Abstract: "Greenmail"
denotes the decision by a corporation's board of directors to
repurchase its shares that are held by a corporate raider,
often at a significant premium, thereby keeping the board of
directors in office. It may represent a conflict of interest
between the corporation's shareholders and the board of
directors. While greenmail is legal, 50% of greenmail gains
are subject to taxation. This Article argues that greenmail
has a healthy role in a competitive market economy.
A corporate raider purchases a significant
number of shares of a stock on the public market, driving the
price of the stock upward. The raider then offers the company
the chance to buy back his shares at an even higher price--or
face the prospect of a hostile takeover, sale of assets, and
new management. Management buys back the raider's shares at a
higher value than on the public market. The raider sells their
shares. The price of the stock on the open then market falls.
Is there anything wrong in this scenario? Before you
answer--what if management did not buy back the raider's
shares? Suppose that the raider then tried to take over the
company driving the public price of the shares even higher. Is
there still something wrong? What if the raider fails to take
over the company? What if the raider succeeds? When we see all
the different basic scenarios, the impossibility of a quick
clear answer becomes apparent: here, one more variable, what
if the company is poorly managed?
This practice of forcing a choice between a
premium share repurchase and the threat of a takeover is
called "greenmail," a term used to contrast the subtsance of
the transaction from "blackmail," or illegal
*428
extortion. What exactly is
greenmail? Is it wrong? Is it legal? What are its effects on
the market? What responses are there to greenmail?
This Article takes the position that
greenmail essentially represents a healthy aspect of
competition to keep entrenched corporate management honest.
Rather than introducing economic distortions, greenmail serves
as an important market signal of an unhealthy company.
Greenmail should not be prohibited and greenmail income should
be taxed at the standard tax rate for ordinary gains.
Greenmail arose as a natural evolution of
corporate takeovers. Prior to the 1960's, raiders sought to
take over companies by proxy fights.
1 A proxy fight occurs
when a raider tries to convince shareholders to vote in favor
of the takeover.
2 Proxy fights are
subject to the Securities Exchange Act of 1934.
3
The 1934 Act requires disclosure of the "identity and
background of the purchaser, the source of funds to be used
for the purchase, the purchaser's plans to liquidate, merge,
or make other major changes to the target company, and the
number of shares owned and sought" to the Securities and
Exchange Commission (SEC") and to the issuer of securities.
4
Trading target shares for raider securities is another route
to accomplishing the same end, with this transaction being
controlled by the Securities Act of 1933.
5
Tender offerings by raiders of cash for targeted stock became
popular in the 1960's and are covered by the Williams Act,
6
which requires disclosure of tender offer information to the
SEC and to the target company. In the 1980's, raiders realized
that they could obtain cash payouts from management without
even taking control of the target company. "Greenmail"
describes this practice of inflating a stock's price by
purchasing it on the open market and initiating a takeover bid
while giving management the option to repurchase its shares
from the raider above the already inflated price. This leads
to an important question: Is greenmail just an elaborate form
of pump and dump? The quick answer is "no." To answer that
question fully we need an exact definition of greenmail.
Greenmail occurs when a shareholder
acquires a significant amount of a company's stock and then
threatens to take over the company unless the purchaser's
shares are bought back by the company at a premium.
7
Greenmail payments represent a repurchase premium.
8
Not all premium rate stock repurchases are considered suspect.
For example, the decision to repurchase the shares of a
company's founder or those shares held by a "white knight" are
not consdiered inherently suspect.
9 Should premium
repurchases be prohibited generally? Founders already have
stock options and, possibly, watered stock. Why should premium
repurchases be allowed to "white knights," traders who are
friendly to management, and not for raiders? The interests of
the shareholders, not those of management, should control and,
thus, if premium share repurchases are allowed as to founders
or white knights, then they should also be allowed as to
ordinary shareholders. To determine whether premium share
repurchases should be allowed, we must consider the economic
effects and theoretical justifications/critiques of greenmail.
One theory, the "management entrenchment"
hypothesis, holds that management pays out greenmail to keep
their own jobs.
10 This is likely the
case as management has an obvious self-interest in maintaining
corporate control. Though management does have an interest in
keeping their jobs, this does not necessarily cause a conflict
of interest between management and ordinary shareholders.
Therefore, greenmail ought not to be prohibited on the basis
of a possible conflict of interest between shareholders and
management. Shareholders have internal governance mechanisms,
as well as the option of not buying into or selling out of
companies with entrenched managers.
*430 Another theory is that
management makes greenmail payments to defend the
"shareholder's interests."
11 According to this
second view, management has inside information that is not
reflected in the stock's price. Greenmail under this second
view is paid to protect the ordinary shareholders' interests.
Another view is that greenmail is paid to reduce the costs of
litigation or opposition to management strategies.
12
Some economists argue that greenmail is justifiable as it
distributes costs of policing management.
13
The obvious self-interest of management to
keep their jobs makes the management entrenchment hypothesis
plausible. However, though greenmail payouts reflect
management's self-interest, they also represent an ordinary
function of competition in the marketplace for good managerial
teams. Greenmail payouts are a penalty for mismanagement and a
market signal. They are a healthy part of the creative
destruction which is the very nature of capitalist
competition.
What are the economic effects of greenmail?
Empirical studies of greenmail on stock price and of
managerial motivation in paying greenmail have been mixed.
14
Greenmail payments usually
15 lead to a decline
in the publicly-traded price of the stock. This is because
management's opposition to takeovers is seen as a sign of
expected poor future performance.
16 Some think that
shows that greenmail is generally not in the shareholders'
interests.
17 I disagree. Even if
greenmail were not an important market signal and a healthy
competitive incentive for the capital market, greenmail does
not generally affect prudent investors in a targeted company.
Shareholders are heterogenous
*431 -- each is in a different
position. When the raider starts buying stock in the target
company, the stock's price will generally rise. Some
shareholders will sell and cash in on a windfall profit. Still
others will hold out and then gladly buy the suddenly
undervalued stock after the greenmail has been paid. In other
words, just as the economic studies yield mixed results, so
too are the effects of greenmail on individual shareholders
unpredictable. Even if takeover rumors always lead to
inflation of a stock price, and even if greenmail payments
always lead to a reduction of the stock's publicly-traded
price, the market, including prudent investors, can take all
of that into account. Greenmail is just one more example of
self regulation of the market through competition. Further, if
greenmail weeds out bad management, which it likely does, then
it is good for the economy.
Greenmail weeds out bad management.
"[F]irms paying greenmail have above-average management
turnover in the following year."
18 Moreover, greenmail
is not effective as a tactic to prevent a hostile takeover.
For example, the St. Regis Co. paid greenmail twice; the third
takeover bid resulted in the sale to a white knight.
19
Though greenmail is not an effective tool for entrenching
management, and is unproblematic for that reason too,
greenmail is an effective way to threaten entrenched and
inefficient managers. Greenmail isn't a problem. It's a
solution.
In other words, greenmail is more than just
an elaborate "pump-and-dump" scheme. True, the takeover bid
generally increases the price of the stock on the open market.
Likewise, the greenmail payout generally results in "falling
stock prices." So what? That's completely normal--it's called
the law of supply and demand. Even if that weren't the case,
regulators must remember: managment can always "just say no"
and refuse to pay greenmail. Raiders take on a significant
risk in hopes of a correspondingly significant reward; they
aren't always right. The good business with bad management may
turn out to be a bad business with good management capable of
ferocious resistance for little or no reward. Second,
management, especially entrenched and inefficient management,
deserves to be threatened with a takeover when it is
ineffective. Greenmail is just one more instance of capitalist
competition leading to best performance.
To the extent that greenmail represents
ordinary competition it does not need a remedy. Responses to
greenmail are essentially anticompetitive. Because greenmail
has a healthy function in the market, it is unsurprising that
greenmail is not considered to be the crime of extortion, or
any crime at all.
20 Greenmail is not
extortion because there is no unlawful obtention of property
21
and because management does not have the right to be free from
the threat of a hostile takeover.
22 Courts recognize
the competitive function of corporate raiding.
1. Greenmail Payments are Lawful and
Subject to the Business Judgment Rule
The decision of management to pay out
greenmail is permitted as an instance of business judgement.
The "business judgement rule" essentially holds that courts
will not second guess the lawful decisions of management by
allowing for various causes of actions, such as the tort of
"negligent management."
23 However the
business judgement rule is modified in the law of Delaware,
New York, and California to take into account the conflict of
interest between managers and shareholders.
24
Each of those states require management to prove there is some
rationale justifying its decision.
25 California requires
the inherent fairness of the transaction to be shown.
26
New York requires the justification be not merely arguable,
but also plausible.
27 Delaware requires
that the transaction be arguably in the shareholders'
interest.
28 Delaware permits
greenmail payments provided the purpose of management is not
self-entrenchment;
29 however, in doing
so, it requires an enhanced business judgement inquiry. Some
"factors that the board of directors should analyze include:
the inadequacy of the price offered, the nature and timing of
the offer, questions on illegality, the impact
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on constituencies other than
shareholders, the risk of nonconsummation, and the quality of
securities being offered in the exchange. "
30
2. Charter/By-Law Amendment
Within the logic of capitalist competition
and freedom of contract it is clear that the principal
response to greenmail should be made by the company and not
the state. Shareholders can and do amend corporate charters to
prohibit greenmail. Amendments to corporate charters, unlike
greenmail payments, do not result in a decline in stock
prices.
31 International
Minerals & Chemicals, Perkin-Elmer, Mobil Oil, and many
other companies have written anti-greenmail provisions into
their charters or bylaws.
32 Thus, there is
little reason for state intervention to prevent greenmail.
33
Government regulation of corporation charters reduces
shareholders' investment choices.
34
Another response to greenmail is
disgorgement statutes which require remittance of greenmail
payments. Critics point out that disgorgement reduces
competition, diminishes shareholder participation, and
depresses stock values.
35 I would argue they
also represent a restraint on trade and a form of
protectionism subject to antitrust law.
Some states have introduced anti-takeover
statutes. State anti-takeover statutes have been challenged as
unconstitutional on the basis of both the supremacy clause,
alleging inconsistency with the Williams Act,
36
and the dormant commerce clause
37 with mixed results.
38
The
*434
Williams Act
39
requires disclosure to the SEC and the target company when a
shareholder acquires more than 5% of a company. A state
anti-takeover statute cannot conflict with the Williams act.
40
That is, the state anti-takeover statute must be consistent
with federal law. State anti-takeover laws have also been made
for reasons of protectionism,
41 which raises the
question of their compliance with the WTO. Competition among
states may be the best way to determine the best regulatory
response to greenmail and hostile takeovers.
In 1987,
Public Law Number 100-203, Sec.
10228(c) established Internal Revenue Code Chapter 54, Section
5881, entitled "Greenmail".
42 Title 26 of the United States Code,
Section 5881 (
I.R.C. § 5881) imposes a 50% tax
on greenmail payments.
43 Greenmail payments
can be in any form, or "consideration."
44
Greenmailed shares must have been held for less than two
years.
45 The sale of stock
must be in connection with a public tender offer.
46
As well, the greenmail payment must be differential, that is
it must be made on terms other than are available to all other
shareholders.
47 Public tender
offers are those offers to purchase stock or assets which
would be required to be filed or registered with federal or
state regulatory agencies.
48 The tax applies
whether or not gain is recognized.
49
The SEC permits greenmail payments because
greenmail payments are taxed at a higher rate than other
income. Coupled with the possibility to amend the corporate
charter, the SEC sees no reason for federal intervention.
50
*435 2. RICO/Hobbs Act
(Extortion)
Critics of greenmail sometimes propose that
it should be covered by the federal Racketeering Influenced
and Corrupt Organizations Act (RICO) or by the Hobbs Act. To
obtain a civil RICO remedy under Section 1962 of the United
States Code, plaintiffs must prove: "(1) a person (2) through
a pattern (3) of racketeering activity (4) directly or
indirectly (a) invested in, (b) acquired or maintained an
interest in, (c) or participated in (5) an enterprise (6) that
affects or engages in interstate commerce and (7) causes
injury thereby. "
51 Proving wrongful
injury, of course, is not really possible. Stock prices are
always speculative. Management and ordinary shareholders have
a conflict of interest. Likewise the Hobbs Act does not seem
applicable. The Hobbs Act
52 has two elements:
obstruction of interstate commerce and robbery or extortion.
53
However, greenmail is not extortion; thus, the Hobbs Act
cannot apply. Again, even if there was a problem, this really
isn't an appropriate remedy.
Corporate takeovers ensure competition
among managers to be efficient and effective businessmen.
Greenmail is one incentive for managerial competition. Thus,
greenmail is not itself problematic; it is just one more
mechanism of efficiency through competition. Greenmail is not
an effective tool for managerial self-entrenchment. However,
the speculative impact of greenmail is good for the economy
since it highlights companies which are poorly managed and
overvalued on the public market. By threatening bad managers
of good companies, and by reallocating capital to efficient
actors, greenmail strengthens the economy. Thus, most of the
responses to greenmail are attempts to remedy a non-problem.
The most effective remedies, consistent
with the capitalist logic of competition and individualism,
are at the corporate level. A prudent corporation can foresee
the possibility of a hostile takeover and amend its articles
of incorporation and bylaws to protect itself. Improvident
corporate managers probably deserve the risk of takeover that
they incur by using shoddy "off the shelf" charters and
bylaws. "Mom and pop" organizations must eventually grow up or
sell out to more efficient operations. Further, the individual
remedy is also effective
*436 at the shareholder level.
Selling stock when there is a takeover rumor and buying the
now (supposedly) undervalued stock in the aftermath of the
payout are rational investor actions that require no inside
information. SEC reporting requirements and shareholder
diligence remove the risk of insider trading.
Individual and corporate responses are
adequate and best. Mercifully, state neo-mercantilist efforts
at regulating takeovers are constrained by regulatory
competition and federal supremacy. Thus many state
anti-takeover statutes have been stricken as illegal.
And the federal response? The federal
government imposes a heavy tax on greenmail, but taxes of 70%
were once common. A 50% tax is onerous enough to discourage
speculative greenmail, but not so great as to prevent raiders
from threatening takeovers assuring management competition. In
the interest of preventing econmic distortion, it would be
wiser to reduce the greenmail tax to the maximum corporate
rate, allow greenmail payments to be characterized as ordinary
and necessary business expenses (that are to be deducted from
taxable income), and allow the greenmail payout to be treated
as ordinary income, and thus able to be offset by any losses.
Such minor tax reforms will occur to the extent that takeovers
become correctly perceived as one more instrument of economic
competition ensuring efficient markets and good economic
performance.