Fama on Corporations and CEO Compensation

by Don Boudreaux on January 22, 2008

in Economics

Back around 1987 I recall hearing the then-Dean of the George Mason University School of Law, Henry Manne, predict that the wave of legislation sweeping through state houses to protect corporations from hostile takeovers (and, hence, protect incumbent corporate managers from losing their jobs) will result in an increase in corporate misbehavior.

In this interview with The Region (a publication of the Minneapolis Fed), Eugene Fama makes a similar point:

Region: In  the early 1980s, you authored three key pieces regarding principal-agent  conflicts [due to differing incentives of an organization’s  owners and employees] and how they play out efficiently in various types of organizations. How have your ideas evolved in light of transformations in the corporate world?

Fama: I  haven’t spent a lot of time on these issues since then, but they keep  popping up. I haven’t seen anything that would cause me to change my  opinions generally, but something that has bothered me is the drying up of the  takeover market due to the installation of antitakeover provisions by most companies, enabled by state legislatures.      

Region:  Poison pills and the like?

Fama:  Right, and that is very unhealthy, I think, for the corporate world  because it takes away the threat of outside takeovers, which is very important for the economy.

Region: A  form of market discipline.

Fama: Yes,  it’s a unique discipline that corporations have that other forms of  organization don’t have. For example, it’s very difficult to attack the  University of Chicago in that  way. It doesn’t need a takeover defense because there’s no real way to attack it. For a corporation, on the other hand, there was a way. That allowed corporations to have expert boards because the board wasn’t the court of last resort. But the institution  of all antitakeover amendments threw a wrench in the process.

[Anyone who hasn't yet read Manne's classic paper  "Mergers and the Market for Corporate Control" (Journal of Political Economy, April 1965) should do so forthwith.  Its insights are keen and important yet sadly too-little understood.]

But here, in the same interview, is what Fama says about CEO compensation:

Region:  Another issue those papers touched on was compensation of CEOs, a  controversial question in recent years. How do you view the suggestion that
        some CEOs are overcompensated?

Fama: If  the [compensation] process gets captured by the CEO, then it can get  corrupted. But if what you’re seeing is a market wage, then I don’t know  why you would say it’s too high. If it’s a market wage, it’s a market  wage. I don’t know of any solid evidence that the process was corrupted.  So my premise would be that you’re just looking at market wages.  They may be big numbers; that’s not saying they’re too high. It’s easy to  say that people are paid too much, but when you’re on the other side of  the fence trying to hire high-level corporate managers, it turns out not to  be so easy.

As patrons of the Cafe might easily guess, I am — like Fama — not especially hot’n'bothered by CEO compensation.  But it strikes me that Fama here skirts close to being inconsistent.  Surely the use of antitakeover statutes to protect incumbent managers from market forces at least partially corrupts the market for managers and, hence, might be at least partly responsible for the height of some CEOs’ salaries.  (Of course, if this is true, the way to correct the problem is to repeal the antitakeover legislation.)

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jp January 23, 2008 at 9:57 am

Thanks for posting this.

One technical point: Under Delaware law (at least), poison-pill authority is not a matter of statute. Delaware does have an anti-takeover statute, but it deals with something separate from poison pills. Poison pills are permitted under judge-made law. Therefore, to get rid of poison pills, one would have to *enact* a statute, not repeal a statute.

Delaware's anti-takeover statute is a default provision (corps can opt out of it under certain circumstances) that has pretty much the same *practical* effect as a poison pill — it encourages the acquirer to negotiate with the incumbent board.

In either case (poison pill or anti-takeover statute), the acquirer can still do a hostile takeover if it can get enough stockholder votes (in the neighborhood of 80%). This does tilt the playing field in favor of incumbents. How much of a tilt, I don't know.

vidyohs January 23, 2008 at 10:59 am

Because I am ignorant of the answer I have to ask.

How many of the past corporate hostile take-overs were of corporations that were well managed and were consistently running in the black; but were targeted by another corporation that managed to muster enough enticement to dangle in front of the shareholders to allow a take-over (I think that is the way it works, does it not?) The take-over being done for the pure purpose of raiding the resources and customer base of the original corporation for the benefit for the new corporate owners. (again, did this sort of thing actually happen as I have the impression it did?)

If I am not too far off base in what I have asked, then that would tend to muddle the market for CEOs, would it not?

I know there are people participating on this blog that could help a country boy out on understanding this.

jp January 23, 2008 at 12:42 pm

vidyohs — I don't have numbers, but I can say that takeovers don't happen only because the target company is poorly managed. The one common element among takeovers is that (in the absence of fraud, of course) the acquirer believes that the takeover will ultimately be a net benefit to it. That may mean that the acquirer thinks it can run the target's operation better than the incumbents have been running it, or it may mean that the acquirer thinks the target is worth more as a collection of assets for sale than as a continuing operation. (To give an extreme example, say the target company owns a hotel built over a gold mine. The acquirer believes the land has more value as a gold mine and therefore buys the target, fires the maids and bellhops, sells the furniture and equipment, and tears down the hotel to dig a mine.)

Both the acquirer and the target's stockholders are making a decision about how much the target is worth to them. If the acquirer believes that the target's "highest and best use" is to be broken up, and feels it's worth more that way than whatever value the stockholders place on their shares, then the acquirer will offer a price high enough buy up the shares (or to cash them out) while still leaving itself room for the profit it hopes to make.

It's hard to argue that the state should step in and keep acquirers and stockholders (owners) from reaching whatever bargain they want.

Of course, one could also argue that the current array of state-level anti-takeover statutes *is* the result of market interactions — specifically, competition among states to get entrepreneurs to form corporations there and pay state franchise taxes. That competition wraps in the desires of both managers and investors, because someone who forms a corporation also has to be mindful of what jurisdictions are most attractive to investors.

vidyohs January 23, 2008 at 7:36 pm

Thanks jp,
That gives me some food for thought.

Appreciate it.

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