Officers’ fiduciary duties and acquisition outcomes

• Author: Syed Walid Reza
• Published date: 01 February 2020
• DOI: http://doi.org/10.1111/fire.12194
• Date: 01 February 2020

DOI: 10.1111/fire.12194

ORIGINAL ARTICLE

Officers’ fiduciary duties and acquisition outcomes

Syed Walid Reza

School of Management, SUNY at Binghamton,

Binghamton, New York

Correspondence

SyedWalid Reza, School of Management, SUNY

atBinghamton, 4400 Vestal Parkway E, Bingham-

ton,NY 13902.

Email:sreza@binghamton.edu

Abstract

Using a Delaware case law that recognized officers’ distinct fidu-

ciary duties for the first time in 2009, I examine the effect of offi-

cers'fiduciary duties (OFDs) on corporate acquisitions. I find that

firms with entrenched officers prior to 2009 experienced increased

announcement-period abnormal stock returns, mainly because their

acquisitions created more synergies and reduced officers’ incentives

to preserve control. These firms increased liability insurance pre-

mium expenditures, but reduced value-decreasing acquisition fre-

quencies. Furthermore, the effect of OFDs is more pronounced in

firms where officers are not directors, have wealth risk, face less

product market competition, are insulated from the market for cor-

porate control, or are able to avoidboard monitoring. Overall, OFDs

are a critical corporategovernance mechanism that works in tandem

with other disciplinary mechanisms.

KEYWORDS

agency costs, corporate governance, mergers and acquisitions, offi-

cers’ fiduciary duties

JEL CLASSIFICATIONS

G30, G34

1INTRODUCTION

Fiduciaryduties for CEOs and senior executives (henceforth jointly referred to as “officers”), together with shareholder

lawsuits, are considered one of the corporate governance mechanisms that align the interests of officers and share-

holders (Becht, Bolton, & Röell, 2003). Yet the literature on officers’ fiduciary duties (OFDs) has receivedvery little

attention. Johnson and Millon (2005) and Thomas and Wells (2011) argue that corporate officers in the United States

often hold corporate board memberships for which theyowe fiduciary duties in their capacity as directors, so a lawsuit

against a board for the breach of fiduciary duties generally includes officers. This overlapping responsibility of corpo-

rate officers restrained the need to developa separate theory of OFDs and left the legal role of officers unrecognized.

As a consequence, most public firms provided their officers in-house legal counseling in their capacity as directors, but

not in their capacity as officers (Garvis& Johnson, 2009). This omission caused officers to underestimate their personal

liability exposure.

Financial Review.2020;55:91–119. wileyonlinelibrary.com/journal/fire c

2019 The Eastern Finance Association 91

92 REZA

A recent Delaware case law has revived our attention byelucidating officers’ distinct fiduciary duties.1In Gantler v.

Stephens (2009), the Delaware Supreme Court held that officers owe the same fiduciary duties of care and loyaltyas do

directors.2Such ratification is legallyimportant because officers are not eligible for exculpation for monetary damages

for breach of fiduciary duties as are directors. In addition, officers do not enjoy protections of company indemnifica-

tions or the coverageof liability insurance for breach of loyalty.3Consequently,officers are liable for court settlements,

substantial attorney fees, and bear the risk of unemployment or underemployment for wrongful conduct. By improv-

ing the corporate governance structure, this court decision (the Rule) reduces conflicts of interest between officers

and shareholders, especially at firms where officers are entrenched, or equivalently,firms where officers are relatively

protected from market discipline. This leads to the following hypothesis on OFDs: Since the Rule increases their liabil-

ity exposure and awareness of fiduciary duties, ceteris paribus, entrenchedofficers are less likely to consider value-decreasing

corporate decisions after the court ruling on OFDs.

Employing this 2009 legal event as a natural experiment, I evaluate the importance of OFDs on the efficiency of

major corporate investment decisions. Specifically,I compare the merger and acquisition (M&A) performance of firms

with entrenched officers to that of firms with nonentrenched officers before and after the court ruling on OFDs.

Because it is widely regarded as an indisputable form of entrenchment, I use the presence of a classified board to mea-

sure whether a firm has entrenched officers (see, e.g., Faleye, 2007; Kadyrzhanova & Rhodes-Kropf,2011). I also use

board co-option, CEO tenure, and product market competition asalternative measures of entrenched officers.

Iexpect M&A transactions to provide the cleanest and strongest test of the court ruling on OFDs for several reasons.

First, they are among the largest corporate investmentdecisions where transaction data are a matter of public record.

Second, acquisitions are long-term discretionary investments that intensify the agency conflicts between officers and

shareholders. Third, officers’ liability exposure from violation of fiduciary duties in M&A transactions should be rela-

tively substantial compared to their personal wealth. I also expect the court ruling to affect all firms with entrenched

management regardless of their state of incorporation, because a majority of states (a) model their corporate laws

on the precedents set by Delaware and (b) do not extend exculpatoryprotections to officers, similar to Delaware.4,5

Moreover,this ruling was one of the rare cases where the Delaware Supreme Court reversed and remanded the Court

ofChancery's dismissal of claims against the defendant officers and directors, instigating considerable debate and anal-

ysis about the Rule's implications within the legal community. Therefore, it is likelythat M&A legal counselors would

advise CEOs, CFOs, and senior executivesof firms across all states about officers’ heightened level of personal liabil-

ity after the Rule. This line of reasoning is similar to Edmans, Fang, and Zur's (2013, p. 1443) view that the “threat of

governance, not just actual governance,can discipline [officers].”

Using a sample of 1,441 M&A transactions (including 499 transactions after the Rule), I find that firms with

entrenchedofficers experience greater acquisition efficiencies after the legal event than firms without entrenched offi-

cers. Specifically, acquisitions initiated after the court decision by firms with classified boards generatean additional

1.5% abnormal bidder stock return. For the average(median) acquirer with a classified board, this increased abnormal

stock return corresponds to a gain of $77 ($40) million in shareholder value. This result is obtained after controlling

for time-variant deal features, firm characteristics, and year effects as well as time-invariant industry and firm effects,

1Fromtime to time, Congress, the Security and Exchange Commission, the NYSE, and the NASDAQ have also imposed rules on the functions of officers and

directors.However, these rules either do not distinguish the duties of officers and directors or are imposed at the same time, making it difficult to identify the

significanceof OFDs.

2Thecourt ruling is available at https://courts.state.de.us/opinions/download.aspx?ID=116710.AlthoughDelaware court clarified OFDs in Gantlerv.Stephens,

it is yet to decide whether officers should be more exposed to liability for breach of fiduciary duties than corporate directors (Hampshire Group,Limited v.

Kuttner,2010). There is also an ongoing unresolved academic discussion on this issue (see, e.g., Hamermesh & Sparks, 2005; Johnson & Millon, 2005).

3An exculpatoryagreement excludes officers or directors from the legal liability (e.g., compensation to shareholders) after they have caused some damages,

whereas an indemnity agreement coverstheir liability when sued by shareholders. Directors, like officers, also do not enjoy coverage of indemnifications or

liability insurancefor breach of loyalty. However, the business judgment rule provides a strong line of defense to independent directors, making it extremely

difficultfor shareholders to prove disloyalty (Becht et al., 2003). Further, it was uncertain after the Gantler case whether the protections of business judgment

rulewould be extended to company officers (Thomas & Wells, 2011).

4Forexample, Romano (2006) notes that vast majority of states adopted Delaware's version of limited liability charter amendments within a short period of

time.

5Sevenstates that allow exculpatory provisions for officers are Louisiana, Maryland, Nevada, New Hampshire, New Jersey,Utah and Virginia (Follett, 2010).