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Public policy towards corporate restructuring.

*Kenneth Lehn is Chief Economist, U.S. Securities and Exchange Commission, Washington, DC, The views expressed here are those of the author and do not necessarily reflect the views of the Commission or the author's colleagues on the staff of the Commission.

[1] See footnote at end of text.

Stockholders in U. S. corporations have benefitted greatly from the widespread corporate restructuring that occurred in the 1980s. The source of these stockholder gains has spawned a public policy debate about the economic and social desirability of these transactions. This article describes several of the major public policy issues concerning corporate restructuring, including securities issues, tax issues, the employment effects of restructuring, and the effects of restructuring on long-term investments. In addition, the article discusses relevant empirical evidence on each of these issues.

ONE OF THE MOST important business developments of the past decade has been the proliferation of corporate restructuring that has occurred through a variety of corporate control transactions, including hostile and friendly tender offers, mergers, going private transactions, leveraged recapitalizations, divestitures, and dual class recapitalizations. Data documenting the restructuring phenomenon are presented by Professor Weston in this issue.

This restructuring of U.S. corporations has greatly enriched stockholders. Jensen (1988) estimates that stockholder gains in corporate takeovers and restructurings during 1977-86 approximated $346 billion.[1] Although the precise amount of stockholder gains can be disputed, most observers, including critics of restructuring, agree that these transactions have benefitted stockholders substantially.

Disagreement about the source of the stockholder gains has precipitated a public debate about the economic and social desirability of these transactions. Proponents of corporate restructuring argue that these transactions promote efficiency by mitigating manager-stockholder conflicts and reallocating resources to more productive uses. Critics argue that the stockholder gains in corporate restructurings do not necessarily represent efficiency gains because the gains are offset, at least in part, by losses sustained by other corporate stakeholders, including employees, taxpayers, bondholders, customers, suppliers, and local communities. In addition, critics express concern about the adequacy of disclosure in these transactions, the macroeconomic implications of the restructuring phenomenon, and the effects of restructuring on research and development and the soundness of the U.S. banking system.

This article describes several of the major policy issues concerning corporate restructuring, with an emphasis on the issues in securities regulation that these transactions have raised. In addition to describing the issues, relevant empirical evidence from the financial economics literature is discussed.

SECURITIES ISSUES

The restructuring phenomenon has raised numerous issues involving securities regulation, including the desirability of additional regulation of both bidder and target tactics in hostile tender offers, possible protections for bondholders in restructurings, and the adequacy of disclosure in management buyouts. Each of these areas is discussed in turn.

Regulating Tender Offer Tactics

The advent of large hostile tender offers in the 1980s has precipitated a variety of corporate restructurings, including many going-private transactions, leveraged recapitalizations, and dual class recapitalizations. According to this argument, the threat of a hostile tender offer has induced many corporate managers voluntarily" to restructure their corporations in ways that either raise shareholder value (e.g., going-private transactions or leveraged recapitalizations) or make hostile takeovers more difficult (e.g., dual class recapitalizations). Some evidence exists to support this argument; research at the Securities and Exchange Commission (SEC) finds that 49 percent of going-private transactions during 1985-88 were accompanied by either competing bids or takeover rumors. Hence, it is likely that further regulation of hostile takeovers would not only affect tender offer activity, but also other forms of corporate restructuring.

Several new regulations of tender offers have been proposed at the federal level. Critics of hostile tender offers have proposed a shorter 13d window;,, this window presently gives potential bidders ten days to acquire more than 5 percent of a target's shares before they are required to disclose their stake to the SEC. In addition, legislation has been introduced in recent years to lower the 13d threshhold from 5 percent ownership of a company's shares to 3 percent. These proposals, of course, are designed to protect stockholders by preventing hostile bidders from secretly acquiring large stakes before they launch their bids. However, these measures, if adopted, could work to the detriment of stockholders, because they would reduce the profits associated with takeovers, and, therefore, possibly the number of takeovers.

Legislation also has been introduced to extend the present tender offer waiting period (i.e., the minimum period before a tender offer can be completed) at the federal level from twenty trading days to as many as sixty trading days. This proposal also is ostensibly designed to promote the interests of shareholders in target firms. Jarrell and Bradley (1980) do find evidence that target shareholders benefitted from adoption of the Williams Act in 1968, which provided for a twenty-day minimum offer period, and that takeover premiums are higher in states with longer minimum offer periods. However, they also find that the returns to acquiring firms declined after the passage of the Williams Act, and that these returns are lower in states with longer minimum offer periods. These data suggest that longer minimum offer periods may deter some takeovers and hence deprive some stockholders of takeover premiums.

Proposals also have been made to require shareholder votes before managers can pay greenmail (i.e., repurchase stock from an actual or potential bidder at a premium over the market price of the stock). Although advocates of this proposal have argued that it would promote shareholders' interests, it could have unintended effects that work contrary to the interests of stockholders.[2] TO see this, consider two effects of a raider's activity on the stock price of a target firm - the 13d effect and the greenmail effect. When a raider files a 13d revealing an equity position of at least 5 percent, the target firm's stock price typically rises. Later, if a raider receives greenmail, the target's stock price declines for two reasons: the likelihood of a takeover has declined, and the firm has just paid a premium to buy back some of its shares. Although the payment of greenmail has negative stock price effects, the net effect of the raider's activity is positive if the 13d effect outweighs the greenmail effect. Hence, a federal statute requiring a shareholder vote on greenmail could have negative net stock price effects if it deterred 13d filings. It is interesting to note that many companies have voluntarily adopted antigreenmail amendments to their corporate charters. The SEC has argued that, compared with a mandated federal rule that would apply to all firms, these amendments provide more discrimination, on a firm by firm basis, in applying antigreenmail measures.

Federal legislation also has been introduced to require bidders to make a tender offer for all of a company's shares if they wish to acquire more than a specified percentage of the company's equity (e.g., 20 percent). The purpose of these proposals is twofold: to require bidders to pay a premium for control and to protect small shareholders who might not have the opportunity to receive a premium if control is purchased in open-market purchases or privately negotiated transactions. During the past several years, the SEC has opposed these proposals on grounds that they would raise the costs of takeovers, discourage bids, and hance deprive some shareholders of takeover premiums.

Proposals also have been made at the federal level to regulate defensive tactics, including, most prominently, poison pills (i.e., antitakeover devices that management can adopt without a shareholder vote) and golden parachutes (i.e., lucrative severance contracts for managers that are triggered by takeovers). However, like legislative attempts to regulate bidder tactics, none of these proposals has passed in recent years. The SEC, however, adopted a rule in 1988 that regulates the use of dual class recapitalizations, which purportedly were used often as antitakeover defenses.

In most dual class recapitalizations, companies offer their stockholders an opportunity to exchange their common stock for a new class of common stock with lower voting rights and, usually, a higher dividend. Upon completion of these transactions, the managers of the companies typically have obtained voting control, and hence the ability to defeat hostile bids. Critics of dual class recapitalizations argue that these exchange offers are coercive," because each individual shareholder is likely to exchange his high voting stock for the low voting stock and the dividend "sweetener." This outcome occurs, it is argued, because each shareholder fears that if he does not participate in the exchange offer, and others do, he could be left with high voting stock that is irrelevant (because the managers have obtained voting control) and pays a low dividend. Adopting this line of reasoning, the SEC adopted Rule 19c-which 4, prohibits public companies from engaging in such exchange offers. The rule does, however, allow companies to come public with multiple classes of common stock with different voting rights, because, the SEC argues, these offerings do not involve a disenfranchisement of existing stockholders. The Business Roundtable, a lobbying organization for corporate management, has filed a lawsuit challenging the SEC's authority to adopt this rule.

Although relatively few changes in the regulation of tender offer tactics have occurred at the federal level in recent years, substantial changes have occurred at the state level. In 1987 the Supreme Court upheld the validity of the Indiana state takeover law that restricts the ability of large acquirers of stock in Indiana corporations to vote their shares until the other stockholders vote to allow them to do so. Following this decision, several states adopted similar takeover laws to protect target companies that were headquartered in their states (e.g., North Carolina passed a law to protect Burlington Industries, Minnesota passed one to protect Dayton Hudson, Florida passed one to protect Harcourt Brace Jovanovich). Hence, even though no significant federal legislation to regulate tender offers has been passed in recent years, the U. S. has a de facto new national takeover law, because most states, including Delaware, have adopted takeover laws during the past few years. Several studies have shown that passage of these laws generally has adversely affected the stock prices of issuers incorporated in these states.[3] Presently, there is little support at the federal level for legislation to preempt the state takeover laws.

Bondholder Protection

Although stockholders have fared exceptionally well in corporate takeovers and restructurings, bondholders often sustain losses in these transactions. Research at the SEC finds that bond prices of target firms decline 3 percent on average from one month before the announcement of a going-private transaction through the completion of the transaction (a period of about six months on average). Asquith and Wizman find similar results for a different sample of leveraged buyouts and restructurings.[4]

Traditionally, U.S. courts have ruled that boards of directors have no fiduciary duty to protect bondholders in leveraged buyouts and restructurings. Instead, the courts have ruled that bondholders are to be protected by the covenants of their bond contracts. Advocates of bondholders' rights argue that bond covenants do not provide sufficient protection for bondholders, and urge adoption of policy measures to protect bondholders in these transactions. For example, McDaniel advocates adoption of two rules: a fiduciary duty requiring corporate directors to treat bondholders "fairly" in leveraged buyouts, and a disclosure rule requiring public companies to state whether holders of each class of their outstanding securities are treated fairly in these transactions.[5]

Proposals to protect bondholders in leveraged buyouts are made on grounds of promoting both efficiency and fairness. However, the efficiency rationale for these proposals is quite weak, because the size of the shareholder gains in these transactions far exceed the losses sustained by bondholders.[6] For example, research at the SEC estimates that the losses sustained by all creditors (not only bondholders) in going private transactions amount to only 10.6 percent of the shareholder gains. Hence, if stockholders were required to compensate bondholders for their losses in these transactions, it would affect the distribution of the gains associated with leveraged buyouts, but probably not the number of these transactions.

Two other arguments are relevant for evaluating the efficacy of mandated bondholder protection in leveraged buyouts. First, notwithstanding the claim that bond covenants are ineffective, new bond covenants have evolved to mitigate the risks associated with leveraged buyouts, including so-called "poison puts" (i.e., provisions allowing bondholders to put their bonds back to the issuer at face value in the event of a takeover or restructuring). If the costs of writing and enforcing these covenants are not prohibitive, the efficient level of bondholder protection will be provided in bond contracts. Second, fiduciary protection for bondholders in leveraged buyouts would likely increase litigation costs, as bondholders and stockholders dispute the distribution of gains in these transactions. Increasing litigation costs would be inefficient, of course, because more resources would be used simply to distribute the gains associated with the transactions.

Economic analysis also casts in a somewhat different light the fairness arguments made by bondholder rights advocates. If event risk is efficiently priced, the losses that bondholders sustain in leveraged buyouts should be offset by the gains they receive on bonds of issuers that do not do a leveraged buyout. If it is fair for bondholders to be compensated for these losses, wouldn't it also be fair for bondholders to pay back these gains?

Management Conflicts of interest

Because incumbent management is often the bidder in leveraged buyouts, a potential conflict of interest exists in many of these transactions. In its role as a fiduciary for stockholders, management has an obligation to seek the highest price for stockholders in takeovers. However, in its role as the bidder in a leveraged buyout, management wants to acquire the company at a price that is less than its reservation price. In light of this potential conflict, in 1979 the SEC adopted Rule 13e-3, which requires managers to disclose more information about the valuation of their bids in management buyouts than third party bidders are required to disclose in other takeovers. The purpose of this rule is to provide shareholders and potential third party bidders with the same information that management has about the future fortunes of their firms.

Many large leveraged buyouts are exempt from Rule 13e-3, because the bidders in these transactions are third parties and not incumbent management. In many of these deals, a third party bidder (e.g., Kohlberg Kravis Roberts) offers incumbent management an opportunity to own equity in the surviving company. Several large leveraged buyouts in the 1980s were structured this way, including Jim Walter, Safeway Stores, and RJR Nabisco. Some policymakers argue that these transactions create conflicts that are similar to those in management buyouts, because incumbent managers may provide more information to bidders who offer them an equity participation than they do to other bidders. As a result, some observers have suggested that Rule 13e-3 be expanded to cover transactions in which third party bidders offer incumbent managers the opportunity to buy equity in the surviving companies. Presently, the SEC is considering the efficacy of expanding Rule 13e-3 in this way.

TAX POLICY

It generally is recognized that part of the gains associated with leveraged buyouts and corporate restructurings derives from the tax benefits associated with these transactions. Several tax benefits have been suggested as providing the impetus behind the wave of takeovers and restructurings in the 1980s, including the liberalization of depreciation rules in 1981 that purportedly created incentives for "step ups" in assets, the reduction in personal tax rates in 1986, the reduction in investment tax credits and other tax subsidies to fixed investment (e.g., the repeal of the General Utilities doctrine, which had provided favorable tax treatment for asset sales following takeovers) in 1986, the tax advantages associated with employee stock ownership, and perhaps most prominently, the interest deduction associated with corporate debt.

Although the evidence on the general importance of tax benefits in takeovers and restructurings is mixed, several studies have shown these benefits account for a large part, but not the entire amount, of the premium paid in leveraged transactions. [7] Not surprisingly, much of the debate about leveraged buyouts following the RJR Nabisco transaction has concerned the tax bias towards debt financing in the United States. Both the Senate Finance and House Ways and Means Committees held extensive hearings on this issue in 1989, and the Treasury Department purportedly is revisiting it with an eye towards possibly removing this tax bias. One way to eliminate the bias, of course, is to allow a dividend deduction; however, the present fiscal situation makes it very unlikely that this route will be chosen. Alternatively, eliminating the interest deduction would remove the tax bias, but this measure also is unlikely because this would adversely affect capital costs for U. S. firms. Hence, it seems unlikely that the favored tax treatment of debt will be removed in the immediate future.

Two points concerning the debate over taxes and corporate restructuring are worth noting. First, although part of the shareholder gains in these transactions may derive from reduced corporate tax liability, the effect of these transactions on tax revenue is ambiguous. The reduced corporate taxes are offset, at least in part, by increased tax revenues associated with (1) capital gains taxes paid by target stockholders who receive premiums in these transactions, (2) income taxes paid by tax-paying recipients of the interest income associated with the debt used to finance the transactions, and (3) increased corporate taxes associated with any increase in operating profits following the transactions. Hence, it is not obvious that these transactions involve a redistribution from taxpayers to stockholders.

Second, the fact that substantial asset restructuring usually accompanies financial restructuring strongly suggests that these transactions are driven by more than simply the interest deduction on debt. Research at the SEC finds that more than 25 percent of a company's assets are sold following going private transactions, suggesting that the raison d'etre of many of these transactions is the acquirer's desire to restructure the target firm's assets. If the shareholder gains in these transactions were derived largely from tax benefits associated with leverage, then little asset restructuring would be expected. With the repeal of the General Utilities doctrine in 1986, it also is unlikely that the subsequent asset sales that frequently accompany corporate restructurings are related to the tax advantages associated with these sales.

EMPLOYMENT EFFECTS

The employment effects of corporate restructuring have also attracted considerable attention from policymakers. It often is argued that the stockholder gains in these transactions are financed, at least in part, by losses sustained by employees in the form of lower wages, reduced employment, and terminated pension plans. As a result, the employment effects associated with corporate restructuring also have attracted considerable attention from policymakers. Numerous congressional hearings have been held in recent years on these employment effects generally, and the effects in the airline industry in particular.

What little evidence exists on the employment effects of restructuring indicates that these effects are either small or nonexistent. In the most comprehensive study to date, Lichtenberg and Siegel (1989) used detailed Census Bureau data to examine the effects of leveraged buyouts on productivity, wages and employment for 1,100 large manufacturing establishments during 1981-86.[8]

They find that production workers receive higher annual wages following leveraged buyouts and that their total hours worked declined more slowly after than before these transactions. In contrast, nonproduction workers sustain declines in both hours worked and annual wages following these transactions, suggesting that the adverse employment consequences of restructuring are highly concentrated among managers and supervisors.

Evidence on pension terminations following corporate takeovers is somewhat mixed, but studies generally find that a relatively small percentage of takeovers are followed by pension fund terminations. For example, Pontiff, Shleifer and Weisbach (1989) find that 15.1 percent of hostile tender offers and 8.4 percent of friendly offers are followed by pension fund terminations.[9] Mitchell and Mulherin (1989) also find that a relatively small percentage of pension fund terminations (12 percent) occur within one year of the acquisition of the pension plan's sponsor.[10] Although the ratio of the excess pension funds to premiums is relatively high in takeovers followed by pension terminations (approximately 0.3 according to Pontiff, Shleifer and Weisbach and 0.23 according to Mitchell and Mulherin), as a percentage of aggregate takeover premiums this ratio is relatively small, because only a small proportion of takeovers involves termination of pension plans. Finally, even where terminations are observed, it is not clear that workers are necessarily harmed, because overfunded plans often are terminated simply to consolidate them with plans already sponsored by the acquirer.

Two additional comments concerning the employment effects of takeovers deserve mention. First, because they own a large percentage of equity in the United States, pension plans (especially defined contribution plans) have been recipients of a large proportion of the premiums paid in corporate restructurings. Second, it should be noted that concomitant with the significant increase in restructuring activity during the 1980s has been a significant reduction in the U. S. unemployment rate. Although these data do not imply a causal relationship between takeovers and unemployment, they are inconsistent with the argument that these transactions have created widespread layoffs of employees throughout the United States.

CORPORATE RESTRUCTURING AND LONG-TERM INVESTMENTS

Many observers have argued that corporate restructurings have adversely affected research and development (R&D) in the United States. According to this argument, the high interest expenses associated with restructurings force firms to cut expenditures on R&D and capital expenditures following these transactions. Most corporate restructurings, however, have not occurred in research-intensive industries. For example, SEC data reveals that during 1980-88, the industries with the greatest intensity of going private activity were textiles, apparel, furniture stores, and grocery stores, four industries with relatively low R&D expenditures. In addition, SEC data reveals that 77 percent of companies that went private during 1980-88 reported that their R&D expenditures were not material during the year preceding the transactions.

Two studies have directly examined the effects of leveraged buyouts on R&D and capital expenditures. Smith (1989) finds that only five out of fifty-eight management buyouts during 1977-86 involved companies with R&D expenditures that were significant enough to be reported in their SEC filings. [11] In those five cases, however, Smith did find substantial reductions in expenditures on R&D. Similarly, Smith (1989) and Kaplan (1988) find significant reductions in capital expenditures following leveraged buyouts.[12]

Although the evidence on capital expenditures following leveraged buyouts is consistent with the critics' view, it also is consistent with a more positive view of these transactions. Jensen (1986) and others have argued that a major source of the stockholder gains in leveraged buyouts is the mitigation of manager-stockholder conflicts over a firm's investment poliCy.[13] According to this argument, managers who choose to invest free cash flow (i.e., cash flow beyond what is necessary to invest in positive return projects) in negative return projects that increase firm size but diminish firm value, are likely to find their firms targets of hostile takeover or leveraged buyout attempts. If so, these transactions effectively "disgorge" free cash flow to stockholders in the form of premiums, and the posttransaction reduction in capital expenditures might reflect an elimination of negative return investment projects. If the premiums are reinvested in securities markets, these transactions free up capital for more productive uses, which, of course, enhances economic efficiency. FOOTNOTES

1. Michael C. Jensen, "Takeovers: Their Causes and Consequences," Journal of Economic Perspectives (Winter 1988), 21-48.

2. Two articles that examine this issue are Wayne H. Mikkelson and Richard S. Ruback, "An Empirical Analysis of the Interfirm Equity Investment Process," journal of Financial Economics (1985), 523-555; and Office of the Chief Economist, Securities and Exchange Commission, "The Impact of Targeted Repurchases (Greenmail) on Stock Prices," 1985.

3. See, Michael Ryngaert and Jeffry Netter, "Shareholder Wealth Effects of the Ohio Antitakeover Law," Journal of Law, Economics and Organization (1988), 373-383; Laurence Shumann, "State Regulation of Takeovers and Shareholder Wealth: the Case of New York's 1985 Takeover Statutes," Rand journal of Economics (1989), 557-567; jonathan M. Karpoff and Paul H. Malatesta, "The Wealth Effects of Second Generation State Takeover Legislation," working paper, University of Washington, 1989.

4. Paul Asquith and Wizman, "Returns to Existing Bondholders in Corporate Restructuring," working paper, Massachusetts Institute of Technology, 1989.

5. Morey McDaniel, "Bondholders and Stockholders Journal of Corporation Law (1988), 205.

6. These arguments are also made in Kenneth Lehn and Annette Poulsen, "The Economics of Event Risk: The Case of Bondholders in Leveraged Buyouts," Journal of Corporation Law, forthcoming.

7. Auerbach and Reishus find that the tax benefits associated with mergers generally are small. See Alan J. Auerbach and David Reishus, "Taxes and the Merger Decision," in john Coffee and Louis Lowenstein, eds., Takeovers and Contests for Corporate Control Oxford: Oxford University Press), 1987. Schipper and Smith (Katherine Schipper and Abbie Smith, "Corporate Income Tax Effects of Management Buyouts," working paper, University of Chicago, 1988) and Leland (Hayne E. Leland, LBOs and Taxes: No One to Blame But Ourselves?" working paper, University of California, Berkeley, 1989) find significant tax savings associated with leveraged buyouts.

8. Frank R. Lichtenberg and Donald Siegel, "The Effects of Leveraged Buyouts on Productivity and Related Aspects of Firm Behavior," National Bureau of Economic Research Working Paper No. 3022, June 1989.

9. J. Pontiff, Andre Shleifer and Michael Weisbach, "Reversion of Pension Assets after Takeovers," working paper, June 1989.

10. Mark L. Mitchell and J. Harold Mulherin, "The Stock Price Response to Pension Terminations and the Relation of Terminations with Corporate Takeovers," Office of Economic Analysis, Securities and Exchange Commission, 1989.

11. Abbie Smith, "Corporate Ownership Structure and Performance: The Case of Management Buyouts," working paper, University of Chicago, 1989.

12. See Smith, note 12, and Steven Kaplan, "The Effects of Management Buyouts on Operations and Value," Journal of Financial Economics, forthcoming.

13. Michael C. Jensen, Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers," American Economic Review (May 1986), 323-329.
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Date:Apr 1, 1990
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