Payments to executives of target firms in mergers : tests using newly-available data *

Using data available as a result of a 2006 change in Securities and Exchange Commission reporting requirements, we document how large the change-in-control payments to executives of target firms are in total. For a sample of firms listed in the S&P small-cap 600 index in 2009, the average (hypothetical) change-in-control payment is 2.2% of target-firm market capitalization. Controlling for endogeneity, we find a positive association between change-in-control payments and firm value. Furthermore, firms that are eventually acquired have change-in-control payments that are statistically indistinguishable from those firms that do not become targets. Overall, our conclusion from this study of total change-in-control payments to named executive officers is that such payments appear to be reasonable, not overly punitive to target shareholders, and do not appear to impede the takeover process. * Preliminary and incomplete – please do not quote. 1 “Accelerated equity awards along with substantial pensions and other deferred compensation all but guarantee significant payouts at many of America’s largest corporations in every termination situation. ” Introduction Until recent (2006) changes in Securities and Exchange Commission (SEC) reporting requirements, outsiders have had scant detail of what is arguably the most important component of change-in-control payments to CEOs: accelerated vesting of equity (options and restricted stock), tax gross-ups, and accelerated vesting of performance awards. In fact, the existing academic literature on change-in-control payments is almost exclusively focused on golden parachutes paid to departing target CEOs (cash awards, usually as a fixed multiple of the CEO’s final salary). However, for the median named executive officer in our sample, a golden parachute represents only 44% of the value of benefits conferred upon the executive around a change-in-control transaction. This suggests that the existing literature ignores a potentially important component of these critical, and criticized, change-in-control payments to executives. In this paper, we take advantage of recent changes in SEC disclosure requirements to document how large change-in-control payments to target executives are in total, not just golden parachutes. The extant literature establishes benchmarks for the size of the golden parachutes for all executives within a given firm. For example, Lambert and Larcker (1985) estimate that at the median in their sample the sum of the (present) value of golden parachutes to the top executives in a given firm is 0.97% of a firm’s market capitalization. Machlin, Choe, and Miles (1993) find that between 1975 and 1988 the average value of executive golden parachutes is 2.98% of the market value of the target, while Lefanowicz, Robinson, and Smith (2000) estimate it to be 2.2% for firms acquired over the period from 1980-1995. However, as noted above, golden parachutes 1 From “Twenty-One U.S. CEOs with Golden Parachutes of More Than $100m,” GMI Ratings, January 2012. 2 comprise less than half of the median total change-in-control payments made to target managers in acquisitions. Therefore, we address the issue of whether considering the totality of change-incontrol payment alters one’s opinion about the size of such payments and their likely affect on the market for corporate control. Ceteris paribus, shareholders would like to transfer the smallest possible portion of the value of the firm to the managers in an acquisition. Consequently, the portion of the proceeds kept by the target’s managers is sometimes referred to in the literature as a tax on the shareholders, a pejorative term that suggests a deadweight loss. In this paper, we focus on the change-in-control payments made to the top five officers of the firm – known as the Named Executive Officers (NEOs) – and refer to the payments to these individuals as the “NEO tax. ” The term NEO tax is used for convenience, and is not intended to be construed as inherently negative. Just as taxes bring value to a community via roads and schools, an NEO tax may bring value to shareholders via a higher takeover premium. Until recently, it was not possible to calculate the NEO tax because firms were not required to disclose the amounts that would be paid to managers upon a change-in-control. Beginning in 2006, the SEC mandates that companies listed in the United States disclose the dollar amount and form of such potential payments. To be clear, all active firms are now required to list all potential payments to their NEOs upon a change-in-control. The NEO tax calculations in this study are based on the hypothetical payments disclosed by firms pursuant to this rule change, not the actual payments made in takeovers. Furthermore, we focus on payments requiring the double-trigger of a change-in-control and termination of employment, as these are 2 Subject to the constraint that the manager’s payment is almost always in cash while the stockholders’ share of the sale proceeds is frequently paid (at least partly) in acquirer stock. 3 Lambert and Larcker (1985) and Choi (2004). 3 always as large or larger than payments requiring a single trigger, and thereby, potentially the most harmful to shareholder wealth, For a sample of firms listed in the S&P small-cap 600 index in 2009, the average NEO tax is 2.2% of market capitalization. Where there is some variance in the distribution, with the largest tax exceeding 20% of market capitalization, the vast majority of firms have a NEO tax below 3% of market capitalization. Takeover premiums increase the value of change-in-control payments made to NEOs because premiums increase the value of (vested) options and restricted stock. However, adjusting for the effects of a presumed 46% takeover premium on the changein-control payments to NEOs generates an increase in the NEO tax to an average of just 2.8% of the pre-deal market value of equity. In addition, the median NEO tax is considerably lower: only 2% including the effect of a takeover premium. As a form of incentive compensation designed to properly align the incentives of the managers with those of the shareholders in an acquisition, the mean (and much-lower median) aggregate NEO taxes documented here appear to be reasonable and not overly punitive to target shareholders. Controlling for endogeneity, we find a positive association between the NEO tax and firm value (measured using the market-to-book ratio). Moreover, firms that are eventually acquired have NEO taxes that are statistically indistinguishable from those firms that do not become targets, suggesting that NEO taxes of the magnitudes presented in this paper do not deter takeover offers or acceptances by shareholders. While NEOs appear to receive about 26% greater change-in-control payments (at the median) in the event of takeovers than reported in SEC filings prior, such payments do not appear to intervene in the takeover process. Overall, our conclusion from this study is that assessing the effect of the total change-in-control payments to named executive officers (as opposed to just the effect of golden parachutes) still leaves the