Moral Hazard in Acquisitions Research Paper

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moral hazard in mergers, acquisitions and takeovers. The essay discusses the definition of moral hazard as well as related agency theory and the role of asymmetrical information in transactions. The essay also reviews insider trading from the perspective of insider trading.

In the context of economic theory, moral hazard describes the tendency of a party to take excessive risks because the costs associated with the unreasonable risk are not incurred by the party taking the risks. That is, when the behavior of one party to a transaction may result in detriment to another party after the transaction has taken place, moral hazard may be said to be present. Moral hazard occurs because an institution or individual does not bear the full responsibility or consequences of its actions, and as a result, there is a tendency to act less carefully than otherwise would be the case; this irresponsible behavior leaves the other party to bear some responsibility for the consequences of actions over which it has no control.

In economics, moral hazard presents a special case of information asymmetry, which occurs when one party in a transaction has more information than another party to the transaction. This is especially likely to create a problem when the following conditions are present: (a) the party which has more information about its intentions or actions has an incentive to behave recklessly or inappropriately as seen from the perspective of the party possessing less information and (b) when the party which is insulated from risk is in possession of more information regarding its intentions and actions than the party which ends up paying for the negative consequences that result from the risk.

Moral hazard in the context of mergers and acquisitions can be explained by agency theory. An agency relationship exists between stockholders and managers, wherein the principals, the stockholders, hire the company's agents or managers, which relationship involves inherent conflicts of interest. Agency theory suggests that managers will seek to maximize their own utility at the expense of corporate shareholders. Therein lies the fundamental problem: shareholders authorize managers to administer the organization's assets on their, the shareholders' behalf, whereas the corporation's managers may have personal goals that compete with the owners' goal of maximizing shareholder wealth (Kleiman n.pag.). This conflict of interest is usually addressed by creating incentives for managers to put shareholder interests ahead of their own, which efforts usually occur at the expense of creating agency costs.

Conflicts of interest can be significant for large, publicly traded corporations where the company's managers own only a small percentage of the common stock. In such cases, maximizing shareholder wealth can be subordinated to various managerial goals. For example managers may wish to maximize the size of the firm. Creating a large, rapidly growing firm may increase the executives' status, as well as create more opportunities for lower and middle-level managers and salaries, and enhance managers' job security by making an unfriendly takeover less likely (Kleiman n.pag.).

To counter the tendency of managers to fail to act in stockholders' best interests requires such mechanisms as incentives, constraints, and punishments. However, these methods work only if shareholders are able to observe all actions taken by managers. The problem of moral hazard exists because it is not feasible for shareholders to monitor all managerial actions (Kleiman n.pag.).

Moral hazard arises during mergers and acquisitions as a result of several scenarios wherein the interests of owners and agents are misaligned. For example, the threat of a takeover may induce "managerial myopia," which is a short-sighted approach or narrow view of which activities may not be in the best long-term interests of shareholders. Managerial myopia can occur when takeover pressure is generated along with the fear of being bought out at an undervalued price. This fear in turn can lead managers to emphasize short-term profits more heavily rather than long-term objectives. Such a scenario can lead to excessive borrowing and what some experts have termed a casino mentality. Or, takeover fears may be intensified for managers when quarterly profits drop, causing the quarterly bottom line to drop. In this scenario, the stock may become undervalued, making the company an easier target. Managers may try to avoid such scenarios by focusing on short-term defensive stances, by selling off assets and reducing long-term capital investments in an effort to stretch fourth quarter earnings (Stein 62).

Managers who boost their stock prices by inflating earnings may be motivated by misguided attempts to keep stockholders from being taken advantage of by raiders. These attempts may be misguided if one considers that such activities can result in ex-ante losses to shareholders. Boosting the stock price may also be by managers who are not attempting to help shareholders, but are instead trying to discourage takeovers so that they can keep their jobs (Stein 63).

The potential for agency conflicts resulting in moral hazard is especially high in the event of a takeover. Both the shareholder welfare hypothesis and the managerial welfare hypothesis are cited as explanations to explain the reaction of target managers to a takeover bid. The shareholder welfare hypothesis argues that management meets its fiduciary responsibility by carefully reviewing proposed tender offers and then taking appropriate actions to promote shareholder interests. In some cases, managers will decide that they are protecting shareholders interests by opposing a takeover. Frequently, target managers opposing takeover bids defend their actions by claiming that the bid price is insufficient (Walkling and Long 54).

The managerial welfare hypothesis suggests that target managers face a problematic choice between their obligations to current shareholders and their duty to aspiring shareholders of the takeover firm. Managers of the firm being taken over can be faced with a significant conflict of interest between their fiduciary responsibilities and their own potential loss of wealth. Managers who believe that a takeover is in the best interests of their shareholders may still be motivated to take undue risks, due to fear of losing their jobs. In fact, Business Week reported on a survey of 1,300 executives who were asked to leave their jobs revealing that one-third of them were let go during mergers, acquisitions and takeovers (Walkling and Long 54). A manager at a target firm who believes that his or her job is at risk may believe that taking an extraordinary risk is appropriate if it will save the manager's job. The threat that a takeover poses to their job security creates an incentive to take undue risk before the formal takeover.

Cases of insider trading occur when information asymmetry exists and insiders have an incentive to capitalize on their inside information. Moral hazard occurs with respect to insider trading if managers perceive a perverse incentive to profit on bad news as well as good. Similarly, insider trading may encourage a manager to invest in risky projects, or impede corporate decision-making, as well as influence managers to delay public disclosure of valuable information (Carlton and Fischel 858).

Some economists draw a distinction between the economic and legal distinctions regarding insider trading. Illegal insider trading is considered illegal because it compromises the basic conditions of a capital market. Insider trading happens when a trade has been influenced by the privileged possession of corporate information that is not yet public. Since the information is not yet available to other investors, the person using such information is attempting to gain an unfair advantage over the rest of the market (Heakal n. pag.).

By using nonpublic information to make a trade, the insider violates transparency, one of the basic principles of a capital market. In a transparent market, information is made available in such a way that all market participants receive it more or less simultaneously. In these circumstances, one investor can gain an advantage over another only by acquiring skill in analyzing and interpreting the available…[continue]

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