Does Takeover Activity Cause Managerial Discipline? Evidence from International M&A Laws

In the paper Does Takeover Activity Cause Managerial Discipline? Evidence from International M&A Laws, which was recently made publicly available on SSRN, we examine if the market for corporate control improves corporate governance. Theory suggests that the threat of takeover is one of the most important external mechanisms for aligning the interests of managers and shareholders. While a large empirical literature analyzes the effects of takeover activity on managerial discipline, it has not been entirely successful in establishing whether an active market for corporate control enhances managerial discipline and often finds mixed results. Partly, this is because many studies rely on sources of variation in the threat of takeover that can generate serious endogeneity and omitted variable biases. For example, tests that employ the mean level of takeover activity as a proxy for the threat of takeover suffer from potential omitted variable biases since overall takeover activity is likely to be accompanied by contemporaneous macroeconomic shocks that could jointly explain management turnover. Further, tests that employ takeover defenses as a proxy for takeover threats suffer from endogeneity concerns as they are often established at the discretion of the firm.

To establish whether the market for corporate control improves corporate governance, we exploit a natural experiment that significantly increased the threat of takeover through the staggered initiation of takeover acts. Takeover acts are laws that are passed specifically to foster takeover activity by reducing barriers to M&A transactions, encouraging information dissemination, and increasing minority shareholder protection. These laws avoid the endogeneity and omitted variable problems to the extent they are passed by countries and not endogenously driven by firm specific conditions. Despite their advantages, it is important to recognize the political economy of these laws in that they may have been passed because of contemporaneous economic conditions and/or lobbying by the firms themselves. We show in a battery of robustness test that the data do not support these as well as other alternative interpretations such as reverse causality and contemporaneous changes in firms’ governance environment.

Using the propensity to replace poorly performing CEOs as a proxy for the effectiveness of managerial discipline, we examine the causal effects of an increase in takeover threats on managerial discipline around the time that laws that increase the threat of takeover are passed. We employ a difference-in-difference methodology that measures CEO turnover surrounding the exogenous shock to takeover threat. This allows us to eliminate any fixed differences between countries passing laws and those not passing laws at different points in time. Our international setting also allows us to exploit cross-country differences in legal protection as a second source of variation to further ensure we identify the effects of M&A laws. Prior research shows that when country level investor protection is poor, firm level governance mechanisms are generally unavailable or prohibitively expensive. Therefore, if the threat of takeover causes managerial discipline, the initiation of M&A laws should have a larger governance impact in countries’ with weak investor protection laws, since alternative governance mechanisms at the firm level are less prevalent. Thus, our cross-country analysis also allows us to provide unique evidence on the ability of internal governance mechanisms to substitute for the external market for corporate control, a central question in the literature that remains unresolved.

Our results show that the enactment of M&A laws increases the sensitivity of CEO turnover to poor firm performance. To the best of our knowledge, these findings represent the first evidence of a causal link between the threat of takeover and managerial discipline. We also find that the increase in managerial discipline caused by the initiation of M&A laws is strongest in countries with weak investor protection law. Therefore, our findings document the important role of M&A activity in ensuring good corporate governance outcomes in firms with inadequate governance mechanisms. Further, our results show that in countries with strong investor protection laws, the threat of takeover does not increase the propensity to terminate poorly performing CEOs. In this way, they provide evidence that internal governance mechanisms, when available, can be an effective substitute for the external market for corporate control.

After establishing the causal link between the threat of takeover and managerial discipline, we also investigate if our findings can be generalized to countries that did not initiate M&A laws during our sample period. We examine this issue by expanding our sample to compare the propensity to fire underperforming CEOs in all countries that have M&A laws versus those that do not, with the caveat that this analysis does not establish causality since some countries have always had (or not had) M&A laws in place during our sample period. The results show that the sensitivity of top executive turnover to poor firm performance is greater in firms located in countries with an M&A law and the effect of such laws is strongest in countries with weak investor protection. These findings suggest that the threat of takeover that emanates from M&A laws is associated with managerial discipline around the world.

The full paper is available for download here.