Using Corporate Governance to Shield Executives

Anti-takeover measures can lead to reckless acquisitions and loss of shareholder wealth

OE_profileMergers and acquisitions are, of course, a major element of corporate strategy. In the role of the acquirer, companies move aggressively to capitalize on perceived opportunities to enhance competitive positioning and stock market value. In the role of the pursued, companies may foresee other, less appealing outcomes. It has become commonplace for potential takeover targets to adopt certain corporate governance provisions as protection against unsolicited acquisitions. These anti-takeover provisions (ATPs) range from insuring corporate officers and directors against job-related liability to providing post-termination compensation and limiting shareholders’ rights in board elections and in amending corporate charters and bylaws.

PHOTO: Ronald W. Masulis, Frank K. Houston Professor of Management

But while ATPs might be good news for corporate executives, the news isn’t so rosy for investors. A wide body of existing research shows that in adopting ATPs, companies may actually end up reducing incentives for management to seek optimal performance, including the ability to find and consummate acquisitions that enhance shareholder value.

Ron Masulis, Frank K. Houston Professor of Management at the Vanderbilt Owen Graduate School of Management, set out to define more specifically how ATPs can impact investors. In the most comprehensive investigation of this issue to date, he finds that firms with fewer ATPs pursue more profitable acquisitions. Moreover, acquisition announcements by firms with more ATPs tend to generate lower returns and more frequent negative returns for shareholders than those with fewer ATPs.

Masulis observes, “Managers at firms with more anti-takeover provisions are more insulated from the discipline imposed by the market for corporate control and thus are more likely to display self-serving behavior such as empire building.”

More ATPs, Lower Returns

In collaboration with Cong Wang of the Owen School and Fei Xie of George Mason University and Owen School, Masulis analyzed a sample of 3,333 acquisitions by 1,268 firms between 1990 and 2003 from the U.S. Mergers and Acquisitions database of Securities Data Corporation (SDC). Linking the data to a set of 24 key anti-takeover provisions of bidders, Masulis sought to determine whether these provisions encouraged less profitable acquisitions and to assess their impact on shareholder value. The 24 provisions included five major types of takeover defenses, including tactics to delay and deter hostile bids, to weaken shareholder voting rights, and to enhanced director/officer protection, among others.

The study —which appeared in a recent edition of the Journal of Finance —also involved more detailed analysis of the impact of six major ATPs which are believed to be the most significant from a legal standpoint. These included staggered boards, where only a third of directors are up for election each year; poison pills that allow existing shareholders to acquire large amounts of stock at a substantial discount when a hostile bidder acquires a large block of shares; and golden parachutes, or extraordinary severance packages for executives terminated or demoted after a change of control.

The presence of a staggered board turns out to the most significant indicator of managers inclined to undertake value-losing acquisitions. Further, a staggered board reduces the stock price reaction to an acquisition announcement by as much as 0.9 percent, representing a significant decrease in a firm’s equity value. Other ATPs such as poison pills and limits to bylaw and charter amendments also had notably deleterious impacts on share price at acquisition announcements.

Masulis also examines the effects of other corporate governance mechanisms and finds firms that separate the positions of CEO and Chairman of the Board tend to make better acquisitions, lending support to recent calls for elimination of dual CEO/Chairman positions. In addition, Masulis reports that firms operating in more competitive industries fare better because “market competition acts as an important external corporate governance device that discourages management from wasting corporate resources.”

New perspective in the debate over corporate governance reform

Masulis believes that his research contributes valuable new evidence to the discussion of corporate governance reform in the U.S., especially with respect to the ongoing debate about the future of Sarbanes-Oxley. First and foremost, future regulation should consider giving shareholders more power to evaluate a company’s takeover defenses and assess the likelihood of value-destroying acquisitions. “Disclosure of the takeover protections that are in place should be stated in the company’s proxy, so investors don’t have to go to great lengths to obtain this information,” he said.

In addition, he can envision the possibility of reforms that make the elimination of certain ATPs easier for shareholders to initiate. Principal among these, he said, is the removal of a staggered board, which requires a hostile bidder to win proxy fights at two successive annual shareholder meetings in order to exercise control over a target firm. Currently, the board itself —not shareholders —must initiate the elimination of a staggered board, an unlikely situation at best. In the meantime, shareholders can try to pressure directors to exercise their powers for shareholders benefit or risk having shareholder activists individually target them to be voted out of office when their terms eventually come up for renewal.

Above all, said Masulis, the study should prompt regulators and shareholders alike to reconsider the concept of what comprises “good” corporate governance. When it comes to ATPs, the likelihood of less profitable acquisitions and loss of shareholder wealth is “a compelling argument for re-evaluating costs and benefits of these frequently used governance mechanisms,” he said.

Reported by Scott Addison

Published 6/25/08 in OWENintelligence