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PERCEPTIONS OF AGENCY MOTIVES IN ACQUISITIONS:
THE MODERATING EFFECTS OF THE EXTERNAL ENVIRONMENT
INTRODUCTION
Extant research on the principal-agent problem in the modern corporation has examined the effectiveness of corporate governance mechanisms in reducing the agency conflicts between investors and top executives. A potential conflict of interest arises between top executives and investors due to the separation of ownership and control (Berle and Means, 1932). Top executives are seen as opportunistic, self-serving individuals promoting self-interests over the interests of the investors. As a result, various governance mechanisms, such as equity compensation for top executives and the presence of independent directors, are adopted to mitigate the opportunistic behaviors of top executives and to detect such behaviors if present
(Walsh and Seward, 1990).
Corporate acquisitions is an area of research that has examined the effects of the principal-agent problem (Amihud and Lev, 1981; Morck et al.
, 1990). Agency motives in acquisitions refer to the opportunistic behavior of top executives in pursuit of acquisitions that maximize self-interests over the interests of the investors. There is empirical evidence that the self-seeking interests of top executives primarily motivate some acquisitions. For instance, acquisitions may be used by top executives to diversify their personal portfolio (Amihud and
Lev, 1981), to increase their compensation indirectly by increasing firm size (Barkema and
Gomez-Mejia, 1998; Henderson and Fredrickson, 1996; Jensen, 1986), and to acquire assets that increase the a dependence on the top executives (Shleifer and Vishny, 1990).

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Investors are likely to use proxies to perceive the presence of agency motives in corporate acquisitions since managers do not readily admit to self-seeking motives (Hoskisson and Hitt,
1990). In the absence of direct objective information, investors may shift emphasis to indirect, secondary information sources that are better understood, such as the effectiveness of a firm’s monitoring mechanisms (Sanders and Boivie, 2004). For instance, agency theorists suggest that investors will respond positively to acquisition announcements when acquiring firms have effective monitoring mechanisms. The rationale is that effective monitors make agency motives in acquisitions less likely to occur. However, absent agency problems, the predicted positive association between monitoring mechanisms and share returns to acquisition announcements should approach insignificance, and may become negative if the marginal cost of monitoring exceeds the marginal benefits. Conversely, when agency problems increase, researchers should observe a significant positive association. Accordingly, the relationship between monitoring mechanisms and share returns to acquisition announcements is contingent on the extent of agency problems perceived by investors. Failure to account for the conditions that influence the extent of agency problems perceived by investors may explain the equivocal results in prior studies (Byrd and Hickman, 1992; Cornett et al.
, 2003; Matsusaka, 1993; Subrahmanyam et al.
,
1997).
The primary argument of this paper is that an acquiring firm’s external environmental conditions influence the extent of agency motives in acquisitions perceived by investors.
Specifically, I assert that (1) goal conflicts between investors and top executives intensify when an acquiring firm’s external environment is resource-scarce, and (2) information asymmetry between investors and top executives are exacerbated when an acquiring firm’s external environment is complex or dynamic. Goal conflicts and information asymmetry between

3 investors and top executives are important concepts because these two conditions (together with opportunistic agents) form the bedrock upon which agency problems arise. Given that an acquiring firm’s external environmental conditions influence investors’ perception of agency motives in acquisitions, I hypothesize that these environmental conditions moderate the relationship between monitoring mechanisms and market reactions to acquisition announcements.
I begin by reviewing the literature on corporate acquisitions primarily from an agency theory perspective. Next, I offer three hypotheses on how a firm's external environmental conditions moderate the relationship between a firm’s monitoring mechanisms and investors’ reaction to acquisition announcements. Finally, I discuss the methodology and the results of the empirical study, and suggest areas for future research.
CORPORATE ACQUISITIONS AND AGENCY MOTIVES
Corporate acquisitions have generated research interests over the last couple of decades.
Researchers have examined a wide variety of topics such as the impact of acquisitions on executive retention (Bergh, 2001; Krug and Hegarty, 2001), the determinants of acquisition activities (Beckman and Haunschild, 2002; Haunschild, 1993; Palmer and Barber, 2001), and the premiums paid for acquisitions (Haunschild, 1994; Hayward and Hambrick, 1997). In particular, wealth creation from acquisitions have received much attention from researchers in strategic management and financial economics (Byrd and Hickman, 1992; Flanagan, 1996; Lubatkin,
1987; Morck et al.
, 1990; Seth, 1990; Wright et al.
, 2002). Researchers have established a plethora of factors that influence wealth creation from acquisitions, such as the number of

4 acquirers, mode of payment, acquirer's approach, type of acquisition, and regulatory changes
(Datta et al.
, 1992).
Wealth creation from acquisitions is closely tied to the acquisition motives of top executives. Two primary motives for acquisitions have been advanced in the literature: the synergy motive and the agency motive. The synergy motive suggests that acquisitions occur because of the resulting economic gains from merging the resources of two firms (Berkovitch and Narayanan, 1993). For instance, synergistic benefits from acquisitions may include wealth creation from exploiting economies of scale, economies of scope, market power economies, or financial economies (Lubatkin, 1987; Seth, 1990; Singh and Montgomery, 1987). Researchers tend to associate the type of acquisition with the wealth created from synergistic acquisitions.
The main argument is that the transfer of core skills between the acquiring and acquired firms in related acquisitions should result in greater wealth creation than in unrelated acquisitions (Datta et al.
, 1992). After decades of research, there appears to be consensus that the relationship between acquisition type and wealth creation is not linear, but an inverted U-shape where wealth creation is maximized when an acquisition exploits some form of relatedness between the acquiring and acquired firm (Hoskisson et al.
, 2004; Palich et al.
, 2000).
Unlike the synergy motive, the agency motive suggests that acquisitions primarily occur to enhance the wealth of the acquiring firm's top executives (Berkovitch and Narayanan, 1993).
Hence, acquisitions initiated with an agency motive may reduce investors’ wealth. Agency theory is one of the main theoretical perspectives used to explain value-reducing acquisitions.
The theory is concerned with exchanges in which a principal delegates work to an agent, but contractual problems arise because the agent is assumed to behave opportunistically due to a conflict of interests with the principal (Eisenhardt, 1989). Agency theorists view top executives

5 as the agents of investors (Fama, 1980; Jensen and Meckling, 1976) with various incentives to grow a firm beyond its optimal size through acquisitions (Jensen, 1986). For instance, agency motives for acquisitions include diversification across various industries to lower the employment risk of executives (Amihud and Lev, 1981) or acquiring other firms to increase managerial compensation (Barkema and Gomez-Mejia, 1998).
The problem of conflicting interests between top executives and investors is not without a solution. Positivist agency theorists have identified two important monitoring mechanisms to check managerial opportunism: corporate boards and large investors (Eisenhardt, 1989; Walsh and Seward, 1990). Board composition has been the subject of much discussion and empirical work with reference to a board’s monitoring role (Dalton et al.
, 1998; Johnson et al.
, 1996).
Early research examined the role of outside directors as an important counterweight to management interests (Fama and Jensen, 1983; Kosnik, 1990; Mizruchi, 1983) although later research recognized the importance of independent outside directors for effective monitoring
(Daily et al.
, 1999; Johnson et al.
, 1993). In addition, researchers found that outside directors have a greater incentive to safeguard shareholders’ interests when they also hold equity stakes in a firm (Mishra and Nielsen, 2000; Yermack, 2004).
The monitoring role of large investors has also generated much research interest (Daily et al.
, 2003). The primary argument is that investors with large ownership stakes are motivated to monitor top executives’ decisions and behaviors (Pound, 1988; Shleifer and Vishny, 1986).
Institutional investors, in particular, have received more attention given their large ownership stakes in U.S. firms and increased activism (Smith, 1996; Useem, 1996). Early research has discussed and examined the effectiveness of institutional investors as monitors of top executives
(Demsetz, 1983; Shleifer and Vishny, 1986; Walsh and Seward, 1990). However, a current trend

6 in institutional ownership research is to examine the different incentives to monitor top executives’ behavior across institutional investor categories (Daily et al.
, 2003; Ryan and
Schneider, 2002). Recent empirical results suggest that pressure-resistant institutional investors, such as mutual funds and public pension funds, do not seek business relationships with the firms in which they invest and are more likely to closely monitor and impose controls on top executives (David et al.
, 1998; Hoskisson et al.
, 2002; Tihanyi et al.
, 2003).
The monitoring of top executives by large investors and outside directors have been examined in the context of corporate acquisitions (Cornett et al.
, 2003; Wright et al.
, 2002).
Agency theorists argue that effective monitoring mechanisms should be positively associated with the wealth created from acquisitions because investors are less likely to perceive agency motives in these acquisitions. Unfortunately, prior studies using the event-study methodology have not established unequivocal support for the argument. For instance, Matsusaka (1993) found that a higher insider/outsider board ratio is associated with a lower stock return on acquisition announcements for the acquiring firm, supporting the assertions of agency theory.
Similarly, Cornett et al.
(2003) found a positive association between the proportion of outside directors and the acquiring firms’ stock returns on acquisition announcements. However, contrary to agency theory, Subrahmanyam et al.
(1997) found a negative association between the proportion of independent directors and the acquiring firms’ stock returns on acquisition announcements, while Byrd and Hickman (1992) found a positive but insignificant association.
The empirical results for large investors are equally dismal. Supporting an agency theoretic argument, Kroll et al.
(1997) found that firms with external shareholders owning at least 5 percent of the outstanding stock experience higher stock returns on acquisition announcements. Similarly, Wright et al.
(2002) found that firms with activist institutional

7 ownership experience higher stock returns on acquisition announcements. However, contrary to agency theory, Harris and Shimizu (2004) and Cornett et al.
(2003) found that the equity owned by blockholders and institutional investors are not significantly associated with the acquiring firms’ stock returns on acquisition announcements.
The discrepant empirical results on the association between stock returns on acquisition announcements and monitoring mechanisms may be attributed to various factors, such as different sampling and research methodologies. However, I argue that important moderating variables omitted from prior research models may account for some of the discrepancies (Li and
Simerly, 1998). In the next section, I argue that one important category of moderating variables is an acquiring firm’s external environmental conditions.
THE MODERATING EFFECTS OF ENVIRONMENTAL CONDITIONS
Agency theory suggests that investors may use the effectiveness of a firm’s monitoring mechanisms as a proxy to gauge the extent of agency motives in acquisitions. However, the reliance that investors place on corporate boards and activist investors to mitigate agency motives in acquisitions may be contingent on a firm's environmental conditions during the acquisition announcements. Specifically, I argue that resource-scarce, complex and/or dynamic environments reinforce investors’ perception of agency problems by exacerbating the goal conflicts and information asymmetry between investors and top executives. As a result, the quality of a firm's monitoring mechanisms to detect and prevent agency motives in acquisitions becomes more important when investors evaluate the value of announced acquisitions.
Goal conflicts, information asymmetry, and opportunistic agents are three basic assumptions of agency theory (Eisenhardt, 1989). When agents and principals have conflicting

8 goals, information asymmetry favoring the agents makes these agents’ opportunistic behavior harder to detect. Hence, agency theory suggests that because agents seek self-interest, agency problems are more likely to occur when goal conflicts between agents and principals widens, and agency problems are less likely to be detected by the principals when information asymmetry between agents and principals increases in favor of the agents. I shall first discuss the impact of a firm’s environmental conditions on goal conflicts followed by its impact on information asymmetry.
Goal Conflicts
Goal conflicts exist between investors and top executives. For instance, Jensen (1986) described the incentive of top executives to grow a firm beyond the optimal size required to maximize investors’ wealth by investing free cash flows instead of paying it out to investors.
Furthermore, researchers also suggest that investors prefer riskier strategies than top executives
(Amihud and Lev, 1981; Hoskisson et al.
, 2004). Portfolio theory indicates that investors may reduce their overall risk by holding a diversified portfolio of equity investments (Fama, 1980).
Hence, investors prefer riskier firm strategies when compared with top executives, whose human capital, compensation, and reputation are closely related to the success of a single firm (May,
1995). However, goal conflicts between investors and top executives differ in intensity. For instance, the goals of top executives and investors tend to diverge in declining industries, where top executives desire growth and risk reduction while investors prefer the return of free cash flows to reinvest in better opportunities (Anand and Singh, 1997; Dial and Murphy, 1995).
The work of Anand and Singh (1997) and Dial and Murphy (1995) suggest that agency problems are likely to be higher in declining industries or in environments with low munificence.
Environmental munificence refers to the extent that an environment can support sustained

9 growth and highlights the impact of resource availability on firm survival (Castrogiovanni, 1991;
Starbuck, 1976). Firm survivability and profitability are adversely affected when resources are scarce under low environmental munificence (Beard and Dess, 1981; Singh et al.
, 1986). When a firm’s external environment is resource-scarce and can no longer sustain growth, top executives may use acquisitions to achieve growth in unrelated industries rather than create value for investors. For instance, Anand and Singh (1997) found that stock returns on acquisition announcements are negative when acquiring firms are located in declining industries. Even if acquisitions may be the appropriate strategy to increase investors' wealth under low environmental munificence, acquisition strategies are not homogenous and create different sources of value (Lubatkin, 1987; Seth, 1990). Hence, maximizing investors' wealth still requires the diligent implementation of value-creating strategies, otherwise corporate acquisitions may simply be used by top executives to promote self-interests (Dial and Murphy, 1995; Hoskisson and Hitt, 1990). Given that the goals between investors and top executives tend to diverge in declining industries, investors are more likely to perceive agency motives in acquisitions. As a result, the effectiveness of corporate boards and large investors to detect and prevent managerial opportunism plays a more important role when investors appraise the value of announced acquisitions. Hence, investors will respond most positively to acquisition announcements in the presence of vigilant boards and activist investors under conditions of low environmental munificence.
Proposition 1: The relationship between monitoring mechanisms and investors’ reaction to acquisition announcements for the acquiring firm is most positive under low environmental munificence.

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Information Asymmetry
A firm’s environmental conditions also impact the extent of information asymmetry between investors and top executives. Adverse selection and moral hazard are two forms of opportunistic behavior that can arise from information asymmetry (Eisenhardt, 1989). Adverse selection is concerned with precontractual opportunism where agents misrepresent their skills and abilities at the time of hiring to the detriment of the principals, and is clearly less relevant in the context of investors’ perceptions of agency motives in acquisitions. On the other hand, moral hazard is a form of postcontractual opportunism that occurs because principals lack adequate information on the appropriate agents' behavior to accomplish the principals' goals (Eisenhardt,
1989). For instance, information asymmetry between top executives and investors may hamper investors’ assessment of whether an acquisition is driven by a synergy or an agency motive. If investors lack adequate information to determine whether an acquisition is consistent with the objective of maximizing investors’ wealth, then they are likely to place more weight on the effectiveness of monitoring mechanisms when assessing the value of announced acquisitions
(Eisenhardt, 1989).
Prior studies found that the extent of information asymmetry between investors and top executives may increase or decrease depending on factors such as the characteristics of a firm’s information environment (Frankel and Li, 2004), the release of macroeconomic news (Green,
2004), or the age of a firm (Sanders and Boivie, 2004; Stuart et al.
, 1999). I argue that complex or dynamic environments may also increase the information asymmetry between investors and top executives. Both of these environmental conditions contribute to the uncertainty in a firm’s

11 external environment (Bantel, 1993; Boyd, 1995; Flynn and Flynn, 1999; Kotha and Nair, 1995;
Wiersema and Bantel, 1993).
Environmental complexity describes the number and variety of constituents in the environment which a firm interacts with (Gibbs, 1994). A complex environment is characterized by high competitive and symbiotic interdependence as firms interact with a large number of diverse constituents, such as competitors, suppliers, and customers, in the environment (Pfeffer and Salancik, 1978). Furthermore, strategic and product market activities are expected to increase in complex environments (Dess and Beard, 1984). Researchers also found that alignment with complex environments require complex firm structures, such as more elaborate structures and planning systems (Thompson, 1967; Woodward, 1965) and higher levels of differentiation and integration (Lawrence and Lorsch, 1967). In general, prior research indicates that environmental complexity is accompanied by an increase in the complexity of a firm’s structure as well as the frequency and diversity of the firm’s activities. If complex environments place higher information processing demand on top executives (Galbraith, 1977), then investors will face an even more daunting task of determining the appropriate strategic actions to maximize investor wealth. Investors do not participate in the strategic decision-making process and are not privy to firm-specific information on demand (Lane et al.
, 1998). As a result, investors’ ability to evaluate strategic decisions is severely compromised when complexity obscures the causality of strategic actions in response to environmental challenges. Hence, complex environments accentuate the information asymmetry between top executives and the investors.
Similar to environmental complexity, dynamic environments also aggravate the information asymmetry between investors and top executives. Environmental dynamism refers to

12 the extent to which volatile changes occur in the environment (Gibbs, 1994). There is anecdotal evidence that high volatility usually reflects greater information asymmetry. For instance, Ejara and Ghosh (2004) found a positive relation between the volatility of a firm’s stock and IPO underpricing, a result consistent with the prediction of asymmetric information models in IPO research. Also, Affleck-Graves et al.
(2002) found that low earnings predictability increases the information asymmetry between investors and dealers in the capital markets. Information asymmetry between investors and top executives widens in dynamic environments because unpredictable changes in a firm’s environment makes it difficult for investors to appraise the contribution of an acquisition to investors’ wealth. When environments are stable, the contribution of an acquisition to wealth maximization is more certain and easier to evaluate
(Blatt, 1979). However, when environments shift and become volatile, it becomes harder to assess the consequences of a specific action because the link between the appropriate strategic actions and maximization of investors’ wealth becomes more tenuous (Miller and Shamsie,
1999). Investors who are distant from the strategic-making process will not understand the preferences and alternatives that top executives develop in response to the volatile environment.
As a result, investors may face difficulty in assessing the efficacy of the adopted strategies (Li and Simerly, 1998). Furthermore, Jurkovich (1974) suggested that dynamic environments are accompanied by differences in the interpretation of market information, which may increase information asymmetry in the marketplace (Green, 2004).
The informational advantage of top executives is a critical condition for the presence of agency problems. Absent information asymmetry, investors would not need to rely on alternative mechanisms, such as corporate boards, to monitor top executives (Eisenhardt, 1989). However, when environmental complexity or dynamism widens the information asymmetry between

13 investors and top executives, investors are likely to attach more importance to better-informed entities (Frankel and Li, 2004) when assessing the value of announced acquisitions. Corporate boards are better informed than investors because they have access to firm-specific information during formal board meetings or informal settings that are not available to investors. Activist investors, such as institutional investors, have superior access to information because they employ professional analysts who are experts at screening and monitoring (Chen et al.
, 1993;
Sanders and Boivie, 2004). The presence of vigilant boards and activist investors in complex or dynamic environments is likely to provide greater assurance to investors that an acquisition is consistent with the objective of maximizing investors’ wealth. Hence, investors will respond most positively to acquisition announcements in the presence of vigilant boards and activist investors in complex or dynamic environments.
Proposition 2:
The relationship between monitoring mechanisms and investors’ reaction to acquisition announcements for the acquiring firm is most positive under high environmental complexity.
Proposition 3: The relationship between monitoring mechanisms and investors’ reaction to acquisition announcements for the acquiring firm is most positive under high environmental dynamism.

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RESEARCH METHODS
Sample
A sample of 100 acquisitions was randomly selected from the SDC database based on the following requirements: First, because I employed event study methodology, data for the estimation of cumulative abnormal returns had to be available from the Center for Research on
Securities Prices (CRSP) database. Second, the initial announcement dates listed in the SDC database must be verified by an independent news source from the Lexis-Nexis database. Third, I included only firms announcing acquisitions not surrounded by confounding announcements
(Brown and Warner, 1980). Confounding events were defined as other economically relevant events that include news related to dividend and earnings announcements, restructuring, stock splits, earnings and sales forecasts, new product announcements and internal disputes
(McWilliams and Siegel, 1997). Fourth, only acquisitions in 1995 were included to control for year effects. Fifth, data for the independent and control variables had to be available from
Standard and Poor’s COMPUSTAT and the firms’ proxy statements.
Measures
Dependent variable.
Central to a financial event study is the measurement of an abnormal stock return (MacKinlay, 1997). The abnormal return is the actual ex post return on the share price of a firm minus the normal return over an event window, AR it
= R it
- E(R it
), where
AR it
is the abnormal return on the share price for firm i on event date t, R it
is the actual ex post return, and E(R it
) is the normal return. The normal return is defined as the expected return if the event had not taken place and was computed using a market model of the normal share price behavior. The market model is a statistical model that relates the return of any given share to the

15 return of a specified market portfolio, E(R it
) =
 i
+
 i
R mt
+
 it
,. The value-weighted CRSP index was used as the market portfolio to derive
 i
and
 i
of the market model. The market model requires an estimation window that is typically prior to and that does not overlap with the event window (MacKinlay, 1997). I set the estimation window at 250 to 50 trading days prior to the event window. The abnormal stock return was computed after determining the normal return from the market model. The abnormal stock returns for each day in the event window was then summed up to arrive at the cumulative abnormal return over the event window. The event window was set at -1 to +1 days, where day 0 is the day of the acquisition announcement. The cumulative abnormal return for each firm was the dependent variable used in the regression analysis.
Monitoring mechanisms.
Three measures of monitoring mechanisms were used in this study. The first two measures capture the vigilance of outside directors on a firm’s board.
Outside directors are important monitoring agents that represent the interest of investors.
Affiliated outside directors are viewed as weaker monitors of top executives when compared with independent outside directors due to the presence of alternative relationships (Daily et al.
,
1999). For instance, an affiliate director who has a consulting agreement with a firm or who represents the firm's supplier or customer may not monitor the firm's top executives in a manner that maximizes investors’ wealth.
I assert that investors’ perception of effective monitoring also takes into account whether an outside director's interests are aligned with those of the investors. Investors are likely to perceive greater board vigilance in maximizing investors’ wealth if the outside directors own more shares of a firm, regardless of whether these directors are independent or affiliate directors.
For instance, an affiliate director who owns a higher percentage of a firm's shares may be more

16 likely to maximize shareholder wealth (and the director's personal wealth) when compared with an independent director who owns a lower percentage of the firm's shares.
Following the above arguments, I captured the vigilance of independent and affiliate directors separately to account for the plausibility that investors may place different emphasis on these two groups of monitors in the context of acquisition announcements. I measured independent directors' vigilance using the sum of the standardized percentage of the independent directors on a firm's board and the standardized percentage of the firm's shares owned by the independent directors (Finkelstein and D'Aveni, 1994; Lane et al.
, 1998). The same standardized measure was adopted for affiliated directors’ vigilance : the sum of the standardized percentage of the affiliate directors on a firm's board and the standardized percentage of the firm's shares owned by the affiliate directors.
The third measure captures institutional investors as monitors of top executives. I used pressure-resistant investors’ ownership to capture the extent of monitoring by large investors because recent studies found that pressure-resistant institutional investors exhibit higher levels of activism (David et al.
, 1998; Hoskisson et al.
, 2002; Tihanyi et al.
, 2003). Pressure-resistant institutional investors include public pension funds, mutual funds, foundations, and endowments
(Brickley et al.
, 1988; David et al.
, 1998; Kochhar and David, 1996). I summed the number of shares held by each pressure-resistant institutional investor and then converted this total to a percentage of the firm’s outstanding shares. All three measures of monitoring mechanisms were extracted from each acquiring firm’s proxy statement closest to the acquisition announcement date.
Environmental measures . I adopted Keats and Hitt’s (1988) measure of environmental munificence, dynamism, and complexity, which were originally developed by Dess and Beard

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(1984). Similar environmental measures were used by other researchers (Boyd, 1995; Carpenter and Fredrickson, 2001; Wiersema and Bantel, 1993). Data from 1990 to 1994, five years prior to the year of announcement, were extracted from COMPUSTAT to compute the three environmental conditions. The external environmental domain of a firm was operationally defined in terms of the primary 2-digit industry-classification code assigned to each firm in
COMPUSTAT.
The five-year industry growth rate in net sales was designated as the indicator for environmental munificence . The basic regression model is, y t
=

0
+

1 t +
 t
, where y t
is the natural log of each firm's annual net sales in the primary industry, t is the year (from 1990 to
1994), and
 t
is the residual. The antilog of the regression slope coefficient (

1
) was used to measure environmental munificence. The volatility of net sales in a firm's primary industry over a five-year period was used as the indicator for environmental dynamism . This measure was the antilog of the standard error of the regression slope coefficient (

1
) from the basic regression model defined for environmental munificence. Environmental complexity was derived as a regression of the 1994 market shares of all firms in a firm's primary industry upon their market shares in 1990 (Grossack, 1965). Market share was computed as the ratio of a firm’s annual sale over the total industry annual sale. Following the arguments of several authors (Khandwalla,
1973; Porter, 1980; Starbuck, 1976; Williamson, 1965), a larger regression slope coefficient
(beta) indicates increasing monopoly power in the industry (or increasing industry concentration) and decreasing environmental complexity (Grossack, 1965). As a result, the reciprocal of the regression slope coefficient (beta) was used as a measure for environmental complexity, where a larger reciprocal indicates greater environmental complexity.

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Control variables . Firm performance was included as a control variable to take into account its impact on stock returns. I measured firm performance using return on equity in fiscal year 1994. Firm size was included as a control variable using the natural logarithm of annual sales in fiscal year 1994. The natural logarithm of the size variable was used so that extreme values would not bias the results (Wade et al.
, 1990). Data for firm performance and firm size were extracted from COMPUSTAT.
The ownership of inside directors (including the CEO) was included as a control variable to take into account the possible reduction in opportunistic behavior due to the alignment of interests between the inside directors and investors (Eisenhardt, 1989; Jensen and Meckling,
1976; Walkling and Long, 1984). This measure was extracted from each acquiring firm’s proxy statement closest to the acquisition announcement date.
The level of diversification for the acquiring firm and the relatedness of the acquired firm were also included as control variables to account for their potential impact on stock returns
(Datta et al.
, 1992; Park, 2003). I used SIC codes to measure diversification and relatedness since these variables were included as controls and are not main variables of interest (Hoskisson et al.
, 1993). Furthermore, SIC codes have been used to measure relatedness in prior financialevent studies on corporate acquisitions (Byrd and Hickman, 1992; Flanagan, 1996; Morck et al.
,
1990; Wright et al.
, 2002). The level of diversification for the acquiring firm was computed as the number of different 2-digit SIC codes assigned to the acquirer in the SDC database. The relatedness of the acquired firm was computed as the number of 2-digit SIC codes that were assigned to the acquired firm but not to the acquiring firm over the total number of 2-digit SIC codes assigned to the acquired firm in the SDC database.

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RESULTS
Table I provides the means, standard deviations, and bivariate correlations for all the study variables used in this study.
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Moderated regression analysis was used to analyze the data. The moderators were tested following the methodology described in James and Brett (1984). Interaction terms were included into the regression model and a significant coefficient for each interaction term provides evidence that the external environment moderates the relationship between a firm’s monitoring mechanisms and the cumulative abnormal returns to investors. Post-hoc probing was conducted for interaction terms found to be significant (Aiken and West, 1991).
A box-cox transformation was applied to the dependent variable to satisfy the assumptions of using OLS regression. I also standardized the independent variables and found that multicollinearity did not pose a problem as the variance inflation factors for the OLS regression model ranged from 1.33 to 3.05, with a mean of 2.12 (Chatterjee et al.
, 2000). Table II presents the results of the analysis.
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Model 1 with the control and independent variables but without the interaction terms was found to be insignificant ( F = 1.19, p > 0.1). Model 2, which includes the interaction terms, is significant ( F = 2.19, p < 0.01) with the R 2 value showing a significant increase of 0.23 over

20 model 1 and an adjusted R
2
value of 0.19. Hypothesis 1 predicted that an acquiring firm's monitoring mechanisms and investors’ reaction to acquisition announcements would be most positively associated under low environmental munificence. This hypothesis is supported. The coefficients for the interactions between environmental munificence and independent directors’ vigilance ( b = -0.28, p < 0.05), affiliated directors’ vigilance ( b = -0.18, p < 0.1) and pressureresistant investors’ ownership ( b = -0.27, p < 0.05) are negative and significant. Hypothesis 2 predicted that an acquiring firm's monitoring mechanisms and investors’ reaction to acquisition announcements would be most positively associated under high environmental complexity. This hypothesis is strongly supported. The coefficients for the interactions between environmental complexity and independent directors’ vigilance ( b = 0.31, p < 0.05), affiliated directors’ vigilance ( b = 0.36, p < 0.01) and pressure-resistant investors’ ownership ( b = 0.36, p < 0.01) are positive and significant. Finally, hypothesis 3 predicted that an acquiring firm's monitoring mechanisms and investors’ reaction to acquisition announcements would be most positively associated under high environmental dynamism. This hypothesis is also strongly supported. The coefficients for the interactions between environmental dynamism and independent directors’ vigilance ( b = 0.25, p < 0.01), affiliated directors’ vigilance ( b = 0.25, p < 0.01) and pressureresistant investors’ ownership ( b = 0.34, p < 0.05) are positive and significant.
Figure 1 presents a graphic representation of the interaction term between environmental munificence and independent directors’ vigilance following the procedure suggested by Aiken and West (1991). The figure displays the relationship between cumulative abnormal returns and independent directors’ vigilance at high (one standard deviation above the mean) and low (one standard deviation below the mean) levels of environmental munificence. The low and high values of independent directors’ vigilance correspond to the minimum and maximum values in

21 the dataset. For firms faced with low environmental munificence, investors respond more positively to acquisition announcements as independent directors’ vigilance increases.
Conversely, for firms faced with high environmental munificence, investors respond more negatively to acquisition announcements as independent directors’ vigilance increases. Post-hoc probing of the interaction terms for affiliated directors’ vigilance and pressure-resistant investors’ ownership revealed similar interaction effects. These results suggest that in the context of acquisition announcements, the market favors vigilant monitors when firms are located in an environment that lacks the critical resources to support sustained growth. However, excessive monitoring when a firm is located in environments with an abundance of critical resources may be viewed negatively by investors. I will discuss this finding in the next section.
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Using the same procedures suggested by Aiken and West (1991), Figure 2 presents a graphic representation of the interaction term between environmental complexity and independent directors’ vigilance. For firms faced with high environmental complexity, investors respond more positively to acquisition announcements as independent directors’ vigilance increases. Conversely, for firms faced with low environmental complexity, investors respond more negatively to acquisition announcements as independent directors’ vigilance increases.
Post-hoc probing of the interaction terms for affiliated directors’ vigilance and pressure-resistant investors’ ownership revealed similar interaction effects. Likewise, post-hoc probing of the three interaction effects for environmental dynamism revealed similar interaction effects. These results suggest that in the context of acquisition announcements, the market favors vigilant monitors

22 when firms are located in an environment that is complex or dynamic. However, excessive monitoring when a firm is located in non-complex or stable environments may be viewed negatively by investors. I will discuss this finding in the following section.
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The associations of the control variables with the dependent variable are also reported.
The relatedness of the acquired firm is positively associated with stock returns ( p < 0.1). This suggests that investors perceive greater value-creation when the acquired and acquiring firms operate in related industries (Flanagan, 1996; Singh and Montgomery, 1987). The acquirer’s level of diversification is negatively associated with stock returns ( p < 0.1). The results for the relatedness of the acquired firm and the acquirer’s level of diversification are consistent with
Park’s (2003) argument that a firm is more likely to make an unrelated acquisition when it has pursued largely unrelated acquisitions over time. Firm performance is negatively associated with stock returns ( p < 0.05) suggesting that acquisitions by high performers may be driven by the presence of free cash flows (Jensen, 1986). All other control variables are not significant ( p >
0.1).
Robustness Tests
I performed separate analyses to determine the sensitivity of the results to choices made in the event-study methodology. First, I experimented with the equal-weighted CRSP index and the S&P 500 index as alternative market portfolios with no appreciable differences in the results.
Next, I used market-adjusted returns instead of the market model to compute abnormal returns.
There are no appreciable differences in the results except that the interaction term between

23 affiliated directors’ vigilance and environmental munificence is still negative but no longer significant ( p > 0.1). Applying the scholes-williams beta estimation to the market model also did not produce any appreciable differences in the results. I also replicated the analysis using a longer event window of -5 to +5 days. The overall model remained significant ( F = 2.06, p <
0.05) and post-hoc probing for all of the interaction terms revealed identical interpretations.
However, two interaction terms for pressure-resistant investors’ ownership were not significant
( p > 0.1): one with environmental dynamism and the other with environmental complexity.
Overall, the above sensitivity analyses provided some assurance that the reported results were not driven by choices made in the event-study methodology.
Other than checking for choices made in the event-study methodology, I also replaced the standard errors in the OLS regression model with the Huber-White robust standard errors to correct for potential heteroskedasticity of the residuals (White, 1980, 1982). There were no appreciable differences in the results. Finally, I obtained similar results from using iteratively reweighted least squares robust regression which confirmed that the reported results were not driven by influential observations (Byrd and Hickman, 1992; Neter et al.
, 1989).
DISCUSSION AND CONCLUSION
Agency theory suggests that vigilant monitors guard against top executives’ opportunistic behavior. Hence, investors are expected to react more positively to acquisition announcements by firms with vigilant monitors. However, the emphasis that investors' place on vigilant monitors is likely to be contingent on the perceived extent of agency motives in acquisitions. I argue that resource-scarce, complex, or dynamic environments increase investors’ perception of agency motives in acquisitions by increasing the goal conflict and information asymmetry between investors and top executives. As a result, the presence of vigilant boards and activist investors

24 will be most valued under these environmental conditions. The findings are consistent with my contentions and support my hypotheses. That is, investors react most positively to acquisition announcements in the presence of vigilant monitors when environments are resource-scarce, complex, or dynamic.
The present study has its limitations. First, although event study methodology has received good reviews (Hitt et al.
, 1998), the usefulness of this technique is heavily dependent on a set of strong assumptions (Brown and Warner, 1985; McWilliams and Siegel, 1997). To address this limitation, I reduced the possibility of alternative explanations by excluding announcements with confounding events and choosing a short event window. I also performed sensitivity analyses to provide added assurance that the reported results were not a function of the choices made in the event-study methodology. The sensitivity analyses revealed that the results largely remained robust to the choice of the market portfolio, event-window, and estimation method used to compute the abnormal returns.
Second, the use of cross-sectional data may limit generalizations of the results to other time periods. For instance, studies in corporate acquisitions reveal that investors’ reaction to diversifying acquisitions exhibited wide variation in different periods, which suggest that investors may be guided by different mindsets over time (Matsusaka, 1993; Morck et al.
, 1990).
It is plausible that investors may also view the effectiveness of the various types of monitoring mechanisms differently over time. The use of longitudinal data to test the generalizability of the results will be one potential avenue for future research.
Third, Harris (2004) found that the three dimensions of external environment conditions
(i.e., munificence, complexity, and dynamism) developed by Dess and Beard (1984) may lack discriminant validity. However, this study followed Keats and Hitt (1988) environmental

25 measures, which are variants of the measures developed by Dess and Beard (1984). Table I shows that environmental complexity and dynamism are not significantly correlated, but environmental munificence has a significant positive association with the other two measures.
Hence, complexity and dynamism appear to be distinct constructs while munificence may be confounded with the other two measures. If discriminant validity is an issue in this study, then we would expect environmental munificence to have the same moderating effect as complexity and dynamism, which is not the case here. The theoretical framework in this paper not only suggests that environmental munificence moderates the relationship between monitoring mechanisms and market reactions in the exact opposite way when compared with complexity and dynamism, the results also strongly support the theory. Furthermore, there is no evidence that multicollinearity influenced these results. Nonetheless, pending the resolution of theory and measurement issues surrounding the three environmental constructs (Harris, 2004), researchers should exercise caution when interpreting the results of this study.
Notwithstanding these limitations, the present study provides interesting implications for theory development. First, this study provides strong support for the assertion that environmental conditions influence the explanatory power of agency theory in the context of investors’ reaction to acquisition announcements. Specifically, resource-scarce, complex, and dynamic environments appear to exacerbate perceived agency problems and hence increase the importance of monitoring mechanisms when assessing the value of an acquisition. This finding is important given that several scholars have questioned the utility of agency theory in management research (Dalton et al.
, 2003; Davis et al.
, 1997; Lane et al.
, 1998). Future research should move beyond the tendency to only examine direct associations between variables based on an agency

26 theoretic framework and extend their research to explore factors that may influence the explanatory power of agency theory in different contexts.
Second, I also found that the market does not always respond favorably to increased vigilance by external monitors. Although this finding appears contradictory to conventional wisdom, some researchers have documented that increased monitoring may be counterproductive (Byrd and Hickman, 1992; Jacobides and Croson, 2001; Zajac and Westphal, 1994).
This study adds on to previous empirical work by suggesting that investors may also perceive increased monitoring as being counter-productive when a firm's external environment is resource-abundant, stable, or not complex.
Third, the results also suggest that investors may perceive affiliate directors in a firm as effective monitors of top executives if these directors have an equity stake in the firm. Although independent directors are seen as better monitors of top executives when compared with affiliate directors (Daily et al.
, 1999), the practice of excluding affiliate directors in corporate governance research may be unwarranted. At the very least, future corporate governance research should take into account the equity ownership of affiliate directors just as the equity ownership of inside directors is taken into account for its role in aligning the interests of top executives with those of investors.
Fourth, the results in this study also highlight an interesting aberration when compared with prior findings. Although investors may increase their reliance on vigilant boards to reduce information asymmetry and goal conflicts between investors and top executives in resourcescarce or complex environments, Zajac and Westphal (1994) and Kesner (1987) found that directors may be less willing or less able to monitor top executives under the same environmental conditions. Hence, resource-scarce or complex environments appear to also

27 exacerbate goal conflicts between directors and investors or increase information asymmetry between directors and top executives, resulting in less effective board monitoring. However, the possibility of less effective board monitoring in resource-scarce or complex environments does not appear to factor into investors’ perceptions of agency motives in acquisition. Rather, the mere presence of vigilant boards appears sufficient to ally investors’ concern about agency problems. This anomaly may be explained from a symbolic management perspective on corporate governance (Westphal and Zajac, 1994, 1998; Zajac and Westphal, 1995). For instance, Westphal and Zajac (1998) found a favorable market reaction to the adoption of longterm incentive plans even if these plans were not subsequently implemented. Their finding suggests that stock market reactions also reflect social benefits resulting from symbolic actions that reduce uncertainty about managerial motives. Similarly, this paper provides evidence that symbolic information about governance arrangements affects investors’ evaluations of managerial motives for acquisitions. However, I also found that symbolic governance structures appear to be most effective when investors are uncertain in resource-scarce, complex or dynamic environments as to whether an acquisition is motivated by synergy or agency reasons. Clearly, more research is required to determine whether a firm adopting symbolic governance structures is always effective in addressing stakeholder concerns or does repeated adoption result in less favorable consequences for the firm over time.
The present study also has implications for managers. This study highlights the importance of a firm’s external environmental conditions in shaping investors’ perceptions of agency motives in acquisitions. If an acquisition is indeed motivated by synergy reasons, top executives should make every attempt to disclose pertinent information that may be used by the market to evaluate the potential value created through the acquisition, especially if the acquisition is announced

28 when a firm’s environment is resource-scarce, complex, or dynamic. Failure to do so may result in investors turning to indirect secondary information sources, such as the perceived effectiveness of a firm’s monitoring mechanisms. Although indirect secondary information sources may be better understood by investors, these sources may also be potentially irrelevant or inaccurate for valuation purposes. Furthermore, top executives must be cognizant that investors do take into account the effectiveness of a firm’s corporate governance mechanism when forming impressions about the potential for managerial opportunism. While the symbolic adoption of corporate governance practices purported to reduce agency problems may be sufficient for the attainment of legitimacy in the short-run, there is less evidence that repeated symbolic management without substantive implementation is beneficial in the long-term.

29
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Table I
Descriptive Statistics and Correlation among Study Variables a
Variable
1 Cumulative abnormal returns
2 Acquirer performance
3 Acquirer sales (natural log)
4 Acquirer level of diversification
5 Relatedness of acquired firm
6 Insider ownership
7 Independent directors’ vigilance
Mean s.d. 1 2 3 4 5 6 7 8 9 10 11
1.24 4.71
6.68 32.81 -.19
5.55 2.04 -.16
2.53 1.78 -.19
0.34 0.45
11.80 20.00 .09
.36
.10
0.00 1.44 -.12 -.12
.51
.09 -.14 -.06 -.02
.04
.15 -.19 -.19 -.09
.04 -.01 -.01
8 Affiliated directors’ vigilance 0.00 1.64 .10 -.13 -.20 -.19 .07 .05 -.48
9 Pressure-resistant investors’ ownership 9.59 14.69 -.05 -.09 .08 -.13 .05 -.12 -.02 .05
10 Environmental munificence
11 Environmental complexity
1.00 0.20
1.34 0.51
.08 -.06 -.09 .09
.00 -.04 -.13 -.05
.20
.02
.13 -.10 .04 .14
.01 -.07 -.09 -.08 .21
12 Environmental dynamism 1.05 0.02 .10 .07 .14 .27 .02 .14 .06 -.02 -.07 .40 -.11 a n = 100 firms. Correlations greater than .19 are significant at p < .05; correlations greater than .26 are significant at p < .01.
41

42
Table II
Results of Multiple Regression Tests on Cumulative Abnormal Returns
Variable a
Intercept
Acquirer performance
Acquirer sales (natural log)
Acquirer level of diversification
Relatedness of acquired firm
Insider ownership
Independent directors’ vigilance
Affiliated directors’ vigilance
Pressure-resistant investors’ ownership
Environmental munificence
Environmental complexity
Environmental dynamism
Interaction terms:
Munificence x independent directors’ vigilance
Munificence x affiliated directors’ vigilance
Munificence x pressure-resistant investors’ ownership
Complexity x independent directors’ vigilance
Complexity x affiliated directors’ vigilance
Complexity x pressure-resistant investors’ ownership
Dynamism x independent directors’ vigilance
Dynamism x affiliated directors’ vigilance
Dynamism x pressure-resistant investors’ ownership
Model F (df)
Overall R
2

R
2
Adjusted R
2 a
All variables are standardized in the regression model.
† p < .10; * p < .05; ** p < .01
Model 1

.00
-.21
†
.05
-.25
†
.07
.06
-.12
†
-.04
-.12
.02
-.02
.17
† s.e.
.10
.11
.13
1.19 (11, 88)
.13
.07
.11
.12
.11
.12
.13
.10
.11
.08
.02
Model 2
 s.e.
.13
-.24 *
.10
-.23
†
.18
†
.07
-.05
.08
.09
-.06
.29 *
.29 *
-.28 *
-.18
†
.15
-.27 *
.31 *
.13
.15
.14
.36 ** .12
.36 ** .15
.25 ** .10
.08
.12
.13
.15
.12
.10
.11
.13
.12
.11
.10
.09
.25 ** .10
.34 * .17
2.19 (23, 76)
.36 **
.23 **
.19 t-tests are two-tailed for control variables and one-tailed otherwise.

43
Figure 1
Interaction Effects of Independent Directors’ Vigilance and Environmental Munificence on Cumulative Abnormal Returns
2.000
1.500
1.000
0.500
0.000
Cumulative
Abnormal Returns
-0.500
-1.000
-1.500
-2.000
-2.500
Low High
High Munificence
Low Munificence
Independent Directors' Vigilance

Figure 2
Interaction Effects of Independent Directors’ Vigilance and Environmental Complexity on Cumulative Abnormal Returns
3.000
2.000
1.000
Cumulative
Abnormal Returns
0.000
-1.000
-2.000
Low High
High Complexity
Low Complexity
-3.000
Independent Directors' Vigilance
44