Shareholder Litigation Rights and Acquisition Decisions: Evidence from a Natural Experiment

Transcription

1 Shareholder Litigation Rights and Acquisition Decisions: Evidence from a Natural Experiment Iftekhar Hasan Fordham University and Bank of Finland ihasan@fordham.edu Marco Navone University of Technology Sydney marco.navone@uts.edu.au Thomas To University of Sydney thomas.to@sydney.edu.au Eliza Wu University of Sydney eliza.wu@sydney.edu.au 1

2 Shareholder Litigation Rights and Acquisition Decisions: Evidence from a Natural Experiment ABSTRACT This paper examines the effect of shareholder litigation rights on acquisition decisions using an experimental design that exploits the reduction in litigation threat generated by a U.S. Ninth Circuit Court of Appeals ruling. We find that firms in the Ninth Circuit states acquire larger targets and acquirer returns are lower after the ruling, especially for acquirers with poor corporate governance. Further analysis shows that the value destruction is due to managers freedom to conduct empirebuilding acquisitions with overvalued equity via inflated earnings. Overall, our findings imply that the threat of shareholder litigation significantly reduces managers incentives to make self-serving acquisitions. JEL classification: G34, K22, M41 Keywords: Shareholder litigation, corporate governance, corporate acquisitions, earnings management 2

3 1. Introduction It is well recognized in the finance literature that managers do not always make shareholder valuemaximizing acquisitions due to agency problems. Jensen s (1986) free cash flow hypothesis argues that managers have incentives to grow their firms beyond the optimal size to increase the resources under their control, Lang, Stulz, and Walkling (1991) provide empirical evidence that supports the hypothesis, and Masulis, Wang, and Xie (2007) show that managers of firms with poor corporate governance are most likely to be the ones engaging in empire-building acquisitions that destroy shareholder value. Given acquisitions are one of the largest forms of corporate investment, it is important to understand how to reduce managers incentives to pursue self-serving acquisitions at the cost of shareholder value. In this paper, we aim to address this issue by examining the effect of the threat of shareholder litigation on acquisition decisions. In the U.S., securities class action litigation provides a mechanism by which shareholders can sue management for managerial misconduct. Such lawsuit is designed to provide recourse in the event that other governance mechanisms are not effective, i.e., in firms with poor corporate governance. 1 However, there is continuing debate regarding whether shareholder litigation rights, in practice, actually serves as an effective corporate governance tool. On the one hand, prior studies find that shareholder litigation rights truly serves as an effective governance tool. For example, Ferris, Jandik, Lawless, and Makhija (2007) show that lawsuits are more likely to be filed against firms with agency conflicts, and significant improvements in corporate governance occur after a lawsuit is filed. Similarly, Houston, Lin, Liu, and Wei (2018) document that the threat of shareholder litigation encourages voluntary disclosure practices, and Appeal (2018) finds that the threat of shareholder 1 Such class action is particularly important in the U.S. as ownership is widely dispersed and hence often does not provide enough incentives for shareholders to constantly monitor the managers. For example, Crane and Koch (2018) find in their sample of U.S. firms that 95% of ownership positions are less than 2% and the top 20% owners only on average have individual positions that are 2% of the firm. 3

4 litigation incentivizes managers to implement shareholder-friendly governance provisions as managers have an incentive to pre-empt lawsuits due to the reputational penalties imposed on them in a lawsuit. 2 Following this line of thought, our managerial discipline hypothesis predicts that the threat of shareholder litigation would improve acquisition performance by reducing managers incentives to conduct self-serving acquisitions at the expense of shareholder value, since managers are aware that shareholders have the rights to file lawsuits and may do so once the selfserving acquisitions cause stock prices to fall significantly after the announcement or when financial and operational problems surface during the post-acquisition integration phase and synergies do not materialize. On the other hand, other studies find that shareholder litigation is frivolous. That is, a significant number of lawsuits are filed by plaintiffs who expect to lose at trial, but files the suit with the expectation that the defendant will settle the case to avoid the considerable costs of litigation. Various studies argue that shareholder litigation is simply a method by which shareholders and lawyers extract wealth from the defendant corporation as many lawsuits are triggered by unexpected declines in stock price (Romano, 1991; Rhode, 2004; Helland, 2006). Jensen (1993) suggests that the legal incentive to avoid lawsuits would encourage managers to minimize downside risk rather than to maximize shareholder value. Concurring with Jensen (1993), Lin, Liu, and Manso (2018) find that managers of firms facing a higher threat of shareholder litigation invest less in R&D and generate fewer patents because of the incentive to avoid lawsuits (since project failure is likely to translate into a decline in stock price (Holmstrom, 1989)) and overall pushes managers to be less innovative in order to play it safe. Built upon these findings, our wealth extraction hypothesis predicts that managers would have legitimate incentives to conduct acquisitions that minimize 2 Niehaus and Roth (1999), Fich and Shivdasani (2007), and Brochet and Srinivasan (2014) provide empirical evidence that shows lawsuits impose heavy reputational penalties on managers and directors. Agrawal, Jaffe, and Karpoff (1999) and Helland (2006) find contrasting results. 4

5 downside risk rather than maximize shareholder value. As a result, the threat of shareholder litigation is expected to be detrimental to acquisition performance. Investigating the effect of ex ante shareholder litigation risk on acquisition performance is challenging because actual litigations are often correlated with unobservable factors. In this paper, we overcome such potential omitted variable bias by exploiting the U.S. Ninth Circuit Court of Appeals ruling of July 2, 1999, In re: Silicon Graphics Inc. Securities Litigation that provides exogenous variations in the threat of shareholder litigation for a subset of firms. The reason we choose this Ninth Circuit ruling is as follows. Despite the Private Securities Litigation Reform Act (PSLRA) of 1995 passed by the U.S. Congress to make it more difficult for shareholders to file frivolous lawsuits, the incidence of securities class actions has not decreased (Choi, Nelson, and Pritchard, 2009). The Ninth Circuit Court s 1999 ruling, therefore, mandated a stricter interpretation of the PSLRA pleading standards and became a turning point in curtailing frivolous lawsuit filings. Under common law, laws are created by courts using the doctrine of precedent, requiring judges to make decisions in respect of past cases which sets a precedent for future cases. The ruling effectively discourages shareholder plaintiffs from proceeding with a legal action unless there is clear evidence of intentional managerial misbehavior. Empirical evidence shows that the ruling resulted in a 43% drop in the number of class action lawsuits in the Ninth Circuit compared to a 14% increase across other circuits (Crane and Koch, 2018). Specifically, we compare acquisition performance for US firms headquartered in the Ninth Circuit states and for firms headquartered in other states around the ruling. This strategy effectively isolates the effect of litigation risk on acquisition performance from unobservable covariates. Using completed merger and acquisition (M&A) transactions announced between 1996 and 2003 in the U.S. market, we examine the performance of such transactions for the four-year periods before and after the 1999 Ninth Circuit Court ruling. We find that, after the ruling, the five-day cumulative 5

6 abnormal returns (CARs) around the M&A announcement dates are, on average, 0.96 percentage points lower for acquiring firms headquartered in the Ninth Circuit states vis-à-vis firms in other states. We interpret these results as the reduction in litigation threat after the ruling increases the probability of undertaking value-destroying M&As. We further address the possibility of selection bias using propensity score matching in that corporate headquarters location might be chosen based on specific firm characteristics. Consistent with our baseline results, we show that managers of the treatment firms (i.e., firms headquartered in the Ninth Circuit states) make worse acquisitions compared to those of the matched control firms after the ruling, and the result is not driven by acquisitions made by high-tech firms during the techbubble around the ruling. We also show that the effect is more pronounced in deals made by acquirers with poor corporate governance, which makes sense as the threat of shareholder litigation was likely playing an important governance role in these firms before the ruling. Next, we investigate the mechanisms through which managers destroy shareholder value. First, consistent with the empire-building motives of managers we find that managers in the Ninth Circuit states start to acquire larger firms when it becomes harder for shareholders to litigate. Second, we find that after the ruling, managers in the Ninth Circuit states heavily inflate earnings in the quarter before making an acquisition. Moreover, this relationship only holds in acquisitions funded with stock, suggesting that managers were incentivized to conduct empire-building acquisitions with overvalued equity after the ruling, fuelling a spate of value destroying self-serving acquisitions. As a last test, we investigate whether the Ninth Circuit s ruling affects the likelihood of CEO replacement, especially when CEOs are engaged in value-decreasing M&As. Lehn and Zhao (2006) document that bad M&A decisions tend to increase the likelihood of a CEO being fired, in addition to their substantial effect on shareholder value. We find a reduction in the probability of CEO replacement (and forced CEO replacement) in the Ninth Circuit states compared to firms in other 6

7 states after the ruling. Moreover, the likelihood of CEO replacement is not much affected by engagement in value-decreasing M&As. This finding suggests that the increase in managerial entrenchment after the ruling is another reason in which managers in the Ninth Circuit firms are able to conduct value-destroying empire-building acquisitions. Our study contributes to the extant literature on corporate governance in the following two ways. First, we find a relation between an exogenous change in shareholder litigation rights and agency problems in acquiring firms. Many studies have examined the role of internal/external corporate governance in the context of M&As. For instance, Bryd and Hickman (1992) find in tender offers that independent boards are associated with higher bidder returns. Masulis, Wang, and Xie (2007) demonstrate that acquiring firms that have higher anti-takeover provisions exhibit announcement returns that are more negative. Krishnan, Masulis, Thomas, and Thompson (2012) report that shareholder litigation lowers the likelihood of M&A completion. Whereas the extant literature uses conventional governance mechanisms (e.g., anti-takeover provisions, board characteristics, or shareholder litigation) to depict their role in M&As, few studies exploit regulatory reforms that could affect the quality of corporate governance in an M&A setting. Second, our study extends a growing body of literature on shareholder litigation, which has documented the role of retail shareholders in corporations. Crane and Koch (2018) find that corporate ownership structures have shifted from retail shareholders to institutional shareholders since the Ninth Circuit s ruling. Chu (2018) finds that shareholder litigation decreases the loan spread because it functions as a tool for extracting wealth during bankruptcy. Hopkins (2018) documents an increase in misreporting by firms after the threat of shareholder litigation decreases. Lin, Liu, and Manso (2018) show that shareholder litigation rights discourages managers from engaging in innovation as the process of innovation involves the possibility of project failure and stock price reductions, which would give shareholders an opportunity to file lawsuits relating to a 7

8 breach of fiduciary duty. We find evidence indicating that corporate managers consider the threat of shareholder litigation in M&A decisions. The rest of the paper is organized as follows. Section 2 introduces the legal background of mergers and acquisition lawsuits. Section 3 describes the data and explains the construction of various variables used in this study. Section 4 examines the impact of the threat of shareholder litigation on acquisition decisions. Section 5 identifies the channel of value destruction and provides robustness tests, and section 6 concludes. 2. Institutional Background In this section, we first describe the various kinds of M&A lawsuits that are filed by shareholders and then provide details on the history of securities litigation reform and the specific ruling by the Ninth Circuit Court of Appeals that generates the exogenous variation in the threat of shareholder litigation Shareholder litigation in M&As Managers and directors owe fiduciary duties to their shareholders, meaning that they are legally obliged to act in the best interests of a firm s shareholders. However, due to the separation of ownership and control, managers have incentives to maximize their own interests at the expense of shareholders (Jensen and Meckling, 1976) in reality. The M&A literature documents that managers often conduct empire-building acquisitions at the cost of shareholder value (Jensen, 1986; Masulis, Wang, and Xie, 2007, Harford, Humphery-Jenner, and Powell, 2012), and one of the possible ways for shareholders to respond to such wrongdoing is to file lawsuits. In the U.S., lawsuits relating to M&As can be filed as class actions, derivative lawsuits, and other less common forms. Both class actions and derivative lawsuits are shareholder representative litigations in that a 8

9 plaintiff's law firm pursues the matter at the request of a particular named shareholder on behalf of all shareholders that are adversely affected by the company's actions. Empirical evidence shows that most of the M&A lawsuits are filed in the form of class actions. For example, Krishnan, Masulis, Thomas, and Thompson (2012) find in their sample of M&A lawsuits that 87.6% are class action suits while only 3.4% are derivative suits. 3 Similarly, Crutchley, Minnick and Schorno (2015) report that M&As and earnings management are the most commonly cited reasons for federal class action suits. For instance, a shareholder of BT Office Products filed a federal class action suit in regards to the company s overly-risky acquisition strategy that resulted in material losses for shareholders Background of the Securities Litigation Reform and the Ninth Circuit Court Ruling Prior to 1995, all types of class action litigation were governed by the same rule (Federal rules of Civil Procedure). Under this rule, shareholders were able to bring lawsuits against firms with minimal evidence of fraud. As a result, a significant portion of lawsuits with dubious merit were filed on a regular basis (Johnson, Kasznik and Nelson, 2001). These abuses imposed excessive burdens on firms and led to the birth of the Private Securities Litigation Reform Act (PSLRA). The PSLRA, enacted in 1995, introduced hurdles to curb potentially frivolous lawsuits. While the PSLRA has contributed to a less litigious environment for all firms, the pleading standards of the law, as a practical matter, was interpreted differently by various U.S. circuit courts, of which the interpretation by the Ninth Circuit Court in the Silicon Graphics case on July 2, 1999 was the most stringent. 4 The Ninth Circuit s ruling requires plaintiffs, prior to forming a 3 Shareholders prefer to bring class actions to challenge M&A transactions because derivative lawsuits involves a number of procedural hurdles and, more importantly, financial recoveries from a derivative lawsuit go to the corporate treasury rather than the shareholders. The limited use of derivative lawsuits makes the exogenous variation in shareholder litigation rights generated by universal demand (UD) laws less useful in our research setting since UD laws only impose significant obstacles in initiating derivative suits. 4 In re Silicon Graphics Inc. Securities Litigation, 183 F.3d 970 (9th Cir. 1999). The case was filed in the Northern District Court of California on behalf of the purchasers of Silicon Graphics, Inc. stock who claimed that the company made misleading statements about its performance and that corporate insiders profited from the inflated stock price. The Ninth Circuit Court of Appeals dismissed the case on July 2, 1999 as they concluded that general allegations that management received "internal reports" at odds with public statements are insufficient unless plaintiffs also plead the details of those 9

10 class, to establish that the defendant acted with deliberate recklessness in making the misrepresentation that gives rise to the claim, whereas in other circuits proving mere recklessness is sufficient. This remarkable decision was largely unanticipated (Johnson, Nelson and Pritchard, 2000) and has since applied to all the securities class actions subsequently filed with the Ninth Circuit Court. Crane and Koch (2018) document that after the ruling the number of class actions in the Ninth Circuit dropped by 43% compared to an increase of 14% across other circuits. Securities class action litigation can be brought in any of the federal circuit courts because shareholders are often geographically dispersed. However, Cox, Thomas, and Bai (2009) show that plaintiffs rarely switch the filing venue to avoid the heighted pleading standard. They find that 85% of the class action cases are filed in the circuit of the defendant corporation s headquarter, and the ones filed in out-of-home circuits are more likely to be low-value cases. This is due to two reasons: First, out-of-home circuit filings are usually consolidated into the home circuit of the defendant either by the federal legal process or by the defendant s motion to relocate the lawsuit, as it is more efficient to litigate the case where all the defendant s officers, main witnesses and documents are. Second, plaintiffs rarely seek to file in another circuit for fear of significant delays and costs involved in the litigation consolidation process. Hence, the Ninth circuit ruling essentially reduces shareholder litigation rights in firms headquartered in states in the Ninth circuit (Alaska, Washington, Oregon, Idaho, Montana, California, Nevada, Arizona, and Hawaii). Furthermore, Cox, Thomas, and Bai (2009) show that regardless of numerous efforts by the Supreme Court, the differences of pleading standards across different circuits still persist, which suggests that the effect of the ruling is likely to be long term. Overall, the ruling provides an ideal quasi-natural experiment to evaluate whether and how shareholder litigation rights may shape acquisition decisions and outcomes. reports, such as authors, recipients and particular contents contradicting the public statements. 10

11 3. Data Sources and Variable Construction 3.1. Data sources We obtain our sample of corporate acquisitions over 1996 to 2003 from the Securities Data Company (SDC) M&A database to study the post 1995 Reform period before and after the Ninth Circuit Court of Appeals ruling. We require a minimum deal value of $1 million and we include only deals where the acquiring firm controls less than 50% of the target's stocks before the announcement and owns 100% of the target's stocks after the transaction. We then obtain accounting data from Compustat, financial markets data from CRSP, and governance data from ExecuComp and Riskmetrics. To recognize a firm s historical headquarter location, we use the disclosed business address in the annual 10-K filings provided by Bill McDonald and supplement it with Compustat records when missing. 5 Our final sample consists of 3,326 acquisitions made by 1,020 acquirers Firm and deal characteristics Following the acquisition literature, we control for a vector of firm and deal characteristics that may affect a firm's acquisition decisions (variable definitions are provided in the Appendix). Our firmlevel controls include Ln (Assets), leverage, tobin's q, free cash flow, sales growth, and board governance quality. All firm characteristics are measured at the fiscal year-end prior to the acquisition announcement. Our deal-level controls include stock price runup, relative deal size, hightech deal indicator, cross-border indicator, cross-industry indicator, method of payment, and target public status. Following Jenter and Lewellen (2015), we combine multiple governance measures into a broader index of governance quality. The measures we use include CEO-Chair duality, board 5 Data is publicly available from Bill McDonald s personal webpage, K_Headers/10-K_Headers.html 11

12 independence, and the G-index. To construct the index, we split each of the governance measures into two groups, with higher values indicating better governance, and cumulate the ranks (0 1). We then divide the cumulated ranks by the number of measures available for the firm-year to obtain the governance index score. 6 Table 1 provides summary statistics. We can see that 24% of the acquisitions are made by firms headquartered in the Ninth Circuit states, which allows us to have a significant amount of treated firms in our differences-in-differences (diff-in-diff) setting. In regards to acquirer characteristics, an average acquirer in our sample has a leverage ratio of 22%, tobin s q of 2.75 and free cash flow of 4%, which is consistent with the figures reported in other recent M&A studies (e.g. Yim, 2013; Huang, Jiang, Lie, and Yang, 2014). Figures for deal characteristics show that 20% of the acquisitions are cross-border deals, 44% are cross-industry deals, and 32% are funded entirely by cash. 4. Shareholder litigation rights and announcement returns In this section we analyze the effect of shareholder litigation rights on deal announcement returns using both our full sample and a matched sample and conduct subsample tests to identify the source of value destruction Baseline results To examine how shareholder litigation threats affect acquisition performance, we estimate the following model: CAR i,t+1 = α + β (1) Treat i Post t + β (2) Treat i + γz i,t + Year t + Industry j + State k + ε i,t (1) 6 Combining different measures into a single governance index helps us to control for multiple aspects of firm governance without sacrificing sample size. It is particularly useful in the M&A setting since data on the G-index is only available until We divide the governance measure at the median rather than into terciles as in Jenter and Lewellen (2015) since CEO-Chair is a binary variable. 12

13 where t denotes year, i denotes firm, j denotes industries, and k denotes incorporation states. The dependent variable, CAR i,t+1, is the 5-day cumulative abnormal returns centered on the acquisition announcement date. Following Masulis, Wang, and Xie (2007), the abnormal stock returns are calculated by estimating the market model for each acquirer over a 200 day period ending 11 days before the announcement date (-210, -11) with the CRSP value-weighted return set as the benchmark market index. The indicator variable Treat differentiates and controls for the differences in the treatment and control group, which takes the value of one when the firm is located in states of the Ninth Circuit and zero otherwise. Post is a time dummy that equals to one for fiscal years after 1999, and zero for years from 1996 to We do not include observations from years prior to 1996 because the Reform Act in 1995 significantly affected the litigation environment governing securities class actions. β (1) is the difference-in-differences coefficient of interest for identifying the treatment effect of the Ninth Circuit ruling. We also include a set of control measures Z i,t, identified in the prior literature as the set of firm and deal characteristics that are likely to affect a firm s acquisition decisions (all variables used are provided in the Appendix). Year t and Industry j capture time and industry fixed effects respectively. Following the recent literature that examines the effects of state laws, we include firms incorporation state fixed effects, State k, and cluster standard errors by acquiring firms headquarter state in all of our regressions to account for differences in incorporation and headquarter state level laws and regulations (Gormley and Matsa, 2017; Houston, Lin, Liu, and Wei, 2018). We report the difference-in-differences estimation results in Table 2. We first report the diff-in-diff results without control variables in columns 1. We find that the coefficient estimate of Treat x Post is negative and significant at the 5% level. We then add firm-level controls and report the results in Column 2. We continue to find the coefficient estimate of Treat x Post to be negative and significant at the 5% level. Lastly, we add deal characteristics as additional controls into the model. Specifically, 13

14 we add an indicator variable to control for whether the acquisition is in the high-tech industry as the Ninth Circuit Ruling was implemented around the tech bubble in year 2000 and firms in the Ninth Circuits (especially California) had significant exposure to the tech bubble. 7 We report the results in column 3 and find that the coefficient estimate of Treat x Post to be negative and significant at the 5% level after adding deal-level controls. In terms of economic magnitudes, the coefficient estimates indicate that acquirers in the Ninth Circuit states experience a reduction of 0.96% in announcement returns compared to acquirers located in the other circuits after the ruling, which translates to a loss of $23.9 million in shareholder value for the median Ninth Circuit firm in our sample. Overall, our results lend more support to our managerial discipline hypothesis Propensity-score matched sample Next, we use a matched sample to address the possibility that corporate headquarters location might be chosen based on specific firm characteristics. We employ the propensity-score matching approach to find the closest non-treated firm for each of our treatment firms located in the Ninth Circuit states. Specifically, we randomly select a firm that is located outside of the Ninth Circuit states for each of our treatment firm (with no replacement) matched on the firm s average logarithm of total assets (size), average leverage, and average Tobins s Q ratio using data from 1996 to Moreover, we require the treatment firms and control firms to operate in the same Fama- French 48 industry. We end up with a final sample of 102 treatment firms and an equal number of matched control firms. Panel A of Table 3 shows that the treatment and control firms are well matched. The test statistics show that there are no significant differences between the treatment and control firms in the three matching variables before the ruling took place. Panel A of Figure 2 shows that there also exists a similar trend in the level of CAR between treatment and control firms 7 We further mitigate this problem by using a propensity-score matched sample that requires an exact match on Fama- French 48 industry in Section 4.2 and also conduct DID estimations after excluding all high-tech firms in the matched sample. 14

15 before the ruling, suggesting that the parallel trend assumption of the DID estimation is valid. We can see from the figure that there appears to be a delayed effect of the Ninth circuit ruling due to the tech-bubble occurring at around the same time as the ruling. We control for this systematic event in all our regression models by using an indicator variable to control for whether the acquisition is in the high-tech industry or not. Using the matched sample, we first conduct a baseline difference-in-differences test to reaffirm that a reduction in the threat of shareholder litigation affects acquisition performance. Panel B of Table 3 shows the results. Consistent with our prior finding, results in Columns 1 and 2 show that after the ruling, acquisitions conducted by firms located in the Ninth Circuit states generate significantly lower abnormal announcement returns compared to acquisitions conducted by firms located in other states. We find that the economic significance is stronger than those reported in the baseline regressions (2.19% vs 0.96%) after removing systemic differences between the treatment and control group. We also conduct placebo tests using an extended sample period from 1996 to 2015, and with the exception of 1999 and 2000, we find no evidence of a similar effect if we use any other (placebo) year between 1996 and 2015 as our treatment year (unreported, but available upon request). Using a matched sample removes systemic differences between the treatment and control group, but one potential concern that remains is that acquisition performance may not be changing in response to the ruling but rather to some other event that happened around the same time as the ruling and affects our treatment firms more than our control firms. As mentioned before, one of these significant events could be the tech bubble. Specifically, firms in the West Coast (especially California) had significant exposure to the tech bubble and hence one may argue that the deterioration in acquisition performance around the tech bubble for our treatment firms, as shown as Panel A of Figure 1, was due to the tech bubble rather than the Ninth Circuit ruling. Hence, to 15

16 further rule out this concern, we remove all high-tech acquirers from the sample. Panel B of Figure 1 plots the average CARs experienced by the treatment and matched control firms not in the hightech industry, and it can be clearly observed that the level of CAR significantly deteriorates for the treatment firms around 1999 to 2000 compared to the control firms due to the Ninth Circuit ruling. In addition, we conduct DID estimations after excluding acquirers in the high-tech industry and find that our previous finding holds despite the significant drop in sample size, as shown in Columns 3 and 4 of Table Subsample tests Next, we conduct cross-sectional tests to identify the types of firms that end up making more value destroying deals upon the easing of litigation threats. Shareholder litigation is designed to provide recourse in the event that all other governance mechanisms fail. This governance mechanism is unlikely to be needed in firms with good corporate governance, since through constant monitoring the board of directors and institutional blockholders are able to identify and exert disciplining to prevent the managers from conducting self-serving acquisitions. In contrast, we expect the threat of shareholder litigation to play a very important governance role in firms with poor corporate governance since without an adequate level of monitoring managers in these firms have the incentive to conduct self-serving acquisitions, and one of the only ways to prevent the managers from doing so is through the threat of shareholder litigation. Therefore, we expect that the valuedestroying acquisitions conducted by firms in the Ninth Circuit after the ruling are more likely to be conducted by firms with weaker corporate governance standards. To test this hypothesis, we conduct DID estimations conditional upon standard proxies for firms corporate governance quality. Following the literature, we measure the quality of corporate governance using the G-index and the degree of institutional monitoring. 16

17 The first proxy we use to measure the quality of corporate governance is the G-index, first introduced by Gompers, Ishii, and Metrick (2003). The G-index is based on 24 anti-takeover provisions and higher index levels correspond to worse corporate governance. Masulis, Wang, and Xie (2007) find that acquirers with more antitakeover provisions are more likely to conduct empirebuilding acquisitions that destroy shareholder value. Hence, we follow Masulis, Wang, and Xie (2007) and use the G-index as a measure of corporate governance. We classify firms as having a higher (lower) quality of corporate governance if the firm has a G-index score of 9 or lower (above 9). Rows 1 and 2 of Table 4 presents the results. We find that the value destruction comes from firms with a higher G-index, as managers in these firms located in the Ninth Circuit States are likely to have the freedom to conduct self-serving acquisitions after the ruling. The second proxy we use to measure the quality of corporate governance is institutional monitoring. Recent evidence shows that institutional investors play a significant role in corporate governance. Aggarwal, Saffi, and Sturgess (2015) show that institutional investors value their votes and use the proxy process to affect corporate governance, McCahery, Sautner, and Starks (2016) find that 45% of surveyed institutional investors have had private discussions with corporate boards outside of management s presence, and Liu, Low, Masulis, and Zhang (2018) find that institutional investors monitoring strengthens board oversight. We measure institutional monitoring as the number of institutional owners (blockholders) that hold more than 5% of the firm s shares, as it is expected that institutional investors who own a larger portion of the firm would have more incentive and ability to discipline managers. Columns 3 and 4 of Table 4 show these results. We find that the value destruction is concentrated in acquirers with a lower number of blockholders. 17

18 5. The underlying mechanism 5.1. Empire-building with overvalued equity Mergers and acquisitions and earnings management are the two most commonly cited reasons for federal class action suits (Crutchley, Minnick, and Schorno, 2015), and studies have found that they go hand-in-hand with each other. For example, Louis (2004) shows that acquiring firms often overstate their earnings in the quarter before a stock swap announcement in an attempt to boost their stock price, and Gong, Louis, and Sun (2008) find that acquirers who manipulate earnings before stock offers are more likely to subsequently attract lawsuits. We expect, with a reduction in the threat of shareholder litigation, managers in firms that are incorporated in the Ninth Circuit states would have the freedom to manipulate earnings upwards before acquisitions to boost the stock price and then use the overvalued stock to fund empirebuilding acquisitions. The managers also are not afraid to lose control of their empire by paying with stock because most of these managers are employed by firms with poor corporate governance (as shown in Table 4) and shareholders have very little power in poorly governed firms. Our view is shared by Jensen (2005) who suggests that the enormous amount of value destruction for acquirers can be explained by the agency costs of overvalued equity, which is also empirically shown in Moeller, Schlingemann, and Stulz (2005) who find that the large loss bidders have significantly higher market-to-book ratios and are more likely to finance their deals with equity. To test our predictions, we first test whether managers in the Ninth Circuit states are more likely to conduct larger acquisitions and use equity financing after the Ninth Court ruling. We measure acquisition size with relative deal size and define an acquisition as equity financed if 80% or more of an acquisition is funded by stock. Table 5 shows the results. In column 1 we show that indeed managers in the Ninth Circuit states start to acquire larger firms after it becomes harder for 18

19 shareholders to litigate, and in column 2 the results from the logit model show that the managers are also more likely to use equity financing. Second, we examine acquirers earnings management by obtaining the quarterly financial data from Compustat to estimate the level of abnormal accruals for acquirers in the quarter before deal announcements using the modified Jones model (Jones, 1991; Dechow, Sloan, and Sweeney, 1995). Our sample size shrinks dramatically due to missing quarterly values for variables required to calculate abnormal accruals. Table 6 presents the results. We find that managers in the Ninth Circuit states significantly manage earnings upwards in the quarter before acquisitions after the Ninth Circuit ruling compared to firms in other states and this relationship holds only in stock offers. Overall, these findings suggest that managers are granted the freedom to conduct self-serving acquisitions with overvalued equity after it becomes harder for shareholders to litigate. In order to confirm that the stock-financed acquisitions are value destroying self-serving acquisitions, we further examine the effect of shareholder litigation threat on acquisition performance for allcash deals and stock financed deals separately. To rule out that the stock financed acquisitions may yield a lower CAR not because of the self-serving nature but because of the market s anticipation of overvalued equity used in stock offers for the Ninth Circuit firms, we also examine the change in operating performance for the acquiring firms around the deal announcement. Specifically, we follow Harford and Schonlau (2013) and use the difference in (Fama-French 48) industry-adjusted ROA in year t+2 compared to year t-1 to capture the change in operating performance since it may take longer than one year to fully reflect the transformation. Table 7 shows that the indeed the value destruction comes primarily from stock financed deals. Overall, our results indicate that the freedom of managers to conduct self-serving acquisitions with overvalued equity via inflated earnings is responsible for the shareholder value destruction. 19

20 5.2. Probability of CEO turnover Lehn and Zhao (2006) document that bad M&A decisions tend to increase the likelihood of a CEO being fired. However, our results show that the threat of being fired is unable to stop CEOs from conducting value-destroying empire-building acquisitions. We conjecture that this is because a reduction of litigation threat increases managerial entrenchment which lowers the chances of being fired, which is consistent with Appeal s (2018) finding that a reduction in shareholder litigation rights allow managers to adopt classified boards, supermajority voting requirements, and poison pills. To investigate whether the Ninth Circuit s ruling affects the likelihood of CEO replacement, especially when CEOs are engaged in value-decreasing M&As, we merge our sample of acquirers with the Execucomp database to examine their probability of CEO turnover around the Ninth Court ruling from 1996 to We obtain CEO turnover and forced CEO turnover data from Professor Andrea Eisfeldt s website. Forced CEO turnovers were identified based on news stories published in Factiva. 8 Table 9 shows the logistic regression results. In column 1, we find a reduction in the probability of CEO replacement for firms in the Ninth Circuit states compared to firms in other states around the ruling, and in column 2 we show that the likelihood of CEO replacement is not much affected by engagement in value-decreasing M&As. Furthermore, we examine forced CEO turnovers in Columns 3 and 4 and we find similar results. Overall, these findings suggest that the lower threat of being fired after the ruling is another reason in which managers in the Ninth Circuit firms are able to conduct value-destroying empire-building acquisitions. 8 CEO-replacement information is from Professor Eisfeldt s website ( See Eisfeldt and Kuhnen (2013) for a detailed explanation of the information collection process. 20

21 5.3. Robustness tests We conduct three additional robustness tests, and report the results in Table 9. First, we control for the staggered implementation of universal demand laws as they have been shown to affect acquisition performance (Chu, 2018). Column 1 of Table 9 shows the results. We find that the estimated coefficient of Treat x Post is of similar magnitude to those in the main analysis and remain statistically significant at the 5% level. Second, we further control for other legal changes related to shareholder litigation and antitakeover provisions to ensure that these changes are not driving our results. Following Karpoff and Wittry (2018), we control for various state antitakeover laws including control share acquisition laws, business combination laws, fair price laws, directors duties laws, and poison pill laws. Column 2 of Table 9 shows the results. We continue to find that the estimated coefficient of Treat x Post is of similar magnitude and significance level to those in the main analysis with the addition of these control variables. Third, we control for whether target firms are affected by the Ninth Court ruling, since one would expect the change in managerial behavior within the target firm may also be driving our results. Our sample size shrinks significantly since cross-border deals are removed for a better comparison and acquisitions involving private targets are also removed since we cannot identify their state of operation. Column 3 of Table 9 reports the results. We continue to find the estimated coefficient of Treat x Post to be negative and significant at the 5% level. 6. Conclusion It is well recognized in the M&A literature that, in the absence of strong corporate governance, managers would have the incentive to conduct empire-building acquisitions that destroy 21

22 shareholder value. Shareholder litigation rights, a governance mechanism designed to provide recourse in the event that all other governance mechanisms fail, should then in theory play a very important external governance role in disciplining managers in these poorly governed firms and thereby increase shareholder value. However, in practice it is often found that shareholder litigation is simply a method by which shareholders and lawyers use to extract wealth from the defendant corporation as many lawsuits are triggered by unexpected declines in stock price, and this pushes managers to conduct acquisitions that minimize downside risk rather than maximize shareholder value. As a result, the threat of shareholder litigation may also be detrimental to shareholder value. In this paper, we study the effect of the threat of shareholder litigation on acquisition decisions to examine whether shareholder litigation rights are able to truly serve as a governance mechanism in preventing managers to conduct self-serving acquisitions at the cost of shareholder value. In order to establish a causal relation, we utilize the Ninth Circuit Court of Appeals ruling of July 2, 1999, In re: Silicon Graphics Inc. Securities Litigation that generates an exogenous reduction in shareholder litigation rights for firms located in the Ninth Circuit states. Based on a difference-in-differences methodology, we document that after the ruling firms located in the Ninth Circuit states experienced significantly lower deal announcement returns, especially for acquirers with weaker corporate governance. Further analysis shows that the freedom of managers to conduct empire-building acquisitions with overvalued equity via inflated earnings is responsible for the value destruction. Overall, we show that the threat of shareholder litigation serves as an important governance tool in mergers and acquisitions as it significantly reduces the incentives of managers to engage in empire-building at the cost of shareholder value. 22

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