence of efficacy Of the
spin-off solution. The dissertation concludes in Chapter

VI.

II. Literature Review

The existence or assumption of asymmetric information
lies at the heart of much of the related work. One Of the
early papers addressing this issue is by Akerlof‘l (1970) who
addressed the problem of buying a 'lemon' when buyers cannot
verify the quality of the product being sold. Because
buyers cannot verify the quality of the product, they demand
a discount. The result is that sellers with a high quality
product will not enter the market at a discount leaving only
sellers of a low quality product in the market. The market
breaks down when both buyers and sellers of a high quality
product avoid the market. As Myers and Majluf (1984) point
out, the difference between their paper and Akerlof’s is
that the seller is not offering a single good but a partial
claim in two different goods--the asset in place and the
project.

Myers2 in a precursor of Myers and Majluf (1984)
examined the question presented by the existence of the tax
shield that if corporate borrowing is so beneficial why do
firms not have 100 percent debt in their capital structure.
The value of a corporation consists of the sum of the market
values of the assets in place and the present value of

future growth opportunities. Myers treats the future growth

 

‘ G.A. Akerlof, The Market for '1gmggg'; Quality and
the_fiazkgt_fleghan1§m, QUARTERLY J. OF ECONOMICS 84, 488-500
(1970).

2 8.C- Hyers. DeIerninanIs_9f_sornorate_ncrroxing. J-
OF FINANCIAL ECONOMICS 5, 147-175 (1977).

27

28
Opportunities as call options to make future investments.
The ultimate value of the firm depends on further
discretionary investment by the firm. He assumes that
managers act in the best interest of the shareholders and
that capital markets are perfect and complete. Risky debt
is issued only for investment not held as cash or used to
purchase other assets. The firm value is maximized by
borrowing less than the maximum amount of debt that the firm
can support. Consequently, corporate debt in excess of the
optimal amount can reduce the value of the firm. There is
no incentive to finance all good future investments with
debt in excess of the optimal amount. Positive net present
value projects are not undertaken, and the value of the firm
is not maximized. The suboptimal investment policy is an
agency cost induced by the risky debt. He speculates that
projects spoil because they may be firm specific, generated
by experience curves, learning by doing, or other similar
phenomena. This may be the basis for utilizing a one period
model in Myers and Majluf (1984).

Another article based on asymmetry of information is by
Leland and Pylefi’ They assert that investment in projects
may not be undertaken for lack of venture capital if
information can not be conveyed costlessly and effectively.

Good quality projects will not be financed unless

 

3 H- Leland and 0- Pyle. Wise.
t ' , J. OF

FINANCE 32, 371-387 (1977) [Hereinafter referred to as
Leland and Pyle (1977)].

 

29
information can be conveyed indirectly. The signal to the
market is the willingness of the entrepreneur with inside
information to invest. The higher the percentage that the
entrepreneur is willing to invest in the project the higher
the quality of the project. Hence, the value of the firm
increases with the percentage of the firm held by insiders.
This creates welfare costs since insiders hold a greater
percentage of the firm than they would otherwise hold
without asymmetry of information. The drawbacks of this
paper are that they assume that the investment decision
already has been made, the only resource of the firm is an
asset in place, and there is a single signal on which the
equilibrium price is determined. Further, it is not geared
toward widely-held, public corporations where insiders hold
insignificant amounts of common stock.

Stiglitz and Weiss‘ provide an economic underpinning
for nonclearing markets based on information asymmetry.
They show that in equilibrium a loan market may be
characterized by credit rationing. The inability of banks
to identify ’good' borrowers results in screening devices
such as interest rates being utilized. High interest rates
induce firms to undertake projects with lower probabilities
of success but higher payoffs when successful. At the

equilibrium interest rate which maximizes the bank's

 

‘ J.E. Stiglitz and A. Weiss, e onin n
, AMERICAN ECONOMIC REVIEW
Part I, 71, 393-410 (1981).

 

 

30
expected return supply of funds does not equal demand. A
higher interest rate needed to clear the market would result
in a lower rate of return to the bank; hence, there is no
incentive for banks to continue to loan money even at higher
rates so credit is rationed.

Miller and Rock’ develop a signalling model based on
net dividends. There are significant announcement effects
which result from asymmetry of information. An unexpected
increase in dividends is interpreted by the market as good
news concerning future prospects of the firm. An unexpected
decrease in dividends is interpreted as bad news. The
important part of the paper here is that Miller and Rock
show that earnings, dividend, and financing announcements
are closely related. Because of the net dividend concept
the financing announcement effect is the dividend
announcement effect with the sign reversed.

Brennan and Kraus‘ assert that the Myers and Maj luf
(1984) problem can be solved costlessly by an appropriate
choice of financing strategy that signals the real prospects
of the firm. They derive the attributes that the securities
must have to be able to costlessly signal the market. They
also claim that if an equity issue is used to refund debt in

addition to financing the project that the market value of

 

5 M.H. Miller and K. Rock, Qiyiggng Policy under

Asymmetric_1nformation. J- OF FINANCE 40. 1031-1051 (1985)-

‘ M. Brennan and A. Kraus, Effggient Financing under
Asymmetric_1nfcrnation. J. OF FINANCE 42. 1225-1243 (1987).

 

 

31
the firm drops less than when equity is issued solely to
finance the project. Their results are restricted and
require a certain compatibility between the nature of the
information asymmetry and the set of financing strategies
available which in turn may rely on the pre-existing capital
structure of the firm.

Bradford" makes a one period model extension of Leland
and Pyle (1977). Here the firm has common stock outstanding
and an existing asset. The firm is considering issuing new
stock and investing in another asset. There are two
signals, the decision to invest and the percentage of the
issue purchased by insiders. Unlike Myers and Majluf,
Bradford lets insiders trade at the issue price. He asserts
that insiders will buy or sell common stock if the capital
gain from the trade is greater than the cost of the trade.
Equilibrium occurs when insiders can no longer gain from an
incremental transaction. The market then uses the
information Observed to form a pooling equilibrium price for
the common stock. The market value is higher when insiders
can trade both before and after the announcement than if
they are prohibited from trading. The share price of a
manager-owner may increase, decrease, or not change with the
announcement of a new issue. Leland and Pyle (1977) and

Bradford deal only with firms where insiders can trade in or

 

7 W. D. Bradford,

The_Issne_necisicn_of_nanagerzguners
undeI_A§¥mnetric_lnfcrnation J. OF FINANCE 42 1245-1260
(1937).

 

 

32
hold substantial portions of the firm's equity. Their
analysis does not apply to the widely-held, public
corporation where managers own a de minimis amount of the
firm's outstanding equity or situations where insider

trading would be prohibited under the securities laws.

 

 

III. Possible Solutions

There are two aspects to the problem--asymmetric
information and managers acting in the best interest of the
Old shareholders. Solutions to either part solve the entire
problem. If managers act in the best interest of the
corporation rather than in the interests of the old
shareholders, they will maximize the value of the
corporation by taking advantage of all positive, net present
value opportunities. On the other hand, if the market had
the same information as managers, the stock would be fairly
priced reflecting the true value of the corporation and
there would be no short term price depression
disadvantageous to the old shareholders.

It is the assumption that managers act in the best
interests of the old shareholders that makes the financing
decision matter. Myers and Majluf (1984) present three
possible assumptions about managerial behavior:

(1) Management acts in the interests of all shareholders,
and ignores any conflict of interest between old and new
shareholders.

(2) Management acts in old shareholders' interest and
assumes they are passive.

(3) Management acts in old shareholders’ interest, but
assumes they rationally rebalance their portfolios as they
learn from the firm's actions.

It is generally assumed that managers act in the best

interest of the old shareholders because that is what is

33

34
taught in financial theory to would be managers and what the
law demanded. The law and financial theory, however, have
diverged so that it may no longer be assumed that managers
act or should act in the best interest of the old
shareholders. Indeed, the law may require them to do
otherwise. Two of the three possible assumptions about
managerial behavior concern the old shareholders. Myers and
Majluf chose assumption number (2) because it offered the
best explanation as to why stock prices fall on an
announcement of a new equity issue and why debt issues have
a lesser impact on stock prices and because they assert that
they "cannot judge the assumption's realism." The
assumption's realism may be tested by examining case law
involving breaches of fiduciary duty and the business
judgment rule.

Unfortunately, an examination of the assumption or
belief that managers act in the best interest of the old
shareholders in the context of the legal environment does
not provide a satisfactory solution to the problem. The
issue is whether or not the assumption has any basis in the
law. The law and financial theory have diverged or are
diverging on this issue. Since the law, particularly the
case law, is a mirror of reality, if the law does not
support this assumption, it is unjustified. There is a
conflict between finance theory and law on this issue.
Managers are under a legal Obligation to act in the best

interest of the corporation even if it is to the detriment

 

35

of the shareholders. Of course, managers could be ignorant
of the legal requirement or actually be knowingly in
violation. In either event, the problem remains. If
managers do act in the best interests of the old
shareholders, what remedy is there? In the first instance,
the law relies on the old shareholders to compel managerial
compliance with the law through elections of directors,
derivative suits, and proxy fights. Election of directors
and the derivative suit are purely legal remedies while the
proxy fight is both a finance and legal remedy. It can
hardly be expected, however, that the old shareholders would
use any Of these remedies to act against their own short-
term best interests. Consequently, the law must rely on
outsiders to protect the corporation's best interest

An outsider who knows or suspects that a corporation
has unused positive net present value projects that would
increase the value of the corporation may acquire stock in
the corporation and then bring a shareholder derivative suit
to force the directors to invest and maximize the value of
the corporation. A shareholder's derivative suit is an
action by a shareholder in behalf of the corporation. The
purpose of the derivative suit is to prevent abuse of
directors' authority by providing a mechanism whereby a
shareholder may sue on behalf of the corporation when the
directors refuse to pursue the corporation's legal rights.
The business judgment rule, however, is a major Obstacle to

shareholder derivative suits.

36

Proxy fights may be evidence that managers forgo
positive net present value projects and that some
shareholders, outsiders, believe that the corporation would
be worth more if new managers were installed who would‘
invest in these opportunities. Dodd and Warner1 found that
there is significant price appreciation associated with
proxy contests consistent with the improved management
hypothesis. The Dodd and Warner findings are consistent
with the hypothesis here that managers often forgo positive
net present value opportunities and underinvest resulting in
a suboptimal value Of the corporation. Outsiders
undertaking proxy contests know or suspect that such
opportunities exist and attempt to obtain control and take
advantage of these unfinanced opportunities increasing the
value of firm. This can account for market price
appreciation in anticipation of such increase in value.

If managers do in fact act in the best interests of the
old shareholders and thereby fail to maximize the value of
the corporation by forgoing positive net present value
projects, the law of corporate governance currently does not
provide an effective solution to the problem. Effective
remedies must be sought in the marketplace. A leveraged
buyout or going private transaction, merger, tender Offer,

spin-off, or equity carve out Offers such a solution. A

 

‘ Dodd. P- and J- 8- Warner. Qn.£ornorate.§exernanCEI
, J. OF FINANCIAL ECONOMICS 11,
401-433 (1933).

 

37
complete discussion of the assumption of acting in the
interest of the old shareholders in the context of the legal
environment is contained in Appendix A.

The primary approach to solving the problem of forgone
corporate opportunities is to solve the asymmetric
information problem. There are several legal and finance
avenues that could be explored. Among them are leveraged
buyouts or going private transactions, mergers and tender
offers, and spin-Offs and equity carve outs. First, there
is a brief description of avenues that are not directly
followed. Finally, the selected avenue is briefly
discussed, and the rationale for choosing it provided.

Asymmetric information in the legal environment is
controlled in large part by state and federal securities
laws. Asymmetric information exists in the main to protect
the firm's proprietary interest in the project. Disclosure
to competitors could prove fatal. Full disclosure is only
required under certain circumstances which acknowledges the
corporation's right to maintain the confidentiality of
proprietary information. Potential solutions to the problem
such as a leveraged buyout or going private transaction,
merger, spin off, equity carve out, or tender offer are
affected by state corporation law and federal and state
securities law. These effects and what that tells us about
the asymmetric information problem are examined.

Managers who do not maximize the value of the firm may

find themselves as targets of takeovers. If the acquiring

38
corporation had sufficient slack or debt capacity to finance
shelved positive net present value projects, a merger or
other type of acquisition would increase the value of the
combined firms. However, the asymmetric information problem
still exists. How would a corporate raider know that
managers have unfinanced positive net present value projects
available? Some signaling mechanism would have to be
employed so that slack poor firms could signal slack rich
firms that they have positive net present value projects
shelved. A full discussion of takeovers as a solution to
the problem is contained in Appendix B.

A leveraged buyout or going private transaction solves
the asymmetric information problem. A leveraged buyout or
going private transaction involves the purchase of the
entire public stock issue of a corporation by its
management. Since management has the information advantage
in the first instance, a leveraged buyout or going private
transaction does not depend on asymmetric information.
Hypothetically, managers may acquire the firm in a leveraged
buyout or going private transaction to avoid the conflict
with the old shareholders over issuing new equity to finance
positive net present value projects. Having acquired the
corporation, managers will then finance the forgone positive
net present value opportunities and increase the value of
the corporation. This hypothesis is consistent with
empirical studies of announcement effects of leveraged

buyouts and going private transactions. DeAngelo, DeAngelO,

 

 

39
and Rice2 reported highly significant two-day abnormal stock
returns of 22.4 percent around the announcement date. The
study indicates that there is under-investment in firms
subject to a leveraged buyout or going private transaction.
The leveraged buyout or going private transaction is not
pursued as a solution beyond this because as a result of the
leveraged buyout or going private transaction the firm is no
longer a publicly held corporation subject to the securities
laws and is no longer traded in the market and is,
therefore, unobservable.

If a firm has positive net present value projects which
managers decide not to finance because of the effect on old
shareholders, some projects may be spun-off or carved out
and offered to investors without regard to the interests of
the old shareholders. Offering such projects as spin-offs
may signal the market that they are positive net present
value projects. Empirical studies by Miles and Rosenfeld

(1933),3 Schipper and Smith (1933),‘:M1te and Owers (1933),5

 

’ DeAngelO, H., L. DeAngelo, and E. Rice, Going
. . . Y I. . ‘ t". . 1-9. ._- Ae‘. 5!, Jo OF

LAW AND ECONOMICS 27, 367-401 (1984).
3 Miles, J. A. and J. D. Rosenfeld, Th§_E_f§g__9fi

- 1 9 91-0 111° 1 ‘H‘1 1 -1 1a ‘1-_d , J.

OF FINANCE'38,1597-1606 (1933).

‘ Schipper, K. and A. Smith,

Effects_9f_Eesgntrasting
gn_Sn§;gggigg;_ngg1tn, J. of FINANCIAL ECONOMICS 12, 437-467
(1933).

5 Hite, G. L. and J. E. Owers, Security_2rige

 

FINANCIAL ECONOMICS 12, 409-436 (1933).

40
Copeland, Lemgruber, and Mayers ( 1986) ,‘ and Schipper and
Smith (1986f’all found significant positive price effects
around a spin-off or equity carve out announcement date.
When compared to the significantly negative price effects
surrounding a seasoned equity issue announcement, it appears
that the market views either a spin-off or equity carve out
as a positive event. The results of these studies are
consistent with the hypothesis offered here. The presence
of unfinanced, positive net present value projects means
that the value of the corporation is not maximized.
Managers who want to maximize the value of the firm without
depressing the market price of the stock by issuing new
equity to finance the projects can spin-off the project or
projects or carve them out. The result is an increase in
value of the firm. A spin-off or equity carve out is
arguably in the best interest of the old shareholders.

A spin-Off or equity carve out may not be a viable
solution under all sets of circumstances. The particular
circumstances of the project and firm must be carefully
considered before a spin-off or equity carve out is
undertaken. For example, projects that require heavy

capital investment may not be amenable to spin-offs or

 

‘ Copeland, T. E., E. F. Lemgruber, and D. Mayers,
o at S i -o ' nd -dat

Abnormal_2erfgrmange in Copeland, ed., MODERN FINANCE AND
INDUSTRIAL ECONOMICS, Chapter 7 (1987).

7 Schipper. K- and A. Smith. 3.99mnariscn_9f_zguitx
a , J. OF FINANCIAL
ECONOMICS 15, 153-136 (1936).

41
equity carve outs. Likewise, projects that are part of a
product mix or firm specific may not easily lend themselves
to spin-Offs or equity carve outs. Characteristics of firms
likely to use the spin-off or equity carve out solutions are
hypothesized, and empirical verification undertaken.

The rationale for studying mergers, spin-offs, and
equity carve outs as solutions to the problem is that they
are large capital investment decisions involving disclosure
requirements of securities laws. Moreover, they are capable
Of being Observed and are large enough in capital terms to
react to. Consequently, spin-offs and equity carve outs are
the solution pursued in this dissertation.

Chapter IV analyzes financial andlegal aspects of the
spin-off and equity carve out solution to the asymmetric
information problem. Chapter V provides further empirical
evidence of the efficacy of the spin-off solution. Chapter

VI concludes and summarizes.

 

Iv. Spin-off and Equity Carve Out Solutions

This chapter examines the spin-off and equity carve out
solutions to the problem in terms of both financial and
legal effects. A spin-off or equity carve out avoids having
to issue new equity of the corporation to finance positive
net present value projects which depresses the market value
of the old shareholders' stock.

If a firm has positive net present value projects which
managers decide not to finance with equity because of the
effect on old shareholders' market value, some projects may
be spun-off or carved out and Offered to investors without
regard to the interests of the old shareholders. Offering
such projects as spin-offs or equity carve outs may signal
the market that they are positive net present value
projects. Empirical studies by Miles and Rosenfeld (1983),l
Schipper and Smith (1983),2 Hite and Owers (1983),3

Copeland, Lemgruber, and Mayers (1986),‘.and Schipper and

 

‘ Miles, J. A. and J. D. Rosenfeld,1h§ Effect of

0 1 ‘m 0 1-- ‘ 111-“1 ‘U‘1 1 01 .1: -1-._' al 1, J.
OF FINANCE 38, 1597- 1606 (1983).

2 Schipper. K- and A. Smith. Effec§§_9f_8929ntragting

gn_§hazehglger_flea1th, J. of FINANCIAL ECONOMICS 12, 437-467
(1933).

3 Hite, G. L. and J. E. Owers, Seguzity_£;igg

Eea2Ii2ns_Ar9und_Q2I92I9Ie_§nin:9ff_Annguncsnents. J- OF
FINANCIAL ECONOMICS 12, 409-436 (1933).

‘ Copeland, T. E., E. F. Lemgruber, and D. Mayers,
.g.. . e SOf1-0 " ‘ .110 1 ‘u‘1 1° ---

Abn_;mg1_2erfigrmang§ in Copeland, ed., MODERN FINANCE AND
INDUSTRIAL ECONOMICS, Chapter 7 (1937).

42

 

 

 

43

Smith (1986)5 all found significant positive price effects
around a spin-Off or equity carve out announcement date.
When compared to the significantly negative price effects
surrounding a seasoned equity issue announcement, it appears
that the market views spin-offs and equity carve outs as
positive events. The results of these studies are
consistent with the hypothesis offered here. The presence
of unfinanced, positive net present value projects means
that the value of the corporation is not maximized.
Managers who want to maximize the value of the firm without
depressing the market price of the stock by issuing new
equity to finance the projects can spin-off the project or
projects or carve them out. The result is an increase in
value of the firm and the old shareholders' interest.

A. Financial

In a spin-off, the original corporation generally
creates a new corporate entity, although an existing
corporation may be used, to which it transfers part of the
assets of the original corporation in exchange for the stock
of the newly-created corporation. The newly-created
corporation's stock is distributed to the shareholders of
the original corporation. The stock distribution is
essentially a stock dividend to the old shareholders. The

spin-off may be a tax free '0' reorganization if it meets

 

5 Schipper, K. and A. Smith,
, J. OF FINANCIAL
ECONOMICS 15, 153-186 (1986).

44
the requirements of section 368(a)(1)(D) of the Internal
Revenue Code of 1986. Since government tax policy favors
'D' reorganizations, spin-offs may be the preferred solution
when taxes are considered; however, tax consequences are
ignored for purposes of this discussion.

A divestiture involves the sale of a portion of the
assets of a corporation to a third party in exchange for
cash or other consideration. Typically, the third party is
an existing firm or corporation that will utilize the
acquired assets in its operation or create a new division.
The particular type of divestiture of interest here is the
equity carve out in which a part of the original corporation
is sold to outsiders through an equity offering. Part of
the assets of the original corporation are transferred to a
wholly owned subsidiary either newly-created or existing.
The stock of the subsidiary is sold to outsiders. In an
equity carve out the old shareholders of the original
corporation no longer have an interest in the subsidiary.
The difference between a spin-off and equity carve out with
respect to the old shareholders is that in a spin-Off the
old shareholders hold stock in both the original corporation
and the subsidiary while in an equity carve out the Old
shareholders hold stock only in the original corporation.

The motivation for a spin-off or equity carve out is to
separate the original corporation's assets. Separation of
assets may be desirable to separate profitable from

unprofitable assets or operations, to separate incompatible

45
divisions, to focus the market's attention on the individual
assets rather than the aggregate, to defend against a
hostile takeover bid, or to dispose of assets that cannot
otherwise be sold at an adequate price. A spin-off or
equity carve out may not be desirable if there is a
symbiotic relationship between the assets, divisions, or
operations. For example, if the original corporation's
divisions are capital intensive it might not be cost
effective to duplicate the capital expenditure necessary to
make the subsidiary viable on its own. A spin-off or equity
carve out may be indicative of inefficient or inexperienced
management. Management may not be capable of managing a
large operation or multiple divisions but quite capable of
managing a smaller operation. The project to be spun-off or
carved out may be outside the expertise of existing
management and better left to new management with the
requisite expertise.

State corporation law governs the procedure for
accomplishing the spin-off or equity carve out. Initially,
the board of directors must decide to spin-off or carve out
the assets or projects. If the spin-off or equity carve out
constitutes a sale or exchange of all or substantially all
the assets other than in the usual and regular course of
business, shareholder approval may be required. What
constitutes all or substantially all the assets is subject
to both quantitative and qualitative analysis. The way the

model is set up in this dissertation the issue would turn on

46
the relative sizes of a and b.

Miles and Rosenfeld‘ suggested that a voluntary spin-
off announcement could increase the value of the original
corporation (1) by eliminating negative synergies affecting
future cash flows, (2) by expanding the opportunity set
available to investors and providing more choice between
dividends and capital gains, and (3) by a wealth transfer
from bondholders to stockholders. They studied 55 spin-off
announcements from 1963 through 1980 using a mean-adjusted
returns technique and found significant positive abnormal
returns immediately surrounding the announcement date. This
finding is in contrast to generally negative abnormal
returns preceding sell-off announcementsJ’ Although spin-
offs and sell-Offs are similar events producing similar
results in terms of restructuring and positive price share
effects following the announcement date, the period
preceding the announcement date shows different effects.
One explanation may be that although similar the underlying
circumstances producing a spin-off or sell-off are quite
different and, therefore, cannot be treated as equivalent

transactions.

 

5 J.A. Miles and J.D. Rosenfeld, Tha_£fifiagt_gfi
V- am ._.°1-O - 1-1-10.1 1.1.1 1 01,11. ‘1- 0.‘ W‘: 12.1, J.
OF FINANCE 38, 1597-1606 (1983) [Hereinafter referred to as
Miles and Rosenfeld (1983)].

7 gag Masulis and Korwar, note 1 aupua; Asquith and
Mullins, note 2 aupua; and Mikkelson and Partch, note 4

mm-

47

Schipper and Smith’ investigated shareholder wealth
effects of voluntary spin-offs from 1963 to 1981. They used
a market model with a pre-event estimation period to
estimate returns over a two day announcement period.
Significantly positive abnormal returns consistent with
Miles and Rosenfeld's findings were found. Unlike Miles and
Rosenfeld, they found no abnormal price behavior in the four
months preceding the announcement date. There was virtually
no evidence of wealth transfers between bondholders and
shareholders. Moreover, they determined that one of the
sources of the gains is increased productivity as a result
of smaller size and diversity of assets under a single
management lending credence to the inefficient management
hypothesis for spin-offs.

In another 1983 article, Hite and Owers9 also found
significant abnormal two day announcement period returns.
However, their findings were not uniformly positive. They
found evidence of positive price performance in the
preannouncement period. Like Schipper and Smith (1983),
they rejected the bondholder expropriation theory. An

important part of this study for this dissertation is that

 

' K. Schipper and A. Smith, Effigcug Q: Recgutracting
, J. OF FINANCIAL ECONOMICS 12, 187-221
(1983) [Hereinafter referred to as Schipper and Smith
(1933)].

’ G-L- Hite and J-E- Owers, Securisx_£rice_zeactign§
AI2unQ_Q2In2IaIe_§nin:2ff_8nngun§smente. J. OF FINANCIAL

ECONOMICS 12, 409-436 (1983) [Hereinafter referred to as
Hite and Owers (1983)].

48
they divided their sample into four groups based on stated
motivation for the spin-off. The four groups consisted Of
(1) spin-offs designed to facilitate mergers, (2) spin-offs
based on specialization, (3) spin-offs used as a defensive
tactic against regulators or antitrust authorities, and (4)
a catchall group. The second subgroup where specialization
was the stated motive for the spin-off had the largest
excess returns. This is significant in terms of this
dissertation's view of the spin-off announcement as a signal
of the value of the unfinanced positive net present value
project. Spinning-off the positive net present value
project produces specialization. The original corporation
continues with the asset in place, a, while the new
subsidiary has the project, b.

Copeland, Lemgruber, and Mayers‘o studied spin-offs and
sought to correct for post-selection bias by selecting a
sample based on announcements rather than completed spin-
offs (11 percent were not completed). Their findings are
consistent with other studies that there are significant
positive announcement effects before and after the
announcement date.

Schipper and Smith" also studied equity carve outs.

 

w T.E. Copeland, E.F. Lemgruber, and D. Mayers,
0100 -t‘ 9 1-0. 8' 1. .- ‘ 1.1-10-1‘u‘1 1 1.10. .l-a ‘
Abng;ua1_2a;£gzuanga in MODERN FINANCE AND INDUSTRIAL
ECONOMICS (T.E. Copeland ed.), Ch. 7 (1987).

n K. Schipper and A. Smith, A qupazisgu of Equity
, J. OF FINANCIAL

ECONOMICS 12, 153-186 (1986) [Hereinafter referred to as

49
Their focus was a comparison of stock price reactions for
issues of seasoned equities and equity carve outs. A market
model with a pre-event estimation period was used.
Significant positive returns were found in equity carve outs
over the five day announcement period which consisted of the
five days immediately preceding the announcement date.
Seasoned equity issues showed the usual negative results
over the five day announcement period. These negative
results are explained as negative signals about future
growth or profits and overvalued stock in the market.
Disclosed motives for equity carve cuts are similar to
motives given for spin-offs with one notable exception. An
equity carve out may be used to finance growth of the
subsidiary without adversely affecting the value of the
original corporation's stock by issuing equity. Schipper
and Smith found support for this hypothesis.

Schipper and Smith’s 1986 article represents one
solution to the asymmetric information problem described in
Chapter I. An equity carve out for the purpose of financing
growth of the newly-created subsidiary results in
significant positive share price reactions. The
announcement may have a signaling effect that overcomes part
of the asymmetric information problem.

The announcement may signal that a positive net present

value project exists and is being carved out, but it may not

 

Schipper and Smith (1986)].

50
convey any price information. Of the seventy-six carve out
Wall Street Journal announcements in Schipper and Smith’s
(1986) sample thirty-seven were announcements of anticipated
carve cuts with varying amounts of information disclosed in
the announcement while the remaining thirty-nine were
announcements that the offering documents had been filed
with the Securities and Exchange Commission, thirty-three of
which announcements followed the filing date by one to three
days. Material information concerning the project, its
value, cash flows, etc. were already public information when
the announcement was made. Assuming a semi-strong efficient
market means that the public announcement carried little or
no information content for the thirty-nine filed with the
Securities and Exchange Commission. This may explain why
Schipper and Smith's cumulative average prediction errors
for the seventy-six carve out announcements leveled off in
the post-announcement period (day -1 to day +40). All of
the relevant material information had already been
disseminated for more than one-half of their sample. This
may also account for the sharp increase in cumulative
average prediction errors in the immediate two day pre-
announcement period rather than a sharp increase on the
announcement date and immediate post-announcement period.
Schipper and Smith did not divide their sample into those
announcements made after SEC filing and anticipation
announcements. Such a division would separate the

signalling effect from the disclosure effect.

51

All of the above results are consistent with the
hypothesis presented in this dissertation. Managers faced
with having to forgo positive net present value projects in
the interest of the old shareholders may take advantage of
these opportunities by spinning-off or carving out the
projects. The result of which is an increase in the value
of the corporation and in the old shareholders' wealth.

A spin-off results in the old shareholders holding
stock in both the original corporation and the subsidiary.
The value of the original corporation's stock is the sum of
the amount of slack retained, S" and the updated estimated
value of the asset in place, a. V,=S,+a. The value of the
subsidiary's stock is the sum of the amount of slack
transferred to the subsidiary, $5, and at a minimum the
expected value of the project which is known to the market,
E. V,=S,+§. In the aggregate, the minimum value of the old
shareholders' stock in both the original corporation and the
subsidiary equals the sum of the values.

v-vo+v,-s.+s.+a+§-s+a+§ .
With full disclosure, Vhs+a+b.

In an equity carve out, the old shareholders hold stock
only in the original corporation. The value of the stock of
the original corporation is equal to the amount of slack
retained in the original corporation plus the value of the
asset in place plus the cash or other consideration received
for the stock of the subsidiary. At a minimum, the value of
the stock of the subsidiary is equal to the sum of the

52

amount of slack transferred to the subsidiary and the
expected value of the project.
Hence, at a minimum

v=vo+v,=s,+a+sb+§=s+a+§ .
Old shareholders are better off by either spinning-off the
project or carving out the project since without the spin-
off or carve out the old shareholders have value of S+a.
With the spin-off or carve out they have at least
S+a+§>s+a. In the case of full disclosure, v=s+a+b, Old
shareholders receive the true value of the original
corporation.

Because of the announcement effect, the value of the
subsidiary’s stock, V" in the hands of the old shareholders
or third party outsiders is greater than the amount of slack
transferred plus the expected value of the positive net
present value project. V,>S,+§. If the updated estimated
value of the project were known to the market through
disclosure documents filed with the Securities and Exchange
Commission, the market price of the subsidiary's stock on
issue should be close to S.+b.

Given the fact that the announcement signal's value may
be limited by prior disclosure in filings with the
Securities and Exchange Commission the disclosure
requirements of the Securities Act of 1933 take on added
significance. The disclosure requirements for an initial
public offering of the stock of the newly-created subsidiary

whether created for a spin-off or equity carve out provide

53
an incentive for truthful disclosure and contribute to the
solution of the asymmetric information problem by providing
the updated estimate of the positive net present value
project.

8. Public Offerings of Securities

1. Federal Regulation
a. Registration

The Securities Act of 1933 regulates the registration
and initial sale of securities by an issuer. The primary
purpose of the act is to provide full disclosure of all
material facts so that the investor may make an informed
decision concerning the investment. Registration is a time-
consuming, expensive, and complex task not to be undertaken
lightly. Nonetheless, registration costs will be ignored
for purposes of this chapter.

The thrust of the Securities Act of 1933 is to provide
the ordinary investor with all relevant and material facts
necessary to make an informed investment decision. Hence,
registration is a disclosure process designed to_elicit that
information for the benefit of the investor. Unlike many
state securities commissions, the United States Securities
and Exchange Commission does not pass on the worth or
desirability of a particular issue.

The registration statement is really two documents:

The prospectus is the selling document provided to all
potential purchasers, and Part II contains other information

and exhibits not furnished to potential purchasers but kept

54
on file by the commission and made available for public
inspection. Section 712 of the Securities Act of 1933
prescribes the information that must be included in the
prospectus.

Registration is accomplished by filing one of the
prescribed forms. Form 8-1 is the basic form required for
registration when no other form is prescribed or authorized.
Form S-1 requires the greatest degree of disclosure of all
registration forms primarily because the users of form 8-1
have little or no previous contact with the Securities and
Exchange Commission.

In 1979, the commission adopted a new form S-18, for
use by small issuers. The disclosure requirements are
essentially the same as for form S-1 except that the format
is simpler and it is not keyed to regulation S-Kl3 which
regulates disclosure requirements under both the Securities
Act of 1933 and the Securities Exchange Act of 1934. Form
8-18 could be used only by issuers who were not registered
under the Securities Exchange Act of 1934 and only for cash
offerings or $7.5 million or less. Form 8-18 was filed at
the nearest commission regional office rather than with the
commission in washington, D.C. In 1992, the Securities and
Exchange Commission adopted Regulation S-B which removed the

$7.5 million limit on small business issues. Form SB-2

 

“ 15 U.S.C. s 779 (1933).

“ 17 C.F.R. Part 229 (1991).

55
replaces and is patterned after Form 8-18.

In addition to the forms and instructions contained
within it, regulation C, which consists of rules 400-499,“
provides registration procedures and general forms.

One of the more important sections of the registration
statement is Management's Discussion and Analysis of
Financial Condition and Results of Operations (MD&A).15
This section has become even more important given the recent
heavy emphasis on it by the Securities and Exchange
Commission. The MD&A requirements changed dramatically in
1989. The contents and explanation of the MD&A are found in
Item 303 of regulation 8-H and Release No. 33-6835.16 Since
1989 in several studies of MDSA's of 500 companies, the
commission found noncompliance in almost every case. Release
No. 33-6835 in part says that the

MD&A is intended to give the investor an

opportunity to look at the company through the

eyes of management by providing both a short and

long-term analysis of the business of the company.

The Item asks management to discuss the dynamics

of the business and to analyze the financials.17
Its purpose is to help the investor make an informed

judgment based on trends and future performance of the

corporation. This section analyzes results of operations in

 

“ 17 C.F.R. ss 230.400 - 230.499 (1991).

” Item 303, Regulation S-K, 17 C.F.R. s 229.303
(1991).

“ 54 Fed. Reg. 22427 (May 25, 1939).

17 L'

56

terms of historical events as well as trends which may be
expected to continue into the future and affect future
performance. The corporation's liquidity position (slack in
terms of the model) and financial condition including
capital resource commitments must be disclosed. Before 1989
forward looking information was encouraged but not mandated.
After 1989 it is mandatory under the following test:

Where a trend, demand, commitment, event or

uncertainty is known, management must make two

assessments:

(1) Is the known trend, demand, commitment,

event or uncertainty likely to come to fruition?

If management determines that it is not reasonably

likely to occur, no disclosure is required.

(2) If management cannot make that

determination, it must evaluate objectively the

consequences of the known trend, demand,

commitment, event or uncertainty, on the

assumption that it will come to fruition.

Disclosure is then required unless management

determines that a material effect on the

registrant's financial condition or results of

operations is not reasonably likely to occur.

Each final determination resulting from the

assessments made by management must be objectively

reasonable, viewed as of the time the
determination is made.“

This certainly implies that management's inside information
concerning the updated estimated values of a and b would
have to be disclosed in the MD8A section of the registration

statement.

Liquidity and capital resources must also be disclosed.

 

" Release NO. 33-6835, 54 Fed. Reg. 22427, n.27 (May
25, 1939).

57
Material commitments for capital resources at the end of the
year, known plans or trends in acquisition or disposition of
capital resources, changes in mix, changes in cost of
capital resources must be disclosed. Amounts and certainty
of cash flows over both short and long-term also must be
disclosed. Hence, the amount of slack, S, and any expected
or anticipated changes in slack would have to be disclosed.
Moreover, the net present value of the project, b, must be
disclosed since it represents a discounted projected cash
flow.

Section 3(b)‘9 of the Securities Act gives the
commission the authority to exempt certain securities from
registration by rules and regulations provided that
registration is not in the public interest or for the
protection of the investor and that the aggregate amount of
the issue is $5 million or less. Small offerings are
included in regulation D”o along with private offerings.

Section 4” of the act provides for transactional
exemptions as opposed to providing an exemption for a class
of securities. Section 4(2) exempts transactions by an
issuer not involving any public offering. The bulk Of
private placements are with institutional investors, which

is consistent with the policy underlying the section 4(2)

 

” 15 U.S.C. s 77c(b) (1933).
m 17 C.F.R. 55 230.501 - 230.503 (1991).

u 15 U.S.C. 5 77d (1933).

58
exemption. Registration is required to provide the ordinary
investor with information he or she could not otherwise
obtain; therefore, investors who have access to the same
kind of information that registration would disclose and who
are sophisticated investors do not require the protection of
the Securities Act of 1933.

To facilitate private offerings, the Securities and
Exchange Commission issued rule 14622 in 1974. Rule 146 was
a safe harbor provision but was not the exclusive means by
which a section 4(2) exemption could be obtained. Rule 146
was not workable; therefore, to simplify matters, rule 146
was repealed in 1982 and regulation D was adopted.23

Regulation D consists of rules 501-508. No general

solicitation or general offering is permitted under
regulation D except for rule 504 offerings after 1992.
Since the purchase of a security under regulation D is not
pursuant to in a public offering, it cannot be resold
without registration unless another exemption is available
such as under section 4(1) or rule 144 pursuant to section
4(1).“

Rule 504 allows an issuer that is not a reporting

company under section 1325 or 15(d)“ of the Securities

 

” 17 C.F.R. s 230.146 (1974).

3 Regulation D also superseded Rules 240 and 242 under
Section 3(b), Securities Act of 1933.

u 17 C.F.R. s 230.144 (1991).

3 15 U.S.C. 5 77m (1933).

59
Exchange Act to sell an aggregate of $1,000,000 of
securities in any twelve-month period to any number of
purchasers without providing any information to the
purchasers. Any issuer except an investment company or
company registered under the Securities Exchange Act of 1934
may use this exemption.

Rule 505 allows aggregate sales up to $5 million in any
twelve-month period to any number of accredited investors
and up to thirty-five other purchases. An accredited
investor is defined in rule 501 as:

1. Any bank, insurance company, investment
company, or employee benefit plan

2. Any business development company

3. Any charitable or educational institution
having assets of more than $5 million

4. Any director, executive officer, or general
partner of the issuer

5. Any natural person with a net worth
individually or with a spouse of more than $1
million

6. Any person with an annual income of more than
$200,000 in each of the two most recent years or
had joint income with the spouse of more than
$300,000 in those years and reasonably expects to
maintain that level of income in the current year.
7. Any trust with total assets in excess of $5
million.

8. Any entity in which all the equity owners are
accredited investors.

Rule 505 is not available to an investment company or an
issuer disqualified from using regulation A by rule 252.”

If there is.a nonaccredited purchaser certain information

required by rule 502 must be furnished to all purchasers.

 

” 15 U.S.C. s 780(d) (1933).

n 17 C.F.R. s 230.252 (1991).

60

If the issuer is not registered under the Securities
Exchange Act of 1934 (not subject to the reporting
requirements of section 13 or 15(d)), (1) the same kind of
information required in Part II of form 1-A if the offering
amount is $2 million or less, (2) the information required
in Part I of form 8-18 if the offering amount is between $2
million and $7.5 million, or (3) if the offering exceeds
$7.5 million, the information required in Part I Of a
registration statement on the form that the issuer is
entitled to use must be provided. If the issuer is
registered, (1) the most recent annual report to
shareholders and proxy statement; (2) updated information
from reports or documents filed with the commission since
the distribution of the annual report or registration, a
brief description of the securities being offered, the use
of the proceeds, and any material changes in the issuer's
affairs not otherwise disclosed; or (3) information from the
last annual report on form 10-x to the commission or
registration statement whichever is the more recent required
to be filed must be provided.

Rule 506 provides that any issuer may sell an unlimited
amount of securities to any number of accredited investors
and up to 35 other purchasers if, prior to the sale, the
issuer reasonably believes that each nonaccredited purchaser
or his or her purchaser representative has such knowledge or
experience in financial and business matters that he or she

is capable of evaluating the merits and risks of the

61
prospective investment. The information required by rule
502 must be disclosed to nonaccredited purchasers.

Notices of sales pursuant to regulation D must be filed
with the commission under rule 503. An issuer who restricts
sales solely to accredited investors in an aggregate amount
of $5 million or less may take advantage of the section 4(6)
exemption as an alternative to regulation D.

For business organizations that are local in nature and
not proximate to a state line, the intrastate exemption is
available. Section 3(a)(11)” provides for an exemption for
securities offered or sold solely to residents of a single
state or territory in which the issuer is a resident and is
conducting business or, if the issuer is a corporation, in
which the issuer is incorporated and is doing business.
Intrastate offerings may make use of the mails or other
interstate commerce facility. The exemption is not based on
the jurisdictional requirements of the Securities Act of
1933.

The rationale for the intrastate exemption is local
financing through local investment. The exemption is
strictly construed according to its rationale, and an Offer
or sale to a single nonresident destroys the exemption for
all.29 The Offering will remain exempt under the intrastate

exemption if no resales are made to nonresidents for at

 

” 15 U.S.C. s 77c(a)(11) (1933).

” Sag, Preliminary Notes to Rule 147. 17 C.F.R. S
s 230.147 (1991).

62
least nine months after the initial distribution is
completed.30

Regulation A,” which consists of rules 251 to 264, was
promulgated under the authority of section 3(b) of the
Securities Act of 1933. Regulation A, however, in practice
is not an exemption but is rather a simplified registration
process for small issues. Regulation A permits an issuer to
offer a maximum of $5 million and any other person to offer
a maximum of $100,000 of the securities during any twelve-
month period.

The exemption may not be used by an issuer,
underwriter, or other related person convicted of securities
offenses, subjected to disciplinary action by the
commission, or involved in certain other proceedings within
specified periods of the issuance of the securities.

To use regulation A, an offering statement, Form 1-S,
must be filed with the regional office of the commission
where the issuer has its principal place of business. After
1992, issuers within limits may provide potential investors
with pre-offering statements provided they contain certain
required information. The Form 1-S, offering statement, was
redesigned in 1992 as a question and answer document to
simplify the procedure and reduce costs.

Even if the offering is exempt from registration some

 

” 17 C.F.R. 55 230.147 (1991).

u 17 C.F.R. 55 230.251 - 230.264 (1991).

63
type of disclosure is required such as in regulation A or D.
The information required to be disclosed includes the MDSA.
Investors will know the values of S, a, and b, and,
therefore, will be able to make an informed decision based
on those values. The asymmetric information problem is
resolved if managers make the requisite full disclosure.
Failure to make the required disclosure may result in civil
or criminal liability or both.

An initial public offering of the subsidiary's stock
would not suffer the negative market reaction that a
seasoned issue encounters.52 Registration of a subsidiary’s
stock in a spin-off or equity carve out is not as burdensome
as registration of a seasoned issue of the corporation.”
The amount of material that must be disclosed is reduced.
Only the project is being transferred to the subsidiary so
other inside, proprietary information need not be disclosed.
In the model, only the value b need be disclosed not the

updated estimate a. MOreover, the market reacts only to the

 

” Empirical evidence shows that the aftermarket in an
initial public offering is efficient. R. Ibbotson, Exiga
O , J. OF FINANCIAL
ECONOMICS 2, 235-272 (1975).

” This burden can be reduced by 'shelf’ registration.
In March 1982, the Securities and Exchange Commission
adopted Rule 415 (17 C.F.R. s 230.415 (1991)) which
increased the opportunities for shelf registration. Shelf
registration allows the issuer to file a registration
statement covering stock that can be issued over a two year
period. Shelf registration avoids the delays involved in
filing a registration statement for each new issue within
the two year period. A disadvantage of shelf registration
is that some of the information may be stale.

64
value b not the combined estimates of a and b. There is no
chance of a reaction to 'a' causing a mixed signal regarding
valuation. Because only the project is being transferred to
the subsidiary, the updated estimate b definitely is
material information.

Assuming full disclosure the following consequences
result. A spin-off results in the old shareholders holding
stock in both the original corporation and the subsidiary.
The value of the original corporation's stock is the sum of
the amount of slack retained, 8., and the updated estimated
value of the asset in place, a. V,=S,+a. The value of the
subsidiary's stock is the sum of the amount of slack
transferred to the subsidiary, S" and the updated estimated
value of the project, b. V,-S,,+b. In the aggregate, the
value of the old shareholders' stock in both the original
corporation and the subsidiary equals the sum of the values.

V-V°+V,- S.+sb+a+b=S+a+b .

In an equity carve out, the old shareholders hold stock
only in the original corporation. The value of the stock of
the original corporation is equal to the amount of slack
retained in the original corporation plus the updated
estimate of the value of the asset in place plus the cash or
other consideration received for the stock of the
subsidiary. The value of the stock of the subsidiary is
equal to the sum of the amount of slack transferred to the
subsidiary and the updated estimated value of the project.

Hence,

65
v=s,+a+s,+b-s+a+b.
Old shareholders are better off by either spinning-off the
project or carving out the project because without the spin-
off or carve out the value of the original corporation is
S+a. Since b is a positive net present value project
S+a+b>S+a.
b. Liability

Section 5“ of the Securities Act of 1933 makes it
unlawful to offer for sale or to sell in interstate commerce
or through the mail, a security that is subject to the act
unless a registration statement has been filed with the
Securities and Exchange Commission or to sell unless a final
prospectus has been provided to the purchaser of the
security.

Section 12(1) of the Securities Act of 1933 provides an
express private cause of action for damages by a purchaser
against a seller who offers or sells a security in violation
of section 5 or who makes an untrue statement of or omits a
material fact by means of the prospectus or any oral
communication. Liability under section 12(1) is absolute.
Damages under section 12(1) are the amount of the purchase
price less any income received on the securities, if the
securities are still owned or the "out of pocket" rule if

sold.

 

“ 15 U.S.C. 5 77a (1933).

66

Section 1135 of the Securities Act of 1933 provides for
civil liability for misstatements or omissions of material
facts in the registration statement or prospectus. This
liability extends to the issuer, underwriters, directors,
every person who signed the registration statement,
specialists or professionals who prepared or certified part
of the registration statement, and controlling persons.
Civil liabilities imposed under section 11 do not apply to
regulation A offerings because of the exemption from
registration under section 3(b); however, section 12(2)36
liabilities may be imposed. To be a plaintiff, one must
have acquired a registered security. No privity of contract
is required.37 The materiality test is the same one used
for rule 10b-5 and section 14(e) of the Securities Exchange
Act of 1934 and section 17 of the Securities Act of 1933.38
Plaintiff need not prove reliance on the misstatement;
however, defendant may assert as a defense that plaintiff
knew that the statements were misleading at the time of the
acquisition.” Neither is causation a requirement for a

section 11 action; however, defendant may be able to reduce

 

” 15 U.S.C. 5 77k (1933).
” 15 U.S.C. s 771(2) (1933).

” Huddleston v. Herman 8 Maclean, 640 F.2d 534 (5th
Cir. 1931).

” TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438
(1976).

” Feit v. Leasco Data Processing Equipment Corp., 332
F.Supp. 544 (E.D.N.Y. 1971).

67

the amount of damages by proving that the loss was caused by
something else. Neither scienter nor fraud is required to
be proved. Defendants may also assert a due diligence
defense. The amount of damages is the "out of pocket” rule,
that is, the difference between the purchase price and the
depreciated value resulting from the violation.40 In no
case may the amount of damages exceed the offering price.‘1

Section 12(2) is a general civil liability section that
applies whether the securities are registered or not. A
plaintiff must plead that the defendant knew or should have
known of the misleading statement or omission at which point
the burden of proof shifts to the defendant. Neither
causation nor reliance need be proved. Section 12(2)
provides for rescission to recover the purchase price plus
interest less any income received if the security is still
owned by the plaintiff. If the security is not still owned,
plaintiff may sue to recover the purchase price less any
income received and less the amount for which the security
was sold which is the usual measure of damages.

Section 17 is a general antifraud provision which
applies to the sale of any security whether it is required
to be registered or not. Section 17 is similar to rule 10b-

5 discussed in Chapter 5. The language of rule lob-5 is

 

w Harbury Management, Inc. v. Kohn, 629 F.2d 705 (2d
Cir. 1980), §g§L_ngm. Wood Walker 5 Co. v. Narbury
Management, Inc., g§z§‘_dgn1e§, 449 U.S. 1011 (1980).

“ Section 11(9), Securities Act of 1933, 15 U.S.C. 5
77k (1988).

68
substantially the same as section 17 except that section 17
applies to offers and sales not purchases. There is
precedent for implying a private civil cause of action for
damages under section 17, thereby circumventing the more
stringent requirements of sections 11 and 12 of the
Securities Act of 1933 and section 10(b) and rule 10b-5 of
the Securities Exchange Act of 1934.‘2 The United States
Supreme Court has not ruled on this question, although it is
highly unlikely that the present conservative court would
find such a cause of action. The elements of a section 17
action are the same as for rule lob-5 except that scienter
may not be a requirement. The United States Supreme Court
has ruled that in injunction suits that negligence is
sufficient for actions under section 17(a)(2) and (3) making
scienter only a requirement for section l7(a)(1).‘3 Damages
under an implied civil cause of action would follow the "out
of pocket” rule.

Knowing the amount of damages that can be assessed for
violation of sections 11, 12, and 17, the cost of lying,
i.e., misstating a material fact or omitting a material fact
on a registration statement or prospectus, can be

calculated. Court costs, attorneys' fees, and other costs

 

” Osborne v. Mallory, 86 F.8upp. 869 (S.D.N.Y. 1949);
Globus v. Law Research Service, Inc., 418 F.2d 1276 (2d Cir.
1969), cert. denied, 397 0.8. 913 (1970). Contra, Dyer v.
Eastern Trust and Banking Co., 336 F.Supp. 890 (D.Maine
1971); Gunter v. Hutcheson, 443 F.Supp. 42 (N.D.Ga. 1977).

“ Aaron v. SEC, 446 0.5. 680 (1980)

69
are not considered. If the managers of the slack poor firm
lie and inflate the value of the firm, the gain from lying
is the difference between the inflated value, V” and the
actual or true value, V9 Based on the inside knowledge of
the updated estimates of a and b, the actual or true value
of the firm,‘% equals S+a+b. The cost of lying, if the
purchaser already sold the stock, is the difference between
the product of the probability of being caught, p, times the
gain and the product of the probability of not being caught,
(1-p), times the gain.

Cost of Lying = p(V,- ,)-(1-p) (V,-V,) .
Rearranged, ’
Cost of Lying = (2p-1)(Vr-,).
It pays to lie if the Cost of Lying is negative, i.e.,
(2p-1) (v,-v,) <0 .

Since (V,-V,) >0, otherwise, the lie is not beneficial, it
pays to lie if (2p-1)<0 or p<.5.

There are no civil penalties assessed under the
Securities Act of 1933.

If the purchaser still holds the stock and rescission
is the remedy, the cost of lying is the probability of being
caught times the purchase price which is the inflated value
of the stock less the probability of not getting caught
times the gain from lying. No income on the stock is
assumed to have been received from the original corporation,
nor is interest assessed.

Cost of Lying - pV,-(1-p)(V,-V,).

70

Rearranged,

Cost of Lying = (2p-1)V,+(1-p)v,<0
which must be negative for lying to pay.
Let T be the total number of shares of the subsidiary sold
and Nl be the number of shares that purchasers sold and N2 be
the number of shares that purchasers retained. The total
cost of lying is the sum of the prorated costs of lying
calculated above.

Cost of Lying=(N,/T) (2p-1) (V,- ,)+(N,/T) [(2p-1)V,+(1-p)V,] <0.

(Nn/T) (ZP-l) (Vr .)+(N2/T) [(ZP‘1)V1+(1'P)V.]<0
(NI/T) (29'1) (VI-Vt)+(N2/T) I: (29'1)V1'(2P'1)V:+PVJ <0
(anT) (213-1) (Vr' .)+(N2/T) [ (29-1) (VI-V.)+PV.]<0
[(an‘l‘) +(N2/T) J (ZP-l) (VI-V.)+(N2/T)PV.]<0
(2P'1) (Vl' :)+(N2/T) PVJ<°
[2(V1' :)+(N2/T)VJP<(V1‘V:)
P< (VI-Vt) / [2 (Vr ,) +(N2/ T) V.)
If ‘N,=0, all purchasers sold their shares, p<.5. If N2=1,
all purchasers retained their shares, p< (V,- ,) / (2V,-V,) . The
upper bound is one-half, p<.5. The highest probability of
getting caught that makes lying worthwhile is less than one-
half.

Managers must determine their subjective assessment of the
probability of being caught. If they believe that the
probability of being caught is less than fifty percent, they
have an incentive to misstate material facts or omit to
state material facts, the values of S, a, and, b, in the

registration statement or prospectus.

71

Knowing the cost of lying, the value of the firm, V,
may be calculated. The value of the firm is equal to the
false inflated value of the firm, V" less the cost of
lying.

V = V,-'cost of lying.
V=Vr'[(2P'1) (VF ¢)+(N2/T)PVJ .
V=2 (1'P)V1+[ (2P-1) '0'lele -

An added incentive to tell the truth is the potential
of a fine up to $10,000 or imprisonment for five years or
both for any person who willfully violates the act, its
rules, or in a registration statement willfully makes an
untrue statement of a material fact or omits to state a
material fact required to be stated or necessary to make the
statements made not misleading.“

2. State Regulation

Part III of the Uniform Securities Act provides for
registration of a security prior to offer or sale of the
security. There are three alternative registration
procedures: notification, coordination, and qualification.

Section 302 of the Uniform Securities Act provides for
registration by notification. This is the simplest of the
three registration procedures. To qualify for registration
by notification, the issuer must (1) have been in continuous
operation for at least five years; (2) not have defaulted in

the payment of principal, interest, or dividends of any

 

“ Section 24, Securities Act of 1933, 15 U.S.C. s 77x
(1988).

72
security within the three fiscal years immediately preceding
the registration; and (3) show an average earnings of at
least five percent on its shares of common stock. A copy of
the prospectus or other sales materials must accompany the
registration form.

Coordination is available to an issuer who has filed a
registration statement relating to the same offering with
the Securities and Exchange Commission under the provisions
of the Securities Act of 1933. Registration by coordination
under section 303 is accomplished by filing the required
number of copies of the federal prospectus with the state
authorities.

Section 304 of the Uniform Securities Act provides for
registration by qualification, which is to be used by
issuers who do not qualify for notification or coordination.
The filing requirements for registration by qualification
are roughly similar to those for registration under the
Securities Act of 1933. Registration by qualification is
not effective until it is approved by the state authority.

Some states require certain documents to be filed even
though the security is exempt. It appears that in many
states, the exemption is not mandatory but is merely at the
discretion of the state authorities. State reaction to the
federal exemption for issues not involving a public offering
under section 4(2) of the Securities Act of 1933 is not
uniform and is uncertain after the adoption of regulation D.

Some states adopted the language of section 4(2) of the

73
Securities Act of 1933 while other states substantially
adopted rule 146 in addition to the statutory language of
section 4(2). Other states merely coordinate their
exemption with compliance with the federal requirements.

Under Sections 306(a)(2)(E) and (F), registration may
be denied if the offering tends to work a fraud upon
purchasers or if the underwriting compensation, promoter's
profits, or options are unreasonable in amount. This
represents a significant difference in philosophy between
the federal securities laws and the states'. The federal
government is primarily concerned with disclosure and makes
no value judgment.

Not only must an issuer comply with federal securities
law but also must comply with the state securities laws of
each state in which the securities will be sold. Exemption
from registration under federal securities law does not
guarantee exemption under state securities law. Even if the
offering is exempt under federal law without disclosure of
the values of S, a, and b, it will not necessarily escape
such disclosure under state law. Once the inside
information concerning the values of S, a, and b is made
public under either state of federal securities laws, the
asymmetric information problem is resolved.

C. Conclusion

Empirical studies show that the market price of stock
increases in the period immediately surrounding an

announcement of a spin-off or equity carve out. The market

74
appears to view such announcements as good news. The spin-
off or equity carve out announcement signals the market that
in the aggregate the sum of the values of the original and
subsidiary corporations is greater than the value of the
original corporation prior to the spin-off or equity carve
out. 01d shareholders are better off if managers spin-off
or carve out the positive net present value project rather
than retain the project and not finance it to protect the
value of the old shareholders' stock.

Generally, a spin-off or equity carve out will require
the original corporation to issue stock in the subsidiary
corporation either to the old shareholders or for sale to
outside third parties. Such an issue entails registration
at the federal and state levels unless the security is
exempt in which case certain disclosures may have to be made
anyway. Disclosure of the inside material information
concerning the values of S, a, and b, resolves the
asymmetric information problem.

Failure to disclose may result in violations of federal
and state securities laws. In light of the penalty
structure of the federal securities law, managers have an
incentive to disclose the material information if the
probability of getting caught lying is greater than or equal
to one-half.

Empirical implications of the hypothesis are that a
corporation likely to spin-off or carve out equity would

have the following characteristics: (1) the corporation

75
would be undervalued and have unfinanced growth
opportunities, (2) it would have a strong ownership
structure, (3) the board of directors would have some
outside directors, (4) the firm would be over-leveraged;
otherwise, it would finance the projects with debt, (5) the
firm would be capital intensive which would be a barrier to
entry by competitors, (6) spin-off and equity carve out
announcements should produce abnormal price returns around

the announcement date.

v. Empirical Studies

In this chapter empirical studies undertaken to
determine whether or not the theory is supportable in fact
are analyzed. This chapter is divided into four parts.
First is a description of the database. The second part of
this chapter verifies prior studies regarding excess returns
on or around the announcement dates. Third, cross sectional
analysis is performed to try to determine factors underlying
the market reaction. Finally, analysis is performed to try
to determine managerial motivation for spin-offs.

A. Database

A search for the word spin-off was made on the Dow
Jones News/Retrieval Service. The Dow Jones News database
consists of the broadtape, Wall Street Journal, and Baron’s
from June 1, 1979 through December 31, 1991. June 1, 1979
is the beginning date of the Dow Jones News database in the
Dow Jones News/Retrieval Service.

To be incorporated in the database the spin-off had to
involve a United States corporation spinning-off United
States based assets for two reasons. First, data is only
available for United States Corporations on CRSP and
COMPUSTAT, and second, spin-offs are examined in the context
of United States law.

The documents were examined to determine the first

public announcement date of a spin-off. In most cases, day

76

77
and time of the announcement were found.1 COMPUSTAT was
used to collect company specific parameters for the firms in
the sample. This examination yielded 158 firms. The
distribution by year is in Table 1, infra.
Table 1

Distribution of 158 Sample Spin-off Announcements
by Year 1979-91

 

 

Year Number Year Number
1979 5 1986 16
1980 15 1987 16
1981 12 1988 17
1982 8 1989 17
1983 12 1990 11
1984 13 1991 5
1985 11

 

 

 

The distribution can be divided into distinct periods--1979,
1980 through 1985, 1986 through 1989, and 1990 and 1991.

The spin-offs in 1979 occurred after June 1, 1979 which is
the beginning date of the Dow Jones News database. The
increase in the number of spin-offs occurring from 1986 to
1990 may be a tax effect due to the more favorable treatment
of spin-offs under the Tax Reform Act of 1986. Regressions
of pre-1986 spin-offs and post 1985 spin-offs on the
prediction errors, however, provide no explanation for
observed positive abnormal returns. Whether the reduction
in the number of spin-offs in 1990 and 1991 is part of a

downward trend in the number of spin-offs is not known.

 

‘ In a few cases the Wall Street Journal Index was
used to determine first public announcement date.

78

B. Wealth Effects and Prior Studies

The market model used is given in (1) and is estimated
for each firm over 180 days ending 120 days before the spin-
off announcement date.’

r,=a,+fi,r_,+e,, for t= -3,-2,-1,o,+1,+2,+3. (1)
where
I} =return on stock of firm i on day t, taken from the CRSP

Daily Stock Returns Tape or the NASDAQ Daily Stock

Returns Tape.

8, =market model intercept estimated by ordinary least
squares.
Bi =slope of the market model estimated by ordinary least

squares.

rm =CRSP or NASDAQ equal-weighted index of returns on
stocks on day t.

e, =residual return to stock 1 on day t.
Estimated intercept and slope coefficients from (1) are used
to compute prediction errors for 154 firms in the sample
during the 7 day event period.3

The daily prediction error, uh, for each day t=-3,-2,
-1,0,+1,+2,+3 for each sample firm i, is computed by

neg-(898,1...) , t=-3,-2,-1,0,+1,+2,+3 (2)

The average prediction errors were computed by

 

2 An alternative 180 day window ending 20 days before
the spinoff announcement date was tested. Using this
different interval did not alter the results.

3 Missing data on CRSP or COMPUSTAT reduced the sample
size from 158.

79

N!
PEFQ: ‘1'.) m (3)
i=1

where N,is.the number of firms with returns available on
day t.

The t-statistic is computed by

t=(Mean x N“)/Std Dev. (4)

Schipper and Smith (1983) reported a +2.17 percent
average abnormal return for the announcement date for the 92
firms in their sample for the period 1963-81. Miles and
Rosenfeld (1983) for the period 1962-80 and Hite and Owers
(1983) for the period 1963-81 found two-day average abnormal

Table 2
Table of Prediction Errors

 

Day‘ Mean Std Dev. Minimum Maximum t-Statistic

 

-3 .00 .03 -.1114 .1780 0.00
-2 .00 .02 -.0596 .1045 0.00
-1 .00 .04 -.2154 .1315 0.00

0 .02 .05 -.1727 .2134 4.96b
+1 .00 .03 -.1490 .1749 0.00
+2 .00 .03 -.1404 .0890 0.00
+3 .00 .02 -.0608 .0917 0.00

 

' Day 0 is the announcement date.
” Significant at the 0.5% level.‘

 

returns of +3.3 percent.‘ The finding here of +2 percent

 

‘ The standardized prediction error for the
announcement date has a t-statistic of 280.46 which is
significant at the 0.5% level.

5 A two day period was used because of lack of
accuracy regarding the announcement date. In this sample,
date and time of the announcement were available for most of

80
average abnormal returns on the announcement date for the
period 1979-90 is consistent with and substantiates the
prior studies.

c. Analysis of Market Reaction to Spin-offs

The theory predicts that undervalued firms with high
debt-equity ratios and low liquidity (slack) would spin-off.
A cross sectional analysis was run to verify the
predictions. The standardized prediction error, SPEQ, is
the dependent variable.

SPEo=a+BV (5)
where V is a matrix of company specific parameters. Data
was collected for the sample firms from COMPUSTAT.

The first test was designed to determine whether or not
the market reacts more favorably when undervalued firms
spin-off. Two different measures were used. The ratios of
market value of equity to book value of equity and market
value of the firm to book value of the firm were considered.
Both are highly correlated. Market value of the firm to
book value of the firm was chosen. Market value of the firm
was calculated by subtracting the book value of common
equity from total assets and adding the market value of the
common stock. Book value of the firm was taken as total

assets. Market value of the firm to book value of the firm

 

the firms; consequently, there is little leakage. Moreover,
if the announcement time were late in the afternoon, the
next trading day was used as the announcement date. Table 2
verifies this observation. There is virtually no market
reaction in the three day periods before and after the
announcement.

81
was computed for three years before and after the year of
the spin-off announcement. The mean market value of the
firm to book value of the firm ratio for the year before the
Spin-off announcement is 1.59.

When prediction errors and standardized prediction
errors are computed dividing the sample into firms having
market value of the firm to book value of the firm ratios
greater than or equal to the mean and those less than the
mean, the prediction and standardized prediction errors are
greater for the sample having market value of the firm to
book value of the firm ratios below the mean,‘ .Although the
market reacts favorably when a firm spins-off, it reacts
more favorably when an undervalued firm spins-off (See Table
3).

Good firms (firms with market value of the firm to book
value of the firm ratios above the mean) spin-off growth
opportunities which is wealth improving and results in

excess returns on the announcement date. Firms with market

 

6 A variable MBS was constructed as follows:

0, if MVBV,,<1. 59

"35" { 1, if mv_,21.59
to test whether or not firms having a market value of the
firm to book value if the firm ratio above or below the mean
had greater market responses. A market value of the firm to
book value of the firm ratio equal to one was tested, and
there was no quantitative difference. By using the mean
rather than one, possible industry effect is avoided.
Moreover, a mean equal to 1.59 indicates that the sample
consisted of relatively good firms.

82

value of the firm to book value of the firm ratios below the

Table 3
Significance of Division at the Mean7

 

 

MVBV,,<Mean MVBV,,2Mean
Prediction Error .02 .01
Number in Sample 119 32

 

The difference in the two groups is statistically
significant at the 10 percent level.

 

mean spin-off assets in place. This may be the result of
spinning-off losers or concentrating on the core business
which in either event evokes a greater wealth response from
the market.

Several proxies for liquidity were examined. Among
them were cash and short term investments divided by total
assets, the change in earnings per share divided by the
market value per share, the current ratio defined as the
ratio of current assets to current liabilities, dividend
payout ratio defined as dividends divided by net income, and
working capital defined as current assets less current
liabilities. All are highly correlated. The ratio of
current assets to current liabilities was chosen because the

current ratio yields a better indicator of the ability of a

 

7 The same pattern is obtained when the sample is
divided into those firms having a market value of the firm
to book value of the firm in the year prior to the
announcement date greater than or equal to one and those
less than one.

83
firm to invest. 0f the different choices only the current
ratio and working capital take current liabilities into
consideration. Current liabilities directly affect the
ability of a firm to invest. The current ratio is a better
measure than working capital because it removes the
magnitude of the difference and firm size from
consideration. A variable for the change in the ratio of
the current assets to current liabilities was computed.

A multiple regression of market value of the firm to
book value of the firm ratio for the year prior to the
announcement year (MVBV4) and the change in the current
ratio from the year before the announcement year to the year
of the announcement date (Cqu) was run on the standardized
prediction error (SPEO) for the announcement date. The
results show that the change in the ratio of current assets
to current liabilities from the year before the announcement
date to the year of the announcement date is positively
correlated with the standardized prediction error in the
year of the announcement date. The higher the change in
liquidity is; the higher is the excess return. This is
significant at the 5 percent level. Given an increase in
liquidity prior to the spin-off announcement date, the
market reacts more favorably to the spin-off announcement.
The greater the increase in liquidity the greater is the
abnormal return. Insufficient liquidity (slack) to finance
positive net present value (NPV>0) projects may have been

depressing stock values before the spin-off. The market

84

value of the firm to book value of the firm ratio for the
year prior to the announcement date is negatively correlated
with the standardized prediction error for the year of the
announcement date. This is significant at the 5 percent
level. The lower the market value of the firm to book value
of the firm ratio is; the higher is the excess return.
Again, the market reacts more favorably when less valued
firms spin-off.

Table 4

Multiple Regression MVBV4 and Cqu
on SPEO where N=137

 

 

Variable B t t Sig
CR4,o 1.041474 2.279 .0242
MVBV.l -1.113469 -2.057 .0416
Constant 1.376928 5.357 .0000

 

Debt-equity ratios were computed by dividing the book
value of the long term debt by the market value of the
equity. A debt-equity ratio also was computed by dividing
the book value of the long term debt by the book value of
the equity. Using this measure created some negative ratios
because of negative entries for owners' equity. Eliminating
the firms with negative debt-equity ratios reduced the
number of firms in the sample but, nonetheless, produced a
similar pattern of increasing debt-equity ratios.and
analyzed. The debt-equity ratios, however, provided no
explanation of the abnormal returns. However, consistent

with the theory, debt-equity ratios increased in the years

85

P. m<m> N- m<m> n- m<m> w- m<m>

. . U.

 

 

 

scams Emzmozaozz<
m5. 8 coca mm<m> see 852 558 0e 53
1 $505

o
Nd

v.9

N...

86
before the announcement year (See Figure 1). One
explanation may be that firms spin-off projects because they
cannot finance them through increased debt.

The findings in this part are consistent with the
theory prediction that the market should react more
favorably when less valued firms spin-off, signalling the
market that the firm has positive net present value projects
that it is not otherwise able to finance through internal
funds or new debt.

D. Motivation of Managers

Seventy-two of the spinoff announcements in the sample
gave a reason for the spin-off. Twenty-five firms spun-off
to restrict their activities to the core business. Seven
firms spun-off to generate funds or restructure debt. Seven
firms spun-off assets in connection with an acquisition.
Twenty-six spun-off losers. Six spin-offs were the result
of court or regulatory agency orders. One spin-off was the
result of bankruptcy or liquidation.

The sample was divided by reason(s) for the spin-off.
Sample firms that spun-off losers and the sample of firms
that either spun-off losers or spun-off to generate funds or
restructure debt produced significant results. Regression
of firms which announced that they were spinning-off losers
on the prediction error for the announcement date produces
positive correlation with the prediction error significant
at the 5 percent level. When this group is augmented with

firms which announced they were restructuring debt or

87
generating cash, the results are still significant at the 5
percent level. The market reacts positively to favorable
news.

In addition to what managers said they were doing in
public announcements, an analysis was made to determine the
mind-set of managers of firms that spin-off. Do managers of
firms that spin-off act in a way consistent with the theory?
Part of the hypothesis is that firms with high debt-equity
ratios not being able to finance acquisitions or new
positive net present value projects by additional debt
refrain from issuing equity to finance acquisitions or net
present value projects. Consequently, a high debt-equity
ratio prior to the spin-off implies that there would be a
reduction in total assets after the spin-off. Firms with
lower debt-equity ratios would still be able to finance
acquisitions or positive net present value projects with
debt after the spin-off, and, hence, there would be an
increase in total assets. Approximately one-half the firms
increased their total assets in the announcement year while
the other half showed a reduction in total assets. An
analysis was performed to determine whether or not the debt-
equity ratio is related to the change in total assets. When
the market value debt-equity ratio for the year before the
announcement is regressed on the percentage of change in
total assets in the announcement year, the percentage of

change in total assets is inversely related to the debt-

88
equity ratio.‘ Firms with lower (higher) debt-equity ratios

had higher (lower) percentages of change in total assets.

Table 5
Regression of Debt-Equity Ratio of Year,1 on the
Percentage Change in the Total Assets in Yearo

 

 

Variable B t-statistic t Sig
Debt-Equityd -.040563 -2.378 .0186
Constant .090073 2.353 .0199

 

The results are consistent with the theory. Managers
of firms with low debt-equity ratios expand while managers

of firms with high debt-equity ratios do not.

 

' To verify that firms with positive changes in total

assets were the firms with lower debt-equity ratios, a
regression was run on a dummy variable, DCHGTA, where

0, if the change in total assets is negative

DCHGTA: {1, if the change in total assets is nonnegative.
Although there is a loss of some power, this regression
substantiates the conclusion that firms with low debt-equity
ratios expand while firms with high debt-equity ratios
contract and retrench.

VI. Conclusions

Empirical studies show that stock prices are depressed
when a corporation announces an equity issue. One
ramification of this phenomenon is that managers acting in
the best interests of existing shareholders will not finance
positive net present value projects with equity issues if
the firm does not have sufficient slack or debt capacity to
do so. Consequently, the value of the firm is not
maximized, and there is a misallocation of resources. One
solution to this problem--the spin-off of positive net
present value projects is analyzed in the context of the
legal environment.

Generally, a spin-off or equity carve out will require
the original corporation to issue stock in the subsidiary
corporation either to the old shareholders or for sale to
outside third parties. Such an issue entails registration
at the federal and state levels unless the security is
exempt in which case certain disclosures may have to be made
anyway. Disclosure of the inside material information
concerning the values of the asset-in-place, a, the growth
opportunity, b, and slack, S, resolves the asymmetric
information problem.

Failure to disclose may result in violations of federal
and state securities laws. In light of the penalty
structure of the federal securities law, it was calculated
that managers would have an incentive to disclose the

material information if the probability of getting caught

89

90
lying is greater than or equal to one-half.

Empirical implications of the hypothesis are that a
corporation likely to spin-off or carve out equity would
have the following characteristics: (1) the corporation
would be undervalued and have unfinanced growth
opportunities, (2) it would have a strong ownership
structure, (3) the board of directors would have some
outside directors, (4) the firm would be over-leveraged;
otherwise, it would finance the projects with debt, (5) the
firm would be capital intensive which would be a barrier to
entry by competitors, (6) spin-off and equity carve out
announcements should produce abnormal price returns around
the announcement date.

Empirical studies show that the market price of stock
increases in the period immediately surrounding an
announcement of a spin-off or equity carve out. This result
is verified in Chapter V. The market views such
announcements as good news. The spin-off or equity carve
out announcement signals the market that in the aggregate
the sum of the values of the original and subsidiary
corporations is greater than the value of the original
corporation prior to the spin-off or equity carve out. Old
shareholders are better off if managers spin-off or carve
out the positive net present value project rather than
retain the project and not finance it to protect the value
of the old shareholders' stock.

Analysis of the market reaction to the 158 spin-offs in

91
the sample shows that (1) prior to the announcement date
debt-equity ratios increase, (2) the higher the ratio of
current assets to current liabilities, the higher the
abnormal returns, (3) the higher (lower) the market value of
the firm to the book value of the firm, the lower (higher)
the abnormal returns, and (4) firms having market value of
the firm to book value of the firm ratios below the sample
mean ratio value had higher abnormal returns than firms
having market value of the firm to book value of the firm
ratios below the mean ratio value These findings are
consistent with the theory predictions that (1) firms with
high debt-equity ratios cannot finance positive net present
value projects by issuing more debt and, therefore, spin-off
the project, (2) that undervalued firms spin-off, signalling
the market that the firm has unfinanced growth
opportunities, and (3) that insufficient liquidity (slack)
to finance positive net present value projects may have been
depressing stock values prior to the spin-off.

Finally, it is observed that following a spin-off
managers of firms with high debt-equity ratios contract and
retrench their firms whereas managers of firms with low
debt-equity ratios expand their firms. This behavior is
consistent with the theory prediction that high debt-equity
ratios constrain managers actions. Managers of such firms
are unable to expand by taking advantage of growth

opportunities.

APPENDICES

APPENDIX A

Assumption of in the Old Shareholders Best Interests

This part examines the assumption that managers act in
the best interests of the "old" shareholders in making
corporate investment decisions. To determine the validity
of the assumption, certain aspects of corporation law and
its development are analyzed. An analysis is made of
fiduciary duties owed in both state corporation acts and
court decisions, particularly Delaware corporation law
because of its preeminence in the field of corporation law;
the business judgment rule; corporate social responsibility;
and state corporate constituency statutes.

Early in American jurisprudence, Chief Justice John
Marshall described a corporation as follows:

A corporation is an artificial being, invisible,

intangible, and existing only in contemplation of

law. Being the mere creation of law, it possesses

only those properties which the charter of

creation confers upon it, either expressly, or as

incidental to its very existence. These are such

as are supposed best calculated to effect the

object for which it was created.‘

Modern corporation law allows the object of a

corporation's creation to be any lawful purpose.2 Such

lawful purpose must be for profit since by definition a

 

‘ Dartmouth College v. Woodward, 4 Wheat. 518, 636
(1819).

2 MODEL BUSINESS CORP. ACT 5 3 (1979); REVISED MODEL
BUSINESS CORPORATION ACT 5 3.01(a).

92

93

business corporation is "for profit. '3 In microeconomics
and finance, it is a tenet of the theory of the firm that
firms are profit maximizers.‘ The central paradigm of
corporate finance is that corporate managers maximize
profits which in turn maximizes the value of the corporation
which in turn maximizes shareholder wealth.‘ Recent
developments in the law, however, are eroding this paradigm.
The trend towards corporate social responsibility, changes
in the object of the fiduciary obligations and the business
judgment rule by the courts, and corporate constituency
statutes that allow corporate managers to consider the
interests of other stakeholders such as creditors,
employees, and the community undermine the profit and value
maximization assumptions of traditional corporate financial
theory.

Clearly, the law and corporate financial theory have
diverged. Since corporations are juridical persons and
exist only in contemplation of the law, managers are

constrained by the law. This part explores the divergence

 

3 1;. MBA s 2(a); RMBA 5 1.410(4).

‘ H. VARIAN, MICROECONOMIC ANALYSIS 6 (2d ed. 1984);
T. COPELAND 8 J. WESTON, FINANCIAL THEORY AND CORPORATE
POLICY 18 (3d ed. 1988).

5 m, '1'. COPELAND & J. WESTON, FINANCIAL THEORY
AND CORPORATE POLICY 18, 401, 553, 667, 743 (3d ed. 1988),
Myers & Majluf, t 'n ' ves ent D c' ion
When Firms gave Informatien Thet Ingesters Do Not Have, J.
OF FINANCIAL ECONOMICS 13, 187-221, 191 (1984), Masulis,
4: ects zeto 1- _ : 9a“: 01 ' ° ' ‘=,
J. OF FINANCIAL ECONOMICS 8, 139-178, 140 (1980).

94

of corporation law and corporate financial theory from the
Berle and Dodd debate to the corporate constituency statutes
and the constraints placed on managers' decision-making
process by the law.

A. Separation of Ownership and Control

Many problems encountered in corporate financial theory
and corporation law are rooted in the separation of
ownership and control.‘

Control has passed from ownership hands into the

hands of management, management personnel is more

highly specialized and selected for professional

competence; its motivations are substantially

different from those of the owner-capitalist; and

its area of discretionary action and the character

of the limitations that bound their area differ

markedly from those relevant to the enterprises of

an earlier capitalism.7
The non-profit maximization theory in the economic
literature is largely associated with corporations where

ownership is separated from control.’ Corporations are

owned by shareholders who do not run them, and run by

 

‘ Berle and Means traced the evolution of modern
corporate structure as it shifted from shareholder to
management control. A. BERLE 8 G. MEANS, THE MODERN
CORPORATION AND PRIVATE PROPERTY 127-152 (1932). In this
article, ”control” means managerial decision or operating
control not the absence of a controlling shareholder or
block.

" Mason. W. J- 01"
BUSINESS 31, 1-11, 1 (1958).

' See 1*. SCHERER, INDUSTRIAL MARKET STRUCTURE AND
ECONOMIC PERFORMANCE 32-33, (26 ed. 1980) (discussing the
separation of ownership and control and its effects).

95

managers who do not own them.’ The depersonalization of the
shareholders' relation to the corporation was explained by
Berle and Means in the following terms:

The spiritual values that formerly went with

ownership have been separated from it. Physical

property capable of being shaped by its owner

could bring him direct satisfaction apart from the

income it yielded in more concrete form. It

represented an extension of his own personality.

With the corporate revolution, this quality has

been lost ... .
Shareholders are no longer owners in the traditional sense.
They have become merely investors in corporate equity
securities.“ The shareholder-investor's interest in the
enterprise is limited to capital appreciation and income.12

It may be open to debate whether or not there has been
a separation of ownership and control as maintained by Berle
and Means and others. The typical individual shareholder
has never really been anything but an investor looking only
for income and capital appreciation. Moreover, there is no

separation of ownership and control in the vast majority of

corporations that are family-owned or closely-held. The

 

’ Ownership of a small percentage of the corporation's
stock by managers does not undercut the analysis, because
managers still control property they do not own: the
percentage of the corporation owned by shareholders other
than management.

w A. BERLE & G. MEANS, figure note 6, at 60-67.

“ See P. BLUMBERG, TRE MEGACORPORATION IN AMERICAN
SOCIETY: THE SCOPE OF CORPORATE POWER 11 (1975).

u 5.9 Hetherinqton. East_and_Legal_Th99121_

,1 -!e 0“ : L2... : ..e eqee ._ - e .A ;':ee!: 9_ I

21 STAN. L. REV. 248, 271 (1969).

96
question of separation of ownership and control really only
arises with respect to the relatively few large, public
corporations. When interlocking directorates, acquisitions,
institutional investors, and family blocks (including
foundations) are considered, a controlling interest is held
by a relatively small group of individuals or institutions.
The real question is just how active are these controlling
shareholders? Are they active enough that managers must
accede to their wishes?

Myers and Majluf (1984) in their model assume that
managers act in the best interest of the old shareholders,
although they admit that they have no theory why. One
theory is that corporations are not as diversely held as
hypothesized in managerialism theory. Old shareholders may
have power because there exists a small group of
shareholders (individuals, foundations, other corporations,
or institutions) that hold a controlling interest in
virtually every major publicly held corporation in the
United States today. Institutional investors alone hold
more than $6.5 trillion or approximately 53 percent of the
country's equity. There is currently great debate among
institutional investors as to their proper role in corporate
governance. Edward V. Regan, the New York state comptroller
and sole trustee of the New York state public pension fund,
is alarmed that pension funds, particularly the California
Public Employees Retirement System (Calpers), may get

involved in corporate governance issues which have nothing

97
to do with providing benefits to retirees. He advocates a
passive investor role.‘3 The California system (Calpers)
and other institutional investors are advocating active
participation in corporate governance.“

Controlling shareholders elect the board. Often, their
representatives control the board of directors. They give
managers a free hand to operate within certain limits, one
of which concerns the value of the controlling shareholders'
stock.

This scenario would seem to support the Myers and
Majluf assumption that managers act in the interest of the
old shareholders, if by old shareholders they mean "old
controlling" shareholders. It also raises the specter of
minority shareholder oppression which is the subject of a
great number of corporate fiduciary and business judgment
rule cases. The following analysis takes both theories of
control into account.

B. The Parting of the lays

In the first part of the Twentieth Century, both
corporate financial theory and the law espoused a profit
maximization paradigm. In microeconomics, it is a tenet of

the theory of the firm that firms are profit maximizers.”

 

” 599 James A. White. H2I_IQIKL§_B§QAD_§Q_£§n§iQn§i_
fienge_gfi1, Wall St. J., C1, cols. 3-5, Sept. 13, 1991.

“ The National Law Journal, Monday, December 2, 1991,
p.23, cols. 2 5 4.

” H. VARIAN, MICROECONOMIC ANALYSIS 6 (2d ed. 1984).

98

Profit maximization is justified on the grounds that if
competitive firms did not maximize profits they would be
inefficient and hence would be forced out of business by the
efficient firms." Menopolists are presumed to be profit
maximizers by virtue of their position." Moreover, if the
shareholders of a corporation were able to directly run the
corporation they would opt for profit maximization and its
corresponding cost minimization. Corporate financial theory
further holds that maximizing profits maximizes firm value
which in turn maximizes shareholder wealth.“ The landmark
case of Dodge v. FOrd Motor CO.” was decided in 1919. In
Dodge, the court addressed whether a corporation organized
for profit could divert its profits from the shareholders to
society-at-large. The court drew a distinction between
incidental humanitarian expenditure of corporate funds for
the benefit of employees and a general purpose plan to
benefit humankind.20 The court unequivocally stated:

A business corporation is organized and carried on

primarily for the profit of the stockholders. The

powers of the directors are to be employed for

that end. The discretion of directors is to be

exercised in the choice of means to attain that

end, and does not extend to a change in the end
itself, to the reduction of profits, or to the

 

16 m.
17 m.

" See T. COPELAND & J. WESTON, FINANCIAL THEORY AND
CORPORATE POLICY 18, 401, 553, 557, 743 (3d ed. 1988).

” 204 Mich. 459, 170 N.W. 558 (1919).

” 1g. at 505-507, 170 N.W. at 684.

99

nondistribution of profits among stockholders in

order to devote them to other purposes....[I]t is

not within the lawful powers of a board of

directors to shape and conduct the affairs of a

corporation for the merely incidental benefit of

shareholders and for the primary purpose of

benefiting others....”

As corporations grew in size and complexity and ownership
was separated from control, the law had to evolve to reflect
these changes in the infrastructure of Twentieth Century
American society.

Under agency law a corporation can only act through
agents.22 Since a corporation can only act through agents,
it must necessarily have the capacity to appoint them;
however, its status as principal confers no consciousness or
individual being.23 In general, the officers and employees
of a corporation are its agents.“ The corporation's agents
owe their allegiance to the corporation, not the

directors.” However, corporate finance textbooks and

articles continue to assert erroneously that managers are

 

" 1g. at 507, 170 N.W. at 684.

n W. SELL, AGENCY 13 (1975).

”Id-

“ See H. HENN 8 J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 586, 593-94 (3rd ed. 1983)
(discussing officers as agents of corporations).

3 1g. at 586-606 (discussing the duties of officers as
agents of the corporation).

100
the agents of the shareholders.“

The board of directors situation is rather unique.
Although shareholders elect and can remove directors, the
directors are not agents of the shareholders, and the
shareholders are not principals.” The directors are not
agents of the corporation because of their statutory powers
of management; they are not subject to control by anyone,
which is a requirement of the principal-agent
relationship.” Since the law of agency deals with the
relationship between principal and agent and since directors
are neither principals nor agents, new law had to be created
or old law modified to deal with the relationship between
director and corporation.

1. The Fiduciary Relationship

Based on their analysis of a series of early
corporation cases, Adolf Berle and Gardiner Means contend
that:

[A111 powers granted to a corporation or to the

management of a corporation, or to any group

within the corporation, whether derived from

statute or charter or both, are necessarily and at

all times exercisable only for the ratable benefit

of all the shareholders as their interest appears.
The use of the power is subject to equitable

 

3‘ 5ee._e_,_g_,_, T. COPELAND AND J. WESTON, FINANCIAL
THEORY AND CORPORATE POLICY 17, 19 (3d ed. 1988); Jensen,
“‘1 0 " 9' -. 010- -, l '12! ‘. ._,._
Iekeoveze, AEA Papers and Proceedings 76, 323-329, 323 (May
1986); Jensen & Meckling, c
Firm, J. OF FINANCIAL ECONOMICS 3, 305-360, 309 (1976).

§ . §
‘ a»

’7 W. SELL, AGENCY 20 (1975).

28 IQ-

101

limitation when the power has been exercised to
the detriment of their interest, however absolute
the grant of power may be in terms, and however
correct the technical exercise of it may have
been....And that, in every case, corporate action
must be twice tested: [FJirst by the technical
rules having to do with the existence and proper
exercise of the power; second, by equitable rules
somewhat analogous to those which apply in favor
of a cestui que trust to the trustee's exercise of
wide powers granted to him in the instrument
making him a fiduciary.”

In effect, Berle and Means believed that corporate law, in
substance, was a branch of the law of trusts.30 The
fiduciary concept in corporation law can, in fact, be traced
back to its roots in the Law of Trusts.31 Acknowledging,
however, that this position was more theory than practice
Berle and Means stated:

"In fact, if not in law, at the moment we are

thrown back on the obvious conclusion that a

shareholder's right lies in the expectation of

fair dealing rather than the ability to enforce a

series of supposed legal claims."32
The position advocated by Berle and Means previously was

adopted in Delaware when the Chancellor in Bodell v. General

Gas and Electric Cbrporation33 held that while not

 

” A. EERLE & G. MEANS, THE MODERN CORPORATION AND
PRIVATE PROPERTY 248 (1932) (emphasis added).

” 13. at 275. §ee_e1ee Berle,
Regeze_1n_nget, 44 HARV. L. REV. 1049 (1931).

” See A. SCOTT, THE LAW OF TRUSTS S 170 (duty of
loyalty) and S 174 (duty of care) (3d ed. 1967).

n A. BERLE & G. MEANS, 539:; note 5, at 275.

” 15 De1. Ch. 119, 132 A. 442 (1925).

102
"trustees in the strict sense of the term, yet for
convenience [directors] have been described as such."”
Since then, in Delaware, directors have stood in the
position of fiduciaries.

The fiduciary relationship consists of two duties: the
duty of care and the duty of loyalty. Delaware courts
impose a third duty of obedience which from an analytic
standpoint is a subdivision of the duty of loyalty.”
Justice Cardozo described the fiduciary duty in his now
famous quote: ”Not honesty alone but the punctilio of an
honor the most sensitive, is then the standard of
behavior."“ This is but the beginning of the problem for
as Justice Frankfurter aptly said: ”But to say that a man
is a fiduciary only begins analysis; it gives direction to
further inquiry. To whom is he a fiduciary?"” This is the
crux of the matter. To whom are corporate officers and
directors fiduciaries?

This question was the topic of the debate between Adolf
Berle and E. Merrick Dodd. Berle defended traditional

corporate financial theory that corporate management

 

” 19. at 129, 132 A. at 445.

” Guth v. Loft, Inc., 5 A.2d 503, 510 (Del. 1939),
Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984), Revlon,
Inc. v. MacAndrews 8 Forbes Holding, 506 A.2d 173 (Del.
1985).

“ Meinhard v. Salmon, 249 N.Y. 458, 454, 154 N.E. 545,
545 (1928).

” SEC v. Chenery Corp., 318 U.S. 80, 85 (1943).

103

exercises its powers solely for the benefit of the
shareholders.” Dodd argued for a broader exercise of
corporate powers contending that management should exercise
its powers in behalf of a broader constituency.” Moreover,
he argued that the corporate purpose extended beyond merely
making a profit for shareholders.‘0 The debate ended in
1954 when Berle capitulated and agreed that the corporate
trust extended to the entire community and not solely for
the benefit of shareholders.“ Although the Berle-Dodd
debate ended with Dodd's view prevailing, corporate
financial theory still embraCes Berle, and there are
lingering elements of the debate in corporation law today.

Corporation statutes are generally consistent as to
whom the fiduciary duty is owed. A very few corporation
statutes extend the duty to both the corporation and
shareholders.‘2 The majority of modern corporation statutes
following the MOdel Business Corporation Act impose the
fiduciary duty on officers and directors for the benefit of
the corporation.

 

” Berle. Q9rn9rate_2exers_as_zexer§_in_mrns§. 44 HARV-
L. REV. 1049 (1931).

” Dodd. E9r_Hh9m_are_Q9raerate_MAEASSrs_Trustees. 45
HARV. L. REV. 1145 (1932).

40 m.

“ A. BERLE, THE 20TH CENTURY CAPITALIST REVOLUTION 159
(1954).

a ”[F]iduciary relation to the corporation and to its
shareholders... .' N.C. BUS. CORP. ACT S 55-35. fiee_elee
S.C. BUS. CORP. ACT 5 33-13-150.

104

A director shall discharge his duties as a

director,..., in a manner he reasonably believes

to be in the best interests of the corporation.‘3
The drafters of the model act and state legislatures have
taken the modern position that the duty is owed to the
corporation not to any particular constituent stakeholder
group.

It is in the case law where most of the remnants of the
Berle-Dodd debate exist. There is a line of cases holding
that the fiduciary duty runs to the shareholders. These
cases typically involve insider trading,“ oppression of

minority shareholders,“ and a purchase or sale of

control.“ Although couched in terms of fiduciary duties

 

“ ALI-ABA REVISED MODEL BUSINESS CORP. ACT 5 8.30; H.
HENN & J. ALEXANDER, LAW OF CORPORATIONS AND OTHER BUSINESS
ENTERPRISES 513 (3rd ed. 1983).

“ See, e.g,, Jacquith v. Mason, 99 Neb. 509, 155 N.W.
1041 (1916), Dawson v. National Life Insurance Co., 176 Iowa
362, 157 N.W. 929 (1916), Childs v. RIC Group, Inc., 331
F.Supp. 1078 (N.D. Ga. 1970), g;1;§_per_enr1en 447 F.2d 1407
(5th Cir. 1971) (Inside information held in trust for
benefit of shareholders under Georgia law.), Sampson v.
Hunt, 222 Ran. 268, 564 P.2d 489 (1977), Weatherby V.
Weatherby Lumber Co., 94 Idaho 504, 492 P.2d 43 (1972).
According to Henn and Alexander these cases constitute the
minority rule that a duty is owed to shareholders in insider
cases. H. HENN 8 J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 648 (3rd ed. 1983).

“ H. HENN & J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 651-56 (3rd ed. 1983). Singer v.
Magnavox Co., 380 A.2d 969 (Del. 1977). Tanzer v.
International General Industries, Inc., 379 A.2d 1121
(1977).

“ H. HENN & J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 656-61 (3rd ed. 1983). Revlon,
Inc. v. MacAndrews and Forbes Holdings, Inc., 506 A.2d 173
(Del. 1985).

105

owed to shareholders, these cases can be explained as
breaches of fiduciary duties owed to the corporation as a
whole where ”Corporation as a whole” encompasses all
intracorporate groups. Favoring one intracorporate group to
the detriment of another is a breach of duty owed to the
corporation as a whole." Mereover, many of these cases
involve discrimination among different groups of
shareholders; therefore, it is only logical that the courts
should speak of duties owed to the shareholders rather than
the corporation. But, even where the fiduciary duty is
extended to the shareholders it has not been extended
exclusively to them. For example, a fiduciary duty is owed
to creditors in a financially troubled corporation“ even
though no duty is owed creditors in a financially healthy
corporation.”

The formulation of the fiduciary concept by the

Delaware Supreme Court appears in Guth v. Loft, .l’nc.‘o

 

a H. HENN 8 J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 652 (3rd ed. 1983). There is a
minority view that wealth transfers from other stakeholders,
bondholders for example, are permitted if not encouraged.
See Revlon, Inc. v. MacAndrews and Forbes Holdings, Inc.,
506 A.2d 173 (Del. 1986).

“ gee Pepper v. Litton, 308 U.S. 295, 305 (1939); CFTC
v. Weintraub, 471 U.S. 343, 355 (1985); Clarkson Co. Ltd v.
Shaheen, 550 F.2d 505 (2d Cir. 1981), sert1_denied. 445 U.S.
990 (1982); Credit Lyonnais Bank N.V. v. Pathe
Communications, Civ. 12150, 1991 Del. Ch. Lexis 215 (Dec.
30 1991). '

“ Simons v. Cogan, Civil Action No. 8890 (Del. Ch.
Dec. 2, 1987). -

w 5 A.2d at 510 (1939).

106

There the court held that while directors are not
technically trustees, they stand in a fiduciary relationship
with the corporation and its stockholders. The court
imposed a duty of undivided and unselfish loyalty to the
corporation.” The subsequent discussion of fiduciary duty
refers to the corporation and does not further mention the
stockholders. Of course, there was no need to mention the
stockholders at all since the case involved an appropriation
of a corporate opportunity. One may speculate that
shareholders were included because in 1939 the interests of
the corporation and its owners were considered to be the
same. Guth has been cited for the fiduciary concept by the
Delaware courts ever since. The unresolved question was:
what if there is a conflict between loyalty to the
corporation and the stockholders. Can undivided loyalty to
the corporation be divided between the corporation and its
stockholders if their interests diverge? The Delaware
Supreme Court would not answer that question for fifty years
when it decided Paramount COmmunications v. Time, Inc.52

Paramount is of particular importance in this analysis.
Justice Horsey clearly distinguished between the corporation
as an entity and the shareholders.” His opinion suggests

that the fiduciary duty is owed to the corporate entity not

 

“ 5 A.2d at 510.
n 571 A.2d 1140 (Del. 1989).

” Id. at 1150.

107
the shareholders.“

Time distinguishes the stance taken by the Delaware
Supreme Court in Revlon, Inc. v. MacAndrews and FOrbes
HOldings, Inc.” which expressly denied that other
constituencies were owed a fiduciary duty by management
under certain conditions. The situation in Revlon involved
a hostile takeover by Pantry Pride. The Revlon board of
directors engaged in defensive tactics to thwart the Pantry
Pride takeover. Of particular importance is that the board
acted to protect noteholders at the expense of the
shareholders. The notes had been issued as a defensive
measure. Hence, Revlon involves an intracorporate
allocation of value. The court did not prohibit the board
from considering constituencies other than the shareholders.

[WJhile concern for various corporate

constituencies is proper when addressing a

takeover threat, that principle is limited by the

requirement that there be some rationally related
benefit accruing to the stockholders.“

This concession by the Delaware Supreme Court is a step
toward liberalization of the fiduciary concept although the
court continued to quote the language from Guth v. Luft,

l’nc.’7 that the fiduciary duty is owed to the corporation

 

54 1g.
” 505 A.2d 173 (Del. 1986).
“ 505 A.2d at 175.

n 5 A.2d at 510.

108
and its shareholders. The concept of concern for other
constituencies comes out of anocal carp. v. Mesa Petroleum
CO.” Mesa argued that action by the Unocal directors in
opposing its two tier tender offer for Dnocal stock was a
violation of the fiduciary duty Unocal owed to all of its
shareholders of which Mesa was one. The Delaware Supreme
Court said that the board of directors could be legitimately
concerned with ”the impact [of the tender offer] on
'constituencies' other than shareholders (i.e. creditors,
customers, employees, and perhaps even the community
generally).” This language is similar to the corporate
constituency statutes of other states.”

The interesting aspect of Revlon is that the court
declared that the initial duty of the board in the face of
the takeover was to preserve the corporation as an entity.
As long as that was the case, the duty was owed to the
corporate entity. When it became apparent to the board that
the corporate entity could not be preserved, its duty
shifted to maximize the firm’s value at a sale for the
benefit of the shareholders. The shareholders take priority
only after the board's obligations to the corporation are
fulfilled. Once the corporation goes on the auction block
the board's duty is to maximize shareholder value and

concern for non-shareholder interests is not appropriate

 

“ 493 A.2d 945 (Del. 1985).

” fiee_infize notes 93-96 and accompanying text.

109
when an auction among active bidders is in progress, and the
object no longer is to protect or maintain the corporate
enterprise but to sell it to the highest bidder.

Time also involved a hostile takeover. The plaintiff
shareholders relying on Revlon argued that Time's board of
directors' decision to merge with warner imposed a fiduciary
duty to maximize immediate share value and not erect
unreasonable barriers to further bids (Paramount's).‘o The
court distinguished Time from Revlon by noting that Time's
corporate integrity was being maintained and that Time was
not to be dismembered on the auction block. Hence, the
Revlon rule was not triggered.

The Court of Chancery in its opinion below posed the
pivotal question of utmost importance in this dissertation.
Under what circumstances must a board of directors
abandon an in-place plan of corporate development

in order to provide its shareholders with the

option to elect and realize an immediate control

premium?“

The Delaware Supreme Court responded by relying on 8 Del. C.
S 141 which vests corporate control and management in the
board of directors and by dietinguishing Revlon. The duty
imposed on directors under Delaware law to manage the

business and affairs of the corporation includes a

"conferred authority to set a corporate course of action,

including time frame. deEiSned_t9_enhanse_cezngrete

 

“ 571 A.2d at 1149.

“ 571 A.2d at 1149.

110
prefii;ebility.' Further, "the question of 'long term'
versus 'short term' values is largely irrelevant because
directors, generally, are obligated to chart a course for a
corporation which is in 1;e_hee;_in§ere§§§ (the
corporation's) without regard to a fixed investment
horizon." (Emphasis added.)

Second, absent a set of facts as in Revlon, a board of
directors is ”not under any per se duty to maximize
shareholder value in the short term, even in the context of
a takeover."62 In the light of these statements by the
Delaware Supreme Court, managers who pass up positive net
present value projects and thereby fail to maximize the
value of firm in the interests of the old shareholders
violate their fiduciary duty to the corporation and could be
held accountable under Delaware law.

Although Time directly involved a takeover, there is no
reason to believe that the extension of the fiduciary duties
would be restricted to this context particularly in light of
the language quoted in the prior paragraph. This case is
extremely important because of the status of Delaware
corporation law in the field. The duty originally imposed
for the benefit of the shareholders has been transferred to
the corporation as a whole. To say that the fiduciary duty
is owed to the corporation is equivalent to saying that a
fiduciary duty is owed to all stakeholders composing the

 

“ 571 A.2d at 1150.

111
corporation. The shift from shareholders to corporation is
in fact a broadening of the scope of fiduciary
beneficiaries rather than a narrowing. The assumption that
managers act in the best interest of the old shareholders is
losing its support in the law, Indeed, in Delaware, it may
be gone. The case law trend is toward finding a duty owed
to the corporation as a whole.
2. Business Jedgment Rule

The business judgment rule is the logical extension of
the fiduciary relationship's transference from the
shareholders to the corporation as a whole. Management is
compelled to act in the best interests of the corporation.
The business judgment rule applies not only to directors but
also officers and controlling shareholders collectively
referred to as management.“

The Delaware Supreme Court stateS'that the business
judgment rule is

a presumption that in making a business decision

the directors of a corporation acted in good faith

and in the honest belief that the action taken was

in the best interests of the company.“
Note that only the ”company” is mentioned. There is no

mention whatsoever of the stockholders. In this respect,

the business judgment rule moved ahead of the fiduciary

 

a H. HENN & J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 663 (3rd ed. 1983).

“ Aronson v. Lewis, 473 A.2d 805, 812 (Del. Sup.
1984).

112
concept in the Delaware courts.

Delaware has adOpted a more stringent business judgment
rule for takeover situations because of an ”omnipresent
specter" that the directors may be acting in their own best
interests rather than the best interests of the corporation
and shareholders.“ The court imposed an ”enhanced” duty
calling for an initial judicial determination before the
business judgment rule is applicable.. In Delaware,
directors in a takeover situation must show that they had
reasonable grounds to believe that there existed a danger to
corporate policy and effectiveness because of another
person's stock ownership. This enhanced duty is shown by
good faith and reasonable investigation particularly if done
by a majority of independent outside directors.

Care must be taken in discussing the business judgment
rule which has been created by courts for evidentiary
purposes in cases involving alleged misconduct by
management.“ The business judgment rule is a standard of
proof which creates a presumption that the board of
directors acted in good faith and in furtherance of the best

 

“ Unocal Corp. v. Mesa Petroleum Co., 493 A.2d at 954.

“ See H. HENN 8 J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 661-663 (3rd ed. 1983)
(summarizing the business judgment rule). fiee_e1ee Manning,

° , 45 OHIO ST. L.J. 615

(1984).

_113

interests of the corporation after exercising due care.67
The purpose of the business judgment rule is to protect
directors from continuously having to justify to
shareholders their decisions made in the ordinary course of
business.“ This is true even if the decisions turn out to
be wrong, provided the directors acted in good faith and
exercised due care.69 Courts are reluctant to substitute
their judgment for that of boards of directors because
courts perceive the boards as possessing skills,
information, and judgment not possessed by the courts.70

The business judgment rule protects only boards that
act in good faith in accord with their duty of loyalty,71
but only a duty of loyalty to the corporation not the
shareholders. If the directors are disinterested, in all

probability they will be deemed to have acted in good

 

” Seee_eege, Tate 8 Lyle PLC v. Staley Continental,
Inc., [1987-1988 Transfer Binder] Fed. Sec. L. Rep. (CCH) 1
93,764 (Del. Ch. 1988).

“ BNS, Inc. v. Koppers Co., 683 F.Supp 458, 473 (D.
Del. 1988).

” Mathes v. Cheff, 41 Del. Ch. 155, 175, 190 A.2d 524,

529 (1963). IEYLd_9n_gther_srennda. 41 Del- Ch. 494. 199

” Auerbach v. Bennett, 47 N.Y.2d 519, 530-31, 393
N.E.2d 994, 1000, 419 N.Y.S.2d 920, 925 (1979); Solash v.
Telex Corp., [1987-1988 Transfer Binder] Fed. Sec. L. Rep
(CCH) 11 93,508, 97,722 (Del. Ch. Jan. 19, 1988).

u H. HENN 8 J. ALEXANDER, LAW OF CORPORATIONS AND
OTHER BUSINESS ENTERPRISES 551 (3rd ed. 1983) (discussing
business judgment rule).

114

faith."2 However, if the directors are not disinterested
and are beneficiaries of the action, they will have breached
their duty of loyalty, and the business judgment rule will
not protect them.” If the plaintiff is able to establish
that the board did not act in good faith or breached its
duty of due care, the burden of proof shifts to the
defendant directors to show that the transaction was
entirely or intrinsically fair."

The business judgment rule really represented a shift

from shareholders to the corporate entity when it was

 

n Beerd_ye_EleterL 39 Del. Ch. 153, 165, 160 A.2d 731,
738 (1950).

” See‘_eege, Maldonado v. Flynn, 597 F.2d 789, 794 n.7
(2d Cir. 1979), gn_regeng, 477 F.Supp. 1007 (S.D.N.Y. 1979);
Beard v. Elster, 39 Del. Ch. 153, 160 A.2d 731 (1960); Puma
v. Marriott, 283 A.2d 693 (Del. Ch. 1971) (directors found
to be disinterested). 4§§§_d1§21_§191. Galef v. Alexander,
615 F.2d 51 (2d Cir. 1980); Clark v. Lamas 8 Nettleton Fin.
Corp., 625 F.2d 49 (5th Cir. 1980), eez§e_genieg, 450 U.S.
1029 (1981); Grynberg v. Farmer, [1980 Transfer Binder] Fed.
Sec. L. Rep. (CCH) 1 97,683 (D. Colo. Oct. 8, 1980)
(directors found to be interested).

" '[The] plaintiff ... must be able to make specific
allegations of malfeasance or bad faith. Where an improper
motive is claimed, plaintiff must allege that it was the
sole or primary reason for the directors' actions."
Eldridge v. Tymshare, Inc., 186 Cal. App. 3d 767, 777, 230
Cal. Rptr. 815, 820 (1986). ”At a minimum, the Delaware
cases require that the plaintiff must show some sort of bad
faith on the part of the defendant." Johnson v. Trueblood,
629 F.2d 287, 293 (3d Cir. 1980), ££I§i_§§n1§§: 450 U.S. 999
(1981). ”Once a plaintiff demonstrates that a director had
an interest in the transaction at issue, the burden shifts
to the director to prove that the transaction was fair and
reasonable to the corporation.” Treadway Cos. v. Care Corp,
538 F.2d 357, 382 (2d Cir. 1980).

115
developed in the thirties.75 In Delaware, the business
judgment rule was formulated in the fifties.” It has taken
more than thirty years for the fiduciary relationships to
catch up to the business judgment rule.
3. Social Responsibility and Third Party

Beneficiaries

The internal relationships between officer,
shareholder, and corporation are governed by the law of
agency, the fiduciary concept including the business
judgment rule, and state corporation laws." Now courts are
considering the relationship between the corporation and
society. The theory of corporate social responsibility is
developing in the wake of concerns about the environment,
product safety, and social justice.

A corporation is private property owned by the
shareholders and operated for their benefit.” The
traditional or classical view of corporate social

responsibility” is that corporations are to make profits

 

” See Walker v. Man, 142 Misc. 277, 253 N.Y.S. 458
(Sup. Ct. 1931); Epstein v. Schenck, 35 N.Y.S.2d 969 (Sup.
Ct. 1939).

” See Gottlieb v. Heyden Chemical Corp., 33 Del. Ch.
82, 90 A.2d 660 (Del. Sup. 1952) and Glassberg v. Boyd, 35
Del. Ch. 293, 116 A.Zd 711 (Ch. 1955).

" See_snnra Parts 1 and 2-
" 204 Mich. 459, 170 N.W. 668, 584 (1919).

” See Eisenberg. sernerate_nesitimasx._§QndnCII_snd
Q9YErnaE9s::TE9_E99215.9f_tne_§9rneretien. 17 CREIGHTON L-
An_ADRIQiQh.§Q.£QIDQI§I§.§Q§i§l

REV. 1 (1983); Engel,
, 32 STAN. L. REV. 1 (1979); Epstein,

.116
for their shareholders.” Nonetheless, there always has
been some constraint on the means, but no constraint on the
goal. The profit motive remains the ultimate legal purpose
for which persons form corporations.

At common law, it is a tenet of sovereignty that a
government may regulate the manner in which citizens use
their own private property, when necessary for the common
good." As the Supreme Court of the United States stated:

Property does become clothed with a public
interest when used in a manner to make it of
public consequence, and affect the community at
large. When, therefore, one devotes his property
to a use in which the public has an interest, he,
in effect, grants to the public an interest in
that use, and must submit to be controlled by the
public for the common good, to the extent of the
interest he has thus created. He may withdraw his
grant by discontinuing the use; but, so long as he
maintains the use, he must submit to the

 

e ‘7'. ,..,e' ._ ..e ‘1”. ” IOA‘ 7: e, egos

-- , 30 HASTINGS L. J.

S92ial_BSEp9nS1bilitY__2rgdust_and_219§ess

1287 (1979); Hetherinqton. £32t_and_nesal_mhegrxi_

.913!’ -_‘ v.1- ‘ :I- 0101- . - -, {‘So-I: .- ,
21 STAN. L. REV. 248 (1959); Mangrum, 1n_§eezeh_efi_e

PaIadi9m.9f_Q9IR9Iate_figsial_neenen§ibilitx. 17 CREIGHTON L-
REVo 21 (1983); Mashaw. Q9rR9rate_Sgcial_BesngnSibilitY1_

eIIIIe, _ e! 9 i" ,!e_ I .!.| e. 1‘ e ;_ e! 1- 1.
Debate, 3 YALE L. 8 POL'Y REV. 114 (1984); Solomon 8

Collins,
, 12 J- CORP. L. 331 (1987)

(discussing theoretical aspects of corporate social
responsibility).

” Dodge v. Ford Motor Company, 204 Mich. 459, 170 N.W.
668, 684 (1919). Al§Q_E§§ M. ERIEIMAN, CAPITALISM AND
FREEDOM 133-136 (1962) (providing a good discussion of
directors responsibility to make profits for their
shareholders).

" See Munn v. Illinois, 94 U.S. 113, 125 (1875)
(stating the common law position).

117

control.‘2

More recent case law requires that corporate directors
recognize that there are other intereSts to be considered
aside from the interests of shareholders. A watershed in
the case law regarding corporate social responsibility was
reached in A. P. Smith Manufacturing CO. v. Barlow,” in
1953. A. P. Smith Manufacturing Company had regularly
contributed to the local community chest and occasionally to
Upsala College.“ In 1951, the board of directors adopted a
resolution to contribute to the Annual Giving to Princeton
University.” The justification was the usual sound
investment, business purpose rhetoric.“ The court, picking
up the thread of the common law as articulated in Munn v.
Illinois, carried the common law further, stating: ”It
seems to us that just as the conditions prevailing when
corporations were originally created required that they
serve public as well as private interests, modern conditions
require that corporations acknowledge and discharge social
as well as private responsibilities as members of the
communities within which they operate.'"

 

” Id. at 125.

9 13 N.J. 145, 98 A.2d 581 (1953).

“ A. P. Smith Manufacturing Co., 98 A.2d at 582.
u 19-

“ Id. at 583.

" Id. at 585.

118

Significantly, the court held not only that the gift
had been made in the reasonable belief that it would advance
the interests of the corporation, but also the court added
that the gift would aid the public welfare and advance the
interests of the plaintiff as a part of the community in
which the gift operates.“ This was an extension of the
common law,” although the court was careful to say that the
charity in question was not a pet charity of the directors
in furtherance of personal, rather than corporate, ends.90
Corporations were authorized to further social welfare.

More recent cases tend toward a social responsibility
theory for corporations.” Nonetheless, the profit motive
remains the driving force behind corporate existence, and
social responsibility is constrained by reasonableness.”

State legislatures are also taking an active role in
the expansion of the scope of fiduciary duties.

Approximately one-half of the states not including Delaware

 

" m. at 590.
89 m.

” Id. Apparently, a different result would have been
reached if the charity were a pet personal one of the
directors.

9‘ See._e_._g_,_, Theodore Holding Corp. v. Henderson, 257
A.2d 398 (Del. Ch. 1969) (adopting a social responsibility
theory).

” '[TJhe test to be applied in passing on the validity
of a gift such as the one here in issue is that of
reasonableness....' 11L at 405.

119
have enacted “corporate constituency“ statutes.” These
statutes appear to be reactions to the takeover mania of the
1980's and shifts from individual to institutional
investors. A typical provision permits the board of
directors when considering the best interests of the
corporation to include not only shareholders but also, to
the extent deemed appropriate, employees, suppliers,
customers, creditors, the community in which the corporation
is located, short- and long-term interests of the
corporation, and all other pertinent factors.“ Moreover,
no one group or intereSt need be considered the dominant or
controlling interest or factor.” Mest of these corporate
constituency statutes are permissive, not mandatory and,
hence, vest great discretion in the board of directors.
Five of the states restrict the constituency statutes to

takeover situations while the rest apply to all decisions of

 

” Ariz. Rev. Stat. Ann. 5 10-1202 (1987); Conn. Gen.
Stat. 5 33-313 (1961); Fla. Stat. 5 607.111 (1975); Ga. Code
Ann. 514-2-202 (1989); Haw. Rev. Stat. 5 415-35 (1983);
Idaho Code 5 30-1702 (1988); Ill. Rev. Stat. ch. 32, para.
8.85 (1987); Ind. Code 5 23-1-35-1 (Burns 1986); My. Rev.
Stat. Ann. 5 2718.12-210 (Baldwin 1988); La. Rev. Stat. Ann.
5 12:92 (West 1968); Minn. Stat. s 302A.251 (1982); Me. Rev.
Stat. Ann. tit 13, S 716 (1985 8 Supp. 1989); Mo. Ann. Stat.
s 351.347 (Vernon 1986 8 Supp. 1990); Neb. Rev. Stat. S 21-
2035 (1988); N.J. Rev. Stat. s 14A:5-1 (10A-1 e;_eege); N.M.
Stat. Ann. 5 53-11-35 (1967); N.Y. Bus. Corp. Law 5 717
(MCKinney 1987); Ohio Rev. Code Ann. S 1701.59 (Baldwin
1989); 42 Pa. Cons. Stat. Ann. 5 8363 (Purdon 1986 8 Supp
1990); Tenn. Code Ann. 8-35-204 (1988); and Wis. Stat. S
180.305 (1987).

94 E“
95 m.

120
the board of directors. Three states require directors to
consider other constituencies.” .Although how they take
other constituencies into account apparently is left up to
the board.

What the corporate constituency statutes do show is
that state legislatures intend directors to take other
constituent stakeholders in addition to shareholders into
account when making decisions. Acting in the best interests
of the corporation means more than just in the interest of
the shareholders. The interests of the corporation and its
shareholders are no longer synonymous.

Business ethics scholars are pushing for an even
broader extension of corporate social responsibility. The
extended stakeholder theory seems to be dominant at the
moment. Proponents urge adoption of this theory since it
can be accomplished within the framework of managerial
capitalism. Ethically responsible management under this
theory will take stakeholders other than shareholders into
consideration in the decision making process. It is already
demonstrated in this dissertation that both legislatures and
courts impose this requirement. What distinguishes the
approach of business ethics scholars is that they advocate a
circle of stakeholders far broader than the corporation.

For example, Professor R. Edward Freeman in Strategic

Management: A Stakeholder Approach, defines a stakeholder

 

0)” §§§l_§191. Conn. Gen. Stat. Ann. 5 33-313(e) (West
199 .

121

as "any group or individual who can affect or is affected by
the achievement of the organization's objectives." Such a
group could include employees, customers, the community,
governments, and markets. This approach calls for some type
of balancing or weighting of interests some of which are
immediate and others are fairly remote. The degree to which
each stakeholder group must or can be taken into
consideration is not well-defined and appears to be highly
subjective and variable depending on the situation.

Professor Freeman also advocates a multi-fiduciary
approach. This approach is particularly troublesome since
the fiduciary relationship traditionally has been reserved
for special trust or trust like relationships. The duty of
undivided loyalty seems incompatible with this approach.
Loyalties may change with the situation. Kenneth E.
Goodpaster promotes a stakeholder theory that retains the
fiduciary relationship between managers and shareholders but
advocates an ethical, non-fiduciary relationship between
managers and non-shareholder stakeholders.” Professor
Goodpaster does not understand that the fiduciary
relationship is between the managers and the corporation
except in certain intracorporate disputes discussed above.

The primary point to make here is that business ethics
scholars and others would move the law even farther away

from traditional financial theory and expand the spectrum of

 

” K. Goodpaster,
Agelyeie, 1 BUS. ETHICS Q. pp. 61-73 (1990-91).

122
stakeholder constituency even broader than the courts or
legislatures have done to date.

0. Conclusions and Remedies

The assumption that managers act in the best interests
of the "old" shareholders is not supported by the law
whether one takes the separation of ownership and control or
controlling shareholder view. The fiduciary concept has
evolved in favor of the corporation as a whole and not any
particular stakeholder group. The business judgment rule
has consistently required a fiduciary duty to the
corporation. Recent developments in corporate social
responsibility and corporate constituency statutes broaden
the number of stakeholders who may or must be considered
rather than maintaining a narrow focus on the shareholders.
The development in the case law is particularly important
since case law develops in reaction to some action already
taken. Acts of managers taking constituencies other than
shareholders into consideration in making decisions have
been upheld.

If the law is a reflection of managerial action, it has
changed dramatically since the days of the Berle-Dodd
debate, and corporate financial theory has lagged behind.

If managers do not invest in positive net present value
projects and thereby fail to maximize the value of the firm,
the explanation must be something other than that managers
act in the best interest of the old shareholders.

Conversely, the law and managerial action may be at

123
odds. In which case, managers either through ignorance of
the law or in deliberate disregard of the law act in the
best interests of the shareholders to the detriment of the
corporation. In this instance, the law provides the
shareholder derivative suit as a strictly legal remedy. The
other potential remedies are the proxy contest and
shareholder proposal which are regulated by federal and
state securities law.

A shareholder derivative suit is a claim asserted by a
shareholder in behalf of the corporation. The shareholder
derivative suit is a recognition by the law that corporate
directors may not act in the best interests of the
corporation by refusing to aesert the Corporation's legal
rights--in this case, by not enforcing the fiduciary duty to
act in the best interest of the corporation. The purpose is
to prevent abuse of authority by the board of directors.
There are two obstacles to use of the derivative suit as a
remedy. First, the suit must be brought by a shareholder
who in this case is the beneficiary of the directors breach
of fiduciary duty to the corporation. Such shareholders are
unlikely to bring a shareholder derivative suit which might
be detrimental to themselves. The second obstacle is a
legal one. The courts have applied the business judgment
rule to shareholder derivatiVe suits.”' The general rule is

that courts will seldom interfere with intra-corporate

 

” United Copper Securities Co. v. Amalgamated Copper
Co., 244 U.S. 261 (1917).

124
decisions.

Federal” and State“ rules of civil procedure require
that prior to bringing a shareholder derivative suit the
shareholder must first formally demand that the board of
directors pursue the specific legal right of the corporation
in question. Failure to make such demand ordinarily results
in dismissal. The demand requirement is excused only if it
would be futile.“” If demand is futile, the Delaware
Supreme Court applies a two-prong test as to whether or not
the suit will be dismissed on motion of an Independent
Investigation Committee of the Board of Directors.“ Such
a committee generally consists of disinterested outside
directors. The first prong is whether or not the committee
is independent and acted in good faith after reasonable
investigation. The second prong is whether the court in its
own independent judgment would come to the same conclusion
as the independent committee. In our case, there probably
would be no independent, disinterested directors although it
is possible.

The use of a shareholder derivative suit requires a
shareholder and an independent director interested in acting
in the best interest of the corporation instead of the

 

” Fed. R. Civ. P. 23.1.
100
§§£1_2191. Del. Ch. Ct. R. 23.1.
1“ Aronson v. Lewis, 473 A.2d 805 (Del. 1984).

‘8 zapata Corp. v. Maldonado, 430 A.2d 779 (Del.
1981). ' ~

125
shareholders. The logical shareholder candidate would be an
outsider who recognizing the under-investment would buy
common stock in order to bring the shareholder derivative
suit. Such a candidate probably would be interested in
taking over the corporation.

The second group of potential remedies is the proxy
contest and shareholder proposal. An insurgent shareholder
may initiate a proxy contest in order to make changes in
corporate policy. If successful, the proxy contest would
place the insurgent's nominees on the board of directors.
However, even if not successful, the board of directors may
make proposed policy changes to ward off further attacks. A
corporation should be vulnerable to a proxy contest if (1)
management owns little or no common stock, (2) the
corporation is undervalued (asset value greater than market
value of stock), (3) the corporation has a poor performance
record such as low earnings or low dividends, (4) the board
of directors is not unified providing potential allies on
the board. .

Proxy contests are regulated by section 14a of the
Securities Exchange Act of 1934 and are quite expensive.
Therefore, the difference between the market value of the
stock and the asset value including the unfinanced positive
net present value projects must exceed the costs of the
proxy contest.

An alternative to a proxy contest is a shareholder

proposal to invest in positive net present value projects.

126
Shareholder proposals are gOverned by Rule 14a-8.“13 Rule
l4a-8 provides that if a shareholder who is entitled to vote
at a meeting wishes to make a proposal, such a proposal must
be presented to management with notice of intent to present
the proposal at the meeting. Management is required to
include the proposal unless it demonstrates that the
proposal falls within one of the exclusions of the rule.”‘
To be eligible to make a shareholder proposal, the
shareholder must hold at least one percent of the
corporation's outstanding voting stock or $1,000 in market
value.“ A shareholder may solicit proxies as well as
submit proposals. In 1987, the Securities and Exchange
Commission eliminated part of the rule that allowed a
corporation to omit shareholder proposals from proxy
materials. ‘°‘ One reason for exclusion which may apply here
is that the proposal may be omitted if it concerns
operations which account for less than five percent of the
corporation's total assets, net earnings, or gross sales
unless it is otherwise significantly related to the

corporation's business."’

 

‘9 17 C.F.R. s 240.14a-8 (1989).

1“ Rule 14a-8(c)(1), 17 C.F.R. s 240.14a-8(c)(1)
(1989).

1“ Rule l4a-8(a)(1), 17 C.F.R. s 240.14a(8)(a)(1)
(1989).

‘“ Exchange Act Rel. No. 25,217.

l” 17 C.F.R. s 240.14a-8(c)(5) (1989).

127

There are two problems which must be overcome. First,
the asymmetric information problem wherein the shareholder
does not know the updated value of the project. Second, a
shareholder willing to act contrary to.his or her own short-
term best interests. As with the proxy contest and
shareholder derivative suit, an outsider with inside
information is needed to pursue the remedy.

Acting in the best interests of the shareholders
instead of the corporation is not a high risk violation of
the law. While the law is explicit with respect to the
duties of managers to act in the best interests of the
corporation, the law does not provide an adequate remedy for
breach of that fiduciary duty. The shareholder derivative
suit, proxy contest, and shareholder proposal are not
effective because they rely on actions by the very persons
who are the beneficiaries of the breach of fiduciary duty.
Such legal remedies rely on outsiders with information
concerning the updated values of the forgone projects who
are willing to invest in the corporation and in expensive
legal contests to maximize the value of the corporation.

If managers do in fact act in the best interests of the old
shareholders and thereby fail to maximize the value of the
corporation by forgoing positive net present value projects,
the law of corporate governance currently does not provide
an effective solution to the problem. Effective remedies
must be sought in the marketplace. A.merger, tender offer,

spin-off, or equity carve out offers such a solution.

APPENDIX B

Merger and Tender Offer Solutions

This part examines the merger and tender offer
solutions to the asymmetric information part of the problem
in terms of both financial and legal effects. Managers of
corporations who do not maximize the value of the
corporation by investing in all positive net present value
projects may find themselves takeover targets. The
hypothesis is: if managers forgo positive net present value
projects in the interest of the old shareholders and the
corporation's value is suboptimal then the corporation
becomes a candidate for a takeover. New management
presumably will invest in the forgone opportunities thereby
increasing the value of the subsidiary or combined entity.

Finance merger literature can be divided into two
groups. The first group consists of the older empirical
studies on conglomerate mergers, and the second group can be
termed the more modern. Mandelkerl found that the target
firms in his sample earned significantly lower rates of
return on equity than other firms over most of the period
prior to merger. Mandelker further discovered a significant
and steady increase in cumulative residuals for the target
corporation over the seven month period preceding the

merger. Other studies establish that there is a positive

 

‘ Mandelker, G., °
Eizmfi, J. OF FINANCIAL ECONOMICS 1, 303-335 (1974).

128

129

relationship between merger activity and strong economic
growth, i.e., periods of economic and market advances.2
While it is true that mergers do not seem to have generated
increases in the value of the acquiring corporation,’ ‘this
phenomenon may be explained by Roll's hubris hypothesis.‘
Roll's hypothesis is that managers are over-optimistic in
evaluating target corporations as takeover candidates and
pay more for the target corporation than they should. This
could be a function of the asymmetric information problem.

The asymmetric information problem posed here is quite
different from other finance literature dealing with mergers
and tender offers. Usually, it is a bidder who has the
information advantage rather than the target management.

Giammarino and Heinkels modelled takeover behavior in
1986. In their model, there is an informed and uninformed
bidder in addition to the target corporation all of which
are risk neutral. The informed bidder has an information
advantage over both the uninformed bidder and the target
corporation. The model is highly structured, and the

uninformed bidder is given a tactical advantage in the way

 

’ Nelson, R., MERGER.MOVEMENTS IN AMERICAN INDUSTRY
1895-1955 (1959); Reid, S. R., MERGERS, MANAGERS AND THE
ECONOMY (1958).

3 Mueller. 0. C-. The_EffeCtS_9f_§98919merate_nerssr§.
J. OF BANKING AND FINANCE 1, 315-347 (1977).

‘ R. Roll,
Iekeeyeze, J. OP BUSINESS 59, 197-215 (1985).

5 R. Giammarino and R. Heinkel,
Tekeeyer_§eneyier, J. OF FINANCE 41, 465-480 (1986).

130
in which the bidding is structured. Under the Bayesian-Nash
equilibrium all actions are optimal, and all bidders and the
target managers correctly anticipate the strategies of the
other participants. The model generates two distinctive
equilibria resulting from different assumptions about the
uninformed bidder's behavior. The first assumption is that
the uninformed bidder will not present a counter offer when
expected payoffs from not bidding and bidding are equal.
This is the passive competition case. In this case, the
informed bidder may acquire the target corporation for less
than its synergistic value. In the second case, the white
knight scenario, the uninformed bidder is assumed always to
counterbid. A counter bid gives the target corporation a
higher price at the expense of the informed bidder.

The Giammarino and Heinkel model gives the target
corporation's management a rational basis for rejecting the
informed bidder's offer in the hope of getting a higher
counterbid from the uninformed bidder. It also accounts for
overbidding by the uninformed bidder and loss of the offer
if the informed bidder's offer is rejected and a counterbid
is not forthcoming, both as a result of asymmetric
information.

Hirshleifer and Png‘ formulated a model with two

bidders for the target corporation. They assume that

 

‘ D. Hirshleifer and I. P. L. Png, MW
, REV. OF

FINANCIAL STUDIES 2, 587-606 (1989).

131

bidding is costly whereas earlier models assume it was
costlessX’ The objective of the target management is to
maximize shareholder value of the stock which implies that
target managers would accept the bid if it exceeds the value
of the target corporation's cash flows without the merger.
The first bidder investigates and formulates a value for the
target corporation. The second bidder is alerted by the
first bidder's offer. Second bidder must then decide
whether to investigate or not and then based on that
investigation whether or not to bid. Second bidder
investigates only if its expected return from investigation
is strictly positive. Bidding is structured in two
different ways. The first model is a single bid model.
Each bidder may only bid once. Alternatively, in the second
model a competing bid may be revised.

Contrary to earlier assumptions' that competitive
bidding for a target corporation always resulted in a higher
price than a single bid, Hirshleifer and Png show that if

bidding is costly, competitive bidding may result in a lower

 

7 Egg. e,g,, A. Shleifer and R. Vishny. fizsfinndili
. , RAND J. OF

ECONOMICS 17, 293-309 (1986); M. Fishman,
, RAND J. OF ECONOMICS 19, 88-101

(1988).

' 5991.9191. L- Bebchuk. The_case_fgr_£acilitatin9
, 95 HARV. L. REV. 1028-1056 (1982);

F. Easterbrook and D. Fischel, Ihe_£repez_fiele_ef_1egge§Le
Eana9ement_in_BeSD9ndin9_t9_a_Tender_foer. 94 HARv. L- REV-
1161-1204 (1981); R- Gilson. A_§tructnral_beereash_te

eyes .» e.:° g‘ 2.-- i" ,; 0' ‘Q: L . ; , 71e-

Qfifignfi, 33 STAN. L. REV. 819-891 (1981).

132
price than from a single deterring bid. under the
Hirshleifer and Png model, the Delaware Supreme Court's
requirement for an auction in a Revlon type situation may
actually be detrimental to the target corporation
shareholders.

Target corporation management may affect the outcome by
the degree to which it is willing to disclose information to
one or the other or both bidders thereby reducing
investigation coSts. This has the unfortunate effect of
lowering the expected price offered for the target
corporation and decreasing social welfare.’ Under the
Hirshleifer and Png model target managers should not
disclose the updated estimates of a and b since this would
decrease the price offered.

Shleifer and Vishny‘0 look at the role of a large
shareholder in corporate control. If the shareholders are
atomistic, it may not pay any one of them to monitor the
performance of the target corporation's management.

However, it may be beneficial for a large shareholder to

 

’ Hirshleifer and Png show that the expected price of
the target corporation and social welfare increase with the
cost of investigation. Conversely, they show that the effect
of reducing the cost of investigation is a reduction in the
expected price of the target and a reduction in social
welfare. Social welfare is defined as the expected
valuation of the acquiring bidder minus the second bidder's
cost of investigation minus the bidding costs of both
bidders. Social welfare increases (decreases) as the cost
of investigation increases (decreases).

m A. Shleifer and R. Vishny,
, J. OF POLITICAL ECONOMY 94, 461-488
(1986). -

133
assume a monitoring role. Shleifer and Vishny assume that
management is inefficient to the detriment of its
shareholders. If the large shareholder discovers
inefficiency and can improve the value of the corporation,
the large shareholder's return on his Or her shares makes up
for costs incurred in monitoring and takeover. The bid that
the large shareholder makes is a function of the number of
shares held by the large shareholder. The larger the
holding the smaller the bid premium but the larger the
increase in the value of the firm. If the large shareholder
can buy anonymously before the takeover bid, he or she can
deprive minority shareholders of any gain from the takeover.
This has ramifications for disclosure under section 13(d) of
the Securities Exchange Act of 1934 which restricts the
ability of a large shareholder to buy anonymously.

While the motives for conglomerate merger are still
largely unknown, one hypothesis is that diversification
reduces product line or industry risk.u The merged firms
have a reduced risk of default which is referred to as the
”co-insurance effect." The implication is that a reduction
in risk should increase the value of the bonds at the
expense of the stockholders. Of course, in a perfect

capital market, diversification through conglomerate merger

 

“ Kim, E. and J. McConnell,
, J. OF FINANCE 32, 349-363

W
(1977): Anihud. Y. and 8- 1.9V. mm
WW3. BELL J. OF

ECONOMICS 12, 605-617 (1981).

134
is unnecessary since shareholders can achieve their own
degree of risk through portfolio diversification. Weston,
Smith, and Shrievesn rejected diversification in a risk
reducing sense because they found betas of the merged firms
nearly twice as high as the comparable mutual funds. They
concluded that conglomerate mergers may reduce product line
risk but increase general economic risk. On the other hand,
Kim and McConnell” concluded that there was a co-insurance
effect but that it was offset by increased use of debt
financing. Their findings are consistent with the
assumption that managers act in the best interests of the
shareholders, at least where there is a conflict between
shareholders and bondholders. Amihud and Lev“ hypothesize
that managers engage in conglomerate mergers to diversify
their employment risk since human capital is not divisible.
The implication is that managers are not acting in the best
interests of either the shareholders or the corporation but
in their own. This type of activity is more likely to occur
in manager-controlled firms rather than owner controlled

firms.

 

" Weston, J. F., K.
e!e .I‘ ' ‘ '- equg, 1.: '0 ‘g; .e . ::; 2‘ ’0

Model, REVIEW OF ECONOMICS AND STATISTICS 54, 357-353
(1972).

V. Smith, and R. E. Shrieves,

” Kin. E- and J- Hcconnell. 9eznsrats_nergers_end_the

Q9:inSuranse_9f_§9rnerate_neht. J. OF FINANCE 32. 349-353
(1977).

“ Amihud. Y- and 3- Lev. Bisk_nednctign_as_a
, BELL J. OF

ECONOMICS 12, 505-517 (1981).

135

Jensen's free cash flow theory” has some relevance
here since one of the empirical implications of the
hypothesis is that acquiring corporations should have free
cash flow or excess debt capacity. Jensen asserts that
managers have incentives to cause their firms to expand
beyond their optimal sizes. Such firms generate large
amounts of free cash flow. Free cash flow is cash flow in
excess of that needed to fund all positive net present value
projects. Rather than pay oUt the free cash flow to
shareholders, managers seek other alternatives, one of which
is merger or takeover. Jensen argues that his free cash
flow theory predicts that such mergers and takeovers are
more likely to destroy rather than create value because
managers will undertake low or negative benefit mergers or
takeovers just to expend free cash flow rather than create
value. This is not the case in the model used in this
dissertation. The problem here is that target managers are
not funding positive net present value projects and thereby
not maximizing the value of the corporation. Under these
circumstances a merger or tender offer should create value
rather than destroy it.

A. Financial Aspects

A corporation that does not maximize its value by not

investing in positive net present value projects may become

 

” H- Jensen. A9snGY_Q9sIs_9f_II:§.QB§E.£1921_99r99rete

, AEA PAPERS AND PROCEEDINGS 75, 323-
329 (1985).

136
a takeover target or could seek out slack rich corporations
as suitors to finance projects without issuing equity
securities.

A merger or tender offer by a slack rich corporation is
assumed to be an all cash transaction so that evaluation of
its securities is not an issue. Further, the slack poor
corporation has not announced any issue-invest decision
regarding the project. The same notation used in the
general model described in Chapter I is used throughout.

In this model, it is assumed that target shareholders
are atomistic although for purposes of target management
acting in the best interest of the its shareholders, the
existence of a large shareholder does not alter the result.
In a contest for corporate control where the large
shareholder is a bidder there may be an effect if the large
shareholder has an information advantage. Here it is
assumed that no shareholder has an information advantage
over any other. The asymmetry of information is between
target management which has the information advantage and
its shareholders and the market.

First, consider an aggressive, slack rich corporation
seeking takeover targets. The assumption of asymmetric
information is maintained in that managers of the target,
slack poor corporation have inside infOrmation about their
corporation that the slack rich, acquiring corporation
managers do not have. This is the opposite information

asymmetry utilized by Giammarino and Heinkel in their 1986

137
paper and Hirshleifer and Png in their 1989 paper.“ They
assume that an informed bidder has an information advantage
over both an uninformed bidder and the target corporation
management. Here both sets of managers, acquiring and
target, know the distributions of A and 8. Only the slack
poor, target corporation managers know the updated estimates
of a and b.

The slack rich, acquiring corporation could acquire the
slack poor, target corporation and sell off its component
parts or continue the target's operations by financing the
positive net present value project.

First, the asset in place may be sold after
acquisition. Under Revlon if the cash poor target
corporation is to be put on the auction block and its assets
sold, the target management is under an obligation to
maximize its shareholders' value. Managers know the updated
estimate, a; hence, they must get at least S+a in the
transaction to fulfill their fiduciary duty to the
shareholders. The acquiring corporation will only be
willing to offer S+A in the absence of inside information.

A holdout or opposition by the target corporation managers
could be interpreted as a signal that the updated estimated

value of a exceeds A. It would be in the best interests of

 

“ R. Giammarino and R. Heinkel,
Inkeeyer_neneyier, J. OF FINANCE 41, 465-480 (1986); D.
Hirshleifer and I. P. L. Png, '
, REV. OF FINANCIAL
STUDIES 2, 587-606 (1989).

138
the shareholders of the target corporation, however, for its
management to hold out for a higher value thereby sending a
false signal concerning the true values of a. If the
acquiring corporation believed the false signal and paid an
amount greater than S+a for the target corporation, the
shareholders of the slack poor, target corporation would
benefit at the expense of the shareholders of the slack
rich, acquiring corporation.

Second, a slack rich corporation, one with slack in
excess of its needs or opportunities, can acquire one or
more slack poor corporations with unfinanced positive net
present value projects. Assuming sufficient slack to
internally finance the projects such an acquisition would
create value and support the notion that the merged
corporations have a synergistic value greater than the sum

of the parts."

 

n This would be true if the managers of the acquiring
corporation accurately assessed the value of the target
corporation. The empirical studies attempting to measure
synergy produce mixed results. £321.3191. P. Halpern,

.HIIe Eli . e 9‘ '10.! 2!. I e_ e! e ;_ !:
§e_gempeniee_1n_yeggeze, J. OF BUSINESS 46, 554-575 (1973)
and P. Dodd and R- Ruback W
An_Eepirieel_Anelyeie, J. OF FINANCIAL ECONOMICS 5, 351- 373
(1977) supporting the synergy theory. On the other hand,
Jensen's free cash flow theory predicates that mergers and
takeovers are likely to destroy rather than create value.
Jensen’s theory asserts that managers spend cash on value
destroying mergers rather than distribute that cash to
shareholders. M. Jensen,

WW: AEA PAPERS AND PROCE-INGS
76, 323-329 (1986). However, this is not the case here.

The target corporation has untapped value in the positive
net present value project. A more troublesome problem is
presented by Roll's hubris hypothesis. Roll asserts that
managers are over-optimistic in evaluating target

139

Maintaining the assumption of asymmetric information
requires that the acquiring corporation know the
distributions of A and B but not the updated estimated
values a and b. The offer for the target cash poor
corporation would be less than or equal to S+A+B but greater
than the market value of the stock. Such an offer would ex
ante make the shareholders of both corporations better off.
The target corporation shareholders are better off because
the market value of their stock is discounted to less than

S+A+B because of the unfinanced positive net present value
project and incomplete information. Moreover, the target
corporation shareholders are better off if the offer exceeds
S+a. In the absence of the merger, the value of the target
corporation is the sum of the slack plus the value of the
asset in place, (S+a), since the positive net present value
project will be not be undertaken. Any offer in the
aggregate in excess of S+a increases the value of the target
shareholders' claim. Acquiring, slack rich corporation
shareholders are better off because they get all or part of
the unrealized value of the unfinanced positive net present
value project. Such an offer would be acceptable under
Delaware law as set out in Time and the corporate

constituency statutes.

 

corporations and over-pay. R. Roll,

e:_ge;pere;e_1ekeeyeze, J. OF BUSINESS 59,197-216 (1986).
For an empirical study showing no synergistic value, eee, T.
unset-R9. MW

 

FINANCIAL ECONOMICS 6, '365-383 (1978).

140

- Managers know the updated estimates a and b; hence,
they must get at least S+a+b in the transaction to fulfill
their fiduciary duty to the corporation. Rational acquiring
corporation managers should only be willing to offer S+A+B
in the absence of inside information.“. A holdout or
opposition by the target corporation managers could be
interpreted as a signal that the updated estimated values of
a and b exceed A and B. It would be in the best interests
of the shareholders of the target corporation, however, for
its management to hold out for a higher value thereby
sending a false signal concerning the true values of a and
b. If the acquiring corporation believed the false signal
and paid an amount greater than S+a+b for the target
corporation, the shareholders of the slack poor, target
corporation would benefit at the expense of the shareholders
of the slack rich, acquiring corporation. Jennings and
Mazzeo” found that target management resistance increased
the likelihood of a revision of the acquiring corporation's
offer benefiting the target.

It may be that the updated estimates of a and b are

less than A and B. In this case in a non-negotiated merger,

 

" Jennings and Mazzeo show, however, that bidders
revise offers in favor of the target even in the face of
adverse market reaction to the announcement. R. Jennings
and M. Mazzeo, ' ° '
'.!J' .. ° ' ‘

x ! -'.' l - '_
139-153 (1991).
" R- Jennings and H- Hausa. W

I 1 . - _ - - - I --
0-40 .101- - '! .9907! —_'1-!— -1’ 13019:" ! - .--°°I--,

J. OF BUSINESS 64, 139-163 (1991).

—;, J. OF BUSINESS 64,

   

141
the target corporation's managers need not Oppose the merger
to fulfill their fiduciary duty. However, if the acquiring
corporation managers observe that the target corporation
managers are not opposing the merger, they may take that
action as a signal that they overbid for the target
corporation and back out, if possible.'0 Therefore, even if
a<A and b<§, target corporation managers should holdout or
oppose the merger in the best interests of the slack poor,
target corporation shareholders.

The best strategy for the managers of a target
corporation always is to holdout or oppose the merger.21
Easterbrook and Fischeln argued that managers of target
corporations should be bound by a "rule of managerial
passivity" that would prohibit target managers from
soliciting a competing bid or opposing a takeover. The law,
however, is to the contrary, a fact they recognized by

 

” Proposed acquisitions may fail for a host of
reasons such as a lack of response or resistance by the
target or the occurrence of a condition precedent which
terminates the proposal. Jennings and Mazzeo studied 472
proposed acquisitions between June 1, 1979 and December 31,
1987. A total of 121 or approximately one-quarter of these
proposed acquisitions were cancelled. Forty-seven were
cancelled by the acquiring corporation alone. 19- at 161.

u G. Jarrell and M. Bradley,
FedeIal_and_SIAte_Begnlat19n_9f_§ash_zendsr. J. OF LAW AND
ECONOMICS 23, 371-407 (1980) concluding that the effect of
federal and state regulation is to raise the price bid for
the target corporation.

n F. Easterbrook and D. Fischel, Ibe_2:epez_aele_ef_e

 

HARV. L. REV. 1151-1204 (1981).

142
calling for the repeal of the Williams Act.” Developments
in state corporation law have encouraged target opposition
to takeover bids.” State takeover statutes tend to be
paternalistic by protecting local businesses. State
legislatures assume that local incumbent managers' interests
are identical with the statefs public policy.” This
introduces an element of agency costs associated with
managers seeking to preserve their own positions.
Consequently, their action cannot be used as a signal to the
acquiring corporation managers concerning the true value of
the target corporation (S+a+b). Target corporation
shareholders are not harmed since their stock is discounted
in the market because of the asymmetric information and
unfinanced positive net present value project to less than
S+A+B which is the maximum offer the acquiring corporation
should make without inside information. Any merger offer
amount between the discounted market Value of the target
corporation stock and S+A+B inures to the benefit of the
target corporation shareholders. Further, any offer greater
than S+a, the value of the firm without investment in the
project, increases the value of the target shareholders'

claim and should be accepted.

 

” 15 U.S.C. ss 78n(d), 78m(e), 78n(d), and 78n(e) and
78n(f) (1988).

” §ee_1n1:e notes 113-124 and accompanying text.

)” See‘_eege, Icahn v. Blunt, 512 F.Supp. 1400 (W.D.Mo.
1985 .

143

A slack poor corporation may aggressively seek a merger
with a slack rich corporation. This action may be
interpreted as a signal that the slack poor corporation has
an unfinanced, positive net present value project and is
seeking outside financing for that project through a merger.
Without the investment, the true value of the slack poor
corporation is S+a; however, the market value of the slack
poor corporation is less than or equal to S+A+B. By seeking
the merger, the slack poor corporation could be signalling
that S+a+b>S+A+B. The problem is that the managers of the
slack poor corporation have an incentive to lie.

Assume that S+a+b<S+A+B and that only the managers of
the slack poor corporation know the updated estimates of a
and b, the slack poor corporation managers would seek a
merger in which they would be willing to accept any amount
between S+a and S+A+B where S+a<S+a+b<S+A+B. The medium of
exchange has an effect. Jensen's free cash flow theory
predicts that takeovers financed with Cash and debt create
greater benefits than those financed through the exchange of
stock.” Empirical evidence shows that the market reacts

more favorably to cash Offers than to stock exchanges.” In

 

” M. Jensen,
, AEA PAPERS AND PROCEEDINGS 76, 323-

329 (1985).

” P. Asquith, R. Bruner, D. Mullins, W

and_the_zerm_9f_£inansin9. unpublished Ianuscript-
Cambridge, Mass.: Harvard University; Y. Huang and R.

Walkling,

 

Menagez131_3e§ie§enee J. OF FINANCIAL ECONOMICS 19, 329-349

144
an exchange of stock, target shareholders are at risk on the
downside if the acquiring corporation managers overbid;
however, if there is synergy from the merger, target
shareholders will benefit at the expense of the acquiring
corporation shareholders. The shareholders of the slack
poor corporation would benefit at the expense of the
shareholders of the slack rich corporation for any cash
offer greater than S+a+b. Indeed, it may be assumed that
the more aggressive the managers of the slack poor
corporation are in seeking a merger the less the true value,
S+a+b, is. Because no meaningful or useful signal is given
by slack poor corporation managers' actions in seeking a
merger, without inside information slack rich corporation
managers should never offer more than S+A+B cash in a
merger; nonetheless, S+A+B may be an overbid if the value of
the stock is overpriced as in the case S+a+b<S+A+B. Given
the tendency of acquirors to overbid, a stock exchange
benefits their shareholders. -

The minimum acceptable offer from the viewpoint of the
slack poor corporation's shareholders is S+a. Rational
slack poor corporation shareholders should reject any offer
less than S+a. A merger offer is only acceptable to the
slack rich corporation if the offer price is between the

market price of the slack poor corporation's stock and

 

(1987); N. Travlos,
' , J. OF FINANCE 42,
943-964 (1987).

145

S+A+B and if the stock is undervalued (S+a+b>market price).
A merger is acceptable to both parties only if

(1) S+a+sz+A+Bzoffer pricezs+a2market price, or
(2) S+A+st+a+b2offer pricezs+azmarket price, or
(3) S+a+bzs+A+82offer pricezmarket pricezs+a, or
(4) S+A+st+a+bzoffer pricezmarket pricezs+a.

The proposed merger will fail in all other cases. Since the
updated estimates a and b are only known to the slack poor
corporation managers, the only concluSion that the slack
rich corporation managers can reach from the slack poor
corporation's acceptance of the offer is that the offer
price is greater than S+a. They know S+A+B but not S+a+b.
The relative position of the offer price vis a vis S+a+b is
unknown to the managers of the slack rich corporation.
Certainly, the merger is unacceptable to them if the offer
price exceeds S+a+b. A cautious management of a slack rich
corporation would not enter into any particular merger with
a slack poor corporation, although on average it would be
beneficial.

Myers and Majluf (1984) show that in a merger situation
where the slack rich corporation offers an amount less than
or equal to S+A+B, the slack poor corporation is better off
issuing equity and investing in the positive net present

146
value project itself.” However, it will not do so if the
value of the corporation without investment is greater than
the old shareholders’ aliquot share of the corporation with
investment. The slack poor corporation would only accept
the merger terms if the offer price exceeded S+A+B, but
without inside information, the slack rich corporation
should never offer more than-S+A+B. Under these conditions
no merger would take place. Mergers do take place.
Ironically, one of the key takeover indicators making a
corporation particularly vulnerable to a takeover is the
type of management-stockholder structure described by Myers
and Majluf in their 1984 paper.” Either slack rich
acquiring corporations obtain inside information from the
slack poor corporation's managers and S+a+b>S+A+B, or they
foolishly offer more than S+A+B which is not acceptable if

managers are rational, or slack poor corporation managers

 

” The proof is as follows: Define a*(N') as the
breakeven value of a, the value at which the slack poor firm
is just indifferent to being acquired at the equilibrium
price 0'. Note that Q'-a*(N')+S. Recall that the
requirement for a corporation to issue stock is
(E/P)(S+a)SE+b. If P were equal to Q', the corporation would
issue and invest in a*(N') for any b>0. That is,
P=Q'=S+a*(N'),

(E/P)(S+a)-[E/(S+a*(N'))](S+a*(N'))=E<E+b.
Thus a*(M'), the breakeven value of a at which the firm is
just willing to issue stock, exceeds a*(N') for any b>0.
Thus,
A(M’)+B(M')>A(N’)+B(N') and P>Q'.

” R- Troubh. Charasteristiss_ef_Target_£9mnanies. 32
BUS. LAW. 1301 (1977).

147

accept terms less than S+A+B, particularly if S+a+b<S+A+B,
that is, managers are not necessarily acting exclusively in
the best interest of their shareholders.

This problem may be circumvented by a cash tender offer
to the slack poor corporation's shareholders. Typically,
the value of the consideration offered to the target
shareholders exceeds the market value of the stock as a
premium to obtain control. In the model used here, the
consideration is in an amount between the market price and
S+A+B. This strategy may succeed because neither party has
inside information. A cash tender offer for the slack poor
corporation's stock would not convey any bad news to the
market or to the slack poor corporation's shareholders since
it would not be based on inside information concerning the
updated estimated values of a and b which are only known to
the slack poor target corporation's management.

Target shareholders wishing to tender their shares do
so by forwarding their stock to the tender offeror's agent,
usually a depository bank. The tender offer must be left
open for at least twenty days which may be extended.30
Commonly, the tender offer is conditional on the occurrence
of certain events, such as tender of all or stated part or
percentage of the target shares, a favorable antitrust
ruling, or the tender offeror's ability to obtain financing.

The advantages of a tender offer are that it is

 

3° 17 C.F.R. s 240.14e-1 (1991).

148
generally cheaper than a proxy fight as a non-negotiated
takeover; if not successful, the tender offeror still has
its investment in the acquired target stock and may be able
to dispose of it at a profit;” a tender offer is faster;
and secrecy is easier to maintain. Tender offers often are
followed by mergers unless prohibited by the state takeover
statutes32 which impose post-acquisition restrictions on
business combinations.

Tender offers may be used to cirCUmvent target
management in a hostile takeover situation. Hirshleifer and
Titman” construct a model for hostile takeovers. In their
model, unlike the model employed here, there is one
potential acquiror who is a minority shareholder of the
target corporation. All other shareholders are atOmistic.
The potential acquiror has only one opportunity to bid. If
the offer is rejected, the potential acquiror loses the
synergistic value. Hirshleifer and Titman show that the
optimal bid is a strictly increasing function of the

improvement in value resulting from the takeover which is

 

” There is evidence that positive, cumulative abnormal
returns persist for approximately two years after a failed
takeover bid thus providing the basis for a gain. M.

Bradley. A- Desai. and B. Kin. The_BaLienale_Behind
InIsIfirm_TendEI_Qffera1_.1n19rmat19n_9r_§Ynergxz
FINANCIAL ECONOMICS 11, 183-206 (1983).

. OF

” fieeL text regarding state takeovers statutes in Part
B-3. infra-

” D. Hirshleifer and S. Titman, Shere_1endering

   

;_ :0 -- I". _g- --- e .e- _
POLITICAL ECONOMY 98, 295-324 (1990).

149

rational since the greater the potential gain, the more the
potential acquiror is willing to bid. This results in a
separating outcome in that the bidders reveal the level of
improvement through their bids. Low improvement value
results in a low bid while a high improvement value results
in a high bid. What the potential bidder does not know is
the price at which the atomistic shareholders will tender
due to personal costs and benefits of tendering not known to
the bidder. The asymmetry of information is between the
large shareholder and the atomistic shareholders of the same
target corporation. Hirshleifer and Titman imply that a
reduction in the degree of asymmetry of information between
the large shareholder and the others increases the
probability of success. Such is not the case in the model
used in this dissertation since there is no difference in
the degree of asymmetry of information. Each is ignorant of
the true or updated estimated values of a and b. The
Hirshleifer and Titman results only obtain if the potential
acquiror, the large shareholder, has superior information.

The Hirshleifer and Titman model also shows that for a
tender offer to be profitable, dilution of the minority
holdings is not necessary as Grossman and Hart“ modelled.

Rejection of a bidis costly to the bidder who loses
both the improvement value and costs incurred in

 

” 8- Grossnan and 0- Hart. Takegxer_nidsi_the_zree

 

ECONOMICS 11, 42-54 (1980).

150
investigation and bidding. Rejection also allows target
management time to react and organize to oppose the hostile
takeover. Hirshleifer and Titman examine management
defensive actions of "poison pill' and "sale of the crown
jewels" and litigation. In such cases, the likelihood of
failure increases.

A major problem for a potential acquiror who holds a
minority of the shares and attempts a hostile takeover is a
control-share statute such as the one enacted in Indiana.”
Indiana's control-share statute withstood scrutiny by the
United States Supreme Court in CTS corporation v. Dynamics
COrporation of America.“ More than one-half of the states
have enacted some form of control-share statute modelled
after the Indiana statute. The purpose of a control-share
statute is keep the acquiror from exercising the voting
power of the acquired stock thereby rendering the acquiror
powerless to make the changes necessary to reap improvement
value. Whenever an entity acquires control as defined in
the statute (any of three possible levels: 20 percent, 33-
1/3 percent, or more than 50 percent) it is not necessarily
entitled to vote those control shares. To be able to vote
the control shares, a resolution must be passed by a
majority of disinterested shares of each class entitled to

vote on the resolution. Disinterested shareholders are

 

” Ind. Code 55 23-1-42-1 e;_§ege

“ 481 U.S. 59 (1987).

151
those other than the acquiror and officers and inside
directors of the acquired corporation. The effect is to
condition control of the corporation on the approval of a
majority of the old, disinterested shareholders of the
target corporation.

In the model used in this dissertation, the managers of
the slack poor corporation may oppose the cash tender offer
and advise their shareholders to reject the offer and
holdout for a higher amount possibly greater than S+A+B.
Without inside information concerning the updated estimated
values of a and b, the slack rich firm should never offer
more than S+A+B. Ex ante both the slack poor corporation's
shareholders and the slack rich corporation would be better
off if an offer between the market price and S+A+B were
accepted. However, the sharcholders Of the slack poor
corporation may be misled by their managers as to the true
value of the corporation and refuse to tender. Ultimately,
the shareholders must make their own decision regarding the
sufficiency of the offer. Management that breaches its duty
by intentionally inflating the value of the slack poor
corporation and misleading its shareholders may be guilty of
violating Section 10b37 and Rule lob-5” of the Securities
Exchange Act of 1934 and the Williams Act.

B. Legal Aspects

 

” 15 U.S.C. s 78j(b) (1988).

” 17 C.F.R. s 240.10b-5 (1991).

152
1. General Antifraud
a. Federal

The antifraud provisions of the federal securities laws
apply to securities whether they are exempt from
registration or not or whether they are transactionally
exempt or not. Consequently, the antifraud provisions apply
to the model under consideration under all circumstances.
The primary antifraud provisions are section 17” of the
Securities Act of 1933, section 10(b) of the Securities
Exchange Act of 1934, and section 206‘0 of the Investment
Advisers Act of 1940.

Section 10 is the catchall provision of the Securities
Exchange Act of 1934. Its purpose is to provide relief from
abuses not otherwise addressed in the act. However, section
10 is not a self-executing provision. It is only effective
through rules and regulations promulgated by the commission
pursuant to the authority of section 10 to make such rules
as are necessary or appropriate in the public interest or
for the protection of investors. In 1942, rule 10b-5 was
issued by the commission.“ Interestingly, rule 10b-5 is
merely modified language of section 17(a) of the Securities
Act of 1933; the principal modification is that section

17(a) only applies to sales of securities whereas section 10

 

” 15 U.S.C. s 77g (1988).
w 15 U.S.C. s 80b-6 (1988).

“ SEC Securities Exchange Act Release No. 3230 (May
21, 1942). r . ,

153
applies to a purchase or sale.
Rule lob-5 provides that

It shall be unlawful for any person, directly or
indirectly, by the use of any means or
instrumentality of interstate commerce, or of the
mails, or of any facility of any national
securities exchange,

(1) to employ any device, scheme, or artifice to
defraud,

(2) to make any untrue statement of a material
fact or to omit to state a material fact necessary
in order to make the statements made, in the light
of the circumstances under which they were made,
not misleading, or

(3) to engage in any act, practice, or course of
business which operates or would operate as a
fraud or deceit upon any person,

in connection with the purchase or sale of any
security.

Section 10 and rule lob-5 are stated as prohibitions
and give rise to administrative proceedings,‘2 suits for
injunction by the commission,“ and criminal actions“
referred to the Justice Department for prosecution.
However, it was established as early as 1946 that there was
an implied civil cause of action for damages in behalf of
the defrauded victim.“

The elements of a cause of action under rule 10b-5 are

(1) use of the mails, an instrumentality of interstate

 

a Sections 21 and 21A, Securities Exchange Act of
1934, 15 U.S.C. SS 78“ and 78u-1 (1988).

° Section 20(d), Securities Exchange Act of 1934, 15
U.S.C. s 78t(d) (1988).

“ Section 32, Securities Exchange Act of 1934, 15
U.S.C. S 78ff (1988).

“ Kardon v. National Gypsum Co., 69 F.Supp 512
(E.D.Pa. 1946). This holding was affirmed in Basic, Inc. v.
Levinson, 485 U.S. 224 (1985).

154

commerce, or any facility of a national securities exchange;
(2) a purchase or sale of a security; (3) fraud or deceit or
a misstatement or omission of a material fact; (4) scienter;
(5) causation; (6) reliance; and (7) damages in a civil
action. A private cause of action must be brought by a
purchaser or seller.“ This requirement is strictly
applied. A merger entails a purchase and sale of a
security."

Two of the three clauses of rule lob-5 deal with fraud
or deceit. Fraud does not include overreaching by a
controlling shareholder unless it is accompanied by actual
deception.“ A cause of action for fraud under rule lob-5
is similar to common law fraud in that there must be a
relationship between the parties which gives rise to a duty
that is violated. In insider trading cases, the insider by
virtue of his or her position gains access to information
intended for corporate purposes and not personal benefit.”
The corresponding duty is to abstain from the marketplace

 

“ Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723
(1975); Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d
Cir. 1952).

” SEC v. National Securities, 393 U.S. 453 (1959).

“ Santa Fe Industries, Inc. v. Green, 430 U.S. 462
(1977).

” Chiarella v. U.S., 445 U.S. 222 (1980); In the
Matter of Cady, Roberts 8 Co., 40 S.E.C. 907 (1961).

155

until the information is made public.’0 The insider must
not take unfair advantage of information unknown to persons
with whom the insider is dealing. In many instances the
courts are not clear as to which clause of rule 10b-5 the
court is applying, particularly in insider trading cases.

Clause 2 of rule 10b-5 deals with misstatements and
omissions of material facts. A fact is material if it is
the kind of information that a reasonable investor would
consider important in making his or her investment
decision.‘1 In the context of an untrue statement of a
material fact, the intentional misstatement is akin to
common law fraud. In the case of an omission of a material
fact where there is a duty to disclose, an element of
conjecture is introduced. The test of materiality then
becomes whether the reasonable investor would have acted
differently had he or she known of the undisclosed fact.’2

Since the U. 8. Supreme Court's decision in Ernst 8
Ernst v. Hochfelder,”3 scienter is a requirement of a cause
of action under section 10b and rule 10b-5. Scienter

requires an intent to deceive, manipulate, or defraud.

 

” Investors Management Co., Inc., 44 S.E.C. 633
(1971); Shapiro v. Merrill Lynch, Pierce, Fenner 8 Smith,
Inc., 495 F.2d 228 (2d Cir. 1974).

“ Basic, Inc. v. Levinson,, 485 U.S. 224 (1988).

” Affiliated Ute Citizens of Utah v. U.S., 405 U.S.
128 (1972).

” 425 U.S. 185 (1975).

156
Negligence will not support a cause of action under section
10b and rule 10b-5. The Supreme Court reserved the issue of
whether recklessness was equivalent to intentional conduct,
but virtually all lower courts hold that it is. Breach of
fiduciary duty without an allegation of deception,
misrepresentation, or deception is not actionable under rule
10b-5.“

Causation is a necessary element of a cause of action
under section 10b and rule 10b-5.“ The misrepresentation
or fraud must be the proximate cause of plaintiff's loss.

If the misrepresentation is of a material fact on which
plaintiff relied but is not the reasonable direct cause of
the pecuniary loss, no recovery is allowed.

In fraud cases and cases involving affirmative
misstatements of material facts, plaintiffs must show actual
reliance.“ However, if the misleading statement
constitutes a fraud on the market, plaintiff does not have
to show reliance but only that he or she bought or sold a
security at a price that was affected by the misleading
statement.” The fraud on the market theory is based on the

 

“ Santa Fe Industries, Inc. v. Green, 430 U.S. 462
(1977).

” Affiliated Ute Citizens of Utah v. U.S., 405 U.S.
128 (1972).

“ List v. Fashion Park, Inc., 340 F.2d 457 (2d Cir.
1965). Gerti_denied. 382 U-S. 811 (1965)..Ishi_denied. 382
U.S. 933 (1955).

9 Basic, Inc. v. Levinson, 485 U.S. 224 (1988).

157

notion that the price of a security is-based on all
available material information concerning the business.
Misleading statements, therefore, affect market price.
Nondisclosure or complete omission cases present another
problem. Plaintiff would have to show that he or she would
have relied on the facts if they had been made known to him
or her, which, in effect, means that the omitted facts were
material facts.“ In a nondisclosure case, if the plaintiff
proves materiality, he or she has in fact proved reliance.”

The measure of damages in most cases is the ”out of
pocket" rule.“ The damages award is based on the
difference between what-the plaintiff gave up and the value
of what was received in the transaction. In the model used
in this dissertation, the penalty for lying is the
difference between the misrepresented value and S+a+b. In
addition to damages awarded to a private plaintiff, the
Commission may assess a civil penalty up to three times the
actual damage. No punitive damages are assessed in an
antifraud case. The potential for liability is great
especially in insider trading cases since liability extends

to all persons who traded in the market during the time that

 

” Affiliate Ute Citizens of Utah v. U.S., 406 U.S. 128
(1972).

99 m.

‘° Section 20A, Securities Exchange Act of 1934, 15
U.S.C. S 78t-1 (1988). 3331.3191. Green v. Occidental, 541
F.2d 1335 (9th Cir. 1976) (Sneed, J., concurring).

158
the inside information was undisclosed.“ However, some
courts attempt to limit the defendant's liability. For
example, the sixth circuit requires “trading causation"
between plaintiff's losses and defendant's trading on the
basis of the undisclosed information.“

Knowing the amount of damages that can be assessed for
violation of section 10(b) and rule 10b-5 and section 14(e),
the cost of lying can be calculated. Court costs,
attorneys' fees, and other costs are not considered. If the
managers of the slack poor firm lie and inflate the value of
the firm, the gain from lying is the difference between the
inflated value, V" and the actual or true value, V,. Based
on the inside knowledge of the updated estimates of a and b,
the actual or true value of the firm, V, equals S+a+b. The
cost of lying is the difference between the product of the
probability of being caught, p, times the gain and the
product of the probability of not being caught, (1-p), times
the gain.

Cost of LYinq - PWI- .)-(1-P) (VI- .) .
Rearranged,
Cost of Lying - (2p-1)'(V,- ,) .
It pays to lie if the Cost of Lying is negative, i.e.,
(2p-1) (v,-v,) <0.

 

“ Mitchell v. Texas Gulf Sulphur Co., 445 F.2d 90
(10th Cir. 1971).

” Fridrich v. Bradford, 429 F.2d 307 (6th Cir. 1975),
cert1_denied. 429 U.S. 1053 (1977).

159
Since (V,-V,) >0, otherwise, the lie is not beneficial, it
pays to lie if (2p-1)<0 or p<.5.

If the possibility of civil penalties, CP, under section
2A(a)(2) of the Securities Exchange Act of 1934 is added,
Cost of Lying - p[ (V,-V,)+CP]-(1-p) (v,- ,) .

Rearranged,
Cost of Lying - (2p-1) (V,-V,) +pCP<0
which must be negative for lying to pay. Consequently,
[CPI (VI'VJ ]<[ (1’2?) IP] -
Assuming the maximum civil penalty equal to three times
(VI. 1) I
[(l-ZP) IPJ>3 -
For lying to pay, p<.2. Managers must determine their
subjective assessment of the probability of being caught.
If they believe that the probability of being caught is less
than twenty percent, they will lie.

Knowing the cost of lying, the value of the firm, V,
may be calculated. The value of the firm is equal to the
false inflated value of the firm, Vfi less the cost of
lying. H

V - V, - cost of lying.
V'VI‘PI (VI’ 4) +CP]'(1‘P) (VI' 1) -
V-V,-pCP.
V-S+a+b-pCP.
The value of the firm is the actual or true value less the
probability of being caught lying times the civil penalty

imposed if caught.

160

Rule 10b-5 applies to preliminary merger negotiations
when there is either non-disclosure of a material fact when
a duty to disclose exists or a misleading material
misstatement or omission.‘3 Both sides of a negotiated
merger would probably prefer not to disclose any information
concerning the negotiations. Premature disclosure could
drive up the price of the stOck, making the merger more
expensive or cause the negotiations to be abandoned.
Disclosure, if made, could be misleading and subject the
parties to liability. On the other hand, failure to
disclose information where a duty to disclose exists is
actionable. Silence is not misleading absent a duty to
disclose. ”No comment” is the equivalent of silence.“

In Basic, Inc. v. Levinson“, the United States Supreme
Court adopted the TSC Industries, Inc. v. NOrthway, Inc.“
standard for materiality in preliminary negotiation cases.
The court went on to say that materiality may vary on a case
by case basis balancing the probability that the transaction
will be consummated and its magnitude or significance to the
issuer. The court in Basic rejected the Third Circuit's
standard set out in Greenfield v. Baublein, Inc.“ that

 

“ Basic, Inc. v. Levinson, 485 U.S. 224 (1988).

“ In re Carnation Co., [1984-85 Transfer Binder] Fed.
Sec. L. Rep. (CCH) 1 83,801, 87,595-95 (July 8, 1985).

“ 485 U.S. 224 (1988).
“ 425 U.S. 438 (1975).

“ 742 F.2d 751 (3d Cir. 1984).

161
merger discussions were not material until agreements with
respect to price and structure of the transaction had been
determined.

Section 10(b) and rule 10b-5 apply in a negotiated
merger situation. Using the slack rich-slack poor model, if
either the slack rich corporation seeks to negotiate a
merger or the slack poor corporation managers actively seek
out a slack rich corporation, the preliminary negotiations
may contain material facts that have to be disclosed to the
target corporation shareholders. Information concerning
price would be of the utmost importance to the slack poor,
target corporation shareholders and, therefore, material.
If the slack poor corporation managers distort or lie about
the updated estimates of a and b in the negotiations such
action could constitute a misstatement of a material fact
which would subject the managers of the target, slack poor
corporation to liability for violation of section 10(b) and
rule 10b-5. If the managers distort or lie about the value
of the slack poor corporation to their own shareholders in
disclosing the negotiations or in recommending approval of
the merger if a shareholder vote is required, they violate
section 10(b) and rule 10b-5. Interestingly enough, if the
directors of the slack poor corporation and all the old
shareholders are involved in the fraud on the slack rich
corporation with respect to the true value of the slack poor

corporation, the slack poor corporation could recover on the

162

basis of a plan to defraud future shareholders.“ Section
10(b) and rule 10b-5 potential liability provides an
incentive for managers of the corporations to tell the truth
about the value of the corporation, if it must be disclosed.
How effective that incentive is depends on the managers'
perception of the possibility of being subjected to such
liability.

Criminal sanctions under the Securities Exchange Act of
1934 provide an even greater incentive to tell the truth
than the criminal sanctions under the Securities Act of
1933. In 1984, Congress passed the Insider Trading
Sanctions Act (ITSA). The ITSA increased the maximum jail
term from five to ten years and increased the criminal fine
for individuals from $100,000 to $1,000,000. For non-
natural persons the fine was increased from $500,000 to
$2,500,000.

5. State

Each of the four major pieces of federal securities
regulation carefully preserves the rights of the states to
regulate securities within their respective jurisdictions.“9
As a result, all states and the District of Columbia have

 

“ Bailes v. Colonial Press, Inc., 444 F.2d 1241 (5th
Cir. 1971).

” 5231.3191. Section 28, Securities Exchange Act of
1934, 15 U.S.C. s 78bb (1988) and Section 18, Securities Act
of 1933, 15 U.S.C. S 77r (1988).

163
enacted their own "blue sky“ laws.”

The commissioners on Uniform State Laws drafted a
Uniform Securities Act" for adoption by the states in 1956
and amended it in 1958. Since 1956 more than thirty states
have adopted, in whole or in part, the Uniform Securities
Act; however, national uniformity even among the adopting
states is still lacking. Most states that adopted the act
did so with substantial changes. Over time, different state
courts have interpreted the language of the uniform act
differently. The large commercial states such as New York,
California, Texas, and Illinois have not adopted any part of
the uniform act.

As is the case with the antifraud provisions of the
federal securities law, antifraud provisions of the state
securities law represent a relaxation of the more stringent
requirements of common law fraud. The manifestation of this
proposition is contained in section 401(d) of the Uniform
Securities Act, which provides that "Fraud,’ 'deceit,’ and
'defraud,’ are not limited to common law deceit.”

The antifraud provision of the Uniform Securities Act
bears a striking resemblance to sections 12 and 17(a) of the
Securities Act of 1933 and rule 10b-5 under the Securities
Exchange Act of 1934. Section 101 of the Uniform Securities

Act provides that:

 

” So called because of the reference to "blue sky" in
Hall v. Geiger-Jones Co., 242 U.S. 539 (1917).

7' 7B U.L.A. 509 (1958).

164
It is unlawful for any person, in connection with
the offer, sale or purchase of any security,

directly or indirectly
(1) to employ any device, scheme, or artifice to

defraud,

(2) to make any untrue statement of a material

fact or to omit to state a material fact necessary

in order to make the statements made, in the light

of the circumstances under which they are made,

not misleading or,

(3) to engage in any act, practice, or course of

business which operates or would operate as a

fraud or deceit upon any person.

All of the states except New Hampshire authorize the
state authority to bring suit for injunction against
fraudulent conduct in the sale of a security, and most
states extend that power to the purchase of a security.

The Uniform Securities Act provides only for a cause of
action by a defrauded purchaser against his or her seller
and makes no provision for a cause of action by a defrauded
seller against his purchaser. This rule is adopted by a
majority of the states. In a merger, the cause of action
would be by the purchaser (slack rich corporation) against
the seller (slack poor corporation). New York and Rhode
Island make no provision for a private cause of action;
however, in New York a private civil cause of action may be
implied.

The elements of a cause of action for fraud under state
securities law are essentially the same as under federal
securities law; however, there are some important
differences. The scienter requirement, which has played an

important role in the development of federal rule 10b-5, is
treated quite differently under state law. The scienter

165
requirement exists as an element of a civil action, but the
burden of proof is shifted from the defrauded purchaser to
the seller to prove that the seller was unaware of any
misrepresentation or omission of material facts and in the
exercise of reasonable care could not have known of any.
The reasonable care standard means that negligence is
sufficient scienter.

Common law reliance is not required as an element of a
civil fraud case under state law; howeVer, the buyer must
show that he or she did not know of the untruths or an
omission to recover. Purchaser's reliance generally must be
reasonable, but some states allow a purchaser to accept the
statements made at face value and rely on them.

Generally, materiality is the same under both federal
and state securities law, utilising the reasonable person
test that the representation be one which the reasonable
person would take into consideration or attach importance to
in determining his or her course of action.

The express civil cause of action in most states is
granted to the purchaser as against his or her seller.
Remedies granted to a successful plaintiff are rescission of
the sale or suit for damages if he or she no longer owns the
securities. The Uniform Securities Act and state securities
laws require privity of contract between the purchaser and
seller. The antifraud provisions of state securities law
are more in the nature of the express civil liability

provision of section 12 of the Securities Act of 1933 rather

166
than section 17(a) of that aCt or section 10(b) and rule
10b-5 of the Securities Exchange Act of 1934, which support
a civil cause of action by any person whether in privity of
contract or not. Since section 410(h) of the Uniform
Securities Act provides that no cause of action not
specified therein may be created, a parallel development of
implied civil causes of action for damages to rule 10b-5 is
foreclosed.

State securities regulation adds an extra incentive to
tell the truth although not as powerful as the federal
securities laws.

2. Tender Offers and the Williams Act”

Mergers and sales of all the assets require action by
the board of directors of the target corporation. A hostile
board of directors generally means instant doom to the
merger or sale. A direct confrontation with a hostile board
of directors may be avoided by dealing directly with the
shareholders of the target corporation by offering to buy
their stock for cash, property, or other stock in a tender
offer.

At first blush, the definition of a tender offer seems
straight forward. The problem is whether the "tender offer"
is subject to the Williams Act. The term ”tender offer” is
not defined in the statutes, and the Securities and Exchange

Commission has refused to define the term for fear that the

 

” 15 U.S.C. ss 78m(d), 78m(e), 78n(d), 78n(e), and
78n(f) (1988).

.167
definition would be too restrictive and provide lawyers with
a weapon to avoid regulation. The SEC has promulgated a
list of eight factors to aid in the analysis, but some
courts have expressed concern as to whether the factors were
"either a permissible or a desirable interpretation of the
statute.“3 The SEC position, although not adopted, is set
out in Exchange Act Release No. 16,385 as Proposed Rule 14d-
1(b)(l)”.

The term "tender offer“ includes a ”request or
invitation for tenders“ and means one or more
offers to purchase or solicitations of offers to
sell securities of a single class, whether or not
all or any portion of the securities sought are
purchased, which (A) During any 4'5-day period, are
directed to more than 10 persons and seek the
acquisition of more than 5% of the class of
securities, except that offers by a broker (and
its customer) or by a dealer made on a national
securities exchange at the then current market or
made in the over-the-counter market at the then
current market shall be excluded if, in connection
with such offers, neither the person making the
offers nor such broker or dealer solicits, or
arranges for the solicitation of any order to sell
such securities, and such broker or dealer
performs only the customary functions of a broker
or dealer and receives no more than the broker's
usual and customary commission or the dealer's
usual and customary mark-up; or (B) Are not
otherwise a tender offer under paragraph (b)(1)(i)
of this section, but which (1) are disseminated in
a widespread manner, (2) provide for a price which
represents a premium in excess of the greater of
5% of or $2 above the current market price, and
(3) do not provide for a meaningful opportunity to
negotiate the price and terms. '-

Although the subject of many court cases, the courts

 

” Brascan, Ltd. v. Edper Equities, Ltd., 477 F.Supp.
773 (S.D.N.Y. 1979).

” 44 Fed. Reg. 70,349 (1979).

168
have yet to produce a clear, comprehensive definition of
"tender offer.” Congress understood the term to mean an
offer to buy or sell securities, or a solicitation of an
offer to sell a security thrcugh some sort of exchange of
the securities for other consideration.” A conventional
tender offer has been defined by the courts as having three
elements, a bid, a premium price, and a conditional
obligation to purchase all or a specified amount of the
tendered shares.” However, courts recognize an
unconventional tender offer as an apparent attempt to gain
control of a corporation by purchasing shares without a
formal tender offer such as open market or block purchases.
The United States Supreme Court test was articulated in
Securities 8 Exchange commission v. Ralston Purina co.”
The test is whether or not the particular class of persons
affected needs the protection of the Securities Exchange Act
of 1934, taking the totality of circumstances into
consideration. Certain transactions have been held not to
be tender offers, including a stock repurchase from a
director who was deemed incompatible by the other

 

” Hearings on S. 510 Before the Subcomm. on Sec. of
the Senate Comm. on Banking and Currency, 90th Cong., 1st
Sess. (1967).

” Kennecott Copper Corp. v. Curtiss-Wright Corp., 584
F.Zd 1195, 1206 (2d Cir. 1978).

W 345 U.S. 119 (1953).

169
directors,” a stock repurchase of a 9.9 percent voting
block as greenmail,” open market transactions at or below
the market price without active solicitations,’0 the
purchase of 42 percent of a class of securities from only
seven security holders,“ and privately negotiated purchases
from large or substantial shareholders.”

A tender offer for the stock of a publicly held
corporation is subject to the Williams Act (sections 13(d)
and (e) and 14(d), (e), and (f) of the Securities Exchange
Act of 1934). Under section 13(d), any person or group of
persons who becomes the owner of more than five percent of
any class of securities registered under section 12 of the
Securities Exchange Act of 1934 must file with the issuer of
the securities and a Schedule 13D with the Securities and
Exchange Commission a statement setting forth (1) the
background of the person or persons, (2) the source of the
funds to be used in the acquisition, (3) the purpose of the
acquisition, (4) the number of shares actually owned, and

(5) any relevant contracts, arrangements, or understandings

 

n In re General Motors.Class E Stock Buyout Securities
Litig., 594 F.Supp. 1119 (D.Del. 1988).

” Pin v. Texaco, Inc., 793 F.2d 1448 (5th Cir. 1986).

” Ludlow Corp. v. Tyco Laboratories, 529 F.Supp. 62
(D.Mass 1981).

“ Stromfield v. Great Atl. & Pac. Tea Co., 484 F.Supp
1254 (S.D.N.Y.) effiLQ, 545 F.2d 553 (25 Cir. 1980).

a University Bank 8 Trust Co. v. Gladstone, 574
F.Supp. 1006 (D.Mass 1983).

.170 .
concerning the ownership of the stock or its acquisition.
The statement must be filed within ten days of acquisition
of the required percentage of stock.

An accurate statement of the purpose of the acquisition
is important since managers' fiduciary duties shift from the
corporation to the shareholders under Revlon if the
acquiring corporation intends to sell the assets rather than
continue the target corporation's operations. Managers of
the target corporation may delay the tender offer by
alleging that the tender offeror has filed a false or
misleading Schedule 13D. A private right of action for
injunctive relief under Section 13d is recognized in many
circuits,” although no private civil cause of action for
damages is permitted.“ A tender offeror's failure to
disclose its intent such as to gain control or sell the
assets may result in injunctive relief granted to the target
corporation's management.“ The tender offeror’s past

activities in takeovers may or may not be used as evidence

 

” See‘_eege, Portsmouth Square, Inc. v. Shareholders
Protective Comm., 770 F.2d 866 (9th Cir. 1985); Gearhart
Industries v. Smith Int'l Inc., 741 F.2d 707 (5th Cir.
1984); Indiana Nat'l Corp. v. Rich, 712 F.2d 1180 (7th Cir.
1983).

“ See‘_eege, Rubin v. Posner, 701 F.Supp 1041 (D.Del
1988); Sanders v. Thrall Car Mfg. Co., 582 F.Supp 945
(S.D.N.Y.), e:fi;§_nez_enrie|, 730 F.2d 910 (2d Cir. 1984);
Schnell v. Schnall, [1981 Transfer Binder] Fed. Sec. L. Rep.
(CCH) 1 97,927 (S.D.N.Y. Mar. 30, 1981).

“ See Chromalloy American Corp. v. Sun Chem. Corp.,
611 F.2d 240 (8th Cir. 1979) and General Aircraft Corp. v.
Lampert, 555 F.2d 90 (1st Cir. 1977).

171
of intent depending on the circuit.“

under section 14(d), no person may make a tender offer
that would result in his or her owning more than five
percent of a class of securities required to be registered
under section 12 of the Securities Exchange Act of 1934
unless a Schedule 14D-1 has been filed with the commission
and a copy of which is furnished to each offeree. The
information to be contained in the statement is essentially
the same information that is required to be filed under
section 13(d).

When managers of a target corporation solicit or
recommend to their shareholders that they accept or reject a
tender offer bid they must file a Schedule 14D-9 with the
Securities and Exchange Commission." The rationale for
these disclosure requirements was aptly stated by the Second
Circuit in Chris-craft IndUstries v. Piper Aircraft carp.”

By reason of the special relationship between

them, shareholders are likely to rely heavily upon

the representations of corporate insiders when the

shareholders find themselves in the midst of a

battle for control. Corporate insiders therefore

have a special responsibility to be meticulous and
precise in their representations to shareholders.

 

“ See Dan River, Inc. v. Icahn, 701 F.2d 278 (4th Cir.
1983) (past performance not indicative of future
performance). Qentre, Trane Co. v. O'Connor Sec., 561

F.Supp. 301 (S.D.N.Y.), gppeel_gielifieed, 718 F.2d 26 (2d
Cir. 1983) (past history persuasive).

" 17 C.F.R. s 240.14d-9(a)(a) (1991).

" 480 F.2d 341, 354-55 (25 Cir.), certi_denied. 414
U.S. 910 (1973).

172
Management's position statement required by rule 14e-2
constitutes a solicitation or recommendation for purposes of
rule 14d-9. Item 4 requires disclosure of management's
position regarding the offer. If the price is stated to be
inadequate, reasons must be given to support that position.
The information in the Schedule 14D-9 is received by the
shareholders of the target corporation since in practice the
Schedule 14D-9 without attachments is used as part of the
initial communication to shareholders following the tender
offer bid.

Section 14(e) makes it unlawful for any person to
misstate or omit a material fact, or to engage in any
fraudulent, deceptive, or manipulative acts or practices, in
connection with a tender offer. While there is no specific
cause of action granted to shareholders of the target
corporation under section 14(e), the united States Supreme
Court has implied one in Piper v. Chris-craft Industries.”
Violation of section 14(e) is the most common claim asserted
by target corporation managers and shareholders. As a
result, judges are becoming skeptical and reluctant to
entertain them.’"

Standing is granted to the target corporation to bring

 

” 43o U.S. 1 (1977).

” .See‘_eege, MacFadden Holdings, Inc. v. JB
Acquisition Corp., 802 F.2d 62 (2d Cir. 1986); Data Probe
Acquisition Corp. v. Datatab, Inc., 722 F.2d 1 (2d Cir.
1983), ee;;e_genie§, 465 U.S. 1052 (1984); Diamond v. Arend,
549 F.Supp 408 (S.D.N.Y. 1985). .

173

suit for injunctive relief to prOhibit the tender offer but
not for damages;” likewise, the tender offeror does not
have standing to sue the target corporation management for
damages.” A tender offeror has standing to sue a competing
tender offeror for injunctive relief” but not for
damages.“ under section 14(e), a non-tendering target
corporation shareholder has standing to sue since the
statutory element is “in connection with a tender offer"
rather than the ”purchase or sale” of a security as under
section 10(b) and rule 10b-5.”

The elements of a cause of action under 14(e) are

similar to those required under sectiOn 10(b) and rule 10b-

 

” 5221.2191. Florida Commercial Banks, Inc. v.
Culverhouse, 772 F.2d 1513 (11th Cir. 1985); E.H.I. of
Florida, Inc. v. Insurance Co. of North America, 499 F.Supp.
1053 (E.D. Pa. 1980), QfifiLfl, 652 F.2d 310 (3d Cir. 1981);
Wellman v. Dickinson, 475 F.Supp. 783 (S.D.N.Y. 1979),
efifiLfi, 582 F.2d 355 (2d Cir. 1982), sert1_denied. 450 U.S.
1059 (1983).

” Piper v. Chris-Craft Industries., 430 U.S. 1 (1977).

” See‘_eege, Humana, Inc. v. American Medicorp, Inc.,
[1977-1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 96,286
(S.D.N.Y. Jan. 5, 1978); Weeks Dredging 8 Contracting, Inc.
v. American Dredging Co., 451 F.Supp 468 (E.D.Pa. 1978);
Mobil Corp. v. Marathon Oil Co., 669 F.2d 366 (6th Cir.

1981), eergegenieg, 455 U.S. 982 (1982).

“ Kalmanovitz v. G. Heileman Brewing Co., 769 F.2d 152
(3d Cir. 1985).

” Birnbaum v. Newport Steel Corp., 193 F.2d 451 (2d
Cir.), gert1_denied. 343 U.S. 955 (1952); Hundahl v. United
Benefit Life Ins. Co., 465 F.Supp. 1349 (N.D.Tex. 1979);
Wellman v. Dickinson, 475 F.Supp. 783 (S.D.N.Y. 1979),
9:1;9, 582 F.2d 355 (2d cir. 1982), certi_denied. 450 U.S.
1069 (1983); In re Commonwealth Oil/Tesoro Petroleum Corp.
Securities Litig., 467 F.Supp 227 (W.D.Tex. 1979).

174

5. The test for materiality in tender offer cases” was
actually set out in a proxy case under section 14(a). A
fact is material if

there is a substantial likelihood that a

reasonable shareholder would consider it important

in deciding how to vote...[T]here must be a

substantial likelihood that the disclosure of the

omitted fact would have been viewed by the

reasonable investor as having significantly

altered the ”total mix” of information made

available.”
The courts have taken a rather pragmatic approach to
materiality rather than engage in a ”nit-picking"
exercise.” This relaxation of the standard in takeovers
occurs because both sides of the issues are represented by
opposing forces making it more likely that all material
information will be disclosed by one or the other sides.”
Moreover, in contested control situations the failure of one

of the contestants to take remedial action with respect to

an alleged misstatement or omission is considered by some

 

“ Piper Aircraft Corp. v. Chris-Craft Indus., 430 U.S.
1, 50 (1977).

” TSC Indus., Inc. v. Northway, Inc., 425 U.S. 443,
449 (1975).

” Seaboard Werld Airlines, Inc. v. Tiger Int'l, Inc.,
600 F.2d 355, 363 (2d Cir. 1979); Kohn v. American Metal
Climax, Inc., 458 F.2d 255 (3d Cir.), eer;e_genieg, 409 U.S.
874 (1972).

” SEC v. Falstaff Brewing Corp., [1978 Transfer
Binder] Fed. Sec. L. Rep. (CCH) 1 96,583 (D.D.C. Oct. 28,
1978); Seaboard Werld Airlines, Inc. v. Tiger Int'l, Inc.,
600 F.2d 355 (2d Cir. 1979); Kennecott Copper Corp. v.
Curtiss-Wright Corp., 584 F.2d 1195 (2d Cir. 1978); Ash v.
LFE Corp., 525 F.2d 215 (3d Cir. 1975); Gerstle v. Gamble-
Skogmo, 478 F.2d 1281 (2d Cir. 1973).

175
courts to be evidence that the alleged misstatement or
omission is not material.” Any significant relationship
between the tender offeror and target managers is material
to an evaluation of the target managers' recommendations to
their shareholders.”'

Scienter which is required in a section 10(b) and rule
10b-5 case may or may not be required in a section 14(e)
case. The language of section 14(e) that makes it unlawful
to make an untrue statement or omit a material fact may be
read as not requiring scienter. Whereas, the language
concerning fraudulent, deceptive, or manipulative acts or
practices could be read as requiring scienter. To date, the
United States Supreme Court has not ruled on this question;
however, several lower courts have required scienter.m2

Causation and reliance in a section 14(e) case are
essential elements of a private civil cause of action.”’
Section 14(e) causation is often analysed in the context of

section 10(b) and rule 10b-5 materiality and reliance;

 

‘” Kennecott Copper Corp. v. Curtiss-Wright Corp., 584
F.2d 1195, 1200 n.4 (2d Cir. 1978); SEC v. Texas Gulf
Sulphur Co., 401 F.2d 833 (2d Cir. 1968), eer;e_denied, 394
U.S. 975 (1959).

‘“ Bell v. Cameron Meadows Land Co., 669 F.2d 1278
(9th Cir. 1982).

‘m Gerstle v. Gamble-Skogmo, Inc., 478 F.2d 1281, 1299
n.17 (2d Cir. 1973); A. 8 K. Railroad Materials, Inc. v.
Green Bay & W.R. Co., 437 F.Supp. 535, 542 (E.D.Wis. 1977).

1“ Berman v. Gerber Products Co., 454 F.Supp 1310
(W.D. Mich. 1978); Halle 8 Stieglitz, Filor, Bullard, Inc.
v. Empress Int'l, Ltd, 442 F.Supp. 217 (D.Del. 1977).

176
causation and reliance are presumed in an omission case if
materiality is proved.‘°‘

As in the case of an allegation of a section 13(d)
violation, a tender offeror's failure to disclose its plans
and purposes such as intent to obtain Control or to
liquidate is actionable under section 14(e).”5 .An accurate
statement of the purpose of the acquisition is important
since managers' fiduciary duties shift from the corporation
to the shareholders under Revlon if the acquiring
corporation intends to sell the assets rather than continue
the target corporation's operations.

In general, the tender offeror may keep secret its own
evaluations or appraisals of the target corporation made
with publicly available information.“ The tender offeror,
however, must disclose confidential information used in
making the evaluation. “n In Envirodyné the target
corporation had considered the possible sale of the

 

‘“ Kramas v. Security Gas 8 Oil, Inc., 672 F.2d 766
(9th Cir.), eer§e_denied, 459 U.S. 1035 (1982); Lewis v.
MCGrdW, 619 F.26 192 (2d Cir.), Q§£§‘_fl§n1§§, 449 U.S. 951
(1980).

'” Georgia-Pacific Corp. v. Great Northern Nekoosa
Corp., No. 89-0254P (D.Me. Feb. 15, 1990); Koppers Co. v.
American Express Co., 689 F.Supp. 1371 (W.D.Pa. 1988);
Marshall Field 8 Co. v. Icahn, 537.F.Supp. 413 (S.D.N.Y.
1982); Pargas, Inc. v. Empire Gas Corp., 423 F.Supp. 199

(D.Me.), EIILQ_R§£_§BIIEI. 546 F.2d 25 (4th Cir. 1976).

‘“ El Paso Co. v. Burlington Northern, Inc., No. EP-
82-CA-397 (W.D.Tex. Jan. 5, 1983); Camelot Industries Corp.
v. Vista Resources, Inc., 535 F.Supp. 1174 (S.D.N.Y. 1982).

no In re Envirodyne Industries Shareholders Litig.,
No. 10702 (Del. Ch. Apr. 20, 1989).

177
corporation. Its largest shareholder, ARTRA, had agreed to
participate in the sale and, consequently, acquired
confidential inside information. No offers were received so
the corporation abandoned attempts to sell. ARTRA's
financial advisor, Salomon Brothers, was made privy to the
inside information. Salomon Brothers subsequently pursued a
takeover bid for Envirodyne using the inside information to
formulate the offer price. The court held that the inside
information was material and must be disclosed to the target
corporation shareholders. Likewise, other misuse of
confidential inside information constitutes a violation of
section 14(e). When confidential inside information is
received by the tender offeror under a confidentiality
agreement, or derived from a former officer or director of
the target corporation, the tender offeror cannot properly
use such information without disclosing it to the target
corporation' s shareholders;“" however, disclosure may
violate the agreement which may be actionable. The tender
offeror is in an untenable position. In such cases the

tender offer typically is not allowed to proceed."’

 

‘“ LFC No. 31 Corp. v. Ransburg Corp., No. IP 88-1277-
C (N.D.Ind. Jan. 9, 1989); A. Copeland Enters., Inc. v.
Guste, 1989-2 Trade Cas. (CCH) 1 68,713 (E.D.La. Nov. 28,
1988), e£1;g, 865 F.2d 1264 (5th Cir. 1989); Murrary Ohio
Mfg. Co. v. AB Electrolux, No.01:88-0387 (E.D.Tenn. May 23,
1988).

‘” General Portland, Inc. v. La Farge Coppee S.A.,
[1982-1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 99,148
(N.D.Tex. Aug. 28, 1981); Burlington Indus. v. Edelman, 666
F.Supp. 799 (M.D.N.C.), 31111, [1987 Transfer Binder] Fed.
Sec. L. Rep. 1 93,339 (4th Cir. June 22, 1987).

178

A tender offer may be initiated in two different ways,
by "bear hug“ or by a surprise announcement of the tender
offer to the shareholders directly bypassing the target
corporation's board.

In the ”bear hug” approach the acquiring corporation
makes an offer to acquire the target corporation at a fixed
price directly to the managers or board of directors of the
target corporation. This approach does several things. The
offer can be in preliminary form and be negotiable as a
friendly takeover. Target directors are forced to disclose
the offer to their shareholders creating pressure on the
directors to accept.” The preliminary negotiations may
contain material facts that have to be disclosed to the
target corporation shareholders. Information concerning
price would be of the utmost importance to the slack poor,
target corporation shareholders and, therefore, material.
Rule 14e--2m requires the target corporation's managers
within ten business days following an offer to publish or
send to their shareholders a statement that it either
recommends acceptance or rejection of the offer, expresses
no opinion and is neutral towards the offer, or is unable to
take a position on the offer. This statement must disclose
the reasons why management either took the position or
refuses to take a position. 'In the ten day interim, the

 

‘” Rule 14d-9 and Basic, Inc. v. Levinson, 485 U.S.
224 (1988).

I" 17 C.F.R. s 240.140-2 (1991)-

179

target corporation may evaluate the offer and communicate
with its shareholders provided that the communication does
no more than identify the bidder, state that the offer is
being considered, state that the corporation will issue its
opinion regarding the offer within the ten day period, and
request shareholders to wait until they are informed of the
corporation's position. All communications must be fair and
in accordance with rule 10b-5 and section 14(e).

Management's statements to shareholders are scrutinized
by the courts particularly regarding statements abOut the
inadequacy of the price. A statement that the price is
inadequate is misleading if the target managers are aware of
non-public information that would dispute their
conclusion. m Therefore, if the slack poor corporation's
managers lie about the updated estimates of a and b to their
own shareholders in determining the adequacy of the tender
offer, they may be liable under section 10(b) and rule 10b-5
and section 14(e). The incentive to tell the truth may
solve the asymmetric information problem in "bear hug" type
tender offers. The offeror Only has inside information if
it is acquired from the target managers. If it is received
from the target managers, that must be disclosed to the

target shareholders. “3 The inside information concerning

 

‘“ Emhart Corp. v. USM Corp., 403 F.Supp. 550 (D.Mass.
1975); SEC v. Texas Int'l Co., 498 F.Supp. 1231 (N.D.Ill.
1980).

1” Crane Co. v. Westinghouse Air Brake Co., 419 F.2d
787 (2d Cir. 1959), eer;e_flenied, 400 U.S. 822 (1970).

180
the updated estimates of a and b also will have to be
disclosed if target managers make any representation
concerning the adequacy of the tender offer.

A troublesome situation after the 1989 Management's
Discussion and Analysis of Financial Conditions and Results
of Operations (MD8A) releases“ is the difference in the
test of Basic, Inc. v. Levinson and Item 303 of Regulation
S-K.m IIf the MD8A.test for mandatory disclosure is
applied to preliminary merger negotiations, the MD8A
requirements would force disclosure in some cases that the
Basic test would not. Under Item 303, forward-looking data
is to be disclosed: (1) if management cannot determine that
the event is unlikely to occur and (2) if it is otherwise of
a material amount. The Item 303 test requires the
probability of occurrence to be treated as if it were either
100 percent or zero percent. The test in Basic allows for a
continuous spectrum from zero to one hundred percent. It is
an unanswered question as to whether or not information
could be withheld under the business purpose exemption in

rule 10b-5 cases.m Disclosure under Item 303 may be more

 

‘“ SEC Releases Nos. 33-5835, 34-26831 (May 18, 1989).
‘” See Chapter III for a discussion of MD8A.

‘“ See‘_eege, SEC v. Texas Gulf Sulphur Co., 401 F.2d
833 (2d Cir. 1968), eer;e_genieg, 394 U.S. 976 (1969).

181
extensive than under the antifraud provisions , "7 although
the HDEA interpretive releases do provide that information
need not be disclosed if it would jeopardize the
negotiations.

If the slack poor corporation managers distort or lie
about the updated estimates of a and b in the negotiations
such action could constitute a misstatement of a material
fact which could subject the managers of the target, slack
poor corporation to liability for violation of section 10(b)
and rule 10b-5 and sections 14(d) and (e). Section 10(b)
and rule 10b-5 and sections 14(d) and (e) potential
liability provides an incentive for managers of the
corporations to tell the truth about the value of the
corporation.

A hostile board of directors of the target corporation
may engage in defensive maneuvers and frustrate the takeover
attempt by stopping it or making it too expensive. A wide
array of defensive maneuvers, such as a friendly merger with
a more desirable corporation (white knight), a counteroffer
to buy by a friendly party, or a repurchase of its own stock
by the target corporation, are available to thwart the

takeover. Uhocal, Revlon, and Time impose restrictions on

 

‘" ”No rule of law condones fraud simply so that other
corporate goals might thereby be served.” Brief for the
Securities and Exchange Commission as Amicus Curiae, Basic
Inc. v. Levenson. ”The securities_laws do not operate under
the assumption that material information need not be
disclosed if management has reason to suppress it.” Roeder
v. Alpha Industries, Inc., 814 F.2d 22, 25 (1st Cir. 1987).

182
the target corporation's board of directors' use of
defensive measures. The modified or enhanced business
judgment rule is in effect in takeover situations. The
purpose of the enhanced rule is to insure that defensive
measures are motivated by a good faith concern for the
welfare of the corporation and its shareholders rather than
to perpetuate management. under Uhocal the board of
directors must make a reasonable investigation before
adopting a takeover defensive measure. The board
investigation must provide material information and expert
advice to the directors on such matters as inadequacy of
consideration, nature and timing of the offer, legality,
impact on stakeholders other than shareholders, and the risk
of nonconsummation, to be able to make an informed,
dispassionate decision. unless it was approved by a.
majority of independent, outside directors, the board of
directors would have the burden of showing the entire or
intrinsic fairness of the transaction. Further, the
defensive response must be reasonable in relation to the
threat posed by the hostile bid.

The Delaware Supreme Court in Time overruled the
Chancery Court holdings in Interco and Pillsbury which
indicated that the board of directors of a target
corporation could only oppose a hostile bid if it were a
coercive two tier bid or constituted an all cash bid at less
than a fair price. The Delaware court held that the board

of directors of a target corporation may refuse to consider

183
an all-cash, all-share offer made at an adequate price.
This is the ”just say no' defense. This holding is in the
factual context of deciding between long-range and short-
range plans.

The fair price defensive tactic is used to defend
against two-tier, front-end loaded attacks to protect
shareholders who may tender because they fear being squeezed
out at a lower price. To protect shareholders, the
consideration paid must be cash or the same type of
consideration paid for the largest block of the stock
acquired and must equal the greatest of: (1) the highest
price paid by the offeror for any shares of the target
acquired during the tender offer period, (2) an amount which
bears the same or a greater percentage relationship to the
then market price of the target corporation's stock as the
highest price paid by the tender offeror bears to the market
price of the stock immediately preceding the commencement of
the tender offer, or (3) an amount equal to the earnings per
share of the corporation for the four full consecutive
fiscal quarters immediately preceding the proposed business
combination multiplied by the then price-earnings ratio of
the offeror. This provision insures equal treatment of all
shareholders during all stages of the tender offer.

An alternate defensive tactic with the same effect is
the right of redemption privilege. Minority shareholders
are granted the right in the articles of incorporation or
bylaws to put their stock to the tender offeror at specified

184
redemption prices. The target corporation could adopt a
right of redemption privilege that reflects the updated
estimates of a and b. Such a signal could overcome the
asymmetric information problem. Right of redemption
privileges are not permitted in all states.“'
3. State Regulation of Takeovers

More than forty states have enacted laws regulating
takeovers of companies incorporated or doing business in
their respective states. These statutes tend to be more
extensive than the federal statute which is perceived by the
states as having shortcomings and tend to favor the
incumbent management of the target corporation. Between
1968 and 1982, thirty-seven states adopted “first
generation” takeover statutes. These statutes required a
bidder to disclose certain information concerning the offer.
One of the more debilitating parts of these state statutes
generally imposed a waiting period from 10 to 60 days from
the announcement and the commencement of the tender offer.
It is this waiting period that allowed hostile incumbent
management of the target corporation to marshall its forces
to ward off the tender offer and frustrate the attempt of
the acquiring corporation's management to take over the

target company. Heat of these statutes empowered a state

 

1“ The Delaware Court of Chancery upheld a fair value
rights plan in MacAndrews 8 Forbes Holding, Inc. v. Revlon,
501 A.2d 1239 (Del. Ch.), m, 505 A.2d 454 (Del. 1985).
Contra, Hinstar Acquiring Corp. v. AMP, Inc., 621 F.Supp.
1252 (S.D.N.Y. 1985) and Buckhorn, Inc. v. Ropak Corp., 656
F.Supp. 209 (S.D. Ohio 1987).

185
official to determine whether or not the disclosure was
adequate and the whether or not the offer was ”fair." The
designated state official was empowered to conduct hearings
to make these determinations. There have been inconsistent
decisions in the federal courts as to whether or not these
more extensive state statutes infringe upon the federal
prerogative of regulating securities.” The United States
Supreme Court's first decision regarding state takeover
statutes resulted in six separate opinions in which a bare
majority voted to overturn the Illinois statute on narrow
Commerce Clause grounds. 120 Following the Supreme Court
decision, state takeover statutes in Michigan,121
Hissouri,m Kentucky,m Virginia,“ naryland,”

 

'” HITE Corp. v. Dixon, No. 79-c-2oo (N.D.Ill. Feb. 9,
1979), afde. 633 F.2d 486 (7th Cir. 1930), a:1;d_§gg_ngm.
Edgar v. HITE Corp., 457 0.8. 624 (1982); Brascan Ltd. v.
Lassiter, [1981-1982 Transfer Binder] Fed. Sec. L. Rep.
(CCH) 1 98,247 (E.D.La. Apr. 30, 1979); Dart Industries v.
Conrad, 462 F.Supp. l (S.D.Ind. 1978) (enjoining state
laws). Contra, AHCA Int'l Corp. v. Krouse, 482 F.Supp. 929
(S.D. Ohio 1979); City Investing Co. v. Simcox, 476 F.Supp.
112 (S.D.Ind. 1979), affid. 633 F.2d 56 (7th Cir. 1980); UV
Industries v. Posner, 466 F.Supp. 1251 (D.Me. 1979)
(upholding state statutes).

‘” Edgar v. EITE Corp., 457 U.S. 624 (1932).

‘” Martin-Marietta Corp. v. Bendix Corp., 690 F.2d 558
(6th Cir. 1982).

no National City Lines, Inc. v. LLC Corp., 524 F.Supp.
906 (W.D.Mo. 1981), 91:19. 687 P.2d 1122 (8th Cir. 1982).

‘” Esmark, Inc. v. Strode, 639 S.W.2d 768 (Ky. 1982).

‘” Telvest, Inc. v. Bradshaw, 547 F.Supp. 791 (E.D.Va
1982), QfifLQ, 697 F.Zd 576 (4th Cir. 1983).

186
Oklahoma, '2‘ and Minnesotam were invalidated. The
Massachusetts statute was upheld.“ Five years after its
decision in MITB, the United States Supreme Court upheld
Indiana's takeover statute by a 6 to 3 vote."’

As a result of these setbacks, states adopted "second
generation" takeover statutes. This second generation of
takeover statutes uses several different approaches. One of
the more common forms is the fair price takeover statute.
Under a fair price takeover statute, certain business
combinations must be approved by a super-majority (usually
80 percent), unless a statutorily determined fair price is
paid. The fair price formulas are complicated and extensive
as evidenced by the Maryland statute on which most of the
fair price statutes are modeled. See Appendix B.1 for text
of the Maryland Statute.

Other states have adopted control share acquisition
statutes which require shareholder approval before an
acquisition of a specified percentage of stock. The

 

‘3 Bendix Corp. v. Martin-Marietta Corp., 547 F.Supp.
522 (D.Md. 1982).

‘” Mesa Petroleum Co. v. Cities Serv. Co., [1982-1983
Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 99,064 (W.D.Okla.
Dec. 21, 1982), flfifLfi, 715 P.2d 1425 (10th Cir. 1983).

‘” APL Ltd. P'ship v. van Dusen Air, Inc., 622 F.Supp.
1216 (D.Minn. 1985).

‘” Agency Rent-A-Car, Inc. v. Connolly, 686 F.2d 1029
(lst Cir. 1982).

‘” CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69
(1987).

187
acquiror may vote its control shares only to the extent
approved by a majority of disinterested shareholders of that
class of stock. Business combination statutes are also
common. These statutes prohibit for a specified period of
time business combinations with any person acquiring a
certain percentage of stock. Cash-out statutes and
shareholder rights plan validation statutes have also been
enacted. The cash-out statutes require an offeror who
acquires a specified percentage of stock to buy out any
shareholder who desires to tender at a price determined by
the statute. A shareholders rights plan allows the target
corporation to issue shareholders rights or Options to
purchase a class of securities on conditions fixed by the
board of directors.

A ”third generation“ of takeover statutes is beginning
to appear. Pennsylvania, Indiana, and New Jersey have
adopted far reaching statutes in reaction to the enhanced
business judgment rule applied by the Delaware court in
Unocal and Revlon. Indiana rejects the Uhocal rule and
establishes a presumption that the board action in taking
defensive measures is ”valid unless it can be demonstrated
that the determination was not made in good faith after
reasonable investigation."”° This third generation of
takeover statutes is broadening the corporate constituency

statutes discussed in Appendix A.

 

‘” Ind. Code s 23-1-35-l(g) (1989).

188

C. conclusion

In this part, proposed solutions of negotiated
(friendly) and hostile mergers and direct and "bear hug"
tender offers are examined. Only in a direct tender offer
where target corporation managers remain neutral and silent
does the asymmetric information problem disappear. In the
direct tender offer, neither the offeror nor the target
shareholders are in possession of inside information. Both
sides would benefit if the offered price is within the
acceptable range between S+a and S+A+§. In all other cases
asymmetric information is problematic. Moreover, target
corporation managers have an incentive to lie about the
updated estimates of a and b.

Federal and state securities antifraud provisions
provide an incentive to tell the truth. In a negotiated
merger or bear hug tender offer, the afferor may obtain
inside information from the target corporation's managers.
If so, disclosure may have to be made. Making a
misstatement of a material fact or omitting a material fact
may result in liability. If the target corporation's
managers mislead or fail to disclose material information to
their own shareholders, they become liable. Defensive
tactics may also be a source of liability under federal
securities law.

Under federal securities law

Cost of Lying - (2p-l) (V,- ,) +pCP.
It pays to lie if the probability of getting caught is less

189
than twenty percent. If managers perceive the probability
of getting caught at less than twenty percent they will lie
about the true value of the corporation. The value of the
corporation becomes

v-v,-pCP or V-S+a+b-pCP .

From the shareholders' viewpoint, they will have no
confidence in the information received from their managers
or the offeror if they perceive that the probability that
the offending management will not be caught lying is greater
than or equal to eighty percent.

The asymmetric information problem also may be
addressed through use of the fair price provisions of state
takeover statutes. The articles of incorporation or bylaws
may be amended to provide that target corporation
shareholders be able to put their stock to the corporation
at a price that represents the updated estimates of a and b.
The fair price provision signals the updated estimates.

The implications of this hypothesis are that (1) target
corporations should be undervalued and have unfinanced
growth opportunities, (2) the target cerporation should have
a lower rate of return on equity than other firms as a
result of not maximizing its value, (3) acquiring
corporations should not have internal growth opportunities
available either as a result of being in a slow growth
industry sector or an older corporation in the growth cycle
with few remaining opportunities, (4) acquiring corporations

should have free cash flows or excess debt capacity, (5)

190
there should be more mergers in periods of strong economic
growth because acquiring corporations are looking for growth
opportunities, (6) merger announcements should produce

abnormal positive stock returns.

APPENDIX B.1

rair Price Statute
(l) The aggregate amount of the cash and the
market value as of the valuation date of
consideration other than cash to be received per
share by holders of common stock in such business
combination is at least equal to the highest of
the following:

(i) The highest per share price
(including any brokerage commissions, transfer
taxes and soliciting dealers' fees) paid by the
interested stockholder for any shares of common
stock of the same class or series acquired by it
within the 5-year period immediately prior to the
announcement date of the proposal of the business
combination, plus an amount equal to interest
compounded annually from the earliest date on
which the highest per share acquisition price was
paid through the valuation date at the rate for 1-
year United States Treasury obligations from time
to time in effect, less the aggregate amount of
any cash dividends paid and the market value of
any dividends paid in other than cash, per share
of common stock from the earliest date through the
valuation date, up to the amount of the interest;

or

191

192

(ii) The highest per share price
(including any brokerage commissions, transfer
taxes and soliciting dealers' fees) paid by the
interested stockholder for any shares of common
stock of the same class or series acquired by it
on, or within the 5-year period immediately
before, the determination date, plus an amount
equal to interest compounded annually from the
earliest date on which the highest per share
acquisition price was paid through the valuation
date at the rate for 1-year United States Treasury
obligations from time to time in effect, less the
aggregate amount of any cash dividends paid and
the market value of any dividends paid in other
than cash, per share of common stock from the
earliest date through the valuation date, up to
the amount of the interest; or

(iii) The market value per share of
common stock of the same class or series on the
announcement date, plus an amount equal to
interest compounded annually from that date
through the valuation date at the rate for 1-year
United States Treasury obligations from time to
time in effect, less the aggregate amount of any
cash dividends paid and the market value of any
dividends paid in other than cash, per share of

common stock from that date through the valuation

193

date, up to the amount of the interest; or

(iv) The market value per share of common
stock of the same class or series on the
determination date, plus an amount equal to
interest compounded annually from that date
through the valuation date at the rate for 1-year
United States Treasury obligations from time to
time in effect, less the aggregate amount of any
cash dividends paid and the market value of any
dividends paid in other than cash, per share of
common stock from that date through the valuation
date, up to the amount of the interest; or

(v) The price per share equal to the
market value per share of common stock of the same
class or series on the announcement date or on the
determination date, whichever is higher,
multiplied by the fraction of:

1. The highest per share price
(including any brokerage commissions, transfer
taxes and soliciting dealers' fees) paid by the
interested stockholder for any shares of common
stock of the same class or series acquired by it
within the 5-year period immediately prior to the
announcement date, over
2. The market value per share of

common stock of the same class or series on the

first day in such 5-year period on which the

194
interested stockholder acquired any shares of
common stock.

(2) The aggregate amount of the cash and the
market value as of the valuation date of
consideration other than cash to be received per
share by holders of shares of any class or series
of outstanding stock other than common stock in
the business combination is at least equal to the
highest of the following (whether or not the
interested stockholder has previously acquired any
shares of the particular class or series of
stock):

(1) The highest per share price
(including any brokerage commissions, transfer
taxes and soliciting dealers' fees) paid by the
interested stockholder for any shares of such
class or series of stock acquired by it within the
5-year period immediately prior to the
announcement date of the proposal of the business
combination, plus an amount equal to interest
compounded annually from the earliest date on
which the highest per share acquisition price was
paidthrough the valuation date at the rate for 1-
year United States Treasury obligations from time
to time in effect, less the aggregate amount of
any cash dividends paid and the market value of

any dividends paid in other than cash, per share

195

of the class or series of stock from the earliest
date through the valuation date, up to the amount
of the interest; or

(ii) The highest per share price
(including any brokerage commissions, transfer
taxes and soliciting dealers' fees) paid by the
interested stockholder for any shares of such
Class or series of stock acquired by it on, or
within the 5-year period immediately prior to, the
determination date, plus an amount equal to
interest compounded annually from the earliest
date on which the highest per share acquisition
price was paid through the valuation date at the
rate for 1-year United States Treasury obligations
from time to time in effect, less the aggregate
amount of any cash dividends paid and the market
value of any dividends paid in other than cash,
per share of the class or series of stock from the
earliest date through the valuation date, up to
the amount of the interest; or

(iii) The highest preferential amount
per share to which the holders of shares of such
class or series of stock are entitled in the event
of any voluntary or involuntary liquidation,
dissolution or winding up of the corporation; or

(iv) The market value per share of such

class or series of stock on the announcement date,

196

plus an amount equal to interest compounded
annually from that date through the valuation date
at the rate for 1-year United States Treasury
obligations from time to time in effect, less the
aggregate amount of any cash dividends paid and
the market value of any dividends paid in other
than cash, per share of the class or series of
stock from that date through the valuation date,
up to the amount of the interest; or

(v) The market value per share of such
class or series of stock on the determination
date, plus an amount equal to interest compounded
annually from that date through the valuation date
at the rate for l-year United States Treasury
obligations from time to time in effect, less the
aggregate amount of any cash dividends paid and
the market value of any dividends paid in other
than cash, per share of the class or series of
stock from that date through the valuation date,
up to the amount of the interest; or

(vi) The price per share equal to the
market value per share of such class or series of
stock on the announcement date or on the
determination date, whichever is higher,
multiplied by the fraction of:

l. The highest per share price

(including any brokerage commissions, transfer

197

taxes and soliciting dealers' fees) paid by the
interested stockholder for any shares of any class
of voting stock acquired by it within the 5-year
period immediately prior to the announcement date,
over

2. The market value per share of
the same class of voting stock on the first day in
such 5-year period on which the interested
stockholder acquired any shares of the same class
of voting stock.

(3) The consideration to be received by
holders of any class or series of outstanding
stock is to be in cash or in the same form as the
interested stockholder has previously paid for
shares of the same class or series of stock. If
the interested stockholder has paid for shares of
any class or series of stock with varying forms of
consideration, the form of consideration for such
class or series of stock shall beeither cash or
the form used to acquire the largest number of
shares of such class or series of stock previously
acquired by it.

(4) (i) After the determination date and
prior to the consummation of such business
combination:

1. There shall have been no failure

to declare and pay at the regular date therefor

198
any full periodic dividends (whether or not
cumulative) on any outstanding preferred stock of
the corporation;
2. There shall have been:

A. No reduction in the annual
rate of dividends paid on any class or series of
stock of the corporation that is not preferred
stock (except as necessary to reflect any
subdivision of the stock); and

B. An increase in such annual
rate of dividends as necessary to reflect any
reclassification (including any reverse stock
split), recapitalization, reorganization or any
similar transaction which has the effect of
reducing the number of outstanding shares of the
stock; and

3. The interested stockholder did
not become the beneficial owner of any additional
shares of stock of the corporation except as
part of the transaction which resulted in such
interested stockholder becoming an interested
stockholder or by virtue of proportionate stock
splits or stock dividends.’

 

1 Md. Corps. & Ass'ns Code Ann. 5 3-603 (1985).

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TABLE OF CASES

TABLE OF CASES

A. & K. Railroad Materials, Inc. v. Green Bay & W.R. co.,
437 F.Supp. 636 (E.D.Wis. 1977).

A. Cbpeland Ehters., Inc. v. Guste, 1989-2 Trade Cas. (CCH)
1 68,713 (E.D.La. Nov. 28, 1988), affLQ, 865 F.2d 1264
(5th Cir. 1989).

Aaron v. SEC, 446 U.S. 680 (1980).

Affiliated Ute Citizens of Utah v. U.S., 406 U.S. 438
(1976).

Agency Rent-A-Car, Inc. v. cannolly, 686 F.2d 1029 (1st Cir.
1982).

AMCA Int'l corp. v. Krouse, 482 F.Supp. 929 (S.D.Ohio 1979).

A. P. smith Manufacturing CC. V. Barlow, 13 N.J. 145, 98
A.2d 581 (1953).

APL Ltd. P'ship v. van Dusen Air, Inc., 622 F.Supp. 1216
(D.Minn. 1985).

Aronson v. Lewis, 473 A.2d 805 (Del. 1984).
Ash v. LEE Corp., 525 F.2d 215 (3d Cir. 1975).

Auerbach v. Bennett, 47 N.Y.2d 619, 393 N.E.2d 994, 419
N.Y.S.2d 920 (1979).

Bailes v. Cblonial Press, Inc., 44 F.2d 1241 (5th Cir.
1971).

Basic, Inc. v. Levinson, 485 U.S. 224 (1988).
Beard v. Elster, 39 Del. Ch. 153, 160 A.2d 731 (1960).

Bell v. cameron Meadows Land co., 669 F.2d 1278 (9th Cir.
1982).

Bendix Corp. v. Martin-Marietta corp., 547 F.Supp. 522
(D.Md. 1982).

204

205

Berman v. Gerber Products Cb., 454 F.Supp. 1310 (W.D.Mich.
1978).

Birnbaum v. Newport Steel COrp., 193 F.2d 461 (2d Cir.
1952), §§:;‘_§gn1g§, 343 U.S. 956 (1952).

Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).
BN8, Inc. v. Rappers Cb., 683 F.Supp 458 (D. Del. 1988).

Bodell v. General Gas and Electric carporation, 15 Del. Ch.
119, 132 A. 442 (1926).

Brascan, Ltd. v. Edper Equities, Ltd., 477 F.Supp. 773
(S.D.N.Y. 1979).

Brascan Ltd. v. Lassiter, [1981-1982 Transfer Binder] Fed.
Sec. L. Rep. (CCH) 1 98,247 (E.D.La. Apr. 30, 1979).

Buckhorn, Inc. v. Ropak COrp., 656 F.Supp. 209 (S.D.Ohio
1987).

Burlington Indus. v. Edelman, 666 F.Supp. 799 (M.D.N.C.),
affLQ, [1987 Transfer Binder] Fed. Sec. L. Rep. 1
93,339 (4th Cir. June 22, 1987).

In the Matter of cady, Roberts & Cb., 40 S.E.C. 907 (1961).

camelot Industries carp. v. Vista Resources, Inc., 535
F.Supp. 1174 (S.D.N.Y. 1982).

In re carnation co., [1984-85 Transfer Binder] Fed. Sec. L.
Rep. (CCH) 1 83,801, 87,595-96 (July 8, 1985).

CFTC v. weintraub, 471 U.S. 343 (1985).
Chiarella V. U.S., 445 U.S. 222 (1980).

Childs v. RIC Group, Inc., 331 F.Supp. 1078 (N.D. Ga. 1970),
QIILQ_9§I_QB:1§1, 447 P.2d 1407 (5th Cir. 1971).

Chris-craft Industries v. Piper Aircraft COrp., 480 F.2d 341
(2d Cir.), 9g;;‘_ggn1gg, 414 U.S. 910 (1973).

Chromalloy American carp. v. Sun Chem. Cbrp., 611 F.2d 240
(8th Cir. 1979).

City Investing CO. v. Simcox, 476 F.Supp. 112 (S.D.Ind.
1979), affid. 633 F.2d 56 (7th Cir. 1980).

Clark v. Lamas & Nettleton Fin. COrp., 625 F.2d 49 (5th Cir.
1980), Q§§§&_g§n1gg, 450 U.S. 1029 (1981).

206

Clarkson co. Ltd v. Shaheen, 660 F.2d 506 (2d Cir. 1981),
ggz;‘_§§n1g§, 445 U.S. 990 (1982).

In re commonwealth Oil\Tesoro Petroleum corp. Securities
Litig., 467 F.Supp. 227 (W.D.Tex. 1979).

Crane co. v. westingbouse Air Brake co., 419 F.2d 787 (2d
Cir. 1969), sertl_dsnied. 400 U.S. 822 (1970).

Credit Lyonnais Bank N;V. v. Pathe communications, Civ.
12150, 1991 Del. Ch. Lexis 215 (Dec. 30, 1991).

CTS Corp. v. Dynamics corp. of America, 481 U.S. 69 (1987).
Dan River, Inc. v. Icahn, 701 F.2d 278 (4th Cir. 1983).
Dart Industries v. Cbnrad, 462 F.Supp. l (S.D.Ind. 1978).
Dartmouth College v. WOodward, 4 Wheat. 518 (1819).

Data Probe Acquisition corp. v. Datatab, Inc., 722 F.2d 1
(26 Cir. 1983), gg:§&_fl§n1gd, 465 U.S. 1052 (1984).

Dawson v. National Life Insurance co., 176 Iowa 362, 157
N.W. 929 (1916).

Diamond v. Arend, 649 F.Supp. 408 (S.D.N.Y. 1986).
Dodge v. Ford Motor co., 204 Mich. 459, 170 N.W. 668 (1919).

Dyer v. Eastern Trust and Banking co., 336 F.Supp. 890
(D.Maine 1971).

E.H.I. of Florida, Inc. v. Insurance co. of Nerth America,
499 F.Supp. 1053 (E.D.Pa. 1980), 31:;1, 652 F.2d 310
(3d Cir. 1981).

Eldridge v. Tymshare, Inc., 186 Cal. App. 3d 767, 230 Cal.
Rptr. 815 (1986).

El Paso co. v. Burlington northern, Inc., No. EP-82-CA-397
(W.D.Tex. Jan. 5, 1983).

Emhart corp. v. USM corp., 403 F.Supp. 660 (D.Mass. 1975).

In re Envirodyne Industries Shareholders Litig., No. 10702
(Del.Ch. Apr. 20, 1989).

Epstein v. Schenck, 35 N.Y.S.2d 969 (Sup. Ct. 1939).
Ernst & Ernst V. HOchfeldar, 425 U.S. 185 (1976).

ESmark, Inc. v. Strode, 639 S.W.2d 768 (Ky. 1982).

207

Feit v. Leasco Data Processing'Eguipment corp., 332 F. Supp.
544 (E.D.N.Y. 1971).

Florida commercial Banks, Inc. v. culverbouse, 772 F.2d 1513
(11th Cir. 1985).

Fridrich v. BradfOrd, 542 F.2d 307 (6th Cir. 1976), cert;
denied. 429 U.S. 1053 (1977).

Galef v. Alexander, 615 F.2d 51 (2d Cir. 1980).

Gearhart Industries v. smith Int'l Inc., 741 F.2d 707 (5th
Cir. 1984).

General Aircraft corp. v. Lampert, 556 F.2d 90 (let Cir.
1977).

In re General Motors Class E stock Buyout securities Litig.,
694 F.Supp. 1119 (D.Del. 1988).

General Portland, Inc. v. La Fargo Coppee S.A., [1982-1983
Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 99,148
(N.D.Tex. Aug. 28, 1981).

Georgia-Pacific corp. v. Great Nerthern Nekoosa corp., No.
89-0254P (D.Me. Feb. 15, 1990).

Gerstle v. Gamble-Skogmo, 478 F.2d 1281 (2d Cir. 1973).
Glassberg v; Boyd, 35 Del. Ch. 293, 116 A.2d 711 (Ch. 1955).

Globus v. Law Research service, Inc., 418 F.2d 1276 (2d Cir.
1969), ggrt‘_§gn1gg, 397 U.S. 913 (1970).

Gottlieb v. Heyden Chemical corp., 33 Del. Ch. 82, 90 A.2d
660 (Del. Sup. Ct. 1952).

Green v. Occidental, 541 F.2d 1335 (9th Cir. 1976) (Sneed,
J., concurring).

Grynberg v. Farmer, [1980 Transfer Binder] Fed. Sec. L. Rep.
(CCH) 1 97,683 (D. Colo. Oct. 8, 1980).

Gunter v. Hutcheson, 443 F.Supp 42 (N.D.Ga. 1977).
Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939).
Hall v. Geiger-Jenes co., 242 U.S. 539 (1917).

Halle & Stieglitz, Filor, Bullard, Inc. v..Empress Int’l,
Ltd, 442 F.Supp. 217 (D.Del. 1977).

208

Huddleston v. Herman & Maclean, 640 F.2d 534 (5th Cir.
1981).

Humana, Inc. v. American Medicorp, Inc., [1977-1978 Transfer
Binder] Fed. Sec. L. Rep. (CCH) 1 96,286 (S.D.N.Y. Jan.
5, 1973).

Hundahl v. united.Benefit Life Ins. co., 465 F.Supp. 1349
(N.D.Tex. 1979).

Indiana Nat'l corp. v. Rich, 712 F.2d 1180 (7th Cir. 1983).
Investors Management co., Inc., 44 S.E.C. 633 (1971).
Jacquith V. Mason, 99 Neb. 509, 156 N.W. 1041 (1916).

Johnson v. Trueblood, 629 F.2d 287 (3d Cir. 1980), ggrrr
dgnigfi, 450 U.S. 999 (1981).

Kalmanovitz v. G. Beileman Brewing co., 769 F.2d 152 (3d
Cir. 1985).

Kardon v. National Gypsum co., 69 F.Supp 512 (E.D.Pa 1946).

Kennecott copper corp. v. curtiss-Wright corp., 584 F.2d
1195 (2d Cir. 1978).

KOhn v. American Metal Climax, Inc., 458 F.2d 255 (3d Cir.),
§§r§r_flgn1§d, 409 U.S. 874 (1972).

KOppers co. v. American Express co., 689 F.Supp. 1371
(W.D.Pa. 1988).

Kramas v. Security Gas 5 Oil, Inc., 672 F.2d 766 (9th Cir.),
ggr§r_flgnig§, 459 U.S. 1035 (1982).

Lewis v. MCGraw, 619 F.2d 192 (2d Cir.), gerrr_dgnig§, 449
U.S. 951 (1980).

LFC No. 31 corp. v. Ransburg corp., No. IP 88-1277-C
(N.D.Ind. Jan. 9, 1989).

List v. Fashion Park, Inc., 340 F.2d 457 (2d Cir. 1965),

, 382 U.S. 811 (1965), rghr_d§n1gg, 382
U.S. 933 (1965).

Ludlow corp. v. TYco Laboratories, 529 F.Supp. 62 (D.Mass
1981).

MacAndrews & Forbes Holding, Inc. v. Revlon, 501 A.2d 1239
(Del.Ch.), arrLQ, 505 A.2d 454 (Del. 1985).

209

MacFadden Holdings, Inc. v; JB Acquisition corp., 802 F.2d
62 (2d Cir. 1986).

Maldonado v..Flynn, 597 F.2d 789 (2d Cir. 1979), gn_remand,
477 F.Supp. 1007 (S.D.N.Y. 1979).

Marbury Management, Inc. v. Kohn, 629 F.2d 705 (2d Cir.
1980), gubr_ngnr, wood'Walker & co. v. Marbury
Management, Inc., ggrrr_ggnigg, 449 U.S. 1011 (1980).

Marshall Field & co. v. Icahn, 537 F.Supp 413 (S.D.N.Y.
1932).

Martin-Marietta Corp. v. Bendix COrp., 690 F.2d 558 (6th
cir. 1982).

Mathes v. Cheff, 41 Del. Ch. 166, 190 A.2d 524, (1963),
rexid_9n_other_9reunds. 41 Del- Ch. 494. 199 A-zd 54a

(1964).

Meinhard V. Salmon, 249 N.Y. 458, 164 N.E. 545 (1928).

Mesa Petroleum co. v. Cities serv. co., [1982-1983 Transfer
Binder] Fed. Sec. L. Rep. (CCH) 1 99,064 (W.D.Okla.
Dec. 21, 1982), QIILQ, 715 P.2d 1425 (10th Cir. 1983).

Minster Acquiring corp. v. AMF, Inc., 621 F.Supp. 1252
(S.D.N.Y. 1985).

Mitchell v. Texas Gulf sulphur co., 446 F.2d 90 (10th Cir.
1971).

MITE corp. v. Dixon, No. 79-C-200 (N.D.Ill. Feb. 9, 1979),
gifLQ, 633 F.2d 486 (7th Cir. 1980), gfifiL§_§nh_ngm.
Edgar v. MITE corp., 457 U.S. 624 (1982).

Mobil corp. v. Marathon Oil co., 669 F.2d 366 (6th Cir.
1981), §gr§r_§§nigg, 455 U.S. 982 (1982).

Munn v. Illinois, 94 U.S. 113 (1876).

Marrary Ohio Mfg. co. v. AB.Electrolux, No. 01:88-0387
(E.D.Tenn. May 23, 1988).

National City Lines, Inc. v. LLC Corp., 524 F.Supp. 906
(W.D.Mo. 1981), grrLQ, 687 F.2d 1122 (8th Cir. 1982).

Osborne v. Mallory, 86 F.Supp. 869 (S.D.N.Y. 1949).

Paramount cemmunications v. Time, Inc., 571 A.2d 1140 (Del.
1989).

210

Pargas, Inc. v. Empire Gas corp., 423 F.Supp. 199 (D.Mo. ),
aff_d_pgr_gnrian, 546 F.2d 25 (4th Cir. 1976).

Pepper v. Litton, 308 U.S. 295 (1939).
Pin v. Texaco, Inc., 793 F.2d 1448 (5th Cir. 1986).
Piper v. Chris-craft Industries, 430 U.S. 1 (1977).

Portsmouth square, Inc. v. Shareholders Protective
committee, 770 F. 2d 866 (9th Cir. 1985).

Puma v. Marriott, 283 A.2d 693 (Del. Ch. 1971).

Revlon, Inc. v. MacAndrews & Forbes Holding, 506 A.2d 173
(Del. 1986).

Roeder v. Alpha Industries, Inc., 814 F.2d 22 (1st Cir.
1987).

Rubin v. Posner, 701 F.Supp. 1041 (D.Del. 1988).
Sampson v. Mont, 222 Kan. 268, 564 P.2d 489 (1977).

Sanders v. Thrall car Mfg. co., 582 F.Supp 945 (S.D.N.Y.),
affiLd_ner_gnrian, 730 F.2d 910 (2d Cir. 1984).

Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977).

Schnell v. Schnall, [1981 Transfer Binder] Fed. Sec. L. Rep.
(CCH) 1 97,927 (S.D.N.Y. mar. 30, 1981).

Seaboard world Airlines, Inc. v. Tiger Int'l, Inc., 600 F.2d
355 (2d Cir. 1979).

SEC v. Chenery corp., 318 U.S. 80 (1943).

SEC v. Falstaff Brewing corp., [1978 Transfer Binder] Fed.
Sec. L. Rep. (CCH) 1 96,583 (D.D.C. Oct. 28, 1978).

SEC v. National Securities, 393 U.S. 453 (1969).
SEC v. Ralston Purina co., 346 U.S. 119 (1953).

SEC v. Texas Gulf sulphur co., 401 F.2d 833 (2d Cir. 1968),
ggrrr_dgni§d, 394 U.S. 976 (1969).

SEC V. Taxes Int’l co., 498 F.Supp 1231 (N.D.Ill. 1980).

Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495
F.2d 228 (2d Cir. 1974).

211

Simons v. cogan, Civil Action No. 8890 (Del. Ch. Dec. 2,
1987).

Singer v. Magnavox co., 380 A.2d 969 (Del. 1977).

Solash v. Telex corp., [1987-1988 Transfer Binder] Fed. Sec.
L. Rep (CCH) 11 93,608, 97,722 (Del. Ch. Jan. 19,
1988).

stromfield v. Great Atl. & Pac. Tea co., 484 F.Supp. 1264
(S.D.N.Y.), gfide, 646 F.2d 563 (2d Cir. 1980).

Tanzer v. International General Industries, Inc., 379 A.2d
1121 (1977).

Tate & Lyle PLC v. Staley continental, Inc., [1987-1988
Transfer Binder] Fed. Sec. L. Rep. (CCH) 1 93,764 (Del.
Ch. 1988).

Telvest, Inc. v. BradShaw, 547 F.Supp. 791 (E.D.Va. 1982),
QfifiLg, 697 F.2d 576 (4th Cir. 1983).

Theodore HOlding corp. v. Henderson, 257 A.2d 398 (Del. Ch.
1969).

Trane co. v. O’Connor Sec., 561 F.Supp. 301 (S.D.N.Y.),
app§§l_§i§mis§§d, 718 F.2d 26 (2d Cir. 1983).

Treadway cos. v. care corp, 638 F.2d 357 (2d Cir. 1980).
TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976).

united copper Securities co. v. Amalgamated copper co., 244
U.S. 261 (1917).

university Bank & Trust co. v. Gladstone, 574 F.Supp. 1006
(D.Mass 1983).

UV Industries v. Posner, 466 F.Supp. 1251 (D.Me 1979).

walker v. Man, 142 Misc. 277, 253 N.Y.S. 458 (Sup. Ct.
1931).

weatherby v. weatherby Lumber co., 94 Idaho 504, 492 P.2d 43
(1972).

Weeks Dredging & contracting, Inc. v. American Dredging Co.,
451 F.Supp. 468 (E.D.Pa. 1978).

Wellman v. Dickinson, 475 F.Supp. 783 (S.D.N.Y. 1979),

AISLE. 682 F.2d 355 (2d Cir. 1982), ggrrr_ggnigg, 460
U.S. 1069 (1983).

212

Zapata Corp. v. Maldonado, 430 A.2d 779 (Del. 1981).

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