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E-MailAiyesha Dey is Høegh Family Associate Professor of Business of Administration at Harvard Business School; and Joshua T. White is Assistant Professor of Finance at Vanderbilt University Owen Graduate School of Management. This post is based on their recent paper.
Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell; The Costs of Entrenched Boards by Lucian Bebchuk and Alma Cohen; and Reexamining Staggered Boards and Shareholder Value by Alma Cohen and Charles C.Y. Wang (discussed on the Forum here).
Few topics have received more attention in the academic literature than public corporations’ use of antitakeover provisions. Despite the voluminous literature, we still do not fully understand why managers adopt antitakeover provisions, if their use represents “good” or “bad” governance, and which of the provisions, if any, offer actual protection against takeovers (Straska and Waller 2014).
Two views, each with different implications for firm value, have emerged in the literature. The first view holds that entrenched managers implement antitakeover provisions in a value-destroying way to shield themselves from the market for corporate control (e.g., Bebchuk et al. 2008). The other view argues that firms adopt antitakeover provisions to protect innovation incentives by reducing capital market pressures (Stein 1988). However, given that the decision to adopt antitakeovers is endogenous to the firm and manager, a resolution on their implications for shareholder value is challenging. Recently, scholars have also raised the possibility that the net benefits of antitakeovers are likely to vary across firms and the circumstances of their use (Johnson et al., 2015).
In Trade Secrets Protection and Antitakeover Provisions, we examine whether and why managers strengthen antitakeover provisions by considering a setting where firms experience an unexpected shock to the threat of being acquired. Our tests exploit the staggered recognition of the Inevitable Disclosure Doctrine (IDD) by U.S. state courts over 1990-2013. The IDD restricts labor mobility by preventing employees with knowledge of trade secrets from joining a rival firm if the new position would inevitably lead to disclosing the prior employer’s trade secrets (see, e.g., Klasa et al. 2018).
The restrictions on labor mobility under the IDD provide a plausibly exogenous increase in a firm’s probability of being acquired for two reasons. First, the IDD prevents competitors from luring away knowledge workers in order to access trade secrets and/or skilled human capital. Second, the IDD increases the probability that key talent will both be retained and will not divulge valuable trade secrets after an acquisition. Both of these factors increase the attractiveness of acquiring a firm domiciled in a state that recognizes the IDD. Indeed, Chen et al. (2017) provide empirical evidence that firms headquartered in states recognizing the IDD experience a significant increase in the likelihood of being acquired. Given that state courts adopted the IDD solely to protect trade secrets of a firm in their jurisdiction and did not intend to promote takeover activity nor induce changes in firms’ governance structures, this provides an ideal setting to examine whether and how firms respond to an increased threat of takeovers.
We first ask whether managers increase antitakeover provisions to combat this increased takeover threat after their state adopts the IDD, and which specific takeover defense provisions they increase. Using a difference-in-differences design, we find evidence that firms in headquarter states that recognize the IDD upward adjust several antitakeover provisions that are specifically related to takeover defenses, as compared to firms in states that did not adopt the IDD. When we consider the individual antitakeover provisions, we find significant increases in seven such provisions: written consent, staggered boards, blank check, directors’ duties, pension parachutes, silver parachutes, and unequal voting. Examining a time trend of the changes in the years before and after the IDD adoption also indicates that the main changes in the takeover defense provisions take place within the first two years following the IDD recognition. Moreover, these results are stronger for firms with greater ex-ante employee mobility.
Two alternative motivations may drive managers’ decisions to increase takeover defenses following the IDD: (1) to protect firms’ innovation capital, particularly if such projects are still in the development stage and undervalued in the market, or (2) to preserve their private benefits, such as their management position in the company. In the next set of analyses, we examine these alternative explanations. We find support for the first mechanism. Firms that are likely to have higher innovative activity, such as those with more knowledge workers and higher levels of research and development expenses, are more likely to increase their takeover defenses. In contrast, firms with CEOs who are more likely to be entrenched (and hence more likely to preserve their private benefits), exhibit no differences in the changes in these provisions as compared to firms with CEOs with lower levels of entrenchment.
As a further confirmation of the primary mechanism driving managers’ choices, we study how the increase in antitakeover provisions correlate with future innovative outcomes by comparing long-run innovation output of firms that increase or do not increase their takeover defenses after the IDD. We find that firms increasing takeover defenses have a greater number and higher quality of patents in several years following the IDD recognition as compared to firms that did not increase takeover defenses.
Our analyses indicates that U.S. state court rulings intended to protect trade secrets by restricting knowledge worker mobility indirectly resulted in important changes in firms’ governance structures. Specifically, managers upward adjusted their level of takeover defenses to protect innovation rather than for self-serving entrenchment reasons following state court adoptions of the IDD.
The complete paper is available here.
