Governance and innovation

Journal of Corporate Finance 17 (2011) 947–958

Contents lists available at ScienceDirect

Journal of Corporate Finance j o u r n a l h o m e p a g e : w w w. e l s ev i e r. c o m / l o c a t e / j c o r p f i n

Governance and innovation John R. Becker-Blease ⁎ Oregon State University, 200 Bexell Hall, College of Business, Corvallis, OR 97371, United States

a r t i c l e

i n f o

Article history: Received 4 November 2009 Received in revised form 31 March 2011 Accepted 8 April 2011 Available online 16 April 2011 JEL classification: G34 O31

a b s t r a c t I examine the relation between the presence of governance provisions and corporate innovation for a sample of firms between 1984 and 1997. I find a positive relation between four proxies for innovation and the broad Gompers, Ishii, and Metrick (2003) Index. However, in subsample analyses, I find that only those provisions that officers and directors actively adopt are positively related to innovation; coverage by state-level antitakeover legislation is typically unassociated or negatively associated with innovation. The evidence suggests that it is the visibility of officers and directors' actions rather than the potency of the takeover protection that best explains the observed pattern. © 2011 Elsevier B.V. All rights reserved.

Keywords: Governance Innovation Antitakeover provisions

1. Introduction A large literature has emerged over the past 25 years investigating the impact of takeover provisions on shareholders' wealth. These provisions essentially impede shareholders' ability to assert control over a firm's assets through the market for corporate control, and researchers have questioned whether the presence of these provisions, on average, is beneficial or deleterious to shareholder wealth. Broadly, the Entrenchment Hypothesis posits that managers exploit the protection afforded by takeover provisions to enjoy perquisite consumption, empire build, or shirk responsibilities. Conversely, the Shareholder Interest Hypothesis posits that the presence of takeover provisions generally benefits shareholders by providing officers and directors the ability to thwart under-priced acquisition attempts, extract the highest takeover premia for successful bids, and better align managers' investment horizons to those of long-term shareholders. In this paper, I examine one facet of this debate, namely the impact of takeover provisions on firm innovation. Shleifer and Vishny (1989) argue that one of the greatest social concerns caused by an active takeover market is that it can lead managers to reduce investment, particularly in hard-to-value areas such as research and development (R&D) and innovation. This view reflects the Managerial Myopia Hypothesis of Stein (1988), who argues that the threat of hostile acquisition can lead managers to avoid undertaking long-term risky investments because such projects can lead to a wide divergence between market and intrinsic values. Within this context, takeover provisions may shield managers from concerns related to short-term performance and permit a more long-term, value-maximizing investment strategy that encourages greater innovation. Conversely, agency theory suggests that the threat of takeover is an important deterrent against managerial self-dealing. Jensen (1988), for instance, argues that without the threat of disciplinary takeovers, managers will lack the incentives to maximize firm value. One permutation of the agency problem related to innovation is what Bertrand and Mullainathan

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(2003) term the Quiet Life Hypothesis. If the presence of takeover protection reduces the effectiveness of the external disciplinary market, then managers may exploit the opportunity to avoid difficult and risky investments, especially if these could reveal managers to be of lower quality. As a result, a firm's propensity to innovate may be negatively related to its degree of takeover protection. The extant literature investigating the relation between innovation and governance suffers from three general shortcomings. First, much of the literature relies on indirect evidence of innovation efforts such as capital expenditures or accounting-based measures such as R&D, which are subject to reporter discretion.1 Second, no evidence, of which I am aware, considers the broad portfolio of takeover provisions in the context of innovation, which ignores the potential for interactions among provisions that , Bebchuk and Cohen (2005), Bebchuk et al. (2009), and Danielson and Karpoff (1998, 2006)suggest is important. Finally, many studies fail to address the likely endogenous nature underlying the officers' and directors' decision to adopt takeover protection.2 In this study, I avoid these limitations by examining the relation between innovation and takeover protection for a sample of 23 firm- and state-level takeover provisions present during 11,340 firm-years between 1984 and 1997 and employing both direct (patents) and indirect (R&D) measures of innovation efforts. The results suggest that higher levels of the 23 takeover provisions, or G-Index, are associated with greater innovation efforts, as evidences by R&D expenditures, awarded patents, the quality of patents awarded, and the number of patents awarded per dollar of R&D. The pattern persists during both the active and inactive takeover periods of the 1980s and 1990s, to the exclusion of all non-innovative firms from the analysis, to controls for other governance features related to board composition, and to various controls for the endogenous nature of the adoption decision. Overall, these results support the Managerial Myopia Hypothesis and suggest that shareholders, on average, benefit from protection against unwanted takeovers. I next explore whether managers respond similarly to coverage by different types of governance provisions. Bebchuk and Cohen (2005), Bebchuk et al. (2009), and Danielson and Karpoff (1998, 2006) suggest that certain combinations of provisions are more potent takeover deterrents. If protection against unwanted acquisition is associated with greater innovation, then one would expect the relation to vary by the strength of the takeover protection. This hypothesis, which I term the Power Hypothesis, predicts that the relation between the number of takeover provisions present and innovation will vary based on the potency of the extant provisions. I analyze three empirically-motivated portfolios of potent combinations of provisions and find generally consistent evidence for two of them that the impact of takeover protection on innovation is greater for the more potent takeover provisions. Evidence on the third portfolio is not consistent with the Power Hypothesis. I next examine a second source of variation in the relation between governance protection and innovation based on the visibility of a firm's efforts to gain takeover protection. Comment and Schwert (1995) suggest that shareholders may perceive takeover provision adoptions as revelations by officers and directors of firm-specific information. However, the role of officers and directors in the adoption of takeover provisions differs. Specifically, officers and directors must act to adopt firm-specific provisions, but protection by state-level takeover laws occurs as a windfall. If officers and directors believe the intensity of shareholder scrutiny will vary depending upon their role in the adoption of a takeover provision, then firms may respond differently to firm-level and state-level provision adoptions. In particular, managers will perceive shareholder scrutiny to be more intense when the firm actively adopts provisions and are more likely to act in the long-term interests of the firm. Conversely, protection afforded by state-level provisions is, in essence, anonymous, and permits managers to reduce their firm-specific investments and follow the “quiet life”. I label this hypothesis the Visibility Hypothesis and test the relation between innovation and takeover provision presence for separate portfolios of firm-specific and state-level takeover provisions. The evidence is consistent with this hypothesis in that the portfolio of state-level provisions is either negatively or insignificantly related to innovation, while the overall portfolio of firmlevel provisions is positively associated with innovation. These results suggest that managers are aware of the attention that firmspecific adoption attracts and respond accordingly. This paper makes several contributions to the literature. First, it provides new evidence on the relation between overall takeover provision adoption and changes in an important component of firm value, namely innovation. The evidence supports the arguments of Shleifer and Vishny (1989) and Stein (1988) that managers use the insulation provided by takeover provision protection to invest in intangible and longer-term innovation efforts. The evidence also provides an explanation for the apparent inconsistencies in much of the literature. That is, while Bertrand and Mullainathan (2003), among others, find evidence of a deleterious impact for takeover coverage, Comment and Schwert (1995), Danielson and Karpoff (2006), and Straska and Waller (2010), among others, report positive effects. This paper provides evidence that directors' and officers' role in the adoption is a potentially important element of this investigation. The evidence also provides insights into the current debate over shareholder-sponsored efforts to limit firms' adoption of takeover defenses or to induce firms to remove extant defenses. Although initially largely ineffective (Gordon and Pound, 1993), recent evidence by Thomas and Cotter (2007) suggests that shareholder proposals targeting antitakeover defenses are increasingly successful. There is emerging evidence that the removal of takeover defenses is unnecessary if shareholders have compensated by increasing the oversight of management via the threat of proxy battles (see Mulherin and Poulsen, 1998 and Ryngaert and Scholten, 2010). This paper provides additional evidence that managers, at least, expect greater scrutiny following governance changes and respond in a shareholder-centric manner. As a result, shareholders appear to benefit along at least one dimension to the presence of firm-level takeover protection.

1 2

See, for instance, Meulbroek et al. (1990), Bertrand and Mullainathan (2003), Pugh et al. (1992), Sapra et al. (2009), and Gompers et al. (2003). Exceptions include Bertrand and Mullainathan (2003) and Sapra et al. (2009), who focus strictly on state takeover laws, which are argued to be exogenous.

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The results also speak to Lehn et al. (2007) investigation of the direction of causation between governance index values and performance. They conclude that performance dictates governance provision adoption, not vice versa. As such, low market-to-book firms are either poorly managed or lack growth opportunities and therefore officers and directors are incentivized to seek takeover protection. The innovation evidence presented in this paper suggests an alternative use of takeover provisions as either enablers of growth-seeking investments or protectors of currently unrecognized growth opportunities. Finally, the evidence of a link between governance provision protection and innovation has implications beyond the firmspecific effect. Bernstein and Nadiri (1989), for instance, find that valuable inter firm spillovers occur from technological advancements, suggesting that actions that improve one firm's ability to innovate can also aid the wider market. More generally, Romer (1990) describes how modern endogenous growth theory stresses the importance of innovation as a driver of economic growth. The evidence in this paper suggests that takeover provision protection may provide an important macroeconomic boost to innovation and economic growth. The next section of the paper reviews the literature and develops the hypotheses; Section 3 discusses the data and provides descriptive statistics; Section 4 discusses the univariate results; Section 5 describes the multivariate results and various robustness checks; Section 6 concludes.

2. Hypothesis development In this paper, I examine four related hypotheses regarding the relation between firm innovation efforts and the presence of takeover provision protection. The first two hypotheses are the competing Managerial Myopia and Quiet Life Hypotheses of Bertrand and Mullainathan (2003) and Stein (1988), respectively. The Managerial Myopia Hypothesis predicts that shareholders benefit from the presence of takeover provisions because their protection affords managers the opportunity to make long-term, but hard to value, investments in the firm without concerns over underpriced acquisition attempts. Conversely, the Quiet Life Hypothesis predicts that managers exploit the protection afforded by the presence of takeover provisions to reduce their managerial efforts, especially into risky projects such as long-term innovation efforts. The next two hypotheses relate to the substitutability of takeover provisions with one another. Specifically, Danielson and Karpoff (1998) provide early evidence that certain combinations of takeover provisions are more prevalent than are others, suggesting that officers and directors have preferences for particular provisions. Similarly, Bebchuk and Cohen (2005) note that the pairing of a staggered board with a poison pill, whether enacted or in a “shadow” form, offers a particularly potent defense against unwanted acquisition attempts. More broadly, Bebchuk et al. (2009) suggest that six provisions in particular (labeled the Entrenchment- or E-Index) provide a powerful cocktail of defenses and variation in this smaller portfolio accounts for the observed relation between governance provision presence and firm value. Overall, these results suggest that not all provisions are equal. If managers perceive certain combinations of provisions as providing stronger takeover protection, then their response to the presence of provisions will likely depend on which provisions are in place. The Power Hypothesis predicts that the relation between innovation efforts and takeover protection will vary depending on the potency of the takeover protection created by the portfolio of provisions in place. Provisions also vary in the involvement of the officers and directors with their adoption. In many instances, officers and directors must take an active role in either proposing for a vote or simply enacting via fiat coverage of certain provisions. These firm-level provisions provide protection strictly for the adopting firm.3 Alternatively, certain states have elected to adopt broad, state-level, provisions that provide protection for all firms incorporated within that state. In the great majority of instances, all firms incorporated within that state are immediately afforded the protection of the state-level provision, although firms may elect to waive coverage. Importantly, officers and directors, in most instances, are not required to take any action to gain coverage through state-level provisions. The action of adopting a firm-specific takeover provision is likely to garner shareholder attention. Indeed, Comment and Schwert (1995) note that many poison pill adoptions are accompanied with assertions that management is not aware of any pending acquisition attempts. While coverage by state-level provisions is similarly thought to attract shareholder interest (Karpoff and Malatesta, 1995), it is plausible that managers do not view shareholders' response to coverage by firm-specific and state-level provisions equally. That is, in adopting a firm-specific provision, the officers and directors are signaling the need to change the firm's extant relationship with the market for corporate control. Conversely, protection created through state-level adoption occurs, in essence, under relative anonymity; it is a windfall for the officers and directors who can more plausibly convey that nothing has changed. Thus, it is possible that the actions of managers of firms that adopt firm-specific provisions will be more carefully scrutinized by shareholders, ceteris paribus, than those of managers who receive protection via windfall. As such, the adoption of firm-specific provision will be associated with shareholder-centric behavior (i.e. innovation) while coverage by statelevel provisions will afford managers the opportunity to pursue the quiet life. Thus, the Visibility Hypothesis predicts a positive relation between innovation and firm-specific governance protection and a negative relation between innovation and state-level governance protection.

3

The creation of the IRRC database is predicated on the visibility of such events.

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Table 1 Mean annual innovation levels.

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999

LN(Patents)

Citation intensity

Patent intensity

LN(R&D)

0.721 0.720 0.703 0.708 0.730 0.724 0.744 0.765 0.761 0.786 0.820 0.881 0.867 0.916 0.879 0.837

0.242 0.237 0.245 0.230 0.218 0.230 0.235 0.232 0.230 0.245 0.242 0.233 0.240 0.222 0.205 0.149

0.447 0.433 0.438 0.451 0.464 0.427 0.447 0.422 0.400 0.395 0.399 0.448 0.412 0.464 0.412 0.389

1.463 1.424 1.384 1.395 1.370 1.307 1.214 1.526 1.550 1.479 1.583 1.500 1.785 1.779 1.647 1.797

LN(patents) is the natural log of one plus the total awarded patents applied for during a given year. Citation intensity is the natural log of one plus the ratio of total patent citations to patents awarded adjusted by the mean ratio for the industry during a given year. Patent intensity is the ratio of the number of patents to R&D expenditures. LN(R&D) is the natural log of one plus reported R&D expenditures.

3. Data and summary statistics 3.1. Innovation Innovation typically takes the form of new or refined products and services or the advancement of general knowledge that will have some potential future benefit. In general, innovation is difficult to directly measure with existing data. I therefore employ two common proxies for innovation: R&D expenditures and patent data. R&D is a critical element of innovation. It measures the intensity with which firms are pursuing new products and refinements, or seeking new knowledge. R&D expenditures are also empirically attractive because R&D efforts can be undertaken relatively quickly and are therefore more easily linked to specific events and, due to Financial Accounting Standards No. 2, must be immediately expensed, and therefore are observable. As such, R&D data have the potential of providing clear evidence of a causal link between innovation efforts and takeover protection. Thus, the first measure of innovation is R&D, which I measure as the natural logarithm of (1 + R&D Expenses). Accounting rules can also detract from R&D's usefulness as a measure of innovation. For instance, GAAP allows for flexibility in determining the timing and identification of R&D expenses. As such, tangible and intangible assets with further uses (either in operations or future R&D) can be capitalized and may not appear as an R&D expense. Similarly, some companies have avoided goodwill associated with acquisitions by assigning a large portion of the acquisition costs as “purchased research and development”. Thus, firm reporting of R&D will not necessarily accurately capture all dimensions of innovation efforts. The second source of innovation data is the NBER patent database. The NBER patent database is more fully described by Hall et al. (2005), and includes information on nearly 3 million U.S. patents awarded between 1963 and 1999, roughly 47% of which are to U.S. corporations.4 Patents offer advantages as a measure of innovation compared to R&D in that they are a direct measure of successful innovation efforts and offer insights into the economic importance and quality of innovation efforts.5 The first patent-based innovation measure, LN(Patents), is the natural logarithm of one plus the count of patent applications during a given year and is intended to capture the overall volume of innovation efforts during that time. Very typically, however, there is a delay between innovation efforts and the creation of patentable information and therefore associating current patenting efforts with current innovation may be misleading. The issue is complicated by the high intra-firm correlation in R&D expenditures. I justify the use of contemporaneous patenting activity based on the evidence of Blundell et al. (2000), among others, that suggests that concurrent patents are as unbiased of a measure of current innovation efforts as are lengthier lag structures. The second patent-based proxy of innovation is Patent Intensity, measured as the ratio of patent applications to R&D expenditures. Lanjouw and Schankerman (2004), among others, argue that this measure captures research productivity and is an indicator of the innovativeness of R&D research efforts. Many sample firms report no R&D expenditures. For these firms, the patent intensity value, as described, will be undefined. I therefore code firms with no reported R&D and no patents as having zero patent intensity. However, some sample firms have patents but with no reported R&D, effectively an infinite patent intensity. In these instances, I substitute the 99th percentile patent intensity value (3.61).6

4

Current efforts to update the complete NBER database through 2006 are incomplete and therefore insufficiently reliable for use in this analysis. As discussed in Himmelberg and Petersen (1994), some firms may elect secrecy, lead time, and manufacturing and design capabilities over patenting to protect innovations. 6 The overall results are similar if these firms are omitted. 5

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The third patent-based measure of innovation is based on the citations made to a given patent. Patent applications include citations to relevant existing patents that are important intellectual antecedents for the submitted patent. Hall et al. (2005) and Trajtenberg (1990), among others, suggest that the number of times a patent is cited by future patents is a significant indicator of the economic importance that patent. A simple citation count, however, suffers from a truncation bias because the NBER database includes only patents approved through 1999. As a result, a patent awarded in the late 1980s will have substantially more time to receive citations than one awarded in 1998. To correct for this bias, I follow the suggestions of Hall et al. (2001) and normalize the number of citations for a given patent by the average number of citations received for all patents issued in the same technological class during that year, and label this variable citation intensity. Due to data limitations with governance provisions, described below, I begin the analysis period in 1984 and end in 1999, the latest date patent data are available through NBER. I report the mean annual values for each of the four innovation measures in Table 1. In general, innovation levels are stable during most of the sample period with two exceptions. First, the number of patents generally trends higher from 1984 through 1997 and R&D levels jump in the early- and mid-1990s. Second, patents, citation intensity, and patent intensity all decline in the last 2 years of the sample period. This pattern is widely acknowledged not to be the result of a decline in innovation efforts, but rather a data limitation inherent in the NBER database. Specifically, since not all patent applications are granted, the database includes only granted patents. However, since there is typically at least a two-year delay between the application for and granting of a patent, there will be a decline in granted patents towards the end of the sample period, resulting in a downward skew in patent-based innovation measures. For this reason, I limit the sample period to the relatively unaffected period of 1984–1997. 3.2. Governance provisions and indexes The governance data for the analysis come from the Investor Responsibility Research Center (IRRC). Firms included in the IRRC database are primarily S&P 1500 firms and therefore constitute the bulk of the market capitalization in the U.S. market. Baumol (2004) finds that large firms account for 70% of R&D expenditures in the domestic market and the IRRC reports that these firms are active adopters of antitakeover provision protection. Thus, this sample provides an ideal venue in which to examine the relation between takeover provision protection and firm innovation. The most widely employed IRRC governance database is that of Gompers et al. (2003), which is based on the periodic IRRC Corporate Takeover Defenses, published in 1990, 1993, 1995, 1998, and 2000. A widely acknowledged limitation of this database is that it misses the active takeover provision adoption period of the 1980s. This limitation can, to a certain extent, be overcome by hand-collecting the governance data from the printed sources for several reasons. First, IRRC's collection of governance provisions was first published in 1985, and contained information for 485 of the 500 firms comprising the S&P 500 index as of Oct 1, 1984. These data were updated in an early 1986 supplement. In 1987, IRRC published a similar directory based on 424 Fortune 500 firms as of May, 1986, and updated these data in early 1988. Finally, in 1989, IRRC published its larger directory of 1440 firms drawn from the S&P and Fortune 500 lists, as well as the Forbes and Business Week 1000s. This sample became the basis of the 1990 Corporate Takeover Defenses series and the widely-known electronic database. Second is the nature of the data included in each of the ten volumes between 1985 and 2000. While the Gompers et al. database includes only binary indicator variables for the presence of each provision during one of the publication years, the printed volumes report both the presence and adoption year of a provision, if known.7 By coding the printed volumes, I am thus able to reconstruct the Gompers et al. (2003) index for roughly 1500 firms starting in 1984. However, roughly 40% of the data remain missing due to omitted or inconsistent reported adoption dates and data missing from delisted or acquired firms.8 In each of these cases, I review proxy statements, annual reports, and news announcements to fill in the missing data. Finally, conditioning on available control data described below, I am left with a sample of 11,340 firm-year observations between 1984 and 1997. Finally, I collect data on six state antitakeover laws from the IRRC, Bebchuk and Cohen (2003), and a review of individual state statutes and media reports. In total, the final governance portfolio consists of 23 provisions including 17 firm-level provisions and 6 state-level provisions.9 The proportion of all sample firms with a given provision in place during each sample year is reported in Table 2. Based on the presence of each provision, twenty-two of the twenty-three provisions show a weakening of shareholder rights between 1984 and 1999. The one exception is confidential voting, which increases from 1% in 1984 to 16% in 1999. The table confirms that the 1980s was a period of active provision adoption. Indeed, except for the State-Level Index in 1991, no single provision or portfolio of provisions was adopted by more than 4% of the sample in any year between 1991 and 1999. In contrast, directors and officer liability insurance and indemnity provisions, poison pills, classified boards of directors, and fair price 7

Gompers et al. (2003), Danielson and Karpoff (1998), and Lehn et al. (2007) also note this feature. IRRC removes acquired firms from its subsequent publications and may elect to cease tracking a non-acquired firm due to lack of institutional interest. The portfolio of provisions is smaller than the 28 provisions analyzed by Gompers et al. (2003). The difference is due to the exclusion of the five non-goldenparachute compensation provisions including “compensation plans”, “contracts”, “severance”, “pension parachutes”, and “silver parachutes”. The IRRC data on these provisions are limited during the 1980s and the resulting database shows a dramatic increase in 1990. A possible interpretation of this pattern is that these items were not coded carefully during the early period and, in the interests of insuring high data accuracy and keeping collection efforts reasonable, I omit these five provisions. 8 9

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Table 2 Proportion of sample firms with takeover provision in place.

Mean index values G-Index

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

1621 5 6 2 2 1 0 52 1 1 1 6 7 1 19 11 1 4 23 14 1 7 0 3

1654 5 9 2 2 1 0 53 2 1 2 9 11 1 18 12 1 5 30 21 3 9 3 4

1708 6 19 15 13 6 6 54 6 5 3 13 15 1 17 16 2 7 37 25 17 11 4 5

1739 17 24 19 13 10 9 57 48 31 4 15 17 1 16 22 2 8 44 28 22 13 5 6

1741 21 30 79 16 11 11 57 64 39 5 17 19 1 16 31 3 10 48 30 34 15 5 6

1730 25 30 83 29 28 11 62 65 40 6 19 20 2 16 38 3 12 51 30 44 16 5 6

1697 29 34 87 30 28 17 74 68 42 6 23 23 3 17 47 3 13 53 31 49 16 5 6

1657 29 37 90 30 29 18 78 68 44 5 26 26 5 17 49 3 14 47 29 50 12 6 5

1642 29 37 90 32 29 18 78 68 43 5 27 26 6 16 50 3 14 47 29 50 12 5 5

1615 29 37 90 32 32 18 80 67 42 5 28 28 9 16 52 3 15 47 29 51 12 5 5

1577 29 37 90 32 32 18 84 68 43 5 30 30 11 15 55 3 16 49 29 52 12 6 5

1542 29 37 90 32 32 18 85 68 43 5 32 32 12 15 56 4 16 50 29 53 12 6 5

1390 30 37 90 32 32 18 88 71 47 5 37 36 13 16 64 4 19 50 30 54 12 6 5

1388 30 37 93 31 33 18 88 71 47 5 36 35 13 16 62 4 18 50 30 55 12 6 5

1298 30 37 93 33 33 18 87 69 42 5 37 36 13 15 62 4 19 50 31 57 12 6 6

1202 30 37 93 35 35 18 89 71 46 5 39 36 14 15 69 4 20 50 31 58 12 6 6

3.33

3.78

4.9

6.17

7.54

8.29

8.89

8.94

9.00

9.03

9.17

9.12

9.41

9.44

9.51

9.68

J.R. Becker-Blease / Journal of Corporate Finance 17 (2011) 947–958

Observations Control share law Fair price law Business combination law Poison pill law Stakeholder law Antigreenmail law Blank check Pfd shares D&O liability insurance Indemnity Stakeholder clause Limit special meeting Limit written consent Confidential voting Cumulative voting Golden parachute Limitations on charter Limitations on bylaws Classified board Fair price Poison pill Supermajority voting Antigreenmail Unequal voting

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Table 3 Correlation and univariate analysis of governance index and innovation. Panel A: pairwise correlations between governance index levels and innovation Measures of innovation LN(Patents) t t to t + 1 t to t + 2 t to t + 3

0.1043 ⁎⁎⁎ 0.1084 ⁎⁎⁎ 0.1109 ⁎⁎⁎ 0.1138 ⁎⁎⁎

Citation intensity , 0.0469 ⁎⁎⁎ ⁎ 0.0511 ⁎⁎⁎ 0.0529 ⁎⁎⁎ 0.0548 ⁎⁎⁎

Patent intensity , 0.0463 ⁎⁎⁎ ⁎⁎ 0.0505 ⁎⁎⁎ 0.0511 ⁎⁎⁎ 0.0501 ⁎⁎⁎

LN(R&D)

Q1

Q2

Q3

Q4

0.723 0.239 0.541 1.359

0.921 +++ 0.256 + 0.442 + 1.428

0.994 ++ 0.279 ++ 0.529 +++ 1.475

1.160 +++ 0.318 +++ 0.611 +++ 1.604 +++

0.0799 ⁎⁎⁎ 0.0837 ⁎⁎⁎ 0.0865 ⁎⁎⁎ 0.0898 ⁎⁎⁎

Panel B: univariate analysis G-Index quartiles

LN(Patents) Citation intensity Patent intensity LN(R&D)

Panel A reports the correlation between the G-Index and four measures of innovation concurrently (t), and over a two-, three-, and four-year window (t + 1, t + 2, and t + 3 respectively). Innovation is measured as the natural logarithm of one plus the number of patents applied for during a given year, the class-weighted number of citations received by patents applied for during a given year, the natural logarithm of one plus total R&D expenditures and the ratio of the number of patents applied for during a given year to R&D expenditures during that year. Panel B reports the mean innovation level for each quartile of firms based on the G-Index quartiles. ⁎ Denotes correlation coefficients statistically different from zero at the 1% level. ⁎⁎ Denotes correlation coefficients statistically different from zero at the 10% level. ⁎⁎⁎ Denotes correlation coefficients statistically different from zero at the 5% level. + Denotes statistically different values that are greater than the previous column's value at the 10% level. ++ Denotes statistically different values that are greater than the previous column's value at the 5% level. +++ Denotes statistically different values that are greater than the previous column's value at the 1% level.

provisions were adopted by large numbers of firms during the 1980s. Similarly, coverage by state takeover laws expanded dramatically during this period, particularly coverage by Business Combination laws. Finally, similar to Gompers et al. (2003), I aggregate the provisions into a single index (G-Index) and report its mean annual value at the bottom of the table. The index is calculated by adding one for each unique provision that is in place during a given fiscal year. Redundant provisions (such as a fair price provision in the presence of a state fair price law) are only counted as a single provision and confidential voting and cumulative voting are reverse-coded, as their presence strengthens shareholder rights. Similar to the evidence for individual provisions, the index indicates a dramatic increase in the number of takeover provisions in place between 1984 and 1990 and a relatively static index level during the 1990s. Given that reliable patent data are only available through 1997, I limit the governance sample to the 1984–1997 period for the remainder of the analysis.

4. Univariate analysis To give an initial sense of the relation between innovation and governance provisions, I report the pair-wise correlation matrix between each of the four innovation measures and the G-Index in Panel A of Table 3. The “t” row reports the contemporaneous correlation between year t values of the governance index and innovation levels. The t + n rows report the correlation between the t levels of the governance index and the average of the innovation value from t through n. Consistent with the predictions of the Managerial Myopia Hypothesis, I find a positive relation between firm innovation efforts and levels of takeover protection. The relation exists for both contemporaneous and future measures of innovation. I next examine the relation between the relative number of provisions in place and innovation efforts. Firms are divided into annual quartiles based on the number of takeover provisions in place during the year and pooled across all sample years. Panel B of Table 3 reports the mean innovation value of each quartile for the G-Index. If greater takeover protection is linked with greater innovation, then mean innovation levels should increase across the quartiles. To examine this, I calculate t-statistics of difference in means between the nth and nth-1 quartiles, and denote significantly positive differences with a superscript “+” and negative with a superscript “−”. Three of the four innovation measures display a consistent positive relation between takeover provision protection and innovation. The one exception is R&D spending, in which only the third and fourth quartiles are different.10

10

In unreported analyses, the interquartile differences are all significantly positive.

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Table 4 Coefficient estimates from two-way fixed effects panel of levels on levels with firm and time dummies (1984–1997).

G-Index Sales R&D Intensity Market-to-book HHI HHI2 Return on assets Cash Capital expenditures Leverage Equity Firm age Institutional ownership R2 F-stat

LN(Patents)

Citation intensity

LN(R&D)

Patent intensity

(1)

(2)

(3)

(4)

0.0060 ⁎⁎ (0.0029) 0.2565 ⁎⁎⁎ (0.0142) 2.5250 ⁎⁎⁎ (0.4051) − 0.0008 (0.0029) − 3.1127 ⁎⁎⁎ (0.7018) 9.1482 ⁎⁎⁎ (2.0070) − 0.0436 (0.1104) 0.0298 ⁎⁎⁎ (0.0061) 0.0047 (0.1290) − 0.1312 ⁎⁎ (0.0559) 0.0359 (0.1207) 0.1787 ⁎⁎⁎ (0.0260) − 0.0868 (0.0552) 92.45 80.32⁎⁎⁎

0.0084 ⁎⁎⁎ (0.0021) 0.0098 (0.0073) 0.6215 ⁎⁎⁎ (0.2088) − 0.0026 ⁎ (0.0015) 0.0506 (0.3616) 0.0611 (1.0343) − 0.0203 (0.0569) 0.0047 (0.0031) − 0.0327 (0.0665) − 0.0679 ⁎⁎⁎ (0.0288) 0.0528 (0.0622) 0.0585 ⁎⁎⁎ (0.0134) 0.0204 (0.0285) 70.55 15.71 ⁎⁎⁎

0.0110 ⁎⁎⁎ (0.0040) 0.3245 ⁎⁎⁎

0.0815 ⁎⁎ (0.0337) 0.8669 ⁎⁎⁎

(0.0140)

(0.1166)

− 0.0121 ⁎⁎⁎ (0.0028) − 5.5886 ⁎⁎⁎

0.0359 (0.0237) − 14.2944 ⁎⁎

(0.6933) 14.5045 ⁎⁎⁎ (2.0025) − 0.5532 ⁎⁎⁎ (0.1067) 0.0150 ⁎⁎

(5.7599) 37.6346 ⁎⁎ (16.5174) − 0.3444 (0.9078) 0.1783 ⁎⁎⁎

(0.0060) 0.1072 (0.1265) − 0.0674 (0.0543) − 0.4783 ⁎⁎⁎

(0.0501) − 1.0975 (1.0595) − 0.3596 (0.4586) 0.4285 (0.9955) 0.5518 ⁎⁎

(0.1198) 0.3967 ⁎⁎⁎ (0.0258) 0.1150 ⁎⁎ (0.0541) 96.94 212.16 ⁎⁎⁎

(0.2145) − 0.5931 (0.4531) 70.11 15.35 ⁎⁎⁎

The dependent variables include four measures of innovation. LN(Patents) is the natural log of one plus the total awarded patents applied for during a given year. Citation intensity is the natural log of one plus the ratio of total patent citations to patents awarded adjusted by the mean ratio for the industry during a given year. Patent intensity is the ratio of the number of patents to R&D expenditures. LN(R&D) is the natural log of one plus reported R&D expenditures. Independent variables include the G-Index, as defined previously, the natural logarithm of sales (Sales), the ratio of research and development expenses to total sales (R&D Intensity), the ratio of operating income to total assets (Return on Assets), the ratio of long-term debt to total assets (Leverage), the natural logarithm of cash and equivalents (Cash), the ratio of capital expenditures to total assets (Capital Expenditures), the natural logarithm of one plus equity issues (Equity), the natural logarithm of the number of years that the firm has been listed on CRSP (Firm Age), the sum of the squared proportion of total industry sales represented by each firm in the industry (Herfindahl−Hirschman-Index), where industry is defined by Fama and French (1997) industry classifications, and the proportion of shares reported as held by institutions (Institutional Ownership). Robust standard errors are reported in parentheses. ⁎ Denotes statistical significance at the 10% level. ⁎⁎ Denotes statistical significance at the 5% level. ⁎⁎⁎ Denotes statistical significance at the 1% level.

5. Multivariate analysis While the results above are generally consistent with the hypothesis that innovation is positively associated with takeover provision protection, multivariate analysis will allow me to better control for alternative determinants of innovation, address the endogenous nature of the adoption decision, and provide specific tests of the Visibility and Power Hypotheses. 5.1. Endogeneity Governance and performance are likely endogenously determined. Failure to address this issue can lead to biased or inconsistent estimates.11 Although several researchers have noted that state-level provisions are much less likely to suffer from an endogeneity problem, one of the hypotheses of this paper is that managers respond differently to the presence of state-level and firm-level provisions. Thus, I cannot address the endogeneity issue with sample selection. I employ several alternative approaches to address this issue. First, Himmelberg et al. (1999) suggest that one treatment for the unobserved heterogeneity issue is to employ a panel data set with firm fixed-effects. Under the assumption that heterogeneity is constant over time, such a method yields consistent estimators. In addition to firm-fixed effects, I also include several firm and industry characteristics that previous research suggests may affect the relation between takeover provision protection and innovation.Hall and Ziedonis (2001), Lanjouw and Lerner (2001), and Lerner (1995), and argue that larger firms may enjoy economies of scope or scale in research production or in the patenting process due to 11

See Himmelberg et al. (1999) and Lehn et al. (2007) for a discussion. R&D Intensity is omitted when the dependent variable is either R&D Intensity or Patenting Intensity since R&D expenditures is the scale variable in the latter. The results are robust to alternative lag structures of R&D Intensity. 12

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their ability to maintain local legal departments. Similarly, Brown et al. (2009) argue that firm age is a good proxy for the severity of the asymmetric information problem facing the firm, in addition to firm size. R&D Intensity measures the efforts of the firm to develop patentable processes or technologies and may affect both the number of patents and quality or citations of the patents and market-tobook value of assets measures current growth opportunities.12 Brown et al. (2009) and Himmelberg and Petersen (1994) argue that financing constraints can impede a firm's ability to innovate. I include several dimensions of financial constraints including cash on hand, equity issues, operating performance, capital expenditures, and leverage. Similarly, capital expenditures and equity issues can indicate efforts to exploit past innovation or potential efforts to undertake future innovation. Aghion et al. (2005) argue that industry competition can affect a firm's incentives to innovate and therefore, similar to them, I include both the Herfindahl–Hirschman index and its squared value. Finally, I include institutional ownership because Bushee (1998) finds that institutional ownership is related to the performance pressures placed on managers and therefore their willingness to pursue innovation to the potential detriment of short-term performance and Sapra et al. (2009) find that monitoring intensity from institutional owners affects the relation between innovation and governance. Specifically, the estimated equation is Iit = γ0 + γ1 Git + γ2 Salesit + γ3 R&D Intensityit−1 + γ4 Return on Assetsit þ γ5 Debtit + γ6 Cashit + γ7 Capital Expendituresit + γ8 Equityit þ γ9 Firm Ageit + γ10 Herfindahl−Hirschman−Indexit 2 þ γ11 Herfindahl−Hirschman−Index + γ12 Institutional Ownershipit þ γ13 Market−to−Bookit + πFFE + φYear + eit

ð1Þ

where G is the level of the beginning governance index, Sales is the natural logarithm of sales, R&D Intensity is the ratio of research and development expenses scaled by total sales, lagged one period, Return on Assets is the ratio of operating income to total assets, Leverage is the ratio of long-term debt to total assets, Cash is the natural log of cash and equivalents, Capital Expenditures is the ratio of capital expenditures to total assets, Equity is the natural logarithm of one plus equity issues, Firm Age is the natural Table 5 Power- and visibility-based indexes and innovation. Panel A: power indexes LN(Patents) PCB Index G Index−PCB Index

E Index G Index–E Index

DK Index G Index–DK Index

Citation intensity

LN(R&D)

Patent intensity

0.0364 ⁎⁎⁎ (0.0121) − 0.0016 (0.0050)

0.0165 ⁎⁎⁎ (0.0062) 0.0064 ⁎ (0.0026)

0.0720 ⁎⁎⁎ (0.0119) − 0.0040 (0.0049)

0.2219 ⁎⁎ (0.0988) 0.0467 (0.0408)

0.0210 ⁎⁎ (0.0096) 0.0007 (0.0051)

0.0141 ⁎⁎⁎ (0.0049) 0.0064 ⁎⁎

0.0418 ⁎⁎⁎ (0.0095) 0.0002 (0.0050)

0.0575 (0.0788) 0.0899 ⁎⁎

0.0126 (0.0125) 0.0106 ⁎⁎ (0.0047)

0.0479 (0.1030) 0.0887 ⁎⁎ (0.0396)

(0.0021)

− 0.0049 (0.0126) 0.0083 ⁎ (0.0048)

− 0.0082 (0.0065) 0.0119 ⁎⁎⁎ (0.0025)

LN(PATS)

Citation intensity

(0.0419)

Panel B: visibility indexes

Firm-level index State-level index

0.0190 ⁎⁎⁎ (0.0052) − 0.0135 ⁎⁎ (0.0062)

0.0056 ⁎⁎ (0.0027) 0.0114 ⁎⁎⁎ (0.0032)

LN(R&D)

Patent intensity

0.0267 ⁎⁎⁎ (0.0052) − 0.0125 ⁎⁎

0.1105 ⁎⁎⁎ (0.0427) − 0.0293 ⁎

(0.0062)

(0.0171)

The dependent variables include four measures of innovation. LN(Patents) is the natural log of one plus the total awarded patents applied for during a given year. Citation Intensity is the natural log of one plus the ratio of total patent citations to patents awarded adjusted by the mean ratio for the industry during a given year. Patent intensity is the ratio of the number of patents to R&D expenditures. LN(R&D) is the natural log of one plus reported R&D. Independent variables include in Panel A the PCB Index, defined as the sum of indicators of poison pills, classified boards, and business combination laws, the E Index, defined as the sum of indicators of the presence of poison pill, classified board, golden parachutes, limitations on changing the bylaws or charters of corporations, and supermajority voting requirements, and the DK Index, defined as the sum of indicators of the presence of classified board, fair price, supermajority voting requirements, and limitations on shareholders' ability to call special meetings. Panel B independent variables include the firm-specific index, defined as the sum of indicators for the presence of poison pills, classified boards, shareholder meeting limitations, stakeholders, limitations on ability to amend corporate charters or bylaws, golden parachutes, greenmail limitations, blank check preferred shares, fair price requirements, limitations on the ability to act by written consent, unequal shareholder voting, D&O liability insurance, and reverse-coded presence of cumulative and confidential voting. In addition, in both panels the complement for each of the four indexes, defined as the G-Index minus the respective index value. Robust clustered standard errors are reported in parentheses. ⁎ Denotes statistical significance at the 10% level. ⁎⁎ Denotes statistical significance at the 5% level. ⁎⁎⁎ Denotes statistical significance at the 1% level.

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logarithm of the number of years that the firm has been listed on CRSP, Herfindahl–Hirschman-Index is the sum of the squared proportion of total industry sales represented by each firm in the industry, where industry is defined by Fama and French (1997) industry classifications, and Institutional Ownership is the proportion of shares reported as held by institutions in the Spectrum database. Table 4 reports the coefficient estimates of the analysis with standard errors reported in parentheses. Each model includes unreported firm-specific and annual dummy variables. Further, as suggested by Petersen (2009), I adjust the standard errors for clustering within firms to address the potential correlation of contemporaneous residuals across firms. Models 1 through 4 report the relation between the G-Index level and innovation, measured by patent count, citation intensity, R&D expenditures, and patent intensity. In each of the specifications, I find a positive and significant relation at the 5% level or less. The economic significance of the relation is also non-trivial. For each of the dependent variables, a movement from the 75th to the 90th percentile in the GIndex (from 10 to 12 provisions), corresponds with a 1% to 5% increase in innovation relative to the mean firm. Results are qualitatively similar when I employ different lags of the governance variables, similar to Coles et al. (2008) and Hermalin and Weisbach (1991), and the innovation variables, similar to Dahya et al. (2008). Zhou (2001) argues that the fixed-effects panel method is not appropriate when there is only variation in the cross-section and not in the time-series. Indeed, Gompers et al. (2003) observe that during the 1990s, there is little variation in the governance index, making identification difficult. Consistent with this, I find that the average pair-wise correlation between current and 1-year lagged G-index values between 1990 and 1997 is 0.98. The evidence in Table 1 suggests potentially greater variation during the active adoption period of the 1980s and indeed the average correlation during this period is 0.81, a value that is still sufficiently large to warrant further investigation. As an alternative treatment for endogeneity, I therefore follow the guidance of Bhagat and Bolton (2008) and Straska and Waller (2010), among others, and employ a simultaneous systems approach with IV estimators. Appropriate instruments should be exogenous and affect only innovation or governance, but not both. Dahya et al. (2008), Durnev and Kim (2005), and Lins (2003), argue that broad industry classification does not affect governance, however industry is widely acknowledged to be related to innovation. Therefore, in the innovation model, I include the previously defined governance level as the simultaneously determined variable and follow Dahya et al. and employ one-digit SIC indicators as instruments. Additional firm-specific controls as reported in Eq. (1) are also included. The governance equation attempts to predict levels of the G-Index. Similar to Bates et al. (2008) and Comment and Schwert (1995), among others, I assume that governance level is associated with the perceived threat of acquisition, and assume that this, in turn, is related to overall industry acquisition patterns. Similar to Straska and Waller (2010), I define industry acquisition as the proportion of same-industry firms that delist due to merger or acquisition within the past calendar year, and employ this value as the instrument. The untabulated results are consistent with earlier evidence supporting the Managerial Myopia Hypothesis. Specifically, in three of the four systems, higher G-Index levels are associated with greater innovation (the only exception being when innovation is measured as R&D expenditures). As additional tests, I have employed industry average levels of innovation and governance provisions as alternative instruments, with similar results. In addition, I have used the t + 1 and t + 2 values for innovation, as well as the three-year average from t to t + 2, and found qualitatively similar results to those reported. While indentifying truly exogenous parameters is difficult, these results provide some assurance, at least, that the previously documented relation between governance and innovation is not the result of spurious endogeneity.

5.2. Power Hypothesis The Power Hypothesis predicts that the protective power of takeover provisions will influence managers' response to their presence. To test this hypothesis, I form three empirically motivated portfolios of takeover provisions thought to be particularly potent. The first, which I label the PCB Index, is based on the evidence that poison pills (Brickley et al., 1994; Comment and Schwert, 1995), classified boards (Bebchuk and Cohen, 2005; Bebchuk et al., 2002), and business combination laws (Subramanian et al., 2010) are particularly effective takeover deterrents. The second is the E-Index of Bebchuk et al. (2009), which is comprised of poison pills, classified boards, golden parachutes, limitations on changing bylaws or corporate charters, and supermajority voting requirements. The third, which I label the DK-Index, is comprised of classified board, fair price, supermajority, and limitations on shareholder meeting provisions based on Danielson and Karpoff's (1998) factor analysis of provisions that are frequently deployed together. To examine whether the relation between innovation and governance is confined to the presence of potent provisions, I include each of the three previously described indexes as well as their complement relative to the G-Index and predict a significant coefficient estimate on the index and an insignificant coefficient estimate on the complement. I estimate the panel for each of the three power indexes and for each of the four measures of innovation, including control variables, and report results in Panel A of Table 5. The evidence is mixed. Consistent with the Power Hypothesis, I find that the PCB and E-Indexes are positively associated with innovation in seven of eight specifications, with larger coefficients than for the complement index (G-Index minus the PCB or EIndex, respectively). However, for patent intensity, the complement index rather than the E-Index is positively related to innovation. Further, in the four models based on the DK Index, I find that the complement rather than the DK Index is significantly related to innovation. Thus, the evidence suggests a positive relation between innovation and index power for certain indexes, but

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the pattern is not uniform. It is noteworthy that in no instance do I find evidence that the presence of provisions is negatively associated with innovation at standard levels. 5.3. Visibility Hypothesis The Visibility Hypothesis predicts that firm innovation efforts will be positively related to firm-specific provision levels and negatively related to state-level provision levels. I test this hypothesis using the firm-level and state-level indexes previously reported and estimate Eq. (1) including both the firm-specific and state-level indexes as measures of governance. The results are reported in Panel B of Table 5. Consistent with the predictions of the Visibility Hypothesis, I find that the firm-level index is positively associated with each of the four measures of innovation. Conversely, evidence of the relation between innovation and state-level takeover protection is more mixed. Higher levels of the state-level index are associated with lower patent counts, R&D expenditures, and patent intensity, but positively related to patent quality (citation intensity). In unreported analyses, I find these results persist when firmand state-level indexes are interacted. Overall, the state-level evidence is consistent with that of Bertrand and Mullainathan (2003) and Atanassov (2008) and suggests that state-level takeover protection encourages managers to pursue the quiet life. 5.5. Robustness The results are robust to several alternative specifications. First, given the relatively high number of firms with no innovation activity, I re-estimate the results using both a Tobit specification as well as limiting the analysis to firms with non-zero innovation levels during the sample period. In addition, I estimate the models using industry mean-adjusted levels of innovation and governance provisions and continue to find the same general pattern of results. There is also a potential omitted variables problem. One possible important indicator of incentive alignment between managers and shareholders is the quality of the internal governance systems such as the board. It is plausible that internal governance systems are related to both innovation and governance provision adoption, and therefore the omission of internal governance measures can result in biased and inconsistent coefficient estimates. Although impractical to collect for the entire sample, I investigate this possibility by collecting board data for 200 randomly selected firms between 1987 and 1991. In particular, I measure the log of board size, the proportion of directors who are independent of management, the proportion of shares owned by directors, and a dummy variable of whether the CEO is also the chairperson of the board. In instances where a sample firm delists, I randomly select a replacement. In total, this subsample analysis covers 1019 firm-years, or about 8% of the broader sample. The results are generally similar to those reported in previous Cs, although the statistical significance levels are lower. In particular, the broader G-Index is positively related to innovation, at standard levels, in only one of four specifications. However, when the G-Index is split into firm-level and state-level provisions, the results are more similar to those documented previously as a positive relation exists between firm-level provisions and innovation in three of four specifications and state-level provisions are unrelated in all specifications. 6. Conclusion In this paper I examine the relation between firm-level innovation and the presence of takeover provisions for large firms in the U.S. between 1984 and 1997. Consistent with Stein's (1988) Managerial Myopia Hypothesis, I find that greater takeover provision protection is positively associated with innovation efforts across multiple specifications. The results support recent evidence by Danielson and Karpoff (2006) and Straska and Waller (2010) that the presence of takeover provisions can be beneficial for certain firms. The results suggest that the relation between innovation and takeover protection is not uniform across all provisions. In particular, I find evidence that the relation between innovation and the level of takeover provisions varies depending upon officers' and directors' involvement in the adoption of the provision. The presence of state-level provisions is frequently associated with lower levels of innovation, consistent with the Quiet Life Hypothesis of Bertrand and Mullainathan (2003), while firmspecific provisions are more uniformly associated with greater innovation efforts. These results are consistent with the arguments of Mulherin and Poulsen (1998) and Ryngaert and Scholten (2010) that the presence of takeover protection can result in changing shareholder scrutiny. Overall, the results improve our understanding of the potential consequences of takeover resistance and suggest that management's role in erecting defenses is an important determinant of their subsequent behavior. Acknowledgments This paper is based, in part, on my dissertation at the University of Oregon. I have benefitted from conversations with John Chalmers, Diane Del Guercio, Laura Field, Jarrad Harford, Jon Karpoff, Swami Kalparthy, Ted Khoury, Wayne Mikkelson, Megan Partch, Donna Paul, Welsey Wilson and especially my chair, Larry Dann. I am also grateful for comments from the editor and an anonymous referee as well as seminar participants at Washington State University, Oregon State University, and the Financial Management Association meetings in 2008. I am particularly indebted to Virginia Rosenbaum for several lengthy conversations concerning early IRRC data collection efforts and to Lyndsay Ruggles, Robert Thompson, Chris Sawyer, Esther Trefz, and Mary Spencer, who provided excellent research assistance. All remaining errors are my own.

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