Does Protectionist Anti-Takeover Legislation Lead to Managerial Entrenchment?

My article, titled Does protectionist anti-takeover legislation lead to managerial entrenchment?, forthcoming in the Journal of Financial Economics, investigates the implications of protectionist interventions into mergers and acquisitions for corporate governance.

Over the last few years, governments worldwide have intervened in a significant number of cross-border mergers and acquisitions, often citing national security concerns. Several countries including the United States, Germany, France, and the United Kingdom have also recently introduced or are contemplating the introduction of legislation that increases the scrutiny of foreign investments. The threat of a takeover is one of several possible ways to overcome the agency problem created by the separation of ownership and control in firms: If a firm’s management is implementing policies that are suboptimal for shareholders, a shareholder or third party can make a profit by acquiring the firm and replacing its management team. In theory, therefore, a reduction in this threat, such as through protectionist legislation, has the potential to entrench a firm’s management, i.e. might allow management to extract private benefits at the expense of shareholders.

While there is a large literature studying the connection between managerial entrenchment and anti-takeover legislation, most of it is based on the second generation of state-level anti-takeover laws introduced in the United States in the 1980s. It is unclear whether these results should apply to today’s protectionist interventions because they are different in nature and corporate governance standards worldwide have become significantly stricter over the last two decades.

My article tests whether protectionism leads to managerial entrenchment based on the Alstom Decree, a protectionist law introduced in France in 2014. The Alstom Decree designated the five industry sectors energy, water supply, transportation, electronic communications and public health, which together account for around 30% of all publicly listed French firms, as strategic to the country’s interests and enables the secretary of commerce to veto M&A transactions targeting companies operating in them if the bidder originates from abroad. Since the introduction of the Alstom Decree until early 2018, over a hundred transactions have been the subject of an investigation. In addition, the law also has the potential to deter M&A transactions ex ante, either because it increases the costs for the bidder through delays or less favorable deal terms or because the acquirer fears the transaction might not be approved.

I find that firms protected by the Alstom Decree, compared to unprotected firms, become substantially less likely to be the target of an acquisition or merger after the Decree’s introduction. An event study around its announcement further indicates that a portfolio holding a long position in protected firms and a short position of the same size in unprotected firms would have produced significantly negative abnormal returns. These results suggest that the protection provided by the Alstom Decree was indeed meaningful.

I then test whether this measurable decrease in the likelihood of being acquired affected corporate policies at protected firms. Jensen’s theory on the agency cost of free cash flow suggests that managers prefer to retain rather than distribute excess cash absent positive net present value investment opportunities. Following the theory, an entrenched manager will seek to decrease the amount of financial leverage (because debt financing commits part of the firm’s cash flow to interest payments) and decrease distributions to shareholders. I test whether the Alstom Decree is associated with changes in protected firms’ capital structure and payout policies, but do not find any evidence for such changes taking place.

The literature has also developed two competing hypotheses on managers’ preferred use for excess cash: empire building and the quiet life. The empire building hypothesis suggests that executives have an interest in increasing the size of their firm, as it is positively correlated with their prestige and compensation. The quiet life hypothesis on the other hand states that managers prefer to avoid difficult decisions and are just as unlikely to aggressively grow a business as they are to restructure it when they are protected. Furthermore, it suggests that they have a preference for paying higher wages and growing the size of their staff, which results in lower productivity and profitability when they are at liberty to do so. I attempt to find evidence for empire building or quiet life behavior at firms subject to the Alstom Decree by testing for changes in firm characteristics that should be affected according to the two theories of managerial preferences. I do not find that affected firms increase capital expenditures, R&D expenses or the number or volume of mergers and acquisitions they engage in. Therefore, I do not find any evidence for empire building. Also inconsistent with quiet life behavior, I do not find an increase wages or employment following the Alstom Decree, and protected firms’ operating performance remains unchanged.

The final firm policy I examine in the light of the Alstom Decree is executive compensation. The most direct way in which an entrenched manager can extract value from a firm is through his or her own compensation contract. In addition, the executive’s compensation contract is one of the most important tools for aligning incentives between shareholders and management. If shareholders or the board of directors were concerned that the Decree would lead to a decrease in managerial discipline, they might have taken measures to increase the performance-sensitivity of executive compensation to substitute for the loss in monitoring by the takeover market. I find limited evidence for an increase in total executive compensation and robust evidence for an increase in the pay-for-performance sensitivity following the Alstom Decree, where I measure the latter as the share of annual CEO compensation paid out in equity instruments.

In summary, my results suggest that a loss in efficiency stemming from an increase in managerial entrenchment cannot explain the negative impact the Alstom Decree had on shareholder value. The potential increase in executive compensation alone is too small to explain the law’s announcement return. I suggest an alternative explanation for the stock market reaction to the Alstom Decree that does not rely on managerial entrenchment: The incumbent shareholders frequently receive a large premium over the pre-offer share price during a takeover, and efficiency gains from removing bad management are only one reason for why the acquirer might be willing to pay such a premium. As protected firms are less likely to be acquired, the Alstom Decree caused a decrease in the expected value of future takeover premiums accruing to affected firms’ shareholders.

The complete article is available for download here.