The call option implicit in proxy contested firms.

Previous researchers have documented changes in the wealth position of shareholders of proxy contested firms (hereinafter referred to as 'contested' firms) (see, for example, Dodd and Warner, 1983, Mukherjee, 1985, DeAngelo, 1988, and Pound, 1988). There is no consensus on the source or longevity of the changes in wealth, or even on the direction of change. Several authors have presented evidence that is consistent with the idea that proxy contests produce efficiency gains through the replacement and/or improvement of inept management, but other work suggests that the gains may be only temporary (see, for example, Austin, 1965a, 1965b, Wattel, 1966, Dodd and Warner, 1983, Mukherjee, 1985 and Mukherjee and Varela, 1992).

A proxy contest involves a dissident shareholder group which seeks to oust the incumbent management team through the corporate voting procedure at the annual meeting.(1) Initiation of a proxy contest is analogous to a call option in that if the value of the firm under new (or improved) management, PN, sufficiently exceeds the value of the finn under incumbent management, PI, then, dissident shareholders may opt to engage incumbent management in a proxy fight (Hancock and Mukherjee, 1992). A proxy contest will only be rationally initiated if the call option is in-the-money (PN|is greater than~PI). However, during the contest period the option can also be at-the-money or out-of-the-money. In any case, the market price of the stock, P, during the contest period reveals information about the value of the firm under a new or improved management team. Thus, from the announcement date of the contest until the annual meeting (the 'contest period'), shareholders own common stock and a call-like claim against incumbent management. Therefore, during the contest period, trades in the common stock of the contested firm represent trades of a portfolio which includes stock with call-like options. Market prices during the contest period then represent not only the value of the common stock, but also the value of the call option (see Bhagat, Brickley and Loewenstein, 1987, for a similar analogy using inter-firm cash tender offers).(2)

The wealth effect for the shareholders of contested firms consists of two components. First, there is a re-assessment of the incumbent management that occurs as a result of the announcement of the contest. This results in a change in the underlying value of the firm's stock due to new information. The second component of the wealth effect is the option to exchange the value of the firm under incumbent management, PI, for the value of the firm under new management, PN. This paper will provide some additional insights into the source of the wealth gains from proxy contests by separating the re-assessment of the contested firm's management from the value of the call option. The analysis begins by documenting the risk level of contested firms' portfolio prices during the contest period compared to pre- and post-contest periods. Option pricing theory predicts that the risk level during the contest period is greater than in other periods since a portfolio containing a call option will have a higher beta than a no-option portfolio (Pettit and Singer, 1985). The analysis will use Margrabe's (1978) option pricing formula, as applied by Hancock and Mukherjee (1992), to study in more detail the pricing of contested firms' stock during the contest period.(3) The portfolio beta during the contest period is shown to be, on average, higher than the beta of the stock in either the pre- or post- contest periods. Therefore, the CAPM predicts that a contested firm's common stock should, at each instant in time, command a higher equilibrium expected return than in either the pre- or post-contest periods. Finally, this study investigates the return characteristics of a contested firm's stock during the contest period.

The organization of this study is as follows. Section I describes the sample and selection criteria. Section II analyzes the behavior of a contested firm's stock transaction prices in the pre-contest, contest and post-contest periods. Section III estimates the values of the underlying stock and call prices during the contest period. Section IV investigates the return characteristics of a contested firm's stock during the contest period. Section V summarizes the findings.

I. The Sample

Fifty-five companies which have had proxy contests for control during the period 1970 to 1986 were selected for inclusion in the study. The sample includes all companies mentioned in the Wall Street Journal Index as having a control contest during this period unless: (a) the firm's common stock did not trade on the New York or American Stock exchanges during the study period, (b) the firm went out of business or merged with another firm within twelve months after the contest, or (c) the firm paid a cash dividend during the contest period. The tests described in the next section require the use of the following information:

(i) Daily stock price data for the pre-contest, contest, and post- contest, periods for each firm. Daily price data for the …