Entrenchment Through Discretion over M&A Contractual Provisions

Managerial entrenchment is detrimental to shareholder value (Faleye (2007), Cohen and Wang (2013), and Cohen and Wang (2017)). Managers are able to become entrenched by making specific investments whose value is higher under their watch than under that of the next-best alternative managers (Shleifer and Vishny (1989)). This value differential will be lost if shareholders replace managers who entered into such deals. As a result, those managers gain leeway to increase their compensation and exercise more discretion over firm strategy in a way that might destroy shareholder value.

In a recent article, we explore how managers who are not yet entrenched can enter into entrenchment-increasing deals, even when the board of directors and shareholders have the power to reject the deals as likely to destroy value and to dismiss the managers. We suggest that managers are able to complete such deals by using their discretion over the transaction contracts (Shleifer and Vishny (1989)) and implement bidder termination fees (alternatively denoted as reverse termination fees). Such fees are cash payable from the bidder to the target upon termination of the deal by the bidder, and so can make it costly for acquirers to terminate the deal.

Termination fees are disclosed in SEC filings at or shortly after deal announcements. We expect, therefore, that an acquirer’s shareholders will anticipate a negative impact on the acquirer’s stock price if the termination fee is high and the managers of the acquirer are on the verge of dismissal. This leads to our central hypothesis: If a manager is likely to be fired and announces a deal with a high termination fee, we expect significantly negative abnormal returns on the acquirer’s stock when the deal is announced.

For our analysis, we use a sample of 852 U.S. deal announcements between 2004 and 2015 that include public acquirers and public as well as private targets.

Main Findings

We find that the market reacts in a significantly negative way to deal announcements if bidder termination fees are high and the acquirer’s one-year stock price performance is negative, i.e., our proxy for higher likelihood of forced CEO turnover. Moreover, we find that our findings are more pronounced for public targets: This indicates that the entrenchment strategy is easier to implement for acquirer CEOs if target managers are less aligned with their shareholders, as we assume is the case with public targets.

We find this negative relation with acquirer announcement returns to be more pronounced

  • if the acquirer CEO’s wealth is less sensitive to acquirer’s stock price changes,
  • if the acquirer CEO is not close to retirement age,
  • if the acquiring firm’s management executives (all vice presidents, CEO excluded) have low equity-based incentives,
  • if the acquiring firm has not implemented a staggered board,
  • if the deal is characterized as a diversifying takeover,
  • if the method of payment is cash only, and
  • if the acquiring firm is in an industry that faces weak product market competition.

This suggests that the entrenchment strategy is easier, and more likely to be pursued by CEOs, if their incentives to do so are high and if they will probably profit from future entrenchment.

We additionally find strong evidence that the level of entrenchment increases in the years after deal announcement, as measured by the acquiring firm’s entrenchment-index changes defined by Bebchuk, Cohen, and Ferrell (2009). Shares of underperforming acquirers that do deals with high termination fees also lose value over the months and even years following the deal.

As one robustness test, we split the size of the bidder termination fees into quantiles and find qualitatively similar results. We document that the effect is mostly driven by excessively high termination fees. This suggests that low- or moderate-sized fees might serve as efficient contractual devices, whereas large fees are most detrimental to shareholder value and therefore signal potential agency conflicts.

Contribution to Literature

We contribute to current research in a variety of ways. First, we extend the corporate governance literature by demonstrating how CEOs can exploit their discretion over contracts to undertake entrenchment-increasing M&A deals, which complements Masulis, Wang, and Xie (2007) and prior theoretical work by Shleifer and Vishny (1989).

Second, we contribute to M&A literature that addresses the impact of target termination fees on deal outcomes. Officer (2003) and Bates and Lemmon (2003) both show that target termination fees are included as efficient contractual devices rather than as devices to deter competitive bidding after deal announcement. Bates and Lemmon (2003) find that bidder termination fees are more likely included in transactions where the costs of negotiation are high. Chen, Mahmudi, Virani, and Zhao (2018) interpret bidder termination fees as a way to facilitate the termination of takeovers that are not optimal for the bidder. We add to the M&A literature by investigating how bidder termination fees affect the acquirer’s stock returns at deal announcement. We also introduce a novel measure to better capture potential wealth effects should bidder termination fees be paid: Prior literature scales termination fees – irrespective of whether they are paid by the acquirer or target – by transaction value; we scale bidder termination fees by an acquiring firm’s market capitalization to assess the potential negative economic impact on an acquirer’s value.

Finally, we add to the growing literature at the intersection of law and finance. Our results deliver an argument to closely monitor the setting and to restrict the size of bidder termination fees, because excessively high fees are associated with shareholder value destruction if a deal is meant to be entrenchment-increasing, signaling agency problems between managers and their shareholders.

Conclusion and Implications for Practitioners and Regulators

We introduce the idea to the literature that excessively high bidder termination fees, implemented by acquirer managers with a high probability of being replaced, might serve as a device to ensure completion of entrenchment-increasing deals in the sense of Shleifer and Vishny (1989). Consistently, we find that high fees are associated with destruction of shareholder value and lead to more entrenchment.

Our study also has implications for practitioners and regulators. First, we suggest that board members should take a close look while negotiating the size of bidder termination fees and should examine fees in comparable deals. Second, corporate boards must be aware of potential collusion between managers and their deal advisers. Third, shareholders should elect board members that have experience in the legal aspects of a deal and are not time-constrained, i.e., serve on no more than one or two boards outside the firm. Finally, our results should prompt regulators to consider limiting the size of bidder termination fees.


Bates, Thomas W., and Michael L. Lemmon, 2003. “Breaking up is hard to do? An analysis of termination fee provisions and merger outcomes”, Journal of Financial Economics 69(3), 469–504.

Bebchuk, Lucian, Alma Cohen, and Allen Ferrell, 2009. “What Matters in Corporate Governance?”, Review of Financial Studies 22(2), 783–827.

Chen, Zhiyao, Hamed Mahmudi, Aazam Virani, and Xiaofei Zhao, 2018. “When a Buyer Gets Cold Feet: What is the Value of a Bidder Termination Provision in a Takeover?”, Working Paper, Chinese University of Hong Kong, University of Oklahoma, University of Arizona, and University of Texas at Dallas.

Cohen, Alma, and Charles C. Y. Wang, 2013. “How do staggered boards affect shareholder value? Evidence from a natural experiment”, Journal of Financial Economics 110(3), 627–641.

Cohen, Alma, and Charles C. Y. Wang, 2017. “Reexamining staggered boards and shareholder value”, Journal of Financial Economics 125(3), 637–647.

Faleye, Olubunmi, 2007. “Classified boards, firm value, and managerial entrenchment”, Journal of Financial Economics 83(2), 501–529.

Masulis, Ronald W., Cong Wang, and Fei Xie, 2007. “Corporate Governance and Acquirer Returns”, Journal of Finance 62(4), 1851–1889.

Officer, Micah S., 2003. “Termination fees in mergers and acquisitions”, Journal of Financial Economics 69(3), 431–467.

Shleifer, Andrei, and Robert W. Vishny, 1989. “Management Entrenchment: The Case of Manager-Specific Investments”, Journal of Financial Economics 25(1), 123–139.

This post comes to us from Richard Schubert, a PhD candidate at Karlsruhe Institute of Technology, and Jan-Oliver Strych, an assistant professor of finance at the institute. It is based on their recent paper, “Entrenchment through Discretion over M&A Contractual Provisions”, available here.