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E-MailEliezer M. Fich is Professor of Finance at Drexel University LeBow College of Business, Jarrad Harford is Professor of Business Administration at the University of Washington Foster School of Business, and Anh L. Tran is a Professor of Finance at City University of London Bayes School of Business. This post is based on their article forthcoming in the Review of Financial Studies. Related research from the Program on Corporate Governance includes Monetary Liability for Breach of the Duty of Care? (discussed on the Forum here) by Holger Spamann.
The corporate opportunity doctrine prohibits officers, directors, and other fiduciaries from personally benefiting from business opportunities that belong to the corporation. This doctrine derives from the long-standing duty of loyalty to the corporation that binds all corporate fiduciaries. In 2000, States, beginning with corporate law standard-setter Delaware, passed corporate opportunity waiver (COW) laws that explicitly permit companies to waive this duty of loyalty for managers and fiduciaries who find new business opportunities in the course of their conduct for the company. As a result, COWs enable fiduciaries to seize for themselves a business opportunity that would otherwise benefit the corporation and its shareholders. In the Review of Financial Studies article titled “Disloyal managers and shareholders’ wealth,” we examine the impact of these waiver laws on corporate innovation and growth strategies at public traded firms.
State legislators noted that the corporate opportunity doctrine left firms, particularly small ones, without contracting flexibility when, for example, pursuing funding from individuals or venture capitalists who might have varied business interests and therefore overlapping duties of loyalty. The waiver laws aimed to help small, emerging firms, but were written with unrestricted applicability to all firms. At larger firms, where contracting flexibility to raise capital is not an issue, the impact is uncertain because the net effect of agency conflicts weighed against the benefits of the waiver is an empirical question. To inform this question, we investigate the corporate opportunity waiver laws’ net effect on a large panel of publicly traded U.S. firms, exploiting the laws’ staggered adoption by nine states between 2000 and 2016.
We first show that R&D spending, patent value and patent counts drop in the year after the waiver adoption, and remain at the new lower levels. We also find that the contribution of marginal spending on R&D to market value is lower, as is the incremental patent value. This evidence rejects the null hypothesis that the laws’ impact on large public firms is limited.
Next, using inventor-level data, we find that after waiver laws pass, firms experience abnormally high inventor departures and a drop in the innovation productivity of the inventors that remain. Moreover, our results show that after waiver laws pass, the most talented (or “star”) inventors move to startup firms. The inventor-level results provide direct evidence on the mechanism through which the COW laws impact corporate-level innovation.
Because of the waivers’ adverse impact on corporate innovation activity, we investigate whether that translates to a lower value of financial slack and a shift in companies’ acquisition activity. The results show that, subsequent to waiver law adoption, the market valuation of a marginal dollar of internal cash is 7 to 12 cents lower than it was prior to the waiver law adoption. Moreover, we find that, with greater potential expropriation of internal growth opportunities, the board turns to acquisitions for growth, and that after a waiver law passes, an acquisition announcement reveals more negative information to the stock market. Indeed, our results indicate that acquisition announcement returns are significantly lower after a waiver law adoption, and that acquirers are less likely to withdraw from acquisitions met with negative returns as well. This last finding supports the interpretation that the announcement reaction is due to the revelation of the waiver’s effect on the acquirer’s internal growth prospects rather than the value implication of the deal itself.
Additional tests provide evidence consistent with the view that managerial incentives tied to shareholder wealth reduce agency conflicts between managers and shareholders. Specifically, consistent with an agency channel underlying the COW effects we observe, we find that higher managerial ownership or a greater proportion of independent board members reduces the effect of the waiver laws on the contribution of innovation to the market value of the firm, the value of internal slack, and the behavior of firms in the acquisition market. Moreover, we show a direct link between inventor departures and the documented value consequences, operating through an agency channel. Specifically, in high-tech industries, firms that lose inventors and exhibit high agency problems suffer significantly worse declines in value than those not losing inventors or those with low agency problems.
Finally, because State legislatures passed COW laws with the goal of providing contracting flexibility that would help small and emerging businesses, we should observe benefits to these firms. Our event study results suggest that the waiver laws helped small and emerging businesses, as their passing generates positive and significant abnormal returns for small cap stocks but not for mid or large cap stocks. Moreover, we also find that after waiver laws pass, accounting returns worsen for large firms but improve for small cap firms.
Overall, our article shows that while corporate opportunity waiver laws helped small and emerging businesses, they also altered the operations of public firms, particularly those seeking both organic and inorganic growth opportunities. On the organic front, some public firms headquartered in states that passed the waivers saw key fiduciaries and innovators leave to pursue their own business opportunities elsewhere. Such departures, in turn, affected the growth path within large public firms, leading to decreases in R&D expenditures, patent quality, and internal slack. On the inorganic front, boards, seeking a way to replace the lost innovative growth, pursue more acquisitions, but with adverse consequences for firm value.
In conclusion, while contracting flexibility is usually helpful for small and emerging businesses, our article provides policy-relevant evidence that in the case of weakening fiduciary duty, the effect for other firms has been negative.
Download the complete paper here.
