Evidence shows shareholders’ wealth is protected from self-serving managers, who are often motivated to divert corporate resources, by both internal and external corporate governance mechanisms (Jensen and Meckling, 1976; Fama, 1980; Fama and Jensen, 1983). However, due to high monitoring costs, retail shareholders – unlike institutional investors – cannot prevent potential agency problems. Therefore, filing a securities class action is one of their few ex-post options for recovering loss of wealth (Gillian, 2006). Empirical evidence on agent-shareholder conflict indicates shareholders have used class action lawsuits to express dissatisfaction or to discipline inefficient management.
In 1995, the U.S. Congress passed the Private Securities Litigation Reform Act (PSLRA) to make it more difficult for shareholders to file frivolous lawsuits. Despite the PSLRA, the incidence of securities class actions increased (Choi, Nelson, and Pritchard, 2009). On July 2, 1999, the U.S. Ninth Circuit Court of Appeals interpreted the PSLRA more rigorously in In Re: Silicon Graphics Inc. Securities Litigation. The court aimed to discourage frivolous shareholder litigation and required shareholders to provide clear evidence of “deliberately reckless or conscious misconduct” by defendants. Exploiting this ruling as a quasi-natural experiment, we examine how changes in the likelihood of shareholder litigation affect decisions on whether and how to engage in mergers and acquisitions (M&A).
Mergers and acquisitions involve substantial corporate investments with significant impact on firm value, and shareholders and managers have significantly heterogeneous views on them (Chen, Harford, and Li, 2007). Managers use M&A to reduce personal undiversified risk or increase their scope of authority (Jensen, 1986). Evidence also indicates that target-firm shareholders often sue the firm’s management for breach of duty by, for example, concealing material information about deals or forcing such shareholders to accept unfavorable terms or low bids (Jarrell, 1985; Rosenzweig, 1986). Further, recent research demonstrates that deals subject to lawsuits by target-firm shareholders are less likely to be completed, and have significantly higher takeover premiums if completed (Krishnan, Masulis, Thomas, and Thompson, 2012). However, prior work has paid little attention to M&A outcomes when a change in regulation reduces the risk of shareholder litigation.
To address this evidence gap, we examine M&A transactions five years before and after the 1999 Ninth Circuit ruling. We collect the details of completed M&A transactions, announced between 1994 and 2004, from the Securities Data Corporation Platinum database. The initial sample includes 29,741 U.S. transactions. We follow inclusion/exclusion criteria of standard M&A literature (e.g., Fuller, Netter, and Stegemoller, 2002), and further require that acquirers have stock market data and accounting data available in CRSP and Compustat. The resulting analytical sample includes 12,868 M&A transactions.
Our findings show:
- After the ruling, the three-day stock cumulative abnormal returns of acquiring firms headquartered in Ninth Circuit states (AK, AZ, CA, HI, ID, MT, NV, OR, and WA) with public targets are on average 1.7 percentage points lower than those of firms in other states around their M&A announcements. These acquiring firms, especially when they have lower levels of institutional ownership, are also more likely to pay for large targets with stock
- After the ruling, firms with headquarters in Ninth Circuit states are 5.9 percent more likely to do all stock deals and 4.4 percent less likely to pay only with cash.
- After the ruling, the negative market reaction around M&A announcements is stronger for firms headquartered in Ninth Circuit states with lower institutional ownership. This finding implies that the monitoring role of institutional investors in M&A becomes more important for firms headquartered in Ninth Circuit states to help offset the lowered threat of litigation by retail investors.
- After the ruling, the stock long-term performance of acquiring firms with headquarters in Ninth Circuit states is 32.7 (27.5) percentage points lower than the performance of firms headquartered in other states, based on three-year market-adjusted BHAR (peer-based BHARs). This suggests that the reduced threat of shareholder litigation lowers the post-merger performance of acquiring firms.
- CEOs at acquirers based in Ninth Circuit states are 1.4 percent less likely to be replaced after the ruling than those in other states. Moreover, we find that CEO replacement is insensitive to value-decreasing M&A decisions. These findings indicate disciplinary mechanisms became less effective after the threat of shareholder litigation was reduced.
Overall, our results indicate the importance of shareholder litigation as an external governance mechanism. In line with Jensen’s findings (1986), we posit that reduced litigation risk may give managers incentives to overpay when acquiring firms and to engage in value-destroying mergers for their own benefit. Our findings imply that, after the ruling, M&A transactions in Ninth Circuit states are likely to be motivated by opportunistic managers, which negatively affects acquiring firms’ performance in the long run. We find evidence indicating that institutional investors play important monitoring roles in M&A and related litigation. Our findings hold up under a battery of sensitivity tests and shed light on the effectiveness of shareholder litigation, especially when led by institutional investors that monitor M&A decisions and the tradeoff between the benefit of shareholder litigation as an external governance mechanism and the related litigation costs.
REFERENCES
Chen, X., Harford, J., & Li, K. (2007). Monitoring: Which institutions matter? Journal of Financial Economics, 86(2), 279–305.
Choi, S. J., Nelson, K. K., & Pritchard, A. C. (2009). The screening effect of the Securities Litigation Reform Act. Journal of Empirical Legal Studies, 6(1), 35–68.
Fama, E. F. (1980). Agency problems and the theory of the firm. Journal of Political Economy, 88(2), 288–307.
Fama, E. F., & Jensen, M. C. (1983). Agency problems and residual claims. The Journal of Law and Economics, 26(2), 327–349.
Fuller, K., Netter, J., & Stegemoller, M. (2002). What do returns to acquiring firms tell us? Evidence from firms that make many acquisitions. The Journal of Finance, 57, 1763–1793.
Gillan, S. L. (2006). Recent developments in corporate governance: An overview. Journal of Corporate Finance, 12(3), 381–402.
Jarrell, G. A. (1985). The wealth effects of litigation by targets: Do interests diverge in a merge? The Journal of Law and Economics, 28(1), 151–177.
Jensen, M. C. (1986). Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review, 76, 323−329.
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360.
Krishnan, C. N. V., Masulis, R. W., Thomas, R. S., & Thompson, R. B. (2012). Shareholder litigation in mergers and acquisitions. Journal of Corporate Finance, 18, 1248–1268.
Rosenzweig, M. (1986). Target litigation. Michigan Law Review, 85(1), 110–150.
This post comes to us from Professor Chune Young Chung at Chung-Ang University’s College of Business & Economics, Professor Incheol Kim at The University of Texas Rio Grande Valley’s College of Business & Entrepreneurship, and Professor Monika K. Rabarison at The University of Texas Rio Grande Valley’s College of Business & Entrepreneurship. It is based on their recent article, “Is Shareholder Litigation an Effective External Monitoring Device? Evidence from M&As,” available here.