Takeovers, shareholder litigation, and the free-riding problem

Highlights

• We analyze tender offers that are followed by a squeeze-out in corporate takeovers.

• We show that shareholder litigation induces some redistribution of takeover gains.

• An offer below the post-takeover share value can still succeed with certainty.

• Flaws in the design of takeover laws however restore the free-riding dilemma.

• Our results hold for the two standard legal remedies of shareholders.

Abstract

When shareholders of a target firm expect a value improving takeover to be successful, they are individually better off not tendering their shares to the buyer and the takeover potentially fails. Squeeze-out procedures can overcome this free-riding dilemma by allowing a buyer to enforce a payout of minority shareholders and seize complete control of the target firm. However, it is often argued that shareholder litigation restores the free-riding dilemma. Applying a sequential takeover game, we examine the two standard legal remedies of shareholders, the ‘action of avoidance’ and the judicial ‘price fairness review’ and demonstrate that it is not shareholder litigation that brings back the free-riding dilemma, but rather the strategic gambling of buyers for lower prices and flaws in the design and application of squeeze-out laws. We also analyze a favorable change in jurisdiction of the German Federal Court and provide implications for legal policy.

Introduction

It is commonly accepted that takeovers of firms play a crucial role in the economy. Given effective competition, successful takeovers accelerate the restructuring and rightsizing of formerly weak and cost inefficient firms. Through the acquisition, buyers are able to realize synergies in production and economies of scope and scale. Furthermore, takeovers often lead to the replacement of the previous management, and this ideally favors change and a quicker adjustment to the market situation (see, among others, Yarrow, 1985; Scherer, 1988; Holmström and Nalebuff, 1992).

Many large firms in the various industries of today's economies can be regarded as widely held corporations¹ (see, e.g., Porta et al., 1998; Faccio and Lang, 2002, and Rubin, 2007), and a successful takeover often requires that a public bid from a corporate buyer is accepted by the firm's shareholders.² It is well known that this takeover bid mechanism is prone to a free-riding dilemma among shareholders: “any profit a raider can make from the price appreciation of shares he purchases represents a profit shareholders could have made if they had not tendered their shares to the raider” (Grossman and Hart, 1980, p. 43). As efficiency enhancing takeovers eventually lead to a higher firm value and thus higher share prices, holding out and keeping the shares will enable minority shareholders to freeride on the buyer's effort and participate in these takeover gains. Thus, shareholders will reject a public bid from the buyer when they expect the takeover to be successful and value improving. As a consequence, such free-riding behavior potentially impedes the takeover as the buyer may not collect enough shares to assume control of the target.

In order to facilitate takeovers, so-called squeeze-out procedures have become increasingly relevant for corporate buyers in many jurisdictions (e.g., United States Delaware law, European Directive 2004/25/EC, German § 327a-327f AktG). In principle, a squeeze-out³ entitles a buyer who has collected the majority of a company’s shares and who meets a required minimum fraction of ownership (the ‘squeeze-out threshold’) to forcibly pay out all the minority shareholders and assume full ownership of the company.⁴ As a consequence, in a tender offer for control, shareholders can no longer expect to participate in the anticipated appreciation of the share price by rejecting the bid. Squeeze-out procedures thus basically eliminate the free-riding problem (see Yarrow, 1985).

However, such squeeze-outs also enable the buyer to seize the complete gains of the takeover and force shareholders out of their investments. Most countries thus enacted specific shareholder protection laws. Standard legal remedies for shareholders include the ‘action of avoidance’, which contests the legitimacy of the squeeze-out itself, and ‘price fairness’-procedures where the payout price is reviewed by the court. In the end, a court ruling can hinder or delay the squeeze-out and change the distribution of takeover gains between the buyer and the shareholders. Several scholars claim that such shareholder litigation effectively restores the free-riding problem and thus frustrates the underlying incentive mechanism of squeeze-out procedures (see, e.g., Mueller and Panunzi, 2004 and Burkart and Lee, 2018).

In this paper we focus on tender offers that are followed by a squeeze-out (i.e., ‘two-step’ tender offers), and examine the effects of costly shareholder litigation on the success of such takeovers. We show that shareholder protection rights and litigation induce a redistribution of takeover gains, as intended by legislators in the United States and Europe, and do not impede efficient takeovers or sizeable rents for the acquirer per se. In the following, we stylize the takeover bid mechanism as a sequential game between a corporate buyer and atomistic shareholders. In this theoretical setting, all takeovers are value improving and individual shareholders may either accept the offered price by the buyer and tender their shares, or reject it. If sufficient shares are collected in the tender phase, the buyer may announce squeeze-out procedures and, in exchange for a compensation payment, force all remaining shareholders out of the target. Shareholders may, however, move to court and seek a review of the fairness of the compensation payment by the judge. A buyer thus has to form rational expectations about the later value of litigation to shareholders, i.e. about their reservation price. In order to accomplish the takeover and eliminate any free-riding incentive, he then makes a profit-maximizing tender offer that equals this reservation price.

We find that, despite the risk of shareholder litigation, a buyer is basically able to make a tender offer at a price below the expected post-takeover share value and achieve a successful takeover. The judicial ‘price fairness review’, however, compels buyers to offer higher prices to incentivize tendering and thus avoid the free-riding problem. Low costs of shareholder litigation, brief court procedures and a low discount rate work in favor of litigating shareholders. As a consequence, the required payments to eliminate free-riding increase, and it becomes costlier for the buyer to achieve a certain takeover. Our analysis shows that the free-riding dilemma in the takeover bid mechanism only re-emerges when buyers try to reduce takeover costs by using lower-than-optimal bids, when dual legal thresholds for corporate control and squeeze-outs are in place, and when the judicial price review focuses on share price fluctuations after the buyer made his public bid.

More broadly, we demonstrate that it is not shareholder litigation that restores the observed free-riding dilemma, but the strategic gambling of buyers for lower prices and flaws in the design of squeeze-out laws and judicial review. This finding applies to the two standard legal remedies of shareholders, the ‘action of avoidance’ and the judicial ‘price fairness review’.⁵ Previous research by Mueller and Panunzi (2004) and Burkart and Lee (2018) does not consider shareholders’ litigation cost and shareholders’ time preferences. They also do not take into account that, in practice, most court proceedings are ended by settlement. Our results corroborate the detrimental effect of separate legal thresholds for corporate control and squeeze-outs shown by Gomes (2012) and Dalkir et al. (2018).

The paper is organized as follows: chapter 2 provides an overview of the related literature and chapter 3 introduces the institutional background. Chapter 4 describes the stylized takeover game and derives first theoretic results. We then apply our model to a major change in the German jurisdiction on squeeze-outs in chapter 5. Chapter 6 concludes.