Who really wants an activist on board? The impact of ownership structure on directors’ reputation

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Who really wants an activist on board? The impact of ownership structure on directors' reputation

David Russell

ESG

CERESG

Ecole Supйrieure de Gestion

Introduction

management director corporate control

For most researchers and practitioners, changes in the composition of the board of directors have been at the forefront of the wider evolution in corporate governance practices (Cuervo-Cazurra and Aguilera 2004; Daily, Dalton and, Cannella 2003; OECD 2003). Calls for more independent directors who will be active on behalf of all shareholders are a significant component of efforts to put good governance practices into place. Limits placed on the number of board mandates that one individual can have at any given time, furthermore, have freed up an increasing number of board seats to permit greater numbers of independent directors on boards (Cadbury report, 1992; Felton, Hudnut and van Heeckeren 1996; Higgs 2003; Monks and Minow 2004; Huse 2007). The end result of this aspect of the evolution of corporate governance practices has been to accelerate the competition on the market for directors, with a declining average number of mandates per director. Thus there has been an increase in the number of new directors on corporate boards, and a decrease in the number of mandates for those already serving. The factors that weaken the position of incumbent directors, or even cause them to lose their mandates, are thus emblematic of the struggle for corporate control and, beyond this, of the balance of power in post-managerialist corporate governance.

Agency theory based corporate governance research has found that a director's reputation as an active board member will be understood as a signal to shareholders that the director in question will undertake more monitoring activities on behalf of shareholders (Fama and Jensen, 1983; Jensen et Meckling 1976; Fama 1980, Williamson 1975). This monitoring behavior, furthermore, will be considered beneficial to all shareholders. This serves to make the governance system more efficient, and it serves to minimize agency costs. In this view, seen from the standpoint of shareholder interests, it would be better for passive directors to lose their mandates than for active directors to lose theirs.

The decision about director recruitment, however, lies with incumbent CEOs and board members. One can surmise that the recruitment decision will be based upon whether the incumbent CEO and board members consider their interests better served by inviting an active or a passive director onto the board (Richarson, 1987; Lorsch and MacIver, 1989; Zajac and Westphal, 1996). According to this view, which is political in nature, the shareholder preference for active directors will be resisted by that of powerful managers for passive directors who will defend the interests of the corporate elite (Hermalin and Weisbach 1998; Davis and Greve, 1997; Pettigrew, 1992). One can further surmise that passive directors are likely to lose fewer mandates in firms that seek passive boards.

According to both the agency theory based view and the political view of director selection, the market for directors is influenced on the one hand by the shareholders' preference for more monitoring, and on the other hand by the resistance of the managerial elite against increased shareholder control. What has received little attention in corporate governance research, surprisingly, is the possibility that shareholders themselves might have divergent interests with regard to director selection. Weak shareholders, for whom the actions of friendly board members are the principle means of influencing managers, have an obvious interest in seeing the power of outside directors increased, as it would increase the likelihood of their voice being heard. Powerful shareholders, on the other hand, can exercise influence over management outside the context of the board, “behind the scenes” (Carleton, Nelson and Weisbach, 1998). Powerful shareholders, therefore, hold a clear advantage over weak shareholders. Because of this, there is no economic rationale for them to have a preference for an active board that would exercise disciplinary control over management in the interests of all shareholders. In order to maintain their control through “behind the scenes” influence, powerful shareholders might have a preference for a passive board, and therefore, for the recruitment of passive directors. The loss of director mandates, therefore, can be affected by the prevailing ownership structure.

In this article, we examine this proposition by presenting the theoretical foundations that support it. Our study builds upon and extends Zajac and Westphal's (1996) findings by suggesting that the relationship between director's reputation, based on prior mandates, and the number and types of subsequent mandates, is moderated by the presence of powerful shareholders in the ownership structure of firms in which the director previously served. We tested our hypotheses on a sample of the 202 largest French companies for the period 2000-2005. Using the context of French civil law is particularly significant for our perspective since the capital structure of the firms studied embraces a wide range of types of ownership. The moderating effect of ownership structure in the building of a director's reputation can therefore be clearly examined. Our results show that ownership structure does influence the context in which director reputation is built. As a consequence, when considering the reasons why some directors lose their mandates, the interests of powerful shareholders versus those of weak shareholders should be taken into account.

1. Theory and hypothesis

1.1 The Role of the Board and Directors' Reputation

As Zajac and Westphal clearly state (1996:508), economic rationale is the deciding factor in director recruitment, while the director's main role is to monitor management. This traditional view of agency theory (Jensen and Meckling 1978, Fama 1980, Fama and Jensen 1983) is based on the assumption that shareholding has become widely dispersed with the advent of the modern corporation (Berle and Means, 1932). Firm owners no longer have the ability to directly exercise control over the firm (Alchian and Demsetz 1973, Fama and Jensen 1983). In this view, powerful CEOs and boards face weak shareholders (see Berle and Means 1932; Roe 1994).

Each individual shareholder, therefore, has three means by which to protect his interests and to satisfy himself with regard to the effectiveness of firm management. The first is for the shareholder to threaten to sell his shares and thereby put pressure on the share price. This action increases the risk that the firm will face a hostile takeover and that the CEO will be fired. The second is for the shareholder to promote the alignment of managers' interests with his own by means of adequate compensation policies for managers. The third is for shareholders to demand the recruitment of activist directors who will monitor management in their place. According to this view, therefore, the board should recruit a sufficient number of active directors in order to guarantee control and to defend the interests of all shareholders, while at the same time minimizing the costs of that control (Hermalin and Weisbach 1998; Weisbach 1988; Winter 1977). Because of this preference on the part of shareholders, an optimal result is achieved, from an economical point of view (Fama and Jensen, 1983a). The decisive criterion in establishing a potential director's value in the market for directors would be director reputation, as a director's reputation would be an indicator of his or her abilities.

In their 1996 article, Zajac and Westphal define active directors as those who recently undertook to increase the level of control over management. They demonstrated that the nomination of a new director was strongly dependent upon the director's previously acquired reputation as an active or passive director. This reputation is established by the director's previous experience on a board that effectively increased the level of monitoring. Previous experience, in turn, signals the ability of the director to be active in the exercising of increased control over management. In the current process of restructuring the market for directors, therefore, we suggest the following hypothesis:

H1: Directors with a reputation of having been highly active are less likely to lose subsequent appointments to boards requiring high control over management than directors with a reputation of having been less active.

The selection of new directors is not necessarily made according to their capacities to monitor management. It could be made, rather, according to directors' capacity to serve the interests of those doing the recruiting i.e CEO and incumbent directors. In particular, experience as an “active” director would indicate that the individual would not be a good candidate in the eyes of a powerful CEO, if that CEO had no interest in increasing the power of the board. Management would rather recruit a new director with little previous experience as a director. If the director, therefore, was a member of a board on which strong levels of monitoring were undertaken, his reputation as an active director would make him an unwelcome candidate for passive boards, and therefore, we suggest the following hypothesis:

Hypothesis 2: Directors with a reputation of having been highly active are more likely to lose subsequent appointments to boards requiring low control over management than directors with a reputation of having been less active.

1.2 Strong Shareholders and their expectations regarding Board Control

Previous reasoning assumed that shareholders were weak, in the sense that no single shareholder had the ability to directly influence management. This assumption becomes debatable, however, when powerful shareholders are present. Powerful shareholders may hold a number of shares sufficient to enable them to exercise control over management without even having to go through the board. Such influence can be seen, for example, during shareholder meetings when the issue of the continuation of a board member's mandate is put to a vote. It could be possible for a powerful shareholder to garner a majority of votes around his or her view (Shleifer and Vishny, 1986; 1997). Powerful shareholders may exercise their influence in subtler ways, such as when the threat of defection during an annual meeting is sufficiently credible to force the CEO to take their specific concerns into account. Even in the case when shareholders' threat to sell their shares is not economically optimal and therefore not credible, Pound's studies on institutional investors showed that the most efficient behavior is to influence management by threatening to publicly disapprove their decision (Pound 1988, 1989). In subsequent research, Strickland, Wiles, and Zenner (1996), Smith (1996), Carleton, Nelson and Weisbach (1998) have shown how the influence of powerful investors was exercised through private discussions with members of top management and “behind the scenes” activism, rather than through positions taken at board meetings, which embroiled them too closely in the day to day affairs of the firm. This conclusion is strongly supported by research in governance of unlisted companies (Gedajlovic and Shapiro 1998; Zahra, Neubaum and Huse, 2000, Wright and al. 1996; for a recent overview, Huse 2007). In family-owned firms, for example, it has been shown that the hiring of independent outside directors rarely jeopardizes the real control exercised by non-independent directors or of influential family members, who come together in family meetings/councils (Landsberg 1999, Ward 1991, for an historical viewpoint Gomez 2004).

Whereas in theory powerful shareholders have the ability to influence board decisions, such shareholders have little interest in using that influence on behalf of all shareholders. To do so would deprive the powerful shareholder of the power, influence, and private benefits that result from his or her dominant position. The powerful shareholder, therefore, will tend to prefer more passive directors. A director's reputation is thus based not only on the behavior demonstrated on previous boards of which he or she was a member, but also on the coherence between the board member's actual behavior, and the behavior expected by the owners. Director behavior will be considered “appropriate” if it meets expectations that are normally associated with a certain type of ownership structure, e.g. not very active if the board is expected to be more passive, or highly active if the board is expected to be highly active. But if the director was a member of a highly active board in a firm whose capital structure left one inclined to think that such monitoring activities were not considered particularly desirable, then that director's reputation as a “reformer” will be greater than if the same director had been an active director on a board that was expected by shareholders to exercise greater control over management. He or she benefits from a reputation for being highly active, and thus we suggest the following hypothesis:

Hypothesis 3: Directors who have the reputation of having been highly active in firms with strong shareholders are less likely to lose appointments to boards requiring high control over management than directors who have been highly active in firms with weak shareholders.

In the case where a director was an activist on the board of a company whose shareholders did not require an activist board, that director's reputation for being an activist would be considered a handicap for him to keep mandates on passive boards. Compared to other activist directors, such a director would represent a handicap in the eyes of those companies seeking to maintain a passive board, and therefore,

Hypothesis 4: Directors who have the reputation of having been highly active in firms with strong shareholders are more likely to lose appointments to boards requiring low control over management than directors who have been highly active in firms with weak shareholders.

These hypotheses, therefore, complement those of Zajac & Westphal (1996) by positing that firm ownership structure will impact the evaluation of the past behavior of the newly recruited director and thus will determine his or her reputation in the market for directors.

2. Methodology

2.1 Sample and Data Sources

Our sample included all directors sitting on the board of 202 firms belonging to the SBF 250, the French index of the leading 250 firms in terms of market value listed on the Paris Stock Exchange. We had to exclude from our sample the remaining 48 firms which were members of the SBF250 because complete data were unavailable. Data were collected for the years 2000-2005, inclusive. Data on board structure and membership, CEO and director characteristics, board committees and CEO duality were collected from reference documents filed with the AMF (the French equivalent of the SEC) and the Who's Who in France database. Data on firm ownership structure, economic performance, size, diversification and industry membership were obtained from Thomson One Banker. In total, our database allowed us to test our hypotheses on 7129 director-year observations.

Independent variables:

Participation in increased control - Director's reputation.

To compute a measure of a director's past participation in increasing the level of control over management, which shapes his or her reputation as a person exhibiting an orientation toward control, we followed the three-step procedure suggested by Zajac and Westphal, (1996).

First, to capture a director's involvement in increasing the level of control over management, we have identified six indicators which have been linked in the strategic management literature to the extent to which a board exercises strong control over management. The first measure captured the increase in the ratio of the number of non-executive directors relative to the total number of directors between year t-1 and t. An increase higher than one standard deviation in this ratio indicates that the focal director sitting on the board of the firm has participated in an action to enhance the level of control over management. The second and third variables measured whether the focal director had participated in putting into place a board nomination committee and a board compensation committee. If the focal director had participated in the creation of these committees, he was considered to have undertaken an action towards increasing the control over management. The fourth and fifth variables captured actions which reinforced the separation between management and control by taking into account whether the focal director had participated in a board which has dissociated the function of CEO and Chairman of the board or adopted a two-tier board structure. Finally, we used an entropy measure of diversification (Palepu, 1985) to capture diversification undergone by managers to increase their own interests (Amihud & Lev, 1981; Zajac & Westphal, 1996). A decrease of one standard deviation in diversification between year t-1 and t suggests that the focal director has participated in increasing the level of control over management. Thus, we obtained six dummy variables depicting the level of involvement of the director in increasing the level of control over management in each mandate.

The second step involved the identification of the presence, or lack thereof, of a powerful shareholder in each firm where the focal director sits. We operationalized this concept by using a dummy variable taking as a cut-off point 10% stock ownership. Accordingly, if the major shareholder owns more than 10% of common equity of the firm, the firm is considered to have a powerful shareholder. Conversely, if the major shareholder owns less than 10% of the firm's common equity, the firm is considered to be without a powerful shareholder.

In the final step, we computed two scores capturing director's reputation as a person exhibiting an orientation toward control. The first score measured director's reputation in past mandates in firms having a powerful shareholder while the second score measured director's reputation in past mandates in firms without a powerful shareholder. To compute the first score, we calculated the number of actions involving an increase in control along the six indicators presented above for all mandates occupied by the focal director in firms having a powerful shareholder. Similarly, the second score was obtained by summing the number of actions involving an increase in control along the six indicators for all director mandates in firms having a powerful shareholder

Dependent variables:

Number of mandates lost by directors: In total, we defined two dependent variables capturing the decrease in director appointments in each board category (1) boards having low control over management and (2) boards having high control over management. We identified the two categories of boards (requiring high or low control) using the four-step procedure suggested by Zajac and Westphal, (1996).

First, we summed the six indicators of board control described above for each board in the sample. Second, we calculated the average value over a two-year period for each board to reduce the potential effect of an extreme but temporary fluctuation. Then, we classified boards in high or low control over management by taking the median split for this measure for each year. Hence, the first group consisted of boards having performed above the median number of actions aimed at increasing control over management, whereas, the second group consisted of boards which have undertaken below the median number of similar actions. Accordingly, we created two variables capturing the number of appointments lost by director in each board category.

Control variables:

We controlled for possible confounding effects using five variables. These include (1) director's number of prior appointments in t-1, (2) director's participation in CEO succession in t-1, (3) director's age, (4) the average return on assets of firms in which the focal director served in t-1 and (5) the logged average of total sales of firms in which the focal director was a board member in t-1.

Descriptive statistics and Pearson correlation coefficients for all variables included in our model are presented in table 1.

2.2 Data analysis

We tested our four hypotheses using Poisson regression analysis. This form of analysis is particularly suitable to test our hypotheses because our dependent variable is the count of a number of events (additions/subtractions of mandates). We cannot use standard multiple linear regressions because count variables violate several assumptions (normal distribution, negative values, independence of errors, etc…). These assumptions do not apply in Poisson regression analysis.

2.3 Results

The results of Poisson regression analysis testing our four hypotheses are reported in tables 2 and 3. Table 2 describes findings testing the baseline hypotheses 1 and 2 suggested by Zajac and Westphal (1996). These hypotheses do not take into consideration interaction effects of ownership structure and participation in increased control on the likelihood of losing board appointments. These interaction effects are investigated using Poisson regressions in table 3.

Hypotheses 1 and 2 address the effect of director's participation in increased control over management on the likelihood of subsequently losing appointments on both types of boards (boards with high levels of control over management and boards with low levels of control over management). Findings reported in table 2 indicate that hypothesis 1 is supported. Indeed, table 2 shows that there is a strong negative relationship (at p ? 0.01; Chi-square = 108) between a director's past participation in increased control over management and the number of appointments lost by the focal director in boards with high control over management. In other words, directors who have been involved in increasing control over management are less likely to lose appointments on active boards.

Hypothesis 2 examines the impact of director's participation in increasing control over management on the likelihood of subsequently losing appointments on boards of firms with low levels of control (passive boards). Findings reported in table 2 suggest that director's participation in increasing control over management has a strong positive impact (p ? 0.01; Chi-square = 40.5) on the likelihood of losing appointments on passive boards. Accordingly, these results indicate that hypothesis 2 is supported.

Hypotheses 3 and 4 presented in table 3 introduce the moderating impact of ownership structure, more specifically the presence or not of a powerful shareholder, on the relationship between a director's participation in increasing control over management and losing appointments on both active and passive boards. Results of Poisson regression analysis presented in table 3 indicate that the likelihood of losing appointments on active boards is lower for directors who have participated in increasing control over management in firms with a powerful shareholder than for those who participated in increased control in firms without a powerful shareholder. Although both types of directors lose fewer appointments on active boards (p ? 0.01) the director who increased control in firms with a powerful shareholder loses fewer than those who increased control in firms without a powerful shareholder as the level of Chi-square is more than 3 times larger for the first group compared to the second (Chi-square = 99.27 and Chi-square = 28.04 respectively). These results provide support for hypothesis 3.

Finally, hypothesis 4 examines the interaction effect of ownership structure and director reputation building on the relationship between participation in increased control and losing appointments on passive boards. Our findings suggest that the likelihood of losing appointments on passive boards is higher for directors who have participated in increased control in firms with a powerful shareholder than for those who participated in increased control in firms without a powerful shareholder. Once more, both types of directors lose appointments on passive boards (p ? 0.01) but directors that increased control in firms with a powerful shareholder lose more appointments than those that increased control in firms without a powerful shareholder. In fact, the level of Chi-square is more than 3 times larger for the first group compared to the second (Chi-square = 33.04 and Chi-square = 9.96 respectively). Consequently, these results provide support for hypothesis 4.

3. Discussion

Agency theory based corporate governance research generally states that the selection of a new director, based on his or her market reputation, is the consequence of the requirement of all shareholders for more monitoring which is constrained by the “resistance” of powerful CEOs who prefer directors aligned with their own interests. In this article, we showed that there are not only powerful CEOs and powerful boards who influence director selection, but also powerful shareholders who consider their own interests when evaluating director behavior. While weak shareholders can find in directors a means of controlling management on their behalf, powerful shareholders can lose a part of their “behind the scenes” power over CEOs. The more a powerful shareholder is in a position to influence management according to his or her own interests, the less he or she will desire to see an active board put into place, one which represents the interests of all shareholders. We have suggested that the loss of director mandates, therefore, can be affected by the prevailing ownership structure.

Our results are clearly consistent with this initial proposition. They show on the one hand that the reputation of having been an active director matters (hypotheses 1 and 2). In the current context where increasing demand for active directors and the competition for board seats lead to a decrease in the number of mandates held by directors in place, those who profit from a reputation of activism lost fewer mandates on active boards. In parallel, those who profit from a reputation for being less active lost fewer mandates on passive boards. This confirms that reputation is a determining factor in the market for directors. Nevertheless, this factor is strongly moderated by ownership structure of the firms where directors were previously appointed (hypotheses 3 and 4). We have detected a “reputational premium” for “deviant directors” (i.e. active directors in firms with powerful shareholders), which can be negative because their reputation as activists may work against them in the market for directors, and this causes them to lose mandates on passive boards. This “reputational premium” can have a positive effect when the reputation as an activist director helps these individuals to retain their position on active boards. It is possible to conclude, therefore, that director reputation is strongly influenced by the ownership structure of the firms in which directors serve.

Conclusions and Limitations

Our study contributes to a better understanding of the factors that influence the market for directors. A main theoretical contribution suggests that the role of a director can either be shaped by a strong shareholder who ensures that he or she does not upset the balance between the board and management or by the shareholders as a whole who will be expecting directors who are able to effectively monitor management. On the basis of this conclusion, new interpretations regarding the evolution of corporate governance systems can be suggested. As Zajac & Westphal remarked, “the rise of shareholder power” documented by Useem (1992: 19), Davis and Thompson (1994) and others (e.g. Zajac and Westphal 1995) appears to have engendered a managerialist response that affects the dynamic structure of board interlocks". To fully comprehend this trend, it can be suggested that this apparent "managerialist response" is not contradictory with the rise or the maintenance of strong shareholder power. As a consequence, the making of a reputation on the market for directors is an indicator of the underlying balance of powers, and it requires careful consideration.

To deepen our understanding of these results and to get beyond the limitations of the present study, further research is required. Our results were observed in a country under French civil law. It was necessary for us to begin by testing our hypotheses in a country with a civil law tradition, in order to verify them where they would be most likely to be confirmed, since this system encourages concentration of ownership. Our results, however, are only an encouraging beginning. Further studies must be undertaken in countries with other corporate governance systems. This is particularly true for countries in the common law tradition such as the United States of the United Kingdom, where ownership is widely dispersed but where some shareholders are able to influence views and attitudes on the financial markets, such as various pension and investment funds. The fact that, in these countries, these market actors generally refrain from active board participation would tend to confirm our intuition in this regard, but it also confirms that further investigation is needed.

Secondly, our study covers the period from 2000 to 2005, during which demands were increasing for more and better monitoring on the part of boards, following the widespread adoption of “good governance practices”. The limitation of the number of mandates meant that directors generally had fewer mandates during this period, since they were limited by law to occupying no more than five board seats. We observed, therefore, a situation where the market for directors offered fewer possible director positions. In this context, it was not possible to verify whether certain behaviors, expected by shareholders, were rewarded by the offer of additional board mandates. To determine this, it would be necessary to wait for board reforms to no longer have an impact on director demographics.

Thirdly, we found that director activism manifested itself by the participation of directors in the institutional changes taking place in corporate governance. This phenomenon is strongly suggested in the literature as well as in the results of preceding studies. This explanation, nevertheless, is not completely satisfying. In fact, as such practices become more common, it becomes increasingly difficult to describe director activism in this way only. It will be necessary to consider additional factors which go to demonstrate effective monitoring of management, such as, for example decisions regarding the nomination and remuneration of CEOs that clearly do not favor their interests. These factors require not only new studies, but also a certain stability in corporate governance practices permitting us to compare levels of director activism, a stability that has not been achieved in this current period of evolution of corporate governance practices.

Despite its limitations, this study represents a first step in our understanding of corporate governance as a contest involving not only two sides, shareholders on the one side and a managerial elite on the other. Corporate governance brings together, in fact, numerous interests represented by diverse actors, working together to monitor firm management. In this view, actors often considered by theorists to be “natural enemies” can sometimes come together in co-operation. CEOs, for example, can ally themselves with powerful shareholders to maintain and strengthen their power. Powerful directors, on the other hand, can base their strength on the fact that they represent weak shareholders against both CEOs and more powerful shareholders. The diversity of these power contests is richer than the more traditional view put forward by agency theory, which focuses on the opposed interests of shareholders and CEOs. This study also opens perspectives allowing us to take into account the diversity of corporate governance practices with increased realism.

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Table 1. Descriptive statistics and Pearson correlation coefficients

All correlations above 0.021 are statistically significant at p=0.05, one-tailed tests, n=7129.

Table 2. Poisson regression models testing the effect of participation in increased control over management on the likelihood of losing appointments

*** p ? 0.01; ** p ? 0.05; * p ? 0.1. Unstandardized coefficients are reported. Standard errors are in parentheses.

Table 3. Poisson regression models testing the moderating effect of ownership structure on the relationship between participation in increased control over management and the likelihood of losing appointments

*** p ? 0.01; ** p ? 0.05; ; * p ? 0.1. Unstandardized coefficients are reported. Standard errors are in parentheses.

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