Journal of Financial Economics 32 (1992) 195-221. North-Holland

Do outside directors monitor managers?

Evidence from tender offer bids*

John W. Byrd Forr Lewis College, Durango. CO 81301. USA

Kent A. Hickman Gonzaga Unirersity. Spokane, WA 99258. USA

Received April 1991, final version received October 1991

Examining 128 tender offer bids made from 1980 through 1987. we categorize outside directors as either independent of or having some affiliation with managers, and find that bidding firms on which independent outside directors hold at least 50% of the seats have significantly higher announce- ment-date abnormal returns than other bidders. However, the relationship between bidding firms’ abnormal stock returns and the proportion of board seats held by independent outside directors is nonlinear. suggesting it is possible to have too many independent outside directors. All results are lost if the traditional inside-outside board classification method is used.

1. Introduction

In publicly-traded corporations, the board of directors is charged with pro- tecting and promoting the interests of shareholders. The board has the legal authority to ratify and monitor managerial initiatives, evaluate the performance of top managers, and reward or penalize that performance. Most corporate

Correspondence to: John Byrd. 64 Oak Valley Drive, Durango, CO 81301. USA.

*We thank Hugh Haworth of the SEC for providing a copy of the tender offer database. We appreciate the comments on earlier drafts of the paper provided by Michael Jensen (the editor), Jon Karpoff. Roberta Romano, Stuart Rosenstein, Dennis Sheehan (the referee), Jeffrey Wyatt, and workshop participants at Texas A&M University, the University of Oregon, Washington State University. the University of Arizona, and Arizona State University, especially Barry Baysinger, Saeyoung Chang. Larry Dann, Michael Hertzel, Michael Hopewell, Marilyn Johnson. Scott Lee. Scott Lummer, Wayne Mikkelson, Helena Mullins, George Racette, Richard Smith. Thomas Turk, and Wanda Wallace. John McDowell and Danny Cooper provided valuable research assistance. Much of the work on this paper was done while the authors were at Washington State University.

0304405X. 92,$05.00 C 1992-Elsevier Science Publishers B.V. All rights reserved

196 J. Byrd und K. Hickmrm. Do outside dirrc~tors monitor munuqrrs?

boards include some of the firm’s top managers as well as directors from outside the firm. The inside directors provide valuable information about the firm’s activities, while outside directors may contribute both expertise and objectivity in evaluating the managers’ decisions. The corporate board, with its mix of expertise, independence, and legal power, is a potentially powerful governance mechanism.

The outside directors’ monitoring of managers has been seen as the most important function of the corporate board [Winter (1977) and American Law Institute (1982)]. It is argued that only outside directors can ask the difficult questions ‘which even a fully conscientious management may not face directly because of an unconscious pride of authorship’ [Winter (1977, p. ZSS)]. The importance of outside directors is not universally accepted. however. Some observers question whether outside directors add to the economic discipline already imposed on managers by product and factor markets, the managerial labor market, the market for corporate control, and alternative internal gover- nance controls such as auditing, bonding, and ownership structure.’ Even if boards do not merely duplicate other governance mechanisms. critics suggest that managers inherently dominate the board by choosing the outside directors and providing the information they analyze [Mace (1986) and Patton and Baker (1987)].

Empirical studies have not resolved the debate about the importance of corporate boards, and particularly outside directors, in protecting shareholder interests. Few studies have directly examined the relationship between the presence of outside directors and the shareholder wealth effects of managerial decisions, and only recently have researchers substantiated the monitoring role played by outside directors. In a study of the banking industry, Brickley and James (1987) find that the presence of outside directors tends to reduce manage- rial consumption of perquisites. Weisbach (1988) finds that the higher the proportion of outsiders on a board, the more likely it is that the board will replace the firm’s chief executive officer after a period of poor corporate per- formance. Rosenstein and Wyatt (1990) provide direct evidence that shareholder wealth is affected by board composition: they document a positive stock price reaction at the announcement of the appointment of an additional outside director.

Our study provides additional evidence on the importance of corporate boards by examining the association between the presence of outside directors and the returns to shareholders of bidding firms in tender offers. Boards are virtually certain to be involved in takeover attempts; in fact, legal commen- tators state that reviewing acquisition proposals put forth by management is a duty of the board [Koontz (1967) and Weiss (1991)]. Acquisitions are major

‘See Hart (1983). Fama (1980). Manne 11965). Jensen and Ruback (1983). and Jensen and Mcckling (1976) for discussions of these control mechanisms.

J. Bvd und K. Hickman. Do outside directors monitor munugers.? 197

investments that may alter the strategic direction of the firm. so they certainly affect the welfare of the shareholders whom the directors represent. The threat of shareholder lawsuits provides a further incentive for directors to review pro- posed acquisitions.

Outside directors may be particularly adept at monitoring acquisition [Bacon (1985)]. They may manage firms that have been involved in acquisitions, and they are likely to be more objective in evaluating the costs and benefits of an acquisition than the managers proposing the takeover. They may also have special information about the target firm’s industry or the target firm itself which is relevant to the acquisition. The objectivity and business acumen of outside directors is particularly important in monitoring the acquisition process when managers’ empire-building ambitions or executive pride conflict with shareholders’ interests.’ Existing evidence confirms that acquisitions enhance the value of some bidding firms, while reducing that of others. Studies using data from the 1970s and 1980s find that the distribution of bidder abnormal returns is centered near zero, with approximately equal numbers of firms falling above and below the mean.’ The fact that abnormal returns are often negative suggests either that bidding firms overestimate a target’s worth or that tender offers are motivated by goals other than shareholder wealth maximization. If outside board members have any influence in corporate decisions, it may be revealed in the acquisition process.

In examining the role of corporate directors, we use the director classifica- tion procedure developed by Baysinger and Butler (1985), which distinguishes between inside directors, affiliated outside directors, and independent out- side directors. The independent outside directors represent the monitoring component of the board. Boards in which independent outside directors hold at least half the seats can block a proposed acquisition, and such boards will approve fewer unprofitable acquisitions than other boards. Moreover, independent directors may influence the acquisition process even when they lack veto power over board decisions; as more directors voice their concerns over a proposed acquisition, the likelihood of swaying the decision increases. We therefore expect a positive association between acquisi- tion profitability and the proportion of independent outside directors on the board.

The quality of board oversight depends on the directors’ incentives to monitor managerial activities. Fama and Jensen (1983) and Ricardo-Campbell (1983) argue that outside board members who hold multiple directorships have

ZBaumol(1959), Marris (1964). and Rhoades (1985) discuss the tendency of managers to increase the firm beyond its optima) size. Executive pride or hubris is central to Roll’s (1986) theory regarding the low profitability of takeovers to bidders.

‘See. for example. Jensen and Ruback (1983). Dodd (1986). Bradley. Desai. and Kim (1988). Jarrell, Brickley. and Netter (1988). and Loderer and Martin (1990).

198 J. Byrd und K. Hickman. Do ourside direcrors moniror mmugers.’

a greater incentive to monitor corporate decisions on behalf of all shareholders because these directors have made a significant investment in establishing reputations as decision experts. While opposing a proposed acquisition may jeopardize a director’s position on the bidder’s board, the cost of supporting a decision detrimental to shareholders could be still greater, because it would reduce the value of the director’s reputational capital in the marketplace for decision experts. The more directorships an individual holds, the greater his or her incentive to oppose unprofitable acquisitions.

In addition, equity ownership by nonmanagement board members creates an incentive for those directors to more actively oppose unprofitable activities in order to protect their financial stake in the firm [Jensen and Meckling (1976)]. Jensen and Meckling argue that as managerial ownership of the

firm’s stock increases, the interests of managers and outside shareholders become more closely aligned. As the objectives of these two groups converge, fewer acquisitions will be proposed for motives other than shareholder wealth maximization. However, this alignment of the interests of shareholders and managers may be limited to relatively low levels of managerial stock owner- ship. Stulz (1988) provides a model in which high levels of managerial stock ownership are harmful to shareholders because managers become insulated from some corporate governance mechanisms, such as the market for corporate control.

Using a sample of 128 tender offer bids by 111 firms, we find that the average announcement-date abnormal return is significantly less negative for bidding firms on whose boards at least half the seats are held by independent outside directors. In cross-sectional piecewise regression tests, we find a curvilinear relationship between the proportion of independent directors on the board and the bidding firms’ announcement-date abnormal returns. This relationship is positive over most of its range, but is significantly negative when independent directors hold a very high proportion of board seats. The curvilinear relation- ship is not affected when other variables which may influence the profitability of an acquisition are added to the regression model; examples of such variables include director stock ownership, the number of other directorships held by bidding firm directors, the terms of the tender offer, and the relatedness of the bidder and target. Furthermore, this relationship is unique to independent outside directors. Reestimating the regression models using a piecewise board composition variable based on the proportion of outside directors on the board (both independent and nonindependent) yields no significant statistical relation- ship between board composition and the acquisition announcement abnormal returns. Interestingly, differences in abnormal returns are not apparent if the traditional two-way (inside-outside) classification of directors is used, sug- gesting that studies of board composition relying on the inside-outside classification may have missed important empirical relationships because they misspecilied the director categories.

J. Byrd and A’. Hickmun. Do oursIde directors monifor managers? 199

Our results are consistent with the hypothesis that independent outside directors monitor firm decisions on behalf of shareholders during the acquisi-

tion process. However, our findings do not support the claim that shareholders are necessarily better off with a board comprised entirely of independent outside directors. In fact, the results suggest that it is possible to have too many independent outside directors. Baysinger and Butler (1985) argue that corporate boards have a variety of responsibilities which require a diverse set of talents to satisfy. Emphasizing one area of expertise, such as managerial monitoring, may reduce the board’s overall effectiveness. Our results are consistent with such a multifaceted view of the role of the board of directors in corporate decision- making.

In the next section we describe the board classification procedure. In sec- tion 3, the sample selection process is described and characteristics of the sample are presented. Our empirical results are presented in section 4, and section 5 contains a summary and our conclusions.

2. Classification of directors

The traditional two-way classification scheme of ‘insider’ (corporate em- ployee) or ‘outsider’ (nonemployee) directors fails to consider potential conflicts of interest when directors are not full-time employee but have affiliations with the firm. We therefore follow the director classification procedure developed in Baysinger and Butler (1985). Depending on affiliations and transactions noted on the bidder’s proxy statement, directors are placed into one of three catego- ries: inside directors, affiliated outside directors, or independent outside direc- tors. Inside directors are typically corporate officers or retirees and members of their families. Affiliated outside directors are not full-time employees of the firm but are associated with it in some way. This class includes investment bankers, commercial bankers that have made loans to the firm, lawyers providing services to the firm, consultants, officers and directors of the firm’s suppliers and customers, and interlocking directors. Independent outside directors have no affiliation with the firm other than their directorship, and include private investors, business executives, academics, and decisionmakers from the public sector.

3. The sample

3.1. The sample selection process

Our sample consists of 128 acquisition bids made by 111 firms during the period 1980-87. To compile the sample, we began with a list of all tender offers field with the U.S. Securities and Exchange Commission (SEC) from 1980

J.F.E. -C

200 J. Bwd and K. Hickman. Do outside direcrors monifor managers.’

through 1988.’ The final sample includes all bidders from the list that satisfy the following five criteria:

1. Both the bidder and the target were listed on the New York or American Stock Exchange at the time of the bid. and the bidder did not already own a controlling interest in the target.

2. The tender offer bid was registered with the SEC between January 1, 1980 and December 31, 1987.

3. The tender offer was announced in the Wall Street Journal, and there were no conflicting news announcements for the day preceding through the day following the bid announcement, such as a change in dividends or earnings, a proxy fight, or the award of a large purchase contract, a feature on the bidder in the ‘Heard on the Street’ column for a matter other than the tender offer, or a report that the target had made a counter offer for the bidder.

4. Each bidder had daily stock returns on the Center for Research on Security Prices (CRSP) Daily Returns File for at least 210 trading days preceding the bid announcement date.

5. A proxy statement for the annual shareholders’ meeting immediately before the bid announcement was available either in the Q-file Corporate Microfile or from Bechtel Information Services.

The requirement of NYSE or AMEX listing imposes an implicit minimum size standard, which helps ensure that the acquisition is material to the bidder. We exclude observations in which the bidder already holds a controlling interest in the target in order to avoid problems of investor anticipation of the acquisi- tion. Eliminating bids with contemporaneous news announcements makes it possible to attribute the announcement-date abnormal return solely to the acquisition offer rather than to some other corporate event.

3.‘. Descriptise statistics of the sample

Table 1 presents a time profile of the sample showing the number of tender offers made in each year, 1980-87, by board type. In panel A, firms are classified as having independent boards (at least 50% independent outside directors) or nonindependent boards (less than 50% independent directors). Of the 128 tender offers, 45 are made by firms with independent boards. Panel B classifies boards using the traditional inside-outside procedure. Using this method, 105

“We are grateful to Hugh Haworth of the SEC’s Office of Economic Analysis for prowding this data.

J. Byrd and K. Hickman. Do outside direcrors moniror managers? 201

Table I

Tender offer bids classified by year and board type for 128 tender olTers by 1 I I firms, 1980-87.

Panel A Independent boards’

Number of bids with board composition of

Year Less than 50%

independent directors 50% or more

independent directors Year total

1980 9 6 15 1981 12 7 19 1982 16 2 18 1983 9 4 13 1984 I2 8 20 1985 10 7 17 1986 7 8 15 1987 8 3 11

Total 83 45 128

Panel B. Outside-direcror-dominated boardsb

Year

Number of firms with board composition of -

Less than 50% 50% or more outside directors outside directors

Year total

1980 1 14 15 1981 3 16 19 1982 -l

; 16 1s

1983 9 13 I984 5 I5 20 1985 4 13 17 1986 7 13 15 1987 2 9 11

Total 23 105 128

“Directors are identified according to affiliations listed in the proxy statement immediately preceding the tender offer. Independent outside directors have no affiliation with the firm or its managers other than their directorship. For details of the categorization procedure, see the text or Baysinger and Butler (1985).

“Outside directors are all directors who are neither current nor former employees of the firm (but who may have some business affiliation with the firm).

bids (82% of the sample) have boards with at least 50% of total seats held by outside directors.

Table 2 presents summary statistics on sample firm boards of directors. Where available, we include comparable statistics from other studies. The average bidding-firm board has 12 directors, of whom 38% are classified as inside directors. 23% as affiliated outside directors, and 39% as independent outside or monitoring directors, (When directors are divided into just two classes - ‘insiders’ and ‘outsiders’ - we find that the average proportion of

Table 2

Summary stattsttcs for board characteristics of bidding tirms in tender offers ~tth comparisons to other studies for I28 tender offer bids by I I I tirms. 19YO-87.

Mean Median Standard deviation

Comparable means

Board size (number of directors) 12.1 12.0 3.7 Inside directors ( o 0 )’ 37.5 36.0 15.9 AAliated outside dtrectors f”,,, Y 13.3 21.8 13.3 Independent outside directors ( o,~Y 39.2 39.4 IS.1 Total outside directors ( ‘%) 62.5 64.0 15.9 Inside dtrector stock ownership (“,O) 10.9 2.0 16.7 Affiliated outside stock ounership (“4,)’ 3. I 0.0-t x.5 Independent outside stock ownership (%)I 2.0 0.08 6.1 Outside director stock ownership (O/O ty 4.1 0.3 9.7 Other directorships” 2.6 2.-t I.3

_______- _____~_.

“As reported tn Worn Ferry (1987).

13”.13.5b,1 I’ 13b 31h 26b

67’.57b.63d 8.8’

3.0* -.___._

bAs reported m Baysinger and Butler (1985). ‘As reported in Singh and Harianto (1989). ‘As reported in Drieghe (19861. ‘Dtrectors are categortzed according to the affiliations for each director found in the proxy

statement immediately preceding the acquisition bid. ‘Director stock o\+nership is the percentage of the common stock of the bidding firm held by all

directors in a particular director category. %Outside director stock ownership is the percentage of the common stock of the bidding firm held

bv all outside directors. hOther directorships ts the aberage number of directorships held by outside directors. excluding

the seat held on the bidding firm’s board.

outsiders on boards of sample firms is 62%. which falls within the range of outsider representation reported in other studies.) Seven observations (by six different firms) had no affiliated outside directors, and three sample firms had no independent outside directors. One firm, Clabir, had no outside directors of either type. Our sample has a higher proportion of independent outside direc- tors and a lower proportion of inside directors than were found by Baysinger and Butler (1955). who document an increase in independent directors and a corresponding decrease in inside directors during the 1970s a trend which our data suggest continued into the 1980s.

Inside directors of bidding firms held, on average, 11% of their firm’s common stock. This finding is similar to the inside ownership stake of 8.8% found by Singh and Harianto (1989). The average stock ownership of all outside directors is 40/b, with independent outside directors holding just under 2% and affiliated outside directors holding just over 2%. For all three director types, the mean ownership stake exceeds the median, indicating that the distribution of stock ownership is skewed to the right. In our sample the total ownership of common stock by all board members is 15%, on average, which is larger than the 10.6% mean board ownership stake reported by Merck, Shleifer. and Vishny (1988) for

directors of Fortune 500 firms in 1980. This difference in the ownership of stock by directors may be due to the inclusion of smaller firms in our sample. Finally, outside directors hold 2.6 other directorships. on average. which is similar to the number reported by Drieghe (1986). (This number does not include the seat held on the sample firm’s board.)

A comparison of independent boards and other boards (not shown in table 2) revealed only one significantly different characteristic: the ownership of stock by inside directors. As a group, inside directors on independent boards held 6% of company stock. on average, compared with 13% held by all inside directors on nonindependent boards. These values are different at the 1% level of significance (r-statistic of 2.49). This result arises in part because nonindependent boards have more inside directors. When ownership is computed on a per director basis, inside directors on nonindependent boards continue to own a larger fraction of shares than their counterparts on independent boards (3.2% versus 1.9%) but the difference is no longer statistically significant (r-statistic of 1.58).

In table 3, we present summary statistics about the tender offer bids and the bidding and target firms. The mean market value of the bidding firms’ common stock 30 days before the tender offer announcement is S1,592 million (median = $861.5 million) and ranges from S20 million to S11.8 billion. The mean market value of the target firms’ common stock 30 days before the tender offer announcement is 5.570 million (median S207 million) and ranges from $4 million to $7.25 billion. The average ratio of target size to bidder size is 0.68, with a median value of 0.30. On average, bidding firms are attempting to acquire firms of about two-thirds their own size in terms of equity value. Over the sample period the mean value of the relative size of the target to the bidder increased from 0.32 in 1980 to 1.24 in 1987: that is, the observations from 1987 involved bidders that, on average, were smaller than the targets they pursued. Bidding firms with independent boards were, on average, smaller than other sample firms and pursued proportionately smaller targets. The average ratio of target size to bidder size for bidders with independent boards is 0.44, compared with 0.81 for bidders with nonindependent boards. These values are statistically distinguishable at the 2.5% level (c-statistic of 2.23).

The total amount of the bid, as reported in the first WalI Street Journal announcement, averaged 5569.4 million dollars. The average bid premium offered by bidding firms, computed using the target’s share price 30 days before the bid announcement and the bid price at the first announcement, was 44%. [This is somewhat larger than the average bid premium of 30% for takeovers in the 1980s reported by Jarrell, Brickley, and Netter (1988)]. The bid premium decreased over the sample period from an average of 51% in 1980-82 to 40% in 1985-87, although these values are not statistically different from each other at conventional significance levels (t-statistic = 1.62). The bid pre- mium differed significantly between firms with and without independent boards: firms with independent boards offered an average premium of 35.5%, compared

x4 J. Byrd and K. Hickmun. Do ourside dirrcrors moniror muntrgrrs.’

Table 3

Summary statistics of the sizes of the bidding and target firms, the bid premium offered. and the industry affiliation in 128 tender offer bids by I1 1 tirms. 1980-87.

Variable Mean Standard

Median deviation

Market value of bidder common stock (Smillions)” Market value of common stock target (Smillions)” Ratio of to bidder” target Total value of the bid (Smillions)b Bid premium (%)’

1.592 862 1779 -._* 570 207 1.083

0.68 0.30 1.08 569 250 896

44 40 34

‘The market value of bidder and target common stock is measured 30 days before to the announcement of the tender offer bid in the Wall Streer Journal.

“The total value of the bid is the bid price in the first Wall Street Journal announcement of the bid times the number of shares sought. In the case of an offer to exchange stock, the bid price is replaced by the bidder’s stock price the day before the announcement times the exchange ratio of the offer.

‘The bid premium is calculated as the difference between the bid price and the price of the target’s shares 30 days before the announcement, all divided by the piice of the target’s shares 30 days before the announcement. In the case of an offer to exchange stock. the bid price is replaced by the bidder’s stock price the day before the announcement times the exchange ratio of the offer.

with 48.6% for firms with nonindependent boards. These values are statistically distinguishable at the 1% level (t-statistic of 2.47).

Of the 128 bids, 116 were cash offers, and in 93 the bidder eventually gained control of the target. Ninety-eight bids were the first offer for the target. The sample includes firms from 84 different four-digit SIC codes, with the most frequent bidder SIC code (1311, petroleum production) appearing in eight tender offers. The related industry groups of petroleum refining and natural gas production and distribution account for another 12 bids. Included in the sample are bidders from 66 different three-digit SIC codes and 34 different two-digit SIC codes. Twenty-seven tender offers involved bidders and targets with the same four-digit SIC code. These are cases of bidders attempting to expand within their own industry: petroleum production and refining (SIC 1311 and 2911) each account for three of these 27 offers. At the three-digit SIC code level, 39 proposed acquisitions were between firms with the same SIC code, and 43 involve firms whose three-digit SIC codes are within one digit of each other. Fifty-four tender offers are between firms in the same two-digit SIC code. Horizontal acquisitions are equally prevalent among firms with independent boards and other boards. Similarly, we find no evidence that firms with executive-dominated boards are more likely to make diversifying tender offers. These data, which are not tabulated, suggest that the sample is not dominated by a particular industry or a particular type of acquisition.

J. Bwd und K. Hickmun. Do ourslde directors moniror monugers’ 205

4. Empirical results

4.1. A bnormd returns

We measure the impact of the acquisition decision on the bidding firm’s shareholders by calculating the abnormal return on the bidding firm’s common stock at the announcement of the tender offer. Data from the CRSP daily returns file and the value-weighted market index are used to estimate market model parameters for each observation. The estimated market model para- meters, ;i and Bi* for firm i are ordinary least squares (OLS) estimates using the 100 nonoverlapping continuously-compounded two-day returns from the 200-day estimation period beginning on day - 209 (that is, 209 trading days before the announcement date, which is designated as day 0). The abnormal return, ARi,, for firm i over the two-day interval t is the difference between the actual continuously-compounded return for firm i over the two-day interval t, Ri,, and the expected return for that two-day period based on the estimated market model parameters and the continuously-compounded value-weighted market return, R,,, over the same two-day interval, or

ARi, = Ri, - ii - P^iR,, . (1)

Significance tests involving the abnormal returns are based on the following Z-statistic for the two-day event window (days - 1 and 0, or the announcement date and the trading day immediately preceding):

(2)

where N is the number of observations in the sample. var(ARi*) is defined as

1 ’ (3)

where V,? is the residual variance from firm i’s market model regression, f?m is the mean of the continuously-compounded two-day market returns over the 200-day estimation period, and a and b represent the beginning and ending two-day periods for the estimation period. The Z-statistic in expression (2) is asymptotically unit normally distributed.

Table 4 reports the average response of the bidder’s stock price to the announcement of a tender offer bid. The two-day announcement period includes day 0, the date of the Wall Street Journal announcement of the bid, and day - 1,

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the trading day immediately preceding the announcement date. The third column of table 4 shows that the average two-day announcement-date abnor- mal return for the entire sample is - 1.23%, which is statistically different from zero at all standard levels of significance (the Z-statistic is - 6.78). [This is similar to the average return of - 1.10% to successful bidders in tender offers during the 1980s reported by Jarrell, Brickley, and Netter (1988).] When the sample is categorized according to the independence of the board of directors. we find that the 83 bid announcements involving firms with nonindependent boards have a statistically significant average two-day abnormal return of - 1.86%, while the 45 announcements by firms with independent boards have

an average return of - 0.07%. These values are different at the 5% level (t-statistic = 2.13). Of the firms with nonindependent boards, 60 of the 83 bids. or 72%, had negative abnormal returns; among firms with independent boards. 58% had negative abnormal announcement-date returns. These proportions. 72% and 58%, are statistically different at a significance level of 10%. Our results not only support the hypothesis that the shareholder wealth effects of an acquisition bid will, on average, be more favorable when independent directors hold at least half the seats on the bidder’s board, they are consistent with the claim that shareholder interests are better served by independent boards of directors.

The results in table 4 are based on the three-way director classification procedure developed by Baysinger and Butler (1985). Using the more typical two-way classification scheme (table 5) yields no significant difference between inside- and outside-dominated boards. Inside-dominated boards are those in which executives of the firm hold more than 50% of all seats. In outside- dominated boards, nonexecutives hold at least 50% of all seats. As shown in table 5, bid announcements involving firms with inside-dominated boards have a statistically significant average two-day abnormal return of - 0.99%. while the outside-dominated board group has an average return of - 1.28%. These returns are not statistically distinguishable from each other, although both are statistically different from zero at the 1% level. This evidence, when combined with the results from table 4, supports the theoretical contention of Baysinger and Butler (1985) that the affiliations of outside directors can affect their monitoring incentives. Our findings also suggest that important relationships may be missed if the simple inside-outside classification scheme is used.

4.2. Cross-sectional regression models

A series of regression models is used for cross-sectional analysis. Shareholder wealth effects at the announcement of the acquisition bid are regressed on explanatory variables including board independence, the fraction of board seats held by independent directors, director stock ownership, other directorships, and a set of control variables. Separate stock ownership variables are included

208 J. Byrd and K. Hickmun. Do ours& drrecrors moniror managers?

Table 5

Two-day risk-adjusted abnormal stock returns for bidding firms at the first announcement of a tender offer bid for 128 bids by 11 I firms. 1980-87. with boards classified using the inside-outside

classification scheme.

Inside-director- dominated boards”

Outside-director- dominated boards All bidding firms

Average two-day risk-adjusted abnormal return

Standard deviation Minimum Median Maximum Z-statistic: H,: Mean = 0.0’ Number of observations Number negative

- 0.99%b 5.30%

- 10.69% - 1.01%

12.36% - 2.70d

23 12’

- 1.28?/ob 4.25%

- 14.65% - 1.39%

11.97% - 6.22a 105 74’

- 1.23% 4.44%

- 14.65% - 1.28%

12.36% - 6.78’ 128 86

‘Outside directors are neither current nor former executives of the firm (or members of the families of current or former executives).

?he mean values for the two board categories are not statistically different at any standard level of significance (f-statistic = 0.24).

‘The null hypothesis being tested is that the mean two-day abnormal return equals zero. dSignificant at the I% level. ‘The proportions of negative returns for the two board categories are statistically different at the

10% level (t-statistic = 1.69).

for inside, affiliated outside, and independent outside directors. In addition, piecewise regression models are used to further investigate the relationship of the acquisition announcement abnormal stock returns to the presence of inde- pendent outside directors. The control variables reflect the results of past studies which suggest that bidder abnormal returns may be influenced by the medium of exchange [Travlos (1987)], the presence of multiple bidders [Bradley, Desai, and Kim (1988)], and whether the bidder and target are from related industries [Merck, Shleifer, and Vishny (1990)].

Table 6 presents coefficient estimates from several cross-sectional OLS re- gression models. In each model, the dependent variable is the two-day risk- adjusted announcement-date abnormal return expressed in percent. The explanatory variables include two board composition variables as well as continuous and dummy variables for the stock ownership of each category of director. The explanatory variables are defined as follows:

Independent Board = 1 if independent outside directors hold at least 50% of all board seats, and 0 otherwise;

Fraction lndependent Directors = number of independent directors divided by total number of directors on the board;

Inside Stock Ownership = fraction of the bidding firm’s outstanding voting shares (and options exercisable within six months) owned by executives (or former executives) holding seats on the board;

J. Byrd and K. Hickmun. Do oursrtle directors monitor munagers? 209

Aflliated Outside Stock Ownership = fraction of the bidding firm’s outstanding voting shares (and options exercisable within six months) owned by affili- ated outside directors;

Independent Outside Stock Ownership = fraction of the bidding firm’s outstand- ing voting shares (and options exercisable within six months) owned by independent outside directors;

Inside Ownership Dummy = 1 if Inside Stock Ownership > 0.002 (0.2%), and 0 otherwise;

Afiliated Outside Ownership Dummy = 1 if Afiliared Outside Director Owner- ship 2 0.002 (0.2%), and 0 otherwise:

Independent Outside Ownership Dummy = 1 if Independent Outside Director Ownership > 0.002 (0.2%), and 0 otherwise.

Other Directorships = average number of other directorships held by outside board members;

Offer Terms = 1 if the bid is entirely for cash, and 0 otherwise; Competing Bid = 0 if the sample firm’s bid is the first bid for the target, and 1 if

there is another bid outstanding when the sample firm enters its bid; and Within One Three-digit SIC = 1 if the three-digit SIC codes of the bidder and

target are within one digit of one another, and 0 otherwise.

In models 1 and 2 the board composition variable is the dummy variable Independent Board. In both models, the Independent Board variable has the predicted positive sign and is significant at the 2% level. This result is consistent with the data shown in table 4. The coefficient estimates imply that the expected return to shareholders of bidding firms with independent boards is about two percentage points higher than for other firms.

We examine the importance of the distinction between independent and affiliated outside directors by replacing the Independent Board variable with a board composition variable based on the traditional inside-outside classifica- tion of directors. The explanatory power of the model is reduced when the Independent Board variable is replaced by a dummy variable which equals one if outside directors (affiliated and independent) hold at least 50% of all seats and zero otherwise. In no case is this alternative board composition variable significant at the 10% level. These results are not tabulated.

In models 3 and 4 the continuous board composition variable, Fraction

Independent Directors, replaces the dummy variable. The coefficients are positive as predicted, but not statistically significant at conventional levels (the r-statistic of 1.63 in model 4 corresponds to a p-value of 11%). Moreover, there is no change in the regression results when this variable is replaced by a board composition variable measuring the fraction of total board seats held by outside directors (affiliated and independent). These results are surprising given the significant relationship of the Independent Board dummy variable to announce- ment-date abnormal returns found in models 1 and 2. We investigate these results further in table 7.

210

i: 3 I

J. Bvd rrnd K. Hickman. Do oursrde direcrors moniror managers? 211

In no models are the coefficients of the continuous ownership variables (Inside

Stock Ownership. AJiliated Outside Stock Ownership, and Independent Outside

Stock Ownership) statistically significant. The lack of significance of inside Stock

Ownership differs from Lewellen, Loderer, and Rosenfeld’s (1985) finding of a positive association between managerial ownership and the cumulative stock price adjustment over the entire acquisition process.

When the continuous ownership variables are replaced by their dummy variable analogues we find statistically significant coefficients for both inside and independent outside director ownership, consistent with the Jensen and Meckling (1976) prediction that stock ownership helps align the interests of managers (and directors) with those of shareholders. The results reported in table 6 are for dummy variables with separation points of 0.2% for all director categories. Although the same breaking point is used to construct all three ownership dummy variables, the three variables differ considerably. This breaking point represents the 16th percentile of inside ownership, so the Inside Ownership Dummy variable distinguishes between almost no aggre- gate ownership by managers and at least some low level of ownership. For both types of outside directors, the breaking point of 0.2% represents approxi- mately the 65th percentile ofthe ownership distributions, so the dummy variable indicates the effect of relatively large outside director holdings. This pattern of results for the ownership dummy variables is robust over a range of breaking points (from 0.12% to 1.25% for the Inside Ownership Dummy and from 0.15% to 0.55% for the Independent Outside Ownership Dummy). Diagnos- tic tests indicate that the dummy variable results might be affected by several influential observations. Rather than discarding these observations, we reesti- mate the regression models usin g a robust regression technique, iteratively reweighted least squares (IRLS), that is more efficient than ordinary least squares (OLS) when the distribution of the error terms has heavier-than-normal tails [Hamilton (1992)-J. The IRLS results confirm the OLS results; that is, in regressions which deemphasized observations with large residuals, the coeffi- cient estimates and significance levels did not differ substantially from the original OLS results.

The variable Other Direcrorships is negatively signed but is not statistically significant in any of the models. The regression models also include three control variables which describe characteristics of the acquisition bid. The coefficient estimates for the control variables confirm the results of previous studies. As in other studies. cash offers are associated with a higher stock price reaction than noncash offers. Similar to the findings of Bradley, Desai, and Kim (1988) the Competing Bia’ coefficients are negatively signed, although not statistically significant, indicating that shareholder wealth is reduced when a bidder enters an ongoing bidding contest. The coefficients on the Within One Three-digit SIC

variable are positive, as in Merck, Shleifer, and Vishny (1990), suggesting that shareholders benefit from acquisitions within the same industry.

J. Byrd and K. Hickman. Do outside directors monitor managers? 213

While the results shown in table 6 verify that independent boards benefit the shareholders of bidding firms during the acquisition process, they provide no statistically significant evidence that those benefits accrue continuously as the proportion of independent outside directors increases. In other words, the relationship of the announcement-date abnormal returns to the proportion of independent outside directors may be nonlinear. We test for a nonlinear rela- tionship by separating the board composition variable, Fraction Independent Directors, into the following piecewise variables:

Fraction Independent Directors (to 0.4) = Fraction Independent Directors if Fraction Independent Directors is less than 0.40, = 0.40 otherwise;

Fraction Independent Directors (0.4 to 0.6) = 0 if the Fraction Independent Directors is less than 0.40, = (Fraction Independent Directors minus 0.40) if the Fraction Independent Directors is between 0.4 and 0.6, = 0.20 other- wise;

Fraction Independent Directors (ouer 0.6) = (Fraction Independent Directors minus 0.60) if the Fraction Independent Directors is greater than 0.6, = 0 otherwise.

The turning points of 0.40 and 0.60 maximized the explanatory power of the full model. Using this method, the sum of the piecewise variables equals the original variable, Fraction Independent Directors.

Table 7 presents the results from several linear piecewise regressions. In all models, the coefficient for the Fraction Independent Directors (0.4 to 0.6) variable is positive and statistically significant, while the coefficient for Fraction Independent Directors (over 0.6) is negative and statistically significant. In no model is the coefficient for a low proportion of independent outside directors statistically significant. Fig. 1 presents these results graphically, using coefficient estimates from model 1. Replacing the single board composition variable with its piecewise analogues increases both the F-statistic and R’ of otherwise comparable models. The results presented in table 7 indicate that a simple linear model does not describe the relationship between the acquisition announcement abnormal returns and presence of independent directors as accurately as a piece- wise model.’

This nonlinear relationship supports the contention of Baysinger and Butler (1985) that there is an optimal mix of inside, affiliated outside, and independent outside directors. When independent directors hold 40-60% of board seats we

‘As an alternative to the piecewise board composition variables we estimated a second-degree polynomial model. In all cases the first-order term is significantly positive. while the squared term is negative. albeit not statistically significant. The inflection point of these quadratic functions ranged from 0.50 to 0.55 (from 50% to 55% independent outside directors).

I.!.

J. Byrd und K. Hickmun. Do outside dirrcrors mom~or managers.? 215

E 2

-1.5 e, z -2

2 -2.5

,” z -3

* -3.5

-4

-4.5

-5-C : : : : : : : : : : : : : ; : I

C 2 0 IA 3 _ c R ;i: 4 2 s z C In g g 2 3 m F I-- z 2’ 6 6 6 6 6 6 j 6 6 c’ j 1 j c=’ j j

Fraction of Independent Outside Directors

Fig. 1. The relationship between the fraction of independent outside directors and the acquisition announcement abnormal returns implied by the piecewise linear OLS regression presented in table 7, column I. of abnormal returns regressed on board composition, director stock ownership,

and control variables for 128 bids by 111 firms, 1980-87.

find evidence consistent with monitoring. Within this range, there is apparently a sufficient critical mass of independent outside directors to effectively oversee managerial activities. When independent outside directors hold only a small proportion of board seats (less than 35540%) we find no evidence of monitoring. At the other extreme, we find that returns to shareholders decrease as the proportion of board seats held by independent outside directors increases beyond 60%, suggesting that it is possible for a board to have too many independent directors.

We test the robustness of the piecewise board composition results by chang- ing the turning points used to compute the variables and by examining the model for influential observations. The results are unchanged in terms of signs and statistical significance for lower turning points from 0.20 to 0.45 and upper turning points from 0.50 to 0.70. We find no evidence of influential observations using the procedures suggested by Belsley, Kuh, and Welsch (1980). Results from iteratively reweighted least squares estimations provide additional confirmation regarding the robustness of the ordinary least squares results.

The explanatory power of the model is reduced when the piecewise variables based on independent outside directors are replaced by similar variables based on inside directors or all outside directors. These results, which are not tabulated. provide additional evidence that important relationships may be missed if the traditional inside-outside director classification method is used.

J. Byrd and K. Hickman. Do ortmde direcrors mmutor managers.” 217

The pattern of results for director stock ownership is identical to that shown in table 6. The coefficients of the continuous ownership variables are not statistically significant, but coefficients for both the inside and independent outside ownership dummy variables are positive and statistically significant. These dummy variables distinguish between almost no aggregate ownership by particular director groups and at least some low level of ownership. Therefore, the significant positive coefficients on these variables indicate that shareholders benefit from director stock ownership, but that these benefits do not necessarily increase as that ownership stake grows. We also examined the relationship of the announcement-date abnormal returns to managerial and independent out- side director ownership using two alternatives to the dummy variable approach. Neither linear piecewise ownership variables nor a quadratic function provided evidence of a curvilinear relationship. Moreover, neither alternative improved the explanatory power of the model.

As in table 6, the Other Directorship coefficient is negatively signed but is not statistically significant. The control variables follow the same pattern as in table 6. Cash offers and proposed acquisitions of firms in related industries enhance the expected returns to shareholders, while entering an ongoing bidding contest for a target is associated with lower abnormal returns.

4.3. Ecidence of monitoring or learning by independent boards

Eighteen firms appear twice in our sample, with four of these firms changing board categories from the first to the second acquisition offer. The evidence from these duplicate observations suggests that all boards, but particularly indepen- dent boards, improve their ability to distinguish between good and bad acquisi- tions. Of the 18, 1 I (or 61%) experienced higher abnormal returns in response to their second tender offers (although these higher abnormal returns were not necessarily positive). We find that the announcement-date abnormal returns for the second bid are 1.4% higher, on average, than for the first bid. The six sample firms with independent boards at the time of their second bid had an average increase in their announcement-date return of 3.5%, while the average increase for sample firms with nonindependent boards was only 0.4%. Five of these six firms (or 83%) had either a positive stock price response to their second bid or an increase from their first bid. Eight of 12 firms with boards dominated by nonindependent directors at the time of the second bid experienced either a positive stock price response to their second bid or an increase from their first bid. Given the small number of observations, these proportions (83% and 58%) are not statistically distinguishable.

From the time of the first to the second bid, three firms changed from a nonindependent board to an independent board. All three firms had positive responses to their second tender offer announcements (two of the three earlier offers were met with negative announcement-date stock price reactions).

A single firm changed its board from independent-director-dominated to nonin- dependent-director-dominated. Both of this firm’s offers were met with negative abnormal returns. with the stock price reaction to the second bid being slightly more negative. Although the small number of firms changing board categories makes statistical testing difficult. these results are generally consistent with the contention that independent boards provide better oversight during the acquisi- tion process than other boards.

4.4. Itrcl~~ptdtwt director ttloriitoritlg or tturnagrriiil quulit~.?

While our results are consistent with the hypothesis that independent boards monitor managers, they are also consistent with an alternative explanation-the managerial quality hypothesis - which involves no such monitoring. Suppose that there are good and bad managers. Good managers make value-enhancing acquisitions. These CEOs also dress up their firms’ boards with independent directors. Bad managers. on the other hand, sometimes choose tender offer targets for reasons besides shareholder wealth maximization, and they appoint their cronies to the board. If investors can distinguish managerial quality, then the average abnormal returns to acquisitions announced by high-quality man- agers will exceed the average abnormal returns to acquisitions announced by lower-quality managers. Although independent directors play no monitoring role, the association of independent boards with good CEOs creates an appar- ent relationship between board independence and the shareholder wealth effects of tender offers. In fact. managerial quality determines both the composition of the board of directors and the quality of the acquisition.

We test the managerial quality hypothesis by examining the relationship of two measures of preacquisition firm performance to the acquisition announce- ment abnormal stock returns and board independence. If our performance measures are indicative of managerial quality and the managerial quality hypothesis is correct, then managers offirms with better performance will make better acquisition decisions. Moreover, after controlling for managerial quality, board of director independence should explain very little of the remaining cross-sectional variation in the announcement-date stock returns.

Following previous studies, we measure managerial performance by examin- ing abnormal stock returns [Murphy (1985), Weisbach (1988)] and Tobin’s Q-ratios [Merck, Shleifer, and Vishny (1988), Lang. Stulz, and Walkling (1989), and McConnell and Servaes (1990)]. Both measures are computed using data from the three-year period immediately before the tender offer announcement, adjusted for industry performance. Usin, 0 either the cumulative abnormal re- turns or the Q-ratios, we find no statistically significant difference between the acquisition-date abnormal returns of the high- and low-performing firms. (We have not tabulated these results, although the results and a description of the methodology used to compute them are available from the authors.)

Furthermore, the proportion of independent to nonindependent boards does not differ significantly between the high- and low-performance groups. These results hold if the performance measures are based on one. two, or three years, and if no industry adjustment is made. We do find that among the higher- performing firms, those with independent boards have significantly higher acquisition announcement abnormal returns than high-performing firms with nonindependent boards; this result is significant at the 10% level.

Adding the performance measures as explanatory variables to the regression models presented in tables 6 and 7 adds nothing to the explanatory power of those models. The board composition variables remain significant, and in no case are the coefficients on the performance measure variables statistically significant. Overall, these findings provide no support for replacing the monitor- ing interpretation of our results with an interpretation based on managerial quality.

5. Summary and conclusions

In this study, we examine the association between characteristics of the board of directors of bidding firms and the shareholder wealth effects of tender offer bids. We document that less-negative returns to shareholders are associated with boards of directors in which at least half the members are independent of firm managers. Our evidence is therefore consistent with the claim that indepen- dent boards benefit shareholders. We find evidence of a nonlinear relationship between the fraction of independent directors on a board and the shareholder wealth effects of tender offer bids. Although this relationship is positive over most of its range, it is negative when the fraction of independent directors is extremely high (over 60%). This result is consistent with the contention of Baysinger and Butler (1985) that all categories of board members - managers, affiliated outside directors, and independent outside directors - play an impor- tant role in guiding the firm. Interestingly, our results are not consistent with the contention that shareholders will be best served by a board comprised entirely of outside directors. Emphasizing the monitoring role of independent outside directors could harm shareholders by making the board less effective in its decisionmaking and advisory roles. Overall, our evidence suggests a richer model of board involvement in corporate decisionmaking than has typically been assumed.

Our findings are sensitive to the method of classifying directors. We use the three-way classification procedure developed by the Baysinger and Butler (1985) which identifies directors as insiders, affiliated outsiders, or independent outsiders. Had we used the conventional inside-outside categories, we would have found no significant association between board of director composition and the shareholder wealth effects of tender offers. This suggests that important

relationships may have been missed in studies that rely on the two-way classi- fication scheme.

In our regression tests, we find evidence that shareholders benefit when managers and independent outside directors own at least a small fraction of the bidding firm’s common stock. This evidence is consistent with hypotheses that ownership structure affects firm value [Jensen and Meckling (1976)].

In general. our results contribute to the emerging understanding of the value of the corporate board. They suggest that one useful approach to this issue is to examine the association between the composition and characteristics of the board and the shareholder wealth effects of board-level corporate decisions such as greenmail payments, golden parachute adoptions, and poison pill plans. It will be interesting to see whether the cross-sectional variation in shareholder returns due to these events is explained by attributes of the board of directors.

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