Target s Corporate Governance and Bank Merger Payoffs

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2 arge s Corporae Governance and Bank Merger Payoffs Elijah Brewer III, William E. Jackson III, and Julapa A. Jagiani December 2007 RWP Absrac: Commercial bank merger and acquisiion (M&A) ransacions are especially informaive for analyzing he impac of differing corporae governance srucures on he balance of corporae conrol beween managers and shareholders. We exploi hese special characerisics o invesigae he balance of conrol beween op-ier managers and shareholders using daa from bank M&A ransacions over he period Unlike research on non-financial firms, he impacs of independen direcors, managerial share ownership, and independen blockholders on bank merger purchase premiums in his environmen are likely o be measured more consisenly because of indusry operaing sandards and regulaions. I is also he case ha research on banks in his area has no received adequae aenion. Our model conrols for risk characerisics of he arge and he acquiring banks, he deal characerisics, and he economic environmen. he resuls are robus. Our resuls are consisen wih hose found for non-financial firms, and are consisen wih he hypohesis ha independen direcors could provide an imporan inernal governance mechanism for proecing shareholders ineress especially in large scale ransacions such as mergers and akeovers. We also find resuls consisen wih he conflic of ineres argumen where op-ier managers end o rade poenial akeover gains in reurn for heir own personal benefis, such as job securiy and oher employmen relaed perquisies. Our overall findings would suppor policies ha promoe independen ouside direcors on he board of commercial banking firms in order o provide proecion for shareholders and invesors a large. Key words: Corporae governance, bank merger, merger purchase premium, performance, bank holding companies JEL classificaion: G2, G21, G28, G3 We hank Rober DeYoung, Sherrill Shaffer, and paricipans a he FMA conference, European FMA conference (Siena), Federal Reserve Sysem Commiee Meeing, and he Federal Reserve Bank of Kansas Ciy Research Workshop for heir helpful commens. he research assisance of Oscar Cerda, Besy Dale, Erin Davis, Adewale Emmanuel, Syed Shah Saeed Hussain, Sumee Sawhrey, and Susan Yuska is grealy appreciaed. he views expressed here are hose of he auhors and do no represen he Board of Governors of he Federal Reserve Sysem or he Federal Reserve Banks of Alana, Chicago, and Kansas Ciy. Please direc correspondence o Elijah Brewer, Finance Deparmen Suie 6100, DePaul Universiy, 1 Eas Jackson Blvd. Chicago, Illinois , , ebreweri@depaul.edu.

3 arge s Corporae Governance and Bank Merger Payoffs 1. Inroducion and Summary he las decade has winessed an unprecedened pace of bank mergers and acquisiions. Beween 1990 and 2004, he number of bank mergers and acquisiions averaged abou 435 per year compared o 345 per year over he period As a resul he number of banks operaing in he U.S. has declined by approximaely 40 percen since Our invesigaion of he facors ha deermine marke prices for bank mergers will likely advance our undersanding of he likely direcions and consequences of coninuing mergers and acquisiions in he banking indusry. In his sudy, we focus on an imporan quesion which remained unanswered in he lieraure -- how he composiion of he arges boards of direcors and he corporae governance srucure, in general, influence he akeover marke and purchase premium in bank mergers. Previous sudies sugges ha corporae boards can be an imporan inernal governance mechanism for proecing shareholders ineress -- see Fama (1980) and Fama and Jensen (1983). Specifically, independen ouside direcors are hough o represen he ineress of shareholders because hey help o miigae shareholder/managemen agency problems. Independen ouside direcors could poenially play an imporan monioring role in merger ransacions. If independen ouside direcors are more likely o make decisions consisen wih shareholder-wealh maximizaion, hen purchase premium in merger ransacions may be expeced o be higher for arges wih a greaer proporion of independen ouside direcors han for oher arges. Coer, Shivdasani, and Zenner (1997) find ha for non-financial firms ha are he arges of ender offers, he iniial ender offer premium, bid premium revision, and arge shareholder gains are higher when he arge s board is independen. We examine he impac of independen ouside direcors on he purchase premium for bank mergers. 3

4 Corporae governance lieraure also idenifies facors oher han board independence ha may be imporan o he effeciveness of he board of direcors in negoiaing bank acquisiions. Specifically, he lieraure suggess ha he share ownership by op-ier managers could have an imporan role in aligning he ineress of managers and hose of he shareholders, hus i could improve he efficiency of he merger marke -- see Mikkelson and Parch (1989) and Coer and Zenner (1994). arge s higher share ownership by op-ier managers in his case could lead o more incenive o push for larger purchase premium (hus, larger gains o insiders from a merger offer). However, as in Moeller (2005), here is a second view of share ownership by op-ier managers. his view suggess ha he op-ier managers may be more willing o accep a lower purchase premium for he arge firm in exchange for higher compensaion and job securiy for hemselves, hus expecing a negaive relaionship beween merger purchase premiums received by arge shareholders and he proporion of shares owned by op-ier managers. We empirically es he impac of managerial share ownership on he purchase premiums for bank mergers. arge s large blockholders have also been found o play an imporan role in corporae governance and in deermining he firm s value. Independen large blockholders, in paricular, can exer pressure on op managemen in he mergers decision and could poenially use he hrea o voe heir shares o unsea managemen o align he ineres of managers wih hose of shareholders see Shleifer and Vishny (1986), Barclay and Holderness (1991), and Hadlock, Houson, and Ryngaer (1999). Previous sudies have also shown arge s share prices are more likely o sar running up prior o he merger announcemen dae wih he presence of large blockholders when compared wih merger deals when he arge has no large blockholders, hus, expecing smaller purchase premiums over he marke value of arge s share price around he merger announcemen dae. his may be due o he anicipaion ha he merger negoiaion would likely be successful wih he influence and he push from large blockholders. We include he large blockholders variable in our analysis o es for he influence ha large blockholders 4

5 could have on merger purchase premiums, and find a weak negaive relaionship beween he presence of independen blockholders and he merger purchase premium. Of course, his negaive correlaion may parially be he resul of large independen blockholders penchan for increasing he likelihood ha a firm will become a merger or acquisiion arge. In addiion o arge s board composiion, we examine oher facors ha migh affec supply and demand condiions in he marke for bank mergers, which may have been he driving force for bank merger waves in our sample period Firs bank mergers may be driven by desires o reduce overall risk by diversifying ino new geographic or producs markes. Benson, Huner, and Wall (1995) label his moivaion as he earnings diversificaion hypohesis. An acquirer may seek earnings diversificaion in an effor o generae higher levels of cash flow for he same levels of oal risk. According o he earning diversificaion hypohesis, an acquiring bank will pay more for a arge ha offers an opporuniy o diversify is earnings. Second, bank mergers may be moivaed by a sraegic decision o aemp o exploi economies of scale, or o cu overhead and eliminae duplicaion by closing branches, or o achieve synergies hrough economies of scope. We define he merger premium as he marke price offered for he arge minus he marke price of equiy (20 days prior o he merger announcemen dae) of he arge imes he number of shares ousanding a he ime of he announcemen. he merger premium is hen correlaed wih he financial characerisics of he arge and he acquiring banks, and composiion of arge s board of direcor, he arge s managerial share ownership, and he independen large blockholder variables. We conrol for all he differen facors, including characerisics of he arge he acquirer, and he merger deal, which are generally expeced o impac merger purchase premiums. Our resuls indicae a significan posiive relaionship beween independence of he arge s board of direcors and he size of he purchase premiums received by he arge. In addiion, we find a significan negaive relaionship beween arge s managerial share ownership and he merger 5

6 purchase premiums, and a weak negaive relaionship beween he presence of independen blockholders and he purchase premiums. he independen direcor resuls are consisen wih hose found in corporae finance lieraure for non-bank mergers. ha is, arge s independen direcors could provide an imporan inernal governance mechanism for proecing shareholders ineress especially in large scale ransacions like mergers. We also find ha managerial share ownership decreases he purchase premium, which is consisen wih an argumen ha arge s op-ier managers/ shareholders are more likely o accep a lower purchase premium for he arge firm in exchange for heir own job securiy and oher benefis ha are ofen offered o hem by he acquiring firm see, for example, Harzel, Ofek, Yermack (2004) and Wulf (2004). Our resuls also sugges a marginal negaive impac of independen blockholders on he purchase premiums, probably due o he arge s share price running up prior o he merger announcemen dae wih he marke s percepion ha he arge s independen blockholders would be able o push he deal hrough successfully. Our conribuion o he lieraure is clear when our analysis and resuls are conrased o he wo papers closes o ours. For example, compared o Benson, Huner, and Wall (1995), we inegrae bank merger premiums ino a modern corporae governance framework. We also use a much more recen daa se and an expanded model. he oher aricle mos closely relaed o our paper is Moeller (2005). We complemen Moeller (2005) in wo imporan respecs. Firs we use a single indusry. his eliminaes he need for [ofen imprecise] indusry conrol variables. More imporanly, he indusry analyzed is excepionally suied for his ype of analysis because of he infrequency of hosile akeovers. I is well known ha wheher he merger or akeover is a hosile or friendly in naure may cause he coefficien esimaes for he impac of managerial share ownership (as a proxy for srong managers relaive o shareholders) on he premium received by shareholders o reverse signs. his presens cerain esimaion and idenificaion problems. Addiionally, we use a broader definiion of managerial ownership han Moeller (2005). Finally, our resuls for he esimaed impac of managerial ownership on 6

7 shareholder premiums are economically a leas wo orders of magniude greaer ha hose in Moeller (2005). he remainder of his paper proceeds as follows. A brief lieraure review is presened in secion 2. Our daa and empirical mehodology are described in secion 3. Our resuls are oulined in secion 4. And, our conclusions are presened in secion Lieraure Review Previous sudies on mergers and acquisiions of non-financial firms have produced mixed resuls abou he deerminans of merger premiums. he analysis of bank merger premiums is less likely o suffer his ambiguiy as bank mergers require ime-consuming regulaory approval, making hosile akeovers exremely difficul o execue. his is imporan because as Moeller (2005) poins ou wheher he merger is a hosile or friendly ransacion may deermine he sign of he correlaion beween srong managemen and he relaive premiums received by shareholders. In previous banking sudies [Beay, Sanomero, and Smirlock (1987); Cheng, Gup, and Wall (1989); Fraser and Kolari (1988); Rogowski and Simonson (1989); Rose, (1991); and Brewer, Jackson, Jagiani, and Nguyen (2000)], asse size, profiabiliy, capial-asse raio, means of paymen and wheher he mergers were inersae or inrasae have been found o be significan in deermining merger purchase premiums or explaining he sock marke reacions o announcemens of bank mergers. Shawky, Kilb, and Saas (1996) find ha smaller arges end o be offered a larger bid premium, and Palia (1993) finds ha he relaive size of arges and acquiring banks are imporan in explaining he variaion in he bid premiums. Wih regard o performance, Shawky, Kilb, and Saas (1996) and Brewer, Jackson, Jagiani, and Nguyen (2000) find ha greaer merger premiums end o be offered o arge banks wih higher profiabiliy. Noe ha he merger premiums used in hese earlier papers are defined as offer 7

8 price relaive o book value of arge s equiy. In his paper, we examine he dollar purchase premiums over marke value of he arge s equiy. Benson, Huner, and Wall (1995) examine he dollar purchase premium (relaive o marke value of arge s equiy) paid o arge banking organizaions during he period , and find ha he coefficien on he variance of he arge s reurn on asses is negaive and saisically significan suggesing ha risky arges are offered a lower purchase premium. hey also find ha he coefficiens on he acquirer s book value capial-o-asse raio and marke-value-o-book-value of equiy are posiive and saisically significanly relaed o he purchase premium, indicaing ha more capialized, more efficien and beer managed acquirers end o offer larger purchase premiums. he coefficien on he raio of arge s asse o acquirer s asse is significanly negaive, suggesing ha he cos of consummaing he merger exceeds he poenial savings due o economies of scale when acquiring a large arge bank. We include he arge s and acquirer s volailiy of reurns and capial-o-asse raio and relaive size as conrol facors in our analysis. Corne and ehranian (1992), examining he pos-merger performance of large bank mergers beween 1982 and 1987, find ha merged banks end o have significan improvemen in operaing preax cash flow reurns in relaion o he indusry in he pos-merger period. his superior performance resuled from improvemen in he merged banks abiliy o arac loans and deposis, improved employee produciviy, and faser asse growh. 1 Uilizing boh accouning daa and marke daa, Corne and ehranian (1992) aemp o deermine wheher sock price gains associaed wih mergers announcemen (shor-run) are he resul of real economic gains (long-run). hey find a significan correlaion beween announcemen-period abnormal sock reurns and he various long-erm performance measures, and conclude ha marke paricipans are able o idenify in advance he improved performance associaed wih 1 For more discussion on bank merger performance, see Berger, DeYoung, Genay, and Udell (2000). 8

9 bank acquisiions. 2 Our sudy of purchase premiums focuses on shor-erm phenomena. We do no es wheher mergers will resul in efficiency gains or improved long-run performance, bu wheher he arge s corporae governance srucure influences he dollar premium (over he marke value of arge s equiy) paid by he acquirer o gain conrol of he arge s asses. Independen Ouside Direcors -- Several auhors have suggesed ha corporae boards can be an imporan inernal governance mechanism for proecing shareholders ineress -- see Fama (1980) and Fama and Jensen (1983). Specifically, independen ouside direcors are hough o represen he ineress of shareholders because hey could help o miigae shareholder/managemen agency problems. Independen ouside direcors could poenially play an imporan monioring role in large scale ransacions, such as mergers. If independen ouside direcors are more likely o make decisions consisen wih shareholder-wealh maximizaion, hen shareholder (or managemen) agency problems can be minimized. Analyss sugges ha an independen board is likely o have a beer alignmen wih shareholders ineress because i is in a beer posiion o monior and conrol managers for example, see Dunn (1987). Anoher claim is ha independen direcors could bring a greaer breadh of experience o he board and improve he board s effeciveness -- see Firsenberg and Malkiel (1980) and Vance (1983). he empirical resuls in Weisbach (1988) and Byrd and Hickman (1992) suppor his claim as hey find ha independen boards end o respond o poor performance by replacing he chief execuive officer (CEO). Sudies by Brickley, Coles, and erry (1994), Byrd and Hickman (1992), and Rosensein and Wya (1997) find relaively beer sock marke performance for firms whose board of direcors are made up wih relaively more ouside, independen direcors. On he oher hand, Subrahmanyam, Rangan, and Rosensein (1997) find ha independen boards have no exra value in evaluaing acquisiion arges. 2 Healy, Palepu, and Ruback (1991) perform a similar sudy on non-regulaed firms. 9

10 Coer, Shivdasani, and Zenner (1997) find ha for non-financial firms ha are he arges of ender offers, he iniial ender offer premium (over he arge s share price), bid premium revision, and arge shareholder gains are higher when he arge s board is independen where he board independence is defined as having more han 50 percen independen direcors. Brickley and James (1987) find ha in saes wih more acive banking akeover markes, he average fracion of he bank s board composed of ouside direcors is higher han in oher saes. his finding suggess ha he srucure of he board is paricularly imporan when a bank may be involved in corporae conrol aciviy. In his paper, we examine he impac of independen ouside direcors on he purchase premium. Corporae governance lieraure also idenifies facors oher han board independence ha may be imporan for he effeciveness of he board of direcors in negoiaing bank acquisiions -- 1) board size; 2) equiy ownership by inside direcors/ op-ier managers; and 3) he presence of large blockholders. Board Size -- Yermack (1996) found an inverse relaionship beween firm value and board size, suggesing ha smaller boards may be more effecive decision-makers and hus enhance firm value. However, his sample omied banks and oher financial firms. We examine he impac of board size on he purchase premiums for bank mergers. Managerial Share Ownership -- he finance lieraure suggess share ownership by managers could be imporan in corporae mergers and acquisiions. Morck, Shleifer, and Vishny (1988) find ha share ownership by managers may be an imporan device o align he ineres of managemen wih hose of shareholders. Mikkelson and Parch (1989) and Coer and Zenner (1994) find ha share ownership by managers is an imporan deerminan of merger marke efficiency. In banking sudies, Brickley and James (1987), Allen and Cebenoyan (1991), and Carer and Sover (1991) find ha share ownership by managers and direcors is beneficial o shareholders of banks. In non-banking sudies, Mikkelson and Parch (1989) and Coer and Zenner (1994) show ha wih greaer share ownership by managers, managerial 10

11 gains from merger offer are larger and managerial resisance less likely. McConnell and Servaes (1990) demonsrae ha he proporion of share ownership by managers is imporan in deermining firm value, and hus higher share ownership by managemen should lead o larger purchase premium. On he oher hand, Moeller (2005) offers an alernaive view. his view suggess a negaive relaionship beween arge op-ier manager share ownership and merger purchase premium since hey would end o rade he exra merger purchase premium for heir own privae benefis (such as job securiy and higher compensaion and perquisies in he posmerger organizaion) a he expense of oher arge shareholders. Harzel, Ofek, Yermack (2004) and Wulf (2004) examine how he pecuniary and non-pecuniary benefis ha arge CEOs receive in merger ransacions influence arge shareholders wealh. Harzel, Ofek, Yermack (20040 and Wulf (2004) find ha managers pursue personal ineress, and are willing o rade purchase premium for personal benefis. We include a measure of managerial ownership in our empirical analysis. Independen Large blockholders -- Previous research has shown ha affiliaed and unaffiliaed (independen) large blockholders can have an impac on corporae conrol decisions see Shleifer and Vishny (1986), Barclay and Holderness (1991), and Hadlock, Houson, and Ryngaer (1999). While affiliaed large blockholders end o align heir ineres wih ha of managemen independen blockholders may faciliae conrol changes by using he hrea o voe heir shares o unsea managemen in a proxy cones. Independen large blockholders can exer pressure on op managemen o accep a reasonably aracive acquisiion offer, resuling in larger gains o arge shareholders. Brook, Hendersho and Lee (2000) finds ha banks wih large independen blockholders are more likely o become a arge for a akeover. However, hey find he presence of independen blockholders o be associaed wih smaller merger announcemen reurns. Mergers ha involve a arge wih independen blockholders end o be anicipaed by he marke so ha par of he gains from he merger is incorporaed ino he arge s sock price prior o he acual merger announcemen causing he calculaed 11

12 purchase premiums o be smaller relaive o hose cases where here is no large blockholder. We es for he effecs of he presence of independen large blockholders on merger purchase premium. Overall, his paper examines he impac of he corporae governance srucure of he arge banks on he merger purchase premium. Our analysis sheds ligh on wheher he srucure of he banking organizaion s board of direcors, managerial share ownership, and he presence of independen large blockholders influence purchase premiums and hus, lead o acions in large ransacions ha enhance shareholders value. III. he Daa and Empirical Mehodology Daa Descripion: he daa used o esimae he above equaion is colleced from a sample of bank merger and acquisiion ransacions ha ook place from 1990 o he deails abou he merger deals are obained from homson Financial Securiies Daa (formerly Securiies Daa Corporaion (SDC)). We sared wih he SDC sample of all bank mergers beween 1990 and 2004, a oal of 11,252 ransacions. Of hese repored 11,252 ransacions, only less han 65 percen were compleed. We resric our analysis o only compleed merger ransacions, yielding 7,185 observaions. Mos of hese 7,185 repored merger ransacions are hen excluded because hey acually represen he firm s inernal resrucuring (where repored arge and acquirer have he same Cusip number) ha have lile if anyhing o do wih changing ownership and conrol or because hey are mergers ha involves foreign eniies, semi-privae firms (where sock price of he arge is no available), or missing deal informaion yielding 693 observaions. Of hese 693 arges, we were able o obain proxy saemens for 632 firms. Of hese 632 observaions, he majoriy are mergers beween very small banks. Chhaochharia and Grinsein (2007) find ha corporae governance rules enhance firm value more in larger firms han in smaller ones as hese rules are boh less cosly and more beneficial 12

13 in larger firms. We exclude hose very small ransacions, using a $250 million in real oal asses ( dollars) as he cuoff level for inclusion in our sample. his resricion reduces our sample size o 424 ransacions. We hen lose 32 observaions due o unavailabiliy of he acquirers sock price daa on he Cener for Research in Sock Prices (CRSP) daabase; so, our final sample consiss of 392 mergers, where boh he acquirers and he arges are U.S. publicly-raded banking organizaions wih asses size of a leas $250 million. 3 Financial daa is obained from he quarerly repors filed by hrifs (Call Repors) and bank holding companies (Y-9 Repors), for each of he 13 quarers prior o he merger announcemen dae. he merger announcemen dae, arge name, acquirer name, value of he deal, and oher characerisics of he merger announcemen come from he SDC daabase. Summary saisics of he sample are presened in able 1. he mean purchase premium using he arge s marke pricing 20 rading days prior o he announcemen is $357 million. Acquirers marke-o-book value raios are on average higher han hose of he arges, alhough he arges appear o have greaer accouning reurns han do acquirers. he mean raio of arge s asses o he acquirer s asses is On average, over 70 percen of arges boards are independen ouside direcors. Independen large blockholders hold a lile over 7 percen of he common shares, on average, compared o a lile under 7 percen held by he arge s managemen. he Basic Model: he premium paid by he acquirer for a arge depends on he difference beween he values he acquirer currenly places on he arge versus he value he marke currenly places on he arge. For example, according o Benson, Huner, and Wall (1995), []he price bid for any asse should be posiively relaed o and no more han he presen value of he change in 3 We are aware of he sample bias problem semming from his crierion, so he resul may no be applicable o very small banks. 13

14 he bidder s expeced ne cash flows Because, a a minimum, he price bid should reflec he sand-alone value of he ne asses acquired, (page 780).] Our basic framework follows he model specificaion used in Benson, Huner, and Wall (1995), and i is given in equaion (1) below. he purchase premiums for merger deal j which was announced a ime (PREMIUM ) are defined as he difference beween he announced offer price for a arge organizaion and he marke price of he arge s common sock 20 business days prior o he merger announcemen dae, all muliplied by he number of common shares ousanding -- hey are measured in $ million. For robusness es we also conduc an analysis using anoher measure of akeover premiums, as used in Moeller (2004), where he purchase premiums are measure as a raio, and equal o he difference beween he offer price and he arge s marke price of equiy prior o he merger divided by he arge s marke price of equiy prior o he merger. he resuls of hese ess are consisen wih our main findings, as repored in Appendix III. PREMIUM = α 0 + α1roa * A + α 2VROA * A + α 3ROA A * 4 VROA A * A + α 5COV, A * A α 6CRAIO * A + α + + α CRAIO A + α RELAIVE (1) 7 10 * A * A + α MARKEBOOK 8 + α INRASAE 11 + * A α 0, IND A + α MARKEBOOK 9 + ε A * A --- Five variables represening he level, variance and covariance of he acquirers and arges reurn on asses are included. he arges and acquirers reurn on asses over he 13 quarers prior o he merger announcemen dae are represened by ROA and ROA A, respecively. he variances of reurn on asses for he arge and acquirer over he 13 quarers prior o he quarer of he merger announcemen dae are represened by VROA and VROA A, respecively. he covariance of he arge s and acquirer s reurn on asses is represened by COV,A. 14

15 he merger lieraure suggess ha managers of acquiring firms may be more superior in generaing value o shareholders han managers of arge firms. We capure his effec by using he raio of he marke o book value of equiy. he variable MARKEBOOK is he markevalue-o-book-value equiy raio of he arge and MARKEBOOK A is he marke-value-o-bookvalue equiy raio of he acquirer. he acquiring banks ha possess superior risk managemen sraegy, as refleced in he larger marke o book value of equiy raio, MARKEBOOK A, are expeced o offer higher purchase premiums, hus a posiive coefficien is expeced. On he oher hand, MARKEBOOK is expeced o have a negaive coefficien implying less opporuniy for he acquiring bank o improve performance of he well-managed arges. Banking organizaions are required by regulaion o hold enough capial o suppor he risk ha hey ake. his risk-based minimum capial requiremen and he leverage raio are aimed a reducing he risk-aking propensiies of bank shareholders. We include he arge s capial-asse raio (CRAIO ) and he acquirer s capial-asse raio (CRAIO A ) in he quarer prior o he merger announcemen dae quarer as a proxy for he bank s capial adequacy. Well-capialized arges may be expeced o receive a larger purchase premium. o ge a beer sense of how he purchase price migh depend on he acquirer s abiliy o reduce he coss of producing he combined organizaion s exising produc mix by achieving economies of scale, we use he relaive asse raio, RELAIVE j. he variable RELAIVE j, which is he arge s oal asses divided by he acquirer s oal asses, may be eiher posiively or negaively associaed wih he araciveness of a given arge. If a larger relaive asse raio provides a greaer opporuniy for merger-relaed efficiencies o be realized, hen he relaive asse raio should be posiively correlaed wih purchase premium. A counervailing facor in large bank mergers, however, is he difficuly of merging wo large banking organizaions, or wo organizaions of equal size. According o organizaion heoriss, melding culures in a merger is more difficul and cosly when he arge is more equal in size o he acquirer -- see Benson, Huner, and Wall (1995). 15

16 Oher conrol facors are INRASAE which is a binary variable ha equals one if he arge and acquirer are locaed in he same sae (zero oherwise) and A which is he oal asses of he arge. We also include ime-period indicaor variables for he year of he merger announcemen ha ranges beween 1990 and IND where =2,...,. hese variables are inroduced o accoun for he effec of omied macroeconomic and oher variables ha may influence he overall level of acquisiion aciviy over ime, and, hus, he merger premium paid for a given ransacion. he Imporance of Board Composiion and Independen Direcors: o capure he corporae governance effecs on purchase premium, we modify Benson, Huner, and Wall (1995) by including measures of shareholder conrol as proxied by he proporion of independen direcors (board composiion), presence of independen large blockholders, and arge s managerial share ownership. Board Composiion: We classify direcors as independen or non-independen. Non-independen direcors are eiher presen or pas employees of he bank or direcors who are family members of insiders and direcors who have some business ies o he bank (e.g. aorneys whose firm represens he bank, consulans o he bank). Independen direcors are direcors who are no curren or pas employees of he bank, do no have subsanial business or family ies wih managemen (as indicaed in he proxy saemen), nor have poenial business ies wih he bank. Coer, Shivdansani, and Zenner (1997) define a board as independen when independen direcors are more han fify percen of he board membership. However, he average bank board ends o have subsanially more han fify percen independen direcors. he median proporion of independen direcors for our sample of banking organizaions is percen. We use his number o creae an indicaor variable for board independence. 16

17 he indicaor variable INDEPENDEN_DIRECOR is equal o one if he percen of he board of direcors ha are independen is greaer han,77.78 and zero oherwise. As an alernaive specificaion, we also include he raio of independen ouside direcors o he size of he overall board, %INDEPENDEN_DIRECOR, in a separae model. In addiion, larger bank boards end o have a large proporion of independen ouside direcors. We conrol for he arge s board size, BOARDSIZE, in our empirical specificaion o isolae he impac of independen ouside direcors on he purchase premiums. arge s Managerial Share Ownership: Anoher corporae governance mechanism ha is designed o align he ineres of managerial and board ineress wih hose of shareholders is share ownership by managers. he measure of managerial ownership included in our analysis is he percenage of equiy ownership by he op-ier managers repored in he las proxy saemen prior o he merger announcemen dae. We define op-ier managers as he op five execuives ypically repored in he proxy saemens. Alhough i is common o use only he CEO s equiy ownership as a measure of managerial ownership, we insead follow he procedure oulined in Lefanowicz, Robinson, and Smih (2000), and use he op five execuives equiy ownership in recogniion of he imporan role of oher senior execuive in corporae conrol changing evens. he indicaor variable MANAGERIAL_ OWNERSHIP is equal o one if he arge s managerial share ownership is greaer han he median percenage (4.82%) for our sample arges, and zero oherwise. Again, as an alernaive specificaion, we include he arge s raio of managerial share ownership, % MANAGERIAL_OWNERSHIP, in a separae model. Independen Large Blockholders: he presence of large block shareholders should miigae any agency conflics beween shareholders and manager, especially in large ransacions, such as mergers and acquisiions. 17

18 Previous research finds ha affiliaed and independen block shareholders can have an impac on corporae conrol decisions. Shareholder inervenion is also more likely when firms have large blockholders. While inside blockholders are expeced o have incenives o suppor he firm s CEO, independen blockholders are expeced o play an imporan role in deermining he degree of shareholder conrol. We define an independen blockholder (a leas 5 percen ownership) as a blockholder ha does no have subsanial business or family ies wih managemen as indicaed in he proxy saemen. We include in he analysis a binary variable INDEPENDEN_BLOCKHOLDER ha is equal o one if here is a large independen shareholder wih share ownership greaer han or equal o 5 percen and zero oherwise. Again, we also exend he model o include %INDEPENDEN_BLOCKHOLDER, which is he proporion of shares held by independen large blockholders, in a separae analysis. he expanded model ha includes corporae governance indicaor variables is shown in equaion (2) below. he resuls are presened in able 2. PREMIUM = α 0 + α1roa * A + α 2VROA * A + α 3ROA A * A α VROA * A + α COV * A + α CRAIO * A + 4 A α CRAIO α α * A 5, A + α MARKEBOOK * A + α MARKEBOOK 7 A 8 9 A 10 RELAIVE * A + α11inrasae + α12boardsize + 13 INDEPENDEN _ DIRECOR + α14independen _ BLOCKHOLDER MANAGERIAL OWNERSHIP j, α16, IND 6 + * A α 15 _ + + ε (2) he alernaive expanded model ha includes corporae governance raio variables (in percen) is shown in equaion (3) below. Like he oher financial variables included in he analysis, we inerac he proporion of independen direcor variable, he proporion of shares held by op-ier managers variable, and he proporion of shares held by independen large blockholders variable wih he arge s oal asses in he analysis. hese resuls are presened in able

19 PREMIUM = α 0 + α1roa * A + α 2VROA * A + α 3ROA A * A + α VROA * A + α COV * A + α CRAIO * A + 4 A α CRAIO α * A 5, A + α MARKEBOOK 6 * A + α MARKEBOOK 7 A RELAIVE * A + α11inrasae + α12boardsize α % INDEPENDEN _ DIRECOR 13 * A α % INDEPENDEN _ BLOCKHOLDER 14 + * A 15 % MANAGERIAL _ OWNERSHIP * A α16, IND ε + + A * A α (3) + IV. he Empirical Resuls We esimae our expanded models equaions (2) and (3) -- o deermine he imporance of boh arge s and acquirer s characerisics on he purchase premium and he impac of he arge s corporae governance srucure on he purchase premium. Our resuls of hese ess are repored in ables 2 and 3, based on equaions (2) and (3), respecively. From able 2, he analysis in column 1 excludes he corporae governance variables (BOARDSIZE, INDEPENDEN_DIRECOR, MANAGERIAL_OWNERSHIP, and INDEPENDEN_BLOCKHOLDER). Column 2 adds o he basic specificaion BOARDSIZE and INDEPENDEN_DIRECOR binary variable. Column 3 adds he MANAGERIAL_OWNERSHIP binary variable, and, finally, he binary variable INDEPENDEN_BLOCKHOLDER is added in column 4. able 3 follows a similar srucure, excep he addiional corporae governance variables ha are included in columns 2, 3, and 4 of able 3 are measured as raios (no binary variables). Risk Characerisics and Merger Purchase Premiums: Ineresingly, he mos imporan characerisics (besides he arge s corporae governance variables) ha impac he purchase premiums seem o cener around characerisics of he acquirers, raher han he arge s risk characerisics. From ables 2 and 3, column 1, he coefficiens on he acquirer s reurn on asses (ROA A ) are significanly (a he 1 percen level) posiive, suggesing ha more profiable acquirers are willing o offer a higher 19

20 purchase premium. he coefficiens on he acquirer s capial-asse raio (CRAIO A ) are also significanly (a he 5 percen level) posiive, indicaing ha well-capialized acquirers are willing o offer a larger purchase premium o acquire a suiable arge. In addiion, he coefficiens on he acquirer s marke-o-book-value equiy raio (MARKEBOOK A ) is posiive and saisically significan (a he 1 percen level), suggesing ha as i is commonly believed, acquirers wih superior risk managemen (high marke-o-book-value equiy) will end o pay more for a suiable arge since here would be more opporuniy for hese efficien and well-managed acquirers o improve he arge s operaions and performance afer he merger. he significanly negaive (a he 1 percen level) coefficien on he raio of he arge s asses o he acquirer s asses (RELAIVE) indicaes ha he acquiring banks are willing o pay smaller premiums o acquire relaive large arge banking organizaions, suggesing ha he benefis of economies of scale may be more han offse by he cos of blending he arge ino he acquirer s culure. his is similar o wha Benson, Huner, and Wall (1995) find for he earlier period ( ), when here were fewer mergers beween large arges and acquirers. he mean raio of arge s asses o he acquirer s asses is for heir sample compared o in our sample. Corporae Governance and Merger Purchase Premiums: Column 2 of ables 2 and 3 include wo of he corporae governance variables in addiion o he characerisics of he arge and acquirer arge s board size (BOARDSIZE ) is included as a conrol variable, and a measure of independence of he arge s board is included o capure he impac of independen direcors on bank merger premiums. Board independence is measured by he binary variable INDEPENDEN_DIRECOR in able 2 and by he raio variable %INDEPENDEN_DIRECOR in able 3. he coefficiens of risk characerisics and conrol facors remain consisen wih hose discussed earlier (from column 1). he BOARDSIZE variable seems o be unimporan in deermining merger purchase premiums as he coefficiens are posiive bu no saisically significan. he significan posiive coefficiens 20

21 of he binary variable INDEPENDEN_DIRECOR (in able 2) and he raio variable %INDEPENDEN_DIRECOR (in able 3) indicae ha independen boards are relaed o higher merger purchase premiums secured by he arge. his is consisen wih an argumen ha arge s independen boards creae value for he shareholders. his finding is also consisen wih corporae finance lieraure on non-financial firms see Coer, Shivdasani, and Zenner (1997). his resul is especially ineresing considering ha he median percenage of independen direcors in our sample is percen. Recall ha our binary variable INDEPENDEN_DIRECOR is equal o one when he percenage of independen direcors is above he median, and zero oherwise. Column 3 of ables 2 and 3 include also a measure of he arge s share ownership by op-ier managers (insiders). Noe ha hese insiders may or may no be on he arge s board of direcors, bu hey do represen insiders ownership and voing righs. he coefficiens of risk characerisics, conrol facors, arge s board size, and arge s board independence remain consisen wih hose discussed earlier (from columns 1 and 2). From column 3 of able 2, he coefficien of he binary variable MANAGERIAL_OWNERSHIP is negaive and significan (a he 1 percen level), suggesing ha more op-ier managemen equiy ownership is associaed wih smaller merger purchase premiums. Similarly, he coefficien of he variable %MANAGERIAL_OWNERSHIP is also significanly negaive -- see column 3 in able 3. hese resuls are consisen wih earlier evidence on non-financial firms in Moeller (2005), who finds ha a low fracion of CEO share ownership is associaed wih larger akeover premiums in his sample of non-financial arges. [Alhough our resuls are qualiaive similar o Moeller (2005), he magniude of our coefficien esimaes are economically much larger han his.] Unlike independen ouside direcors, share ownership by op-ier managers is associaed wih lower purchase premiums received by he arge banks. his suggess ha share ownership by op-ier managers is less likely o maximize shareholders wealh due o conflics of ineres and his argumen seems o hold for boh banking (highly regulaed) and non-banking firms. 21

22 Finally, in column 4 of ables 2 and 3, we include a measure of independen large blockholders in he analysis. he resuls remain unchanged for he board size variable (posiive bu insignifican), board independence (significanly posiive), and managerial ownership (significanly negaive). From column 4 of able 2, he coefficien of he binary variable INDEPENDEN_ BLOCKHOLDERS is negaive and weakly significan (a he 10 percen level), consisen wih an argumen ha wih he presence of independen large blockholders, he marke anicipae he akeover and incorporae par of he gains ino he arge s share price prior o he merger announcemen dae, resuling in smaller observed purchase premiums. When he variable is measured in erms of he raio of equiy ownership held by large independen blockholders o he overall shares ousanding (insead of he binary variable), in column 4 of able 3, he coefficien of %INDEPENDEN_ BLOCKHOLDERS is sill negaive bu no saisically significan. Robusness ess: Several robusness ess of our resuls have been performed. Firs we include he arge s asse size as an addiional conrol variable o he basic model he resuls are presened in Appendix I. Since he arge s oal asses is posiive correlaed wih he proporion of direcors ha are independen (wih 12 percen correlaion coefficien and significan a he 5 percen level), i is possible ha our binary variable INDEPENDEN_DIRECOR variable may be serving as a proxy for arge s asse size. Afer conrolling for he arge s asse we sill find he same resuls, where he coefficien of INDEPENDEN_DIRECOR is sill significanly posiive, indicaing larger merger purchase premiums o arges wih independen boards of direcors. Second, we include he means of paymen as an addiional conrol variable he resuls are presened in Appendix II. he variable Means of Paymen is a binary variable ha is equal o one if more han 50 percen of he value is paid in socks, and equal o zero oherwise. he resuls remain unchanged in erms of signs and significance of he coefficiens of risk 22

23 characerisics and corporae governance variables. Board size remains insignifican while he arge s independen board adds value and share ownership by managers reduces value o arge s shareholders. In addiion, independen blockholders coninue o have weakly negaive impac on he purchase premiums. hird, we use an alernaive measure of he purchase premiums, %PREMIUM, which is calculaed as he offer price per share minus he arge s sock price 20 days before he announcemen dae, divided by he arge s sock price 20 days before he announcemen dae. he analysis is based on he expanded model in equaion (2) below, and he resuls are presened in Appendix III. he resuls are consisen wih our earlier findings alhough he significance of he risk characerisics and conrol facors change and he goodness of fi is much weaker in his model han hose presened in ables 2 and 3 (wih purchase premiums measured in $ million). he posiive impac of independen direcors and negaive impac of managerial ownership and he presence of independen large blockholders are confirmed in he robusness es. % PREMIUM α + α ROA + α VROA + α ROA + α VROA + COV + α α α = A 4 A α 5, A 6CRAIO + α 7CRAIO A + α 8MARKEBOOK + α 9MARKEBOOK A + 10RELAIVE + α11inrasae + α12boardsize + 13 INDEPENDEN _ DIRECOR + α14independen _ BLOCKHOLDER + α 15 _ + + ε (2) MANAGERIAL OWNERSHIP j, α16, IND Overall, our robusness es resuls confirm ha unlike inside direcors, independen ouside direcors could provide an imporan inernal governance mechanism for proecing shareholders ineress especially in large scale ransacions like mergers. V. Conclusions he objecive of his paper is o examine he balance of conrol beween op-ier managers and shareholders using daa from bank mergers over he period Several sudies have invesigaed he role of independen ouside direcors a non-financial firms. 23

24 Independen boards (wih more han 50 percen ouside direcors) have been found in corporae finance lieraure o be associaed wih larger shareholder gains and being more effecive in monioring he firm s managemen. Unlike research on non-financial firms in corporae finance lieraure, he role of independen ouside direcors in banking firms has no received as much aenion in he lieraure. he role of independen ouside direcors in banking firms could be very differen from hose of non-financial firms due o banking regulaions and supervision (a he sae and federal level), he federal deposi insurance (federal subsidy), he oo-big-o-fail implicaions for very large banks, ec. We define bank board o be independen if he proporion of independen direcors is more han our sample median of 78 percen (higher han he usual 50 percen used for nonfinancial firms) since banks are more likely o seek more ouside direcors wih various experise. Our model conrols for risk characerisics of he arge and he acquiring banks, he deal characerisics, and he economic environmen. he resuls are robus and indicae significan posiive relaionship beween independence of he arge s board and he size of merger purchase premiums received by he arge. Unlike he independen ouside direcors, he arge s managerial share ownership and he presence of independen blockholders have a negaive impac on he merger purchase premiums received by he arge bank. Our resuls are consisen wih hose found for non-financial firms in he corporae finance lieraure, and are consisen wih he hypohesis ha independen direcors could provide an imporan inernal governance mechanism for proecing shareholders ineress especially in large scale ransacions such as mergers and akeovers. In addiion, our resuls are consisen wih he conflic of ineres argumen where op-ier managers end o rade poenial akeover gains in reurn for heir own personal benefis in erms of job securiy and oher benefis. Our resuls on he independen blockholders are weak bu overall consisen wih a belief ha he presence of independen blockholders makes i more likely for a banking organizaion o become a arge of a akeover and ha he successful compleion of he merger 24

25 ransacion may be anicipaed by he marke leading o smaller observed merger purchase premiums. Independen blockholders seem o help pu he firm in play, while independen direcors help make cerain ha shareholders receive larger purchase premiums. I should also be poined ou ha in addiion o being saisically significan he coefficiens of our board independence measure also show srong economic significance, wih coefficiens ranging from 72 o 100, suggesing ha arges wih independen board, on average, receive abou $72 million o $100 million more in merger purchase premiums. his is a significan amoun of excess premium compared wih he average oal bid premium of $357 million for our sample of 392 bank-merger deals a 20 o 28 percen increase in he addiional premium, on average, when he arge s board is independen. Similarly, he coefficien of our managerial ownership variable suggess ha on average, he arges wih large managerial share ownership receive abou $114 million (abou 32 percen of he sample average premium) less. his is he cos borne by oher shareholders in exchange for privae benefis o he managerial shareholders. Given he objecive of proecing shareholders ineress, our overall findings suppor public policies ha promoe independen ouside direcors on he boards of banking firms 25

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