The potential pitfalls of mergers and acquisitions (M&As) are well known. They may include overpayment, overestimation of synergies and the inherent complexity of integration.
Recently, a lot of attention has been directed towards another hazard of M&As: corporate governance failures. Of course, pre-acquisition due diligence is critical to detecting governance failures before they can hurt the merging companies. As a series of current post-acquisition litigations illustrate (Sunbeam/Coleman, MCI/WorldCom, Cendant and AOL/Time Warner), allegations of fraud surfacing after the merger taint all merging entities and not just the one where the fraud occurred. In this respect, a rigorous pre-acquisition assessment of the internal controls and corporate governance practices of the merging businesses, as mandated by the Sarbanes-Oxley Act, is clearly a step in the right direction.
Still, even the best due diligence can only tackle corporate governance failures occurring before the acquisition. The post-acquisition integration process itself can increase the likelihood of fraud and decrease shareholder protection.
The critical part of any M&A is the integration of distinct entities. Integration is a highly complex process that can promote the transfer of value-creating as well as harmful practices. Even with the best intentions, acquirers can trigger corporate governance failures that would not have occurred had the merging companies not been integrated.
Corporate governance failures caused by post-acquisition integration can occur in the short term, during the transition period, because of weakened internal control systems and increased performance pressures. They can also occur in the longer term, during the integration period, because of the harmful transfer of inferior or inappropriate governance practices from one business to another or, in the context of cross-border acquisitions, because of shifts to weaker national legal environments which offer lower investor protection (see figure 1).
The short-term problem
Merging companies have to cope with a rapid increase in the size, scope and breadth of control requirements, a patchwork of control systems, often widely different norms and internal labour markets. Thus, M&As often entail a chaotic transition period that is characterised by organisational turmoil, leadership change, cost-cutting and employee anxiety. During this period, employees may be left with little or no supervision due to a weakening of internal controls. In turn, this provides greater opportunities for fraud, notably among disgruntled employees.
Staff may also be subjected to greater pressure from their new management to meet aggressive business objectives in order to save their jobs and meet the expectations of the financial community. When opportunities and incentives come together, the potential for fraud is heightened.
Weakened internal control systems
Acquisitions alter existing processes, procedures and relationships, and lead to a considerable amount of uncertainty and leadership confusion because of executive departures, the emergence of co-heads or a leadership void. During this period of disruption, employees are caught in a maelstrom of organisational change and do not understand where their company is heading, to whom they should report or what is expected of them. Furthermore, merging businesses rarely have similar or compatible control systems, and confusion when attempting to align or rationalise them is inevitable. Until new systems are established, controls are often overlooked or worked around, which opens up new opportunities for fraud.
When the M&A has been undertaken primarily to save costs, budget cuts are often imposed on functions that do not generate revenues but are important for preventing and detecting fraud, such as internal audit, employee screening and training. This leaves employees with less supervision and support. Naturally, when controls are weak and confusion is high, it is easier for employees to defend themselves and invoke “good faith” mistakes if the fraud is discovered. In a study of 57 organisations, Professor Schnatterly found that companies that had white collar crime occurrences had weak internal controls, loose policies and procedures, and weak ethics policies.
At the same time, employees feel threatened during the M&A process. Acquirers commonly fail to undertake a balanced process of restructuring, and the target’s employees generally pay a substantial toll. A study of 250 M&As by Professor Capron revealed that the target company’s assets are three to five times more likely to be downsized than the acquirer’s assets.
What is more, in addition to the fear of being fired, employees at the target business may also experience pay cuts, depreciated status and fewer chances of promotion. Some may see an M&A as breaking the psychological contract between a company and the individual. Thus, employees are more likely to feel justified to commit fraud if they feel that the new company is unfair, and that they have been personally mistreated.
Pressure to perform
On average, acquisition gains at the announcement accrue to the target’s shareholders at the expense of the acquirer’s shareholders, and acquirers face pressure from the financial community to deliver rapidly on announced synergies. To cope with these pressures, merging companies often embrace the pernicious logic of “doing more with less”.
When businesses belong to similar industries, acquirers tend to overestimate cost synergies and take a sanguine view of the target’s resources by depriving the target of its unique capabilities. Some employees may fall short of the newly stretched performance goals and may be inclined to cheat the system to protect their jobs or maintain their professional reputation in an environment of heightened performance pressure. For example, in a 1994 landmark survey of 4,035 US employees undertaken by the Ethics Resource Center, 29 per cent of respondents reported that they felt pressured to engage in conduct that violated their companies’ standards of business in order to meet business objectives.
The long-term problem
While the short-term effects of M&As can be costly and traumatising, the long-term effects can be deadly. Long-term, negative impacts can stem from the harmful transfer of governance practices across merging companies or – in the context of cross-border M&As – from changes in investor protection due to the shift to a less protective legal environment.
Harmful transfer of governance practice
Integration does not necessarily lead to leveraging the best of both worlds. Integration is often a politicised process through which acquirers impose their control systems and corporate governance practices on the acquired businesses. Prof Capron’s research has shown that 76 per cent of acquirers transfer their managerial systems to target, while only 6 per cent adopt the target’s managerial systems.
Transferring the acquirer’s control systems and governance practices to the target can be beneficial when the target has been mismanaged and has activities with similar governance requirements to those of the acquirer. On the other hand, such a transfer can be harmful if the acquirer’s governance practices are inferior to those of the target or if they do not fit the acquired businesses. The acquired business may have superior corporate governance practices, such as stricter accounting standards, more elaborated communication practices, a more clearly defined code of conduct and anti-fraud policies, better screening and compensation of employees and a more ethical corporate culture, indicating lower probability of fraud.
Even if the governance practices of the acquired business are not intrinsically superior to those of the acquirer, they may be more appropriate considering its competitive environment or internal context. When an acquirer blindly applies its inferior or inappropriate governance practices to the acquired business, out of internal politics or hubris, the target company suffers from a decreased level of internal monitoring and impaired governance practices, which in turn hurt the shareholders of the newly merged entity.
Cross-border M&As
Increasingly, companies use cross-border acquisitions to broaden their geographical scope and access new capabilities from heterogeneous business environments. However, the act of crossing national boundaries compounds the already complex transition and integration processes of an M&A. Language barriers, cultural idiosyncrasies, differences in market regulation, corporate codes, law codes and even accounting practices naturally complicate deals and increase opportunities for abuse.
Countries also have different legal environments with varying levels of investor protection (the extent of the laws that protect investors’ rights and the strength of the legal institutions that facilitate enforcement). An acquisition of a company by a foreign business triggers a shift in the law applicable to the target company. As a result, a cross-border acquisition can reduce the level of investor protection, when a target business in a stronger corporate governance environment adopts the weaker governance practices of the acquirer.
For example, based on a sample of 15,000 cross-border M&As completed between 1990 and 2001, Arturo Bris and Christos Cabolis at Yale discovered that 17 per cent of targets were acquired by a company from a less protective country. They also found that the market reacts positively when a foreign target is taken over by an acquirer from a country that offers stronger investor protection.
Prescription for prevention
Employees, managers, board members and shareholders need to address issues of corporate governance at all stages, from pre-acquisition due diligence to post-acquisition integration. Here are our key recommendations.
• More comprehensive due diligence
Assessing the quality of governance practices requires going beyond an assessment of the internal control systems (a Sarbanes-Oxley requirement). Shareholders not on the board should expect a corporate governance report as part and parcel of M&A information, addressing questions such as whether the target company supports effective governance policies, communication, company ethics and anti-fraud policies, and whether it can prove it.
• Better pricing
Value the governance issues. An acquiring business must know how to adjust the price of the potential target based on the likely costs of fraud itself and of the procedures required to alleviate it. During the negotiation process, managers should set up explicit objectives with their analysts, M&A advisers and auditors regarding their assessment of the risk of governance failure.
• Minimise leadership confusion during the transition period
In the transition phase of an M&A, management should communicate immediately who is in control across the different levels of the organisation. A leadership void and confusion allow employees to ignore policies more easily.
Managers should communicate information not only on the status of the integration, but also on the increased likelihood of fraud. The fraud prevention system the acquirer has in place is likely to be challenged or ignored while the two companies restructure themselves into a single, new entity. Any steps that management can take with respect to clear policies and procedures, communication opportunities or hotlines for reporting problems will be time and effort well spent.
• Diminish employee angst during the transition period
There is no point in delaying harsh measures for people who do not fit with the new business. Not only do delaying tactics generate inertia in the implementation process, but they also sow the seeds of employee dissatisfaction which ultimately increases the chances of fraud. For the remaining people, managers must also be sensitive to the increased pressures generated by the transition period.
• Attend to the transfer of best governance practices during the integration phase
Businesses that understand the negative effects of the transfer of systems that facilitate fraud can consciously choose to transfer the systems that deter fraud. To do so requires a fair assessment of the current governance practices and the humility (notably on the part of the acquirer) to adopt the target company’s practices when they are superior.
• Assess country governance practices
As managers increasingly pursue cross-border acquisitions, it is important to assess the quality of governance practices in each national environment, including shareholder protection, creditor protection, accounting reporting standards and level of country corruption.
Managers of a target company from a stronger investor-protection regime can make contractual arrangements so that the merged organisation adopts their governance practices to compensate for deficiencies in the acquirer country’s legal environment.
• The lessons
Merging companies must devote resources to addressing corporate governance issues associated with the acquisition process. While such efforts add costs and time to the deal, managers should bear in mind that M&As provide organisations with an opportunity to gain greater control of existing or newly acquired businesses.
M&As also provide the momentum to revisit long established governance practices and to open a dialogue with employees and various stakeholders on corporate governance issues, fairness processes and ethical values.
Laurence Capron is associate professor of strategy at Insead and a visiting scholar at the Kellogg School of Management of Northwestern University. Her research is on M&As and corporate diversification.
Karen Schnatterly is assistant professor of strategy at the Carlson School of Management at the University of Minnesota. Her research is on corporate governance and white-collar crime.
