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
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