A member of a corporation’s board of directors may exert a similar amount of influence on a business’ outcome as its CEO.
Particularly if that board member has endured a bankruptcy at another company where they serve as a director.
So finds a new study forthcoming in the Journal of Financial Economics from Washington University in St. Louis researchers in the Olin Business School and an Olin PhD graduate now at Indiana University.
In fact, Olin’s Radhakrishnan Gopalan and Todd Gormley along with Indiana’s Ankit Kalda learned that firms take more risks after a member of their board of directors undergoes a bankruptcy at another firm where they serve as a director. The co-authors discovered such risk-taking usually occurs when this particular director both experienced a quick, less-costly bankruptcy elsewhere and serves in a position of greater influence.
Their findings suggest that these firsthand bankruptcies provide board directors with a learning experience that causes them to lower their estimate of distress cost — expenses faced by firms in financial distress beyond the cost of doing business.
“This is one of the first studies to highlight how a director’s later-life experience influences their attitudes about risk and risk-taking,” said Gopalan, professor of finance. “Our study highlights the importance of learning and understanding the director’s life experience when making hiring decisions.”
There are two extreme parts of the bankruptcy spectrum, the co-authors noted. A director could have seen a contentious process that ends in liquidation, emboldening a perspective that bankruptcy is costly. Or a director could have experienced a tidy, pre-packaged bankruptcy that ends in a successful return to operation, causing the director to infer that bankruptcy, and hence risk-taking in general, need not be as costly as they originally assumed.
To research a set of such corporate directors from the period 1994-2013, the co-authors used the Lopucki Bankruptcy Research Database; a U.S. Securities and Exchange Commission database (Electronic Data Gathering, Analysis and Retrieval, or EDGAR); BoardEx; data from proxy statements; and more. That enabled them to identify 718 firms sharing a director with 261 firms that filed for bankruptcy at some point in the study’s roughly 20-year window.
Next, they stacked these firms and a control group (lacking any bankruptcy-veteran directors) against three sets of risk measures: corporate financial policies such as net leverage, cash holdings and equity issuance; corporate risk such as cashflow volatility, stock volatility and distress; and measures of acquisition activity. Why acquisition activity? Because prior evidence showed firms engage in diversifying their acquisitions to reduce their risk.
On average, the data showed, firms increased their risk-taking and moved closer to bankruptcy, following a director’s previous experience with it.
The firms with bankruptcy veterans on their boards saw their net leverage increase after their own bankruptcies, as well as seeing increases in cash flow volatility (by 0.9 percentage points), stock volatility (by 0.2 percentage points) and distress events. Similarly, those businesses’ diversifying acquisitions (by 2.9 percentage points) decrease and their likelihood of default increases.
These weren’t new or even newly bankruptcy-scarred directors, either. On average, they were sitting on these boards for more than six years prior to a bankruptcy filing.
To try to ensure that there weren’t any crossover issues in their findings, the co-authors analyzed for any possibility of common shocks and industry-wide issues in a shared business silo. They conducted what they called placebo tests, identifying multiple firms that previously shared a director with a corporation that filed for bankruptcy but didn’t share one at the time of that corporation’s bankruptcy. They found no evidence of a shift in behavior in this placebo test. Nor did they observe a change in risk-taking when a director experiencing bankruptcy elsewhere exits that board soon after.
The co-authors also analyzed how risk-taking differed based on how costly the previous bankruptcy was.
It didn’t surprise them to find more risk-tasking by businesses with directors who experienced lower-cost, pain-free bankruptcies, and less risk-taking by firms with directors who endured protracted, costly ones.
What did surprise them: The aftershocks to that particular director’s career. The data showed that a person’s number of board memberships declined in the years following a bankruptcy, but this only occurred among directors who led their firms through protracted, costly bankruptcies.
“Directors serve two main roles,” said Gormley, assistant professor of finance. “One, monitor the manager to make sure they act in shareholders’ best interests. Two, advise the manager on important decisions.
“Typically, independent directors — those with no prior connection to the firm or CEO — are thought to serve more of a monitoring role. Non-independent directors are thought to provide more of an advisory role. We find our results are concentrated among non-independent directors, suggesting the change toward risk-taking is driven by a change in the advice directors provide rather than a change in their monitoring.”
Moreover, in parsing the influence of board members who aren’t on the management team but have some connection or advisory role, the co-authors found that many of them had backgrounds in private equity (13.1%), manufacturing (10.3%), venture capital (8.6%) and consulting (7.5%). Such portfolios might explain why CEOs and other directors might more highly regard, and abide by, their views when making decisions over finance and risk.
“It’s well known that CEOs and their experience matter,” Gormley said. “But here, we are seeing that individual directors also matter. This is different than what most investors typically focus on, which are the board-level characteristics like what fraction of directors are independent.
“These findings suggest that it’s important for firms to hire individual directors with the experience set they consider most important for improving the quality of the advice they will provide the manager.”