The Effects of Takeover Defenses: Evidence from Closed-End Funds

Matthew Souther is Assistant Professor of Finance at the University of Missouri. This post is based on Professor Souther’s recent article, available here. Related research from the Program on Corporate Governance includes The Powerful Antitakeover Force of Staggered Boards: Theory, Evidence, and Policy by Lucian Bebchuk, Charles C. Coates, and Guhan Subramanian; The Costs of Entrenched Boards by Lucian Bebchuk and Alma Cohen; and How Do Staggered Boards Affect Shareholder Value? Evidence from a Natural Experiment by Alma Cohen and Charles C. Y. Wang.

In the paper, The Effects of Takeover Defenses: Evidence from Closed-End Funds, forthcoming in the Journal of Financial Economics, I use a sample of closed-end funds to show that takeover defenses reduce firm value and promote entrenchment, allowing managers and directors to earn excess levels of compensation while protecting them from shareholder action. The defenses used by these funds are a subset of defenses available to general corporations; there are no “fund-specific” defenses. These funds have several unique characteristics, however, that make them an ideal setting for testing the implications of the use of defenses.

First, the closed-end fund discount provides a direct and accurate measure of the disparity between net asset value (NAV) and market value. Q-ratios, used as a proxy for firm value in many previous studies of shareholder rights, only allow estimation annually and are inherently noisy due to inconsistent accounting, misstated liabilities, and varying opportunity sets. The closed-end fund discount provides an asset valuation via the fund’s NAV, representing a more accurate accounting valuation of assets than is observed in general corporations. The use of the closed-end fund discount is therefore likely to be more informative than the Q-ratios often used in prior studies. While there are various explanations for the closed-end fund discount, impediments to shareholders’ ability to realize net asset value should play a role.

These funds also provide a level of homogeneity in manager skill sets and compensation contracts not found in general corporations. Managers and directors of general corporations are compensated in a variety of forms, including stock, options, cash, and bonuses, which makes total compensation difficult to measure and presents risk-return tradeoffs that influence compensation levels. These management teams also undertake diverse tasks that require a wide range of talent levels and skill sets; certain positions may face varying supply and demand conditions for talent, further influencing compensation levels. Managers and directors of closed-end funds, on the other hand, undertake similar tasks and are always paid in cash. The fund manager is paid as a contractually stated percentage of the fund’s net asset value, while directors are always paid in the form of a cash retainer fee. The standardized nature of the job tasks and compensation schemes allow for more effective tests of the impact of takeover defenses on compensation levels that generalize to a broad set of corporations.

The defenses employed by closed-end funds have become more relevant in recent years. Activist investors such as Bulldog Investors, led by Phillip Goldstein, have targeted closed-end funds trading at large discounts. These activists acquire a substantial stake in the fund, work to elect a new board, and then take action to address the discount, either by open-ending the fund or forcing repurchases of shares. This is very similar to the style of activism observed in major, publically traded corporations, but in the case of closed-end funds, the observed discount provides activists with easy estimation of the potential profits realized upon taking control. Funds have responded to the possibility of losing control to an activist shareholder by adopting additional takeover defenses that serve as impediments to shareholders seeking to gain power over management.

In this study, I first identify a set of nine commonly used defenses. These include staggered boards, super-majority voting requirements, obstacles to removing a director, advance notice provisions, restrictions on shareholder meetings, ownership or voting power limitations, opt-in to state business combination laws, director qualification provisions, and exclusive board control of bylaws. While I test the individual effects of each of these defenses, I focus primarily on an index based on the total number of defenses used by a particular fund. This reduces the problem of high correlations between the various defenses.

Using the takeover defense index, which tracks each fund’s takeover defenses annually across a 15-year period, I first show that defenses are associated with larger closed-end fund discounts and weaker (less positive) reactions to activist 13D filings. These results both indicate that defenses have a negative effect on market values. My unique data set allows me to confirm this finding in a time-series setting around the adoption of new defenses. I then show that fund managers and directors financially benefit from the use of defenses. Compensation levels are positively related to the defense index, and the adoption of additional defenses is associated with simultaneous increases in compensation for both managers and directors. Finally, I verify that defenses are effective impediments to shareholder action. The index of takeover defenses is negatively and significantly related to the likelihood of success in activist attempts. This study provides greater clarity on the relation between takeover defenses and firm value while producing new evidence of the entrenchment-promoting effects of defenses. In particular, the board of directors, in the unique position of setting their own compensation contracts, while having power over defense adoptions, are shown to reap significant financial benefits from the use of defenses.

The full paper is available for download here.

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