Academic journal article Financial Management

The Board of Directors and Dual-Class Recapitalizations

Academic journal article Financial Management

The Board of Directors and Dual-Class Recapitalizations

Article excerpt

This paper examines stock price reactions to announcements of dual-class recapitalizations as they relate to characteristics of the board of directors. Our results show that certain board characteristics provide insight into directors' incentives. We differentiate characteristics of the board that are associated with management attempts to entrench its position and characteristics that may indicate an attempt to improve performance of the firm in the event of a takeover. We find that high levels of insider and affiliated outsider stock ownership, board tenure, and the presence of staggered board elections affect the stock market's reaction to these plans.

A persistent debate in the finance literature concerns the benefits of shareholder-approved issues of dual classes of common stock. According to one hypothesis, shareholders approve the creation of a second class of stock because it gives management more negotiating power in the event of a takeover attempt. A second class allows management to extract a higher bid, and thus it serves the best interests of the shareholders.(1) This hypothesis views the dual-class recapitalization as optimal recontracting that is intended to create shareholder wealth. Takeover-resisting mechanisms have been shown to give target-firm managers bargaining power. As a result, target-firm shareholders experience a positive wealth effect when companies adopt them (see Jarrell, Brickley, and Netter, 1988).

We note that the resulting gains may accrue disproportionately to various constituent groups unless the firm's charter includes a "fair-price" clause that requires all shares to be purchased at an equal price. In the absence of such a clause, a takeover bidder would be expected to bid first for voting equity, which is disproportionately held by management, and second, to freeze out the holders of limited voting stock to the extent legal. Although they do not examine dual-class recapitalization, Jarrell and Poulsen (1988) find that adoption of supermajority provisions, which also give increased bargaining leverage to large blockholders of stock, leads to a small but statistically significant decrease in shareholder wealth. Fair price amendments, which typically impose a supermajority requirement unless all shareholders are offered the same price, have no such statistically significant effect.

Another view is that creating a second class of stock could allow entrenchment of an inefficient management group.(2) That is, the second class of stock can result in a redistribution of voting rights such that an inefficient management team could obtain or maintain voting control, or dilute the voting control of another group that could replace them. This is known as the management-entrenchment hypothesis. Previous studies find that mechanisms that entrench an inefficient management team are detrimental to shareholder wealth (Jarrell, Brickley, and Netter, 1988), and companies whose voting rights are controlled by a single entity can trade at a discount (Kunz and Angel, 1996). It should be noted that either explanation could describe management's motivation for a dual-class recapitalization, but which explanation is the dominant one is likely to depend on organization structure.

Empirical results on dual-class creations are mixed. Lease, McConnell, and Mikkelson (1984) examine the creation of dual classes of stock in 30 companies and find that superior voting stock trades at a statistically significant premium. In similar studies, Bhagat and Brickley (1984), DeAngelo and DeAngelo (1985), Meeker and Joy (1980), and Megginson (1990) also document that stock with superior voting rights trades at a premium. Although the strength of this relation varies according to the study, the overall conclusion is that the market places a higher value on superior voting stock.

Partch (1987) examines announcement-period returns for a sample of 44 firms that created dual classes of stock. …

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