Corporate governance and divestitures: the effectiveness of internal and external control mechanisms

Abstract

This paper studies divestitures to explore whether stock ownership by managers and the board of directors are effective mechanisms for controlling agency costs. Stock ownership provides managers incentives to sell poorly performing assets that no longer fit the firms operating strategy while monitoring by the board of directors encourages the sale of assets that perhaps serve the interests of managers more than shareholders. As part of our analysis, we examine insider trading activity as a way to gauge agency costs that arise from managers exploiting their inside information. We examine external controls by investigating monitoring by external blockholders and assessing the divesting firms activity as bidder or target in the market for corporate control. Results show that announcement period returns are significantly related to insider ownership, the fraction of unaffiliated outside directors on the board, changes in trading activity by insiders, and whether the firm becomes a takeover target within two years of the divestiture. Divesting firms underperform a control sample of nondivesting firms over the two years preceding the divestiture, but show similar long-term performance the two-years following the divestiture. Moreover, divesting firms are more frequently involved in transfer of control activities as bidders before and targets after the divestiture when compared to nondivesting firms. Our results, overall, are consistent with the notion that divestitures create value because they help resolve agency problems, and the managerial ownership and the board of directors play a significant role in helping to resolve these problems.