How M&A Laws Affect the Risk of Stock Price Crashes

In a new cross-nation study, we discuss our findings on how the takeover market affects stock-price crash risk, defined as the likelihood of a sudden, drastic decline in the stock price of a firm. An important consideration for risk management and investment decisions, crash risk has received much interest in recent years from academics, regulators, and practitioners due to the series of high-profile corporate scandals (e.g., Enron, WorldCom, Satyam) and the financial crisis of the last decade.

Prior research suggests that the risk of security price crashes stems from agency problems (i.e., managers do not act in the best interests of shareholders) between managers and shareholders when the former has an informational advantage over the latter. Without an optimal contract, selfish managers can exploit this advantage to engage in opportunistic misbehavior to the detriment of long-term shareholders. In addition, managers can have incentives to withhold the disclosure of “bad news” when they are concerned about their career, employment, compensation, reputation, or litigation risk. These actions, however, are unsustainable, because, beyond some tipping point, all the bad news must eventually be released to the market, thus revealing the true fundamentals of the firm and causing large stock price declines. An important question then is whether corporate governance mechanisms can mitigate these opportunistic managerial behaviors and prevent stock price crashes. We address this question by focusing on the monitoring role of the takeover market.

Financial theory has long established that the pressure from the takeover market is an important external governance mechanism that helps align the interests of managers and shareholders. Empirical research dating as far back as Fama and Jensen (1983) and Shleifer and Vishny (1989, 1997) suggests that as the threat of takeover increases, so does managerial discipline, because poorly performing managers are usually replaced if the firm is targeted because of its own poor performance. If the threat of takeover enhances managerial discipline in poorly performing firms through the incentives it provides to the board to monitor managers, then does it have a role to play in helping curb managers’ hoarding of bad news and thus reducing stock-price crash risk? So far there have been many empirical studies that look at various determinants of stock-price crash risk, but there remains scant evidence on whether an active takeover market affects crash risk, especially in an international setting.

In this new working paper, we exploit the staggered initiation of M&A laws across 12 countries between 1995 and 2002 as a plausibly exogenous shock to the threat of takeover to examine how the market for corporate control affects stock-price crash risk. Over past decades, regulators across nations have passed M&A laws to foster takeover activity by reducing legal barriers to transactions, encouraging information dissemination, and increasing shareholder protection. Several studies have found that, after the enactment of these laws, poorly performing firms are more likely to be acquired and poorly performing CEOs more likely to be replaced, implying that the passage of M&A laws are associated with stronger managerial discipline. As these are laws and not company policies, they provide a useful way to assess whether the threat of takeover helps curb the short-sighted, opportunistic behavior of managers in stockpiling bad news, a precursor to stock-price crash risk.

We first examine how stock-price crash risk has changed, before and after the passage of these M&A laws, for firms from countries that passed such laws between 1995-2002 and firms from countries that never adopted such laws in that period. We find that stock-price crash risk decreased significantly for firms after the countries in which they were based passed the laws. The decrease in crash risk was meaningful: 16 percent, on average. We conclude that the passage of M&A laws, which increased the threat of takeover, is associated with lower future crash risk.

We then look at whether the effect of the M&A laws on crash risk varies according to the strength of shareholder protections in different countries. We find that the effect of M&A laws on crash risk becomes stronger for firms in countries with weak shareholder protections and legal enforcement. Next, we investigate whether the effect of M&A laws changes with variations in the external governance mechanisms and information environment at the firm level. We find that the effect is weaker in firms with greater foreign institutional ownership, product market competition, and financial analyst coverage. We therefore conclude that the effect of M&A laws in reducing crash risk is evident primarily in countries with weak investor protections and in weakly governed firms.

Finally, we examine how the increased threat of takeover due to the adoption of M&A laws can mitigate future crash risk by exploring an explicit form of bad-news hoarding: earnings management. Due to various incentives such as career concerns, compensation contracts, reputation, or short-sightedness, managers can maintain an inflated stock price by using accounting techniques to produce financial reports that present an overly positive view of a company’s business activities and financial. We find that, after the enactment of M&A laws, earnings management decreases significantly. We thus conclude that the increased threat of takeover prompted by the passage of M&A laws can be an effective disciplinary device that deters bad-news hoarding.

In conclusion, we show that an active market for corporate control can be an effective external governance mechanism that deters managers’ myopic misbehavior in bad-news hoarding and thus reduces the risk of future stock price crashes. This mechanism is more effective in countries with weak shareholder protections and weak institutions and in weakly governed firms. Our study highlights the beneficial role of M&A laws in preventing stock market crashes.

This post comes to us from professors Balasingham Balachandran at La Trobe University, Huu Nhan Duong at Monash University, Hoang Luong at RMIT University, and Lily Nguyen at La Trobe University. It is based on their recent paper, “Does the Market for Corporate Control Affect Stock Price Crash Risk? Evidence from the International M&A Laws,” available here.