Hynes, Richard M., Journal of Corporation Law
I. INTRODUCTION II. THE CHOICE OF GOVERNANCE TERMS IN A TAX-FREE WORLD III. NON-PECUNIARY BENEFITS AND TAX DISTORTIONS IV. EXAMINING THE FUNDAMENTAL ASSUMPTIONS A. The Private Benefits of Control B. The Taxation of Pecuniary and Non-Pecuniary Benefits V. CORRECTIVE ACTION IN AN IMPERFECT WORLD VI. CONCLUSION
Academics and activists advocate for corporate governance reforms designed to increase the value of publicly traded firms by making managers more accountable to shareholders. (1) After years of struggle, they are finally having some success. Publicly traded firms are eliminating staggered boards of directors, (2) providing shareholders with a "say on pay," (3) and directors are paying closer attention to shareholder desires. (4) Yet not all of the evidence fits neatly in this trend toward "good governance." Firms continue to adopt anti-takeover protections when they make their initial public offerings. over 86% of firms that went public in 2012 have a staggered board of directors, (5) and both Google and Facebook chose dual-class capital structures that allow the founders to retain voting control disproportionate to their economic stake. (6)
The inclusion of anti-takeover protections in initial public offerings presents a puzzle. Much of the corporate governance literature suggests that anti-takeover protections are inefficient because they make it harder to remove ineffective or unfaithful management and therefore increase agency costs. (7) But this literature also suggests that firms will adopt efficient corporate governance terms before their initial public offering because concentrated ownership reduces agency costs. (8) Firms with better terms should command a higher price from new investors in an initial public offering, and this higher price will lead to greater wealth for the managers and investors who control the firm.
Other scholars have noted this puzzle and have offered a number of explanations. (9) Capital market imperfections may prevent initial public offering prices from reflecting differences in corporate governance terms. (10) Firms may choose inefficient terms due to bad legal advice (11) or because of frictions in the market for financing prior to the initial public offering. (12) Anti-takeover protections could be efficient after all, at least for some firms, because they correct for myopic investors or some other problem. (13) Finally, managers may choose anti-takeover provisions to signal something about their firms. (14) This Article advances a very different explanation, one based on the Internal Revenue Code (Tax Code). (15)
This Article begins with a variant of one of the existing efficiency explanations for anti-takeover protections. The heart of the argument is that managers are not driven solely by a desire for material gain but derive some happiness or utility from the control they exercise over their firms. (16) When investors removed Steve Jobs from Apple, (17) he did not just lose a future stream of income as CEO, he lost control of "his" firm. To the extent that managers derive happiness from control, they may not choose governance terms that maximize the dollar value of the firm. However, unless there is some contracting failure, they will still choose efficient terms--terms that maximize the total value of the firm (the dollar value plus the control value).
Once we introduce taxation, the manager no longer chooses efficient terms because the government taxes pecuniary benefits more effectively than it taxes non-pecuniary benefits. Even if the manager can increase the total value of the firm by ceding some control, she may fail to do so as she must share some of the increase in the monetary value of the firm with the public treasury. (18) The government could eliminate this distortion by taxing the potential value of a firm (its value with optimal governance terms) or by taxing the benefits of control. …