Stock Issuances and Managerial Agency Costs

Mira Ganor, The Power to Issue Stock (2011), available at SSRN.

Every state corporation statute authorizes the board of directors to issue stock. While one could imagine arguments for allocating this authority to the shareholders, the board of directors is better positioned to respond quickly to financing needs or to provide stock as a motivation for employees. Nevertheless, whenever the board of directors is given an important power, we must be attentive to the potential for abuse. In her new article, The Power to Issue Stock, Mira Ganor reveals various ways in which directors may pursue their own interests at the expense of a majority of the shareholders or thwart the veto power of minority shareholders through the issuance of stock.

Stock issuances are important in Ganor’s account of corporate governance because of the possibility of voting dilution, which occurs when an existing shareholder owns a smaller ownership interest after a new stock issuance. For example, assume that an investor owned one million shares of common stock in Company A, equal to a 25% ownership interest (i.e., the investor owned one million of four million shares outstanding). If Company A subsequently proposed to sell another one million shares to a new investor, the existing investor would see her ownership interest decline from 25% to 20% (she would own one million of five million shares outstanding).

Recognizing this risk of dilution, corporations (especially privately held corporations) sometimes place constraints on the power to issue stock to reassure prospective investors. For example, the number of authorized shares in the corporate charter may be limited or the existing investors may have veto rights or preemptive rights, which would allow them to maintain their ownership interest. In addition, public corporations may be subject to stock exchange listing requirements, which force managers to gain shareholder approval for all new stock issuances exceeding 20% of the outstanding shares.

Despite these potential constraints on the power to issue stock, most publicly held corporations grant the board of directors a great deal of discretion in this area, and boards frequently use that discretion for control purposes. The most familiar example of an issuance motivated by control is the poison pill, which is employed by managers to resist hostile takeovers. Another example is the top-up option, which has become an important mechanism used by managers to facilitate two-step mergers by a favorite bidder. A top-up option gives bidders who acquire a specified percentage of the target company–usually 50%–the option to purchase enough newly issued shares of the target company to reach 90% of the outstanding shares. At that level of ownership, the bidder is allowed to consummate a short-form merger, which does not require a shareholder meeting or a vote of the minority shareholders. Ganor describes the details of the purchase as follows:

Once the bidder exercises the top-up option, she needs to buy the new shares from the company and pay for these shares the same price that she paid in the tender offer. A lower price will not represent a fair market price and may be easily challenged since the tender offer price establishes a fair market price for the shares. [A] large number of shares is issued when the top-up option is exercised, hence the consideration that the bidder should pay the company for these shares is substantial. However, the consideration for the shares can be, and often is, paid with an unsecured note except for a small part, which represents the par value of the shares. Following the short form merger, the unsecured note issued in exchange for the shares is nulled, because after this merger the holder of the note is combined with the issuer of the note and they become one.

Dissenting shareholders may pursue an appraisal remedy after a short-form merger, but their ability to stop the merger seems rather limited. In a case involving a top-up option in the acquisition of Cogent, Inc. in 2010, In re Cogent, Inc. Shareholder Litigation, the Delaware Court of Chancery denied a request for an injunction, reasoning that the harm from the top-up option was too speculative. The plaintiffs in Cogent argued that the top-up option was a sham transaction because the note offered in consideration of the option shares was “illusory consideration,” but Vice-Chancellor Parsons was deferential to the board of directors, concluding that the Delaware code “leaves the judgment as to the sufficiency of consideration received for stock to the conclusive judgment of the directors, absent fraud.”

Top-up options provide an excellent illustration of the agency problems that may arise from the power to issue stock. The most original and important contribution of this article is Ganor’s attempt to capture the potential for abuse with the “excess-ratio,” which is the ratio of authorized non-outstanding shares to the issued and outstanding shares. Ganor observes:

[A]n excess-ratio of one signifies that there are enough authorized but not outstanding shares to double the number of shares already issued and outstanding. The stock exchanges‘ requirement of shareholder approval for an increase of more than 20% of the issued share is equivalent to a 0.2 excess-ratio; and the German limit of 50% can be expressed as a 0.5 excess-ratio.

Ganor concludes her paper with some limited empirical evidence on the excess-ratios of non-financial companies incorporated in Delaware that have completed an initial public offering in the United States. While the ratios seem high–with reported means in excess of 5 and reported medians typically between 3 and 4–Ganor found no meaningful correlations between the ratio and firm size or between the ratio and the likelihood of acquisition.

This paper focuses our attention on an aspect of director power that is rarely acknowledged in the vast literature on managerial agency costs. Ganor offers useful descriptions of the manner in which the power to issue stock can be problematic, and she takes the first step toward systematically analyzing that power.