Why Do Corporations Merge and Why Should Law Care?

Chris Sagers* July, 2023

Abstract

Mergers and acquisitions are extraordinarily prevalent in the United States, generating massive expenditures every year. However, a serious empirical puzzle lies at the heart of all that activity. That empirical phenomenon’s most remarkable feature by far is that even though it is well established in an extensive literature and implies far-reaching policy consequences, American law ignores it entirely.

Generations of researchers have failed to find evidence that merger and acquisition activity generates any lasting benefits for the combining firms’ owners or anyone else. No one seriously doubts that efficiencies of scale or technological integration are real or that acquisitions sometimes achieve them. Still, the evidence strongly implies that they are mostly available in small deals among small firms. While the results are no longer very seriously contested, no one has any conclusive explanation for the several puzzles they pose.

This paper comprehensively reviews the empirical literature and works through the policy implications for the major bodies of law it affects. The most important insights are two. First, the evidence should undermine the confidence among scholars of corporation law in the regulatory self-sufficiency of market institutions, on which corporation theory depends so heavily. In particular, a major hope for controlling managerial agency cost—one of the theory’s chief preoccupations—remains the hope that the so-called “market for corporate control” governing hostile takeovers will discipline underperforming managers. The evidence discussed here suggests that the market produces no meaningful benefits at all. The second lesson is simpler. The other major legal regime governing mergers and acquisitions—antitrust—should return to the simpler, pro-enforcement presumptions by which it once more effectively limited market concentration. The fear of jeopardizing pro-competitive gains, on which antitrust merger law has been rendered largely inert, is no longer very defensible. The balance between false positive and false negative should be reset.

Why Do Corporations Merge and Why Should Law Care?

Merger and acquisition activity is an extremely busy engine in the U.S. economy. At its heart, however, lies a serious empirical puzzle. It remains not only unsolved but largely ignored, and it reflects an incoherence throughout much of American business-regulatory policy and its theoretical foundations.

Namely, though corporate combinations are hugely common and have been for over a century, a large body of empirical evidence now suggests that they do not do any good for the combining firms’ owners or anyone else. While the problem is not unknown among academics and the result is no longer very seriously doubted, no one has any good explanation for it.

Not only do corporate managers continue in this apparent omnipresent irrationality, but they spend massive amounts of money on it.¹ Most remarkable—and a fact that will turn out to be significant in this study—is that acquiring firms pay large “premiums” for their targets. A takeover proponent ordinarily must spend substantially more for a controlling percentage of shares in a target firm than the shares’ current trading price.² Assuming that large premiums reflect rational estimates of cost-saving synergies, pricing power, or some other advantage that will come from a merger, they imply very large gains, either for shareholders or society, or both. Based on that reasoning, merger premia under current circumstances would indicate that acquisitions contribute more than $300 billion in shareholder or social gains per year, an amount that would represent a non-trivial fraction of the entire U.S. GDP.³

But therein lies the empirical puzzle. Over several decades of research, the dozens of researchers who have looked for those gains have been unable to find any meaningful evidence of them at all. Even the large premium payments enjoyed by target-firm shareholders represent merely a one-way wealth transfer from acquiring-firm shareholders. And aside from that one-time payday, the empirical evidence strongly suggests that growth by acquisition, on average, causes both acquiring and target firms to lose value or break even at best, generating no demonstrable benefit to anyone else. No one seriously doubts that efficiencies of scale or technological integration are real or that acquisitions can achieve them. Still, the evidence strongly implies that these benefits are mostly available only in small deals among small firms. The only deals relevant to important policy issues are very large in relative terms—that is, deals are typically policy-significant only when they are between firms that hold substantial market shares in concentrated markets. Surprising as these results may seem, they just confirm with empirical rigor what was already longstanding Wall Street wisdom: most deals fail, and they fail with capricious unpredictability.⁴ As many as 70% of acquisitions are said to fail on some measure,⁵ and easily a third or more fail in the ultimate sense that the acquired assets are later resold.⁶

These results are starkly at odds with presumptions underlying American business regulation and its theory. Leading theoretical models in law, finance, and economics presume the rationality of business firms and thus take for granted that mergers and acquisitions create value for someone.⁷ Otherwise, the thinking goes, rational firms would not pursue them. It is lost on no one that executives might disserve their shareholders through selfishness or incompetence—this is the problem known as “agency cost” and it is taken as uncontroversial in corporate theory.⁸ However, it is widely presumed that market forces control that behavior pretty well, especially when companies adopt governance tweaks recommended in the academic literature of the day.⁹ Thus while corporate, securities, antitrust, and some other bodies of law oversee merger conduct, they each do so only nominally and, on the presumption of that conduct’s rationality, wind up leaving it effectively unregulated. Admittedly, these laws’ combined effect is a very expensive compliance obligation, and no doubt merging parties and their lawyers would be amused to hear that their deals are “unregulated.” But indeed, the whole regulatory edifice rarely stops or seriously limits their ability to merge. It merely imposes costs.

Certain puzzles remain unexplained. Above all, if mergers really do no good even for the merging firms’ shareholders, some explanation is needed for why their managers would still seek them out. That puzzle has been a preoccupation of management scholars and economists for a generation or more.¹⁰ A separate puzzle stems from the presumption that mergers are at least sometimes anti-competitive. There is an assumption that some mergers create profitable market power by reducing the number of competitors in a market and empowering those that remain to raise their prices. The whole antitrust law of merger and acquisition is predicated on that assumption. The mechanisms by which anti-competitive effects could occur are well understood,¹¹ and evidence of it happening has recently grown.¹² But it remains a mystery how mergers could generate market power, enabling supra-competitive prices, without systematically benefitting shareholders. If mergers give firms market power, why do firms struggle to make money from them?

While dozens of explanations have been offered for the empirical mysteries surrounding mergers and acquisitions, many can be rejected. The best-supported explanation is that large-firm managers are comparatively free from shareholder interests. In other words, the explanation for merger riddles that best fits the evidence turns out to be the familiar problem of agency cost. Managers can make decisions to some degree for their own reasons. In fact, empirical “puzzles” of this kind are common throughout corporate governance and economic regulation. They often seem puzzling only because of strong assumptions, like firm-level rationality or the strength of market institutions that will keep firms rational. That same slippage of incentives probably explains counter-intuitive trends like the seemingly counterproductive design of governance institutions,¹³ excessive executive compensation,¹⁴ and the widespread pursuit of celebrity CEOs.¹⁵ There is no need to believe in systematic irrationality or failed economic theory to explain these things if market institutions do not work very well to control managerial opportunism, slack, or incompetence. This Article’s concluding section will offer ideas for retooling policy without making such presumptions.

This Article comprehensively reviews the empirical literature and the several confusing puzzles it raises and works through the policy implications for the bodies of law it affects. It begins by briefly recounting the histories of American merger activity and merger regulation, both of which disclose a key theme. Popular concern over rapid consolidation drove periodic reform efforts that sought to control it, but in every case the reforms were ineffective because enforcement proved politically costly. The Article then briefly reviews the theoretical foundation on which merger activity has been justified. That is, it considers the body of economic theory that has mostly persuaded American policymakers to leave merger activity alone, the central thrust of which has always been theoretical arguments that business activity must be rational and, therefore, beneficial. That review is important in understanding the popular and government ambivalence that frustrates enforcement and in judging the policy recommendations that will be made here. The Article then turns to the heart of its study, the empirical mergers and acquisitions literature and the several puzzles it raises. It concludes by working out some implications for the legal rules that mostly deal with acquisitions: the law of corporations, securities, and antitrust.

These policy lessons are not extensive or revolutionary and they are secondary to the Article’s main focus, which is on the empirical puzzle. But they are nevertheless fundamental. The lesson for corporate and securities law is simply that market institutions cannot constrain managerial agency costs in the way the literature has overwhelmingly presumed. The literature’s key remedy for agency costs remains the market for corporate control, and many scholars cling to a commitment that it can outperform legislation or judicial intervention. But that market institution depends on an efficient world of hostile takeover that the empirical evidence discredits entirely.

As for antitrust merger law, there is no longer any compelling reason for the caution by which the law has been rendered so ineffective. The policy judgment driving it—that we should be cautious in stopping mergers because of the good they might do—turns out to have effectively no support. Meanwhile, the theory that mergers can do harm is well established, and empirical corroboration is growing and real. The balance between false positives and false negatives should be reset.

I. A Brief History and Legal Context: Mergers Go
Systematically Unregulated

There were not always corporate acquisitions in the United States, at least in routine numbers. Before the turn of the twentieth century, state corporation laws sharply limited acquisitions.¹⁶ Acquisitions were also probably hindered by a lack of limited-liability incorporation and modern capital markets.¹⁷ Even during the late 1800s, when mergers were finally freed up by less restrictive state laws and easier access to capital, they were met with antitrust challenges and popular opposition. However, mergers finally arrived in numbers around the turn of the twentieth century, and when they did, they exploded. A decade-long wave of mergers began in 1895 that is still known as “the Great Merger Movement.” Historians disagree over its causes,¹⁸ but in its course it caused the elimination of thousands of firms and was the largest business consolidation in history.¹⁹

The experience since has been one long stream of merger activity, punctuated every few decades by further massive waves. There have been perhaps five or more major waves since the Great Merger Movement, each on some measures larger than the last, reshaping whole sectors.²⁰ While determining whether there has been a “wave” at any given time is itself a complicated empirical problem,²¹ no one doubts that there have been a half-dozen or so. Interestingly, each merger wave has had its own peculiar character. After the Great Merger Movement, which mainly consisted of horizontal mergers and often generated near-monopoly in particular sectors, a wave in the 1920s consisted of smaller deals that have been called “merger for oligopoly.”²² Conglomerate deals dominated another wave during the 1960s, and another wave in the 1980s involved large deals and new financial or strategic novelties, including heavy leverage and hostile takeover. Another wave in the 1990s culminated in the dot-com bust of (circa) 2001, and perhaps one or two more have occurred since.²³ In addition to the fact that mergers come in waves, there is the interesting and poorly-explained fact that waves are, to some degree, industry-specific. In each given wave, merger activity will be most intense in one or a few industries.²⁴

The law, for its part, has always imposed various limits on this enthusiasm, though it probably only meaningfully constrained mergers during short episodes. Mergers have predominately been addressed through three areas of law: corporate, securities, and antitrust law. The history of these laws’ merger rules is a fascinating topic on its own, fraught with confusion and ideology. Waves of mergers have generally led to some public controversy and have often prompted legal reforms. Reform efforts have occasionally been so major that they influenced presidential elections or whole political eras. In every case, however, reforms have faded, often quickly, when enforcement proved politically costly. These varying efforts and the political challenge they pose reflect America’s complex, changing, and often confused efforts to reconcile popular fear of corporate power with a generally liberal political philosophy that favors private enterprise.²⁵ And so it is that after a century of popular concern and legal efforts to constrain them, mergers are more prevalent now than at any previous time and are largely free of meaningful legal constraints.

The rest of this Part explores these policy trends and sets out the major legal rules that currently govern mergers and acquisitions.

A. Corporate and Securities Law: Shareholder and Constituency Protections

For the most part, corporate and securities law rules governing mergers serve the routine goal of protecting shareholder value. Passive investors are thought to face various threats in change-in-control transactions. State corporate law attempts to protect passive investors with procedural requirements, the “appraisal” remedy, and the general demand that fiduciaries take care for shareholder value. Hostile takeovers in particular are subject to special fiduciary protections.²⁶ However, passive shareholders are not the only concern of corporate and securities law. State anti-takeover laws and Securities & Exchange Commission (SEC) oversight under the Williams Act protect other constituencies.²⁷

Corporate control transactions generally require approval by target-firm shareholders and directors.²⁸ More generally, the law protects shareholders by imposing fiduciary duties on officers and directors and insists that management make their decisions in the interests of the shareholders.²⁹ Consequently, managers negotiating, approving, and recommending sale-of-control transactions must ensure that shareholders receive “fair value.”³⁰ Even where full business-judgment-rule deference is available, the managers are obliged to investigate fair value adequately, and, in principle, can be responsible for a breach of their fiduciary duty to shareholders if they fail.³¹ Shareholders are also protected by the statutory appraisal remedy when their firms are acquired, under which dissenting shareholders can sometimes ask the courts to revalue their shares.³² Though it is a limited remedy in several ways, appraisal litigation has blossomed in recent years.³³

In the last several decades, a set of narrower state fiduciary rules evolved to deal with the particular problem of hostile takeovers and the entrenched managements who often resist them. Hostile takeover is thought to be desirable to target-firm shareholders, both because they can enjoy large premiums and because hostile deals might unseat ineffective managers. Incumbent management, however, usually attempts to stop those deals to protect their interests; thus, there is an inherent tension. Courts recognized the tension by mid-century, and by 1964 they developed a modest rule to curtail it.³⁴ They took renewed interest during the period of hostile takeovers of the mid-1980s and substantially toughened their oversight of incumbent managers. This was in part because the 1980s takeover wave generated substantial public concern and, in part, because it spawned a complex new world of anti-takeover defenses, deal protections, and hard-fought, multi-party acquisition battles.³⁵ Starting in 1985,³⁶ the Delaware Supreme Court enhanced the mild restrictions it had traditionally put on management self-defense.³⁷ In certain special cases, directors are entirely precluded from stopping a takeover and can only take action to ensure the highest premium price.³⁸

A very interesting part of this history, and further evidence of how American business regulation is frustrated by political ambivalence, is that merger and acquisition rules are often internally contradictory. The rules discussed so far effectively favor changes in control, especially the fiduciary rules for hostile takeovers. The rules encourage changes in control because shareholders stand to gain financially from control premiums.

But separate reforms arose around mid-century, when America saw its first real incidence of hostile takeovers—first during the 1960s and then with greater intensity during the 1980s³⁹—which sought to protect incumbent managers and local communities. This body of rules cuts the other way. These separate rules seek to discourage takeovers, or at least slow them down and control them, because of the damage they might do. The rhetoric driving these rules could sometimes be vitriolic, and anti-takeover animus often ran high. While debating the bill that eventually became the Williams Act in 1968, one co-sponsor called tender offerors “pirates,”⁴⁰ and another compared hostile takeover to rape.⁴¹ For what it is worth, under pressure from academics and securities regulators, that particular bill took on a policy of neutrality, seeking only to protect target shareholders from non-disclosure and coercion. Under that law as adopted, plus several SEC rules interpreting it during the 1980s, meaningful acquisitions of public company stock require certain disclosures, and must comply with a timeline and various procedural protections.⁴²

Similarly, since the perceived takeover crisis of the 1980s, many states have adopted “anti-takeover statutes” to limit control changes. Generally, they sought to protect communities and local interests from the dislocations of hostile takeover or movement of firms out-of-state.⁴³ Various statutory and regulatory controls have been proposed e that would limit or discourage takeovers, including miscellaneous tax rules,⁴⁴ an interpretation of a Federal Reserve lending rule modestly limiting leveraged deals,⁴⁵ and a spate of attempts by Democrats in Congress to augment the Williams Act.⁴⁶

This mish-mash of disparate rules has occasionally imposed some limits on mergers, and during a few recent periods, they have generated significant amounts of important litigation. For the most part, however, these rules have made little impact; at the moment, they are mostly effectively unenforceable. So long as no one negotiating a deal is conflicted, garden-variety fiduciary challenges to takeover are analyzed under the business-judgment-rule. Fiduciary Challenges under that standard are all but literally unwinnable. When plaintiffs once scored a victory in a closely watched case at the beginning of the 1980s takeover wave,⁴⁷ state legislatures quickly rendered it almost completely inert.⁴⁸ Even in the presence of an explicit conflict of interest, as when minority shareholders are misled or coerced into sale by a parent corporation,⁴⁹ recent doctrinal innovations in Delaware have made it possible for merging firms in essentially all circumstances to secure business-judgment treatment and make all claims against them easily dismissible.⁵⁰ Accordingly, in the wake of all these changes, Delaware fiduciary litigation has ground down to nearly nothing. Meanwhile, the Williams Act was never very restrictive to begin with, and state anti-takeover statutes are mainly compliance obligations that rarely impose meaningful limits.

Finally, while there has been something of a renaissance in appraisal litigation and while early evidence suggests it may have generated shareholder benefits,⁵¹ serious caveats apply. First, appraisal is subject to several limits that will make it unavailable or unrealistic in many cases,⁵² and there is indication that courts may soon restrict it further.⁵³ More importantly, hedge funds bring a large proportion of current appraisal litigation, and there is real uncertainty about whether it benefits other shareholders or anyone else. But fundamentally, even effective appraisal—and, for that matter, most of the corporate law of mergers and acquisitions—ignores the social problem at the heart of this Article. An appraisal claim aims to prove that a takeover premium is too low. Its effect would exaggerate its estimate of the social value of acquisitions even further when that value appears not to exist.

B. Competition Protections

A separate and very different regime regulates mergers and acquisitions under antitrust law, which serves different goals and constituencies. Since 1914, section 7 of the Clayton Act has prohibited business combinations whose “effect . . . may be substantially to lessen competition, or to tend to create a monopoly.”⁵⁴

Over its long and complicated history, antitrust merger law has probably not been very effective. A recurrent theme over the course of this history has been a struggle between Congress and the courts over whether enforcement would be vigorous and meaningful—as Congress has repeatedly indicated was its intention—or restrained and cautious. Every few decades Congress intervenes to shore it up, but each time the courts have re-construed the law in ways favorable to defendants. That was true of the initial adoption of the basic merger law, Clayton Act section 7, as well as each significant reform thereafter.⁵⁵ Most significant for the law’s modern life was a 1950 amendment to section 7,⁵⁶ on the heels of what was perceived as a wave of consolidation in the 1940s and growing popular dissatisfaction with underenforcement.⁵⁷ The Supreme Court, finding in the legislative history a desire to toughen merger law,⁵⁸ deployed the amended law in a series of decisions during the 1960s that adopted simplified, streamlined, and extremely enforcement-friendly prophylactic rules. Most importantly, in the 1963 United States v. Philadelphia National Bank (PNB) decision,⁵⁹ the Court adopted a still-used burden-shifting rule under which a merger can be found illegal on nothing more than the increased concentration in an already concentrated market.⁶⁰ For a time, that innovation was very effective. Over the course of the next decade, the federal government won twelve merger cases before the Supreme Court and lost none.⁶¹

However, vigorous antitrust merger enforcement met political hostility and quickly proved unsustainable. By 1974, just over a decade after PNB, a Supreme Court newly populated with Richard Nixon’s unusual number of appointments⁶² announced a set of closely divided decisions reaching much more defense-friendly results.⁶³ Lower courts took them to significantly soften the PNB presumption and demand much more proof from merger plaintiffs.⁶⁴ Because merger policy is almost inherently speculative—enforcement actions are usually brought prospectively before deals are consummated—the setting of evidentiary burdens largely determines which parties win or lose. At length, while PNB nominally remains the law, and is still cited as seminal,⁶⁵ its rule is honored only in the breach. With some exceptions, only the very largest horizontal mergers are now challenged,⁶⁶ and not infrequently even those claims lose⁶⁷ or just barely win.⁶⁸

* * *

In the end, America’s long history of fretting over its hundreds of thousands of mergers and the tension between the fear of mergers’ bad consequences and the risk of mistakenly upsetting desirable business behavior, has left us in a remarkable state. The United States administers a regime of merger law that keeps thousands of attorneys, economists, and government officials employed. It entails substantial social costs,⁶⁹ but virtually never constrains any transaction in any meaningful way. Given this extraordinary state of affairs, one would imagine not only that mergers do some good, but that they must generate really exceptional, dramatic, and measurable social gains. It would seem unreasonable to bend so far backwards to facilitate them unless they do. And yet, at least so far as any evidence has been able to establish, they do not.

II. The Theoretical Foundation on Which Mergers Become
Unregulated: That There Must Be Something Good About Them

One major contributor to the ambivalent politics of merger history is the diverse body of theories that predict social benefits from mergers. They are of basically three varieties: (a) the argument that, first and foremost, mergers generate “efficiencies” or “synergies” or in some other way deliver net social gain; (b) closely related theoretical controversies over whether concentration in itself can indicate social injury or risk—whether “big” is “bad”—as was implied in antitrust policy under the Warren Court; and finally, (c) the rather different argument that policy should foster a “market for corporate control,” because the possibility of hostile acquisition disciplines incumbent management and directs assets to the most capable owners.

These theories are related. Each arose or was significantly advanced during the revolution among American economists commonly thought of as a “conservative” revolution, and each came to exert extensive influence on the law. But while each came to face substantial academic critique and none now holds more than a controversial position within academia, their influence on the law has remained unchanged.

A. Efficiencies

The chief theoretical justification for growth by acquisition has always been efficiency. In various ways, proponents of merger activity claim that firms can make their goods better or more cheaply if they can do it at a larger volume, and that for various reasons growth by acquisition might be preferable to internal growth. Theorists have suggested a huge range of possible mechanisms by which growth could generate efficiency.⁷⁰ No one seriously doubts that efficiencies can occur with growth or consolidation, and real-world evidence exists.⁷¹ However, there is serious reason to doubt that efficiencies are significant or common in mergers of the size and competitive risk relevant to public policy, much less that they commonly outweigh the risks posed.

Before the mid-20th century, traditional arguments for merger efficiencies tended to be simple-minded generalities. Even now, it is often said without elaboration that mergers will make bigger firms “stronger competitors” or better able to confront buyers or suppliers with market power.⁷² In general, such claims have not been taken too seriously because simple economics implies that competition improves efficiency more than a lack of it does.⁷³ However, economists began working out merger efficiencies with more theoretical rigor in the 1960s, first in a key 1968 paper by Oliver Williamson.⁷⁴ Williamson’s insight was that under certain assumptions and for a simple mathematical reason, efficiencies could sometimes outweigh the deadweight loss of increased market power. He set out a formal demonstration, along with a table of striking numerical results, showing that mergers should usually be net socially desirable. The central theoretical insight was simple: deadweight loss affects only those sales lost by the monopolist’s price increase, whereas efficiency gains are spread across the firm’s entire remaining production.

It is worth dwelling on the serious problems that complicate Williamson’s model, because it remains a cornerstone of modern merger policy even though its weaknesses are well known.⁷⁵ Williamson acknowledged some of the weaknesses himself.⁷⁶ First, he assumed a perfectly competitive pre-merger market that develops market power after just one merger. That is extremely unlikely empirically, and it is also legally irrelevant because under antitrust law—as it has existed for more than forty years—mergers in competitive markets are effectively per se legal. But it also seriously distorts the striking numbers he was able to generate.⁷⁷ As has now been shown several times with a useful graphical representation,⁷⁸ it matters quite a lot in measuring the effects of a merger whether the pre-merger market was competitive or not. Price increases imposed on a perfectly competitive market cause relatively little harm because marginal consumers were already nearly indifferent between having the good and not having it. But if the pre-merger market already reflects substantial market power—as will be the case in all mergers likely to be challenged under antitrust law—even consumers at the margin would have paid more than marginal cost for the good. When output goes down after the merger, that benefit they enjoyed by having the product will be a deadweight loss. Real-world cases have shown that this distortion can be very large.⁷⁹

A second major problem is that Williamson hypothesized mergers in which there would be both a price increase (which will reduce quantity) and some cost reduction.⁸⁰ But it is empirically unlikely that gains from scale would accompany a market power increase. For one thing, scale benefits likely won’t improve when output goes down. Though a merged firm can simultaneously increase its own scale while reducing total output, any scale benefits gotten that way are emphatically the kind that competition itself is supposed to produce.⁸¹ Moreover, efficiencies from growth tend to be exhausted at a comparatively small scale.⁸² The model conceals other problems as well.⁸³

In essence, Williamson made a perceptive mathematical observation about a rare, idiosyncratic set of hypothetical transactions that might never occur and would not be legally challenged if they did. Indeed, no such case has ever been identified in American merger law.⁸⁴ Williamson predicted that such cases would be only “occasional”⁸⁵ and repeatedly warned that his model was “naive.”⁸⁶

Nevertheless, the mere possibility of efficiencies still largely governs American merger policy. Courts, commentators, and policymakers still take for granted that very significant improvements in production cost or quality are commonly available through corporate combinations and consider it a serious risk that government interference in those transactions will inadvertently jeopardize gains that could have been realized. This idea infuses corporate and securities merger law, and, while its role in antitrust has been somewhat complex, it overwhelmingly drives antitrust as well.⁸⁷

B. The Disputed Relevance of Concentration: SCP, Entry Optimism,
and the Contestability “Uprising”

An argument for permissive merger policy closely related to the efficiency claims just discussed is that the size of corporations and the concentration of markets are themselves not relevant to public policy. The argument relates mainly to competitiveness and antitrust, and the claim is that size and concentration in and of themselves do not generate market power. “Big,” in other words, is not “bad.” In extreme forms, important theoretical movements have gone so far as to claim that even outright monopoly might generate no market power at all and claims even that radical have at times held sway in policy.

Perhaps more than any other issue, it was crucial to the mid-century economic revolution to argue that market concentration and firm size could not prove social harm. Up until that time, economists of the influential “Structure-Conduct-Performance” tradition (SCP) argued that concentration alone could predict bad outcomes from merger.⁸⁸ The movement was mainly empirical and rested on a well-established correlation between concentration and profit. The idea implied the significant policy argument that the law might regulate concentration for its own sake, without further investigating actual consequences.⁸⁹ The idea was basic to the PNB presumption and the strict antitrust law of the Warren Court era. During a harsh reactionary period, however, conservatives argued that government should disregard concentration entirely and regulate only conduct.⁹⁰ Those critics were so successful that not only did SCP fall out of favor, but empirical study of industry structure ended more or less altogether.⁹¹

The critics did not doubt the basic empirical result underlying SCP—that concentration correlates with accounting profit. They generally acknowledged it as fact.⁹² Instead, they attacked SCP’s causal reasoning.⁹³ Most importantly, they argued that no inference of market power could be drawn from accounting profits, which might entail no economic profit at all.⁹⁴ The critics explained the concentration-profits correlation by efficiency or other advantages that might correlate with firm size,⁹⁵ and they generated preliminary empirical support for it.⁹⁶ They further argued that if the profits typical of concentration were caused by anti-competitive behavior, they should invite entry.⁹⁷ Rents could persist only if entry barriers were high, and conservative critics were skeptical that they could be.⁹⁸ They also contributed to the evolving industrial-organization theory of imperfect competition, purporting to show that the cartels or oligopoly interdependence that could generate economic profits should be difficult to sustain.⁹⁹

Confidence in the irrelevance of concentration led to one final theoretical elaboration that, in retrospect, seems like an almost bizarre extreme of the new market optimism. A theory known as “contestability”¹⁰⁰ purported to explain how concentrated markets could mimic competition and, under the right circumstances, generate perfectly competitive outcomes even in total monopoly. In those markets, the mere threat of entry would constrain incumbent prices.¹⁰¹ This theory had an implicit but deep influence on the law.¹⁰² Notably, contestability was typically ignored when its application suggested a need for stricter antitrust or regulatory intervention.¹⁰³

These theoretical propositions remain very influential. They have been so fully absorbed that even now some advocates find “simply no general theoretical relationship between market concentration and price,” at least where products are differentiated, and differentiated products are found in most markets in the economy.¹⁰⁴

And yet, as with Williamson’s model, critiques of SCP themselves came under doubt. The original argument that concentration is profitable because it is efficient implied certain logical tensions.¹⁰⁵ The contestability thesis too has been rendered all but irrelevant to real-world cases. It remains theoretically significant on some level of abstraction, but observers realized that the conditions for strong contestability were oddly specific and implausible, and that outcomes were sensitive to them.¹⁰⁶ The empirical evidence was against it,¹⁰⁷ and even its progenitors came to acknowledge that it had been overstated.¹⁰⁸

Meanwhile, the theoretical case that concentration does correlate with competitive injury has grown much stronger, and most conservative critics acknowledge it.¹⁰⁹ That theoretical literature poses its own problems—it is large and complex, and it often generates indeterminate outcomes and copes with some theoretical challenges.¹¹⁰ And yet it is now widely accepted that concentration will diminish competition under common circumstances. Finally, the most important rebuttal to the conservative attack on SCP has been a return to empirical study of industry structure. The evidence that concentration correlates with market power has grown significant enough that the original SCP movement’s core results—so soundly rejected by the academic consensus—have come to seem plausible again.¹¹¹

And yet, as with Williamson’s now much-contested efficiency argument, the influence on the law of the SCP critique has not caught up with the academic state of play.

C. The Market for Corporate Control

Finally, a theoretically distinct justification for mergers has been that acquisitions themselves occur within a market—the “market for corporate control”—that is desirable and should be encouraged.¹¹² Within that market, acquirors take advantage of undervalued companies because their management has run them poorly. That process allocates ownership of business assets efficiently, the argument goes, and more effectively regulates management than fiduciary litigation or SEC enforcement.¹¹³ Advocates of the theory argue that takeovers best serve these goals only if they are left free from regulatory constraints.

This justification has been a prominent and explicit influence throughout merger policy. It surfaced first in congressional consideration of the Williams Act, where its advocates persuaded Congress to drop the strong anti-takeover bias of the law’s initial proponents.¹¹⁴ The idea then found its way into antitrust law during the 1980s, ¹¹⁵ and the Reagan administration prominently deployed it in its antitrust,¹¹⁶

corporate and securities, ¹¹⁷ and general economic policy.¹¹⁸ At the same time, it would become a driving spirit of the Delaware judiciary’s important fiduciary innovations of the 1980s, which were designed to protect desirable takeovers from the machinations of entrenched management.¹¹⁹ And finally, the theory played a role in a brief, strange episode within the Supreme Court, where it narrowly avoided adoption as a doctrine of federal constitutional law.¹²⁰

Corporate control theory, like the other theories already discussed, also invited severe attack. As will be seen, the evidence now seems to corroborate a simple logic problem with the theory, with which it was confronted early on. Holdout shareholders should frustrate efficient takeovers, at least where the shares are dispersed among small shareholders,¹²¹ and the evidence suggests that does, in fact, occur.¹²² So the motive for takeover seems likely to be something other than rationally anticipated gains from superior management or reorganization. Separately, unfriendly takeovers are very costly and uncertain, and should be justified only by severe mismanagement at target firms. But as we shall see, the evidence is that takeover targets tend to be in better health than their peers, especially during merger waves.¹²³ Perhaps most significantly, merger waves turn out to correlate with stock market over-valuations, contrary to what might be expected were there an efficient market for corporate control.¹²⁴

While some still cling to the idea as a justification of merger activity, its foundations are theoretically and empirically very shaky. And yet, as with each of the other traditional theoretical justifications, this theory still holds strong sway. It is still cited in support of merger activity and restrained antitrust enforcement, and indeed it remains a primary argument for corporate law scholars who hope to discipline managers without judicial or legal interference.

III. In Fact, They Appear To Do Little Good at All

All that background finally brings us to the heart of the Article, which is a survey of the empirical evidence that has looked for the gains predicted by the theoretical tradition, and for which the law observes so much caution.

The empirical study of mergers and acquisitions is of longstanding interest. Whether or not consolidation was desirable was a raging preoccupation of lawyers and economists for some decades around the turn of the 20th century.¹²⁵ Like most of the more sophisticated research that would follow years later, those early studies found that consolidation generated little or no benefit at all.¹²⁶ Interest quieted for some time, however, and though there were a few subsequent studies,¹²⁷ as late as 1955 a famous survey complained that most of this work remained divorced from both theory and data.¹²⁸

Since then, the empirical state of play has advanced dramatically. As it stands, a large body of research, much of it dating from mid-century but still relied upon by some researchers and policymakers, purported to show substantial gains from merger based on stock market reaction to merger announcement. Ranged against it, however, is another now-dominating body of more modern evidence that seriously undermines the earlier stock market studies, measuring merger consequences directly and finding them to generate no systematic benefits at all.

A. The Event Studies

Modern merger study mainly began in the mid-1970s with work by academic financial economists, often explicitly designed to substantiate the market for corporate control hypothesis.¹²⁹ Their work employed the “event study” approach, in which stock returns¹³⁰ for both the acquired and acquiring firms were measured over a brief period surrounding the acquisition. If returns improved, it was thought, it would indicate the market’s judgment that the takeover was a good idea. Implicit is a strong commitment to capital market efficiency. The idea is that capital markets effectively integrate relevant information into security prices and can very quickly measure the consequences of ongoing events for firm value.¹³¹ If that is true, then stock returns should accurately and quickly reflect gains from merger. Dozens of event studies emerged, eventually synthesized in several extensive surveys, and the studies found on the whole that the shareholders of merging firms earned large, statistically significant gains.¹³² There were some tantalizing subsidiary findings as well. For example, some scholars identified evidence that takeover announcements produce target-firm gains even when a buyer drops a takeover attempt. This was taken to show that if someone wanted to buy a firm, they must have discovered non-public evidence that the firm was undervalued or that buying it promised untapped synergies.¹³³ The researchers also found evidence they thought was inconsistent with market power as the motive for merger. They took it as further proof that the likely motive was efficiency.¹³⁴ Some other empirical analyses have corroborated the event study literature in one way or another, such as evidence that governance structures that deter hostile takeover correlate negatively with firm performance.¹³⁵

But the event study literature always suffered certain problems, and a few serious ones cropped up early on. Its results could be sensitive to minor differences in experimental design and data selection.¹³⁶ It also posed a problem of case-by-case unpredictability that would frustrate use of the evidence in policymaking.¹³⁷ But more to the point of this Article, even at its peak, the literature’s proponents had trouble explaining the gains they discovered.¹³⁸ Among other things, it was known early on that a major prediction of corporate-control theory—that target firms should be undervalued—was often untrue.¹³⁹ On the one hand, acquiring firms tend to have higher valuations than the firms that they buy, and some evidence shows that merged firms enjoy better stock returns when the acquirer is better-valued than the target. But on the other hand, the firms targeted for acquisition also tend to outperform their peers and often have high valuations.¹⁴⁰ Likewise, researchers had difficulty documenting other effects that should be present if mergers really are driven by efficiency. For example, there was no evidence that merger announcements affected the merging firms’ bond prices.¹⁴¹ While study of the issue had been more limited, there was little evidence that mergers drove any meaningful measure of productivity.¹⁴² Any number of other miscellaneous results seemed hard to explain, including this strange and striking result: in a sample of “clean up” deals conducted by tender offer, in which the bidding firm already had majority control of the target, the bidders wound up paying premiums comparable to those in any takeover. That could not be explained by any synergy, special information, or replacement of inefficient management.¹⁴³ It seems better explained by the problem of opportunistic holdout behavior that has always been a major critique of efficient merger theories.¹⁴⁴

But the most serious problem of all was that gains by target firm shareholders massively outweighed gains to acquiring firm shareholders. That target firm shareholders enjoyed large, immediate gains from takeover announcements was beyond empirical doubt as early as the mid-1980s.¹⁴⁵ But gains for acquiring firm shareholders were hard to find. So far as the event studies could show, the effect on their shares was small in magnitude and statistical significance, and ambiguous in sign.¹⁴⁶ Theorists proposed several explanations for the anomaly and tested them empirically. Several suggested that it could result from bargaining between acquiring and target firms, or from competition among rival bidders for the same target.¹⁴⁷ Still, they had no good explanation why target firms should enjoy such a large advantage.¹⁴⁸ Others tried to explain the difference by the structure of transactions or the means of payment. For example, many studies have found significant differences in bidding-firm gains depending on whether acquisitions were paid for with cash or equity, and in general that acquirers suffer larger losses when they pay with their own equity.¹⁴⁹ Some have explained this fact with a theoretical model under which markets disfavor purchases with equity.¹⁵⁰

But in any case, a bigger problem was emerging evidence that shareholder gains might not be permanent for either firm. The original event studies used very short windows, often measuring stock price changes over a few days. As researchers began to expand the event window, they found that a year or so after acquisition, even target-firm gains often dissipated.¹⁵¹ Later research undercut the tantalizing early finding that unsuccessful takeover attempts caused permanent target-firm gains. In fact, those gains dissipate fairly quickly unless another takeover bid comes through and succeeds.¹⁵² In retrospect, that intriguing result just seems to confirm that the gains to target firm shares merely reflect the anticipation that another takeover is forthcoming.

Another promising finding would be the relation of merger “waves” to systematic stock market overvaluations. Since the beginning of heavy merger activity, observers have remarked that mergers are cyclical, occurring in large, periodic waves, and, to early observers, they seemed to coincide with business cycles.¹⁵³ While it was discovered early on that mergers don’t actually correlate well with business cycles,¹⁵⁴ mergers are correlated with swings in stock prices (which do not necessarily coincide with cycles in the real economy).¹⁵⁵ Moreover, they tend to correlate specifically with over-valuations.¹⁵⁶ That in itself seems somewhat counter-intuitive. All things being equal, one might expect more interest in acquisitions when capital markets undervalue firms, a specific prediction of market-for-control theory being that firms would be bought when they were bargains.¹⁵⁷ The evidence is to the contrary. This can be shown with a common valuation measure known as aggregate “Tobin’s q.”¹⁵⁸ Where Tobin’s q is high, it implies that the firms in a given sector are systematically overvalued. And it so happens that public-market acquisition activity, and especially merger waves, appear to be correlated with high aggregate Tobin’s q.¹⁵⁹ Not only that, but merger waves have almost always ended with precipitous declines in equity prices.¹⁶⁰ This has come to be a fairly robust finding that merger waves coincide with stock market bubbles. That result has not yet been very well explained, but it is in substantial tension with any theory of merger efficiency.

During the 1980s, various theorists, including the event-study proponents themselves, began to question whether target-firm shareholder gains really reflect any social value.¹⁶¹ The event studies might merely have measured the likelihood of control-premium buyouts, and that whatever explains those premiums, it was not the rational expectation of durable efficiencies. As early as 1988, one of the progenitors of the event-study effort, Richard Ruback of the Harvard Business School, wrote “[r]eluctantly” that “we have to accept this result—significant negative returns [over the longer term] following a merger—as a fact.”¹⁶² For some, the confusion cast doubt on capital market efficiency more generally, and especially the extravagant assumption that stock prices could really impound information as well and quickly as event-study proponents had thought.¹⁶³

B. Direct Study of Merger Effects

Meanwhile, other approaches to studying mergers were gaining ground. The most significant development in the empirical effort was the growth of new methods of research design that gained prominence while the event-study literature was beginning to falter. The newer studies—which had previously been rare because they are demanding—used accounting and engineering data for merging firms, rather than stock market performance, measured much longer time periods and controlled for effects across industries (and sometimes over whole economies).¹⁶⁴ That literature began in part with a large, seven-country study in 1980 that found very little evidence of benefits from consolidation.¹⁶⁵

Research in this newer vein discovered certain significant peculiarities early on. For example, even though U.S. firm sizes had increased over the twentieth century, to some large degree as the result of merger and acquisition, plant sizes stayed the same.¹⁶⁶ That is, firms seemed to be growing not by consolidating and synthesizing their production processes, as one might expect if their goal were technological or operating efficiency. By appearances, they were just gathering free-standing businesses and putting them under common ownership. Likewise, it seemed significant that when U.S. merger enforcement became vigorous in the 1960s and aimed its attack mainly at horizontal and vertical deals, managers turned to conglomerate mergers. Thus ensued the first and only conglomerate merger wave in history, and it was truly a massive wave.¹⁶⁷ If conglomerate deals are just as good as horizontal or vertical ones, even though they differ substantially in their economic substance, then perhaps managers are not doing deals because consolidation itself is synergistic or desirable. They might just do deals because, for whatever reasons, they want to do deals.

But at length, one thing these dozens of papers have not found is systematic evidence either of lasting shareholder gain or increases in the performance in merged firms. As is now shown in a large number of papers and several surveys, merged firms actually appear to lose value in the longer-term following merger, or at best, see no systematic gain.¹⁶⁸ The large, one-time gains to target-firm shareholders cannot measure the social value of acquisitions. At most, they can only reflect inframarginal shareholders’ different estimates of future earnings under uncertainty.¹⁶⁹

Certain studies in this tradition have come to be particularly large and striking. One analyzed all friendly acquisitions between exchange-listed firms over a thirty-year period. It found that shareholders in acquiring firms suffered a statistically significant loss of about 10% over the five-year post-merger period.¹⁷⁰ Another study, on a very large set of finely disaggregated data and deploying certain important methodological improvements, found that U.S. manufacturing mergers led to large and statistically significant price increases in the merging firms’ product markets, without evidence of efficiency gains.¹⁷¹ Some important findings of other kinds have also emerged. For example, while the effort to relate merger activity to broader economic trends is challenging and controversial, one study measuring a large dataset over a long period found that even the biggest merger waves had no effect on overall economic productivity, even when measured for periods as long as three years.¹⁷²

It has not been fully explained why mergers produce such disappointing results, but there are likely answers. First of all, the technological or other efficiencies that could plausibly generate social gains are not that likely, except in small deals between small firms. The empirical evidence that exists suggests that minimum efficient scale¹⁷³ in most U.S. markets is probably fairly small.¹⁷⁴ The most obvious and easily measurable gains—scale, scope, and technological integration¹⁷⁵—should mostly be exhausted at comparatively small scale.¹⁷⁶ Occasionally merger studies have found efficiency gains, even on large samples, but if anything, those exceptions prove the rule. Whether they mean to show it or not, they imply that the gains are restricted to small firms doing small deals. For example, one large study, taken by some to prove substantial efficiencies, really seems to show the opposite. It lends support to the view that efficiencies are real but are usually available only among very small deals.¹⁷⁷ Moreover, if, to any degree, efficiencies do explain merger activity, then one would expect mergers to be more common among small firms. They appear not to be. They are more common among large firms, which are less likely to gain efficiency by growth, at least by way of traditional technological integrations.¹⁷⁸

Moreover, even where efficiencies would be available in principle, combinations typically suffer serious implementation problems. A long and well-documented history of failed implementation appears to reflect both clashes of corporate cultures and diseconomies of large size or scope.¹⁷⁹ Scholars in management and economics have struggled to find the determinants of post-acquisition success. They have found that the implementation strategies most likely to succeed are rarely followed.¹⁸⁰ So it may be that however real size-related benefits might be, mergers are a bad way to achieve them; it is just too hard to pull off. Accordingly, it should often be that firms’ incentives to achieve them by internal growth would be as great as to achieve them by merger. The odds are poor that firms will do any better or have any more incentive to obtain efficiencies by the costly and fraught work of consolidation than through internal growth.¹⁸¹ That seems particularly true of gains other than scale improvements, like the need to replace inefficient management or redesign products or marketing.¹⁸²

Nowadays, even the most sympathetic literature reviews, which attempt to cast mergers in the friendliest light, tend only to claim that shareholders should be indifferent to them. The argument goes that acquiring firm shareholders are usually left with net present returns of roughly zero, so at least they are no worse off than if a merger didn’t happen.¹⁸³ That is not a ringing endorsement, but it may be the best that can be said.

IV. The Remaining Puzzles

So all of this leaves a few serious and not well-answered questions. The biggest is why firms and shareholders would systematically engage in conduct that should seem irrational from both their points of view. Many theories attempt to explain the persistence of acquisitions despite their disappointments, but none yet has decisive support.

A. Why Do They Happen at All?

1. If There’s Nothing to Gain, Why Do Buyers Continue to Buy? A variety of explanations have been offered for why firms would engage in activity that seems not to benefit shareholders. Some can be rejected fairly easily. It was once thought that tax savings might be the real goal, in which case mergers might seem rather benign, at least in terms of effects on shareholders and the competitiveness of markets. That now seems very unlikely, as this argument fails to explain much of the empirical evidence.¹⁸⁴ Separately, a “bargains theory” of takeover presumed that acquirers would snatch up firms when they were undervalued, and it was a core prediction of corporate-control theory. It seems quite clearly rejected by evidence that target firms tend to be profitable and valued by investors.¹⁸⁵ Likewise, the common suggestion that acquisition might sometimes just be cheaper than internal growth¹⁸⁶ seems at odds with the substantial history of failed implementation and shareholder losses. If growth by acquisition is so difficult to pull off and likely to generate losses, would it not be cheaper to generate the same growth internally? There was some empirical support for the related idea that some efficiencies require acquisitions because some inputs are “lumpy.”¹⁸⁷ An activity might require some asset that can be gotten only in discrete lumps and cannot be shared between independent firms. An example of an asset like this might be know-how.¹⁸⁸ In any case, though—except perhaps where overall demand is significantly contracting—acquisition is probably an uncommonly risky, disruptive, and expensive means of growth or synergy. Whatever might be gained through scale or sharing lumpy assets across broader activities, it is hard to imagine they are so much more expensive to achieve through internal growth that the evidently costly alternative of acquisition is really better.

The strong correlation between merger waves and stock market overvaluations suggests other possible motives, and these perhaps have stronger support. It may be that during bubbles, managers exploit the opportunity to use their own overvalued stock to acquire real assets, essentially arbitraging for their shareholders’ benefit.¹⁸⁹ That theory, however, is at odds both with evidence that firms with large shareholders are less likely to make acquisitions¹⁹⁰ and that the percentage of acquisitions financed with cash and debt (as opposed to the acquiror’s own equity) is about the same during waves and during normal times.¹⁹¹ A different but closely related explanation, which is analytically elegant and perceptive, is that “economic shocks”—technological innovation or other disruptions that alter expectations of future earnings—increase the range of disagreement over the value of particular firms. As disagreement grows between owners and non-owners of any given firm over its future profitability, the possibility increases that some non-owner will begin to value it sufficiently more highly than its owners so that gain from trade becomes possible.¹⁹² This “economic disturbance” theory enjoys the corroboration that, in fact, merger waves tend to have industry-specific effects and correlate with higher trading volume, which might indicate increasing divergence of opinion among traders over true valuations.¹⁹³ However, “disturbance” explanations are hardly arguments that disturbances generate correct decisions or accurately anticipate efficiency gains. One party that disagrees with the value of a stock is wrong, and there is no reason to believe it is always the seller. In any event, it appears that disturbances do not drive merger activity in non-wave periods.

The explanations that are left, and that fit the evidence best after these decades of empirical study, depend on simple agency cost. They have the advantage of explaining the evidence without relaxing the rationality assumption, and elsewhere in corporate theory, agency cost arguments are uncontroversial. A corporation is not a unitary entity with a single goal that it maximizes, and those who manage it often hold incentives at odds with their shareholders. So long as they are unconstrained by shareholders or stock price discipline, they can cause mergers that do not benefit their firms, and they might very rationally do so to serve their own interests. Agency explanations now enjoy the substantial validation that merger waves affect publicly traded companies but largely do not affect privately held ones.¹⁹⁴ Likewise, mergers are generally less likely where some stockholder or group of them holds a large share of voting stock.¹⁹⁵ These results should not follow if efficiencies generally drive merger and acquisition.

It is unknown why corporate managers should like takeovers so much, and there could be different explanations. Managers, and their lawyers and financiers, might gain individually from increasing firm size, even when the companies do not, either by direct pecuniary benefit or some other, perhaps psychological gain from managing bigger firms.¹⁹⁶ There are any number of related agency-cost suggestions. Common among them is the free cashflow hypothesis, under which managers are reluctant to pay out cashflows as dividends, even when they should, and hoard it or reinvest it inefficiently in internal projects.¹⁹⁷ Somewhat cruder but perfectly plausible ideas include the “hubris hypothesis,” under which managers systematically overestimate their own ability to identify undervalued assets.¹⁹⁸ That theory is corroborated by the otherwise unexplained fact that acquiring firms often experience substantial supernormal returns in the few years before they undertake acquisitions.¹⁹⁹ Perhaps managers who’ve done well for a while overspend on acquisitions, thinking their judgment is better than it is.

In any case, whatever it is that motivates acquisition activity, it is not a rational or reliable estimate of sustainable efficiency.

2. If Markets Are Efficient, Why Would Shareholders Hold Out? Shareholder behavior in takeovers poses a double-sided logic problem. On the one hand, some theorists have found it puzzling that target-firm shareholders would hold out for premium prices because that behavior is at odds with any strong efficient-markets commitment. On a strong efficiency view, shareholders should not need substantial price increases to be persuaded to sell.²⁰⁰ But on the other hand, if takeover proponents are willing to pay high premiums, it implies they believe they can make the stock more valuable than what they’ll pay. So why wouldn’t a target-firm shareholder prefer to keep their stock and share in those gains?

Shareholder behavior, however, seems easy to explain. A takeover, by definition, corners the market in a scarce commodity and inflates its price. The only thing necessary to believe shareholders would rationally hold out for higher prices is the relaxation of the most unrealistic efficient capital markets presumption.²⁰¹ To whatever extent capital market returns measure anything, it is something other than efficiency gains in the underlying transactions. Capital markets continue to support large takeover premiums despite decades of evidence that takeovers generate no real gains. By now, the markets should have priced out the possibility, and takeover premiums therefore must be measuring something else. It appears the markets are merely pricing takeover proponents’ willingness to spend their own shareholders’ money to pay large premiums. To that extent they merely measure the agency cost imposed by acquiring firm managers.

3. And Why Can’t They Make Money? One final puzzle remains. Whether mergers generate efficiency or benefit shareholders, it is generally thought that at least some mergers create market power. Antitrust law takes it for granted, and both standard economic theory²⁰² and a recently growing body of empirical evidence suggests it.²⁰³ If this is true, it would help explain the prevalence of mergers. But one would assume that increases in market power should also increase profitability. If acquisitions generate monopoly, then someone should at least be able to profit from it.

This final tension has received little attention, but a few likely explanations make it quite plausible that mergers could increase pricing power while failing to increase the firm value or accounting profits. Most importantly, profits from pricing power might just be wasted through “X inefficiency.” The theory predicts that lack of competitive discipline leads to slack and inattention to productive efficiency.²⁰⁴ When firms compete, all managers are pressured to find productivity savings to translate into lower prices. But since non-owner managers might prefer less effort, they do not try as hard when competition lessens. There follows the famous folk wisdom that “[t]he best of all monopoly profits is a quiet life.”²⁰⁵

In fact, if product-market competitiveness is a determinant of organizational slack, then mergers creating market power should tend to reduce efficiency. They should dissipate monopoly profits which might otherwise appear as shareholder gains. The idea has formal theoretical support,²⁰⁶ and substantial empirical literature establishes corroborating facts.²⁰⁷ Productivity varies substantially among real-world firms, even within narrowly defined industries,²⁰⁸ and competition correlates with higher productivity.²⁰⁹ There could be more than one mechanism by which competition produces these effects,²¹⁰ but whichever best explains it, support has increased that competition correlates with productive efficiency.

A second, separate reason that mergers could generate market power without shareholder gain is wasteful expenditures taken to get or keep market power. The hunt for market power is generally thought to be socially wasteful and, under at least some circumstances, should lead firms to dissipate most or all the gains of monopoly in seeking it or protecting it once achieved.²¹¹

V. Policy Implications

What should the law do to accommodate the empirical results discussed here? To summarize, mergers and acquisition are unlikely to lead to social gains and might cause serious social loss. Efficiencies of scale and technological integration are probably real but available only in deals too small to be of policy relevance. Large takeover premia are apparently driven by target shareholder holdout and represent no more than one-time transfers of acquiring-firm wealth. While exactly what motivates this seemingly irrational conduct is unknown, large-scale acquisition activity seems best explained by management agency cost. Connections might exist to stock market overvaluations or economic shocks. Still, they are not well understood, and in any event, they would not support explanations based on efficient merger or rational expectations of efficiency. Meanwhile, the evidence increasingly supports the traditional expectation that concentration generates market-power harms and is worsened by mergers and acquisitions.

So what policy corrections could be useful?

First, there is no obvious call for new law, or at least no opportunity for new lawmaking that seems both politically plausible and up to any necessary task. Existing law seems adequate to pressing needs, so long as certain recalibrations are made.

The less important concern is in corporate and securities law. To be clear, there is room for a substantial theoretical re-examination in corporation scholarship. The large extent to which scholarship presumes market institutions are better able to control corporation problems than legal rules is badly at odds with the evidence here. At least one very significant class of market activity operates very ineffectively. It seems unwise to assume on a priori grounds that institutions are available that operate with automatic effectiveness. In particular, the confidence of that literature that agency cost or any other problem could be constrained by an efficient market for corporate control seems wholly misplaced.

But reform of existing legal rules in corporate or securities law would not accomplish much concerning the problems that acquisitions cause. Those laws are already basically inert, at least as they relate to acquisitions. Moreover, it is hard to imagine corrections in them that would solve any relevant problem. Admittedly, the empirical evidence discussed in this paper suggests that the caselaw on point indulges empirical presumptions that are incorrect. However, the rules in question don’t usually generate especially bad results because they generate hardly any effects at all. Substantive corporation law does not specifically encourage acquisitions, except that it makes all challenges to management decisions extremely difficult. In some sense it encourages deals because, absent conflict of interest, challenges face business-judgment-rule treatment and are effectively impossible to win. But that is just a consequence of the law’s extraordinary deference to all management decisions, not to acquisitions in particular. To some degree, the law might encourage hostile takeovers because the courts have created special, somewhat tougher rules in that context to limit how incumbent managers react to them. If hostile takeovers are as unlikely to do good as other deals, these rules may be undesirable. Perhaps incumbent managers should be largely free to thwart hostile deals if they like. But they are already largely free to do that on current law. So-called Unocal and Revlon challenges may be easier than business-judgment-rule cases, but they are still extremely challenging and plaintiffs rarely succeed.²¹²

Conceivably, there could be some value in making shareholder merger challenges easier to win, and there is no particular reason that corporate law reforms should not be made. The point is merely that they cannot remedy the real and potentially very serious harms likely done by mergers and acquisitions. On the one hand, maybe target-firm shareholders should more often win the fiduciary or appraisal lawsuits they usually bring, in which they claim that the prices they were paid were too low. Even though the evidence suggests that they are already substantially overpaid, a greater legal risk of liability to those shareholders might discourage merger activity overall, and maybe that would be a good outcome. Or, on the other hand, acquiring-firm shareholders should have an easier time challenging their managers’ decisions to make acquisitions since they are so often ill-advised. But these ideas just lead to the second problem.

But more importantly, corporate and securities laws probably cannot do much to address the real harms caused by mergers because those harms are felt by third parties. Corporate and securities laws are devoted on a fundamental level to protecting companies and their investors. Their basic mechanism is to impose liability on managers when they take culpable action that reduces shareholder value. Accordingly, the only parties who actively enforce corporate law are shareholders. They have very little incentive to stop inefficient mergers. Generally speaking, target-firm shareholders favor takeover regardless of efficiency, because of the large premium prices they generate. Likewise, except in closely held firms with large individual shareholders, no acquiring-firm shareholder likely has a sufficient financial interest to challenge ill-starred acquisition deals. These incentives are telling, in fact, because the real harm they cause is not to companies or their owners. Deals among large firms can definitely waste the acquiring firm’s money, but do not always, and on average they may leave shareholders more or less just as well off. The real harms of mergers are to third parties—the merging firms’ suppliers, labor, and customers. When firms do gain market power, they use it either to raise prices to those who buy their products or lower the prices they pay to those who supply their inputs. Those who are the real parties in interest to some policy problem tend to be the best enforcers of policy to correct that problem. The fact that corporate third parties can effectively never enforce corporation law is the key reason that that law is not well suited to the problems that mergers cause.

As a separate problem, the only routine corporation law challenge that could actually address the harm that mergers pose to companies or shareholders—claims by acquiring-firm shareholders to stop their managers wasting company money—would logically entail speculative, prospective judicial guesses on whether particular deals will be profitable. That is a judgment even managers themselves are manifestly bad at making, and the large empirical record sheds no light on which deals will fail and which will succeed. Admittedly, the major alternative this Article will suggest—revitalized antitrust enforcement—might also have to make efficiency determinations, but as will be discussed, antitrust is better suited to do it.

So, if there is any lesson for corporate or securities law, it is more abstract. It goes to the general approach or mood that has dominated that law and its theory for some time. It has become so deferential to businesses and their managers that scholars now often describe the “death of corporate law,”²¹³ and many of them welcome it. That has taken form most recently in the dramatic rise in institutional ownership,²¹⁴ which many scholars expect will bring the sophisticated oversight of institutional investors as alternatives to courts and law.²¹⁵ But that position is just characteristic of the dominant attitude in corporate scholarship for decades. The view is that rationality and strong market institutions—like the enlightened self-interest of institutional shareholders—will do the best job of regulating companies, including by constraining their managers’ self-interest. The fact that rationality and market institutions preserve an emphatically failed and wasteful universe of takeover transactions suggests otherwise.

But that is a side issue, because there is a real policy solution at hand and it is simple re-vitalization of existing antitrust law. In this area, the empirical evidence favors radical readjustment of priorities and enforcement, but it can be accomplished without any new legislation or changes to the basic law. All that is needed is for the federal judiciary to take notice of the evidence presented here. The existing law is entirely judge-made, and it was made on a priori judgments of a small number of lower-court judges many years ago that now seem demonstrably, emphatically false. They believed that mergers probably can’t cause much harm, and that constraining them threatens loss of substantial social gains.²¹⁶ There is in fact so little evidence of social gain from any merger even distantly likely to face antitrust challenge that we could comfortably return to the stark prophylaxis of PNB with no fear of loss.

The fact that a revitalized merger law could entail some speculative efficiency determinations, of the kind that seem very hard for judges to make, is only a regrettable inevitability, and is best handled institutionally in antitrust if it must be handled at all. During the PNB regime of the Warren Court years, efficiency was disregarded entirely.²¹⁷ That seems a reasonable enough trade-off if it really is true that mergers systematically generate harm but do not systematically generate any social gain at all. But even if efficiencies must be measured, there are several advantages in measuring them through antitrust. Antitrust merger law is primarily enforced by two federal agencies that both maintain large, sophisticated bureaus of economists. Moreover, antitrust theory and scholarship contain more than fifty years of elaborate, extensive analysis regarding whether and when merger efficiencies are possible, and how they can best be measured institutionally. And a key benefit would be the law’s assignment of party incentives. In antitrust, there will always be a party—the plaintiff—with a substantial interest in challenging a defendant’s efficiency claims. In corporation law there frequently will not be.

So, in mergers and acquisitions we have come fully around the circle. We have lived through a conservative revolution driven almost entirely by a priori theoretical critiques. Those critiques apparently reflected pre-theoretical, ideological pre-commitments to prove that “big” is not necessarily “bad,” and might often be desirable, and to oppose government interventions that don’t give defendants the benefit of extensive doubt. Those critiques and ideological priors never earned meaningful empirical corroboration, despite decades of robust inquiry. It seems that the apparently crude and empirically thoughtless presumptions of vigorous antitrust and non-deferential corporation law might have been pretty reasonable after all. “Big” is perhaps a pretty reasonable proxy for “bad,” such that concentration control using crude, prophylactic measures is more than adequate and desirable, and is not unduly costly.

The balance between false positive and false negative, at long last, should be reset.

Appendix: Difference in Total Welfare Loss

Depending on Pre-Merger Market Power

Figure 1 assumes that the pre-merger price, P₁, was competitive—and therefore equal to the merging firms’ marginal cost, MC. When the post-merger price rises to P₂, the deadweight loss is only the shaded triangle, representing the lost surplus that consumers would have enjoyed from the sales between quantities Q₁ and Q₂. Figure 2 more plausibly assumes that firms merging to significant market power were already charging a supra-competitive price. Deadweight loss is now the shaded trapezoid.

* James A. Thomas Professor of Law, Cleveland State University, c.sagers@csuohio.edu. Material in this paper was presented at the law schools of the University of North Carolina and the University of Pennsylvania. Thanks for feedback and discussion (over years and different versions of this project) to Neil Averitt, Jonathan Baker, Michael Borden, John Coyle, David Forte, Doron Kalir, Ken Kowalski, John Kwoka, Christa Laser, Joe Mead, Diana Moss, John Newman, Russell Pittman, Rick Su, Eric Tucker, and Jonathan Witmer-Rich. Particular thanks to Peter Carstensen for feedback and for allowing me to build on our separate work together.

Why Do Corporations Merge and Why Should Law Care?

Abstract

Why Do Corporations Merge and Why Should Law Care?

I. A Brief History and Legal Context: Mergers Go Systematically Unregulated

A. Corporate and Securities Law: Shareholder and Constituency Protections

B. Competition Protections

II. The Theoretical Foundation on Which Mergers Become Unregulated: That There Must Be Something Good About Them

A. Efficiencies

B. The Disputed Relevance of Concentration: SCP, Entry Optimism, and the Contestability “Uprising”

C. The Market for Corporate Control

III. In Fact, They Appear To Do Little Good at All

A. The Event Studies

B. Direct Study of Merger Effects

IV. The Remaining Puzzles

A. Why Do They Happen at All?

V. Policy Implications

Appendix: Difference in Total Welfare Loss

Depending on Pre-Merger Market Power

I. A Brief History and Legal Context: Mergers Go
Systematically Unregulated

II. The Theoretical Foundation on Which Mergers Become
Unregulated: That There Must Be Something Good About Them

B. The Disputed Relevance of Concentration: SCP, Entry Optimism,
and the Contestability “Uprising”