Employee-Manager Alliances and Shareholder Returns from Acquisitions

In this article, we examine the potential for management-worker alliances when employees have substantial voting rights from their equity ownership, and how such alliances affect the agency relationship between managers and shareholders in the context of corporate acquisition decisions. Employee equity ownership can provide workers with substantial cash flow and voting rights. The cash flow rights give workers residual claims to firm profits, partially aligning their interests with shareholders. Employee voting rights, on the other hand, can be a key factor in determining the likelihood of a firm becoming a takeover target as well as for the outcomes of such control contests (Gordon and Pound (1990), Chaplinsky and Niehaus (1994), and Rauh (2006)). Together, employees’ claims to cash flow rights and voting rights make them an important force that can affect corporate governance and firm policies.

We develop two competing hypotheses regarding the effect of employee equity ownership on managerial behavior in corporate acquisition decisions. On the one hand, employee equity ownership can enable managers to make ill-advised acquisitions. The theory on management-worker alliances developed by Pagano and Volpin (2005) suggests that when workers control substantial voting rights, they can use their power to protect managers from hostile takeover attempts, so long as management ensures that workers enjoy favorable treatment in terms of wages, working conditions and job security. As managers form alliances with employees with major voting rights and become less concerned with the discipline of the market for corporate control, they are more likely to pursue unprofitable empire-building acquisitions that destroy shareholder value.

Another factor that aligns manager and worker interests is that they both hold undiversified portfolios and a large portion of their wealth (e.g., wage income, benefits, and human capital) is tied to the firm employing them. Thus, they share a preference for acquisitions that reduce firm risk and increase employment security, even at the expense of shareholder value. Equity ownership in an employer makes employees more undiversified, enhancing their preferences for risk-reducing and diversifying acquisitions.

On the other hand, employee ownership may compel managers to eschew empire-building value-destroying acquisitions. The negative stock price impact of such transactions can result in large losses in the value of employee shareholdings, which can lead to adverse consequences for firms and managers through several channels. First, firms can experience declines in employee morale, decreases in productivity, and increases in voluntary employee turnover, all of which can lower a firm’s operating efficiency and performance. Also, as employees’ financial wealth is damaged by bad acquisitions, managers may find them more demanding at times of contract renewals and renegotiations. More contentious labor relations can lead to temporary work stoppage or prolonged strikes and cause disruptions to a firm’s operations. Even absent any work stoppages, a strained relationship between employees and management can make employees unwilling to support incumbent managers and cost managers an important ally in the event of unsolicited takeover bids. These considerations should discourage empire-building acquisitions that depress stock price and hurt the value of employee stock ownership. However, this mechanism can be rendered ineffective when employees receive large benefits from labor-friendly policies of incumbent managers that outweigh the losses in their share value.

In a sample of 3,778 acquisitions made by large U.S. firms from 1996 to 2009, we find that acquirers with substantial employee equity ownership (at least 5% of shares outstanding) experience lower abnormal stock returns on acquisition announcements, suggesting that firms with employee block ownership are more prone to engage in shareholder value reducing acquisitions. We further find that employee block ownership significantly reduces the likelihood of empire-building acquirers receiving a takeover bid within three years following an acquisition. This is consistent with a white squire role played by employee blockholders (Pagano and Volpin (2005)), where they insulate managers from the discipline of the market for corporate control, thereby encouraging empire-building behavior.

We next investigate employee incentives to use their voting rights to protect managers and allow them to make bad acquisitions with seeming impunity. The worker-management alliance theory of Pagano and Volpin (2005) argues that workers are motivated to support incumbent managers when they enjoy favorable employment policies, such as long-term contracts, high wages, generous benefits and infrequent layoffs. We also expect employees to have stronger incentives to form alliances with empire-building managers when their employment status is more secure and less susceptible to adverse consequences of poor acquisitions. Under these conditions, managers have stronger incentives to pursue empire-building acquisitions without fear of market discipline.

The results of our analysis confirm the above prediction and lend direct support for the Pagano and Volpin (2005) theory. Specifically, the negative relation between employee block ownership and acquirer shareholder returns is concentrated in firms with better employee treatment, more unionized workforces, abnormally high employee wages, and in diversifying acquisitions. These findings highlight a key difference between employee ownership and other takeover defenses such as staggered boards and poison pills in that its support for management is conditional on whether employees receive sufficient quid pro quo benefits in their alliance with management.

Overall, our evidence suggests that substantial employee voting rights can provide a catalyst for managers and workers to form implicit alliances to realize reciprocal benefits at shareholders’ expense. This reciprocal relationship between managers and employees is consistent with the worker-manager alliance theory of Pagano and Volpin (2005) and portrays a more complex and nuanced picture of the interactions among managers, workers, and shareholders. Our results raise the concern that large employee ownership positions can undercut shareholder value rather than aligning employee interests with those of outside shareholders.