In addition to change-of-control benefits (“golden parachutes”), executives often negotiate for personal side-payment at the same time that they are bargaining with an acquirer over the sale of their firm. Side-payments differ from golden parachutes in that they are negotiated ex post in connection with a specific acquisition proposal, whereas golden parachutes are part of the executive’s employment agreement negotiated when she is hired. Side-payments are structured in a variety of different ways: by awarding a merger bonus (often structured as a non-compete agreement); augmenting parachute entitlements during deal negotiations; signing a post-merger consulting or employment contract; or granting ‘unscheduled’ stock options during merger negotiations. The dollar amounts paid out by such side deals are substantial, on average larger than payouts from golden parachute arrangements.
While side-payments may benefit shareholders by countering managerial resistance to an efficient sale (“Incentive Alignment”), they can also be used to redistribute merger proceeds to management at shareholder’s expense (“Rent Extraction”). Consistent with rent extraction, recent empirical studies in finance find lower acquisition premiums when the target CEO receives either post-merger employment or a side-payment, and some forms of side-payments are also associated with positive acquirer abnormal returns.
Despite this evidence, legal scholars have given little attention to the issue. Presumably one reason is that the law already requires that any extra benefits – including side-payments – received by senior management be disclosed to shareholders and that the entire transaction is approved by both the board and shareholders. Informed shareholder approval generally mitigates concern related to conflicts of interest. Given these procedural safeguards, why would a target’s shareholders vote to approve a merger that gives money away to the CEO? The existing literature in both law and finance does not have a good answer to this question.
In CEO Side-Payments in M&A Deals, I propose a new theory for merger side-payments. While agency conflicts are typically driven by shareholders’ inability to observe bad behavior and lack of incentive to invest effort monitoring management, merger side-payments present a different problem. Similar to a legislative rider attached to a popular bill, management can use its agenda setting power to bundle a side-payment with a sale of the firm that is desired by target shareholders. Shareholders cannot oppose the side-payment unless they are willing to block the entire deal and give up the acquisition premium associated with the sale. Even if shareholders would not have approved the side-payment for purposes of ex ante incentives, it may rationally receive ex post shareholder support as part of a take-it-or-leave-it merger vote. Disclosure and voting rights cannot adequately protect shareholders against rent extraction through bundled side-payments.
To be sure, legal and extra-legal constraints – such as an auction that may force an acquirer to devote its funds to a shareholder premium or the threat of tax penalty (e.g. IRC 280G) for side-payments over a threshold level – may limit the use and magnitude of merger side-payments. These constraints, however, are incomplete. Indeed, as long as side-payments are disclosed to shareholders and there is no bad faith in the negotiation process, corporate law largely shields side-payments from judicial review, giving shareholders little ability to counteract the CEO’s agenda setting power.
Acknowledging that the law fails to prevent rent extraction, one may still view the current set of legal protections as the best available for an imperfect world. Given judicial acceptance of takeover defenses such as the poison pill, side-payments are a useful mechanism to overcome managerial entrenchment. The law responds by allowing side-payments but adding disclosure and a tax penalty to discourage especially large side-payments. This, however, ignores the distorting effect that side-payments can have on incentives for managerial effort and on the cost of capital.
To address such concern, I propose a small reform to corporate law. In particular, firms should be permitted to opt into a heightened fiduciary standard by placing language in their charter requiring that any side-benefit received by the CEO (& possibly other members of senior management) can only be cleansed via a separate vote, upon which the broader acquisition cannot be contingent. To avoid the possibility that shareholders may decline to approve an ex post side-payment, firms selecting this option would be encouraged to address the problem ex ante by adopting golden parachutes and related agreements. I explain how this proposal could reduce the CEO’s agenda setting power with respect to side payments, while still giving firms flexibility to compensate the CEO for negotiating a sale of the business.
This post comes to us from Brian J. Broughman, Associate Professor of Law at Indiana University’s Maurer School of Law. The post is based on his recent paper, which is entitled “CEO Side-Payments in M&A Deals” and is available here.