Does takeover activity cause managerial discipline? Evidence from international M&A laws UGUR LEL and DARIUS P. MILLER* This draft: July 2012 Abstract The staggered initiation of takeover act across countries offers a natural experiment to examine the causal effects of the market for corporate control on managerial discipline. The passage of M&A laws increased the threat of takeover, causing a significant increase in the level of M&A activity. Exploiting this exogenous source of variation in the threat of takeover, we show that the propensity to replace poorly performing CEOs increases following the enactment of M&A laws. Taking advantage of differences in legal protection and firm-level internal governance as a second source of variation, we also show that this increased sensitivity of CEO turnover to performance depends on availability of internal governance mechanisms as substitutes. Managerial discipline is positively related to the threat of takeover in countries where internal firm level governance mechanisms are weakest. Keywords: threat of takeover, managerial discipline, mergers and acquisitions laws, corporate control JEL Classifications: G34, G38, K22 * Lel is from Pamplin College of Business at Virginia Tech and Miller is from Edwin L. Cox School of Business at Southern Methodist University. We would like to thank Mark Carey, Kasper Nielsen, and participants at the Federal Reserve Board, George Mason University, National University of Singapore, Nanyang Technology University, Rutgers School of Business, Texas A&M University, University of Georgia, University of Kansas, University of Oregon, and Virginia Tech for helpful comments. All errors are our sole responsibility. 0 Electronic copy available at: http://ssrn.com/abstract=1730316 Does takeover activity cause managerial discipline? Evidence from international M&A laws Theory suggests that the threat of takeover is one of the most important external mechanisms for aligning the interests of managers and shareholders.1 Not surprisingly, a large empirical literature in corporate finance analyzes the effects of takeover activity on managerial discipline. However, this literature has not been successful in establishing whether an active market for corporate control enhances managerial discipline and often finds mixed results. Partly, this is because many studies rely on sources of variation in the threat of takeover that can generate serious endogeneity and omitted variable biases. For example, tests that employ the mean level of takeover activity as a proxy for the threat of takeover suffer from potential omitted variable biases since overall takeover activity is likely to be accompanied by contemporaneous macroeconomic shocks that could jointly explain management turnover (Mikkelson and Partch (1997)). Further, tests that employ takeover defenses as a proxy for takeover threats suffer from endogeneity concerns as they are often established at the discretion of the firm (Comment and Schwert (1995), Gompers et al. (2003)). To establish whether the market for corporate control improves corporate governance, we exploit a natural experiment that significantly increased the threat of takeover through the staggered initiation of takeover acts.2 Takeover acts are laws that are passed specifically to foster takeover activity by reducing barriers to M&A transactions, encouraging information dissemination, and increasing minority 1 See, for example, Scharfstein (1988) and Hirshleifer and Thakor (1998). 2 Staggered law changes are widely used as an instrument in U.S. and international empirical research (see, e.g., Bertrand and Mullainathan (2003), Cornelli, Kominek, and Ljungqvist (2010)). 1 Electronic copy available at: http://ssrn.com/abstract=1730316 shareholder protection. These laws avoid the endogeneity and omitted variable problems to the extent they are passed by countries and not endogenously driven by firm specific conditions. Despite their advantages, it is important to recognize the political economy of these laws in that they may have been passed because of contemporaneous economic conditions and/or lobbying by the firms themselves. We show in a battery of robustness test that the data do not support these as well as other alternative interpretations. Our international setting also allows us to exploit a second source of variation to further ensure we identify the effects of M&A laws: cross-country differences in legal protection. Prior research shows that when country level investor protection is poor, firm level governance mechanisms are generally unavailable or prohibitively expensive (e.g., Bergman and Nicolaievsky (2007), Doidge, Karolyi, and Stulz (2007)). Therefore, if the threat of takeover causes managerial discipline, the initiation of M&A laws should have a larger governance impact in countries with weak investor protection laws, since alternative governance mechanisms at the firm level are less prevalent. Therefore, our cross-country analysis also enables us to provide unique evidence on the ability of internal governance mechanisms to substitute for the external market for corporate control, a central question in the literature that remains unresolved (see, e.g., Mikkelson and Partch (1997), Huson, Parrino and Starks (2001)).3 In this way, our experiment also allows us to provide new evidence on the corporate governance effects of cross-border M&A activity and their implications for the desirability of corporate governance reform, 3 In contrast, U.S. firms are recognized to have relatively optimal internal governance mechanisms at their disposal because of the U.S.’s high financial and economic development and strong investor protection (Aggarwal et al. (2009)). 2 as M&A laws significantly increase cross-border M&A activity (see, e.g., Bris and Cabolis (2008a), Ferreira et al. (2010)). Our proxy for the effectiveness of managerial discipline is the propensity to replace poorly performing CEOs. Replacing poorly performing CEOs is argued to be a necessary condition for good corporate governance (Shleifer and Vishny (1989, 1997)), and the sensitivity of top executive turnover to performance as a measure of the quality of corporate governance has been supported by a large number of studies in the U.S. and abroad, including recent research by Dahya, McConnell, and Travlos (2002), Volpin (2002), Gibson (2003), DeFond and Hung (2004), and Aggarwal, Erel, Ferreira, and Matos (2011).4 To explore the causal effects of an increase in takeover threats and managerial discipline, we examine changes in the propensity to fire poorly performing CEOs around the time laws that increase the threat of takeover are passed. We employ a difference-in- difference methodology that measures CEO turnover surrounding the exogenous shock to takeover threat. This allows us to eliminate any fixed differences between countries passing laws and those not passing laws at different points in time. Our sample includes about 11,500 firm-year observations from 12 countries that passed a takeover law over the 1992 to 2003 time period. Using this natural experiment, we find strong evidence that the enactment of M&A laws increases the sensitivity of CEO turnover to poor firm performance. To the best of our knowledge, these findings represent the first evidence of a causal link between the threat of takeover and managerial discipline. We also find that the increase 4 For U.S.-based studies see Hermalin and Weisbach (2003) and citations contained therein. 3 in managerial discipline caused by the initiation of M&A laws is strongest in countries with weak investor protection laws. Therefore, our findings document the important role of M&A activity in ensuring good corporate governance outcomes in countries where firm level governance mechanisms are unavailable or prohibitively expensive. Further, our results show that in countries with strong investor protection laws, the threat of takeover does not increase the propensity to terminate poorly performing CEOs. In this way, we provide evidence that internal governance mechanisms, when available, can be an effective substitute for the external market for corporate control. Our findings survive a number of specification and robustness tests. For example, our identification strategy assumes that M&A laws increase the threat of takeover. The data supports this assumption as we show that after the passage of these laws, M&A activity increases significantly, and more importantly, poorly performing firms are more likely to be acquired. We also allay concerns about the effect of lobbying (or reverse causality) on our results by estimating our primary models in event time surrounding the passage of the international M&A laws. To reduce the chance that our instrument is picking up the effect of another contemporaneous shock besides M&A laws, we control for the issuance of country-wide corporate governance recommendations. We also use institutional ownership to control for potential changes in firm-level governance environment (Aggarwal et al. (2011)). We investigate the influence of large blockholders, full acquisitions by foreign investors, and follow Bertrand, Duflo, and Mullainathan (2004) to perform placebo law estimations to verify our corrections for the presence of serial correlation in the data. In all instances we find 4 that our results continue to hold. We also take into account the nonlinear nature of discrete choice models in computing interaction effects (Ai and Norton (2003)). In our analysis, we also consider the possibility that some