Multiple Directorships and Acquirer Returns*
Seoungpil Ahna, Pornsit Jirapornb, and Young Sang Kimc,*
First draft: June, 2006
Current draft:August, 2007
JEL Classification: G30, G34
Keywords: Multiple directorships, Agency theory, Board appointments, Mergers and Acquisitions.
Abstract
This paper examines the impact of multiple directorships on stockholder wealth around the announcements of mergers and acquisitions. Grounded in agency theory, our study argues that multiple directorships affect the quality of managerial oversight and, hence, influence agency conflicts in acquisition decisions. We find that acquiring firms where independent directors hold more outside board seats experience more negative abnormal returns upon announcement. We also decompose the reputation effect and the busyness effect of multiple directorships. After controlling for the reputation effect, our results support the notion that multiple directorships overstretch directors’ time, resulting in less effective monitoring.
JEL Classification: G30, G34
Keywords: Multiple directorships, Agency theory, Board appointments, Mergers and Acquisitions.
1. Introduction
The board of directors constitutes a crucial corporate governance mechanism. Traditionally, the literature has concentrated on two features of the board of directors (i.e., board composition and board size). However, recently, the issue of multiple directorships has garnered attention from both academics and practitioners alike. In academics, several recent important studies attempt to ascertain whether overcommitted directors harm firm performance or not (e.g., Ferris, Jagannathan and Pritchard, 2003; Fich and Shivdasani, 2006; Loderer and Peyer, 2002; Perry and Peyer, 2005). Likewise, corporate reformers, recognizing that executives’ time is finite, have advocated placing restrictions on how many outside board seats individuals may hold. For instance, the National Association of Corporate Directors guidelines (NACD, 1996) recommend that senior corporate executives and CEOs should hold no more than three outside directorships. Similarly, the corporate governance policies of the Council of Institutional Investors (2003) suggest that individuals with full-time jobs should not serve on more than two other boards.
Although the attention on the issue of multiple directorships has increased recently, the impact of multiple directorships on firm value is not clear and needs further investigation. Specifically, it is important to examine the link between multiple directorships and major investment decisions such as mergers and acquisitions. In this paper, we explore the impact of multiple directorships on shareholder wealth around the announcements of mergers and acquisitions (M&As).Previous studies employ a cross-sectional analysis between multiple directorships and firm value.[1] We complement the previous studies in this area by offering an analysis using bidder announcement returns.Our methodology has a critical advantage over the previous studies.Unlike the previous research on multiple directorships utilizing either Tobin’s q or the market-to-book ratio in a cross-sectional analysis, our event study setting using announcement period returns provides evidence less vulnerable to the endogeniety issues.
The bidder announcement returns on mergers and acquisitions have been examined extensively and provide mixed evidence. While the recent empirical evidence shows a value reduction associated with M&A activities (Moeller, Schlingemann, and Stulz, 2004 and 2005, for instance), the link between multiple directorships as a corporate governance mechanismand mergers and acquisitions has not been examined.
There are two competing hypotheses on the issue.First, the number of outside directorships may signal director quality (Fama and Jensen, 1983; Ricardo-Campbell, 1983). Directors with more outside board seats may be more experienced, provide better advice, and offer better monitoring. If this is the case, they should help attenuate agency costs and discourage value-reducing acquisitions that are motivated by agency conflicts.This hypothesis is called the ReputationHypothesis and predicts that the market reaction is more positive (or, less negative) for acquiring firms where directors hold more outside board seats.
On the contrary, the Busyness Hypothesis contends that directors with too many outside board seats may be so busy that they do not function well as effective monitors. This diminished oversight may lead to more severe agency conflicts as managers are better able to enhance their own private benefits at the expense of the shareholders. One well-known consequence of agency conflicts is the depletion of the free cash flows on unnecessary acquisitions that destroy value (Jensen and Meckling, 1976; Jensen, 1986). To the extent that directors’ busyness reduces managerial oversight, permitting value-reducing acquisitions, the announcement period abnormal returns should be more negative for firms with overstretched directors. In other words, the busyness hypothesis predicts an inverse relation between the number of outside board seats and the stock market reaction (i.e., the busier the directors, the more adverse the market response).
We find the empirical evidence consistent with the busyness hypothesis. The abnormal returns are lower for firms with busier directors. It appears that investors expect acquisitions announced by firms with overstretched directors to be motivated by agency costs and, hence, likely value-destroying.[2] We employ several alternative definitions of directors’ busyness and obtain similar results. The results appear to be robust after control for a large number of firm- specific and deal-specific characteristics.
Furthermore, we introduce a novel approach that decomposes directors’ outside directorshipsinto two components;the first component can be attributed to the reputation effect while the other is related to the busyness effect. We show that the number of outside directorshipsthat is attributable to directors’ reputation and qualityis, in fact, positively related to the bidder announcement returns. We also find that the residual component of outside directorships held by directors in excess of their qualifications continues to be negatively related to the announcement returns. Our study is the first to provide evidence that multiple directorshipscan enhance firm value in certain circumstances. The results imply that it is not alwaysappropriate to impose a fixed maximum number of directorships across all types of firms. The number of directorshipsthat is related to directors’ reputation and quality (which is beneficial to the firm) varies from one firm to another and, therefore, imposing an ad-hoc threshold, such as “three” outside board seats, would be value-decreasing for some firms.
The rest of the paper is organized as follows. In section 2, we briefly review the prior literature on multiple directorships and acquirer returns and discuss the contribution of our study. In section 3, we describe the data, report descriptive statistics, and explain our measure of directors’ busyness. Section 4 examines the relation between acquirer returns and the presence of busy directors. Section 5 provides the decomposition analysis of multiple directorships. Section 6 concludes.
2. Related Literature
Our study connects two separate literatures that examine the relation between multiple directorships and firm performance and the relation between CEO incentives and acquirers’ announcement returns. In this section, we review prior literature in these areas and describe how our study contributes to each area.
2.1.Prior evidence on multiple directorships and firm performance
There is a controversy regarding the impact of multiple directorships on firm value. Some argue that multiple directorships can be value-enhancing. For instance, executives sitting on outside boards may learn about different management styles or strategies used in other firms (Booth and Deli, 1996; Carpenter and Westphal, 2001). In addition, sitting on other firms’ boards may permit executives to establish a network or to monitor business relationships (Mace, 1986; Rosenstein and Wyatt, 1994; Loderer and Peyer, 2002). Moreover, Fama and Jensen (1983) contend that demand for the executive to serve as an outside director can be an independent certification or signal of the executive’s competence. Kaplan and Reishus (1990), Gilson (1990), Shivdasani (1993), Brickley, Linck, and Coles (1999), and Ferris, Jagannathan and Pritchard (2003) offer empirical evidence showing a positive association between the number of directorships held by an executive and director quality. Thus, it can be argued that multiple directorships can be beneficial. In fact, Loderer and Peyer (2002) report a positive relationship between firm value as measured by Tobin’s q, and the number of directorships a chairman holds for a sample of Swiss firms.[3]Perry and Peyer (2005) examine the announcement effects of outside director appointments for sending firms. They report that when executives join other boards as outside directors, the announcement return for the sending firm is positive if the executive has high equity ownership or if the firm has an independent board. They conclude that when executives have strong incentives to enhance shareholder value, accumulation of board seats has a positive impact on firm value.
On the other hand, there is ampleevidence to the contrary. Ferris, Jagannathan and Pritchard (2003) investigate the frequency of securities fraud lawsuits and firm performance and report no evidence that firms with busy directors fare worse. Core et al. (1999) report that busy outside directors offer CEOs with excessive compensation packages, which in turn leads to poor firm performance. Additionally, Jiraporn et al. (2007), examining directors’ meeting attendance, reports that directors holding more outside board seats are more likely to be absent from board meetings.
Further, Fich and Shivdasani (2006) question the methodology of Ferris et al. (2003) and re-examine the relation between firm performance and multiple directorships. Claiming a better methodology, Fich and Shivdasani (2006) report that busy directors can hurt firm performance. Specifically, they find that firms with boards where the majority of outside directors are busy (i.e., holding three or more directorships) are associated with weak corporate governance, lower market-to-book ratios, weaker profitability, and lower sensitivity of CEO turnover to firm performance. Consistent with this view, the National Association of Corporate Directors (1996) and the Council for Institutional Investors (2003) have adopted resolutions calling for limits on the number of directorships held by directors of publicly traded companies.
2.2.Acquirers’ announcement returns: An agency cost perspective
A number of studies have documented the adverse impact of mergers and acquisitions for acquirers (Morck, Shleifer, and Vishny, 1990; Lang, Stulz, and Walking, 1991; Datta, Iskandar-Datta, and Raman, 2001; and Bliss and Rosen, 2001). More recently, Moeller, Schlingemann, and Stulz (2004) examine extensive an sample of 12,023 acquisitions by public firms from 1980 to 2001 and find that acquiring-firm shareholders,on average, lose $25.2 million upon announcement. In a related study, Moeller, Schlingemann, and Stulz (2005) discover that acquiring-firm shareholders lost 12 cents around acquisition announcements per dollar spent on acquisitions for a total loss of $240 billion from 1998 through 2001. They also find that firms that make these unwise acquisitions with large dollar losses perform poorly afterwards.
One explanation for the value reduction related to acquisitions is predicated on agency theory. The free cash flow hypothesis (Jensen and Meckling, 1976; and Jensen, 1986) contends that managers are inclined to spend the free cash flow in a manner that enhances their own private benefits but not necessarily shareholder wealth. One example would be empire building, making unnecessary acquisitions, resulting in a value discount for the firm. Masulis, Wang, and Xie (2007) document negative abnormal returns upon announcement of diversifying acquisitions, and note that this effect is especially strong for firms with weak shareholder rights. This evidence implies that firms with severe agency problemsandweak shareholder rights are more vulnerable to unwise wealth-diminishing decisions.Similarly, Malmendier and Tate (2005) find that “overconfident”managers are more likely to undertake acquisitions and that the adverse market reaction is substantially stronger among firms managed by overconfident CEOs as opposed to firms with “rational” managers.
2.3. Our Study
Our study links these two literatures by studying the relation between multiple directorships held by outside directors and acquirers’ announcement returns. There are two competing hypothesis regarding the impacts of multiple directorships on acquisition decision. Because multiple directorships affect the quality of managerial oversight, multiple directorships influence shareholder wealth in acquisition decisions. First, the number of outside board seats signals directors’ reputation (Fama, 1980; Fama and Jensen, 1983; Mace, 1986). Individuals holding multiple board seats are high-quality directors with more experience and competence.As a result, they can perform their monitoring duty more effectively, resulting in more rigorous managerial oversight and, hence, fewer wealth-diminishing decisions. Furthermore, these executives have a strong motivation to work hard and be vigilant because they have made a significant investment in establishinga reputation as decision experts. While opposing a proposed acquisition mayjeopardize a director’s position on the bidder’s board, the cost of supportinga decision detrimental to shareholders could be still greater, because it wouldreduce the value of the director’s reputational capital in the marketplace fordecision experts. In sum, the reputation hypothesis predicts that the abnormal returns are more positive (or less negative) for firms where directors hold more outside board seats.
Second, a director’s time is finite and thus holding too many outside board seats may make the executive so “busy” to the point where his or her ability to monitor management is compromised, resulting in less effective managerial oversight. As a result, managers, taking advantage of less effective oversight, engage in activities that enhance their own private benefits at the expense of shareholders. One possibility would be for managers to promote empire building, making acquisitions that do not provide adequate returns to shareholders. The inclination for managers to make unnecessary acquisitions is well argued and empirically documented in many studies. For instance, Marris (1964)discuss the tendency for managers to increase the firm beyond its optimal size. Executive hubris is central to Roll’s (1986) theory regardingthe low profitability of takeovers to bidders. Additional evidence can be found in Jensen and Ruback (1983), Bradley, Desai, and Kim (1988), Jarrell, Brickley, and Netter (1988) and Loderer and Martin (1990). In sum, the busyness hypothesis predicts that the market reaction should be more negative for firms where directors hold more outside board seats.
3. Sample Selection and Data Description
3.1. Sample Selection
Our initial sample consists of completed acquisitions extracted from the Securities Data Corporation's (SDC) U.S. Mergers and Acquisitions Database.We obtain the initial sample over the period of years 1998 to 2003 that meets the followingcriteria:
(1)The deal is announcedbetween January 1, 1998 and December 31, 2003.[4]
(2)The deal is successful and completed in less than one thousand days after the announcement date.
(3)The acquirer controls less than 50% of the shares of the target at the time of announcementand obtains 100% of the target shares.
(4)The deal value is equal to or greater than $1 million.[5]
(5)The target is a U.S. public or private firm.
(6)Stock return data and other required financial data on the acquirer are available from CRSP and COMPUSTAT.
(7)The acquirer is covered in the InvestorResponsibilityResearchCenter (IRRC) director database.
The IRRC director database provides detailed information on directors’ outside directorships for approximately 1,500 firms during our sample period. After the screening process, our final sample consists of 1,163 observations from year 1998 to 2003.
In Table 1, Panel A provides the distribution of mergers and acquisitions by year and Panel B shows the sample frequency by acquirer’s industry. The number of acquisitions is more concentrated in the earlierpart of the sample period, reaching the highest level of 270 deals in year 2000 and dropping to 150 deals in year 2003. The acquirers are widely distributed across industries with relatively high concentration in technology and financial industries.
Table 2 presents the summary statistics for the sample acquisitions. Panel A displays the deal characteristics and acquire characteristics. The average (median)dollar amount of deal size is $1,328.28 ($193.67) million. Relative size of the deal, defined as the target market value of equity relative to acquirer’s market value of equity, is,on average, 8.95% (2.79% median). About 43% of the acquisitions are paid for by equity only and 32.48% are paid for by cash only. We classify the sample into related and unrelated acquisitions. Using the Fama-French 49 industrial classification, an acquisition is considered as a related deal when acquirer and target are operating in the same industry. About 38% of deals in our sample areunrelated acquisitions. We also document that 36% of acquisitions involves private targets. Some acquisitions are conducted in a competitive environment, i.e. when multiple firms make a public bid for the same target. The proportion of the competed deals in our sample is 1.82%. Panel A of Table 2also reports descriptive statistics for acquirer characteristics. The average book value of assets is $19,735 million ($4,411 million in median). The market-to-book ratio is on average 2.76 (1.76 in median). Leverage, computed as long-term debt scaled by total assets, is on average of 21.59% (20.96% in median). The ratio of operating cash flow to total assets is 7.28% (6.19% median).
Panel B of Table 2 documents the stock market reaction to the acquisition announcement. Cumulative abnormal returns are computed based on standard market model event study methodology (Brown and Warner, 1985). The market model parameters are estimated over the period from day -210 to day -11, using the equally weighted market index. Acquirer abnormal announcement return for the (-1, +1) day window is -1.30% and significantly different from zero, with more negative CARs in wider event windows. The result shows that average stock market response for acquirer is negative and statistically significant, consistent with the findings in Moeller, Schlingemann, and Stulz (2004).
3.2. Measures of directors’ busyness
Our measure of directors’ busyness is computed using the number of “other” outside board seats held by each directoras reported in the IRRC director data. For example, in the IRRC database, a director who holds a “total” of 5 board seats would be holding 4 “other” or “outside” board seats. This definition is also used in Perry and Peyer (2005).We employ fourdifferent measures of directors’ busyness. Our first measure of directors’ busyness is directorships per director, which is the average number of other outside board seats held by each director. As in Ferris et al. (2003), it is calculated as the total number of other directorships divided by the total number of directors on the board.[6] Second, we focus on the monitoring role of outside directors and compute directorships per outside director, which is the total number of other directorships held by independent directors divided by the number of outside directors. We follow the classification of outside directors in the IRRC director database. Outside directors are directors who are not classified as inside or grey directors, where grey directors include former employees, relatives of employees, or persons who provide significant contractual services to the company.