Shleifer and Summers (1988) The breach of trust hypothesis

In 1988, two American scholars, André Shleifer and Lawrence Summers, published their

influential paper titled “Breach of Trust in Hostile Takeovers.”65 _{It came at a time when}

many US companies were being subject to takeover bids and taken over at a premium price.

They studied the takeover of a company called Youngstown Sheet and Tube in 1977 and

found a total loss of 6,000 jobs between 1977 and 1979. The researchers explained the loss

of jobs using their breach of trust hypothesis.

The main factor behind the breach of trust hypothesis is the relationship between implicit

contracts and takeovers. According to the researchers, employees make firm specific human

65_{Andrei Shleifer and Lawrence H Summers, Breach of Trust in Hostile Takeovers in Alan J Auerbach, Corporate}

capital investments in the company, with a promise of job security in return for their

investment. Firm specific human capital includes the “skills or knowledge or networks of

personal relationships that are specialized to a given enterprise and that are more valuable

in that enterprise than they would be in alternative uses.”66 _{Due to firm-specific}

investments, employees become ‘locked in’ the company. The researchers argued that this

leaves employees highly vulnerable to future renegotiation of contract.

Takeovers may deter employees from making firm specific investments due to worries over

downsizing and renegotiation of implicit contracts.67 _{In regards to the former, takeovers}

may result in downsizing in order to cut costs and create more efficiency. Thus, any income

stream accruing from employees made redundant are converted into takeover premiums for

outgoing shareholders. Downsizing also amounts to a wealth transfer from employees to

shareholders. According to Professor Margaret Blair, “firms that focus solely on share value

will have an incentive to shut down operations that are not generating profits for

shareholders even though these operations may still be generating substantial real economic

rents...over time such policies are likely to discourage further investments by employees in

firm-specific human capital.”68

Shleifer and Summers advanced literature by arguing that a wealth transfer from employees

to shareholders mainly occur due to a change in management after a takeover. According to

the researchers, if management is not replaced after a takeover, implicit contracts are less

likely to be breached for fear that the company’s reputation may be damaged. However,

following a successful takeover bid, a new management team would need to realize short-

term gains in order to recoup the costs of the takeover through asset disposal and

downsizing of labour force.

66 _{Margaret Blair, Wealth Creation and Wealth Sharing (Washington, D.C: Brookings, 1996) 8.}

67 _{Andrei Shleifer and Lawrence H Summers, Breach of Trust in Hostile Takeovers in Alan J Auerbach, Corporate}

Takeovers: Causes and Consequences (University of Chicago Press: Chicago 1988) 53.

They summed up the wealth transfer argument as follows: “takeovers are external means of

removing managers who uphold stakeholder claims. Takeovers then allow shareholders to

appropriate stakeholders’ ex post rents in the implicit contracts. The gains are split between

the shareholders of the acquired and the acquiring firms. At least in part, therefore, the

gains are wealth redistributing and not wealth creating.”69

Furthermore, they argued that although shareholders are not the owners of the company,

there are fundamental differences in the treatment of their shareholding contract as

compared to an employment contract.70 _{Both employees and shareholders have an implicit}

contract but shareholders claims are protected by corporate law to a greater extent than

employee claims. This is unjustified since shareholders are being treated as company

owners.

In the UK, three empirical studies tested the breach of trust hypothesis. First, a study was

carried out on 433 companies involved in 240 takeovers between 1983 and 1996.71 _The

researchers found a 7.5 per cent decline in employment in those firms. In a follow up study,

covering the period of 1967 to 1996, a 9 per cent decline in employment was found.72 _In

support of the breach of trust hypothesis, the researchers concluded that:

“[I]f the observed employment reductions constitute a reneging on the implicit terms of the labour contract, in the sense of...there may be associated costs generated through the

subsequent reductions in firm-specific human capital investment by employees. These will

be manifested in lower output levels but any such changes would be very hard to identify”.73

69 _{Ibid 44.} 70 _{Ibid 43.}

71_{Martin Conyon, Sourafel Girma, Steve Thompson and Peter Wright, Do hostile mergers destroy jobs? (2001)}

45 (4), Journal of Economic Behaviour and Organization 427, 438.

72_{Martin Conyon, Sourafel Girma, Steve Thompson and Peter Wright, The impact of mergers and acquisitions on}

company employment in the United Kingdom (2002) 46 (1), European Economic Review 31, 38.

Second, a qualitative empirical perspective on the effect of takeovers on employees was

provided in a study of 15 takeovers during the period of 1993- 1996. The researchers

reviewed reports and conducted interviews in a bid to find evidence of a breach of trust. The

researchers found employee redundancies in all the takeover cases. One of the case studies

was the Glaxo takeover of Wellcome in which 7500 jobs were lost in a bid to cut costs by

£340 million. The unions involved argued that “there had been no prior consultation and it

was a unilateral decision by an arrogant management.”74

The researchers found that successful takeovers result in large-scale job losses and asset

disposals. This study provides strong empirical support to wealth transfer from employees

to shareholders since most of the acquired companies had to take on cost saving measures in

order to recoup the money used to pay for the high premium.

Third, the breach of trust hypothesis in the UK was tested in a study which investigated the

effect of takeovers on employment and wages between 1987 and 1995.75 _{The aim was to test}

whether takeovers result in a wealth transfer from employees to shareholders via the bid

premium. They found that total employment decreased by 11 per cent over a period of five

years pot-takeover. The study also found a substantial decline in wages following takeover.

As a result, the researchers concluded that the destruction of employee contracts is likely to

be related to the bid premium that had to be paid to outgoing shareholders.

However, even though there is strong empirical support for the breach of trust hypothesis

in the UK, the studies did not refer to takeover cases after 2000. Since the turn of the

twenty-first century, no UK based study has investigated job losses pot-takeover.

74_{Ibid 32.}

75_{Til Beckman and William Forbes, An examination of takeovers, job loss and wage decline within UK Industry,}

2.5.2. Krug and Aguilera (2005) Top team management after a