Board of Directors Research Evidence PDF

Module 2 Board of directors Research evidence Learning objectives After studying this section, you should • Understand the concept of optimal board characteristics • Understand why it is difficult to make any conclusions on optimal board characteristics • Know the key board characteristics and the...

Module 2 Board of directors Research evidence Learning objectives After studying this section, you should • Understand the concept of optimal board characteristics • Understand why it is difficult to make any conclusions on optimal board characteristics • Know the key board characteristics and their effect on firm performance 2 Why do board characteristics matter? • Board of directors plays a key role in the governance system of the firm • Hence, it is not surprising that there is a lot of research evidence on board characteristics and their influence on firm performance • Corporate Governance codes and legislation often assumes that certain board characteristics such independence or gender distribution affect positively board work and consequent firm performance • Empirically, we expect to observe an increase in the performance of a given firm, if the firm ‘improves’ its board characteristics - Or do we…? • Consider the example given in next two figures 3 Example: Firm performance and board size Performance Performance Firm A’s optimization problem Firm A × × Firm B × Board size Firm B’s optimization problem × Board size 4 Example: Firm performance and board size • Firm performance (e.g. ROA or stock return) decreases with the board size • Consequently, one might be tempted to conclude that a firm would do better if it reduces the size of its board • However, we must consider why firm B has chosen a larger board • These two firms face different optimization problems ˗ For a given firm, there is no linear relationship between performance and board size – the relationship is concave and admits an interior maximum ˗ Moreover, both firms are already at their maximum • If Firm B cuts the size of its board, its performance would decline – not increase, which is opposite to what we concluded based on the first figure • This example demonstrates how governance structures arise endogenously, because firms choose them in response to the governance issues they face • Since firms differ in their business models and other fundamentals, they often have different optimal governance structures 5 Example: Firm performance and board size • In our example, Firm B may have a more complex business model compared to Firm A, which requires more expertise from directors in the board of Firm B →Firm B needs to hire more directors with diverse expertise →Optimal board size of Firm B is greater than that of Firm A • Note that sometimes there is no relationship (negative or positive) between the firm performance and governance structure as illustrated in the next figure • One might be tempted to conclude that the governance structure of interest does not matter at all 6 Example: Still optimization problems… Performance Firm A’s optimization problem × Firm B’s optimization problem × Board size 7 Endogeneity • Our example illustrated one form of endogeneity problem ˗ A given governance attribute (like board size) may reflect other exogenous factors • A given governance attribute and firm performance may also be jointly determined or there may exist a reverse causality between performance and governance attributes ˗ Example: ▪ Firms may go into bankruptcy, because they have poor directors, OR ▪ Troubles firms may not be able to attract high quality directors like board professionals ▪ So, how does this go, after all…? 8 How to address endogeneity? • More rigorous theoretical analyses may help ˗ Why and how should a given governance attribute matter? • Econometric techniques may help ˗ Control variables including firm fixed effects ˗ Instrumental variable estimations ˗ Lead-lag structures of the variables ˗ Non-linear models ˗ Random coefficient models • Analysis of the shocks of the governance attributes ˗ How do changes in board structure affect future performance? ˗ How does firm performance change, if executives accidently die (Are there really such macaaber studies…?, YES!) 9 Market reaction to managers’ death • Events like accidental death are truly exogenous (or they should be…) • Johnson et al. (1985) explore stock market response to the announcements of executives’ (mainly board members) sudden deaths ˗ It may be costly to transport current managers’ human capital, talent and other personal characteristics to the new ones ˗ Labor contract with the manager may be costly for shareholders • A sample of 53 sudden deaths of the executives’ of the listed US firms ˗ Heart attacks ˗ Accidents or suicides ˗ Deaths that follow a brief illness 10 Market reaction to managers’ death 11 Market reaction to blockholders’ death • Slovin and Sushka (1995) explore blockholders’ (main owners) deaths affect firm value, ownership structure and corporate governance ˗ Stock price reactions reflect blockholders’ effect on governance • A sample of 85 deaths of the blockholders’ of the listed US firms • For firms with highly concentrated equity ownership, the death of an insider blockholder increases shareholder value ˗ Supports the managerial entrenchment hypothesis • Blockholders’ deaths open the firm to hostile and friendly takeovers 12 Market reaction to blockholders’ death Stock price reactions of deaths of blockholders holding 5% or more of the firm: 13 Market reaction to blockholders’ death Stock price reactions of deaths of blockholders holding different stakes of the firm 14 Determinants of board characteristics • It is often believed that firms should have as many independent directors as possible (or even all directors should be independent) • In many countries, Governance Codes and even company legislation is based on this view • However, there also problems related to independent directors ˗ Lack of incentives: Outside directors typically own few shares in the firm and have their own agendas and incentives (they may have incentives to shirk and to use corporate resources to increase their utility) ˗ Outside directors can have different risk preferences than the typical diversified shareholder: reputational concerns might motivate them to oppose highly risky, but positive NPV projects 15 Determinants of board characteristics ˗ Outside directors may lack competence: a director with very similar backgrounds and experience to the board is unlikely to produce new insights after reviewing the same material for board meetings ˗ Outside directors’ lack of competence can be a major problem, if directors are appointed to ’make up’ the board composition to have a ’better looking’ gender, age, racial or geographic distribution in the board • These problems typically do not apply to inside directors 16 Determinants of board characteristics • Linck et al. (2008) is an example of studies exploring factors affecting the board characteristics • They find that firms structure their boards in ways consistent with the costs and benefits of monitoring and advising by the board ˗ Board structures develop as an efficient response to the perceived agency problems • Firms with high growth opportunities, high R&D expenditures, and high stock return volatility have smaller and less independent boards ˗ Firms with high monitoring and advising costs need directors with high expertise, which is costly in terms of compensation and free rider costs 17 Determinants of board characteristics • Large firms have larger and more independent boards ˗ These firms have complex business models that calls for broader expertise in the board • High managerial ownership is associated with smaller and less independent boards ˗ Substitute governance mechanisms • CEO and Chairman of the Board (COB) posts are combined in large firms and when the CEO is older and has had a longer tenure ˗ These CEOs have a strong position due to their personal skills • Linck et al. (2008) also report clear patterns in the change of board structures over time 18 Board characteristics and firm performance • There is vast literature on how firm performance is affected by various board characteristics ˗ Independent directors ˗ Board size (a free rider problem) ˗ Gender distiribution ˗ Directors’ equity incentives in the firm ˗ Directors’ criminal convictions (!?!) • Endogeneity problem makes it difficult to draw clear conclusion in many studies ˗ Exogenous shocks is likely to be the best way to handle the problem 19 Board independency and firm performance • Bhagat and Black (2002) is an example of studies exploring how board independency affects firm performance • Their results of analyzing large US firms show that ˗ Low-profitability firms respond to their business troubles by increasing the proportion of independent (outside) directors of their firm ˗ There is no evidence that this strategy works: firms with more independent directors do not perform better – they may actually perform worse than other firms ˗ Firms size seem to be negatively correlated with firm performance • Many other papers have explicitly or implicitly (control variables) addressed the same issue with mixed results 20 Board size and firm performance • A free-rider problem ˗ Larger boards are less effective in monitoring due to worse coordination and less freeriding within the board (Jensen,1993) ˗ Example: Consider problems that arise, if the number of students working together on the term paper increases…? • There is empirical evidence supporting this view, but remember the endogeneity problem • For large US industrial firms, Yermack (1996) reports that ˗ Firm value decreases with the board size ˗ Firms with smaller boards also have stronger financial ratios and are more likely to fire CEO after periods of poor performance ˗ Stock price reactions show that investors react negatively when boards shrink and positively when board size increases 21 Board size and firm performance Means and medians of Tobin’s Q for different board sizes. Yermack, 1996 Tobin’s Q = Market value of assets / Replacement cost of assets, where: ˗ Market value of assets is the market value of equity and liabilities (book values of liabilities are often used as a proxy for their market values) ˗ Replacement costs of assets can be calculated with certain algorithms or, most often, book values of assets are used as a proxy for their market values 22 Board size and firm performance • There is a negative relationship between board size and operating performance of small unlisted firms (Eisenberg, Sundgren and Wells, 1998) • In small firms, there is less separation of ownership and control than in large firms ˗ The effect still exists in small firms • If there is an optimal board size, its seems to vary firm size • Small firms are under a strict, direct control of their owners ˗ It is a bit surprising that directors’ free-rider problem exists among these firms ˗ Board-size effects may have different roots in small, closely held firms than in large firms 23 Board size and firm performance The relations between board size and mean and median industry-adjusted returns on assets (ROA) for small unlisted Finnish firms (Eisenberg et al., 1998) 24 CEO duality and firm performance • It is often assumed that CEO should not be the chairperson of the board ˗ CEO is monitoring herself… • However, CEO as a board chairperson can actually be good for the firm, because it may ˗ foster greater operational efficiency, ˗ improve the internal communication from and to the board. • Again, everything depends on the characteristics of the firm and directors • Empirical evidence is mixed 25 CEO duality and firm performance • It is often assumed that CEO should not be the chairperson of the board (+) Clear separation from management (+) Clear authority to speak on behalf of the board (+) Eliminates conflicts (+) CEO has more time to run the company • However, CEO as a board chairperson can actually be good for the firm ˗ foster greater operational efficiency, ˗ improve the internal communication from and to the board. • Again, everything depends on the characteristics of the firm and directors • Empirical evidence is mixed 26 Gender distibution and firm performance • Directors are typically males • Appointing female directors may expand the diverse opinion in board meeting, and consequently, improve board’s decision making • Adams and Ferreira (2009) report that gender-diverse boards allocate more effort to monitoring ˗ Female directors have better attendance records than male directors ˗ Male directors have fewer attendance problems the more gender-diverse the board is ˗ Female directors are more likely to join monitoring committees 27 Gender distibution and firm performance • As for the effect on firm performance, Adams and Ferreira (2009) find that a greater gender diversity of the board reduces firm profitability  ˗ However, potential reverse causality is a problem • Could it be so that gender diversity only increases value when additional board monitoring would enhance firm value? • Yes, they also find that ˗ Gender diversity has beneficial effects in the performance of companies with weak shareholder rights, where additional board monitoring could enhance firm value ˗ Gender diversity has negative effects in the performance of companies with strong shareholder rights 28 Gender distibution and firm performance • In 2003, a new law required that 40 percent of Norwegian firms’ directors be women after few years ˗ At the time, only 9 percent of directors were women ˗ The change was not motivated by a desire to improve firms’ performance but rather to increase “equality between the sexes,” in order to create a “fairer society” ˗ An excellent environment to explore how major change in the gender diversity of boards affects firm performance! • A finding of any effect on firm performance would be important evidence that boards affect value ˗ Negative effect: firms already have optimal boards ˗ Positive effect: firms have to few women in their boards 29 Gender distibution and firm performance • Ahern and Dittmar (2012) did this analyses with the following results • Forcing firms to appoint more female directors decreased the firm value Q indicating that ˗ Board members were already chosen in an attempt to maximize shareholder wealth ˗ Constraint imposed by the law led to less optimal boards, and hence a decrease in firm value • Loss in the firm value was not caused by the sex of the new board members, but rather by their younger age and lack of high-level work experience 30 Gender distibution and firm performance Source: Ahern and Dittmar (2012), “The Changing of The Boards: The Impact on Firm Valuation of Mandated Female Board Representation”, The Quarterly Journal of Economics:127, pp. 137–197. 31 Gender distibution and firm performance Source: Ahern and Dittmar (2012), “The Changing of The Boards: The Impact on Firm Valuation of Mandated Female Board Representation”, The Quarterly Journal of Economics:127, pp. 137–197. 32 Gender distibution and firm performance Relationship of Tobin’s Q and Women Board Members. Source: Ahern and Dittmar (2012) 33 Gender distibution and firm performance, really? • Eckbo et al. (2022) criticize results by Ahern and Dittmar (2012) • Eckbo et al. (2022) show that Ahern and Dittmar (2012) ˗ allocate their negative market reaction to the wrong event, which reverses their inference, and ˗ report abnormal return estimate that becomes statistically insignificant once adjusted for contemporaneous cross-correlation of stock returns. • Eckbo et al. (2022) also show that ˗ the pool of qualified female directors was sufficiently deep to avoid significant shareholder-borne costs of the quota. 34 Gender distibution and firm performance, really? Eckbo et al. (2020): 35 Female CEOs in Finland (will be translated into English in the lectures) 36 Female CEOs in Finland (will be translated into English in the lectures) 37 Crime convictions and firm performance • Amir, Kallunki, Nilsson (2014), ‘Criminal Convictions and Risk Taking’ • What is the effect of having convicted directors, CEOs and CFOs on ˗ Profitability ˗ Good-will write-offs • Criminal convictions, regardless of the nature or seriousness of the crime, are likely to reflect on an individual's negative behavioral attributes such as overconfidence • Studies suggest that firms sometimes appoint and promote to top managerial positions individuals who may be incompetent, narcissistic and manipulative 38 Crime convictions and firm performance • Firms do not require a criminal record check or similar checks of unethical behavior on candidates for board membership • If directors and other executives with crime convictions are overconfident, what are the business outcomes for the firm? ˗ Overconfident management often makes business decisions without proper consideration for bad outcomes, which is likely to result in lower profits ˗ Overconfident managers make unsuccessful acquisitions • Directors having lower ethical standards who fail to follow the standards and norms of society, put less emphasis on corporate governance rules and principles that require board members to monitor and advise management 39 Crime convictions and firm performance • All firms listed on the Swedish stock market for the period 1999-2007 and monitored by Finansinspektionen (the Swedish securities regulator) • Dataset on criminal convictions contains information on criminal activity for all Swedish citizens as of 1974 ˗ Information about individuals who have been found guilty by a court of law or received summary punishments by prosecutors ˗ No minor offences like speeding, parking and violations of local bylaw 40 Laws violated by Swedish executives Code 1951:649 1972:603 Title Act on Criminal Responsibility for Certain Traffic Offences Road Traffic Promulgation 1998:1276 Vehicle Ordinance 1960:418 # of Example convictions 285 Drunken or reckless driving Maximum penalty 2 years in prison 163 Various traffic-related crimes, all types of vehicles Fines 134 Various traffic related crimes, all kinds of vehicles Fines 97 Importing/Exporting goods without proper payment of duty or other taxes 71 Shoplifting, robbery 6 years in prison Ch. 8 Act on Criminal Responsibility for Smuggling Theft, robbery, other stealing 1972:595 Ch. 3 Vehicle Promulgation On Crimes against Life and Health 27 Driving a car with a driving ban 30 Assault, manslaughter Ch. 9 Fraud and Other Acts of Dishonesty 22 Fraud Fines Life time in prison 6 years in prison Ch. 12 Ch. 11 Ch. 17 Crimes Inflicting Damage Crime Against Creditors Crime Against Public Activity … All other crimes Total crime convictions Suspected of crimes Total convictions/suspicions 15 Damage to public property 5 Crime against creditors 6 Obstruction of police … … 164 1,106 244 1,350 10 years in prison 4 years in prison 6 years in prison 8 years in prison … 41 Table 2. Crime convictions by positions 42 Table 3. Characteristics of Sample Firms 43 Table 3 (continues). Characteristics of Sample Firms 44 Summary of Results • Surprisingly, a non-trivial proportion of board members, CEOs and CFOs in Swedish listed firms have been convicted of crimes ˗ Board members with dishonest behavior are more likely to be males than females • Firms with more criminally convicted/ suspected directors and CEOs: ˗ are smaller and less profitable ˗ report more volatile earnings, ˗ engage more in goodwill write-offs due to more unsuccessful acquisitions, and ˗ recognize bad news in earnings in a less timely manner. 45 Policy Implications • Given the strong legal enforcement in Sweden, our results raise serious concerns about the effects of board members’ personal dishonest behavior on firm performance and risk taking in other countries, particularly the United States and the United Kingdom • Appointing dishonest individuals to boards of directors is costly to the firm and its shareholders in terms of lower profits, excessive risk and lower quality reporting • To reduce this cost, companies should avoid appointing dishonest individuals to boards of directors (screening) • A lesson for you as an auditor, investor, debt-holder, business partner etc: Always look at the persons within the firm! 46 CEO turnover • Board of directors is responsible for hiring and firing a CEO ˗ It is easier to hire than fire people… • A strong board should fire a CEO, if the firm is not performing well and bad performance is due to the CEO’s lack of competens • Supporting this view, many studies report that the likelihood of CEO turnover is positively related to annual earnings decreases, and to negative stock price behavior • Dikolli et al. (2009) show that the number of past earnings decreases, negative analysts’ forecast errors, and negative stock returns, are positively related to the likelihood of CEO dismissal 47 CEO turnover CEO turnover frequencies and negative performance surprises (Dikolli et al., 2009) 48 Bibliography • Adams, R. B., & Ferreira, D. (2009), ”Women in the boardroom and their impact on governance and performance”, Journal of Financial Economics 94(2), pp. 291-309. • Ahern, K. R., & Dittmar, A. K. (2012), “The changing of the boards: The impact on firm valuation of mandated female board representation”, The Quarterly Journal of Economics 127(1), pp. 137-197. • Amir, E., Kallunki, J. P., & Nilsson, H. (2014), ”Criminal convictions and risk taking”, Australian Journal of Management 39(4), pp. 497-523. • Bhagat, S., & Black, B. (2001), “The non-correlation between board independence and long-term firm performance”, Journal of Corporation Law, p. 231. • Dikolli, S. S., Kulp, S. L., & Sedatole, K. L. (2009),”Transient institutional ownership and CEO contracting”, The Accounting Review 84(3), pp. 737-770. 49 Bibliography • Eckbo, B. E., Nygaard, K., & Thorburn, K. S. (2022), “Valuation effects of Norway’s board gender-quota law revisited”, Management Science 68(6), pp. 4112-4134. • Eisenberg, T., Sundgren, S., & Wells, M. T. (1998), “ Larger board size and decreasing firm value in small firms”, Journal of Financial Economics 48(1), pp. 35-54. • Jensen, M. C. (1993), “The modern industrial revolution, exit, and the failure of internal control systems”, Journal of Finance 48(3), pp. 831-880. • Linck, J. S., Netter, J. M., & Yang, T. (2008), “The determinants of board structure”, Journal of Financial Economics 87(2), pp. 308-328. • Slovin, M. B., Sushka, M. E., & Ferraro, S. R. (1995), “A comparison of the information conveyed by equity carve-outs, spin-offs, and asset sell-offs”, Journal of Financial Economics 37(1), pp. 89-104. • Yermack, D. (1996), “Higher market valuation of companies with a small board of directors”, Journal of Financial Economics 40(2), pp. 185-211. 50