Poison pills, anti-greenmail, classified boards, golden parachutes … Those are just some of the colorfully named corporate techniques devised over the years to keep barbarians from the gate. Corporate boards have long adopted such techniques to stave off hostile takeovers and other attacks by outsiders, arguing that shareholders are better served by stability – that change is best guided by insiders. And yet, shareholders’ organizations have generally decried such techniques. Anti-takeover defenses, they say, are really meant to protect, or “entrench,” bad executives, preventing the better stock performance that can follow change, even if instigated by uninvited outsiders. Who is right? So far, the research indicates the shareholders’ groups have it right, says Wharton finance professor
Poison pills, anti-greenmail, classified boards, golden parachutes … Those are just some of the colorfully named corporate techniques devised over the years to keep barbarians from the gate.
Corporate boards have long adopted such techniques to stave off hostile takeovers and other attacks by outsiders, arguing that shareholders are better served by stability – that change is best guided by insiders.
And yet, shareholders’ organizations have generally decried such techniques. Anti-takeover defenses, they say, are really meant to protect, or “entrench,” bad executives, preventing the better stock performance that can follow change, even if instigated by uninvited outsiders.
Who is right?
So far, the research indicates the shareholders’ groups have it right, says Wharton finance professorAndrew Metrick, co-author of a recent paper, Corporate Governance and Equity Prices, with Paul A. Gompers, professor of business administration at Harvard, and Joy L. Ishii of the Harvard Economics Department. “For whatever reason, the economic conditions of the ‘90s were very good – much better than expected – for companies that had very strong shareholder rights,” Metrick said.
During the 1990s, companies deemed the most shareholder-friendly enjoyed average annual returns 8.5 percentage points higher than those of the most anti-shareholder firms, the study found. Put another way, said Metrick, pro-shareholder firms beat the Standard & Poor’s 500 index by about 3.5 percentage points a year, while anti-shareholder firms trailed that benchmark by about 5 points.
Metrick notes the study is not definitive, since it only examined the 1990s and market conditions could be different in the future. Moreover, the study did not prove that having strong shareholder rights causes a company’s stock to do better. The level of shareholder rights and stock prices could each be influenced by other factors.
Nonetheless, the study, especially when seen in the light of other research, does appear to support the views, long held by shareholder rights groups, that poison pills and other anti-takeover defenses undermine stock returns, he said.
Metrick and his colleagues rated 1,500 companies for each year of the ‘90s on a “Governance Index” which gave equal weight – one point, or “G” – to each of 24 shareholder-rights provisions. Among the best known:
- Poison pills: These are special rights given to all shareholders other than those involved in unwanted, or “hostile” takeovers. Typically, they confer the right to buy more shares at deep discounts during takeover battles. The flood of new shares would dilute the value of the shares owned by the hostile bidder, making a takeover prohibitively expensive.
- Anti-greenmail: These prohibit the company from paying a premium, or above-market price, to buy out a large shareholder threatening a takeover. By preventing the payment of greenmail, the provision removes one incentive for a hostile individual or group to acquire a large block of shares.
- Classified Board: Also called a staggered board, this gives directors overlapping terms, making it impossible for hostile shareholders to replace the entire board at once.
- Golden parachutes: These are generous severance payments to senior executives who are fired or demoted after a takeover.
- Supermajority: These rules require that changes in control be approved by more than a simple majority of shareholder votes. Typically, they require 66.7, 75 or 85% approval.
- Unequal voting rights: These give some shareholders stronger voting rights than others. They might favor shareholders with large blocks, or people who have owned their shares a long time.
At individual companies, the authors say, such provisions can be used to shareholders benefit by giving executives leverage to demand higher share prices from prospective acquirers. But defenses work against shareholder interests when they are used to protect bad executives.
To determine which effect was most common in the ‘90s, the authors used data on governance provisions collected by the Investor Responsibility Research Center, a pro-shareholder organization. Each company was assigned one point for each provision it had in place.
The firms were then ranked by decile: The 10% of firms with the most anti-shareholder provisions – at least 14 — were in the highest decile of the index, comprising the “Management Portfolio.” Those with the least provisions – five or fewer — were in the lowest decile, the “Shareholder Portfolio.”
In 1990, for example, the largest firms in the Shareholder Portfolio included IBM, Wal-Mart, DuPont and PepsiCo, while the largest in the Management Portfolio included GTE, Waste Management, General Re, The Limited, Inc. and NCR.
In theory, an investor could have earned the entire 8.5% annual difference between the portfolios (less trading costs) by purchasing shares in the Shareholder Portfolio companies and selling short shares in Management Portfolio companies.
In addition, the study found that shareholder-friendly firms tended to have higher value as measured by Tobin’s Q, a ratio of market value to replacement cost. When Tobin’s Q exceeds 1, market value is greater than replacement cost. Generally, that means the market, in pricing the stock, sees value beyond the value of buildings, equipment and other assets – perhaps because the company is well managed or has good products.
Finally, shareholder-friendly companies tended to have higher profits, higher sales growth and lower capital expenditures, and they take part in fewer corporate acquisitions.
While all this suggests that enacting takeover defenses helps entrench managers, the research does not prove this is so, Metrick says. It could be, for example that high G is merely a symptom of powerful management, with takeover provisions enacted at firms that already have pro-management biases.
It also is possible that takeover protections were put in place in the 1980s by managers who could foresee problems in the years ahead and wanted to protect their jobs, the paper says. In that case, poor stock performance in the ‘90s was caused by business problems or market conditions, and not necessarily by poor management or the creation of takeover defenses. “Performance may have been just as bad without the additional governance provisions, and the only difference [at firms with or without the provisions] is the relative ease of blaming and firing management,” the paper says.
Metrick said his best guess is that enacting takeover defenses does help undermine stock returns. But it will take additional research to pinpoint the relationship.
For now, he adds, investors should consider high G – a lot of anti-takeover provisions – a warning sign when choosing stocks. But, he adds, it would be unwise to base an investment strategy on takeover defense data alone, because the past is not necessarily prologue.
“The study is not really giving G as an investment strategy for the next 10 years,” he said. “It’s saying what would have been a good investing strategy for the last 10 years, but they were a dime a dozen.”