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The Inefficiency of Hostile Takeovers as a Disciplinary Mechanism: A Theoretical Analysis

Author(s)

Sang Yop Kang
Professor of law at Peking University, School of Transnational Law

Posted

Time to read

6 Minutes

Traditionally, hostile takeovers have been regarded as a mechanism to enhance societal efficiency. When a corporation’s management or governance standards are poor, its value and stock price tend to decline, thereby making it a target for acquisition by a bidder. To avoid such consequences, companies are incentivized to improve their performance and governance practices. This traditional view rests on the assumptions that a company’s firm value and stock price adequately reflect its operational efficiency and governance quality, and that underperforming firms are disciplined through the hostile takeover system.

In contrast, my working paper titled The Inefficiency of Hostile Takeovers as a Disciplinary Mechanism: A Theoretical Analysis challenges this traditional view.[1] Specifically, the paper illustrates how ‘market infrastructure issues’ can restrict the pool of potential targets or distort firm values and stock prices, undermining their role as indicators of management and corporate governance quality. These issues include controlling ownership structures, information asymmetry, dominant market positions (eg, monopoly or oligopoly), government (or other entity) support and subsidies, and imperfections in the capital market.

When market infrastructure issues disrupt the price mechanism, underperforming companies may be overvalued, while high-quality companies may be undervalued. Such mispricing obscures signals of corporate quality, leading potential bidders to target high-quality firms, while low-quality firms evade discipline. Consequently, the role of takeovers as a disciplinary mechanism can be inadvertently and significantly compromised and takeovers can even become detrimental to economic efficiency. Below, I discuss how market infrastructure issues can create overlooked or unforeseen challenges, impeding the takeover system’s role as a disciplinary mechanism.

Corporations’ ownership structures play a crucial role in shaping the availability and efficiency of hostile takeovers. Globally, controlling ownership structures prevail in most countries,[2] with exceptions such as the United States and the United Kingdom. In economies where controlling ownership is predominant, potential target companies are restricted to a small subset of corporations with dispersed shareholding, for example 10%.[3] Then, the remaining 90% would largely fall outside the scope of the takeover system. The limited scope of takeovers reduces their effectiveness as a ‘generally applicable’ disciplinary mechanism. Moreover, the companies targeted among the 10% are not necessarily the worst-performing or the most poorly governed compared to the unaffected vast majority, which can impair the disciplinary function of takeovers.

Additionally, my paper examines how information asymmetry, a well-known contributor to market failures, obstructs the disciplinary function of hostile takeovers. Information asymmetry is especially severe in the capital markets of countries with underdeveloped disclosure and enforcement systems, where reliable information about a company’s financial performance, management quality, and future prospects is often lacking. Given this situation, the accuracy of the disclosed information is frequently compromised.

Without accurate information, corporate stock valuations are flawed, as ‘material information’ that should be reflected in stock prices is not fully available. Moreover, companies may misrepresent material information, inducing investors to misjudge the relative value and performance of firms. Accordingly, investors are unable to distinguish high-quality corporations with accurate disclosures. Under these circumstances, high-quality companies may suffer from lower stock valuations due to a lack of investor confidence, whereas companies that manipulate information may sometimes attract investors more and attain higher valuations. In such cases, the hostile takeover system appears to mirror Gresham’s law, rewarding companies with opaque or manipulated information while penalizing those that uphold transparency, thereby failing as an effective disciplinary mechanism.

Furthermore, information asymmetry in the product market can skew consumer preferences and behaviour, prompting them to purchase products they would not have chosen while overlooking products they otherwise would have chosen. These shifts in purchasing patterns may distort financial indicators such as revenues and earnings. This distortion, in turn, affects firm values and stock prices. Consequently, such price distortions prevent the hostile takeover system from functioning efficiently as a disciplinary mechanism.

Monopolistic or oligopolistic market power can also undermine the disciplinary role of hostile takeovers. Poor managerial performance or weak corporate governance may decrease a corporation’s value. However, companies with strong market dominance can generate substantial ‘economic rents’, offsetting declines in firm value or even causing it to rise. In other words, these companies have an advantage in the capital market compared to those lacking dominance in the product market.[4] Accordingly, their economic rents, positively reflected in stock prices, reduce the likelihood of hostile takeovers. Moreover, acquiring companies with market power requires potential bidders to secure substantial acquisition funds, shoulder significant financing costs, and bear the considerable opportunity cost of forgoing alternative investments, making takeovers challenging to implement in practice.

Government subsidies and support also create significant obstacles for hostile takeovers as a disciplinary tool. In many countries, government interventions through subsidies, tax incentives, or regulatory advantages bolster certain companies, inflating their stock prices independently of management efficiency or corporate governance. This phenomenon, which my paper terms ‘government-generated rents,’ enables companies to evade the disciplinary pressures of hostile takeovers, while companies that lack government support, even if they are better managed, may face lower valuations and become unintended takeover targets. Entities other than the government, such as corporate groups, also support or subsidize a corporation.[5] For instance, a corporate group may subsidize an affiliated company through another affiliated company. In this case, a subsidized affiliated company enjoys transactional or financial advantages, thereby enhancing its firm value even if the corporation’s management performance and quality of corporate governance are not outstanding. Conversely, companies that do not receive support from a corporate group are placed at a disadvantage, for example, in product market competition, resulting in reduced revenues and earnings, which in turn puts pressure on their share price. In essence, the disciplinary role of takeovers is hindered.

Capital market imperfections further impede the takeover system’s efficiency. In countries with restrictive policies on trading practices like short-selling, price discovery is hampered, resulting in inaccurate stock valuations. Furthermore, in many countries, including China and Korea, where retail investors are dominant or significantly influential in shareholding and trading volumes, stock prices are highly susceptible to noise trading and behavioural biases, which increase market volatility and distort valuations. Retail investors, who lack the analytical resources of institutional investors, tend to trade based on rumours and exhibit herd behaviour, leading to frequent mispricing in the market. These price distortions erode the takeover system’s ability to correctly identify low-quality firms for discipline, as stock prices no longer reliably reflect the intrinsic values of corporations based on the quality of management and corporate governance.

It is noteworthy that even in the United States, hostile takeovers are rare. This is primarily due to poison pills, a game-changer in the market for corporate control, which significantly restrict takeovers. Nevertheless, the use of golden parachutes—lucrative severance packages for outgoing executives—facilitates smoother management transitions. By contrast, in many countries, such as China and Korea, golden parachutes are legally, culturally, or practically limited. As a result, corporate decision-makers lack motivation to relinquish control, further weakening the disciplinary role of the market for corporate control.

In conclusion, various market infrastructure issues may cause the hostile takeover system to overlook poorly performing companies and mistakenly target relatively well-performing ones. Under these circumstances, invigorating the takeover system may diminish economic efficiency. Therefore, addressing these market infrastructure issues should take precedence. Further country-specific empirical research is encouraged to explore the complex relationship between market infrastructure issues and the disciplinary role of takeovers across diverse legal and economic environments.

The author’s paper can be found here.

Sang Yop Kang is a Professor at the Peking University School of Transnational Law and a research member of ECGI.

 

FOOTNOTES:

[1] My paper is theory-oriented, but it occasionally references examples from large economies like China and Korea. This blog article minimizes specific country examples, as addressing the multi-dimensional complexities of various countries’ market and legal systems in concise terms in the blog article risks oversimplification or potential misleading.

[2] There is no universally agreed-upon standard for establishing control over a corporation. However, one perspective suggests that holding approximately 30% of the voting rights may be sufficient to exert control, especially when the remaining shares are widely dispersed, and shareholder turnout is low at a shareholder meeting. Nevertheless, in certain circumstances, even with 30% voting rights, control can be threatened in cases such as hostile takeovers.

[3] However, a company with controlling ownership (eg, 30% voting rights) is not entirely immune to hostile takeovers. Additionally, for instance, corporate groups organized through circular shareholding are more vulnerable to hostile takeovers compared to those based on a pyramidal structure. This is because an external attack that severs one link in the circular shareholding chain could lead to the collapse of the entire corporate group. Furthermore, in cases where control is established through a dual-class equity structure, special voting right shares may not apply in the context of mergers and acquisitions.

[4] Companies with market power, owing to their robust cash-generating capabilities, are further favoured by investors, enabling them to achieve a lower cost of capital when issuing bonds or new shares. In this way, market dominance in the product market also translates into financial advantages in the capital market.

[5] I do not mean that government intervention or support from affiliated corporate groups is entirely unnecessary or undesirable, as such measures can sometimes address market failures. However, within the specific context of my paper, I highlight that such intervention or support has the potential to weaken the disciplinary mechanism of hostile takeovers.

 

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