The Costs of Entrenched Boards

Featured in print Digest

Staggered boards have a decidedly negative effect on firm value... that ... is several times larger than that of some two dozen other management-favoring provision.

In The Costs of Entrenched Boards (NBER Working Paper No. 10587), researchers Lucian Bebchuk and Alma Cohen ask if the market value of publicly traded corporations is related to whether a firm's board of directors is strongly protected from removal by shareholders. They find that a strong protection from removal is associated with, and indeed even partly responsible for, an economically significant reduction in a firm's value.

The level of protection from removal that directors of public companies enjoy depends substantially on whether the firm has a staggered board. A firm with a unitary board requires all directors to stand for election (or re-election) at each annual shareholders meeting. By contrast, a staggered board most often has three classes of directors, with only one class of directors standing for election (or re-election) at each annual meeting. In that case, to gain control over the board via a proxy contest, a challenger has to win at least two elections, one year apart.

In addition, directors protected by a staggered board typically have an advantage in defending against a hostile takeover bid. Because incumbents can use a poison pill to prevent the bidder from purchasing shares, a hostile bidder's chief hope likely lies in replacing the resistant board of directors with a team that would redeem the pill and make an acquisition possible. With a staggered board, however, even if the bidder dangles an attractive offer before the shareholders and suggests board candidates favoring the takeover, replacing the incumbents remains a lengthy and difficult process. A staggered board therefore makes gaining control of a company -- either in a proxy contest or in a hostile takeover -- much more difficult.

The majority of U.S. companies have staggered boards, but over the past 10 years staggered boards have met increasing resistance from institutional investors. During this period, shareholders have generally been unwilling to approve charter provisions that establish a staggered board in companies without such provisions. Shareholders also have increasingly been voting for advisory resolutions that recommend dismantling staggered boards.

Bebchuk and Cohen studied the association of staggered boards and firm value between 1995, when the rules giving such boards their protective powers were firmly in place, and 2002, the last year for which pertinent data are available. As a proxy for firm value, they use Tobin's Q, a standard valuation measure based on market-to-book ratios. Their study is based on data gathered by the Investor Responsibility Research Center (IRRC), which analyzes governance provisions in all of the S&P 500 companies and in other significant firms as well. Bebchuk and Cohen find not only that staggered boards have a decidedly negative effect on firm value, but also that this effect is several times larger than that of some two dozen other management-favoring provisions identified by the IRRC.

The researchers determine that even after controlling for firm value in 1990, having a staggered board in 1990 is associated with a significantly lower value during the period 1995-2002. This finding is consistent with staggered boards bringing about a lower firm value and not merely being selected by low-value firms.

Moreover, the researchers find that the extent to which staggered boards are associated with reduced firm value depends on whether such boards are established in the firm's charter, which shareholders cannot amend, or in the firm's bylaws, which shareholders can change. Most staggered boards are established in company charters, but about 10 percent of staggered boards are set up in company bylaws. Bebchuk and Cohen find that bylaws-based staggered boards do not show the same negative correlation with firm value as charter-based boards do. Bylaws-based staggered boards provide the same commitment to continuity and stability in board composition that supporters of staggered boards favor, but they do not provide the same insulation from removal by determined shareholders as charter-based staggered boards. This feature of bylaws-based staggered boards might explain the lack of correlation with reduced firm value.

Bebchuk and Cohen note that their study does not examine other factors affecting levels of protection for corporate board members. For example, among firms that do not have effective staggered boards, some have arrangements whereby shareholders can remove the board immediately, while in other frameworks shareholders have to wait until the next annual meeting in order to remove a board. The Bebchuk and Cohen study has not identified which of these two groups tends to have firms with higher value, but they say this is clearly deserving of further analysis. Because staggered boards are a key feature of corporate governance, Bebchuk and Cohen suggest, it is worth inquiring how staggered boards affect various corporate decisions, and why firms going public include staggered boards in their IPO charters.

-- Matt Nesvisky