The effect of Sarbanes Oxley on return of mergers and acquisitions in the pharmaceutical sector
Bachelor thesis
Jeroen Glebbeek 10002524 Economie & Bedrijfskunde Studiejaar 2016/2017
Statement of Originality
This document is written by Student Jeroen Glebbeek who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Table of contents
1.) Introduction ... 4
2.) Literature Review ... 5
2.1 Sarbanes Oxley ... 5
2.2 The pharmaceutical sector ... 7
2.3 Intangible assets ... 9
2.4 Mergers and Acquisitions and information asymmetry ... 11
3.) Research Setup ... 14
3.1 Hypotheses ... 14
3.2 Data ... 15
3.3 Model ... 16
4.) Results ... 18
4.1 Descriptives and full regression ... 18
4.2 Regression with Sarbanes-Oxley ... 20
4.3 Regression with the payment type ... 21
Conclusion ... 23
1.) Introduction
By the end of the 90’s and beginning of the 00’s the US and the world were shocked by a number of accounting scandals. Accounting scandals such as Enron and Xerox caused a lot of harm to shareholders in monetary terms for shareholders of the companies involved
(Rockness & Rockness, 2005). The US government called for action which lead to the creation of the Sarbanes-Oxley act which was enacted in 2002 (SEC, 2002).
One of the main causes of these accounting scandals was information asymmetry. A company executive could be able to manipulate its expected earnings or engage in off
balance sheet activities to sort an effect on the estimated earnings which was one of the main reasons of the accounting scandals. These activities influence the share price of a company. Reducing of inflating the share price using these kind of tactics has an effect on the share price. One of the main goals of the SOX-law is to improve shareholder protection against these activities. Asymmetric information is an issue in M&A’s (Berk and Demarzo, 2014). A company is best known by the people who work for the company. The acquiring company needs to know if the target company provides enough information about its activities to make a reliable estimate of the share-price and for example future returns of the acquisition. The objective of an acquiring company and target company in an efficient market is to achieve the highest possible value for its stakeholders. In what way does Sarbanes-Oxley improve this and does it add value for an acquiring firm due to improved regulation? Chhaochharia and Grinstein (2007) found that after the implementation of SOX there were significant abnormal returns for firms that were less compliant with the rules implemented by SOX. In this
research the focus lies on the impact of SOX on M&As and especially in the pharmaceutical industry.
A lot of negative attention to a number of big firms was what lead to the initiation of the act. Pharmaceutical companies are even more under the looking glass because of their social responsibility (O’Riordan and Fairbrass 2008), it makes it interesting to see if SOX improved disclosure practices by pharmaceutical firms. In this research the focus lies on the mergers and acquisitions in this field of business and if there is a positive effect following the change in legislation. Decisions that affect a firm on all spectra are interesting phenomena to study, and mergers and acquisitions are a classic example of one of these firm wide decisions. The announcement of a merger often involves significant price information. The efficient market hypothesis states relevant information is reflected in the market valuation of a security (Keown and Pinkerton, 1981). Mergers and acquisitions are known to add value for
shareholders of a target company but seldom for the acquirer. Acquiring company stocks do not show exceptional performance, often due to the large premium paid on the expected merger effect (Block, 1968). Does the return in M&A’s for acquiring companies in the pharmaceutical industry change because of the change in legislation caused by the Sarbanes-Oxley act? This research will focus on the effect of SOX in M&A’s. If Sarbanes-Sarbanes-Oxley lowers the information asymmetry in mergers and acquisitions and improves disclosure by pharmaceutical firm managers should be able to make a better decision about whether the deal is good for a company or not. Shareholders on the other hand now know a manager should be able to make a better decision which profits the company.
2.) Literature Review 2.1 Sarbanes Oxley
The Sarbanes-Oxley act of 2002 (often shortened to SOX) is a United States federal law which set new and expanded requirements for all public companies. The bill was signed on July 30, 2002 by President Bush which he characterized as “the most far reaching reforms of American business practices since the time of Franklin D. Roosevelt” (SEC, 2002). That day stock market indices of large capitalization stocks had dropped 40 percent over the past 30 months (Coates IV, 2007). SOX was enacted as a reaction to corporate and accounting scandals such as Enron and WorldCom. These accounting scandals have, in monetary terms, the largest dollar level of fraud caused by accounting manipulations and unethical behavior (Rockness & Rockness, 2005). The scandals caused billions of dollars in losses for
shareholders and investors when these companies collapsed.
The primary focus of SOX is on regulating corporate conduct to promote ethical behavior and preventing fraudulent financial reporting. SOX – also known as the “Public Company Accounting Reform and Investor Protection Act” aims to protect shareholders and the public from fraudulent financial reporting and accounting errors. SOX results to top management having to certify the accuracy of financial information and in addition penalties for fraudulent behavior are more severe (SEC, 2002).
The Sarbanes-Oxley act has economic consequences which influence public firms. The legislation creates incentives for firms to spend money on internal controls, beyond the increase that would have occurred after the corporate accounting scandals (Coates IV, 2007). It was found that cumulative abnormal returns of firms complying with SOX are negative and
these extra costs on the complying firms as expected. SOX promises various long-term benefits. These benefits are as follows according to Coates IV (2007). Shareholders face a lower risk of losses caused by fraudulent practices. On top of that shareholders will benefit from more reliable financial reporting, increased transparency and greater accountability. This will cause public companies its cost of capital to decrease and a better allocation of resources and faster growth will benefit the economy. The reforms were introduced with diminutive scientific evidence to support these supposed benefits (Masulis et al., 2007). In mergers and acquisitions the motivation for earnings manipulation is higher due to the nature of the transactions. Investors suspect that a target-firm its earnings will be managed upwards and will be rationally adjusted through a discounted transaction price (Gavious & Rosenboim, 2013). SOX seeks to improve earnings quality, which is the overall reliability of reported earnings, and investor confidence. Gavious and Rosenboim (2013) found that the earnings quality did not significantly change after the implementations of the Sarbanes-Oxley act. Selling managers had become more conservative in their earnings reports due to market developments and buyers seem to have expected that Sarbanes-Oxley does not increase a managers’ intention to inflate earnings.
Sarbanes-Oxley raises criminal penalties for white-collar crimes and corporate fraud. CEO’s and CFO’s have to certify quarterly and annual reports to the SEC (Section 302 SOX). SOX directs the U.S. Sentencing Commission to proclaim amendments which tighten fraud and white-collar crimes sentencing guidelines (Sections 805, 905 and 1104, SOX). The increased criminal penalties intend to improve the accountability of executives and directors to the shareholders (Zhang, 2007?). Besides this the increased penalties are expected to reduce the incentive to commit fraud by executives and enhancing the monitoring by directors.
White-collar crime sentencing guidelines were lengthened in 2001 and 2003. These changes were already initiated prior to SOX (Perino 2002 and Brickey 2004). Top executives
involved in corporate scandals did receive long sentences. WorldCom’s CEO received 25 years, Enron’s CEO 24 years and Dynergy’s CEO 24 years. These sentences reflect the law and guidelines before the enactment of Sarbanes-Oxley. The act does increase resources for the SEC but the SEC does not enforce criminal law (Coates IV, 2007). SOX did not increase the number of prosecutions by the Department of Justice in white-collar crimes in the five years following SOX. So it is unlikely that the enactment of the Sarbanes-Oxley law and its criminal provision caused an effect on an executive’s incentive to commit fraud or a white-collar crime. But it could have had an effect on the information available to potential investors.
The implementation of Sarbanes-Oxley came in a time the corporate governance system of the US failed, but Kaplan and Holmstrom (2003) argue that the overall system in the US actually performed well. They fear that the US governance system now faces the risk of over-regulation due to the implementation of Sarbanes-Oxley. Companies tend to reveal
accounting problems through a restatement of the financial reports, which means a
restatement often goes hand in hand with an accounting problem. One of the provisions of SOX required is that a majority of the board consists out of independent directors. Another requirement is that at least one member of the audit committee should have financial capabilities. These independent directors do however lack the incentive to help a company, unlike the CEO their job is not at stake in the firm and on top of that they do face liability when things go wrong. Also their reputation is at stake which could affect their future career. This does mean that the independent members do not gain much but have more to lose if they help a company in fraudulent activities. Research by Agrawal and Chadha (2005) points out that the probability of restatements is lower in firms who do have such an independent audit committee with financial expertise in their midst. These restatements bring new information to light for shareholders, so one would prefer to steer away from restatements. Of course this does not mean if it is necessary a firm should not make a restatement of the financial
accounts. One would expect this provision of SOX would sort an effect. A positive abnormal return was found after the implementation of SOX for firms that were less compliant with the corporate governance rules. Evidence was found by Chhaochharia and Grinstein (2007) that the board provisions in small firms do not increase a firm its value. For larger firms the implementation of SOX does not seem to have a significant impact.
2.2 The pharmaceutical sector
Holder-Webb (et al., 2008) point out that when making an investment decision, investors consider matters concerning corporate just as significant as the financials of a firm. Patel and Dallas (2002) even state there is a price premium paid on governance as well, which is also influenced by the disclosure policy a firm has. Improved disclosure allows a firm to respond more on time to underlying economic problems, which could be intensified by poor
disclosure. When a firm has higher transparency and proper disclosure stakeholders have access to more reliable information thus reducing the information asymmetry. Research by Patel and Dallas (2002) suggest that firms with a corporate governance policy which focuses
on higher transparency and better disclosure receive a higher valuation than comparable firms with a corporate governance policy which focuses less on high transparency and disclosure. They also conclude that transparency and disclosure has increased since the Asian crisis in 1997 and in the light of the US accounting scandals.
Pharmaceutical firms regularly face stakeholders who actively monitor their company and are well informed of their practices. The pharmaceutical industry deals with an important aspect of human rights, the right of health care (O’Riordan and Fairbrass, 2008). When a
pharmaceutical company has a poor corporate governance policy with low transparency and little disclosure but does make profits it might not be understood by stakeholders while on the other hand this company may for example need these profits to finance future drug
development. The main faults of the industry, which are often discussed in the media, are known and discussed. They include excessive profits, unnecessary drug development, price fixing etc.
The objectives for increasing disclosure are apparent, increasing disclosure should lead to a reduction of the information symmetry. This in turn leads to a lower cost of capital and can increase shareholder return and enhance growth (Verrecchia, 2001). So why wouldn’t all firms increase disclosure? Naturally it comes at a cost. Increasing disclosure can benefit your competitors or even increase the exposure to litigation (Darrough and Stoughton, 1990), especially when you are a firm developing a new drug. The pharmaceutical industry is a competitive market. The cost of disclosure is higher for a pharmaceutical company compared to the average firm because most companies only develop a couple of products (Guo et al., 2002). Benefits however are high as well due to the large asymmetry of information between managers and investors. Managers know more about their products than investors. Looking at a firm and its level of disclosure its size also comes into play. Smaller firms may have lower quality of disclosure due to the fact these firms are not known to the public. Research suggest an explanation for this could be that these smaller firms are less known to the public and have a smaller following of analysts (Healy and Palepu, 2001). There is a variability in what is mandatory to report and what is not, this leads to the concerns that investors are not able to get the information needed for their decision-making or that the information is incomplete and flawed (Holder-Webb et al., 2008).
The legitimation of mergers and acquisitions in the pharmaceutical sector used by managers is, as in most M&As, foremost the existence of synergies and economies of scale. In their case study on M&As in France Vaara and Monin (2010) mention examples of made-up synergies and integration problems are easy to find in the pharmaceutical sector. The
pharmaceutical industry is a setting which thrives on innovation and M&A’s are strategically essential in which M&As are often used to acquire new technology and patents thus
improving R&D. Parachuri et al. (2006) found that acquired inventors cease patenting for the merged companies and reduced productivity by these ceased inventors. The combination of both leads to reduced output in the post-acquisition period, which in turn is not profitable for the new company. Research between 1985 and 1996 by Ravenscraft and Long (2000) on pharmaceutical mergers did find abnormal stock returns around the announcement date in their event study. Rising R&D spending has not lead to an increase of the compounds which get approved per year by the food and drug administration. The number has declined since 1996 and the number of the compounds which originate from large firms has decreased (Danzon et al., 2007). This raises the question if merger and acquisition activities in the pharmaceutical industry are effective. Combined firms in Ravenscraft and Long’s (2000) study did not perform significantly different from zero, cross-border and horizontal mergers however did. Danzon et al. (2007) found that mergers in the pharmaceutical industry by large firms have little effect on a firm its growth in enterprise value, R&D expenses, sales and employees. It was also found operating profit was reduced by more than 50% in the third year after a merger relative to a similar firm which did not merge.
2.3 Intangible assets
Intangible assets are not always properly accounted for. The balance sheet does not always give investors useful information about intangibles (Prescott, 2007).
Intangible assets are assets which lack physical elements, it includes among others patents, copyrights, trademarks, trade names and goodwill. Intangible assets cannot be valuated objectively (at least not by a universal model) and they are difficult to monitor and observe for outsiders. These characteristics leave intangible assets vulnerable to accounting
manipulation. GAAP does limit the ability for management to record intangible assets. These GAAP limits intend to improve the quality of information in financial markets. According to Wyatt (2005) given management discretion under some circumstances the ability of earnings to predict performance could be improved. Management has to report a company its
intangible assets in order to inform investors correctly.
Information about intangibles poses a challenge for investors to unravel the economic implications from contracting and signaling motives which may not be informative about cash flows and directly attributable to intangible assets (Wyatt, 2005).
Managers of high leveraged firms can have incentives to record intangible assets to increase a firm its total assets and hereby increasing a firm its ability to issue debt. Wyatt (2005)
suggests a positive relation between intangible assets and leverage. Firms with managers who expect the intangible assets will lead to increased future performance will have an incentive to report these assets. The recording of intangible assets which are otherwise unobservable by investors could signal expected growth and might distinguish the firm from firms of lower quality (Leland and Pyle 1977). Given this it is important to correctly report a firm its intangible assets.
Because a firm with substantial intangible assets it is harder to monitor for outsiders if these investments are correctly recorded and it can be considered as an earnings measurement problem. Kumar (2008) found that cash flow from operation response coefficients were higher and accrual response coefficients were lower for firms with high intangible
investments. The higher CFO response coefficients are consistent with a lower visibility to outside investors with intangible investments opposed to tangible investments. The intangible investments lead to higher differences between external and internal financing. These cost differentials cause the internally generated cash flow from operations to be more important for determining if investments are realized when comparing intangible with tangible. This gives less information when investments are more focused on intangible assets compared to tangibles. Although it might not be clear how intangible assets create value exactly and how it is recorded. When managers define their company and its interests broad enough including the interest of customers and employees a spiral of value creation can occur. Motivated and properly trained employees plus effective R&D investments can lead to products adding a value to a company and generate higher margins (Lin & Tang 2009). Claessens and Laeven (2003) found that industrial sectors which relatively use more intangible assets develop faster in countries which have better property protection rights. Improved property rights stimulate economic growth. Growth is facilitated by a better allocation of the assets in firms who would inherently prefer a higher amount of investment in intangible assets. This asset allocation growth effect is on top of the increase in a firm its growth because of greater external financing.
Countries with a poorly developed financial system and weak property rights have a double effect on a firm. First of all, a company cannot optimally allocate its resources and secondly the access to external financing is reduced.
The research by Claessens and Laeven (2003) suggests that the asset allocation effect is important in hindering the growth of new firms. Intangible assets protection and the asset allocation coming from this is important for the growth of firms.
Efficient markets include the value of its intangible assets in the price of the stock. For example in 1995 (Chan et al., 2001) R&D expenditures and assets which represent an important important intangible asset were not accounted for fully on the book value of common equity. This means that stocks with high R&D capital and thus high intangible assets which were not fully accounted for appear to be more expensive than when differently. Benefits of these R&D capital (and also other intangible assets) are highly unpredictable. The accounting information about these assets is limited in its usefulness for investors.
Changing the way these intangibles are recorded has a potential to have a large effect on a firm its financial statement. When investors fail to adjust their valuation methods to the benefits of R&D mispricing can arise. Louis (et al.) found that there is no direct link between R&D spending and future stock returns. The research pointed out that after a three-year period stocks of companies who record R&D have an average return of 19.65% percent per year and without R&D an average of 19.5 percent. It appears that companies with high R&D do not tend to outperform companies without R&D according to Chan et al. (2001)
Looking at the pre-SEC era when managers had more freedom in reporting their intangibles so does this lead to a difference in the share price. Ely and Waymire (1999) found evidence that coefficient which relates earnings to the share prices decreases with capitalized
intangibles. This corresponds with the believe of investors that managers may overstate their earnings through the capitalization of intangibles. It was tested if these findings implied that if a firm its stock price is lower because intangibles are reported separately instead of
aggregated with other assets. Intangibles might not have a relation to the price because only a part of the assets is perceived by investors to be measured reliably. Investors valued the companies in this sample by Ely and Waymire (1999) based on earnings and only attached value to intangibles when they lead to higher earnings rather than when the investments were made.
2.4 Mergers and Acquisitions and information asymmetry
Normally managers have an advantage when predicting firm specific events compared to the market, this creates information asymmetry between the managers and the investors
and sellers. If no information is transferred markets will perform poorly. Certainly considering the financing of projects with a variable quality.
While a manager might know the quality of his own project an investor as an outsider cannot observe which quality a project has. When markets place an average value on projects this may be greater than the average cost of a project. This could lead to a large supply of projects with a low quality because the managers of these projects can sell the project on the
uninformed market and make a profit. For projects of high quality selling for an average price it will cause managers to lose money as the cost of capital is higher than the return of the project. The consequence will be that the supply of poor quality projects relative to the high quality projects is relatively higher. If high quality projects want to get financing information needs to be provided. This is an adverse selection problem (Berk and Demarzo, 2014). But the distribution of information also has its downsides. Borrowers know their characteristics like their collateral and moral behavior better than the lender does. Managers have inside information about the projects they want to finance. The lender can profit from knowing the characteristics of a borrower. Moral hazard hinders the transfer of information between parties. A borrower can benefit from not being honest about his characteristics and for managers the same applies regarding his project as they can both profit from overstating certain qualities (Berk and Demarzo, 2014). Thus it is essential for information to be transferred without having to incur high costs.
In the specific case of intangible assets market failure arises because acquirers often possess less information regarding the quality of intangible assets than the target does (Leland and Pyle, 1977). This information asymmetry can create uncertainty about the quality of a target firm its assets which leads to adverse selection. The potential targets could be lemons and the targets of better quality are only available at prices exceeding the acquirers’ budget.
This is where the lemons problem arises, all available targets are of poor quality and the targets with a better quality are thus too expensive. The question is even when wrongfully recording of the intangibles is not intentional this information asymmetry issue can be overcome. For example, a target drug company and its researchers are too optimistic about the release date of a drug currently in development (Zaheer et al. 2010). A potential acquirer cannot correctly form an idea about the true value of this drug. If this drug is one of the main reasons for initiating the takeover it will be difficult to assess how the acquisition can be a success.
Acquiring a company creates organizational and management challenges as the assets and fraudulent reporting can be implied and embedded in individuals and groups or intertwined
with other resources. This makes is difficult to correctly value these assets and acquiring the company for the right price. Sarbanes-Oxley comes with a set of rules to improve financial reporting and protecting shareholder rights. It is interesting if these results improve the reporting of intangible assets and assure an acquiring firm can collect the information needed to make a profitable deal with a target.
As Jensen and Ruback (1983) concluded in their analysis: ’the evidence indicates that corporate takeovers generate positive gains that target firm shareholders benefit and bidding firm shareholders do not lose’. There is a benefit for target firms in M&A’s but for acquiring firms the goal is to improve performance results after a merger or acquisition.
Outperformance of merging firms can be linked to the differences in the size of the two firms and merging firms engage in acquisitions after a time of superior performance (Gosh, 2001). These differences in size and their influence on outperformance can be deducted from the implication that larger firms are more profitable than smaller firms (Fama & French, 1995). Meaning that larger firms are expected to outperform smaller firms. A firm engages in mergers and acquisitions after a period in which it has realized above average operating performance which is likely to be caused by temporary factors which in time will be driven away by competitors (Morck et al. 1990). But according to Gosh (2001) there is no evidence that after an acquisition firms are able to increase the operating cash flow performance. Profitable M&A’s seem to occur in situations where the target company is managed poorly. An acquiring firm which is under proper management can create more value in these kind of acquisitions (Wang and Xie, 2009). It was also found that a difference in the shareholder rights presents an opportunity for a positive effect on the performance of the merged firm, which leads to a higher abnormal return. Sarbanes-Oxley has the intention to make the management of a firm better and increase shareholder value, but for every firm. One would expect that there will be a smaller gap between the management capabilities of an acquiring or a target firm.
Stock returns in M&A’s researched by Hackbarth and Morellec (2008) suggest there is no significant change preceding a merger or acquisition. Beta’s on firm level prior to the announcement date of an acquiring company compared to the target company do however move in a significant way. The research suggests if the beta is higher for the acquirer it will result in a decrease upon the announcement and vice versa.
Because of the large size of many deals in M&A’s financing decisions have an impact on the ownership structure of a company and financing decisions following up on a deal. Martin
cash flows were unstable for deals in the United States. In the European market however different results were found by Faccio and Masulis (2005) who did find significant effects from the difference in payment type for a deal. The announcement date of mergers and acquisitions is the day the market learns an acquiring firm made a bid on the target firm. When investors perceive the information asymmetry to be low and they can make a fair judgement about the deal their reaction to announcement can be more in line with the
acquiring firms perceived advantages of the deal. On the other hand, if investors perceive the information asymmetry to be high they cannot make a fair judgement about the deal as they cannot know what the expected synergies may be. The announcement of a deal can also reveal the strategy of management even more so because a merger or acquisition is in many cases one of the biggest decisions a firm can make. If the market perceives the announcement of the deal as bad news it can have an impact on the share price which leads to shareholders having doubts about a manager its capabilities (Luo, 2005). The market can only base their decision on the publicly available information of the two companies. Luo found that
companies learn from the market during M&As. The companies can use the market reaction to the announcement and incorporate this in their decision making. It was found that
combined abnormal return of acquirer and target around the announcement predicts if the deal was finalized later on. The majority however experienced negative market reactions but do finalize the deal. When looking at the pharmaceutical companies a target may for example develop a drug which is in line with a product an acquiring company is developing and the synergies of developing the drug at the same time could increase the targets company value. A manager might know this but investors may not. The announcement of a merger often involves significant price information. The efficient market hypothesis states relevant
information is reflected in the market valuation of a security (Keown and Pinkerton, 1981). It is however found that superior returns can be gained from possessing special information not known to the market. Results by Keown and Pinkerton (1981) do support the semi-strong efficient market hypothesis in which the market reaction to public information is completed a day after the announcement.
3.) Research Setup 3.1 Hypotheses
This research will focus on the effect of SOX in M&A’s surrounding the announcement date. The announcement date of an action, like M&As, is the date the information about that
certain action becomes available to the public. If Sarbanes-Oxley lowers the information asymmetry in mergers and acquisitions and improves disclosure by pharmaceutical firm managers should be able to make a better decision about whether the deal is good for a
company or not. Shareholders on the other hand now know a manager should be able to make a better decision which profits the company. Specifically, it will focus on the abnormal return in M&A’s for listed acquiring companies in the pharmaceutical industry and if the return is affected by the change in legislation by Sarbanes-Oxley in 2002. Does the Sarbanes-Oxley act lower the information asymmetry between managers and shareholders in the
pharmaceutical sector in M&A’s? The first hypothesis is that the Sarbanes-Oxley act causes an increase in the abnormal return surrounding the announcement date of M&As, especially in the pharmaceutical industry. An increase in the abnormal return is expected due to the corporate governance provisions in the SOX act which should lower information asymmetry and improve shareholder protection (SEC, 2002) and improve managerial decisions.
Secondly the type of deal payment will be looked at. The second hypothesis will be if the payment type and size of the deal affects the abnormal return surrounding the announcement of a deal and in the given time frame and the enactment of SOX. One could argue that the type of payment influences the abnormal return due to for example tax shields, shareholder rights and the cost of capital (Wansley et al., 1983). Chhaochharia and Grinstein (2007) looked at the announcement effect of the Sarbanes-Oxley and the impact on firms and
shareholder return and the costs of Sarbanes-Oxley. Their results were focused on the relative benefits and costs between firms that were more compliant and firms that were less compliant with SOX. In this research I will follow up on the research by Chhaochharia and Grinstein (2007) and look at the effect of Sarbanes-Oxley on mergers and acquisitions and compare this pre-SOX and post-SOX. This research will only focus on the abnormal return in M&As and not the impact of SOX firm-wide, although it of course has its effects as was found by Chhaochharia and Grinstein (2007).
3.2 Data
The timeframe of the research is 1999 to 2005. The year 2002 is omitted from the data set to exclude companies who changed their policy preliminary to SOX or straight after the
implementation of the act. The sample contains 4055 deals affected by the change in
legislation in the United States, this means either the acquirer or target is based in the US. A subset of 218 deals include all the deals in pharmaceutical sector. The sample is taken from
zephyr and includes all deals in which acquirers take a stake with a minimum of 51% in a target company. The sample contains deals which have been completed or are assumed to be completed. The timeframe takes the announcement date of a deal into account. The minimum value of a deal in the sample is $ 10 million to exclude small deals with companies who do not have to comply with the corporate governance rules as they are too small. As was found Chhaochharia and Grinstein (2007) small firms have positive abnormal returns if they do not comply with the Sarbanex-Oxley act. Deals below the $ 10 million mark are considered small in this research and excluded.
To check if there are abnormal returns for shareholders surrounding a merger and acquisition deal in the timeframe 1999-2005 (excluding 2002) an event study is used. Event studies are used to measure the reaction to major corporate decisions, such as mergers and acquisitions, focused on the announcement date (MacKinlay 1997). The announcement date is when the news should become available to the general public, including shareholders. The goal is to see if there is any abnormal return for shareholders of the acquiring firm due to the
announcement.
3.3 Model
The abnormal return is calculated with the use of the Capital Asset Pricing Model (Berk and Demarzo, 2014).
E(R)=Rf+ß*(E(Rm)-Rf), AR=R-E(R)
With AR = abnormal return, ER = expected return, Rf = risk free rate, Rm = market rate, ß = Bèta-coefficient (systematic risk). The data needed is taken from CRSP, and with the
following estimation parameters the abnormal return is calculate. The estimation window is 100 days with 70 non-missing returns. The event window is 21 days, 10 days preceding the announcement date and 10 days following the announcement. The following step is to calculate the cumulative abnormal returns. With the cumulative abnormal return being the sum of the abnormal returns according to the following formula with the use of the event study tool provided by WRDS.
With the use of the CAR a simple regression is set up to calculate if there is any effect for the coefficient of Sarbanes-Oxley:
CAR=ß0+ß1*DummySOX+e where ß0 is the constant and e is the error term.
The dummy variable for Sarbanes-Oxley takes the value 1 if the deal took place before Sarbanes-Oxley and the value 0 if the deal took place after the implementation of SOX. After the check if SOX has an influence I will research if the type of deal has an effect on the CAR around the implementation of SOX.
CAR=ß0+ß1*CashPayment+ß2*DebtPayment+ß3*Shares+ß4*ln(Dealsize)+e
With the following coefficients: cashpayment is a dummy which takes the value 1 if the deal is paid in cash, 0 otherwise. Debtpayment will take the value 1 if the deal is paid by issuing debt, 0 if otherwise. Shares has the value 1 when the deal is financed by equity and 0 otherwise. Ln(Dealsize) is the natural logarithm of the value of the deal (in US $) and e the error term. Does the type of deal influence the cumulative abnormal return around the implementation of SOX is what will be investigated with this multiple regression analysis. Financing decisions can have an impact on the ownership structure and leverage of a company.
4.) Results
4.1 Descriptives and full regression
Below the descriptive statistics and correlations of all the variables used in the regression. Descriptives
Pharma
M&As n=217 All M&As n=4055
Mean Standard Error Mean Standard Error CAR -0,00571 0,01352 0,00427 0,00293 PreSOX 0,45622 0,03389 0,44414 0,00780 CashPayment 0,57604 0,03363 0,51788 0,00785 DebtPayment 0,05530 0,01555 0,05993 0,00373 Shares 0,23041 0,02865 0,23674 0,00668 LogDealsize 11,88821 0,11787 11,47432 0,02462 Correlations
n=217 CAR PreSOX CashPayment DebtPayment Shares LogDealsize
CAR 1,00000 PreSOX 0,04954 1,00000 CashPayment -0,08203 -0,20646 1,00000 DebtPayment 0,10615 0,10222 -0,28202 1,00000 Shares -0,04159 0,17992 -0,63780 -0,13239 1,00000 LogDealsize -0,01987 0,15414 -0,06437 0,08512 0,14842 1,00000 n=4055 CAR 1,00000 PreSOX -0,01236 1,00000 CashPayment 0,01709 -0,14870 1,00000 DebtPayment 0,02306 0,01479 -0,26168 1,00000 Shares -0,04967 0,20622 -0,57722 -0,14062 1,00000 LogDealsize -0,01745 0,15969 -0,09009 0,14516 0,13102 1,00000
As can be seen in the correlation table, there is some correlation but not high enough to cause problems in the regressions, no signs of multicollinearity.
CAR=ß0+ß1*CashPayment+ß2*DebtPayment+ß3*Shares+ß4*ln(Dealsize)+e
Pharma M&As F = 1,07772 R Square = 0,02490
n=217 N Coefficients Standard Error t Statistic P-value
Intercept 217 0,06034 0,09691 0,62267 0,53418 PreSOX 99 0,01665 0,02810 0,59251 0,55415 CashPayment 125 -0,05973 0,04083 -1,46303 0,14495 DebtPayment 12 0,03807 0,06884 0,55305 0,58081 Shares 50 -0,06378 0,04691 -1,35975 0,17536 LogDealsize 217 -0,00224 0,00804 -0,27871 0,78074
All M&As F=2,42007* R Square = 0,00298
n=4055 N Coefficients Standard Error t Statistic P-value
Intercept 4055 0,02960 0,02227 1,32911 0,18389 PreSOX 1801 -0,00050 0,00608 -0,08176 0,93484 CashPayment 2100 -0,00368 0,00793 -0,46413 0,64258 DebtPayment 243 0,01200 0,01396 0,85953 0,39010 Shares 960 -0,02243* 0,00926 -2,42241 0,01546 LogDealsize 4055 -0,00162 0,00193 -0,84083 0,40049
*significant at the 5% level
The full model does not give a significant F-value for the pharmaceutical subset but does give a significant F-value for the full M&A dataset. The coefficient shares is significant at the 5% level.
4.2 Regression with Sarbanes-Oxley
Did the enactment of the Sarbanes-Oxley act cause an increase in the abnormal return surrounding the announcement date of M&A’s and especially in the pharmaceutical sector. This is what has been tested with the simple regression: CAR=ß0+ß1*DummySOX+e. Firstly the regression is calculated on the entire sample, next the regression is calculated with the subset of the pharmaceutical sector deals.
CAR=ß0+ß1*DummySOX+e
Pharma M&As F = 0,52894 R Square = 0,00245
n=217 N Coefficients Standard Error t Statistic P-value
Intercept 217 -0,01473 0,01836 -0,80199 0,42344
PreSOX 99 0,01977 0,02718 0,72728 0,46785
All M&As F = 0,61930 R Square = 0,00015
n=4055 N Coefficients Standard Error t Statistic P-value
Intercept 4055 0,00633 0,00393 1,61322 0,10678
PreSOX 1801 -0,00464 0,00589 -0,78695 0,43135
For the entire sample the coefficient for the dummy variable SOX is -0,00464 with a P-value of 0,43135, which means it is not significant at the 5% level. For the pharmaceutical subset the coefficient is 0,01977 with a p-value of 0,46785 which means the subset also does not give a significant result in the CAR after the change in legislation by Sarbanes-Oxley. Which means I can reject the hypothesis that SOX has an effect on mergers and acquisitions in the given timeframe. Also for pharmaceutical firms there are no significant results. Chhaochharia and Grinstein (2007) did find some significant effects by the announcement of Sarbanes-Oxley, but this result has no significant outcome. This might be due to the fact that the year 2002, when SOX was enacted has been omitted from the regression. It is however interesting to see that both ß0 coefficients, 0,00633 and -0,01473 respectively, in the model also give non-significant p-values, 0,10678 and 0,42344 respectively for the full sample and the pharmaceutical subset. These results suggest that the cumulative abnormal return for M&A’s in the given timeframe is not significant for an acquiring company. This is in line with previous research which suggests M&A transactions rarely provide abnormal return on the acquiring side. Jensen and Ruback (1983) already said that evidence suggest that takeovers only generate gains for target shareholders but not for acquirer shareholders. Not much seems to be different in this case as no significant abnormal returns can be found. Ravenscraft and
Long (2000) however did find abnormal stock returns in their study, they found that acquiring firms had a significant abnormal return of 2,1% around the announcement date. This could be due to the timeframe difference and the fact several macroeconomic factors influenced their research and this research, for example the internet bubble and the crash by the end of the 80’s. Mergers and acquisitions are however not the only form in which pharmaceutical firms, or other firms, can combine resources. Common practices in the industry are product-specific alliances for drug development and marketing alliances (Danzon et al., 2007). Companies who are already working together and decide to merge might not lead to abnormal returns as the market already expected this to happen and its seen as a formality.
4.3 Regression with the payment type
Does the size of a deal and the payment type in a merger and acquisition deal have an impact on the cumulative abnormal return in the given time frame? And in the pharmaceutical sector? This is tested with the following multiple regression.
CAR=ß0+ß1*CashPayment+ß2*DebtPayment+ß3*Shares+ß4*ln(Dealsize)+e Pharma M&As F = 1,26325 R Square = 0,02328
n=217 N Coefficients Standard Error t Statistic P-value
Intercept 217 0,06130 0,09674 0,63364 0,52700
CashPayment 125 -0,06169 0,04063 -1,51850 0,13038
DebtPayment 12 0,04065 0,06860 0,59265 0,55405
Shares 50 -0,06189 0,04672 -1,32456 0,18674
LogDealsize 217 -0,00164 0,00796 -0,20548 0,83739
All M&As F = 3,02415* R Square = 0,00298
n=4055 N Coefficients Standard Error t Statistic P-value
Intercept 4055 0,02963 0,02226 1,33103 0,18326
CashPayment 2100 -0,00366 0,00793 -0,46208 0,64405
DebtPayment 243 0,01199 0,01396 0,85895 0,39042
Shares 960 -0,02253* 0,00918 -2,45402 0,01417*
LogDealsize 4055 -0,00164 0,00191 -0,85937 0,39019
*significant at the 5% level
In both regression outputs it can be found that the constant (intercept) is insignificant, which again suggest CAR in the given timeframe is insignificant for mergers and acquisitions. Both
hypothesis that there is a significant abnormal return in the given timeframe can be rejected with the calculated values. Only the payment with shares in the full sample leads to a significant coefficient. A payment in shares in a deal suggests the CAR will reduce with -0,022526987, significant at the 5% level with a p-value of 0,0142. But given the small value of the coefficient of Shares it is unlikely it will have a large impact on the CAR. Premiums should be larger for cash mergers than payments using securities due to the fact capital gain taxes can be postponed until the securities are sold, but in cash mergers this cannot be done. It was found by Wansley (et al., 1983) that cash acquisitions earn on average significant higher abnormal returns, 33,54 percent was their result, which was higher than the 17,47 for mergers paid in securities. This difference was said to be due to the tax effect, regulatory requirements which favored cash and the increased popularity of mergers using cash. The small negative but significant effect of shares on the CAR can be explained by their findings. The deal size does not seem to have a significant impact on the CAR. This suggests it does not matter if a company is either small or large in the given timeframe. The model for the full sample does however produce a significant for the F value at the level of 0,0167. The subset model produces an insignificant level of 0,2855. Analyzing the model suggests this is only due to the significance of the coefficient Shares. The results are in line with Martin’s (1996) conclusions that the type of payment in the US market gives insignificant results. This is different from M&A deals in the European market, where Faccio and Masulis (2005) suggest the type of payment and size does matter for the abnormal return of shareholders surrounding the announcement of a deal. The pharmaceutical sector which could seemingly benefit from stricter corporate governance deals due to the disclosure practices in the sector and the low transparency does not see any significant results. The results suggest shareholders in the pharmaceutical sector do not seem to profit from abnormal returns of M&A’s. It seems the shareholders do not experience any significant form of abnormal return in general.
Chhaochharia and Grinstein (2007) found there was a significant effect for companies that were less compliant with SOX in particular for small firms, one would expect the deal size to have an effect on the abnormal return due to their results. The results point out there is no significant effect in deal size. The hypothesis that the payment types with cash and debt and the size of the deal have an effect on the abnormal return surrounding the announcement of a deal and in the given time frame and the enactment of SOX. The hypothesis can however not be rejected for a payment in shares as it has a small but significant effect.
Conclusion
In this thesis I researched if there are significant effects in M&A abnormal return due to the implementation of the Sarbanes-Oxley law in 2002. The law came in to play due to large accounting scandals leading to public and political pressure to change the US corporate governance rules and prevent future damages. The decision making process does however seem to lack clear economic morale. In the light of M&A’s which could benefit from a reduction of the information symmetry in especially the pharmaceutical sector Sarbanes-Oxley has no effect on the abnormal returns for an acquiring firm its shareholders. Using the sample of 4055 deals and 217 deals in the pharmaceutical sector no significant results can be found following the enactment of Sarbanes-Oxley. It is however the question if the effect of Sarbanes-Oxley is truly measured in this research. The effect of Sarbanes-Oxley is not only on shareholders but also influences company policies, employees and other stakeholders. The enactment of Sarbanes-Oxley also caused other countries to update their corporate
governance provisions, for example the Netherlands came up with Code-Tabaksblat as their updated corporate governance code. One could also argue there are several other factors to be reckoned with and the regression suffers from omitted variable bias. It can be researched if there is any effect by the internet bubble which came up in the early 00’s. The payment type and deal size do not seem to provide any explanation for the CAR apart from the payment in shares. The payment in shares provides a small negative effect, but significant on the CAR for acquiring firms.
Future research should point out if the legislation change of Sarbanes-Oxley has an effect on the stakeholders apart from the shareholders. Maybe there is no clear profit for shareholders but the public good does profit from the Sarbanes-Oxley law. Once again the question arises why firms keep engaging in merger and acquisition activities.
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