[By Vidushi Gupta]
The author is a student of National Law School of India University, Bengaluru.
INTRODUCTION
Hostile takeovers make up a great proportion of global deal activity and have become a well-established strategy for growth in the corporate world. Golden Parachutes (GPs) are clauses within employment contracts, that grant the key executives of corporate entities lucrative severance benefits when their services are terminated. These benefits can include long-term salary guarantees, stock options, cash bonuses, generous severance pay, ongoing insurance and pension benefits etc., and are triggered only by a change in the company’s control/management through a sale, merger, acquisition, or takeover.
Interestingly, GPs are also a type of shark repellent, i.e. they may be adopted by target companies as a tool to ward off hostile takeover attempts. They have attracted much attention around the world, due to their common use and significance in takeover activities. Although GPs have not been a prominent issue in the Indian corporate governance discourse, they are fast gaining traction in India as well.
This article aims to contribute to the existing discussions and jurisprudence on GPs, and seeks to analyse whether GPs are a desirable way of trying to prevent hostile takeovers, by adopting a law and economics perspective. In India, GPs are primarily dealt with under Section 202 of the Companies Act, 2013. However, since hostile takeovers are quite uncommon in India, GPs are not really used as takeover defences in the Indian context.
It is argued that GPs are a weak and inefficient form of takeover defence, due to the costs associated with them. They largely help to convert hostile takeovers into friendly ones, rather than deterring hostile ones. However, it is possible to overcome some of the shortcomings of GPs, if they are treated as a reactive defence, rather than as a pro-active defence. The article also argues for a binding, disclosure-based regime as an effective means of promoting GPs which reflect shareholder interests.
GAINS ASSOCIATED WITH GPs
Proponents argue that GPs can prevent hostile takeovers, by threatening high transaction costs, making acquisitions more expensive, and making target companies unattractive or less profitable for the acquiring entity. Further, GPs can provide a soft landing for executives who lose their jobs, protect them against financial and career-related risks, and help to attract talented executives in industries and sectors that are takeover-prone and face talent crunch. Therefore, GPs can be said to help reduce agency cost problems between shareholders and managers of the target, by helping executives of corporations to remain objective and impartial, and preventing them from opposing takeovers that benefit shareholders. GPs can also improve the bargaining position of the target management, enabling them to negotiate better terms with the acquirer. However, the acquisition can no longer be termed to be truly hostile in such a situation. Hence, GPs are correlated with a higher likelihood of receiving an acquisition offer or of being acquired, leading to a paradox.
COSTS ASSOCIATED WITH GPs
GPs can lead to significant countervailing costs as well. GPs fail to thwart/deter hostile takeovers, since payments under GPs are minuscule compared to the cost of the acquisition, thereby having little impact on the outcome. A recent example of the failure of GPs to act as takeover defences can be seen in the successful hostile acquisition of Twitter by Elon Musk in a $44 billion deal and the subsequent firing of the top executives of Twitter (including CEO Parag Agrawal), despite the fact that these executives were entitled to GPs or severance pay-outs amounting to around $90 million or more upon termination of their employment.
Further, GPs do not necessarily correlate the pay with the performance of the company or the value created for shareholders. Short-lived executives may get paid large sums for little work. Executives may be paid GPs, even when shareholders and the company suffer losses or the latter becomes insolvent. Hence, GPs can lead to perverse incentives for the executive officers of corporates by providing a “guaranteed bonus” to them. Moreover, GPs are essentially sunk costs, as the acquiring entity cannot expect to gain any returns on the payments made.
Executives have a fiduciary responsibility to act in the best interests of the company, and should not require additional financial incentives to remain objective and fulfil their duties. Moreover, GPs can also lead to the creation of agency cost problems, since the executive has an incentive to enable the takeover to happen, which may prove detrimental in case a takeover is not wealth-enhancing for the shareholders. Further, GPs fail to serve the interests of target shareholders and investors. They are associated with lower (risk-adjusted) stock returns and erosion of firm value. This indicates that by ensuring executives of a cushy landing after an acquisition, GPs weaken the disciplinary force on executive performance exerted by the market for corporate control and lead to increased slack. GPs may be tied to the volume, not the quality, of business, but few companies may require executives to return bonuses based on inflated numbers. Hence, GPs incentivise short-term behaviour to the detriment of long-term shareholder interests.
Additionally, GPs are negatively associated with the acquisition premiums earned by target shareholders. They weaken executives’ bargaining position in acquisitions that would take place regardless of a GP. GPs can’t be used to negotiate better offers, since hostile takeovers involve little negotiation. If there is serious negotiation, it in fact becomes a friendly takeover, meaning that the GP is not a defence anymore. GP’s nature as a pre-emptive defence also prevents negotiation, as they cannot be entirely eliminated due to being guaranteed and promised in the employment contract. Hence, even if negotiation happens, executives may use their bargaining power only to extract benefits for themselves.
The shortcomings indicate that the costs of GPs exceed the benefits, and the gains are insufficient to offset the losses resulting from such GPs, thereby leading to inefficient outcomes. Moreover, it is evident that GPs, instead of functioning as a hostile takeover defence, are more helpful to convert hostile takeover into a friendly one.
THE NEED FOR A DIFFERENT APPROACH
Section 202 does not adequately address any of the aforementioned costs. It has limited coverage, and does not discourage GP payments by insolvent companies. Further, fixing the ceiling of three years as a rule for determining the maximum quantum of compensation creates problems, since the acceptable level of GPs may vary across transactions, depending on the annual executive pay, the size of the acquisition etc. Moreover, managerial remuneration is subject to quantitative restrictions, under Sections 197 of the Companies Act, 2013.
Hence, the grouse in India has been one of excessive regulation. Put in terms of Calabresi-Melamed’s Cathedral Model from a law and economics perspective, Section 202 (predominantly a liability rule model), should be transformed into a property rule model instead, to preserve the autonomy of companies. We need to adopt a disclosure-based regulatory regime. Managerial remuneration should be left to the company to decide, with prior shareholder approval. Hence, shareholders should have a binding “say on pay”, as is the case in the UK. Institutional investors can exert pressure on firms with respect to the form and nature of GPs. Failure to comply should render the payment illegal, the director liable to a fine, and the sum to be returned. Moreover, in India, controlling shareholders themselves are often managers or possess the power to appoint their representatives as managers. Hence, to ensure fair play and accountability, “interested shareholders” should be restricted from voting on their own pay proposals. Moreover, there should be mandatory separation of the positions of Chairperson and CEO/MD, to allow for transparency and oversight and monitoring of the board of directors over the management of the company.
However, this may not adequately protect shareholders’ interests. When voting is done prior to an offer, shareholders may be unable to make an informed decision, as the terms of the offer may not be available for them to consider. Hence, GPs should be construed as a reactive defence, to respond to a takeover bid, when a specific amount of the target’s shares has been acquired. If the takeover is positive for the shareholders, GPs should only be to the extent of compensating the executive. If it is detrimental, GPs should be appropriately determined to prevent the takeover. Thus, the employment contract should only provide for a GP in case of loss of office due to change in control, with the specifics left to be decided upon later. This will help reduce many of the costs associated with GPs, and help entities employ GPs more efficiently.
Thus, there is a pressing need to make the aforementioned shift from the existing approach towards GPs, since the current legal framework governing GPs and the way in which GPs are presently construed render them completely inefficient as takeover defences, in their current form. Only then can the true purpose and potential of GPs as a tool be realised to the fullest extent.