Corporate Governance: Market for Corporate Control and Governance Indices
Market for Corporate Control
An effective market mechanism to discipline underperforming management.
Hostile takeover: Acquisition of a company against the wishes of the target company’s management.
Friendly takeover: Takeover bid made with the approval of both acquirer and target company management and board of directors.
Examples:
Elon Musk acquired Twitter in 2022.
Facebook acquired WhatsApp for $19 billion in 2014.
Examples of hostile takeovers:
Oracle’s acquisition of PeopleSoft for $10.3 billion in 2004.
Sanofi-Aventis’ acquisition of Genzyme Corp for $20.1 billion in 2011.
InBev acquired Anheuser-Busch for $52 billion in 2008, creating ABInBev.
Hostile Takeovers as a Discipline Mechanism
Occur to replace managers not maximizing shareholder wealth.
The threat of hostile takeovers disciplines managers to maximize shareholder value.
Factors affecting the likelihood of hostile takeover:
Firm performance:
Old firms with slow growth and poor financial performance are more likely targets (Shleifer & Vishny, 1988).
Ownership by management and board (Shivdasani, 1993):
Higher management ownership lowers agency costs, making takeovers less likely.
Higher management ownership makes takeovers more costly.
Ownership by blockholders (Shivdasani, 1993):
Higher ownership by affiliated blockholders makes takeovers less likely.
High ownership by unaffiliated blockholders makes takeovers more likely.
Costs of Hostile Takeovers
Hostile bidder may reap all the benefit of taking over an under performing company.
Hostile takeover can be very costly for the bidder too (Hart 1995):
Identification and bidding costs
Competition from white knight
Competition from incumbent management
White knight: a friendly company that a target firm seeks out to avoid a hostile takeover, offering a more favorable acquisition deal compared to the hostile bidder.
White Knight defense
Schering AG (German pharmaceutical company) targeted for hostile takeover by Merck KGaA (German pharmaceutical company).
In 2006, Merck launched a hostile takeover bid of bn for Schering.
Schering sought a white knight and was acquired by Bayer AG (German pharmaceutical and biomedical company) for billion in a friendly merger.
Takeover Defense Mechanism (US)
More statutory defense mechanisms embedded in corporate charters in the US.
Incumbent management’s tools include:
Poison pills: Issuing extra shares at a discount to existing shareholders.
Greenmail: Repurchasing company shares at a premium.
Require supermajority for merger
Golden parachute
Staggered board (classified board)
Supermajority requirement for charter amendments
Takeover Defense Mechanism (UK)
Differences in the 1980s between the UK market for corporate control and the US (Sinha, 2004):
UK’s equity market counts more in national GDP.
More dispersed ownership.
More hostile takeovers.
Companies tend to use financial defense against hostile takeovers.
Pay dividend
Update financial forecast
Disposal or revaluation of assets
Invite a white knight
The Dutch Poison Pill
Continuity foundations, Stichting Continuïteit (STICO), and administrative foundations, or Stichting Administratiekantoor (STAK).
With Call option rights in case of takeover bid to have 50% of control of the company
Typically, such foundations are valid for a year and need shareholder vote to continue.
Carlos Slim acquired 30% of KPN shares in early August 2013.
August 14, 2013, Mr. Slim offered 100bn to take control of OpenAI
Other anti-takeover mechanisms
Golden shares held by government
Shares with super voting rights concentrated in the hands of managers or founding families.
Merger and Acquisitions (M&A)
Economic rationales of the bidder:
To exploit synergy effect, economies of scale
To create/enforce market power
Vertical or horizontal M&A
Antitrust regulations makes it harder to achieve
To discipline and replace incompetent management
Through hostile takeovers
Mainly happened in 1980’s (14% of all M&A)
Creative Destruction (Sinha 2004)
Driven by technological advancements, deregulation in the markets
To diversify portfolio
More than half ended in failure
Only 17% created more value
To acquire expertise and/or brand name
Often used by Chinese companies when expanding abroad
To save tax
Tax saving motivated acquisitions on the rise
Col, B., & Errunza, V. (2022). Havenly acquisitions. Journal of International Financial Markets, Institutions and Money, 77, 101504.
Incentives of the managers
CEO of the target company
Reluctant to accept
Either for his own job security considerations
Or in the interest of the company
Potential measures:
Poison pills
Greenmail
Golden parachute
Find white knight
Financial measures: Announce dividend, update forecast, asset disposal or revaluation
What could shareholders do?
Proxy contests
When a group of shareholders are persuaded to join forces and gather enough shareholder proxies to battle the incumbent management
Very costly and no guaranteed success
Mainly used in the context of merger and acquisitions
Shareholder proposals
A more modest form of proxy protest
Fairly cheap but usually not binding
Can be effective if the board accommodates the proposals
HP-Compaq merger and the proxy contest (2001-2002)
Carly Fiorina (Former HP CEO) Proposed the $$24bn merger with Compaq
Walter Hewlett (Member of the founding family and the board of HP) Started a proxy contest to stop the merger.
Beneficiaries of M&A
On average premium that acquirers pay for target ranges from 20-30% or higher.
Share price of target companies mostly immediately increase at announcement
Sometimes the acquirer’s share price also increase after announcement
But the empirical evidence about value gain from M&A is mixed.
It benefits the target shareholders the most
Challenges of M&A
Legal challenges
Competition law may prevent the deals
Local legislation may pose extra challenges
It takes years to complete a deal, if at all!
Cultural differences
It takes much longer time to successfully merge two cultures
Example: ABN and AMRO (De Prooi, The Prey)
Other challenges
Social costs: lay-off labors (may also be a blessing), strategic reallocation
Active players in M&A deals
Major bidders
Corporations
Private Equity
Service providers
Investment bankers
Legal advisors, notaries
Market intelligence services
Auditors (due-diligence)
Corporate Governance Indices
Corporate Governance Indices—why?
Does quality of corporate governance affect the financial performance of firms?
If so, having an indicator about the corporate governance quality would help predict firm performance.
Institutional investors need some guidance on the corporate governance quality of firms for:
Screening: which companies to invest?
Monitoring: how are the investees doing financially and in corporate governance?
Proxy guidance: how to vote at annual general meetings?
Corporate Governance Indices—How?
Corporations are republics.
Democratic firms: shareholders have more rights
Dictatorship firms: managers have more rights
Corporate Governance Indices—G-index
Gompers, Ishii & Metrick (2003) created G-index (G for governance)
Research Question: how does corporate governance index affect firm’s financial returns, operation performance and firm value.
Data:
Corporate governance provisions: Investor Responsibility Research Center (IRRC) publishes firm and state corporate governance provisions for 1500 US firms in 1990, 1993, 1995, 1998
Financial data: CRSP, Compustat
Methodology: 24 governance provisions, equal weight, 1 score for each provision. 5 categories
Delay (takeover)
Protection (of manager job security)
Voting (rights of shareholders)
State (law that impede takeovers)
Other (takeover defense)
Key findings:
The lower the G, the better shareholder rights, therefore higher governance quality
Democratic firms (less than 5 provisions) outperform dictatorship firms (with more than 14 provisions by 8.5% per year!!
Min. 2 provisions
Mean 9 provisions
Max 17 provisions
Corporate Governance Indices—E-index
Bebchuk, Cohen, Ferrell (2009) created E-index (E for entrenchment)
Research question: which of the 24 provisions in the G index really matter (for firm performance)?
Data: IRRC 1990, 1993, 1995,1998, 2002; CRSP, ExecuComp
Methodology: only 6 of the 24 provisions really matter
Staggered board
Limits to amend bylaws
Limits to amend charter
Supermajority
Golden parachutes
Poison Pill
Key findings:
Firms with higher E-index are associated with negative firm value (Tobin’s Q)
Trading strategy that long E=0 firms and short E=5,6 firms, would yield 7% abnormal return!
The other 18 provisions do not influence firm performance
Corporate Governance Indices—limitations
Corporate governance indices may proxy some unidentified factors (i.e. risk taking) which are correlated to governance quality.
Low comparability across firms with the same number of provisions.
To be used with caution by investors and regulators
Too complicated
Institutional Shareholder Service (ISS) has governance metric based on 61 factors
Governance Metric International (GMI) bases their rating on 600 provisions.
Recap
Hostile takeover
Motivation
Defense mechanisms in the US, UK and the Netherlands
Corporate governance indices
G-index
E-index
Limitations of governance indices