By Bill Gerdes
If you think finance research is boring, you need to hang out for a while with Anup Agrawal.
The internal fighting that goes on between members of the boards of directors and officers of the nation’s public companies is seldom made public. Like Las Vegas, what happens there stays there. And what takes place inside boardrooms is essentially a black box to outsiders.
“There has been a lot of research on corporate governance and much research on corporate boards,” says Agrawal, a professor of finance and the William A. Powell Jr. Chair of Finance and Banking at The University of Alabama’s Culverhouse College of Commerce. But, Agrawal says, not much research has been done inside the black box of boards.
Agrawal and a team of researchers are changing that. A new paper by Agrawal and Mark Chen of Georgia State University examines 181 board disputes between 1995 and 2006 that resulted in one or more director departures. “This is the first paper to look empirically at the inner functioning of boards,” Agrawal says.
TURMOIL SHEDS LIGHT
Although the paper is not yet published – it’s going through the peer review process – the draft is already drawing attention. “There seems to be a lot of interest in the paper,” Agrawal says.
Agrawal has attended conferences around the country, presenting the paper and defending and explaining his findings. “People throw a lot of eggs at you,” he says, “but that is part of the process.”
The reason this research is drawing attention in academic finance circles nationwide is because turmoil on a board of directors can shed light on the causes of company performance and influence stock prices.
Several categories of disputes can cause directors to leave the board and perhaps impact company performance and stock price. These include board functioning, management looking more after its own interests than those of stockholders, and financial policy or corporate strategy.
“In this paper, we provide the first systematic evidence on the nature, determinants and consequences of major internal board disputes,” Agrawal and Chen write. Boardroom disputes can sometimes be a good thing when they highlight serious issues facing a corporation. But, according to the study, they result in large and significant stock price declines, on average, when the fight becomes public. Companies involved in these disputes have been performing poorly and face a higher probability that their stock may be delisted by the exchange during the year following news of the dispute.
“Upon news of internal disputes accompanied by director departures, stock prices decline significantly,” the researchers say. The price drop is greater when the resigning director is an insider of the firm rather than someone from outside the company.
Agrawal says the study shows the decline in stock prices is particularly large for certain types of disputes, such as those involving agency problems, corporate strategy or financing decisions. Stock prices for the companies going through the disputes show poor operating performance up to a year before and after the disagreement.
The key to the Agrawal-Chen investigation is Form 8-K of the United States Securities and Exchange Commission. The document contains current disclosures that public companies must file with the commission to announce major events that shareholders should know about as they happen, rather than wait until the year-end 10-K annual report.
One of these events is when a director resigns or declines to stand for re-election due to “differences involving company operations, policies or practices.” While this disclosure requirement has been around since 1979, disclosure was triggered only if the resigning director wrote a letter to the company describing the circumstances behind his resignation and requesting that the company make the matter public.
A TRIGGER CHANGE
Effective Aug. 23, 2004, the SEC changed the disclosure trigger. Disclosure is now triggered as long as a company officer knows the reason behind the director resignation, even if the resigning director does not write a letter to the company.
Agrawal says the expanded disclosure was originally proposed by the SEC in 1978, before being modified in response to strong objections from companies. But in the aftermath of Enron and other corporate scandals earlier this decade, the SEC reverted to its originally proposed rule.
Agrawal says he was traveling to a finance conference when he noticed an article in the Wall Street Journal about this disclosure. He discussed the issue with Chen, and they decided to pursue the research.
“We found about 1,100 director resignations with a director resignation letter during 1994–2006, and then we had to identify those caused by a dispute,” Agrawal says. That number turned out to be 181, Agrawal says, and the research team began gathering information on the 181 resignations. “The project took a year and half to put the data set together,” Agrawal says, “and it took us a year before that to figure out a way to identify the disputes.”
ONE SIDE HOLDS BACK
The descriptions of the disputes vary in detail, Agrawal says. “It depends on the original letter from the resigning director describing the dispute. If that is detailed, so is often the company’s response.”
But, Agrawal says, the companies are not usually very forthcoming. “Their tendency seems to be to make the minimum disclosure that is required, depending upon the issues raised by the resigning director. The resigning directors often don’t hold back.”
The research finds that directors with shorter tenures on the board and directors who are entrepreneurs, venture capitalists or investment bankers are more likely to be involved in a dispute. Does this indicate that directors with strong personalities might be more prone to originate the differences?
“Probably,” says Agrawal.
The time frame for the Agrawal-Chen paper predates the recent economic crisis and the stress and tension now being exerted on the market and on shareholders. Agrawal says he hopes his research will help both board members and shareholders alike to recognize board room disagreements and take action before damage is done.
As for those directors who leave the board during a dispute?
“Well, one follow-up project that we are working on is how directors who leave amid a dispute fare subsequently in the market for directorships,” Agrawal says.
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