Golden Parachutes and the Wealth of Shareholders

The Program on Corporate Governance recently issued our study, Golden Parachutes and the Wealth of Shareholders.

Golden parachutes have attracted much debate and substantial attention from investors and public officials for more than two decades, and the Dodd-Frank Act recently mandated a shareholder vote on any future adoption of a golden parachute by public firms. Our study uses IRRC data for the period 1990-2006 to provide a comprehensive analysis of the relationship that golden parachutes have both with the evolution of firm value over time and with shareholder opportunities to obtain acquisition premiums. We find that golden parachutes are associated with increased likelihood of either receiving an acquisition offer or being acquired, a lower premium in the event of an acquisition, and higher (unconditional) expected acquisition premiums. Tracking the evolution of firm value over time in firms adopting GPs, we find that firms adopting a GP have a lower industry-adjusted Tobin’s Q already in the IRRC volume preceding the adoption, but that their value continues to decline during the inter-volume period of adoption and continues to erode subsequently. A similar pattern is displayed by an analysis of abnormal stock returns prior to the adoption of GPs, during the inter-volume period of adoption, and subsequently.

Here in some more detail is what our study, which is available here, does:

Golden parachutes (GPs) have attracted much debate and substantial attention from investors and public officials ever since their use became common in the midst of unprecedented takeover activities in the late ‘70s and early ‘80s. In 1984, Congress enacted sections 280G and 4999 of the Internal Revenue Code, which seek to discourage GPs with large monetary value by imposing substantial tax penalties on their use. Over the last fifteen years, precatory resolutions opposing GPs have been brought in significant numbers and have commonly passed. More recently, The TARP legislation and the regulations implementing it precluded financial firms receiving government funding from making golden parachute payments to top executives. And and the 2010 Dodd-Frank Act mandated advisory shareholder votes on all future adoptions of a GP by public firms.

Our study seeks to inform the ongoing evaluation of and debate on GPs. In particular, we seek to contribute to an understanding of the relationship that GPs have both with ongoing firm value and with shareholder opportunities to obtain acquisition premiums. To the best of our knowledge, our paper is the first study focusing on GPs that takes advantage of the IRRC dataset, which enables us to track the GP status and other governance provisions of all public firms of significance in the US stock market for a long period of time. Using this dataset, we obtain and analyze three sets of findings concerning the relationship that GPs have with (i) acquisition incidence, (ii) acquisition premiums, and (iii) the evolution of firm value over time.

We begin by analyzing the relationship of GPs and acquisition likelihood. We find that, controlling for publicly known financial characteristics that are known to be associated with higher ex ante likelihood of acquisition offers and acquisitions, GPs are associated with both a higher likelihood of receiving an acquisition bid and a higher likelihood of a completed acquisition. The association is economically meaningful; the presence of GPs is associated with a 25.4% proportional increase in the likelihood of takeover bids and a 28.4% proportional increase in the likelihood of acquisition. The association is present among both firms incorporated in and outside of Delaware, both high-value and low-value firms in an industry (as measured by positive and negative industry median adjusted log Tobin’s Q), both large and small firms in an industry (as categorized by whether a firm is above or below the industry median market capitalization), and firms in both the most and least competitive industries (as indicated by whether a firm belongs to the highest or the lowest quartile of the Herfindahl Index).

We also explore the possibility that the identified association between GPs and acquisitions is driven solely by a “private information” explanation (Lambert and Larcker (1985)) under which GPs are adopted when managers have private information indicating that, controlling for the firm’s publicly known characteristics, the company is relatively more likely to become an acquisition target. If the association between GPs and acquisition likelihood is due to such a signaling explanation, then this statistical result should be driven by “fresh” GPs – that is, GPs that were recently adopted. We find, however, that both old and fresh GPs have a positive association with takeovers, with magnitudes that are statistically no different.

Our findings are also consistent with the possibility that the positive association between GPs and acquisition likelihood is at least partially explained by the effect of GPs on managers’ incentives. It has been long argued that GPs may bring about a higher acquisition likelihood by making an acquisition more attractive to managers (e.g. Lambert and Larcker (1985), Jensen (1988), Kahan and Rock (2002)). On the other hand, our findings are not consistent with the hypothesis that, by “taxing” acquisitions in the form of required payments to target executives, and thus reducing the surplus captured by target and acquirer shareholders in the event of an acquisition, GPs reduce the incidence of acquisitions.

We next investigate the relation between GPs and the premiums earned by the acquired firms’ shareholders when acquisitions are completed. Our results show that, controlling for a firm’s governance structure, financial fundamentals and the deal’s characteristics, the presence of GPs is negatively associated with the acquisition premiums earned by acquired firm shareholders. This statistical relation is economically meaningful: for the average firm in our data, the presence of GPs is associated with an average decrease in 1-week acquisition premiums of 3.57 percentage points (which translates to a 12.8% proportional decrease). As was the case for our findings concerning the positive association between GPs and bid and acquisition likelihoods, our findings concerning the negative association between GPs and acquisition premiums are consistent with the possibility that GPs affect executives’ incentives by lowering the threshold above which accepting an acquisition premium would serve executives’ private interests. GPs both weaken executives’ bargaining position in acquisitions that would take place regardless of the presence of a GP, and add lower-surplus acquisitions that are in executives’ interests only due to the presence of a GP.

Having considered the relationship between GPs and conditional acquisition premiums, which is conditional on a takeover, as well as the relationship between GPs and takeover likelihood, we turn to study the association between GPs and the unconditional acquisition premiums, which combines the two effects. Following the methodology of Comment and Schwert (1995), we find that, controlling for firm characteristics, the presence of GPs is associated with an average increase in unconditional expected 1-week premiums of 36 basis points (which translates to a 3.4% proportional increase).

After completing the analysis of acquisition likelihood and premiums, we proceed to examine the relationship between GPs and the evolution of firm value over time. Prior work has shown GPs to be negatively correlated with industry-adjusted Tobin’s Q (Bebchuk, Cohen, and Ferrell (2009)). But when does this association arise? Might it be that firms which adopt GPs tend to already have lower value prior to the adoption of a GP? Or might it be that firms adopting GPs experience decline in firm value after the adoption? We seek to contribute to answering these questions.

We show that firms adopting a GP tend to have a lower industry-adjusted Tobin’s Q already in the IRRC volume prior to the adoption. Such firms also experience negative abnormal stock returns during the inter-volume period ending with the IRRC volume preceding the adoption of a GP. These findings indicate that the negative association between GPs and firm value documented by prior work is not fully driven by value erosion that follows (and might be brought about by) the GP adoption. At least part of the association is driven by a selection effect, namely the higher inclination of low-value firms to adopt a GP.

Even though the negative association between GPs and firm value is not fully driven by value erosion that follows GP adoption, however, we show that it is partly and significantly driven by such value erosion. In particular, we show that the industry-adjusted Tobin’s Q levels of firms adopting a GP (i) further erode during the inter-volume period surrounding the GP adoption, and (ii) subsequently continue to erode over the next several years. Consistent with our findings concerning the erosion in industry-adjusted Q, we also find that (i) among firms that do not have a GP, those who adopt a GP by the next IRRC volume experience lower abnormal stock returns, compared with firms that do not do so, during the inter-volume period of adoption, and (ii) firms that adopt a GP and do not subsequently drop it experience lower abnormal stock returns during the two inter-volume periods following the adoption than firms that do not have a GP and do not adopt one subsequently.

Our findings concerning the erosion of firm value after the adoption of a GP are consistent with the view that, by making managers less fearful of an acquisition, GPs weaken the discipline of the market for corporate control and thereby lead to increased managerial slack (Shleifer and Vishny (1989), Gompers, Ishii, and Metrick (2003), Bebchuk, Cohen, and Ferrell (2009)). In contrast, we do not find evidence for the view that, by weakening the pressures of the market for corporate control, GPs bring about an increased firm value by inducing more focus on the long-term (see, e.g., Stein (1988)) or by encouraging executives to invest in firm-specific human capital (see, e.g., Jensen (1988), Shleifer and Vishny (1989)). These findings, as well as our other findings discussed above, should be taken into account by investors and others as they assess golden parachutes.