The Sarbanes-Oxley Act (SOX) was enacted by the U.S. Congress in 2002 in the aftermath of a series of corporate scandals. It aims to strengthen investor protection by promoting better corporate governance and auditor independence. In particular, Sections 302 and 404 require top management to assess and certify the effectiveness of internal controls over financial reporting and an external auditor to attest to the validity of management’s assessment. Firms that cannot do so must disclose the existence and nature of their internal control weaknesses (ICWs). While a number of academic studies have documented associations between ICWs and suboptimal corporate behaviors (e.g., lower earnings quality, higher cost of debt, under- or over-investment and poor inventory management), the impact of SOX on managerial decisions in the context of mergers and acquisitions (M&As) has not been fully studied. Mergers and acquisitions are among the largest and most visible investments made by firms. They represent a substantial proportion of economic activity, totaling over $1 trillion a year with deal values ranging from 5 percent to 10 percent of U.S. GDP in recent years (McCracken 2009). It is a natural question to ask whether acquirers that have disclosed ICWs (ICW acquirers) appear to make suboptimal acquisitions. We try to provide an answer in this study.
We compare ICW acquirers with non-ICW acquirers (acquirers that have not disclosed ICWs) in regard to the premiums paid, announcement returns and future performance of combined companies. Our sample is collected from Securities Data Corporation (SDC) Mergers and Acquisitions database and includes deals that were announced after the enactment of SOX, from 2003 to 2014. We focus on acquirers that have reported one or more material weaknesses in their most recent 10-Q (Section 302) or 10-K reports (Section 404) before the acquisition announcements. Our final sample (the treatment sample) consists of 381 acquisitions made by ICW acquirers that acquired targets without ICW disclosures. We compare this sample with matched control samples of non-ICW acquirers that are matched by (i) “propensity scores” that estimate firms’ likelihood of making ICW disclosures, and (ii) industry, year and M&A deal value. The firms in the first control sample may have failed to disclose ICWs even though they have them, while the firms in the second control sample are likely to be free of ICWs.
We find that ICW acquirers pay larger premiums to their targets than the acquirers in the second control sample even after controlling for a host of variables that are associated with firm and deal characteristics. We estimate that an ICW acquirer, on average, pays $46.6 million more in premium than a non-ICW acquirer. This represents an economically meaningful increase in premium of approximately 6 percent. Acquirers that have similar propensities to disclose ICWs (even though they have not disclosed them) pay just as high premiums as ICW acquirers, possibly due in part to faulty information provided by their ineffective internal controls.
We find that the market reacts differentially to the announcements of mergers by the three groups of acquirers. ICW acquirers experience substantially more negative announcement-period cumulative abnormal returns than both groups of non-ICW acquirers. Overall, these results suggest that the market is skeptical of ICW acquirers; investors suspect that ICW acquirers overbid, perhaps because they overestimate the value of the targets or potential synergies. The market, however, does not discount non-ICW acquirers that are matched by propensities as much as they discount acquirers with ICW disclosures. Thus, the market appears to focus more on disclosures than propensities.
We further examine the future performance of M&As by estimating two-year buy-and-hold abnormal returns and returns on net operating assets. Our results suggest that the future returns of ICW acquirers are lower than those of matched acquirers. This suggests that the stock market continues to be skeptical of these acquisitions and the promises of synergies. Our analyses of accounting returns on net operating assets confirm that ICW acquirers perform poorly after M&As compared to non-ICW control samples. Overall, our evidence is consistent with ICW acquirers suffering from poor accounting information quality and making poor M&A decisions.
As part of additional analysis, we examine whether acquirers that report the remediation of ICWs behave similarly to acquirers with effective internal controls. They do. Our results show that they pay lower premiums than ICW and propensity score-matched acquirers. They do not pay significantly different premiums from acquirers matched on industry, year, and deal value. When firms assert that they have remediated ICWs, the market responds similarly to their acquisition announcements as to those of acquirers matched on industry, year, and deal value. We also find that the market reacts more negatively to the merger announcements of ICW acquirers even after controlling for the larger premiums they pay. Thus we document that the disclosure of ICWs matters in determining M&A profitability, as measured by the cumulative abnormal returns around the announcement dates and future performance.
Our study contributes to the debate over the costs and benefits of SOX 302 and 404. Although we cannot estimate the overall benefits and costs of the law, we show that lack of effective internal controls manifests itself in larger premiums paid to targets. This finding points to a benefit of SOX-mandated disclosures in the market for corporate control that has not been documented in prior research. While maintenance of effective internal controls is costly, not having them imposes significant costs on acquirers in the form of a higher premium and a lower cumulative abnormal return.
This post comes to us from Professor Masako Darrough and Associate Professor Rong Huang of the Stan Ross Department of Accountancy at the City University of New York and from Assistant Professor Emanuel Zur of the Robert H. Smith School of Business at the University of Maryland. It is based on their paper, “Acquirer Internal Control Weaknesses in the Market for Corporate Control,” which is available here.