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Chapter 17 THE 1997 NASDAQ TRADING RULES YAN HE, Indiana University Southeast, USA Abstract Several important trading rules were introduced in NASDAQ in 1997. The trading reforms have significantly reduced bid–ask spreads on NASDAQ. This decrease is due to a decrease in market-making costs and=or an increase in market competition for order flows. In addition, in the post-reform period, the spread difference between NASDAQ and the NYSE becomes insignificant with the effect of informed trading costs controlled. Keywords: NASDAQ; trading rules; reforms; bid– ask spread; SEC order handling rules; the sixteenths minimum increment rule; the actual size rule; NYSE; informed trading costs; SEC The National Association of Securities Dealers (NASD) was established in 1939. Its primary role was to regulate the conduct of the over-the-counter (OTC) segment of the securities industry. In the middle of 1960s, the NASD developed an electronic quote dissemination system, and in 1971, the system began formal operation as the National Association of Securities Dealers Automated Quotations (NASDAQ) system. By the mid1980s, timely last-sale price and volume information were made available on the terminals. Through the late 1980s and the early 1990s, more functions were added to the system. For instance, the Small Order Execution System (SOES) was introduced in 1988, and the Electronic Communi- cation Networks (ECN) was introduced in the 1990s. Services provided by the NASDAQ network include quote dissemination, order routing, automatic order execution, trade reporting, last sale, and other general market information. NASDAQ is a dealer market, and it is mainly quote driven. On NASDAQ, the bid–ask quotes of competing dealers are electronically disseminated to brokers’ offices, and the brokers send the customer order flow to the dealers who have the best quotes. In comparison, the New York Stock Exchange (NYSE) is an auction market, and it is mainly order driven. Several important trading rules were introduced in NASDAQ in 1997, including the SEC Order Handling Rules, the Sixteenths Minimum Increment Rule, and the Actual Size Rule. The experimentation of the new rules started on January 20, 1997. The SEC Order Handling Rules were applied to all the NASDAQ stocks in October 1997. The Actual Size Rule was applied to 50 NASDAQ stocks on January 20, 1997 and 104 additional stocks on November 10, 1997. The Sixteenths Minimum Increment Rule was applied to all the stocks in NASDAQ on June 2, 1997. The following table provides a detailed implementation schedule for the new trading rules. NASDAQ implemented the Order Handling Rules according to a phased-in schedule. On January 20, 1997, the first group of 50 stocks became subject to the Order Handling Rules. The SEC Order Handling Rules include the Limit Order 444 ENCYCLOPEDIA OF FINANCE Table 17.1. New trading rules’ implementation schedule Date Number of stocks affected by the rules Rules implemented 01=20=1997 50 NASDAQ stocks ................................ The same 50 NASDAQ stocks ................................ All the NASDAQ stocks 51 NASDAQ stocks added 52 NASDAQ stocks added 563 NASDAQ stocks added The SEC Order Handling Rules The Actual Size Rule The Relaxation of the Excess Spread Rule The SEC Order Handling Rules The SEC Order Handling Rules The SEC Order Handling Rules All NASDAQ stocks with bid price not less than $10 250 NASDAQ stocks added 251 NASDAQ stocks added 800 NASDAQ stocks =week added The Sixteenths Minimum Increment Rule The SEC Order Handling Rules The SEC Order Handling Rules The SEC Order Handling Rules All NASDAQ stocks 104 stocks added The SEC Order Handling Rules The Actual Size Rule 02=10=1998 02=24=1997 04=21=1997– 07=07=1997 06=02=1997 08=04=1997 08=11=1997 09=08=1997– 10=13=1997 10=13=1997 11=10=1997 Display Rule, the ECN Rule, and the Relaxation of the Excess Spread Rule. The Limit Order Display Rule requires displaying customer limit orders that are priced better than a market maker’s quote, or adding them to the size associated with a market maker’s quote when it is the best price in the market. Before the new trading rules, limit orders on NASDAQ were only offered to the market makers. The Limit Order Display Rule promotes and facilitates the public availability of quotation information, fair competition, market efficiency, the best execution of customer orders, and the opportunity for investors’ orders to be executed without the participation of a dealer. By virtue of the Limit Order Display Rule, investors now have the ability to directly advertise their trading interests to the marketplace, thereby allowing them to compete with market maker quotations, and affect bid–ask spreads. The ECN Rule requires market makers to display in their quotes any better-priced orders that the market maker places into an ECN. The ECN Rule was implemented partially because market participants had increasingly been using ECNs to display different prices to different market participants. In particular, NASDAQ was concerned that the reliability and completeness of publicly available quotations were compromised because market makers could widely disseminate prices through ECNs superior to the quotation information they disseminate on a general basis through NASDAQ. Accordingly, the ECN Rule was adopted to require the public display of such better-priced orders. Prior to January 20, 1997, NASDAQ continuously calculated for each stock the average of the three narrowest individual spreads among all dealers’ spreads. The Excess Spread Rule (ESR) forced all dealers to keep their spreads within 125 percent of this average. On January 20, 1997, the ESR was amended for all NASDAQ stocks to stipulate that each dealer’s average spread during the month could not exceed 150 percent of the three lowest average spreads over the month. The new ESR defines compliance on a monthly basis rather than continuously, placing no limits on the market makers’ ability to vary their spreads during the month as long as their monthly average is in compliance. THE 1997 NASDAQ TRADING RULES The Actual Size Rule is a by-product of the Order Handling Rules. This rule repeals the regulatory minimum quote size (1000 shares). With the implementation of the SEC’s Order Handling Rules, the 1000 share minimum quote size requirements impose unnecessary regulatory burdens on market makers. Since the investors are allowed to display their own orders on NASDAQ according to the Limit Order Display Rule, the regulatory justification for the 1000 share minimum quote size requirements is eliminated. So, it is appropriate to treat NASDAQ market makers in a manner equivalent to exchange specialists, and not subject them to the 1000 share minimum quote size requirements. On January 20, 1997, 50 pilot stocks became subject to the Actual Size Rule. These 50 stocks also became subject to the SEC Order Handling Rules. On November 10, 1997, the pilot program was expanded to an additional 104 stocks. After 1997, the Rule was implemented to all stocks on NASDAQ. The Sixteenths Minimum Increment Rule requires that the minimum quotation increment be reduced from one-eighth to one-sixteenth of a dollar for all securities with a bid price of $10 or higher. On June 2, 1997, NASDAQ reduced the minimum quotation increment from one-eighth to one-sixteenth of a dollar for all NASDAQ securities with a bid price of $10 or higher. The reduction is expected to tighten quoted spreads and enhance quote competition. Furthermore, it complements the Order Handling Rules by allowing orders to be displayed in increments finer than one-eighth of a dollar. Specifically, the opportunity is increasing for small customers and ECN limit orders to drive the inside market. Overall, all these new rules were designed to enhance the quality of published quotation, promote competition among dealers, improve price discovery, and increase liquidity. Under these rules, NASDAQ is transformed from a pure quote driven market to a more order driven market. Successful implementation of these rules should result in lower bid–ask spreads by either reducing order execution costs or dealers’ profits. 445 Before 1997, a host of studies compared trading costs between NASDAQ and the NYSE based on the old trading rules. It is documented that bid–ask spreads or execution costs are significantly higher on NASDAQ than on the NYSE. Researchers debate whether NASDAQ bid–ask spreads are competitive enough to reflect market-making costs. Christie and Schultz (1994) find that NASDAQ dealers avoid odd-eighth quotes. This evidence is interpreted as consistent with tacit collusion, due to which bid–ask spreads are inflated above the competitive level. Moreover, Huang and Stoll (1996) and Bessembinder and Kaufman (1997) contend that higher spreads on NASDAQ cannot be attributed to informed trading costs. Since the Securities and Exchange Committee (SEC) changed some important trading rules on NASDAQ in 1997, studies attempt to assess the effect of these reforms on market performance. Barclay et al. (1999) report that the reforms have significantly reduced bid–ask spreads on NASDAQ. Bessembinder (1999) finds that trading costs are still higher on NASDAQ than on the NYSE even after NASDAQ implemented new trading rules. Weston (2000) shows that the informed trading and inventory costs on NASDAQ remain unchanged after the reforms, and that the reforms have primarily reduced dealers’ rents and improved competition among dealers on NASDAQ. He and Wu (2003a) report further evidence of the difference in execution costs between NASDAQ and the NYSE before and after the 1997 market reforms. In the prereform period the NASDAQ–NYSE disparity in bid–ask spreads could not be completely attributed to the difference in informed trading costs. However, in the postreform period the spread difference between these two markets becomes insignificant with the effect of informed trading costs controlled. In addition, He and Wu (2003b) examine whether the decrease in bid–ask spreads on NASDAQ after the 1997 reforms is due to a decrease in marketmaking costs and=or an increase in market competition for order flows. Their empirical results show 446 ENCYCLOPEDIA OF FINANCE that lower market-making costs and higher competition significantly reduce bid–ask spreads. REFERENCES Barclay, M.J., Christie W.G., Harris J.H., Kandel E., and Schultz P.H. (1999). ‘‘Effects of market reform on the trading costs and depths of NASDAQ stocks.’’ Journal of Finance, 54: 1–34. Bessembinder, H. (1999). ‘‘Trade execution costs on NASDAQ and the NYSE: A post-reform comparison.’’ Journal of Financial and Quantitative Analysis, 34: 387– 407. Bessembinder, H. and Kaufman H. (1997). ‘‘A comparison of trade execution costs for NYSE and NASDAQ-listed stocks.’’ Journal of Financial and Quantitative Analysis, 32: 287–310. Christie, W.G. and Schultz, P.H. (1994). ‘‘Why do NASDAQ market makers avoid odd-eighth quotes?’’ Journal of Finance, 49: 1813–1840. He, Y. and Wu, C. (2003a). ‘‘The post-reform bid-ask spread disparity between NASDAQ and the NYSE.’’ Journal of Financial Research, 26: 207–224. He, Y. and Wu, C. (2003b). ‘‘What explains the bid-ask spread decline after NASDAQ reforms?’’ Financial Markets, Institutions & Instruments, 12: 347–376. Huang, R.D. and Stoll, H.R. (1996). ‘‘Dealer versus auction markets: a paired comparison of execution costs on NASDAQ and the NYSE.’’ Journal of Financial Economics, 41: 313–357. Weston, J. (2000). ‘‘Competition on the NASDAQ and the impact of recent market reforms.’’ Journal of Finance, 55: 2565–2598. Chapter 18 REINCORPORATION RANDALL A. HERON, Indiana University, USA WILBUR G. LEWELLEN, Purdue University, USA Abstract Under the state corporate chartering system in the U.S., managers may seek shareholder approval to reincorporate the firm in a new state, regardless of the firm’s physical location, whenever they perceive that the corporate legal environment in the new state is better for the firm. Legal scholars continue to debate the merits of this system, with some arguing that it promotes contractual efficiency and others arguing that it often results in managerial entrenchment. We discuss the contrasting viewpoints on reincorporations and then summarize extant empirical evidence on why firms reincorporate, when they reincorporate, and where they reincorporate to. We conclude by discussing how the motives managers offer for reincorporations, and the actions they take upon reincorporating, influence how stock prices react to reincorporation decisions. Keywords: incorporation; reincorporation; Delaware; corporate charter; director liability; antitakeover; takeover defenses; contractual efficiency; managerial entrenchment; corporate law; shareholders 18.1. Introduction Modern corporations have been described as a ‘‘nexus of contractual relationships’’ that unites the providers and users of capital in a manner that is superior to alternative organizational forms. While agency costs are an inevitable consequence of the separation of ownership and control that characterizes corporations, the existence of clearly specified contractual relationships serves to minimize those costs. As Jensen and Meckling (1976, p. 357) noted: The publicly held business corporation is an awesome social invention. Millions of individuals voluntarily entrust billions of dollars, francs, pesos, etc., of personal wealth to the care of managers on the basis of a complex set of contracting relationships which delineate the rights of the parties involved. The growth in the use of the corporate form as well as the growth in market value of established corporations suggests that, at least up to the present, creditors and investors have by and large not been disappointed with the results, despite the agency costs inherent in the corporate form. Agency costs are as real as any other costs. The level of agency costs depends among other things on statutory and common law and human ingenuity in devising contracts. Both the law and the sophistication of contracts relevant to the modern corporation are the products of a historical process in which there were strong incentives for individuals to minimize agency costs. Moreover, there were alternative organizational forms available, and opportunities to invent new ones. Whatever its shortcomings, the corporation has thus far survived the market test against potential alternatives. Under the state corporate chartering system that prevails in the U.S., corporate managers can affect 448 ENCYCLOPEDIA OF FINANCE the contractual relationships that govern their organizations through the choice of a firm’s state of incorporation. Each state has its own distinctive corporate laws and established court precedents that apply to firms incorporated in the state. Thus, corporations effectively have a menu of choices for the firm’s legal domicile, from which they may select the one they believe is best for their firm and=or themselves. The choice is not constrained by the physical location either of the firm’s corporate headquarters or its operations. A firm whose headquarters is in Texas may choose Illinois to be its legal domicile, and vice versa. Corporations pay fees to their chartering states, and these fees vary significantly across states, ranging up to $150,000 annually for large companies incorporated in Delaware. State laws of course evolve over time, and managers may change their firm’s legal domicile – subject to shareholder approval – if they decide the rules in a new jurisdiction would be better suited to the firm’s changing circumstances. This is the process referred to as reincorporation, and it is our topic of discussion here. 18.2. Competition Among States for Corporate Charters There has been a long-running debate among legal and financial scholars regarding the pros and cons of competition among states for corporate charters. Generally speaking, the proponents of competition claim that it gives rise to a wide variety of contractual relationships across states, which allows the firm to choose the legal domicile that serves to minimize its organizational costs and thereby maximize its value. This ‘‘Contractual Efficiency’’ viewpoint, put forth by Dodd and Leftwich (1980), Easterbrook and Fischel (1983), Baysinger and Butler (1985), and Romano (1985), implies the existence of a determinate relationship between a company’s attributes and its choice of legal residency. Such attributes may include: (1) the nature of the firm’s operations, (2) its ownership structure, and (3) its size. The hypothesis fol- lowing from this viewpoint is that firms that decide to reincorporate do so when the firm’s characteristics are such that a change in legal jurisdiction increases shareholder wealth by lowering the collection of legal, transactional, and capital-marketrelated costs it incurs. Other scholars, however, argue that agency conflicts play a significant role in the decision to reincorporate, and that these conflicts are exacerbated by the competition among states for the revenues generated by corporate charters and the economic side effects that may accompany chartering (e.g. fees earned in the state for legal services). This position, first enunciated by Cary (1974), is referred to as the ‘‘Race-to-theBottom’’ phenomenon in the market for corporate charters. The crux of the Race-to-the-Bottom argument is that states that wish to compete for corporate chartering revenues will have to do so along dimensions that appeal to corporate management. Hence, states will allegedly distinguish themselves by tailoring their corporate laws to serve the self-interest of managers at the expense of corporate shareholders. This process could involve creating a variety of legal provisions that would enable management to increase its control of the corporation, and thus to minimize the threats posed by outside sources. Examples of the latter would include shareholder groups seeking to influence company policies, the threat of holding managers personally liable for ill-advised corporate decisions, and – perhaps most important of all – the threat of displacement by an alternative management team. These threats, considered by many to be necessary elements in an effective system of corporate governance, can impose substantial personal costs on senior managers. That may cause managers to act in ways consistent with protecting their own interests – through job preservation and corporate risk reduction – rather than serving the interests of shareholders. If so, competition in the market for corporate charters will diminish shareholder wealth as states adopt laws that place restrictions on the disciplinary force of the market REINCORPORATION for corporate control (see Bebchuk, 1992; Bebchuk and Ferrell, 1999; Bebchuk and Cohen, 2003). Here, we examine the research done on reincorporation and discuss the support that exists for the contrasting views of both the Contractual Efficiency and Race-to-the-Bottom proponents. In the process, we shall highlight the various factors that appear to play an influential role in the corporate chartering decision. 18.3. Why, When, and Where to Reincorporate To begin to understand reincorporation decisions, it is useful to review the theory that relates a firm’s choice of chartering jurisdiction to the firm’s attributes, the evidence as to what managers say when they propose reincorporations to their shareholders, and what managers actually do when they reincorporate their firms. Central to the Contractual Efficiency view of competition in the market for corporate charters is the notion that the optimal chartering jurisdiction is a function of the firm’s attributes. Reincorporation decisions therefore should be driven by changes in a firm’s attributes that make the new state of incorporation a more cost-effective legal jurisdiction. Baysinger and Butler (1985) and Romano (1985) provide perhaps the most convincing arguments for this view. Baysinger and Butler theorize that the choice of a strict vs. a liberal incorporation jurisdiction depends on the nature of a firm’s ownership structure. The contention is that states with strict corporate laws (i.e. those that provide strong protections for shareholder rights) are better suited for firms with concentrated share ownership, whereas liberal jurisdictions promote efficiency when ownership is widely dispersed. According to this theory, holders of large blocks of common shares will prefer the pro-shareholder laws of strict states, since these give shareholders the explicit legal remedies needed to make themselves heard by management and allow them actively to influence corporate affairs. Thus, firms chartered in strict states are likely to remain there until owner- 449 ship concentration decreases to the point that legal controls may be replaced by market-based governance mechanisms. Baysinger and Butler test their hypothesis by comparing several measures of ownership concentration in a matched sample of 302 manufacturing firms, half of whom were incorporated in several strict states (California, Illinois, New York, and Texas) while the other half had reincorporated out of these states. In support of their hypothesis, Baysinger and Butler found that the firms that stayed in the strict jurisdictions exhibited significantly higher proportions of voting stock held by major blockholders than was true of the matched firms who elected to reincorporate elsewhere. Importantly, there were no differences between the two groups in financial performance that could explain why some left and others did not. Collectively, the results were interpreted as evidence that the corporate chartering decision is affected by ownership structure rather than by firm performance. Romano (1985) arrived at a similar conclusion from what she refers to as a ‘‘transaction explanation’’ for reincorporation. Romano suggests that firms change their state of incorporation ‘‘at the same time they undertake, or anticipate engaging in, discrete transactions involving changes in firm operation and=or organization’’ (p. 226). In this view, firms alter their legal domiciles at key times to destination states where the laws allow new corporate policies or activities to be pursued in a more cost-efficient manner. Romano suggests that, due to the expertise of Delaware’s judicial system and its well-established body of corporate law, the state is the most favored destination when companies anticipate legal impediments in their existing jurisdictions. As evidence, she cites the high frequency of reincorporations to Delaware coinciding with specific corporate events such as initial public offerings (IPOs), mergers and acquisitions, and the adoption of antitakeover measures. In their research on reincorporations, Heron and Lewellen (1998) also discovered that a substantial portion (45 percent) of the firms that 450 ENCYCLOPEDIA OF FINANCE reincorporated in the U.S. between 1980 and 1992 did so immediately prior to their IPOs. Clearly, the process of becoming a public corporation represents a substantial transition in several respects: ownership structure, disclosure requirements, and exposure to the market for corporate control. Accordingly, the easiest time to implement a change in the firm’s corporate governance structure to parallel the upcoming change in its ownership structure would logically be just before the company becomes a public corporation, while control is still in the hands of management and other original investors. Other recent studies also report that the majority of firms in their samples who undertook IPOs reincorporated in Delaware in advance of their stock offerings (Daines and Klausner, 2001; Field and Karpoff, 2002). Perhaps the best insights into why managers choose to reincorporate their firms come from the proxy statements of publicly traded companies, when the motivations for reincorporation are reported to shareholders. In the process of the reincorporations of U.S. public companies that occurred during the period from 1980 through 1992, six major rationales were proclaimed by management (Heron and Lewellen, 1998): (1) takeover defenses; (2) director liability reduction; (3) improved flexibility and predictability of corporate laws; (4) tax and=or franchise fee savings; (5) conforming legal and operating domicile; and (6) facilitating future acquisitions. A tabulation of the relative frequencies is provided in Figure 18.1. As is evident, the two dominant motives offered by management were to create takeover defenses and to reduce directors’ legal liability for their decisions. In addition, managers often cited multiple reasons for reincorporation. The mean number of stated motives was 1.6 and the median was 2. In instances where multiple motives were offered, each is counted once in the compilation in Figure 18.1. 18.4. What Management Says It is instructive to consider the stated reincorporation motives in further detail and look at examples of the statements by management that are contained in various proposals, especially those involving the erection of takeover defenses and the reduction of director liability. These, of course, Stated motives for reincorporation One of multiple motives cited Sole motive cited Facilitate acquisitions Conform legal and operating domicile Tax or franchise fee savings Flexibility or predictability Director liability reduction Takeover defenses 0% 10% 20% 30% % of sample Figure 18.1. Stated motives for reincorporation 40% 50% 60% REINCORPORATION represent provisions that may not be in the best interests of stockholders, as a number of researchers have argued. The other motives listed are both less controversial and more neutral in their likely impact on stockholders, and can be viewed as consistent with Contractual Efficiency arguments for reincorporations. Indeed, reincorporations undertaken for these reasons appear not to give rise to material changes in firms’ stock prices (Heron and Lewellen, 1998). 18.4.1. Reincorporations that Strengthen Takeover Defenses Proponents of the Race-to-the-Bottom theory contend that the competition for corporate chartering may be detrimental if states compete by crafting laws that provide managers with excessive protection from the market for corporate control – i.e. from pressures from current owners and possible acquirers to perform their managerial duties so as to maximize shareholder wealth. Although takeover defenses might benefit shareholders if they allow management to negotiate for higher takeover premiums, they harm shareholders if their effect is to entrench poorly performing incumbent managers. The following excerpts from the proxy statement of Unocal in 1983 provides an example of a proposal to reincorporate for antitakeover reasons: In addition, incorporation of the proposed holding company under the laws of Delaware will provide an opportunity for inclusion in its certificate of incorporation provisions to discourage efforts to acquire control of Unocal in transactions not approved by its Board of Directors, and for the elimination of shareholder’s preemptive rights and the elimination of cumulative voting in the election of directors. The proposed changes do not result from any present knowledge on the part of the Board of Directors of any proposed tender offer or other attempt to change the control of the Company, and no tender offer or other type of shift of control is presently pending or has occurred within the past two years. 451 Management believes that attempts to acquire control of corporations such as the Company without approval by the Board may be unfair and=or disadvantageous to the corporation and its shareholders. In management’s opinion, disadvantages may include the following: a nonnegotiated takeover bid may be timed to take advantage of temporarily depressed stock prices; a nonnegotiated takeover bid may be designed to foreclose or minimize the possibility of more favorable competing bids; recent nonnegotiated takeover bids have often involved so-called ‘‘two-tier’’ pricing, in which cash is offered for a controlling interest in a company and the remaining shares are acquired in exchange for securities of lesser value. Management believes that ‘‘two-tier’’ pricing tends to stampede shareholders into making hasty decisions and can be seriously unfair to those shareholders whose shares are not purchased in the first stage of the acquisition; nonnegotiated takeover bids are most frequently fully taxable to shareholders of the acquired corporation. By contrast, in a transaction subject to approval of the Board of Directors, the Board can and should take account of the underlying and long-term value of assets, the possibilities for alternative transactions on more favorable terms, possible advantages from a tax-free reorganization, anticipated favorable developments in the Company’s business not yet reflected in stock prices, and equality of treatment for all shareholders. The reincorporation of Unocal into Delaware allowed the firm’s management to add several antitakeover provisions to Unocal’s corporate charter that were not available under the corporate laws of California, where Unocal was previously incorporated. These provisions included the establishment of a Board of Directors whose terms were staggered (only one-third of the Board elected each year), the elimination of cumulative voting (whereby investors could concentrate their votes on a small number of Directors rather than spread them over the entire slate up for election), and the requirement of a ‘‘supermajority’’ shareholder vote to approve any reorganizations or mergers not 452 ENCYCLOPEDIA OF FINANCE approved by at least 75 percent of the Directors then in office. Two years after its move to Delaware, Unocal was the beneficiary of a court ruling in the Unocal vs. Mesa case [493 A.2d 946 (Del. 1985)], in which the Delaware Court upheld Unocal’s discriminatory stock repurchase plan as a legitimate response to Mesa Petroleum’s hostile takeover attempt. The Unocal case is fairly representative of the broader set of reincorporations that erected takeover defenses. Most included antitakeover charter amendments that were either part of the reincorporation proposal or were made possible by the move to a more liberal jurisdiction and put to a shareholder vote simultaneously with the plan of reincorporation. In fact, 78 percent of the firms that reincorporated between 1980 and 1992 implemented changes in their corporate charters or other measures that were takeover deterrents (Heron and Lewellen, 1998). These included eliminating cumulative voting, initiating staggered Board terms, adopting supermajority voting provisions for mergers, and establishing so-called ‘‘poison pill’’ plans (which allowed the firm to issue new shares to existing stockholders in order to dilute the voting rights of an outsider who was accumulating company stock as part of a takeover attempt). Additionally, Unocal reincorporated from a strict state known for promoting shareholder rights (California) to a more liberal state (Delaware) whose laws were more friendly to management. In fact, over half of the firms in the sample studied by Heron and Lewellen (1998), that cited antitakeover motives for their reincorporations, migrated from California, and 93 percent migrated to Delaware. A recent study by Bebchuk and Cohen (2003) that investigates how companies choose their state of incorporation reports that strict shareholder-right states that have weak antitakeover statutes continue to do poorly in attracting firms to charter in their jurisdictions. Evidence on how stock prices react to reincorporations conducted for antitakeover reasons suggests that investors perceive them to have a value- reducing management entrenchment effect. Heron and Lewellen (1998) report statistically significant (at the 95 percent confidence level) abnormal stock returns of
1.69 percent on and around the dates of the announcement and approval of reincorporations when management cites only antitakeover motives. In the case of firms that actually gained additional takeover protection in their reincorporations (either by erecting specific new takeover defenses or by adopting coverage under the antitakeover laws of the new state of incorporation), the abnormal stock returns averaged a statistically significant
1.62 percent. For firms whose new takeover protection included poison pill provisions, the average abnormal returns were fully
3.03 percent and only one-sixth were positive (both figures statistically significant). Taken together with similar findings in other studies, the empirical evidence therefore supports a conclusion that ‘‘defensive’’ reincorporations diminish shareholder wealth. 18.4.2. Reincorporations that Reduce Director Liability The level of scrutiny placed on directors and officers of public corporations was greatly intensified as a result of the Delaware Supreme Court’s ruling in the 1985 Smith vs. Van Gorkom case [488 A.2d 858 (Del. 1985)]. Prior to that case, the Delaware Court had demonstrated its unwillingness to use the benefit of hindsight to question decisions made by corporate directors that turned out after the fact to have been unwise for shareholders. The court provided officers and directors with liability protection under the ‘‘business judgment’’ rule, as long as it could be shown that they had acted in good faith and had not violated their fiduciary duties to shareholders. However, in Smith vs. Van Gorkom, the Court held that the directors of Trans-Union Corporation breached their duty of care by approving a merger agreement without sufficient deliberation. This unexpected ruling had an immediate impact since it indicated that the Delaware Court would entertain the possibility of