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The Boardroom Edge against Bankruptcy

Bigger and more independent boards help shield companies from distress.

(originally published by Booz & Company)

Title: Corporate Board Attributes and Bankruptcy (fee or subscription required)

Authors: Harlan Platt and Marjorie Platt (both Northeastern University)

Publisher: Journal of Business Research, vol. 65, no. 8

Date Published: August 2012

Companies that have relatively large boards of directors with greater numbers of independent members are less likely to file for bankruptcy than their industry peers. That’s one major finding of this study, which compares bankrupt and solvent firms in terms of their board size, makeup, and governance. More generally, the study suggests that various board attributes — including age of members, amount of stock held, presence of CEOs of other firms or board members of other companies, and staggering of board member terms of office — can significantly affect a firm’s chances for overall success.

To explore the types of impact that boards can have, the authors checked a database of director characteristics and responsibilities against the UCLA–LoPucki Bankruptcy Research Database, which contains information on all bankruptcy cases in the United States involving large public companies. Companies qualify as large if they reported assets of more than US$100 million (in 1980 dollars, the starting point of the database) on their last SEC filing prior to declaring bankruptcy.

Then, using financial data from the Compustat database, the authors created a sample of 87 firms that filed for Chapter 11 bankruptcy protection sometime between 1998 and 2009. Companies in the sample operated in 30 industries. Each of the companies in the sample was compared with at least one of the 205 non-bankrupt firms in the data set; variables considered included total assets, the filing year for bankruptcy, and the industry.

Overall, the findings suggest that several board characteristics and functions tend to differentiate stable firms from those that ultimately file for protection from creditors. Researchers in prior studies have disagreed about the impact of specific board characteristics; some argue, for example, that larger boards — which can bring more perspectives, skills, and experiences to the table — help keep companies out of bankruptcy, whereas others tout smaller boards for working more efficiently. This study finds that bigger is indeed better: The board of a firm that did not file for bankruptcy had 9.96 members, on average, whereas the average company facing bankruptcy had 8.89 members, a statistically significant difference, the authors report.

The authors next examined board independence, an issue that has come to the fore in the wake of the recent financial crisis. They looked at the difference between inside directors (who are employees of the firm, such as CEO, president, or vice president) and outsiders, who are typically classified by researchers and regulators as either independent or “gray.”

Independent directors have no ties to the firm other than their position on the board, and are widely seen as a check on potential wrongdoing. A gray director, however, has some type of affiliation with the company — as a consultant, former employee, leader of a partnering firm, or relative of a senior manager, for example. These relationships have the potential to create conflicts of interest, and some legislation aimed at curbing corporate malfeasance has focused on gray directors.

In line with this thinking, the authors found that the presence of independent, rather than gray, directors on a board indeed seems to correlate with a healthier financial outlook for the firm. About 66 percent of directors were independent at firms that did not go bankrupt, compared with 60 percent at failing firms, again a statistically significant difference, the authors report. For their part, gray directors represented 14 percent of board members at companies that avoided bankruptcy, compared with 20 percent at Chapter 11 firms. The percentage of inside (or management) directors was about 20 percent at both types of companies.

“Presumably, the independent directors working in concert with the well-informed internal management directors effectively monitor and control the firm’s strategic business activity,” the authors write. “Alternatively, gray directors’ potential conflict of interest may work at cross purposes, thereby inhibiting effective corporate governance and control.”

In fact, bankrupt companies had many more gray members serving on both their audit and compensation committees, among the most powerful perches a director can have to exert control over the board and its corporate strategy.

Some other findings: The CEOs of solvent companies were typically older by several years than their counterparts at bankrupt firms, as were the directors, on average. With greater age also came increased experience; the board members of non-bankrupt companies sat on more boards than their peers at failing firms. In addition, both types of outside directors of non-bankrupt boards owned less stock in the company on whose board they sat, on average, than their peers at bankrupt companies did.

Interlocking boards, or those that have at least one member in common, have been widely denigrated, and such links have long been illegal in the U.S. among firms competing in the same industry. But for those in different markets — as in the case of an automaker’s director holding a position on a steel company’s board — the ties are permitted and seen as beneficial, because they can potentially facilitate the flow of information across related industries.

This study lends credence to the latter theory, finding that non-bankrupt firms had a significantly higher percentage of interlocked directors across related industries (1.6 percent) than did companies that went under (0.3 percent). By obtaining information that helps their firm glean knowledge from others experiencing downturns in similar industries, the authors argue, directors can help steer their companies clear of financial ruin.

Having sitting CEOs on the board is also beneficial. Companies that did not go bankrupt had 1.49 directors, on average, who were serving as CEO of another firm, compared with a significantly lower number (1.10) among those that went bankrupt. Although sitting CEOs are often regarded as a threat to a company’s leadership, their strategic knowledge can also aid in decision making, the findings suggest.

Finally, a higher percentage of solvent firms’ boards were staggered, meaning they held elections for only some of the members each year — an approach that presumably wards off raiders and allows companies to take a longer-term strategic view.

The authors advise firms to take the findings into consideration when reconfiguring or expanding their boards, replacing retiring members, or leading searches for new directors. In doing so, it’s imperative that companies recognize the “corporate governance factors that distinguish between healthy firms and those that fail.”

Bottom Line:
A company’s board can play a major role in a firm’s ability to avoid bankruptcy. A larger and older board with more sitting CEOs and independent members, who typically own less stock in the company, is better equipped to lead the firm through difficult economic challenges.

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