Earnings management, lawsuits, and stock-for-stock acquirers’ market performance

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday October 20, 2008 at 2:21 pm
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Editor’s Note: This post comes from Henock Louis, Guojin Gong, and Amy X. Sun at the Smeal College of Business at Pennsylvania State University.

In a forthcoming Journal of Accounting and Economics paper entitled Earnings management, lawsuits, and stock-for-stock acquirers’ market performance, we analyze whether postmerger announcement lawsuits are associated with pre-merger abnormal accruals and the potential effects of lawsuits on acquirers’ market performance. We posit that, by subjecting stock-for-stock acquirers to lawsuits, pre-merger earnings management can have an indirect effect on acquirers’ performance around and after the merger announcement, in addition to the direct effect associated with post-merger accrual reversals.

After analyzing the association between pre-merger announcement abnormal accruals and post-merger announcement lawsuits, we examine whether the market anticipates the potential lawsuits and their consequences at the merger announcement. It is well documented that the average stock-for-stock acquirer experiences significant market losses at the merger announcement. In a fully efficient market, the probability of a lawsuit should be reflected in the market reaction to the merger announcement. To examine the association between the merger announcement abnormal return and the probability of a lawsuit, we use an instrumental variable approach. In a first step, we estimate the probability that an acquirer would be sued, using ex-ante predictors of lawsuits. In a second step, we analyze the association between the merger announcement abnormal return and the probability of a lawsuit. We use the two-stage estimation process because of the potential endogeneity in the relation between lawsuits and performance.

Consistent with our conjectures, we find that pre-merger abnormal accruals are a strong determinant of post-merger lawsuits. The effect of abnormal accruals is significant even after controlling for the post-merger abnormal return, which suggests that pre-merger earnings management has a first order effect on the likelihood of a lawsuit. We also find evidence that the market anticipates the lawsuits at merger announcements. There is a significantly negative association between the market reaction to a merger announcement and the probability that a stock-for-stock acquirer is subsequently sued. Further analyses suggest, however, that the market reaction to the merger announcement only partially reflects the probability of a lawsuit. First, we find that stock-for-stock acquirers’ long-term market under performance is largely limited to litigated acquisitions. Second, and more importantly, we find a very strong negative association between the likelihood of a lawsuit and the long-term market performance over the four years after the merger announcement. Therefore, post-merger announcement long-term market performance can be predicted using lawsuit-related information that is available at the time of the merger announcement. We do not claim that lawsuits are the only cause of the post-merger announcement long term under performance. The evidence only indicates that lawsuits are a contributing factor to the under performance.

The full paper is available here.

  1. If you look at most mergers and acquisitions in general, you will find that 60-80% of them fail to add shareholder value. The main reason for that is poor management and corporate culture clash post merger.

    Management of the company doing the acquiring usually doesn’t really have a sound vision of how the two companies will fit together after the merger or acquisition is complete. Furthermore, management also doesn’t really have a sound vision of how to run the acquired company at the same level or better than their previous owners did.

    The second part of the equation is merging two separate corporate cultures. The heart of any organization is its employees and the knowledge they bring to the job. Corporations each have their own way of doing things and culture to go along with it. Many times a company that acquires another company doesn’t take into consideration the culture of that company they are acquiring and how that will work out once the two companies are put together. As a result, once the two companies are merged, there is culture shock for the acquired company personnel, and, the company becomes far less productive than they were before.

    Let’s take the AOL and Time Warner Merger for example – which as you know ended in a shareholder lawsuit. AOL was a fantastic internet company, and Time Warner is one of the leading Movie and Music studios. The idea was that taking Time Warner’s huge content library and combining it with AOL’s large internet presence would create a new way to distribute content online. The crux of the idea was good, however, what the managers of AOL didn’t know was how to monitize content online, and neither did Time Warner executives. Also, they didn’t understand how to run an internet business and grow it. So what happened? AOL slowly died, and Time Warner suffered – as did their shareholders.

    Can you do a statistical analysis to say that a merger annoucement correlates to a lawsuit? Sure you can, but that is like saying there is a statistical relationship between someone crossing the street and getting hit by a car. It only makes sense if you understand the reasons why it happens.

    The lawsuits happen as a result of the mismanagement of the company doing the acquiring, and the poor performance that results from lack of or poor integration between the two acquired companies. The result is rarely better afterwards. Hence, the stock price of the acquiring company tends to drop, and shareholders sue the company because shareholder value has been wasted.

    Doing a statistical analysis of merger announcements and how that correlates to shareholder lawsuits only makes sense because the underlying fundamentals that drive corporate merger failures dictate that the majority of mergers will fail. However, the math is flawed, and is right for the wrong reasons.

    Comment by Stocks — October 24, 2008 @ 9:35 am


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