Five Decades of Corporation Law: From Conglomeration to Equity Compensation

This brief essay recounts developments in corporation law over the last fifty years. It begins with the rise of finance capitalism and the conglomerate corporation which was followed by the emergence of hostile takeovers in the late 1970s and 1980s. One of the key events in this saga was the February 1, 1983 decision by the Delaware Supreme Court in Weinberger v. UOP, Inc. that effectively permitted the at-will elimination of minority stockholders through cashout mergers. Takeovers were also facilitated by two major financial developments: (1) the growth of institutional investors coupled with the growing taste of diversified investors for risk and (2) the emergence of the junk bond market as a source of cash to finance takeovers. Target managers vigorously sought ways to defend themselves from takeover. But the genie was out of the bottle. Although the initial motivation for takeovers was the bust up of inefficient conglomerate companies –because investors figured out that they could roll their own diversified portfolios more cheaply – diversified investors also figured out that they could tolerate more risk. So they demanded higher returns from all companies. Faced with this irresistible force, target managers also sought ways to share the gains. The result was that executive compensation evolved from a salary and bonus system to one based on stock options and other forms of equity. Equity compensation gave rise to two unintended –but quite happy – consequences. One is that it permits managers to share in the gains from divestitures and thus eliminated the bias for growing the company that went with the old salary and bonus system. The other is that it causes public companies to distribute available cash through repurchases designed to deal with the dilution that comes from the exercise of stock options. Ironically, the primary justification for takeovers had been that target companies tended to hoard cash and use it for uneconomic growth. Thus, the takeover did not die because of defensive tactics and protectionist state takeover laws. It simply went in house. The implications of this evolution are significant. For one, it calls into question the traditional notion that the stockholders own the company and that the CEO is a glorified employee. It may make more sense to think of stockholders and managers as in partnership with each other with the board of directors charged primarily with the role of arbitrating the competing claims of these two groups of owners. If this is the better view of the corporation, then executive compensation becomes the central concern of corporation law rather than an interesting subset of problems falling somewhere between the duty of care and the duty of loyalty. Moreover, under this view of the corporation, it would seem quite important to enforce rules against insider trading, whereas under the traditional view of the corporation the rationale for the prohibition of insider trading is not at all clear. This text of this essay was delivered as a lecture at the inauguration of the McGuinn Chair of Business Law at Villanova University School of Law on October 12, 2007. FIVE DECADES OF CORPORATION LAW – From Conglomeration to Equity Compensation