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E-MailAlan Marcus is a Professor of Finance at Boston College Carroll School of Management. This post is based on a recent paper, forthcoming in the Review of Financial Studies, authored by Prof. Marcus; Pouyan Foroughi, Assistant Professor of Finance at York University; Vinh Q. Nguyen, Assistant Professor of Finance at The University of Hong Kong; and Hassan Tehranian, Professor of Finance at Boston College. Related research from the Program on Corporate Governance includes What Matters in Corporate Governance? by Lucian Bebchuk, Alma Cohen, and Allen Ferrell.
Corporations that share board members with other firms tend to have similar corporate governance practices. But this commonality is difficult to interpret. It may reflect peer effects, where governance practices propagate from one firm to another. Alternatively, it may reflect selection effects, where firms with similar preferences self-select into linked groups. Specifically, associations between corporate practice and board membership could arise from firms’ decisions to recruit directors who have already exhibited similar governance preferences. Moreover, omitted variable bias can result from unobserved common shocks that cause all firms in a board-interlocked network to adopt similar practices. We seek to identify the degree to which commonality can be cleanly attributed to the propagation of practice from one firm to another. In so doing, we provide evidence for a specific transmission mechanism: the interlocking board network.
We exploit the staggered adoption across states of changes in the legal environment, specifically, passage of Universal Demand (UD) laws, to disentangle peer effects from self-selection effects. We show that firms not subject to new legislation nevertheless change corporate practice when they are board-interlocked with peer firms that become subject to that legislation.
Our particular setting focuses on the adoption of anti-takeover and other governance practices, but our broader interest is in the propagation of practice across firms. Nevertheless, our results on the economic implications of UD laws on governance are also interesting. UD laws are known to tilt the behavior of firms toward management—as opposed to shareholder-friendly policies such as higher CEO cash compensation, the adoption of poison pills, supermajority voting requirements, and classified boards. We find that UD laws also have a significant impact on legally unaffected firms, specifically, those incorporated in other states but with board interlocks to the affected firms. Crucially, we consider only board interlocks in place prior to the passage of UD legislation, thus eliminating concerns that these links are themselves affected by the passage of the law. While UD laws predispose directly affected firms to facilitate management entrenchment by adopting anti-takeover provisions, we find that board interlocked firms adopt similar policies even when their states of incorporation have not themselves adopted UD laws. In other words, even controlling for the litigation environment, there appears to be a propagation effect of corporate practice from UD-affected to unaffected firms.
Governance propagation seems most direct with regard to management entrenchment measures. A one point increase in the instrumented E-Index of peer firms leads to an increase of 0.333 point in the entrenchment (E-Index) of the focal firm. The impact on the E-Index arises primarily from the adoption of poison pills and classified boards.
The interpretation of governance commonality as resulting from a learning/practice propagation channel is mainly supported by several related patterns. First, firms with boards composed of directors with greater experience, especially experience in takeover attempts, appear less influenced by the impact of their interlocked directors. Second, governance policy is most affected by board interlocks when the interlocking directors serve on the governance committee in particular. Third, firms with busier boards seem more influenced by the presence of interlocking directors. Finally, the impact of interlocking directors is greater when those directors come from firms that initially had low E-indexes before the initial passage of a UD law in that state. The implication is that directors serving at firms whose governance practice most changed following the implementation of UD law have a greater impact on their interlocked firms. This would be the case if their experience gave them the opportunity to witness and learn from changes in governance, lessons that they could then bring to their interlocked firms.
Our results may also shed light on the role of reputation in the labor market for directors. As explained elsewhere by Levit and Malenko, in a “strong governance” equilibrium, value-maximizing and shareholder-friendly policies will enhance the value of directors’ human capital. But in a “weak governance” equilibrium, a reputation for being management friendly is more valuable.
In our context, when states pass UD laws, they ease the way for management-friendly policies, and risk tilting the equilibrium toward the weak governance outcome. Consistent with these dynamics, we find that after the passage of a UD law, firms in affected states are increasingly prone to recruit directors with experience in firms that practice management-friendly governance. Moreover, our results suggest that interlocking board members who sit on the board of a firm incorporated in a state that has passed a UD law are significant actors in the adoption of management-friendly governance provisions at the firms they serve in other states. Thus, while our empirical evidence is consistent with a simple learning model, it is also consistent with the governance equilibrium model focused on the career incentives of directors.
The complete paper is available for download here.
