Antitakeover Statutes and Internal Corporate Governance

• Author: Choonsik Lee,Kee H. Chung
• Published date: 01 September 2016
• Date: 01 September 2016
• DOI: http://doi.org/10.1111/corg.12156

Antitakeover Statutes and Internal Corporate

Governance

Choonsik Lee and Kee H. Chung*

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper examines the relation between internal corporate governance and the market for

corporate control by analyzing how f‌irms’internal governance mechanisms are related to states’antitakeover statutes (ATS).

Specif‌ically, we testtwo competing hypotheses concerningthe effect of ATS on internal governance: the substitutionhypothesis

and the complementarity hypothesis.

Research Findings/Insights: We provide evidence that is consistent with the complementarity hypothesis that exposure to a

possible takeover increases rather than decreases the need for better internal governance mechanisms. Specif‌ically, f‌irms that are

exposed to takeover threats (i.e., f‌irmsinstateswithoutATSorf‌irmsthatoptoutofstates’ATS)have stronger internal governance

mechanisms (i.e., adopt a greater number of governance standards) than do f‌irms that are not exposed to takeover threats (i.e., f‌irms

in states with ATS). In a similar vein, f‌irms adopt more internal governance standards when states abolish existing ATS.

Theoretical/Academic Implications: Although prior research suggests that exposure to takeover threats reduces managerial

entrenchmentthrough its disciplinaryeffect, our study providesevidence that exposure to a possible takeover couldexacerbate

the managerial myopia problem and thatf‌irms mitigate this problem through internal governance mechanisms. The results of

the presentstudy suggest that certain governance mechanisms(e.g., state-level ATS) aremore effective in addressingthe agency

problem in the presenceof other complementary governancemechanisms (e.g., f‌irm-level governance standards), contributing

to the growing literature that calls attention to the importance of viewing various governance mechanisms from a bundle

perspective. In addition, our study contributes to the literature with a new identif‌ication strategy. Our identif‌ication strategy

makes use of the fact that f‌irms would not be subject to the same shock from the abolition of ATS if they had already opted

out, which enables us to analyze the relation between ATS and internal governance mechanisms more accurately. This

identif‌ication strategy may benef‌it future studies that consider state-level changes in ATS to be exogenous shocks.

Practitioner/Pol icy Implications: Our study provides empirical evidence concerning the complex ramif‌ications of states’

antitakeover statutes for corporate governance that policymakers and market regulators should consider in their decision-making.

The complementarity, particularly between state-level laws and f‌irm-level board functions, may deserve better attention from

policymakers, regulators, and corporate managers.

Keywords: Corporate Governance, Antitakeover Statutes, Internal Monitoring

INTRODUCTION

In this study, we examine the relation between internal

corporate governance and the market for corporate control

(i.e., external governance) by analyzing how f‌irms’internal

governance mechanisms are related to states’antitakeover

statutes (ATS).

1

Specif‌ically, we test whether internal gover-

nance mechanisms substitute or complement the market for

corporate control embodied in states’antitakeover statutes.

Prior research analyzes the interrelatedness of different

governance mechanisms and provides mixed evidence.

Cremers and Nair (2005) examine whether the market for

corporate control and shareholder activism interact. The

authors conclude that the two governance mechanisms are

complements based on their f‌inding that public pension fund

ownership affects f‌irm value only in the presence of takeover

vulnerabilityand the market for corporate control affects f‌irm

value onlyin the presence of an active shareholder.In contrast,

Gillan, Hartzell, and Starks (2011) show that f‌irms with more

independent boards have more charter provisions and

interpret the result as evidence that powerful boards serve as

a substitute for the market for corporate control.

Guo, Lach, and Mobbs (2015) analyze the interaction be-

tween internal and external governance mechanisms using

the Sarbanes-Oxley Act as an exogenous shock. They f‌ind

that, relative to compliant f‌irms, noncompliant f‌irms reduced

*Address for correspondence: Kee H. Chung, School of Management, State

University of New York at Buffalo, Buffalo, NY 14260, USA; Tel: +716-645-3262;

E-mail: keechung@buffalo.edu.

© 2016 JohnWiley & Sons Ltd

doi:10.1111/corg.12156

468

Corporate Governance: An International Review, 2016, 24(5): 468–489

exposure to externalgovernance mechanisms by adding anti-

takeover provisions, adopting off‌icer and director protection

provisions, and reducing debt levels, indicating that internal

and external governance mechanisms are substitutes. Our

study differs from their study because we analyze how

changes in state-level antitakeover statutes affect f‌irms’inter-

nal governance mechanisms, whereas they analyze how an

exogenous shock on f‌irms’internal governance standards

exerts an effect on f‌irm-level exposures to outside disciplines

(e.g., takeover defense). Another important difference is that

we measure the f‌irm’s internal governance using 33 different

governance standards, whereas their study focuses on board

independence.

Rediker and Seth (1995) underscore the importance of

governance mechanisms as a bundle, suggesting that the

benef‌it of corporate governance in mitigating the principal-

agent problem may come from the effectiveness of a bundle

of mechanisms rather than from an individual mechanism.

The authors argue that optimal governance structure may be

determined by the cost–benef‌it analysis of different bundles

of mechanisms. In a similar vein, Aguilera, Filatotchev,

Gospel, and Jackson (2008) and Yoshikawa, Zhu, and Wang

(2014) suggest that a particular governance standard or

practice may show only an imperfect picture of the f‌irm’s

internal monitoring mechanisms and that its effect is likely

to vary across f‌irms.Our study sheds further light on whether

the f‌irm’s internal governance mechanisms are related to the

market for corporate control (i.e., external governance) using

a comprehensive measure of governance quality.

We use state-level changes in ATS as exogenous shocks in

external governance. This natural experiment enables us to

analyze the effect of external market discipline on the f‌irm’s

internal governance mechanisms witha minimal endogeneity

problem. Prior studies (Bertrand & Mullainathan, 2003;

Cheng, Nagar, & Rajan, 2005;Garvey & Hanka, 1999) analyze

the effect of the passage of a state antitakeover law on

managerial and corporate behavior. Garvey and Hanka

(1999) f‌ind evidence that the threat of a hostile takeover

motivates managers to take on more debt. Bertrand and

Mullainathan (2003) show that when managers are insulated

from takeovers, worker wages rise and overall productivity

and prof‌itability decline. Cheng, Nagar, and Rajan (2005)f‌ind

that second-generation antitakeover legislation led to lower

managerial ownership because managers could maintain the

same level of control with fewer shares. In contrast, the main

research question of the present study is whetherand how in-

ternal governance mechanisms respond to exogenous shocks

in external governance mechanisms. In particular,we propose

and test the following two competing hypotheses.

Thesubstitutionhypothesisispredicatedonthenotionthat

the need for internal governance mechanisms is greater in

f‌irms that are subject to weaker outside discipline from the

market for corporate control because the two mechanisms

are substitutes for reducing the principal-agent problem. This

hypothesis assumes that the incremental benef‌ittoshare-

holders from improved internal governance is likely to be

greater than the cost of improving internal governance for

f‌irms with weaker outside disciplines. The substitution hy-

pothesis predicts that f‌irms increase internal governance

mechanisms when states adopt new ATS and decrease inter-

nal governancemechanisms when states abolishexisting ATS.

In contrast, the complementarity hypothesis suggests that

internal governance mechanisms may act as complements

(or supplements)to the market for corporate control,i.e., f‌irms

use the former to address agency problems that might result

from an active market for corporate control. In particular, the

complementarity hypothesis underscores the managerial

myopia problemassociated with managers’riskof losing their

jobs because of a takeover and predicts that f‌irms need

stronger, not weaker, internal governance mechanisms when

they are subject to higher takeover risks. That is, f‌irms with

greater takeover risks (hence greater managerial myopia

problems) need stronger internal monitoring and control

because the marginal benef‌its of improving internal monitor-

ing and control mechanisms would be larger for such f‌irms.

The complementarity hypothesis predicts that f‌irms increase

internal governance mechanisms whenstates abolish existing

ATS and decrease internal governance mechanisms when

states adopt new ATS.

We sh ow th at f‌irms that areopen to takeover threats (i.e., f‌irms

in states without ATS or f‌irms that opt out of states’ATS)

have stronger internal governance mechanism s (i.e., adopt

a larger number of governance standards) than do f‌irms that

are not open to takeover threats (i.e., f‌irms in states with

ATS).

2

In a similar vein, we f‌ind that f‌irms adopt more

internal governance standards when states aboli sh existing

ATS. These results are consistent with the pred iction of the

complementarity hypothesis that f‌irms need strong er inter-

nal governance mechanisms when manager s face a greater

risk of losing their job because of a state’s abolition of ATS.

However, we f‌ind that state adoption of ATS does not have

a material effect on the f‌irm’s internal governa nce structure

and offer possible explanations for the result.

Although our result that f‌irms strengthen internal gover-

nance mechanismswhen states abolish existing ATS is consis-

tent with the complementarity hypothesis,we cannot rule out

the possibilitythat the result could be drivenby other reasons.

For instance, social and politicalclimates may force states and

f‌irms to improve both internal and external governance

mechanisms, resulting in increases in both governance mech-

anisms. In addition, directors may have their own concerns

about on-the-job security from takeover threats or possible

lawsuits from shareholder activists, and the abolition of ATS

may motivate directors to monitor management more

carefully by adopting stronger internal governance mecha-

nisms. To rule out these alternative explanations, we examine

whether the relation between internal governance mecha-

nisms and ATS depends on f‌irms’free cash f‌lows.

We sh ow t ha t f‌irms with large free cash f‌lows strengthen

internal governance mechanisms when they are subject to

greater takeover risks, whereas f‌irms with small free cash

f‌lows do not exhibit such behavior. Because alternative

explanations (i.e., social and political climates or directors’in-

centives associated with their own job security) do not imply

that the relation between internal governance mechanisms

and takeover threats depends upon free cash f‌lows, we inter-

pret these results as more evidence for the complementarity

hypothesis as opposed to the alternative conjecture.

As an alternative test of the complementarity hypothesis,

we analyze an event at the f‌irm level that is likely to have an

effect similar to the abolition of ATS at the state level: the

f‌irm’s decision to opt out of ATS after a state’sadoptionof

469ANTITAKEOVER STATUTES AND CORPORATEGOVERNANCE

© 2016 JohnWiley & Sons Ltd Volume 24 Number 5 September 2016