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ECONOMIC PERSPECTIVES
J A IX IU A r t Y /r f c B K U A r t Y 1 9 8 9

H o s tile ta k e o v e rs and th e
m a rk e t fo r c o rp o ra te c o n tro l

Contents
H o s tile ta k e o v e rs and th e
m a rk e t fo r c o rp o ra te c o n t r o l................................................................... 2
D iana L. F ortier

Theory lags practice as researchers
try to sort out the pros and cons
of hostile takeovers—while
corporate raiders put more targets
to their tender mercies
C o u n te rtra d e —
c o u n te r p r o d u c tiv e ? ................................................................................... 17
Ja ck L. Hervey

When your currency is soft and
your economy a shambles,
barter may be the answer,
though the price is high

FEDERAL RESERVE BANK
OF CHICAGO

ECONOMIC PERSPECTIVES

JANUARY/FEBRUARY 1989 Volume XIII, Issue 1

Karl A. Scheld, senior vice president and
director o f research
Editorial direction
Edward G. Nash, editor, David R. Allardice, regional
studies, Herbert Baer, financial structure and
regulation, Steven Strongin, monetary policy,
Anne Weaver, administration
Production
Nancy Ahlstrom, typesetting coordinator,
Rita Molloy, Yvonne Peeples, typesetters,
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Roger Thryselius, Thomas O’Connell, graphics,
Chris Cacci, design consultant,
Kathryn Moran, assistant editor

ECONOMIC PERSPECTIVES is published by the
Research Department of the Federal Reserve Bank of
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do not necessarily reflect the views of the management
of the Federal Reserve Bank.
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vided with a copy of the published material.

ISSN 0164-0682

H o stile ta k e o v e rs and th e
m a rk e t fo r co rp o ra te
co n tro l

Do hostile takeovers create new wealth?
Or, do they simply move wealth
from Column A to Column B, enriching
some at the expense of others?
The evidence is mixed

D iana L. F ortier

defensive or offensive strategies. Such
‘7/i recent years, the tender
offer takeover has been
battles may also impose large costs on share
praised and damned with a
holders, creditors, management, employees,
ferocity suggesting that the
customers, and communities. These private
and social costs of takeovers have recently
survi val of capitalism is at
stake. The truth, as in most disputes with significant legislative interest in
spurred
substantial metaphysical content, hostile takeovers and defensive tactics.2
is more
This
prosaic. ” F. M. Scherer, Journal of Eco paper discusses the corporate con
nomic Perspectives, Winter 1988, trol 69.
pg. market by focusing on hostile takeovers
as a mechanism for corporate control. It
The market for corporate control—
discusses the causes of hostile takeovers and
firms competing for the rights to manage
the methods of defensive action by hostile
their corporate resources—has become an
takeover targets. It then analyzes their
increasingly important element of the corpo
effects not only on the bidder and target
rate landscape. Mergers and acquisitions
shareholders but also on other stakeholders
have increased every year since 1982, reach
(e.g., management and employees). A final
ing an all time high of 3,336 net announced
section reviews the evidence on the sources
transactions in 1986. (See Table 1.)
of takeover gains. Are such gains redis
Although contested tender offers— hos
tributions of wealth to one group at the ex
tile takeovers—only account for a small
pense of another or are they derived from
fraction of all merger and acquisition activ
improved efficiency? Finally, what does this
ity, they involve large publicly traded com
evidence imply about the effect of hostile
panies with substantial market values across
takeovers on social welfare?
many industries. The $12.8 billion aggre
gate dollar value of 15 successful hostile
H ostile tak eov ers: W hy do they occur?
takeovers in 1987 accounted for 7.7 percent
Hostile takeovers, those opposed by the
of the total dollar value of the 972 mergers
target’s hoard of directors, became an “ac
and acquisitions for which such data were
cepted” part of the corporate control mar
disclosed. Moreover, the number of un
ket in 1974 with Morgan Stanley and Com
friendly takeovers was higher in each of the
pany’s representation of International
past three years than in any of the previous
Nickel Company of Canada in its hostile
eleven years.1
takeover of ESB, Inc. In a hostile takeover,
Hostile takeover activity has a substan
a hid is made directly to the shareholders of
tial impact on corporate behavior. Indeed,
the target rather than to the target’s man
organizations involved incur substantial
agement. The acquirer obtains the needed
costs and devote much time to developing
2

ECONOMIC PERSPECTIVES

TA B LE 1

M erger and acquisition statistics'
Contested tender offers
Year

Total mergers
& acquisitions

Total tender
offers
#

Total
contested

Successful
offers2

% of
col. 2

% of
col. 3

Target remained
independent

% of
col. 4

Acquired by
w hite knight
#

% of
col. 4

1978

2,106

4.3%

30%

48%

30%

22%

1979

2,128

106

5.0%

25%

31%

35%

34%

1980

1,889

2.8%

23%

25%

50%

1981

2,395

3.1%

37%

46%

21%

33%

1982

2,346

2.9%

43%

59%

34%

1983

2,533

1.4%

30%

64%

27%

33%

11%
28%

1984

2,543

3.1%

23%

56%

1985

3,001

2.8%

38%

44%

28%

1986

3,336

150

4.5%

27%

38%

25%

37%
23%

27%

1987

2,032

116

5.7%

27%

58%

19%

Ten
year
total

24,309

858

3.5%

254

30%

118

46%

27%

'Data refer to net announcem ents (com pleted o r pending transactions) o r pu b lic ly announced fo rm a l transfers o f o w n e rs h ip o f at least ten
percent o f a com p a n y 's assets o r e q u ity w h ere the purchase price is greater than or equal to $500,000 and one o f the parties is a U.S.
com pany. Tender o ffe r data refer to tender offers fo r pu b lic ly traded com panies. Successful offers refer to both fu lly and p a rtially
successful deals.
JO ffers s till pen ding as o f year-end are also included in these totals.
SOURCE: W.T. G rim m , M e r g e r s t a t R e v ie w , selected years.

votes, gains control, and replaces existing
management. But what factors need be
present in the target and the bidder firms
for hostile takeovers to occur?
Conflicts of interest between the target
firm’s management and shareholders lie at
the root of the hostile takeover phenome
non. These conflicts result from the separa
tion of ownership (shareholders) from con
trol (management). Conflicts arise from
management’s desire to use the firm’s re
sources to achieve outcomes that do not
coincide with shareholders’ interest, which
is maximizing the net present value of
the firm’s future profits.
Economists term the lost profits arising
from the separation of ownership and con
trol, agency costs. Internal controls are
generally sufficient to hold down these
agency costs. But when agency costs become
too high and internal controls, particularly
the hoard of directors, have failed to protect
the interests of shareholders from inefficient

FEDERAL RESERVE BANK OF CHICAGO

performance and non value-maximizing
behavior of management, the firm is likely
to become the target of a hostile take
over bid.*
Several factors can influence the level of
agency costs. Often factors such as deregu
lation and increased competition create a
need for valuation and restructuring of cor
porate assets in an effort to continue to
maximize shareholder value. But sometimes
current management fails to undertake the
necessary steps to do so. New management
without prior ties to employees or the com
munity may he more objective and better
able to adapt the firm’s productive assets
to its changing environment. Hostile
takeovers are one way of effecting the
necessary changes.4
Diana L. Fortier is an econom ist at the Federal
Reserve Bank of Chicago. The author thanks
Herbert Baer and Bruce Petersen for their
helpful comments.

Firms that are undervalued by the mar
ket, that is, there is a mismatch between
realizable asset value and stock price, for
whatever reason, are prime takeover tar
gets. It is often argued that firms with man
agements that concentrate on long-term in
vestments (e.g., research and development)
at the expense of short-term earnings are
susceptible takeover targets. The premise to
this explanation of hostile takeovers is that
markets are short-sighted and poor current
profits lead to stock undervaluations which
create favorable takeover conditions.
Agency costs arise here as the market puts
more emphasis on current cash flows and
management places greater weight on future
cash flows. However, evidence does not
support this “ myopic market” hypothesis.5
Significant amounts of free cash flow
also contribute to agency costs. Free cash
flow is that cash flow in excess of the amount
required to fund all projects that have a
positive net present value when discounted
at the relevant cost of capital. With high
levels of free cash flow, managers may seek
to secure their own position by making inef
ficient low-return investments rather than
paying out the free cash flow to shareholders
in the form of dividends.6 Yet, it may he
difficult to distinguish this behavior from
prudent investing that turns out to be less
profitable than expected.
Agency costs may also explain why some
companies choose to initiate hostile take
overs. Companies with significant free cash
flow and unused borrowing power may en
gage in unwarranted acquisition activity—
paying significant premiums for targets to
fulfill objectives other than value maximiza
tion. Acquisitions aimed at diversification,
geographic expansion, or increased firm size
may be pursued in order to further manage
ment’s goals of self-entrenchment or “'em
pire-building” rather than enrich sharehold
ers. Thus, unwarranted acquisition activity
not only explains why firms may become
targets, but is also one explanation of bidder
behavior in takeovers. This may also ex
plain instances of negative returns to share
holders of acquiring firms—management
benefits at the expense of shareholders.
Firms initiating hostile takeovers may
also he victims of hubris. This “winner’s

curse” hypothesis asserts that takeovers may
he motivated by the bidder’s overestimation
of the value of the target firm, when there
may not be any true gains to be had.'
Defensive tactics—the target’s response
Whatever the cause of the hostile take
over attempt, a target or potential target
must respond. Data in Table 1 indicate that
only 25 percent of all targets are successful
in remaining independent. Another 25 per
cent are saved from the hands of the hostile
bidder but are acquired under friendly
terms by a “ white knight.” The remaining
50 percent ultimately fall prey to the
hostile acquirer.
Despite the fact that few targets are
successfid at fending off hostile suitors,
there are several defensive measures avail
able to boards, managements, and share
holders to assist them in their efforts to
maintain an independent organization or
current management.
The best defense
It is often said that the best defense is a
strong offense. In the case of hostile take
overs a firm’s best defense is the restoration
of a closer relationship between asset values
and share price. Thus, increased returns to
shareholders or increased price/earnings
ratios may be the most effective and direct
“defensive” measure for an organization.
Indeed, taking actions to increase the firm’s
value (e.g., selling underperforming units)
before someone else takes over and does so
may also achieve the results of increased
stock prices and possible shareholder gains.
An evaluation of the firm’s business
strategies, ownership composition, and capi
tal structure is a prerequisite to achieving
these goals. Internal restructurings have a
dual benefit of improving shareholder value
through a more efficient allocation of re
sources and reducing the need to rely on
other more costly takeover defenses.
Employee stock ownership plans
(ESOPs) and leveraged recapitalizations or
leveraged cash-outs (LCOs), are among the
commonly used methods of restructuring a
firm’s capital and equity position and subse
quently building its takeover defenses.8
Both of these methods have a positive im
pact on shareholder wealth through an
ECONOMIC PERSPECTIVES

improved alignment of shareholder and
management interests and shareholder
tax benefits.
ESOPs change the equity structure to
ward a greater proportional ownership by
employees. Also, ESOPs may improve take
over defenses because the trustees of the
voting stock of the ESOP are often con
trolled by management. LCOs, which re
quire shareholder approval, increase firm
leverage and management’s proportional
ownership. Efficiency and performance
should improve under incumbent manage
ment as commitments to debt repayment re
duce management’s discretionary use of free
cash flow. Hence, the agency costs of management/shareholder conflicts decline be
cause default on debt service would have
substantial negative financial impacts on
management. In addition to increasing capi
tal market scrutiny of the firm, the in
creased leverage also decreases the opportu
nity for a bidder to borrow against the assets
of the firm to finance its acquisition.
Although size alone was once thought to
he an effective takeover deterrent, it has
become increasingly evident that it is no
longer a reliable defense. Small firms may
obtain acquisition resources for larger firms
by issuing claims on the value of the target
firm’s assets, as with any other corporate
investment. The ability to do this has been
facilitated by the increase in financial mar
ket liquidity, particularly with increased
acceptance of, and usage of, junk bonds.9
Antitakeover amendments
Despite an excellent offense, protection
from hostile takeovers may still he difficult
without some other line of defense. There
are numerous defensive mechanisms or
“ shark repellents’’ available through corpo
rate bylaws and charter amendments. Not
all of these provisions require shareholder
approval. (See Box.)
Yet, as defensive tactics develop, so too
do methods to render them ineffective. As a
result, antitakeover amendments do not
generally halt takeovers, rather they make
them more difficult, more costly, more time
consuming, and may also be harmful to
shareholders. Basically, these defensive
tactics impose conditions that must be met

FEDERAL RESERVE BANK OF CHICAGO

before control can be changed, whether by
tender offer, merger, or replacement of the
board. For example, shareholder rights
plans dilute the equity holdings of the bidder
and fair price amendments increase the cost
of acquisition.
A study of hostile takeover attempts in
1985 indicates that the most often used de
fensive measures of targets in those cases
were acquisition by a white knight, recapi
talization such as a stock buy-back, and
litigation.10 As noted earlier, leverage-in
creasing transactions such as recapitaliza
tions can diminish the attractiveness of the
target by decreasing the ability of the ac
quirer to borrow against the assets of the
target to finance the acquisition. LCOs also
enhance takeover defenses by reducing
the agency costs created when high levels of
free cash flow are available. Litigation
serves as a defense by increasing the costs
and uncertainty of takeover and thus deter
ring bidders.
The ability of a firm to defend itself is
also affected by its state of incorporation.
The powers of firms, shareholders, and
managers are controlled by state statutes
that define and regulate corporations. (See
Table 2.) The constitutionality of state
restrictions on takeovers was supported by
an April 1987 Supreme Court ruling.11
Also affecting the battle lines between
bidders and targets are administrative and
regulatory requirements. Tender offer
disclosure, delay rules, and regulatory ap
proval periods slow the acquisition process.
This usually gives targets additional time
to build defenses and often leads to increases
in multiple and preemptive bidding and
auction contests, all of which tend to
decrease bidder returns by increasing
target premiums.12
The impact of antitakeover amendments
Several researchers have studied the
impact of antitakeover amendments on
targets’ shareholders. Those amendments
adopted by management without share
holder approval are in most cases found to
be detrimental to shareholders. Although
amendments requiring shareholder ap
proval should he lees likely to harm share-

TA B LE 2

Provisions o f state corporation laws in the Seventh D istrict
State

Effective
date

Illinois

Statute

Code

1985

Fair price am endm ent
N onm onetary factors

III. Rev. Stat.
Chpt. 32, 7.85 & 8.85

Indiana

1986

Control share acquisitions
Business com bination

Ind. Code Ann.
23-1-43-0-24)

Iowa

None

M ichigan

1984

Fair price am endm ent

Mich. Comp. Laws Ann
450.1775-1784

W isconsin

1986
1987

Fair price am endm ent
Anti-greenm ail
Business com bination
(sunset provision effective 9/10/91)

Wis. Stat. Ann.
180.725 & 180.726

Other states w ith the same provisions'
Fair price am endm ent: CT, FL, GA, KY, LA, MD, MS, NC, PA, VA, and WA
Business com bination: AZ, DE, KY, MN MO, NJ, NY, and WA
Control share acquisitions: AZ, FL, HI, LA, MA, MN, MO, NV, NC, OH, OK, OR, and UT
N onm onetary factors: AZ, ME, MN, and PA
Anti-greenm ail: AZ, MN, and NY
'The specific characteristics of these provisions may vary across different states.
SOURCE: S t a t e T a k e o v e r S t a tu te s a n d P o is o n P ills , Robert H. Winter, Robert D. Rosenbaum, Mark H. Stumpf, and L. Stevenson Parker,
Vol. 3 of S h a r k R e p e lle n ts a n d G o ld e n P a r a c h u te s : A H a n d b o o k f o r th e P r a c titio n e r .

holders, about half of them have also been
found to result in significant negative
abnormal returns to target shareholders.
(See Box.)
Among the most common defensive de
vices that require shareholder approval are
fair price amendments, which have been
found to have no significant effects on share
holders, and classified boards and superma
jority clauses, both of which have been
found to have significant negative impacts
on shareholder wealth. The poison pill,
which does not require shareholder ap
proval, has proven to be an effective and
popular, yet controversial, defensive meas
ure. However, its adoption has been
shown to have significant adverse effects
on shareholders.13
Why do shareholders approve amend
ments that may decrease shareholder
wealth? Proponents of antitakeover amend
ments argue that such amendments are in

the shareholders’ interest by giving boards
the power to ensure that the shareholder
receives a fair price reflecting their maxi
mum possible share of expected acquisition
gains. Management, by acting as a negotiat
ing agent for diffuse shareholder interests,
is better able to hold out for the best
price by reducing individual incentives to
tender at too low a price. Of course, the
composition of ownership will also affect the
dispersion of shareholder interests. The
greater the proportion of insider (manage
ment) stockholders, the more likely
antitakeover amendments will be in the
shareholders’ interest.
According to this shareholder interest
hypothesis, antitakeover amendments are a
negotiating tool rather than a takeover de
terrent. This argument seems to rest on the
assumption that antitakeover amendments
are ineffective at ultimately deterring take-

ECONOMIC PERSPECTIVES

overs. It suggests that the adoption of anti
takeover amendments should have a positive
impact on stock prices not because of the
antitakeover amendment per se, but from
the anticipation of ultimate takeover and
positive returns. However, many of these
antitakeover provisions have been found to
decrease shareholder value, and research
provides weak support for the shareholder
interest hypothesis.14
Opponents of antitakeover amendments
argue that management may abuse their
veto power and act in their own interests at
the expense of shareholders. They view
such amendments as detrimental because
they can entrench current management,
reduce shareholder wealth by deterring
tender offers and potentially valuable take
over bids, or reduce their share of the take
over premiums due to the acquirer’s in
creased transactions costs as a result of the
amendments. In general, they argue that
such amendments have a negative impact on
the efficient allocation of real capital in the
economy. A fall in equity values resulting
from adoption of antitakeover amendments
would support the managerial entrench
ment hypothesis.13
One way of dealing with, though not
eliminating, this shareholder/management
conflict of interest is for the board to estab
lish management compensation contracts
with ownership stakes (e.g., stock options) to
promote value-maximizing behavior by
management.16 Yet, boards often are not ef
fective in controlling management behavior
because the managers are able to create a
board of directors loyal to management or
with financial interests in maintaining
existing management. Moreover, directors
may lack sufficient information to determine
the degree of value-maximizing behavior
of management.
Ownership composition

A firm’s ownership composition also
influences its defensive position. The per
centage of institutional holdings and insider
holdings affect the ability to get shareholder
approval of antitakeover provisions. The
lower the percentage of institutional hold
ings and the higher the percentage of insider

FEDERAL RESERVE BANK OF CHICAGO

holdings, the more likely antitakeover meas
ures, particularly those with negative wealth
effects, will obtain shareholder approval.17
Although inside holdersTiave financial
interests to protect, they also have careers
to be concerned about. Thus, inside holders
may trade-off wealth accumulation for
greater corporate control. Data suggest that
the greater the percentage of insider hold
ings of the hostile target the better the tar
get's chances of remaining independent. In
stitutional holders also have large economic
interests to protect; however, data do not
suggest that relatively large shares of institu
tional holdings are indicative of greater
takeover vulnerability.18
Also of importance is the percentage of
low-stake uninformed shareholders. The
costs of assessing antitakeover amendments
are high for uninformed shareholders and
incentives are relatively low for low-stake
holders. Thus, such shareholders tend to
vote with management under the assumption
that voting more often with management
than against them is more likely, in the long
run, to yield greater shareholder wealth.
Effects of hostile takeovers and policy
implications

The previous actions have presented the
major elements of the hostile takeover battle
and, as with any battle, there will be a win
ner and a loser. However, the effects of the
battle go beyond the direct combatants. The
remaining sections will discuss the impact of
hostile takeovers on various stakeholders:
shareholders, management, labor, and soci
ety in general. Although conclusive evi
dence on the net economic welfare impacts
of hostile takeovers is elusive, arguments for
and against them are not.
The winners: Target shareholders

Evidence from short-period merger
event studies (covering the few weeks
around a takeover announcement) clearly
indicate that stockholders of target firms
benefit by receiving positive abnormal
returns—gains above those that would have
occurred had the stock followed overall
market movements. A recent study conser
vatively estimates the gain to target share
holders from takeovers of publicly traded

Takeover and defense tactics*

There are numerous tactics for taking over
corporations. Even more numerous are the
modes of defense against takeovers. Follow
ing is a list of the major actions available to
the offensive and defensive players of this
increasingly popular enterprise, corporate
takeover. The defensive tactics are grouped
according to their impact on shareholder
wealth, as indicated by research to date.
TAKEOVERS
■ Leveraged buyout: heavily debt-financed
buyout of shareholder equity often by in
cumbent management.
■ Merger: bidder negotiates with target
management on the terms of the offer which
is then submitted to a vote of the target’s
shareholders.
■ Proxy contest: by a vote of the share
holders a dissident group tries to gain a con
trolling position on the board.
■ Tender offer: bidder makes offer to
shareholders for some or all of the
target’s stock.
Friendly: offer supported by the target
company’s management.
Unfriendly (hostile): offer opposed by
target management.
DEFENSIVE TACTICS

(Shareholder approval required)

N o im pact or no evidence o f im pact
on target shareholder wealth
■ Dual-class recapitalizations: restructure
equity into two classes with different voting
rights with the goal of providing manage
ment or family owners with voting power
disproportionately greater than provided by
their equity holdings under a one-share,
one-vote rule; typical dual class firm is al
ready controlled by insiders and the recapi
talization may also provide needed capital
without dilution of control and without
harm to the stock value.

■ Fair-price provision: a supermajority
provision which applies only to nonuniform
two-tier hostile takeover bids; insures that
all shareholders selling within a certain time
period receive the same price; the usual
determination of fairness is the highest price
paid by the bidder for any of the shares it
has acquired in the target during a certain
time period; has a low deterrence value and
is not detrimental to stock values.
■ Rights o f shareholders: restricts rights of
shareholders to vote on issues between an
nual meetings or at special shareholder
meetings (e.g., only supermajority vote of
the shareholders or the president of the
board may call a special meeting).
Positive im pact
■ Leveraged recapitalization or leveraged
cash-out: a change in capital structure and
equity ownership, retaining a publicly
traded company; financial leverage is in
creased significantly as the company re
places the majority of its equity with debt so
that a raider can not borrow against the
assets of the firm to finance an acquisition;
management (insiders) in essence receives a
stock-split and proportional increase in
ownership as all but inside shareholders
receive a large one-time payout in cash or
debt securities and continued equity interest
in the restructured company.
N egative im pact on target
shareholder wealth
■ Change state o f incorporation: strin
gency of state antitakeover laws vary; may
harm shareholders because it reduces take
over chances; may benefit states as they
increase the likelihood of keeping jobs with
strict state laws.
■ Reduction in cumulative voting rights:
increases management’s ability to resist a
tender offer but appears to reduce share
holder wealth. (Cumulative voting rights
allow a group of minority shareholders to

ECONOMIC PERSPECTIVES

elect directors even if the majority opposes
because each shareholder is entitled to cast
a number of votes equal to the number of
shares owned multiplied by the number of
directors to be elected—thus one could ac
cumulate votes for a particular director or
group of directors.)
■ Staggered directors or classified board:
directors are broken into classes (usually
three groups) with only one class being
elected each year; works best with limit on
number of board members; makes it diffi
cult for a substantial shareholder to change
all of the board at once without approval or
cooperation of the existing board, but also
makes any change of directors more diffi
cult; also lowers the effectiveness of cumula
tive voting; has impact of significant nega
tive abnormal returns.
■ Supermajority clause: increases the num
ber of votes of outstanding common stock
needed to approve changes in control to twothirds or nine-tenths from a majority of onehalf (director must also be removed for
cause); found to have significant negative
stock-price effects around their introduction
and on average they appear to reduce share
holder wealth; important to have an escape
clause (provision allowing for simple major
ity vote) so that friendly offers are not also
foreclosed; almost always combined with a
lock-in provision.
■ Lock-in provision: prevents circumven
tion of antitakeover provisions; most com
mon provision requires a supermajority vote
to change antitakeover amendments or lim
its the number of directors; has impact of a
significant negative abnormal return.
(Shareholder approval not required)

N egative im pact on target
shareholder wealth
■ Litigation by target management: a win
by target may harm shareholders in that
chances of acquisition may be lost or
lowered—this may be reflected by a fall in

FEDERAL RESERVE BANK OF CHICAGO

share price, whereas the acquisition is likely
to have increased share prices (examples:
charges of securities fraud, antitrust viola
tions, or violations of state or federal
tender offer rules); delays control fight, yet
also gives management time to find a
friendlier deal.
■ Shareholder rights plans or poison pills:
do not require majority voting approval by
shareholders; are triggered by an event such
as a tender offer, or by the accumulation of
a certain percentage of target’s stock by a
single stockholder; trigger allows target
shareholders with rights to purchase addi
tional shares or to sell shares to the target at
very attractive prices; can be cheaply and
quickly altered by target management yet
makes hostile takeovers very expensive by
diluting the equity holdings of the bidder,
revoking his voting rights or forcing him to
assume unwanted financial obligations; dif
ferent types include: flip-over, flip-in, back
end, and voting plans; generally harmful to
stock values; judicial approval of certain
types of plans (e.g., flip-in and back-end) is
still not clear.
■ Target block stock repurchases or green
mail: target repurchases, at a premium, the
hostile bidders block of target’s stock; often
results in substantial fall in stock returns for
the target or reduced shareholder value
from foregone takeover potential as opposed
to normally positive stock price effects of a
repurchase of stock by a nontargeted firm;
yet evidence indicates that a net positive
stock price may result from the initial hos
tile bidder purchase (positive impact) to the
target repurchase (negative effect); benefits
returns for bidder firm shareholders; prac
tice is controversial and has been challenged
in federal courts, congressional testimony,
and SEC hearings.*
*For empirical evidence of the effects of defensive tactics
and the market for corporate control see footnote 14
of the text.

companies between 1981 and 1986 to be 47.8
percent, or an estimated dollar value of
$134.4 billion. Additionally, the average
premium on all mergers and acquisitions
in 1987 was 38.3 percent whereas the aver
age for hostile takeovers that year was
42.7 percent.19
Bidder shareholders may gain or lose

For the acquiring firm, the results from
the same studies are not so unequivocal.
They indicate that on average there is no
significant short-period effect, positive or
negative, on shareholder returns, and, if
anything, there is at best a slight positive
impact on the acquirer’s share value.20 Evi
dence from longer-period event studies (one
to three years) suggests that increases in
target stock prices during takeovers overes
timate the post-merger increase in firm
value. Despite this overvaluation, recent
research concludes that the average success
ful tender offer results in a statistically sig
nificant positive revaluation of the combined
firm. Such increases have been fairly
consistent over time. However, bidder
gains have been diminishing over the last
two decades while target returns have in
creased.21 Thus, it appears that on average
takeovers and mergers enhance share
holder value.
While it is concluded that mergers and
acquisitions enhance shareholder value, this
conclusion does not imply that such value is
derived entirely, or at all, from increased
efficiency (e.g., resource reallocation, re
moval of inefficient management, or econo
mies of scale or scope).
Sources of gain: Improved efficiency or
wealth redistribution

Although easily measured, shareholder
gains do not provide an accurate measure of
welfare gains. If takeover gains are a result
of wealth transfers, then the increase in
share prices overstates the efficiency gains
of takeover. Shareholder gains must be
weighed against the losses of other stake
holders such as management and employees.
As opponents of hostile takeovers argue,
takeover gains result primarily from wealth
redistributions: one stakeholder’s gain—the
target shareholder—is at the expense of an

other’s economic loss—such as the target
employee or bondholder. In the extreme,
such takeovers are merely costly and disrup
tive restructurings of corporations that pro
vide no social benefits. Preventing such
takeovers would, it is argued, improve
economic welfare.
Proponents argue that takeovers pro
vide net gains to society by reducing the
agency costs related to management/shareholder conflicts, which, in turn, improves
resource allocation and efficiency and en
courages value-maximizing behavior. Thus,
attempts to prevent a free corporate control
market would have negative effects.
Overall, research is not conclusive on
the sources of takeover gain and indicates
that gains from redistribution as well as in
creased efficiency may be occurring. The
sources of gain vary from deal to deal, from
industry to industry, and from year to year.
Studies have addressed the wealth transfers
to target shareholders from target bond
holders, government, and target labor.
One version of the redistribution theory
asserts that the gain of one class of security
holders comes at the expense of another.
For example, bondholder values may de
cline as common shareholder values in
crease. This example may be more relevant
to highly leveraged transactions in which
corporate bond prices may fall and yields
rise as increased leverage contributes to
uncertainty about the acquirer’s ability to
service its debt. Despite some recent ex
amples of such behavior related to leveraged
buy-outs, studies of both mergers and lever
aged buy-outs have failed to find consistent
support for this theory.22 Moreover, when
such redistributions have occurred, the
increase in shareholder value often more
than offsets the fall in bond values. Thus,
takeovers appear to result in net gains to
investors as a group. In general, target
shareholders’ gains do not occur at the ex
pense of either bidder shareholders or other
classes of target or bidder investors.
The increase in shareholder value re
sulting from hostile takeovers could also be
a redistribution from the government to
shareholders. Hostile takeovers may gener
ate tax savings without any underlying effi
ciency gains. Thus, government becomes

ECONOMIC PERSPECTIVES

another stakeholder in the takeover
battle. But the evidence indicates thdt tax
benefits have been only a minor force be
hind takeovers.23
Another form of redistribution espoused
recently is that shareholder gains come at
the expense of labor through long-term la
bor contract concessions which reduce em
ployment or wages. Evidence from small
firm acquisitions (not hostile takeovers) does
not support assertions that acquisitions have
an overall negative effect on labor in terms
of lower employment and wages.24 However,
hostile takeovers usually involve large or
ganizations and create a fear that both ex
plicit and implicit commitments by target
management to labor will be broken follow
ing the takeover. A notable example is Carl
Icahn’s hostile purchase of TWA which
resulted in improved management and
shareholder premiums worth $300 to $400
million, but also resulted in wealth transfers
to Icahn from three labor unions which one
researcher valued at $600 million or one
and a half times the takeover premium.25 In
this case, it would appear that shareholders
gained principally at the expense of labor.
The unanswered question is whether such
labor concessions are simply wealth trans
fers or actually enhance efficiency.
Labor-related inefficiencies may result
from the inability of management to respond
appropriately to factors, such as technologi
cal developments, which decrease the de
mand for labor, or result from failure to
deal successfully with a labor force that
wields market power. In either case, these
inefficiencies create conditions ripe for hos
tile takeovers, which in turn become the
mechanism by which efficiency is enhanced.
This does not mean that labor will always be
a casualty in a hostile takeover battle.
Takeover activity, and hence the fear of
takeover, may be favorable to labor in that
efficiency gains at potential target compa
nies can lead to job preservation and greater
long-run growth and employment.
Economic efficiency theories argue that
net gains may occur from increases in eco
nomic efficiency achieved through major
restructurings and better management of
corporate assets. Takeovers can reduce

FEDERAL RESERVE BANK OF CHICAGO

agency costs and result in more efficient
capital investments by subjecting the firm to
the scrutiny of the capital markets and by
reducing resources under management con
trol. Benefits accrue when target share
holder wealth that had been appropriated to
target management, employees, suppliers,
or customers under non value-maximizing
behavior is reallocated to target sharehold
ers and the acquirer upon acquisition.
Business line financial data has been
used to test the efficiency enhancement the
ory of takeovers by analyzing the ex post
financial performance of acquiring firms.
Two implications of the theory that take
overs increase efficiency due to improved
management have been tested. First, the
target’s pre-takeover profits should be less
than its industry peers’, and second,
ceteris paribus, post-takeover profitability
should be relatively higher than pre
takeover profitability.
Examining these hypotheses, Scherer
found that targets were slight underper
formers relative to their industry norm, but
that “ operating performance neither im
proved nor deteriorated significantly follow
ing takeover,” and “ there is no indication
that on average the acquirers raised their
targets’ operating profitability net of
merger-related accounting adjustments.” 26
Generally, studies using accounting data
to analyze post-takeover performance do
not clearly support the economic efficiency
theory of takeover gains. Unless this incon
clusiveness can be attributed to measure
ment problems associated with the use of
accounting data or the lack of coordination
in the use of market and accounting data in
analyzing shareholder gains and the sources
of those gains, one must question whether
there are any true wealth gains derived from
the supposed improved management and
efficiency subsequent to takeover.
While operational efficiencies may be
elusive, it appears that financial market
inefficiencies do create opportunities for
takeover gains. If takeovers lead to the
revaluation of undervalued firms, the cost of
raising additional capital will be lower and
more investment will take place. Several
studies have tested the market undervalu
ation hypothesis. Evidence on it is mixed.

Empirical evidence using stock price
data do not generally support the theory
that target firms are victims of undervalu
ation. Stock prices of targets successful at
fending off hostile bidders decline to ap
proximately pre-bid levels. That is, the
tender offer process does not reveal to the
market significant new information about
the intrinsic value of the target such that
substantial price adjustments (increases)
occur due to prior undervaluations of the
target by the market. It is not merely the
information generated from putting a firm
into play, but the actual acquisition and
expected gains that result in positive
stock returns.27
However, an analysis of market valu
ation of large, multidivisional targets using
business line financial data as well as market
data provide somewhat different results. If
the sum of the liquidation or replacement
value of the firm’s parts is greater than the
market value of the firm as a whole then it is
undervalued by the market. It is argued
that this provides incentive for takeover by
creating opportunities to improve perform
ance and add value by divesting the target of
certain units whose assets are more produc
tively managed elsewhere. This has been the
strategy in the recent takeovers of many
conglomerates formed by previous diversifi
cation acquisitions.
Recent research suggests “ that there is
some undervaluation in the market as a
whole, which can probably be attributed to
underpricing of both multi-industry compa
nies and small companies.” Further, this
undervaluation is proportional to the num
ber of firm divisions and is more prevalent
in certain industries and organizations with
low institutional holdings.28

Conclusion

Although contested tender offers are a
small fraction of all merger and acquisition
activity, the target and bidder costs of fight
ing a hostile battle and the slight chances of
targets remaining independent, as well as
the attendant social costs of the fight, mag
nify the importance of understanding and
dealing with the corporate control market.
A successful and profitable takeover
depends on the extent to which the target
firm is undervalued, the inefficiency
of target management, the cost of over
coming the target’s takeover defenses, the
ability of the acquirer to transfer wealth
from other stakeholders, and the ability of
the bidder to divert some gains from the
target shareholders.
Target shareholders are definite win
ners in the hostile takeover battle. Bidder
shareholders, on average, have equal proba
bilities of gaining or losing and, at best,
obtain modest gains.
However, the source and quantification
of the gains to target shareholders remain
elusive. Research does not provide clear
support for the hypothesis that there are
real efficiency gains from takeovers. Sup
port for the several versions of the wealth
redistribution theory is mixed. Wealth
transfers are most likely to have negative
effects on target management.
What is clear, however, is that net
shareholder gains are not an accurate meas
ure of welfare gains resulting from take
overs. Only with additional research can
the social and economic welfare implications
and policy directives regarding hostile take
overs be more precisely drawn.

F o o tn o te s

'Data on net merger and acquisition announcements are
from M erg ersta t R eview 1978-1987. (Chicago: W. T.
Grimm & Co.) Of the 2,032 net merger and acquisition
announcements in 1987, there were only 972 in which
the dollar value of the deal was disclosed.
2For instance, S. 1323 and S. 1324, 100th Cong. 1st sess.
(1987) (amending Section 14 of the Securities Exchange
Act of 1934, 15 U.S.C.).
“ Securities Regulation, Hostile Corporate Take
overs: Synopses of Thirty-Two Attempts,” United

States General Accounting Office, March 1988, GAO/
GGD-88-48FS, a study of 32 hostile takeover attempts in
1985 provides data indicating that, although financialadvisory-related service fees totaled approximately $60
million, this is only a minor fraction of the total value of
the deals. Nonetheless, that data also indicate that in
successful hostile takeovers, the target spent approxi
mately twice as much as the bidder on such services.
3For a sample of papers dealing with the value maximi
zation hypothesis, see Eugene F. Fama and Michael C.

ECONOMIC PERSPECTIVES

Jensen, “ Organizational Forms and Investment Deci
sions,’’ Jo u rn a l o f F in an cial E conom ics, Vol. 14, No. 1,
(March 1985), pp. 101-119; Eugene F. Fama, E. and
Martin H. Miller, T he T h eo ry o f F inan ce, (Hinsdale,
111.: Dryden Press, 1972), Chapter 2; and Paul Asquith,
Robert F. Bruner, and David W. Mullins, Jr., “ The
Gains to Bidding Firms from Merger.” J o u rn a l o f Fi
n an cial E conom ics, Vol. 11, No. 1-4, (April 1983), pp.
121-139. Andrei Shleifer and Robert W. Vishny, “Value
Maximization and the Acquisition Process,” Jou rn al o f
E conom ic P ersp ectives, Vol. 2, No. 1, (Winter 1988),
pp. 7-20, examine the failure of internal control mecha
nisms as one explanation of hostile takeovers.
‘Randall Morck, Andrei Shleifer, and Robert W.
Vishny, “ Characteristics of Targets of Hostile and
Friendly Takeovers,” in Auerbach, C o rp o ra te T a k e
o v ers, pp. 101-136 study the characteristics of hostile
takeover targets and suggest that hostile takeovers occur
in declining industries and those in a state of change,
where management is slow to adjust to the changing envi
ronment for whatever reasons—e.g., to maintain their
control or to protect employees from pay reductions or
job eliminations.
5Michael C. Jensen, “ Takeovers: Their Causes and
Consequences,” Jo u rn a l o f E conom ic P ersp ectives,
Vol. 2, No. 1, (Winter 1988), pp. 55.; Randall J.
Woolridge, “ Competitive Decline and Corporate Re
structuring: Is a Myopic Stock Market to Blame?,”
J o u rn a l o f A p p lied C o rp o ra te F inan ce, V ol.l, No. 1,
(Spring 1988), pp. 26-36 finds that a myopic market is
not to blame as “ common stock prices react positively to
announcements of corporate strategic investment deci
sions and the market appears to place considerable
emphasis on prospective long-term developments in
valuing securities.” See also Bronwyn H. Hall, “ The
Effect of Takeover Activity on Corporate Research and
Development,” Alan J. Auerbach, ed., C o rp o ra te T a k e
overs: C auses a n d C onsequ en ces, (Chicago: University
of Chicago Press, 1988), pp. 69-100; John J. McConnell
and Chris J. Muscarella, “ Capital Expenditure Deci
sions and Market Value of the Firm,” J o u rn a l o f F inan
cia l E conom ics, Vol. 14, 1985, pp. 523-553; and Jeremy
C. Stein, “ Takeover Threats and Managerial Myopia,”
J o u rn a l o f P o litica l E con om y, Vol. 96, No. 1, (Feb.
1988), pp. 61-80.
6See Michael C. Jensen, “ Agency Costs of Free Cash
Flow, Corporate Finance, and Takeovers,” A m erican
E conom ic R e view , Vol. 76, No. 2, (May 1986, Papers
and Proceedings, 1985), pp. 323-329.
7Richard Roll, “ The Hubris Hypothesis of Corporate
Takeovers.” J o u rn a l o f B usiness, Vol. 59, No. 2, (April
1986), pp. 197-216.
"For a series of articles discussing methods of and effects
of corporate restructuring including Employee Stock
Option Plans and Leveraged Cash-outs, see Jo u rn a l o f
A p p lied C o rp o ra te F inan ce, Vol. 1, No. 1, (Spring
1988). For evidence of stock price reactions to capital
structure changes generally indicating a direct correla
tion between changes in leverage and stock prices, see

FEDERAL RESERVE BANK OF CHICAGO

Michael C. Jensen and C. W. Smith Jr., “ Stockholder,
Manager and Creditor Interests: Applications of Agency
Theory,” in E. Altman and M. Subrahmanyam, eds.,
R ecen t A dvan ces in C o rp o ra te F inan ce, (Homewood:
Richard Irwin, 1985), pp. 93-131.
9Although 30-40 percent of the junk bonds issued since
1985 have been used in acquisition-related financing,
these junk-bond-financed transactions only accounted
for approximately 8 percent of total merger financings in
1986, up from 4.3 percent in 1985. (M ergers a n d A cqu i
sition s, 1987).
10GAO, Securities Regulation.
"Supreme Court of the United States, C T S C orp. v.
D ynam ics C o rp o ra tio n o f A m erica , 107 S Ct 1637(1987).

Appeal from the United States Court of Appeals for the
Seventh Circuit, No. 86-71. Argued March 2, 1987 and
decided April 21, 1987. This decision reverses prior
court trends and raises the possibility that state legisla
tion may have a substantive impact on corporate control
contests. The case upheld one form of takeover statute,
the Indiana control share acquisition provision. For an
invalidation of a state control share statute on constitu
tional grounds, see R T E C o rp o ra tio n v. M ark IV In d u s
tries, Civ. Action No. 88-C-378 (E.D. Wis.) May 6, 1988.
Also see Lynn E. Browne and Eric S. Rosengren,
“ Should States Restrict Takeovers?” N ew E n glan d
E conom ic R eview , Federal Reserve Bank of Boston,
(July/August 1987), pp. 13-21, for a discussion of state
antitakeover laws.
l2Sanford J. Grossman and Oliver D. Hart, “ Takeover
Bids, the Free-Rider Problem, and the Theory of the
Corporation.” B ell J o u rn a l o f E conom ics, Vol. 11, No.
1, (Spring 1980), pp. 42-64 discuss the ability of bidders
to gain from takeover, and Andrei Shleifer and Robert
W. Vishny, “ Greenmail, White Knights, and Sharehold
ers’ Interest,” R a n d Jo u rn a l o f E conom ics, Vol. 17, No.
3, (Autumn 1986), pp. 293-309 discuss the accumulation
of shares prior to full disclosure.
The Williams Act, a 1968 amendment to the Securi
ties and Exchange Act of 1933, Public Law No. 90-439,
82 Stat. 454 (July 29, 1968) as amended in 1970 Public
Law No. 91-567, 84 Stat. 1497 (December 22, 1970)
governs tender offers with disclosure, offer period and
other procedural requirements, as well as antifraud
provisions. It was intended to protect shareholders by
allowing sufficient time and information to properly
analyze a tender offer.
,3For empirical evidence of the effects of defensive
tactics and the market for corporate control see Greg A.
Jarrell, James A. Brickley, and Jeffery M. Netter, “ The
Market for Corporate Control: The Empirical Evidence
Since 1980,” J o u rn a l o f E conom ic P ersp e ctiv e s, Vol. 2,
No. 1, (Winter 1988), pp.49-68; Gregg A. Jarrell and
Annette B. Poulsen, “ Shark Repellents and Stock
Prices, The Effects of Antitakeover Amendments Since
1980.” J o u rn a l o f F inan cial E conom ics, Vol. 19, No. 1,
(Sept. 1987), pp. 127-168; John Pound, “ The Effects of
Antitakeover Amendments on Takeover Activity: Some
Direct Evidence,” The Jo u rn a l o f L aw a n d E conom ics,

(Oct. 1987), pp. 353-367; and Michael Ryngaert, “ The
Effect of Poison Pill Securities on Shareholder Wealth,”
J o u rn a l o f F in an cial E conom ics, Vol. 20, No. 1-2,
(January/March 1988), pp. 127-168.
l4Scott C. Linn and John J. McConnell, “ An Empirical
Investigation of the Impact of ‘Antitakeover’ Amend
ments on Common Stock Prices,” J o u rn a l o f F inancial
E conom ics, Vol. 11, No. 4, (April 1983), pp. 361-399.
l5Harry DeAngelo and Edward M. Rice, “ Antitakeover
Charter Amendments and Stockholder Wealth,” J o u r
n al o f F inan cial E conom ics, Vol. 11, No. 1-4, (April
1983), pp. 329-359 find weak support for the managerial
entrenchment hypothesis.
lflKevin J. Murphy, “ Corporate Performance and
Managerial Remuneration: An Empirical Analysis,”
Jo u rn a l o f A ccou ntin g a n d E conom ics, Vol. 7, No. 1-3,
(April 1985), pp. 11-42 found a positive relationship
between stock performance and managers’ pay; and
James A. Brickley, Sanjai Bhagat, and Ronald C. Lease,
“ The Impact of Long-Range Managerial Compensation
Plans on Shareholder Wealth,” Jo u rn a l o f A ccounting
a n d E conom ics, Vol. 7, No. 1-3, (April 1985), pp. 115130; and llassan Tehranian and James F. Waegelein,
“ Market Reaction to Short Term Executive Compensa
tion Plan Adoption,” Jo u rn a l o f A ccou ntin g a n d E co
nom ics, Vol. 7, No. 1-3, (April 1985), pp. 131-144 find
introductions of incentive-based compensation programs
cause stock price increases. The problem of management
performance not achieving cost minimization and profit
maximization at the expense of shareholders (absentee
owners) was first identified by Adolf A.Berle, Jr. and
Gardiner C. Means, The M odern C o rp o ra tio n a n d
P riva te P ro p e rty , 1932, (New York, New York:
Macmillan, 1932).
' Jarrell and Poulsen, “ Shark Repellents and Stock
Prices.” Today, institutional investors account for
approximately 66 percent to 75 percent of equity owner
ship and trading compared to about 5 percent in the
early 1960s.
l8GAO, Securities Regulation. 1985 data indicate that
insider holdings averaged 21.8 percent for nine targets
of unsuccessful takeover attempts and averaged 4.8
percent and 9.5 percent, respectively, for nine successful
takeovers and seven targets acquired by white-knights.
T. Boone Pickens, Jr., “ Professions of a ShortTermer,” H a rv a rd B usiness R eview , Vol. 64, No. 3,
(May/June 1986), pp. 77 states that takeover targets
from 1981-1984 averaged 22 percent institutional owner
ship compared to a market average of 35 percent.
'^Bernard S. Black and Joseph A. Grundfest, “ Share
holder Gains From Takeovers and Restructurings
Between 1981 and 1986: $162 Billion is a Lot of
Money,” Jo u rn a l o f A p p lie d C o rp o ra te F inan ce, Vol. 1,
No. 1, (Spring 1988), pp. 5-15; Michael C. Jensen and
Richard S. Ruback, “ The Market for Corporate Con
trol,” J o u rn a l o f F inan cial E conom ics, Vol. 11, No. 1-4,
(April 1983), pp. 5-50; Roll, “ The Hubris Hypothesis of
Corporate Takeovers” ; Jarrell, Brickley, and Netter,

“ The Market for Corporate Control: The Empirical
Evidence Since 1980,” J o u rn a l o f E conom ic P ersp ec
tives, (Winter 1988), pp. 49-58; Michael Bradley, Anand
Desai, and E. Han Kim, “ Synergistic Gains from Corpo
rate Acquisitions and Their Diversion between the
Target and Acquiring Firms,” Working Paper, School of
Business Administration, University of Michigan, 1987;
and Asquith, Bruner, and Mullins, Jr., “ The Gains to
Bidding Firms from Merger.”
20Jensen and Ruback, “ The Market for Corporate
Control” provides an extensive review of corporate
control market studies and finds shareholders of acquir
ers do not lose; and Roll, “ The Hubris Hypothesis of
Corporate Takeovers” finds statistically insignificant
results showing that acquirers, on average, do lose on
bid announcements. Jarrell, Brickley, and Netter, “ The
Market for Corporate Control: The Empirical Evidence
Since 1980” updates and confirms the earlier Jensen
and Ruback (1983) study.
2'In contrast to the earlier studies using aggregate data,
Michael Bradley, Anand Desai, and E. Han Kim, “ Syn
ergistic Gains from Corporate Acquisitions and Their
Diversion between the Target and Acquiring Firms”
study the gains and losses of matched pairs of bidders
and targets from 1962-1984 and find a statistically sig
nificant synergistic gain of 7.5 percent created from
tender offer combinations.
For empirical evidence on post-merger (long-run)
negative returns and discussion of the issue, see F.M.
Scherer, “ Corporate Takeovers: The Efficiency Argu
ments,” Jou rn al o f E conom ic P ersp e ctiv e s, Vol. 2, No.
1, (Winter 1988), p. 71; Jensen and Ruback, “ The
Market for Corporate Control,” pg- 20; and Ellen
Magenhein and Dennis C. Mueller, “ On Measuring the
Effect of Mergers on Acquiring Firm Shareholders” in
John C. Coffee, Jr. et.al, eds. K n ig h ts, R a id ers a n d
T a rg ets, (New York: Oxford University Press), 1988.
22Debra K. Dennis and J. McConnell, “ Corporate Merg
ers and Security Returns,” J o u rn a l o f F inan cial E co
nom ics, Vol. 16, No. 2, (June 1986), pp. 143-187; Ken
neth Lehn and Annette B. Poulsen, “ Sources of Value in
Leveraged Buyouts,” in P ublic P olicy T o w a rd s C o rp o
ra te T a k eo vers, (New Brunswick, NJ: Transaction
Publishers), 1987; Paul Asquith and E. Han Kim, “ The
Impact of Merger Bids on the Participating Firms’
Security Holders,” J o u rn a l o f F inance, Vol. 37, No. 5,
(December 1982), pp. 1209-1228; and “ Buyouts
Devastating to Bondholders,” N ew Y ork T im es,
October 26, 1988.
23Alan J. Auerbach and David Reishus, “ Taxes and the
Merger Decision,” in J. Coffee and Louis Lowenstein,
eds., T a k eo vers a n d C ontests f o r C o rp o ra te C on trol,
(Oxford: Oxford University Press, 1987); D. Breen,
“ The Potential for Tax Gains as a Merger Motive,”
Federal Trade Commission, Bureau of Economics, July
1987; and Lehn and Poulsen, “ Sources of Value in
Leveraged Buyouts.”
24Andrei Shleifer and Lawrence Summers, “ Hostile
Takeovers as Breaches of Trust,” in Auerbach, C o rp o

ECONOMIC PERSPECTIVES

ra te T a k eo v ers, pp. 33-68; and Charles Brown and
James L. Medoff, “ The Impact of Firm Acquisitions on
Labor,” in Auerbach, C o rp o ra te T a k eo vers, pp. 9-32.
In Bernard S. Black and Joseph A. Grundfest, “ Share
holder Gains From Takeovers and Bestructurings Be
tween 1981 and 1986: $162 Billion is a lot of Money,” on
pg. 7 the authors noted that “ Yago and Stevenson also
find ‘no evidence that unsolicited deals had systemati
cally different effects than friendly transactions’.”

“ Andrei Shleifer and Lawrence Summers, “ Hostile
Takeovers as Breaches of Trust,” pg. 50.
“ Scherer, “ Corporate Takeovers: The Efficiency Argu
ments,” pp. 75-76; and David J. Ravenscraft and F. M.
Scherer, “ Life After Takeover,” T he Jo u rn a l o f In du s
tria l E conom ics, Vol. 36, No. 2, (December 1987), pp.
147-156.
27Michael Bradley, Anand Desai, and E. Han Kim, “ The
Rationale Behind Interfirm Tender Offers: Information
R e fe re n ce s

Asquith, Paul, “ Merger Bids, Uncertainty,

and Stockholder Returns,” Journal of Fi
nancial Economics, Vol. 11, No. 1-4, (April
1983), pp. 51-83.

Asquith, Paul, Robert F. Bruner, and
David W. Mullins, Jr., “ The Gains to Bid

ding Firms from Merger,” Journal of Fi
nancial Economics, Vol. 11, No. 1-4, (April
1983), pp. 121-139.
Auerbach, Alan J., ed., Corporate Take

overs: Causes and Consequences, Chicago:
University of Chicago Press, 1988.
Black, Bernard S., and Joseph A.
Grundfest, “ Shareholder Gains From Take

overs and Restructurings Between 1981 and
1986: $162 Billion is a Lot of Money,” Jour
nal of Applied Corporate Finance, Vol. 1,
No. 1, (Spring 1988), pp. 5-15.
Browne, Lynn E., and Eric S. Rosengren,

eds., “ Are Hostile Takeovers Different,”
The Merger Boom: Proceedings of a Con
ference held at Melvin Village, New Hamp
shire, October 1987. Federal Reserve Bank
of Boston, Conference Series; No. 31, pp.
199-229.
Browne, Lynn E., and Eric S. Rosengren,

“ Should States Restrict Takeovers?,” New

FEDERAL RESERVE BANK OF CHICAGO

or Synergy?,” J o u rn a l o f F in an cial E conom ics, Vol. 11,
1983, pp. 183-206. Frank H. Easterbrook and Gregg A.
Jarrell, “ Do Targets Gain from Defeating Tender
Offers?,” N ew Y ork U n iversity L a w R eview , 1984, Vol.
54, pp. 277-299 show that stock returns of targets of
defeated hostile bidders fall to approximately pre-bid
levels. Sanjai Bhagat, James Brickley, and Uri Lowenstein, “ The Pricing Effects of Inter-Firm Cash Tender
Offers,” Jou rn al o f F inance, Vol. 42, 1987, pg. 965-986
find that increased valuations of target firms are too
large to be explained solely by adjustments for prior
undervaluations.
“ See Dean LeBaron and Lawrence S. Speidell, “ Why
are the Parts Worth More than the Sum? ‘Chop Shop,’ A
Corporate Valuation Model.” T he M erger B oom , Fed
eral Reserve Bank of Boston, pp. 78-101; and Michael
E. Porter, “ From Competitive Advantage to Corporate
Strategy,” H a rv a rd B usiness R eview , Vol. 65, No. 3,
(May/June 1987), pp.43-59.

England Economic Review, Federal Reserve
Bank of Boston, (July/August 1987),
pp. 13-21.
Brown, Stephen J., and Jerold B. Warner,

“ Using Daily Stock Returns: The Case of
Event Studies,” Journal of Financial
Economics, Vol. 14, No. 1 (March 1985),
pp. 3-31.
DeAngelo, Harry, and Edward M. Rice,

“ Antitakeover Charter Amendments and
Stockholder Wealth,” Journal of Financial
Economics, Vol. 11, No. 1-4, (April 1983),
pp. 329-359.
Eckbo, B. Espen, “ Horizontal Mergers,
Collusion, and Stockholder Wealth,”
Journal of Financial Economics, Vol. 11,
No. 1-4, (April 1983), pp. 241-273.
Jarrell, Gregg A. and Annette B. Poulsen,

“ Shark Repellents and Stock Prices: The
Effects of Antitakeover Amendments Since
1980,” Journal of Financial Economics,
Vol. 19, No. 1, (Sept. 1987), pp. 127-168.

Jarrell, Gregg A., James A. Brickley, and
Jeffry M. Netter, “ The Market for Corpo

rate Control: The Empirical Evidence Since
1980,” Journal of Economic Perspectives,
Vol. 2, No. 1, (Winter 1988), pp. 49-68.

Jensen, Michael C., “ Agency Costs of Free

Cash Flow, Corporate Finance, and Take
overs,” Papers and Proceedings of the
Ninety-Eighth Annual Meeting of the Ameri
can Economic Association, New York, New
York, Dec. 28-30, 1985, The American Eco
nomic Review, Vol. 76, No. 2, (May 1986),
pp. 323-329.

Jensen, Michael C., “ Takeovers: Their

Causes and Consequences,” Journal of Eco
nomic Perspectives, Vol.2, No. 1, (Winter
1988), pp. 21-48.

Jensen, Michael C., and Richard S. Rub-

ack, “ The Market for Corporate Control:
The Scientific Evidence,” journal of Finan
cial Economics, Vol. 11, No. 1-4, (April
1983), PP. 5-50.
Linn, Scott C., and John J. McConnell,

Palepu, Krishna G., “ Predicting Takeover

Targets: A Methodological and Empirical
Analysis,” Journal o f Accounting and Eco
nomics, Vol. 8, No.l, (March 1986),
pp. 3-35.

Pound, John, “ The Effects of Antitakeover
Amendments on Takeover Activity: Some
Direct Evidence,” The Journal of Law and
Economics, Vol. 30, No. 2, (October 1987),
pp. 353-367.
Ravenscraft, David J., and F. M. Scherer,

“ Life After Takeover,” The Journal of
Industrial Economics, Vol. 36, No. 2,
(December 1987), pp. 147-156.

Roll, Richard, “ The Hubris Hypothesis of

Corporate Takeovers,” Journal of Business,
Vol. 59, No. 2, (April 1986), pp. 197-216.

“ An Empirical Investigation of the Impact
of ‘Antitakeover’ Amendments on Common
Stock Prices,” Journal of Financial Eco
nomics, Vol. 11, No. 1-4, (April 1983), pp.
361-399.

Scherer, F.M., “ Corporate Takeovers:
The Efficiency Arguments,” Journal of Eco
nomic Perspectives, Vol. 2, No. 1, (Winter
1988), pp. 69-82.

Malatesta, Paul H., “ The Wealth Effect of

“ Value Maximization and the Acquisition
Process,” Journal of Economic Perspec
tives, Vol. 2, No.l, (Winter 1988), pp. 7-20.

Merger Activity and the Objective Functions
of Merging Firms,” Journal of Financial
Economics, Vol. 11, No. 1-4, (April 1983),
pp. 155-181.
Mandelker, Gershon, “ Risk and Return:

The Case of Merging Firms,” Journal
of Financial Economics, Vol. 1, No. 4,
(December 1974), pp. 303-335.

Shleifer, Andrei, and Robert W. Vishny,

Stein, Jeremy C., “ Takeover Threats and

Managerial Myopia,” Journal of Political
Economy, Vol. 96, No. 1, (Feh. 1988),

pp.

61 - 80 .

Woolridge, Randall J., “ Competitive De

McConnell, John J., and Chris J. Muscarella, “ Corporate Capital Expenditure

cline and Corporate Restructuring: Is a
Myopic Stock Market to Blame?,” Journal
of Applied Corporate Finance, Vol. 1, No.
1, (Spring 1988), pp. 26-36.

ECONOMIC PERSPECTIVES

Decisions and the Market Value of the
Firm,” Journal of Financial Economics,
Vol. 14, No. 3, (Sept. 1985), pp. 399-422.

C o u n te rtra d e —
c o u n te rp ro d u c tiv e ?

Costly, inefficient, and disruptive,
countertrade is still a significant factor in
modern international trade, mainly because
of political and economic policy distortions

J a c k L. H e r v e y

It started, perhaps, with a
couple of Stone Age hunt
ers. An agreement between
the two to share the bounty
of their daily hunt worked
well until the day one bagged a pheasant and
the other, an elephant. On that day the
need for a more efficient mechanism for
exchange became apparent.
Over time, forms of “ money'’'’ were de
veloped to help solve this discontinuity in
the value of exchanged goods. This led to
more efficiently functioning markets in
which these exchange discontinuities were
no longer a major problem.
Nonetheless, in modern times barter
and its numerous derivations, which have
conceptually been gathered together under
the rubric “ countertrade,” have gained
renewed stature in international trade. This
has occurred despite the fact that interna
tional money and credit markets have at
tained unparalleled levels of sophistication.
Where readily acceptable forms of
money exchange and viable credit facilities
are available, markets shun cumbersome
and inefficient barter-type transactions.
But, international liquidity problems and
government restrictions on the operation of
markets have prompted many less developed
countries (LDCs) and nonmarket economies
(NMEs),1as well as industrial countries, to
promote “ creative” trade transactions that
circumvent the normal exchange medium of
modern markets.
FEDERAL RESERVE BANK OF CHICAGO

What is countertrade?
The term countertrade does not tell us
much about what it is, or is not. As the
concept has evolved it has taken on a broad
range of meanings. At present, the term
“ countertrade” includes practices that go
well beyond the simple barter of goods.
Indeed, the literature on countertrade leads
one to suspect that more and more trade
forms are being defined as countertrade. It
has been defined to include transactions that
range from the basic barter of goods to off
setting hard-eurrency cash transactions that
take place over long periods of time.2
In the definition of countertrade, intent
is the key. A goods-for-cash deal with no
strings attached is not classified as counter
trade. A goods-for-goods deal is counter
trade. But, a goods-for-hard-currency deal
is countertrade if the seller agrees to make
an offsetting purchase at some future date.
Strings, however long, make the difference.
Countertrade is tied trade.
Countertrade agreements take several
basic forms:
1. Barter;
2. Compensation or buy-back;
3. Counterpurchase;
4. Offset; and
5. Switch trading, an activity that
often accompanies countertrade as
an adjunct to any of the previous
four forms.
Jack L. Hervey is a Senior Economist at the Federal
Reserve Bank of Chicago.

Barter is the oldest form of exchange
transaction and involves the direct exchange
of goods or services without recourse to
currency. Although currency is not a part
of the transaction, participants in interna
tional barter must establish, nevertheless,
the relative price of the goods or services
exchanged. They must then determine an
implicit exchange rate in order to set the
relative value of quantities to be traded.
Barter, in the strict commodity-forcommodity sense, is not currently a widely
used form of countertrade. This attests to
the widespread understanding by trade par
ticipants of the basic economic inefficiencies
associated with countertrade, especially
when taken to the barter extreme.
Nonetheless, even the United States gov
ernment has formally embraced barter, par
ticularly to assist in the disposal of surplus
agricultural products. In the Agricultural
Act of 1949, again in the Agricultural Trade
Development and Assistance Act of 1954
(also known as Public Law 480 or the Food
for Peace program), and most recently in
the Food Security Act of 1985, legislation
specifically sanctioned barter trade.
PL 480 set the procedure for the U.S.
Department of Agriculture, through its
Commodity Credit Corporation (CCC) to
dispose of surplus U.S. agricultural prod
ucts, especially wheat, cotton, and dairy
products. During the 1950s and 1960s the
act facilitated exchange of these surplus
domestic food staples for storable foreign
nonfood products, especially goods that
could be added to the U.S. strategic stock
pile.3 Title I of the act provided for the sale
of commodities for local (nonconvertible or
“ soft'”) currencies, which were required to
be used to purchase goods or services in the
local economy. Such transactions might be
considered to be on the fringe of barter.
Title III provided for the strict goods-forgoods barter.
During the period 1950 to 1973, when
the barter program was suspended after
CCC-held surpluses ran out, $6.6 billion in
surplus agricultural products were bartered
for materials added to the government’s
strategic stockpile, goods and services
for overseas military operations, and
AID projects.4

When the agricultural surplus once
again became burdensome in the 1980s,
political interest in barter arrangements
once again arose. During the early 1980s,
for example, several barter arrangements
were carried out between the CCC and the
government of Jamaica—the U.S. govern
ment traded dairy products, wheat, and rice
for bauxite.5
Outside the United States, proposals for
and completed barter arrangements appear
to he common. In particular, Middle East
oil-exporting countries engage in the barter
of crude oil for goods and services. A typi
cal example is a recent contract for the con
struction of an oil pipeline in Iraq by the
South Korean firm Hyundai Engineering.
According to reports, about 90 percent of
the more than $200 million pipeline cost
is to be paid for in oil with the remainder
in cash.6
Buy-back agreements became common
during the 1960s with the advent of major
economic development projects in the NMEs
and the LDCs. Large industrial projects
built by Western firms occasionally have
been “ financed” in this manner. The pur
chasing NME or LDC country buys the
plant. In turn, the plant is paid for by sell
ing to the Western firm (i.e., the exporting
company buys back) some portion of the
output of the plant over an extended period.
Several Eastern European industrial de
velopment projects have been financed in
this manner. One of the best known proj
ects of this type was the USSR’s purchase of
fertilizer plants and technology during the
early 1970s from Occidental Petroleum.
The plant and equipment were paid for by
the subsequent importation by Occidental of
nitrogen fertilizers produced at the facili
ties. In another case, General Electric sold
machines for the production of medical
equipment and the license to produce such
equipment to Poland. Payment was in the
form of electrocardiogram meters.'
Counterpurchase agreements, as the
name implies, involve standard hard-cur
rency transactions between the seller and
buyer. The tie in the transaction is that, in
order to make the sale, the seller (usually
an industrial-country firm) agrees to a
“■ return” purchase, that is, to counter

ECONOMIC PERSPECTIVES

purchase with hard currency a minimum
quantity of specified goods or services from
the buying country (a developing or nonmarket country) within a specified period.
Failure by the seller to meet its coun
terpurchase requirement often results in
substantial penalties.
A typical, hut hypothetical, example of
such a transaction might have a U.S. con
struction equipment company selling $10
million in road construction machinery to
the Indonesian government (a country that
in fact actively engages in countertrade).
This hypothetical contract calls for the U.S.
company to be paid in U.S. dollars. The
contract also calls for the U.S. company to
buy from Indonesia a minimum of $8 million
in Indonesian-sourced goods within a period
of five years. This contract would constitute
an 80 percent counterpurchase agreement,
(the agreement could call for a $12 million,
or 120 percent, counterpurchase). The
counterpurchase agreement would most
likely exclude petroleum—a product that
Indonesia has no difficulty selling for dollars
on world markets—from the permitted
counterpurchase items. If the U.S. com
pany fails to meet the $8 million coun
terpurchase, the contract might specify a
penalty of the difference between the con
tracted amount and actual purchases,
plus some percentage of the contracted
counterpurchase.
The catch to this type of agreement is
that the “ specified goods” to be counterpurchased, especially nontraditional
goods from an LDC or NME country, may
be of the type for which a ready market has
not been established. Counterpurchase
agreements are increasingly appearing in
combination with offset agreements.
Offset agreements are an increasingly
common form of countertrade. Offsets are
unique in that they are more likely to in
volve (but are not restricted to) transactions
between industrial countries—often a firm
in one country and the government of an
other country. As a condition for a firm to
sell its product in the second country, the
government of the second (buying) country
requires that some portion of the final out
put be produced in that country, or the
buying government may request that the

FEDERAL RESERVE BANK OF CHICAGO

seller firm assist in marketing or in finding a
market for other goods made in the buying
country.
Sales of commercial aircraft or military
equipment, where portions of the product
are made in the purchasing country, are
among the most common forms of this type
of countertrade. For example, in 1987 the
U.S. aircraft manufacturer Boeing con
cluded a sale of AW ACS (airborne early
warning systems) aircraft with the French
government with the offset, in part, being
that the aircraft would be outfitted with
French-built Snecma engines.8 Other ex
amples include the U.S. sale of F-15 fighter
aircraft to Japan with the offset that the
airframe and other components are built in
Japan. Commercial U.S. jet aircraft are
often purchased by airlines in the U.K., but
with the stipulation that they be outfitted
with British Rolls-Royce engines.
Switch trading is not a specific form of
countertrade in the same sense as the above
categories. However, it is often a part of
these transactions in that switch trading
identifies a second or subsequent stage in a
countertrade transaction.
For example, consider a hypothetical
case where a U.S. exporter enters into a
countertrade, let’s say barter, agreement
and accepts $5 million in indigenous art
objects in exchange for $5 million in exports
of natural-gas-powered electrical genera
tors. The U.S. firm is unable to use the
goods directly (its halls are already covered
with pictures from a previous transaction)
and lacks the marketing expertise or retail
outlets to market the goods directly.
Rather, the firm simply wishes to get rid of
the goods as quickly as possible and “ get its
money out.” This is done by enlisting the
aid of a switch trader.
The switch trader buys the art at a dis
count for $4.75 million (the U.S. exporter
knew the goods would be sold at discount so
it attempted to build some or all of the dis
count into the price of its exported goods).
Now, the switch trader accepts the obliga
tion of finding a home for the goods.
In some cases the switch trader may
have to go through several additional
countertrade transactions before all
countertrade obligations are settled and a

final hard-currency transaction is com
pleted. The art objects may be traded for
canned hams and the eanned hams for steel
bars and the steel bars for dollars. Each of
these steps cuts the margin the switch trader
receives, so its final profit depends impor
tantly on its negotiating skill in the trades
and on its knowledge of the market for the
goods it is trading.
The allure of countertrade
The primary reasons for countertrade
fall into three areas:
1. Countertrade provides a trade
financing alternative to those countries
that have international debt and liquid
ity problems.
2. Countertrade relationships may pro
vide LDCs and NMEs with access to new
markets. Countertrade may also pro
vide a positive competitive element for
those exporting companies willing to
engage in it.
3. From a trade perspective, counter
trade fits well conceptually with the re
surgence of bilateral trade agreements
between governments.
Debt and hard currency issues. Cen
tral to the expanded use of countertrade in
recent years is the shortage of hard-cur
rency reserves available to the LDCs and
NMEs. Countries in this situation find it
difficult to service their foreign debt obliga
tions. Thus, they often face difficulty in
attracting foreign capital in the form of
international credits to finance imports and
foreign investment to finance domestic de
velopment projects. This development
hearkens back to the reason countertrade
(barter) occurred in the first place—the
lack of (or breakdown in) a system of
monetary exchange.
Such debt problems have prompted
some governments to impose austerity meas
ures on their domestic economies and re
strictions on the use of scarce foreign ex
change to acquire certain types of imports.
Sometimes, external authorities such as the
International Monetary Fund, the World
Bank, and foreign commercial hank lenders
insist on such measures as a condition for
the extension of additional international
credits. Countertrade transactions, which

can avoid hard-currency exchange, may be
utilized to circumvent such restrictions.
When a country’s economy (like those of
Eastern Europe) is not “ plugged into” the
exchange system of the rest of the world, its
ability to purchase goods or services from
the rest of the world is strictly limited, in the
short- as well as long-term, by its ability to
generate convertible currencies through
conventional export sales to convertible
currency countries. For the NMEs this has
typically meant a shortage of convertible
currency. They have responded by request
ing countertrade provisions in many of the
trade transactions entered into with West
ern companies. The argument supporting
these transactions is that countertrade has
facilitated an increase in world trade.
The rebuttal to this argument is that, if
the world market really wanted the NME
product or service that was the key to the
transaction, that product or service, if com
petitive, could have been sold in the world
market for convertible currency without the
disruptive strings of countertrade. Further
more, by avoiding the costly machinations of
countertrade the NME would have received
a higher price for its export, paid a lower
price for its import from the Western ex
porter, or some combination of the two. In
the longer-term, if not in the short-term, the
NME would be better off had it utilized con
ventional markets instead of countertrade.
A potentially more serious issue arises
with respect to the relationship of counter
trade to the debt-ridden LDCs (in some
cases this also applies to the NMEs). At the
first stage, the issue of the use of counter
trade by these countries is the same as out
lined above for the NMEs. But the second
stage is more critical. If the debt burden
for one of these countries becomes so great
that it is forced to default on its interna
tional borrowing obligations, its capital
inflow from international markets would
likely dry up.
The question then arises: Without this
capital (i.e., credit) inflow, would not im
ports of food and manufactured goods on
which these countries depend cease? Not
necessarily. Initial disruptions in trade
would occur, of course. But, “ collateral
ized countertrade” trade would take over

ECONOMIC PERSPECTIVES

(the term seems redundant, yet it empha
sizes the tie of goods-to-goods). Interna
tional trade would continue. It would be
more costly in terms of the real resources
that would have to be committed by the
LDC. Consequently, the volume of trade
would decline from what it otherwise would
be. But, other things remaining equal (a
major concern likely would be political sta
bility), the LDC’s economy would continue
to engage in international trade.
Importantly, the structure of the rela
tionship between the defaulting country’s
domestic and international economy would
he substantially altered, after default. It
can be argued that because the LDC’s im
ports would be tied closely to its transfer of
real resources abroad in the form of ex
ports, there woidd be a strong incentive on
the part of the LDC’s government to arrange
the composition of imports so that they
would be tied closely to the support of do
mestic economic development. In this con
text, a countertrade framework, in place as
a contingency for reducing the external
disruption to the international trading sys
tem from a major default on international
debt by the LDCs, may have merit. Even so
it is a costly and inefficient contingency.
New markets and competitive issues.

The LDCs and NMEs may also choose to
promote countertrade transactions as a
means to break into new markets with, for
them, nontraditional exports. In the proc
ess they attempt to take advantage of the
more sophisticated marketing knowledge or
the greater name acceptance of the counter
trade partner.
Such a transaction may develop as fol
lows: An LDC enters into a counterpur
chase agreement to purchase irrigation
equipment from a multinational company.
The multinational agrees to counterpur
chase a specified value of goods from the
LDC within three years. However, the
goods available for counterpurchase are
limited to manufactured goods of a type that
the LDC has not traditionally exported but
for which it is attempting to build an inter
national market, for example, automotive
parts or consumer electronics. Additionally,
the LDC only proposes goods for which the
multinational company has world-wide mar

FEDERAL RESERVE BANK OF CHICAGO

kets and marketing knowledge. The multi
national’s use or marketing of the LDC’s
nontraditional exports will ease the prod
uct’s entry into the world market and may
add credibility to the LDC’s bid to become
an exporter of a nontraditional product.
Export firms in industrial countries
provide another reason for the increased at
tractiveness of countertrade. As the various
forms of countertrade gain greater accep
tance in the marketplace, export firms may
use their own willingness to accept counter
trade proposals as a key competitive element
in transactions. The more successful the
export firm is in engaging in and carrying
out countertrade transactions, whether
through internal expertise or external con
tacts, the better its position against firms not
so endowed when it competes for transac
tions in which countertrade is a required or
desirable condition imposed by the
importing country.
The resurgence of bilateralism. The
world trade environment has changed dra
matically in the post-World-War II period.
According to GATT (General Agreement on
Tariffs and Trade) estimates, the real vol
ume of trade, as measured by exports, in
creased nearly ten-fold from 1950 to 1987.9
During the post-war period, trading nations
of the noncommunist bloc completed seven
“ rounds” of multilateral trade negotiations
that were directed toward reducing the
number of restrictions on and distortions to
international trade.
From the standpoint of multilateral
trade, the freeing of international trade in
terms of reduced tariff and nontariff barri
ers has taken great strides during the last
three decades. Furthermore, the interna
tional community is continuing its efforts
towards freeing world commerce from the
costly distortions that still stifle the effi
ciency of international trade transactions.
To that end the members of the GATT are
currently engaged in the eighth round of
multilateral trade negotiations.
Ironically, as the most obvious of the
world trade distortions have dissipated over
time, other restrictions and distortions that
had gone unnoticed—indeed, may have been
ineffective when the more onerous restric

tions were in place—have taken on new im
portance. Some may not be easily dealt with
in a multilateral environment.
The response to this difficult environ
ment has been a resurgence of (regression
toward) the bilateral and reciprocal trade
agreements common to the late 1930s when
governments were attempting to dry them
selves out after a binge of protectionism
earlier in the decade. In short, the negotia
tion of conditional trade relationships be
tween two governments has once again be
come an important element of trade policy.
While bilateral arrangements may be more
desirable than the continued trade restric
tions they displace, they are only partial
solutions to the problem.
Unfortunately, bilateral agreements be
tween governments often take on the charac
teristics of countertrade. Examples include
“ voluntary marketing agreements” in which
one party agrees to restrict the volume of its
exports in exchange for the other party’s
agreement to guarantee a certain level of
access to its market. Such marketing
agreements—in effect they are quotas—are
as trade restrictive and distortive of trade
patterns as surely as legislated quotas are.
The only ingredient lacking in such volun
tary agreements, in terms of the similarity to
countertrade, is the transfer of goods or
services.
Thus, it can be argued that, while the
official position of industrial-country gov
ernments in general is to discourage
countertrade, the example they set is less
than consistent. Indeed, many industrialcountry governments directly encourage
countertrade offset agreements, especially
for military equipment.
The shortcomings of countertrade
1. Countertrade has a high inherent
transaction cost.
2. Countertrade limits competitive
markets.
3. Countertrade contributes to market
distortions that lead to inappropriate
economic planning.
Inefficiency in transaction costs. The
underlying weakness of countertrade as a
mechanism of trade and exchange is its inef
ficiency. The indivisibility of goods made

barter inefficient, for example, and forced
those involved with such trade to search for
a better way. Barter gave way to goods/
services-for-money exchange, which permit
ted transactions to incorporate divisibility
as well as time-shifting. The opportunity for
more convenient (i.e., efficient), multiparty
trade, became a reality.
A major factor in the expansion of
world trade during the last half of the 20th
century has been the emergence of a few
widely accepted currencies, especially the
U.S. dollar, as settlement currencies for
international transactions. The develop
ment of international credit markets to sup
port trade depended upon the fact that
transactions could be entered into without
undue concern by the parties involved as to
the delivery of the specific quantity and
quality of goods and the timeliness of pay
ment. A key characteristic of this type of
market is that the channels of communica
tion and exchange are well defined and rela
tively simple.
As a consequence of this clarity and sim
plicity, such markets are efficient. Specifi
cally, the direct and indirect costs involved
in the process of exchange account for a
relatively small portion of the total cost of
the transaction.
Such efficiency is not present in the con
ditional transactions that make up counter
trade. The inefficiency cost must be borne
hy one or more of the parties involved.
Many countertrade transactions are en
tered into because the importing country is
unable to obtain financing in the interna
tional markets and is short of hard-currency
reserves. The lack of access, or limited
access, to the credit markets may be due to
restrictions on the country, placed as a con
dition for specific new lending by the Inter
national Monetary Fund (IMF) or foreign
commercial banks. In this environment
countertrade is sometimes viewed by an
LDC government as a means of engaging in
trade without the cost of entering the inter
national finance markets.
While it is correct that countertrade
may mean that the international financial
markets may not have to he tapped, it is not
correct to assume that there are no financ
ing costs associated with a countertrade

ECONOMIC PERSPECTIVES

transaction. In fact, due to the complexity
associated with carrying out a countertrade
transaction, the cost is higher than if the
LDC had had access to those credit markets.
Moreover, countertrade may end up sub
verting the capital and austerity restrictions
that in some cases are a part of an IMF/LDC
lending agreement.
In countertrade the costs of financing
are shifted. They become implicit rather
than explicit. The seller may absorb this
cost in the form of accepting the obligation
to buy and use or resell goods it otherwise
would not accept (thus reducing its return
on the transaction). Alternatively, the seller
may build the transaction’s finance costs
into the price the buyer must pay. The
finance costs are there, though hidden.
Limiting competition. There is another
implicit cost when countertrade is required
by the LDC or NME buyer as a condition of
the transaction. Countertrade limits the
potential number of sellers in the market.
Not every seller firm is willing or able to
engage in countertrade, thus, a LDC or
NME buyer that insists on countertrade as
part of a trade package limits its potential
for obtaining a competitive product, service,
or price. The fact is, engaging in counter
trade costs the LDC or NME economy more
in terms of real resources than a straight
commercial transaction.
Market distortions and false signals.
Developing countries may not have well
developed international marketing facilities.
As a result they often find it difficult to
break into international markets with goods
and services that are nontraditional for
their economy.
In other cases an LDC or NME may
choose to develop a new domestic industry
by buying the technology and plant from
abroad. Domestic demand may not be ade
quate for an efficient plant size. In re
sponse, they may opt for a larger, more
efficient (but possibly from a world supply
view, redundant), plant with the expectation
of placing the marginal production on the
international market.
Under such conditions counterpurchase
or buy-back agreements may be sought by
the LDC or NME to finance the importation
of plant and equipment for a new industry

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(as in a buy-back agreement) or general
imports (as in a counterpurchase agree
ment). The LDC or NME also may be seek
ing a more knowledgeable partner to handle
the international marketing of goods for
which it does not have the expertise.
The difficulty with this approach is that
countertrade may be used to get goods onto
the international market that would not
“ make it” under usual conditions and will
not be competitive once the buy-back agree
ment expires. Further, the industrial coun
try firm that accepted the countertraded
goods may dump them, which would be dis
ruptive to international markets. The result
may be that the LDC or NME producer may
falsely interpret the signals and overestimate
the real market demand for the dumped
goods as being stronger than a longer-term,
unsubsidized, market can bear.
Moreover, the secondary consequences
of countertrade transactions are not benign.
The inefficiencies of countertrade—the false
price signals that result in the building of
redundant plant and equipment—tend to
promote the establishment of bureaucraeies
within governments and private firms that
have “ bought into” countertrade. In turn,
these bureaucracies have a vested interest in
maintaining the economic distortions that
undergird the growth in countertrade.
Summing up
Countertrade is a significant factor in
modern international trade. In its different
forms it is used as a marketing tool, as a
competitive tool, as a tool to restrict trade
alternatives, and as a tool to tie the trade of
one country to another country. Counter
trade in a modern world economy with
highly developed goods, capital, and finan
cial markets appears on its face to be an
incongruous development. Countertrade is
a costly, inefficient, and disruptive anom
aly. Yet observers of international trade
suggest that the volume of countertrade
is growing.
Countertrade takes place in a world of
imperfection where government and indus
trial political and economic policies distort
the relationships between and within the
goods, capital, and financial markets. Rec
ognizing the imperfections and the limita
tions these policies impose on trade, some
23

buyers and sellers conclude that the
countertrade framework offers a viable, and
even apparently necessary, alternative form
of transaction. However, the thought oc
curs: The recent growth in countertrade
may well be a reflection of, as well as a con

tribution to, the emerging nontariff distor
tions in the world economy. If the trade and
financial distortions currently imposed on
the world economy were to be substantially
reduced, would not countertrade go the way
of the Stone Age hunter?

Fo o tn o te s

'The term “ nonmarket economies” (NMEs) refers to
those countries where state central planning performs
the function of price and output determination. It refers
specifically to the communist bloc countries of Eastern
Europe and South East Asia.

‘Hearings on Countertrade and Offsets in International
Trade, U.S. Congress, House Subcommittee on Interna
tional Economic Policy and Trade, Committee on For
eign Affairs, 100th Cong., 1st Sess., June 24 and July
10. 1987, p. 120.

Taken to an extreme, a recent article in C o u n tertra d e
& B a rte r referred to negotiations between Canada and

Mbid., pp. 138-139.

the United States concerning the free trade agreement as
follows: “ The Canada-US pact, while proving that the
high art of horsetrading is very much alive, shows,
moreover, that ‘free trade’ is really nothing more than
countertrade elevated to the broadest bilateral ground
and injected with a heady dose of political will.” “ Ulti
mate Countertrade,” viewpoint in C o u n tertra d e &
B a rte r , No. 16, October/November 1987, p. 7.
‘Lawrence W. Witt, “ Development through Food Grants
and Concessional Sales,” in A gricu ltu re in E conom ic
D evelo p m en t, edited by Carl K. Eicher and Lawrence
W. Witt (New York: McGraw Hill), 1964, pp. 339-359.

6"Deals,” C o u n tertra d e & B a rte r, No. 16, October/
November 1987, p. 51.
7Ronald J. DeMarines, A n alysis o f R ecent T ren ds in
ll.S . C o u n tertra d e, U.S. International Trade Commis
sion, USITC Publication 1237, March 1982, pp. 48-49.
""AW ACS-ING Poetic,” C o u n tertra d e & B a rte r, No.
13, April/May 1987, p. 9.
“From In tern a tio n a l T ra d e , (Annual) General Agree
ment on Tariffs and Trade, various issues.

R e fe re n ce s

American Banker, “ Countertrade: An old
concept with new impact,” a special section
devoted to countertrade, (September 21,
1984), pp. 13-44.

Agriculture in Economic Development, New
York: McGraw Hill, 1964.

Countertrade and Barter Quarterly, se
lected issues.

International Trade 1987/88, advance re
lease of sections 1 and 2, Geneva: 1988, and
previous annual issues.

DeMarines, Ronald J., Analysis of Recent

Trends in U.S. Countertrade, U.S. Interna
tional Trade Commission, USITC Publica
tion 1237, Washington, DC: March 1982.
de Miramon, Jacques, “ Countertrade: A

Modernized Barter System,” Organization
for Economic Cooperation and Develop
ment, The OECD Observer, No. 114, (Janu
ary 1982), pp. 12-15.

Eicher, Carl K., and Lawrence W. Witt,

General Agreement on Tariffs and Trade,

Group of Thirty, Countertrade in the

World Economy, New York: 1985.

Organization for Economic Cooperation
and Development, East-West Trade: Re

cent Developments in Countertrade, Paris:
1981.
U.S. Congress, House of Representatives,

_____ , “ Countertrade: An Illusory Solu
tion,” Organization for Economic Coopera
tion and Development, The OECD Ob
server, No. 134, (May 1985), pp. 24-29.

Countertrade and Offsets in International
Trade, Hearings before the Subcommittee
on International Economic Policy and
Trade, Committee on Foreign Affairs, 100th
Congress, 1st session, June 24 and July 10,
1987, Washington, DC: 1988.

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