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Governance antecedents of board entrenchment: the case of classified board provisions.

The abuses resulting from managerial entrenchment and the concomitant need for effective governance of corporate management actions have triggered significant research attention from multiple disciplines including sociology, organizational theory, and economics. Researchers seeking to understand and improve corporate governance have been especially interested in the roles of corporate boards of directors, the market for corporate control, and performance contingent executive compensation in preventing managerial entrenchment and promoting actions that protect stockholder interests (Finkelstein & Hambrick, 1988; Jensen & Ruback, 1983; Ungson & Steers, 1984; Zahra & Pearce, 1989).

Surprisingly little attention has been focused, however, on the entrenchment of corporate boards. This omission is particularly troublesome given the potentially powerful effects of such entrenchment on other critical elements of our existing governance system (Walsh & Kosnik, 1993). Corporate board members directly mediate many other elements of the accepted system of checks and balances (e.g., control over type and level of executive compensation, ability to adopt charter amendments which constrain the market for corporate control). Thus, actions that allow the members of corporate boards to entrench themselves clearly have significant potential to diminish overall governance effectiveness.

Adoption of classified board provisions (the division of boards into three classes with only one class of directors standing for election each year) represents the most recent development in legitimizing board entrenchment. During the 1980s, a number of firms changed their board structure by staggering their directors' terms of office. More recently, large shareholder groups have begun to focus on this change in board structure and are demanding that firms repeal such amendments (Harlan, 1993; Pozen, 1994). Classified boards are especially relevant given the fact that mergers and acquisitions are currently revisiting the business scene.

Researchers have emphasized the importance of understanding the origins and consequences of entrenchment practices as firm performance depends upon the efficient operation of internal and external control mechanisms (Walsh & Seward, 1990). Moreover, for shareholders to succeed in their attempts to repeal staggered terms, it is important to delineate factors that first enabled adoption. Inasmuch as approval of classified board provisions rests with corporate boards, and subsequently with stockholders, governance attributes of the board and stock ownership variables represent a logical initial step in understanding the adoption of classified boards. The purpose of our investigation, therefore, is to examine the impact of the governance attributes of corporate boards and ownership structure of firms on adoption of classified board amendments.

Classified Boards: Board Entrenchment

Classified board provisions adversely affect shareholder interests inasmuch as they entrench directors, protect managers from external market control, and potentially compromise the effectiveness of corporate boards (Kesner & Dalton, 1985). Staggered terms, therefore, increase governance problems by reducing both internal and external control of modern corporations.

Shareholders indirectly oversee the affairs of their corporation by electing representatives on the board. Each year shareholders can exercise their right to change board members, and, unless stipulated in the company's charter, can remove directors at any time by a majority vote (De Angelo & Rice, 1983). In contrast, longer-term staggered elections make it difficult for shareholders to remove directors before directors' terms expire. This restriction makes it difficult for shareholders to change board composition quickly when their interests are not being protected. Shareholders will have to wait for at least two annual meetings before they can gain complete control of their board.

Typically, cumulative voting is a powerful way for minority shareholders to influence the board of directors as each share entitles a shareholder to as many votes as there are directors to be elected. Unfortunately, dividing the board into classes and staggering elections reduces the number of votes minority shareholders are entitled to (because only a third of the directors are elected in a given year) and makes it more difficult to achieve minority representation on the board. Thus, classification of the board reduces shareholders' control over election of board members, reducing shareholders' influence over internal control of a corporation.

The classification of boards also restricts the influence of an important external control mechanism, the market for corporate control (Manne, 1965; Pound, 1987; Walking & Long, 1984). If a firm's management engages in inefficient behavior or follows inappropriate strategies, the firm will be devalued in the market and consequently, will become a prime takeover target.

The existence of a takeover threat disciplines corporate managements and prevents self-indulgent behaviors (Fama & Jensen, 1983; Manne, 1965). However, classified board provisions can delay a change of corporate control and reduce the probability of a takeover bid (Pound, 1987). Entrenched managements, effectively shielded from the discipline of the market, can continue to take actions against stockholder interests.

Some argue that classified board provisions can, in theory, provide boards of target firms greater power to negotiate a higher collective price for their shareholders by making it costly for a bidder to replace the board without its consent (De Angelo & Rice, 1983; Pound, 1987). It should be noted, however, that classified board provisions are geared not only against two-tier offers but also against uniform offers (non-tiered), thereby shielding firms from all takeover threats (Pound, 1987). From a governance perspective, provisions such as fair price amendments which provide target management more negotiating power in the case of two-tier offers without diminishing the likelihood of other types of offers would be preferable (Jarrell & Poulsen, 1987).

Empirical evidence underscores the negative effect of classified board structure on shareholder wealth. While initial empirical investigations indicated that classified board provisions adopted in the 1970s had a minimal positive impact (Linn & McConnell, 1983), subsequent studies have repeatedly shown that classified boards adopted in the 1980s had a significant negative impact (Agarawal & Madelker, 1990; DeAngelo & Rice, 1983; Jarrell & Poulsen, 1987). For example, Mahoney & Mahoney (1993) examine the impact of amendments adopted during both periods (pre-1980 and post-1980) and find amendments proposed in the 1970s had no impact on stock value, whereas those proposed in the 1980s had a significant negative impact. Bhagat & Jefferis (1991) correct for sample selection bias by including both firms that adopted amendments in 1984-1985 and those that did not, and find strong significant negative impact of classified boards.

Changes in the nature of stockholders and in the structure of the takeover market itself over that time period may explain the change in stock market evaluation of classified boards. The increased presence of institutional investors and the corresponding increase in control accorded such investors who are better informed and more active surely contribute to the negative reactions over time. These stockholders were in a better position to update their expectations of the effects of classified boards on the basis of experiences with firms that adopted these actions in the 1970s. Thus, stockholder reactions to amendments adopted in the 1980s incorporate more information than those of the earlier period.

Governance Context

The governance functioning of corporate boards may be an important antecedent to the adoption of classified boards. Boards are an important internal control mechanism entrusted with the responsibility of protecting shareholder interests (Fama & Jensen, 1983). The board is the first group that considers the adoption of classified board provision even before stockholder approval is sought (Linn & McConnell, 1983). In fact, managements use their boards' "unanimous approval" to urge their stockholders to vote in favor of classified board provisions (see, for example, Dow Chemical's 1986 proxy statement and Anheuser-Bush's 1985 proxy statement).

Even though the corporate board is viewed theoretically as an important governance mechanism, historically, board members have often simply rubber-stamped managers' requests (Herman, 1981; Vance, 1983). Consequently, corporate reformists have suggested several changes to corporate boards to promote board members' independence from management and to improve board functioning. The focus of suggested changes has included board composition (Baysinger & Butler, 1985; Kosnik, 1987), leadership structure (Rechner & Dalton, 1991; Vance 1983), and tenure of board members (Kosnik, 1990; Mallette & Fowler, 1992). The following discussion describes each of these suggested changes and identifies the impact each is expected to have on the adoption of classified board provision.

Board Composition

Board composition is the relative mix of insiders (employees of the organization) and outsiders (non-employee directors) on the board. Board activists advocate increased outsider representation on the basis that outsiders are likely to be less subjective, and consequently, more independent of corporate managements (Baysinger & Butler, 1985; Cochran, Wood & Jones, 1985; Fama & Jensen, 1983; Kesner & Johnson, 1990). As the ratio of outsiders increases, the board is more likely to be independent of management and thereby be in a better position to protect shareholder interests. To the extent that classified board provisions harm shareholder interests by impeding shareholders' ability to quickly change their representatives, an outsider-dominated board is less likely to adopt such provisions.

Others argue that outsiders may not have access to the quality of information required to effectively assess managerial competence, which can lead to ineffective monitoring (Baysinger & Hoskisson, 1990, pp. 78-79). These authors acknowledge outsiders' capacity to "make detached judgements about the quality of the strategic decisions of top managers" (Baysinger & Hoskisson, 1990, p. 79), but indicate outsiders do not enjoy the informational advantages that insiders do. Insiders enjoy access to quality information because they participate in the day-to-day activities of the firm, and therefore, can provide outside directors

"insights . . . concerning whether periodic losses either were the result of strategically appropriate actions of management that simply turned out poorly, or were due to incompetence or opportunistic actions" (Baysinger & Hoskisson, 1990, p. 77).

Such input is considered valuable for the board to appropriately evaluate incumbent management.

Conflicting views regarding increased outsider representation are rooted in the relative benefits of outsiders versus insiders. Outsiders provide independence of judgement and access to external information, whereas, insiders provide access to internal firm-specific information. While internal information is clearly critical in evaluating strategic decisions such as diversification, divestment, and R&D investments, the value of such information appears to be significantly less critical in the adoption of classified boards. Rather, external information including legal and shareholders' opinions of such provisions would seem to be much more vital. Outsiders, relatively free from internal pressures and biases, are more likely to bring these external perspectives to bear when evaluating the board's decision to adopt classified boards. Therefore, we expect:

H1: A greater proportion of outsiders on the board will decrease the rate of classified board adoption.

Loyalty of Outside Board Members

Independence of outside members - the basis for increased outside representation - can depend on who appointed them to the board (Boeker, 1992). It is argued that CEOs can dominate the board by carefully choosing outside directors (Mace, 1971; Patton & Baker, 1987). Outside board members appointed during the current CEO's tenure are more likely to be beholden to the CEO and current management. Since a longer-tenured CEO is likely to have appointed many of the outside members, tenure of the CEO would be important in influencing outsiders' loyalty to incumbent management (Boeker, 1992). A board dominated by members loyal to the incumbent management would likely approve proposals which protect that management. Therefore:

H2: A more loyal set of outside directors will increase the rate of classified board adoption.

Tenure of Outside Board Members

Past research has focused on the relative number of outsiders as a measure of outsiders' dominance. However, seniority on the board can provide members the knowledge and power to influence board decisions (Kosnik, 1990; Mallette & Fowler, 1992; Singh & Harianto, 1989). If outside directors are relatively junior, they may be less confident and more willing to conform to organizational norms. Consequently, the board's capacity to resist the adoption of classified board provisions may be compromised. A relatively senior group of outside directors, on the other hand, would be more likely to be confident and relatively more powerful in influencing board actions (Alderfer, 1986; Kosnik, 1990; Mallette & Fowler, 1992; Singh & Harianto, 1989).

As outside directors remain on the board for longer and longer periods, however, it is quite possible that they are more likely to be coopted by the incumbent management and cease to be effective monitors. Thus, the combination of these forces would result in a curvi-linear relationship between the average tenure of outside directors and board' s ability to resist adoption of classified board provision. More specifically, a U-form relationship between average tenure of outside members and a firm's rate of adoption of classified board provisions is expected:

H3: There will be a curvi-linear relationship between the average tenure of outside board members and the rate of classified board adoption.

Board Leadership

Advocates of board reform recommend dual leadership because of the potential conflict of interest that exists when a CEO also serves as chairperson of the board (unitary board leadership exists when one individual serves as both CEO and chairman of the board; when two different individuals hold the two positions, the structure is considered one of dual leadership). They argue that since the chairman controls the agenda and discussions of board meetings, dual leadership reduces management's control over the substance and process of board deliberations and promotes the board's independence (Rechner & Dalton, 1991; Vance, 1983). This independence is likely to decrease the adoption of actions that are detrimental to stockholders' interests (Mallette & Fowler, 1992). Therefore, we expect:

H4: Dual board leadership structure will decrease the rate of classified board adoption.

Board Members' Identification with the CEO

The extent to which board members identify with the CEO can also influence their choices. Board members who are themselves CEOs of other firms are more likely to identify and be sympathetic to the firm's CEO; these directors share a common experience with the CEO, which is likely to be part of their cognitive framework (Hambrick & Mason, 1984). Within the context of the adoption of poison pill provisions, Mallette & Fowler (1992, p. 1029) argue,

Perhaps a common mind-set among [these] CEO-directors influences their positions on matters of corporate governance. One example may be their response to the market for corporate control. When faced with a generalized takeover threat, directors who are CEOs may "circle the wagons" and indiscriminately oppose forces that could ultimately affect their control positions in their own companies. Or perhaps directors who are also CEOs are more likely to take a future-oriented perspective and pass poison pills to distance their companies from the pressure to realize short-term gains.

Thus, a board comprised of a greater proportion of CEOs is likely to identify with the CEO and approve a classified board provision.

H5: A greater proportion of directors who identify with the CEO are more likely to increase the rate of classified board adoption.

Ownership Context

Several authors indicate that ownership structure is an important predictor of organizational actions (Berle & Means, 1932; Hill & Snell, 1989; Williamson, 1964). Hill and Snell (1989, p. 44) examined the impact of ownership structure on productivity and conclude on the following note:

From a research perspective, the study points to the importance of ownership structure as a determinant of strategic choice. Essentially, it seems that powerful owners constrain the freedom of choice that managers might otherwise enjoy to pursue certain strategies. Consideration of ownership, therefore, might explain why firms choose different strategies, a possibility that warrants further investigation.

In line with their recommendation, we consider two aspects of ownership: institutional investors' stockholding, which reflects the ability of owners to constrain managerial actions; and managements' stockholding, which reflects the alignment of interests between managers and stockholders.

Institutional Stockholder Control

The basic premise of Berle and Means' (1932) work, The Modern Corporation and Private Property, is that ownership of large public corporations is dispersed among many stockholders, and consequently, owners do not constrain managerial actions. Since stockholders are not involved with the day-to-day operations of the company, while managers are, information asymmetries exist between stockholders and managers. Stockholders will have to obtain costly firm-specific information in order to effectively evaluate and constrain managerial actions (Hill & Snell, 1989).

In the 1980s, over 50 percent of a large company's stock was owned by institutional investors who can efficiently obtain information and influence managers' actions (Demsetz, 1983; Graves & Waddock, 1990). As these investors own large blocks of shares, moving their stock among firms is inefficient. Consequently, they started participating more actively in the 1980s in company management, including the governance process (Brickley, Lease & Smith, 1988; Graves & Waddock, 1990).

Institutional investors can coordinate actions and use their voting power to exercise control. Institutional investors are more organized than individual stockholders. For example, public institutional owners organized to form the Council of Institutional Investors, which spearheads movements for changes that protect shareholder fights. This ability to organize and exercise control is especially important regarding matters that require stockholder approval, including the adoption of classified board provisions (Brickley, Lease & Smith, 1988).

Institutional investors also have the information required to vote more consistently in accordance with their economic interests. Jarrell and Poulsen (1987) found that firms proposing the more harmful antitakeover amendments (classified boards) have lower institutional holdings than those proposing less harmful amendments (fair-price). Therefore:

H6: Greater levels of institutional stockholder control will decrease the rate of classified board adoption.

CEO Stockholdings

Agency theorists note that stock-based compensation schemes are another important internal monitoring device which can align managers' and stockholders' interests (Jensen & Meckling, 1976; Walking & Long, 1984). That is, if managers own stock in their companies, they become stockholders and are likely to take actions that are consistent with stockholders' interest. For example, managers resistance to takeover attempts is reduced when they own stock in their companies (Walking & Long, 1984). This alignment view posits a negative relationship between managerial stock ownership and the adoption of classified boards.

Recently, in another context, others have noted that significant managerial stock ownership can protect managers from other governance mechanisms, such as the market for corporate control (Morck, Shleifer & Vishny, 1988; Stulz, 1988). They argue that when managers own a substantial portion of a company's equity, they may have enough voting and bargaining power to increase the premium paid in a tender offer and reduce the probability of a takeover. In fact, prior research reports that no faro in which managers own over 30% had been acquired in a takeover attempt (Morck, Shleifer & Vishny, 1988). Therefore, from both an alignment and a bargaining perspective:

H7: Higher levels of CEO stockholdings will decrease the rate of classified board adoption.

Method

Sample

We initially collected classified board adoption data for 287 randomly selected firms from the 1985 Standard & Poor's 500 firms. The sample time frame covers a period from 1978 through 1988, a period which includes the takeover wave of the 1980s (Davis & Stout, 1992). This period is particularly appropriate because antitakeover actions, including the adoption of classified boards, are likely to correspond with takeover activity. Of our initial sample, 127 firms had adopted this provision within the time period of our study and 111 had not. The remaining 49 firms were discarded as 25 of them did not have information on the year of adoption and 24 had adopted classified boards over the time period of 1929-1977 and data were not available for all independent variables. Our final sample consisted of 192 firms that had complete data available for both adoption date and the set of independent variables of interest. As of 1989, 88 of these firms had not adopted classified board provisions and 104 had made such adoptions.

Information regarding amendment adoption date was obtained from the Investor Responsibility Research Center's publication, Corporate Takeover Defenses, and companies' proxy statements. The year of adoption was obtained from the former publication; the month of the proxy statement in which the amendment was initially proposed was considered the month of adoption as well. This approximation of the month of adoption is typical of other classified board event studies, especially in finance (DeAngelo & Rice, 1983; Jarrell & Poulsen, 1987).

Measures

The dependent variable was the number of months between January 1978, when all firms were part of the "risk set," and the month in which the firm adopted classified board provision. For example, if a firm adopted classified board provision in January, 1979, it was coded as having survived 12 months. Similarly, firms that had not adopted classified board provisions at the end of the study period (1988) were coded as having survived at least 132 months (11 years, 1978-1988, inclusive). These firms were treated as censored observations.

We considered five structural attributes of the board: board composition, outsider's loyalty to the CEO, outsiders' tenure on the board, dual leadership, and board members' identification with the CEO. Data for all board attributes were obtained from company proxy statements for the period preceding the adoption of classified board provisions. In the case of censored firms, 1988 data were used.

Board composition was measured as the proportion of outsiders on the board. Outsiders were classified in two ways: first, we classified outsiders as those members who are not current or retired executives of an organization and, current or retired executives of one of its subsidiaries (Kesner, Victor & Lamont, 1986; Kosnik, 1987; Rechner & Dalton, 1986). The second description of outsiders was a more fine-grained description, one which excludes those outsiders who have personal or professional connections to the firm (Gilson, 1990; Johnson, Hoskisson & Hitt, 1993).

Loyalty of outside board members was measured as the proportion of outside directors who were hired during the incumbent CEO's tenure (Boeker, 1992). Average tenure of outside board members was used as a measure of seniority of outside board member. Board leadership was a binary variable: unitary leadership was coded 0, and dual leadership was coded 1. Board members' identification with the CEO was measured as the proportion of current or past CEOs on the board.

We used the proportion of shares held by the CEO as the measure of CEO's stockholdings; these data were obtained from company proxy statements. Level of institutional stock holder control was measured as the percentage of total shares held by institutional investors divided by total number of shares outstanding. Institutional data were obtained from Moody's Handbook of Common Stocks and Standard & Poor's Stock Guide.

In addition to the variables discussed above, we consider four control variables: firm size, firm performance prior to amendment adoption, a dummy variable to control for the presence of other antitakeover provisions and board size. Large firms are less susceptible to threat of takeovers as a raider would require enormous funds; consequently, large firms are less likely to seek protection through the adoption of classified boards. Total number of employees was used as the measure of firm size.

Theoretically, poorly performing firms are under-valued by the market and become prime takeover targets (Manne, 1965). These firms, therefore, are more likely to adopt antitakeover measures, such as classified boards, than those that are not under-valued by the market (Davis, 1991). Market value of a firm's outstanding common equity divided by the book value of its equity (Market-To-Book) served as a market measure of a firm's performance. These data were obtained from COMPUSTAT-PC+.

A firm's decision to adopt a classified board provision might also be influenced by whether it has any other antitakeover provisions in its charter. Other amendments may be substitutes or may be used in conjunction with classified board provisions (Davis, 1991). A prior amendment variable coded as a dummy variable indicates whether a firm had previously adopted either a supermajority, fair price, restriction of cumulative voting or poison pill provision.

The size of a decision-making group is an important antecedent to the outcome of decisions made by that group. Singh & Harianto (1989) argue that top managers of firms with large boards will have greater trouble influencing all board members to concede to the passage of questionable actions, such as golden parachute agreements. Their logic can be applied to the passage of classified board provisions as well. Total number of directors served as a measure of board size and this information was collected from company proxy statements.

Analysis

We used the continuous-time event-history analysis, or survival analysis technique, to study the adoption rate of classified boards. The Cox proportional hazard regression model, a semi-parametric model, was used. This model was appropriate since the observed rate of classified board adoptions at different time periods, as illustrated in Figure 1, did not fit any particular distribution (Davis, 1991).

The rate was calculated by dividing the number of firms that adopted classified boards during each month by the number of firms in the risk set in the beginning of that month. Figure 1 indicates the rate of adoption was initially low, increased in the third quarter of 1984, dropped in the fourth quarter of 1984, increased sharply in the third quarter of 1985, and peaked again in the third quarter of 1986, then dropped again, indicating no particular pattern which can be fitted by any parametric model.

The Cox model takes the form:

h(t) = q(t) exp (xb)

where: h(t) is the probability of adoption at time t (or the hazard rate),

q(t) the baseline hazard function and is not estimated,

x a vector of explanatory variables, and b the vector of coefficients corresponding to the explanatory variables.

To estimate b in the Cox model, we used partial likelihood method which provides sensible estimates even when there are many right-censored observations (Cox, 1972). The model is estimated by COXREG, a program in SPLUS software package.

Results

Descriptive statistics and a correlation matrix for the independent variables are reported in Table 1. Table 2 reports the results of the survival analysis of all classified board adoptions over the sample period, 1978-1988. Model 1 reports results of survival analysis using a less refined measure of outsider, whereas Model 2 indicates the results of the analysis using the more refined measure of outsiders, which is used for hypothesis testing. The likelihood ratio statistics in both instances indicate that the overall fit of the specified models is good.

Consistent with Hypothesis 1, the proportion of outsiders on the board marginally decreases the rate of adoption of classified board provision. Interestingly, when outsiders' professional and personal connections are not considered, the proportion of outsiders does not impact the adoption of classified board provisions (Model 1). Contrary to our expectations (Hypotheses 2-5), other attributes of the board did not have a significant impact on the rate of adoption.

With respect to ownership variables, institutional stockholder control has a very highly significant negative effect on classified board adoption. More specifically, as predicted in Hypothesis 7, higher level of institutional control decreases the rate of adoption of classified board provision. Contrary to Hypothesis 6, shares [TABULAR DATA FOR TABLE 1 OMITTED] [TABULAR DATA FOR TABLE 2 OMITTED] held by the CEO do not have a significant impact on the adoption of classified board provisions.

The presence of another antitakeover amendment was a highly significant control variable. Firms that had already adopted an antitakeover amendment adopted classified board provisions at a significantly lower rate. Higher market-to-book value ratio also reduced the rate of adoption. The size of the firm was not significant.

Discussion

During the 1980s, a number of firms changed their corporate charters by incorporating classified board provisions, primarily as a response to the latest wave of takeovers. Shareholders have criticized adoption of this provision as a mechanism entrenching both managers and the board itself. Moreover, shareholders are currently demanding firms repeal such actions, especially in light of revival of merger activity.

The focus of our study was to delineate factors that facilitated the initial adoption of classified board provisions. Results indicate that board attributes and ownership of a firm impact the adoption of classified board provision.

An interesting finding of this study is that when a more rigorous definition of an outside director is considered, increased outsider representation on the board decreased the rate of adoption of classified boards. However, a less rigorous definition, one which does not incorporate personal and professional links of outside directors, indicates no relationship between outsiders on the board and the adoption of classified board provisions. Instead, misleading effects of tenure is indicated.

When the more fine-grained measure is used, board composition is the only board attribute which has a significant effect; other attributes of the board, including outsiders' tenure and directors' identification with the CEO, are not associated with the rate of adoption.

The finding with respect to outsiders on the board highlights the attention researchers need to pay to defining outsiders. Mixed impacts of outsider representation indicated in prior studies (Davis, 1991; Kesner, Victor & Lamont, 1986; Kosnik, 1987; Mallette & Fowler, 1992; Singh & Harianto, 1989), may well be due to differences in how outsiders are categorized in the literature. Future studies interested in explaining the impacts of increased outsider representation, therefore, need to consistently use a more fine-grained measure of outsiders, one incorporating directors' personal and professional ties to the corporation.

Dual board leadership, another important board reform, was not associated with the adoption of classified boards. This result was inconsistent with that of Mallette and Fowler's (1992) study, which found dual leadership reduced poison pill adoption. A reason for these mixed findings may be the presence of a retired CEO as chairman of the board. In such cases, splitting the two roles itself does not secure an independent chair. Characteristics of the chair, such as tenure and prior association with the company (founder/non-founder), may further explain mixed effects of dual leadership.

The most significant finding of the study relates to the effect of institutional investors on the rate of adoption of classified board provisions. High levels of institutional investment significantly reduced the rate of classified board adoption. We expected institutional investors to have the incentive and capacity to actively monitor managements and, thereby, reduce the adoption of classified boards. Our finding lends support to the view that the presence of institutional investors leads to better monitoring of managers (Agarwal & Mandelker, 1990; Brickley, Lease & Smith, 1988; Sheifer & Vishny, 1986). This view of active institutional investors stands in marked contrast to one recently expressed by Bhide (1994, p. 132):

Thanks to these extensive, transient outsiders, [institutional investors] now hold a significant share of U.S. stocks. The typical institutional investor's portfolio in the United States contains hundreds of stocks, each of which is held for about a year. Institutions tend to follow the so-called Wall Street rule: sell the stock if you're unhappy with the management.

We believe, however, that the potential power of institutional investors may well have additional governance implications. For example, institutional investors' current efforts to get firms to repeal charter provisions may well be fruitful. Recently, several institutional investors acting together were successful in persuading Westinghouse to make several governance changes, including declassifying its board (Pozen, 1994). Institutional investors' efforts to repeal classified board terms can be particularly beneficial since staggered terms can depress stock prices by reducing merger activity currently revisiting several industries, such as telecommunications, banking and, health care. Therefore, as Pozen aptly notes (1994, pp. 147-148):

Corporate executives should also be reluctant to make proposals to curtail the procedural rights of shareholders or to adopt antitakeover measures. Institutional investors strongly believe that the corporate governance process must serve as an effective means of holding management accountable. And although the takeover binges of the 1980s undoubtedly involved abuses of the governance process, the 1990s are a very different decade, without midnight raids and with much less junk bond financing. Moreover, the latest round of state antitakeover laws already provides corporate managements with adequate protection against the abuses of the 1980s.

We also found that firms that had previously adopted other antitakeover amendments were less likely to adopt a classified board provision. This result suggests that firms that had other more potent amendments, such as poison pills, saw less of a need for classified board provisions.

Overall, the results of our study contribute to the governance conversation by highlighting the relationship between governance variables and entrenchment of directors through staggered terms - a context which has received very little attention. Although the results of this study cannot be generalized to other entrenchment practices, it extends the governance literature by including a richer set of variables and examining traditional governance relationships using a contingency approach specific to classified boards. Finally, the study contributes methodologically by using survival analysis which is relatively new to the study of corporate governance.

Based upon the mixed results related to different measures of outsider representation, we suggest that our understanding of the effectiveness of proposed board reforms may be confounded. Future research on corporate boards needs to use a fine-grained definition of outside directors and might consider reliance upon multiple measures in order to assess differential effects. Using multiple measures and including the more rigorous definition of outsider should provide a more accurate evaluation of the governance impact of increased outsiders - a board reform strongly supported by shareholder activists, corporate governance reformists, and the Securities Exchange Commission.

A second avenue of future research pertains to studying shareholders' direct influences, especially institutional investors' current efforts to repeal classified boards and other restrictive provisions. Shareholders can use a variety of techniques for such action: proxy campaigns against management proposals, shareholder resolutions, and direct discussion with managements of firms regarding rescission of classified boards. Of these techniques, shareholder resolutions appear to be the most popular (Pozen, 1994). A study examining shareholder proposals to rescind classified boards, particularly the role of institutional investors might provide an interesting comparison to the results of our study.

Acknowledgement: We wish to thank Terry Amburgey, John Garen, Joe Mahoney and, Keith Provan for comments on earlier drafts of this paper. The comments of anonymous Journal of Management reviewers and those of Dan Dalton, the past editor, are acknowledged. An earlier version of this paper appeared in the Academy of Management Best Papers Proceedings, 1993.

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Author:Sundaramurthy, Chamu; Rechner, Paula; Wang, Weiren
Publication:Journal of Management
Date:Sep 1, 1996
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