Board Capital and the Downward Spiral: Antecedents of Bankruptcy in a Sample of Unlisted Firms

• Author: Ann Jorissen,Jonas De Maere,Lorraine M. Uhlaner
• DOI: http://doi.org/10.1111/corg.12078
• Date: 01 September 2014
• Published date: 01 September 2014

Board Capital and the Downward Spiral:

Antecedents of Bankruptcy in a Sample of

Unlisted Firms

Jonas De Maere, Ann Jorissen*, and Lorraine M. Uhlaner

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines whether certain proxies for board incentives and board capital are linked

with bankruptcy in unlisted f‌irms.

Research Findings/Insights: Based on data analyzed over a f‌ive-year period with a sample of 232 matched pairs of unlisted

f‌irms, results reveal that f‌irms with boards led by an independent Board Chair (vs. CEO duality), and including longer-

tenured directors, and directors with fewer additional directorships on average, are less likely to become bankrupt. Results

of analyses of board size and board change support a “reputation” hypothesis, i.e. that directors begin to f‌lee f‌irms in a

downward spiral prior to bankruptcy.

Theoretical/Academic Implications: Results support an eclectic model of board incentives and board capital, which

integrates elements of agency and resource dependence theories, and the group decision-making literature to explain

governance antecedents of f‌irms that went bankrupt. It builds on a model proposed by Hillman and Dalziel, while

identifying important differences, including lack of support for predicted moderating effects between board incentives and

board capital. Findings also support applicability of the threat-rigidity logic and reputation hypothesis in this context, and

the importance of anchoring corporate governance research more precisely on prediction of certain levels of performance.

Practitioner/Policy Implications: Findings support governance recommendations to separate Board Chair and CEO lead-

ership and limit a director’s number of outside directorships. Negative effects of director tenure on bankruptcy contradict

the notion of “term limits,” suggesting that benef‌its of f‌irm-specif‌ic knowledge and experience may outweigh risks of

entrenchment.

Keywords: Corporate Governance, Bankruptcy, Boards of Directors, Board Composition, CEO Duality

INTRODUCTION

Firm bankruptcy can engender enormous costs to a range

of stakeholders, including shareholders, employees,

creditors, and society at large. Given the importance of

reducing such risks, one should understand their possible

antecedents. In the current study, we test whether certain

differences in board composition – using certain proxies of

board incentives and boardcapital – differentiate those f‌irms

eventually declaring bankruptcy from the more general

population of unlisted f‌irms.

A number of meta-analyses (Dalton, Daily, Certo, &

Roengpitya, 2003; Dalton, Daily, Ellstrand, & Johnson, 1998;

Deutsch, 2005) and comprehensive literature reviews

(Krause, Semadeni, & Cannella, 2014) have claimed that

links between board composition and f‌irm performance are

inconclusive. These conclusions maylead some to argue that

board composition research has reached a “dead end.” Yet

closer examination of such studies reveals two important

research gaps: (a) a lack of attention to (especially smaller)

unlisted f‌irms, and (b) lack of control for the level or type of

performance being examined (e.g., bankruptcy vs. rate of

growth) (Judge, 2011; Krause & Semadeni, 2013; Ward,

Brown, & Rodriguez, 2009). Given these gaps and given the

wasteful societal consequences of bankruptcy, research into

such relationships is thus both timely and relevant.

The current study examines whether certain proxies for

board incentives and board capital are linked with f‌irm

bankruptcy, building upon a corporate governance frame-

work proposed by Hillman and Dalziel (2003), which com-

bines insights from agency and resource dependence theory.

*Address for correspondence: Ann Jorissen, Department ofAccounting and Finance,

University of Antwerp, Prinsstraat13, 2000 Antwerp, Belgium. Tel: 00 32 3 265 40 92;

Fax: 00 32 3 265 40 64; E-mail: ann.jorissen@uantwerpen.be

387

Corporate Governance: An International Review, 2014, 22(5): 387–407

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12078

As applied to corporate governance research, agency theory

focuses on board incentives (or their proxies), that is, variables

tapping the board’s motivation to monitor management and

f‌irm performance. Resource dependence theory focuses

on the board’s ability to provide resources to the f‌irm

through board capital, i.e. its human capital (e.g., experience,

skills and knowledge) and relational capital (e.g., external

networks). Whereas agency theory typically ignores the

importance of resources, most adaptations of resource

dependence theory fail to attend to the importance of moni-

toring (Bammens, Voordeckers, & van Gils, 2011; Hillman &

Dalziel, 2003). ThereforeHillman and Dalziel (2003) propose

that board incentives and board capital should be examined

together to predict the board’s abilities to monitor and

provide resources to the f‌irm, and in turn to inf‌luence f‌irm

performance. They explain that the lack of f‌indings in pre-

vious studies examining the link between board incentives

to monitor and f‌irm performance may be the result of a

failure to include board capital in these models. The

primary contribution of this study to the corporate gover-

nance literature is a test and ref‌inement of this framework in

the context of unlisted f‌irms, and to provide more insight

on the link between board composition and low levels of

performance (e.g., bankruptcy vs. survival). Our results

conf‌irm some aspects of the framework, especially the

importance of including both board incentives and board

capital as signif‌icant explanatory variables of f‌irm perfor-

mance. However, we f‌ind no evidence of previously pro-

posed interaction effects between board incentives and

board capital to explain bankruptcy. Further contributions

include support for the applicability of both the threat-

rigidity logic and reputation hypothesis in this context, and

f‌inally, the importance of anchoring research more precisely

on prediction of certain levels of performance (in this case

bankruptcy vs. survival).On a more general level, our study

further contributes to theory by suggesting the benef‌its of

relying more extensively on the group decision-making lit-

erature to understand board composition effects, as a

supplement to that of agency and resource dependence

theory.

From a practical standpoint, our study empirically vali-

dates whether certain governance recommendations com-

mon to many governance codes are indeed applicable to

unlisted f‌irms, especially with respect to reducing the risk of

bankruptcy. Past recommendations lack such validation,

resting primarily on research for listed companies. More

specif‌ically, our results strongly support the recommenda-

tions of separating the role of chairman of the board and

CEO, and of restricting the total number of outside director-

ships held by each director. However, our results do not

support the common recommendation of “term limits,”

f‌inding that in unlisted f‌irms, longer tenure actually reduces

bankruptcy risk.

To test our hypotheses, we use a matched-pairs popula-

tion of 232 bankrupt and non-bankrupt private limited

liability f‌irms in Belgium. Belgian limited liability f‌irms

provide an interesting population for such a study, as they

are mandated by Belgian law to install a board of directors.

Furthermore, the corporate governancesystem in Belgium is

a one-tier governance system, which is similar to the Anglo-

American systems of governance, permitting companies

to combine the board chair and CEO if they wish to do so.

Belgium developed its f‌irst governance code for unlisted

f‌irms in 2004, revised in 2009.1Many recommendations,

including separation of the Board chairman and CEO roles,

term limits, the appointment of outside directors, and limits

on the maximum number of directorships held by directors

are voluntary. There is, however, a compulsory minimum

board size of three directors for companies with three or

more owners.

The remainder of this paper proceeds as follows. In the

next two sections, we f‌irst summarize prior research on

bankruptcy and governance in unlisted f‌irms, reviewing the

background literature on agencytheory and resource depen-

dence theory. The fourth section presents our framework

and hypothesis development. In the f‌ifth and sixth sections,

we present the method and results. In the discussion section,

we present the theoretical and practical implications of our

f‌indings, as well as limitations and directions for future

research, followed by our conclusions in the last section of

the paper.

PRIOR RESEARCH ON BANKRUPTCY

Finance Indicators Predicting Bankruptcy

Research on f‌inance indicators predicting bankruptcy dates

back at least to the 1960s (Altman, 1968; Beaver, 1966), with

ongoing interest within the f‌inance literature in models that

provide an early warning of failure (Agrawal & Taff‌ler, 2008;

Balcaen & Ooghe, 2006; Löff‌ler & Maurer, 2011; Ohlson,

1980). More recent models also combine accounting ratios

and market information, such as share prices (Campbell,

Hilscher, & Szilagyi, 2008; Wu, Gaunt, & Gray, 2010).

Although broadly accepted as valid for both listed and

unlisted f‌irms, only a few studies use unlisted f‌irm popula-

tions to validate such indicators (Ooghe & Van Wymeersch,

2006; Pompe & Bilderbeek, 2005). These prediction models

focus mainly on f‌inding measures of default risk.

Governance Antecedents of Financial Distress and

Bankruptcy

Research on corporate governance and f‌inancial distress f‌irst

appeared in the mid-1980s, with renewed interest after the

2008 f‌inancial crisis. Most studies with few exceptions

(Huse, 1994) are based on either listed US or UK f‌irms

(Baysinger & Butler, 1985; Daily, 1995, 1996; Daily & Dalton,

1994a, 1994b; Fich & Slezak, 2007; Gales & Kesner, 1994;

Hambrick & D’Aveni, 1992; Lajili & Zéghal, 2010; Mellahi,

2005; Mellahi, Jackson, & Sparks, 2002; Mueller & Barker,

1997; Platt & Platt, 2012; Rauterkus, Rauterkus, & Munchus,

2013). These studies focus mainly on two topics: board

(in)dependence and director behavior prior to bankruptcy.

Board Independence. Board independence is one of the

most widely researched corporate governance phenomena

(Dalton,Hitt, Certo, & Dalton,2007; Krause et al., 2014). Prior

studies on governance antecedents of listed f‌irms in distress

have used two types of proxies for board independence:

f‌irst, whether or not the roles of the Board Chair and CEO

388 CORPORATE GOVERNANCE

Volume 22 Number 5 September 2014 © 2014 John Wiley & Sons Ltd