International Corporate Governance Spillovers

The following post comes to us from Rui Albuquerque of the Department of Finance at Boston University; Miguel Ferreira, Professor of Finance at Nova School of Business and Economics; Luis Brandao Marques, Senior Economist at the International Monetary Fund; and Pedro Matos of the Finance Area at the University of Virginia.

In the paper, International Corporate Governance Spillovers: Evidence from Cross-Border Mergers and Acquisitions, which was recently made publicly available on SSRN, we investigate whether the change in corporate control following a cross-border M&A leads to changes in corporate governance of non-target firms that operate in the same country and industry as the target firm. We focus on the strategic complementarity in governance choices between the target firm and its rival firms in the local market. We take the view that corporate governance is affected by the choice of other competing firms as in the models developed by Acharya and Volpin (2010), Cheng (2010), and Dicks (2012).

To provide guidance for our empirical analysis, we develop a simple industry oligopoly model, which captures the idea that rival firms operating in a given industry change their governance in response to competitive forces. The spillover effect occurs as firms in an industry recognize that corporate governance is used more efficiently by the target firm and therefore strengthen their own governance as a response. The model has two decision stages and builds on the work of Shleifer and Wolfenzon (2002) and Albuquerque and Wang (2008). In the first stage, outside shareholders choose firm-level governance (i.e., how much to monitor and limit of managerial private benefits), given the governance choices of other firms. In the second stage, firm managers choose output and the level of private benefits that they extract in the context of a symmetric oligopolistic industry. In the Nash equilibrium outcome, managers have an incentive to “overproduce” (because their private benefits increase with revenues) and industry-level profits are not maximized.

The model allows us to examine the effects of a cross-border M&A. If a firm is the target of a cross-border M&A and the acquirer firm imposes a higher level of governance (and therefore its managers enjoy a lower level of private benefits), then other firms in the same industry will need to adjust their equilibrium private benefits and output. We derive the following hypotheses on the spillover effects of cross-border M&As. First, better governance imposed on the target firm leads to lower private benefits in the targets’ local rival firms. Intuitively, when the target improves its governance, and thus reduces overproduction, more rents can be extracted by other firms in the oligopoly. These additional rents increase the marginal benefit to improving governance as otherwise more private benefits are extracted by managers. This provides the first testable hypothesis: following a cross-border M&A from a high governance acquirer firm, we expect a positive governance spillover as the target’s local rival firms have an incentive to improve their governance.

Second, we consider how the spillover effect varies with the intensity of product market competition. The model suggests that when governance improves in a firm, and more rents are available to competitors, it pays off to improve governance especially if governance is low, which is true when the number of firms is large and there is more competition. This provides the second testable hypothesis: following a cross-border M&A from a high governance acquirer firm, we expect a more pronounced positive spillover to the governance of the target’s local rival firms in more competitive industries.

We empirically study these questions using a firm-level sample of cross-border M&As and corporate governance indices in 22 countries in the 2004-2008 period. Our dependent variable is firm-level governance and our main explanatory variable is the entry of foreign firms into an industry via cross-border M&As. We measure the mean transaction value of cross-border acquisitions in the target firm’s industry (at the two-digit SIC level) as a fraction of the industry’s market capitalization in each country and year. Following Aggarwal, Erel, Ferreira, and Matos (2011), we measure firm-level governance using the percentage of attributes for which the firms meet the minimum acceptable requirements out of 41 attributes (in terms of board, audit, anti-takeover provisions, and compensation and ownership). The data source is RiskMetrics, the leading proxy advisory firm in the world.

We find that cross-border M&As lead to significant positive governance spillovers within the target firm’s industry. We show that the positive relation between cross-border M&A and rival firm’s corporate governance remains strong after controlling for covariates such as firm size, growth opportunities, leverage, tangibility, ownership structure, among others. Furthermore, the results are unchanged after the inclusion of firm fixed effects, suggesting that time-invariant unobserved firm characteristics cannot explain our findings. We also use an instrumental variables approach to provide evidence that causality runs from cross-border M&A to governance improvements, rather than in the reverse direction.

The magnitude of the corporate governance spillover is heterogeneous across firms. The effect is more pronounced when the acquirer firm comes from a country with a better legal environment than the one in the target firm’s country, which is consistent with the first hypothesis that shareholders of non-target firms have an incentive to improve their governance when the acquirer firm comes from a high governance environment as it is more likely to impose similar standards on the target firm. Furthermore, the corporate governance spillovers are more pronounced when the target firm faces tougher product market competition as competitive forces spur the impact of governance improvements in the target firm’s rivals. This is consistent with the second hypothesis.

The magnitude of the spillover effects is economically significant. The improvement in governance in a non-target firm is as high as 5 percentage points in perfectly competitive industries when the acquirer country investor protection is better than that of the target country. This corresponds to twice the annual variation in the governance index (2.2%) or to the firm adopting 2 (out of 41) additional governance provisions. Government regulatory reforms (e.g., the Sarbanes-Oxley Act) typically do not affect as many governance mechanisms. In additional tests, we also examine spillover results across governance subcategories. Cross-border M&A activity in an industry seems to affect internal governance mechanism (board structure and executive compensation) rather than external governance mechanisms (audit and anti-takeover provisions).

Next we test whether the governance spillovers produce real effects. We find that cross-border M&A activity in an industry is associated with higher valuation of non-target firms. In our sample, a one standard deviation increase in cross-border M&A activity is associated with a 12% increase in market-to-book relative to the sample median. This firm-level evidence is consistent with the industry-level evidence in Bris, Brisley, and Cabolis (2008). They find a positive relation between the industry Tobin’s Q and the average change in investor protection (difference between acquirer’s and target’s country investor protection) following a cross-border M&A. Finally, we find significant productivity spillovers on the target firms’ rivals following a cross-border M&A.

Overall, we find that cross-border M&A in an industry generates positive spillover effects particularly on board structure, compensation and ownership attributes of non-target firms that operate in the same industry as the target firm. These findings suggest that the international market for corporate control spreads corporate governance standards across country borders.

Naturally, there are alternative mechanisms of corporate governance spillovers. For example, Doidge, Karolyi, and Stulz (2004) analyze a firm’s decision to cross list in a U.S. exchange as bonding mechanism and Fernandes (2009) documents positive valuation spillover effects to other firms in the local market following the cross listing. Aggarwal, Erel, Ferreira, and Matos (2011) show that cross-border portfolio investment, rather than FDI, is associated with own-firm corporate governance improvements but do not look at externality effects to other firms. However, the potential corporate governance effects are likely to be stronger for FDI than for portfolio investment because foreign direct investors assume control, partially or fully, and are more likely to enact governance changes, which then produce spillover effects in the economy.

The full paper is available for download here.

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