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E-MailJeffrey N. Gordon is Richard Paul Richman Professor of Law at Columbia Law School. This post is based on his recent paper.
This paper argues that the prevailing corporate governance regime in the United States has produced a level of mergers and acquisition activity that is higher than the social optimum because of a high-powered incentive for a CEO to exit through target-side M&A, the contemporary golden parachute.
In the late 19th through the 20th century M&A activity was characterized by “waves” that reflected adaptations to changing external environment, whether the efficient production frontier, regulatory constraints, or capital market developments. Economically motivated parties saw the opportunities in changing the boundaries of the firm; successful first-movers spawned imitators, hence a wave, which eventually subsided, often alongside deteriorating capital market conditions. The 21st century is different. There is a persistently high level of M&A. Yes, there are fluctuations but not “waves.” The troughs in M&A activity over the past 25 years commonly exceed the peaks of prior waves.
This pattern can be explained at least in part by the introduction of an internal driver of M&A activity, the “golden parachute,” a super-bonus payoff to a target CEO. Golden parachutes were introduced as a corporate governance innovation in the 1980s to overcome managerial hostility to an unsolicited premium bid. Over time, especially as executive compensation radically shifted toward stock-based pay, golden parachutes have become increasingly lucrative, platinum in many cases They now provide a CEO with a high-powered incentive to become a target CEO, compensating the CEO like a deal-hunting investment banker, and thus have changed the pattern of M&A activity.
What’s some of the evidence? When parachutes were initially introduced, they were coded as negative in the corporate governance indices, meaning that M&A would be less likely for the adopting firm. In the 2000s the coding switches; parachutes are now a positive for the likelihood of target-side M&A. Executive compensation transforms over the period (under the influence of accounting changes) away from plain vanilla options towards out-of-the-money options that, with accelerated vesting, produce large gains in M&A. CEO retirement age becomes an important predictor of becoming a target. In purple prose, the retiring CEO outfitted with a golden parachute is in the position of a homeowner occupying a well-insured house which, it turns out, the homeowner cannot sell after the move to Florida on retirement. The only way to realize value on the house, then, is to burn it down and collect the insurance.
The consequences are several. From the shareholder perspective this new source of agency costs produces three sorts of inefficiencies. The CEO will excessively tailor project selection and investment with an eye towards M&A exit. The CEO may satisfice in evaluating merger proposals, settling for immediate gains to realize a sure-bet parachute payoff. The CEO will avoid grooming a successor because the absence of an obvious successor enhances the CEO’s M&A optionality. In a framing drawn from behavioral corporate finance, rich parachutes have helped establish exit-through-merger as part of a “good” CEO career, as opposed to “left the company in capable next-generation hands.” Yes, shareholders approve the merger, but there is not a counterfactual alternative developmental path over which they have choice.
The resulting excess M&A has negative social consequences. M&A is commonly associated with significant employee layoffs that may produce significant loss of human capital, lower pay and diminished career prospects. Even if layoffs associated with M&A might be thought of as an inevitable consequence of a dynamic economy, and we would rapidly be worse off without that dynamism, there is no reason to build in high-powered managerial incentives that promote M&A, particularly where the benefits are so skewed in favor of the individual CEO. Such a structure is likely to produce socially costly distortion.
The mixture of M&A, layoffs, and golden parachutes may have particular socio-political consequences. The forced sociability and interaction of the workplace is a counterweight to the echo chamber of individual narrow-casting and (imperfectly) helps people steer clear of rabbit holes. Thus the disruption of an established workplace has costs beyond the economic. But one element stands out: even if there is pain among those who are laid off when the firm is sold and layoffs occur, there is plainly one winner: the CEO with a golden parachute. This mismatch of fates, this inequality with privity, is the kind of economic event that may activate the behavioral responses associated with other economic shocks in which the losers perceive that their losses are tied to others’ gains, namely, a sense of resentment and grievance.
What is the recourse? Shareholders could decide to intervene in the fashioning of golden parachutes to avoid costs to shareholder welfare from distorted project choice, failures in CEO succession planning, and the greater propensity to enter into value-reducing M&A transactions. Shareholders could also decide that the socio-political effects create systemic risks to their portfolio by inviting a politics that would disrupt innovation and economic growth. The annual “say on pay” vote affords ample opportunity.
The paper provides figures and charts that show the pattern of M&A activity since 1900 and the escalation in golden parachute size since the advent of one SEC disclosure regime in 2004 and the “say on golden parachute” regime in the Dodd-Frank Act of 2010. The core “causal” claim is straightforward: the parachute payouts are now structured to become quite large. If they do not have incentive effects, what is their justification?
