Hostile to Whom? "Economic Patriotism" To Resist "Market Dictatorship"

When the state-controlled Chinese oil company CNOOC tried to buy Unocal and the all-cash offer looked attractive enough to make it likely that the requisite proportion of shareholders would accept it, the furious noise in Congress and the media reached a pitch quite out of proportion to the intrinsic importance of the affair. China was going to undermine US national security, divert ‘essential’ energy supplies from the American consumer, and so forth. The political climate became so stormy that CNOOC was frightened away and Unocal was picked up at a somewhat lower price by Chevron. Some cool heads have reckoned that the Chinese offer overvalued Unocal, but happily American economic patriotism saved the Chinese from overpaying.

When the Dutch bank ABN Amro tried to buy the Italian bank Antonveneto in the face of board opposition, wheels within wheels started to spin, submerged power networks were activated and the prolonged legal and financial battle ended with a resounding scandal and the forced resignation of the governor of the Bank of Italy. Some took the subsequent buyout of Banca Nazionale del Lavoro by the French bank BNP Paribas for a capitulation of the Italian national interest.

When all too audible stage whispers have expertly spread the word that Pepsico was preparing to make a ‘hostile’ bid for the French yoghurt and mineral water firm Danone, a ‘national champion’, President Chirac personally vowed to ‘resist the attack’ and defend the brave French yoghurt against the brazen invader—though the bluster had little substance in it for lack of any clear legal power to stop Pepsico to make the offer and the Danone shareholders from accepting it. The prime minister solemnly appealed to ‘economic patriotism’, called upon French companies to ‘padlock their capital structure’ to make changes of control less easy, and initiated legislation giving the government powers to ban control passing to foreign hands in eleven ‘strategic’ sectors of the economy.

Among a handful of other examples of ‘hostility’, Mittal Steel’s offer to buy Arcelor is creating the most emotion. Mittal, the world’s biggest steel producer, is legally European, but is 85 per cent controlled by the Indian Mittal family. Arcelor, the world’s No.2, is European in both legal domicile, management and ownership. Mittal is downmarket, Arcelor is upmarket and proud of it. Its shareholders may choose to sell out to Mittal all the same, which the French and Luxemburg governments deem an intolerable ‘dictatorship of the market’ and are angrily trying to block. The attempt is mainly bluster, but the rhetoric accompanying it is as ugly as it is confused.

Objectively, ‘hostile’ offers are hostile only to the sitting management and related vested interests. However, when they are cross-border, they are invariably styled as attacks upon the host nation of the target company. When Dubai Ports is trying to buy the worldwide port installations of Peninsula & Orient, including those in five US East Coast ports, it is threatening American national security and must be stopped, though Dubai Ports would not replace American customs and port security personnel by Arab terrorists, and could not if it would. Likewise, when the Italian power utility Enel sounds as if it were planning to make a ‘hostile’ offer for the Franco-Belgian power and water utility Suez, Paris quickly rushes through a shotgun marriage that pre-empts the possible Italian bid in the name of French ‘energy security’. Presumably, there was a danger that Enel would pay big money for the Suez power stations in order to shut them down and plunge France and Belgium into darkness. However, the most inane pretext will do to brand perfectly bona fide transactions ‘hostile’ especially if the widely hated stock market is involved in it.

Protecting the Principal-Agent Dilemma

The result of ‘economic patriotism’ is to curb the liberty of owners to use their assets as they see fit within agreed liability rules. This includes the liberty of selling assets to the highest bidder who thinks he can make more productive use of them and will bet money on his belief. The cost of curbing this liberty is best understood by considering the principal-agent dilemma.

There is a general presumption that it is efficient for principals to delegate certain functions to agents and pay them for carrying out the tasks so delegated. The arch-example is owners of corporate equity confiding management to professional boards of directors. In democratic political theory, the citizenry is supposed to confide to the state the task of managing society. In any principal-agent relation, the incentives guiding the principal partly overlap but in part also conflict with the incentives pursued by the agent. The corporate director and the shareholder both prosper when the company’s profits rise and its prospects improve. However, the director is in addition also interested in getting the most fabulous compensation package, the most secure tenure, the least stress and conflict, and also in empire-building that puts sheer size ahead of profitability. Analogous contradictions can be found between the interests of citizens and their state when the observer takes off the rose-tinted spectacles of democratic theory.

These are the costs of agency, and the dilemma of the principal-agent relation consists in this: you cannot reap the efficiency gains of agency without bearing its costs. The balance between the two depends in large part on the agency contract. The principal may seek contract terms that will minimise the conflict between his incentives and those of his agent. In politics, constitutions are attempts to frame such a contract, and we know from modern history how successful they have been. In business life, the great shift in managerial compensation from fixed salary to stock options in the last two decades of the 20th century was another such attempt. Despite much and gross abuse and self-dealing, stock options have had some success in bringing owner and manager interests closer to each other. The recent accounting reforms have put a brake on such tendencies. In any event, it is logically impossible to frame an agency contract which would completely eliminate agency problems without effectively transforming the agent into the principal and losing the efficiencies yielded by the allocation of special tasks to specialists.

It is this dilemma that the ‘hostile’ bid is designed partially to resolve. ‘Economic patriotism’ is unwittingly combating this design, especially if carried out by foreigners or other outsiders not recognized by the domestic establishment of ‘cosy crony capitalism’ which would, if it could, perpetuate the principal-agent dilemma.

The Market for Corporate Control

It is of course the height of absurdity to term offers made by buyers to sellers as ‘hostile’ or ‘friendly’. They are neither. The seller is free to accept or reject them. They may be hostile, though, to the sellers’ agent who may lose his tenure if the seller accepts the bid. He can protect himself against this risk in two ways. One is by populist appeals to public opinion, legislative and regulatory manoeuvres, ‘poison pills’ and the like. The other is by brilliant managerial performance that gets so close to the ideal of long-run profit maximisation that no one thinks he can make much better use of the assets by wresting control of them from the sitting directors.

The branch of theory dealing with the value of corporate control was grafted onto the theory of the firm by Henry Manne1 . It would be impertinent to try and give a capsule summary of his short seminal article here. Suffice it to say that the control premium offered by a bidder will lie in a gap, if any, between the company’s market capitalisation under its sitting management and the present value of all future earnings the bidder expects the corporate assets to yield under the best management he can appoint. The bigger the gap, the bigger must the agency problem be. Equally, however, the bigger the gap, the stronger is the incentive potential bidders have to try and buy the corporate control. If potential bidders are not deterred by regulatory twists, poison pills and appeals to patriotism or good manners, the sitting management must strain to ‘increase shareholder value’ (as the current jargon has it) by better performance as well as by inspired rumours of impending bids so as to reduce the remaining gap between the current value of the company and its expected value to a rival, i.e. the control premium the rival would be willing to pay. Discouraging bids is to encourage sloth and inefficiency. Until this is better understood, agents will ride high on the backs of principals.