Board informal hierarchy and stock price crash risk: Theory and evidence from China
DOI | http://doi.org/10.1111/corg.12282 |
Date | 01 September 2019 |
Author | Khalil Jebran,David H. Zhu,Shihua Chen |
Published date | 01 September 2019 |
ORIGINAL ARTICLE
Board informal hierarchy and stock price crash risk: Theory and
evidence from China
Khalil Jebran
1
|Shihua Chen
2
|David H. Zhu
3
1
School of Accounting, Dongbei University of
Finance and Economics, Dalian, China
2
School of Business Administration, Dongbei
University of Finance and Economics, Dalian,
China
3
Department of Management and
Entrepreneurship, Arizona State University,
Tempe, Arizona
Correspondence
Shihua Chen, School of Business
Administration, Dongbei University of Finance
and Economics, 217 Jianshan Street, Shahekou
District, Dalian 116023, China.
Email: shihuachen@dufe.edu.cn
Funding information
National Natural Science Foundation of China,
Grant/Award Number: 71472030, 71533002
ABSTRACT
Research Question/Issue: This study examines how the informal hierarchy among
directors of a firm influences the risk of stock price crash. We theorize that a clear
informal hierarchy among directors increases managerial coordination of activities
to hide bad news, which increases the risk of future stock price crash.
Research Findings/Insights: Consistent with our theoretical predictions, our findings
show that the informal hierarchy among directors, measured based on the number of
board appointments they have, is positively associated with the risk of future stock
price crash. This association is weaker for firms with larger boards but stronger when
the CEO's status is higher than that of the majority of the directors on the board. We
also find evidence that information hierarchy increases the degree to which managers
hide bad news.
Theoretical/Academic Implications: This study advances our understanding by show-
ing that an informal hierarchy that tacitly forms among directors on a board can sig-
nificantly guide boardroom interactions. Specifically, the findings suggest that a clear
informal hierarchy among directors enhances their coordination to hide bad news and
thereby increases stock price crash risk. Furthermore, the results provide evidence
that CEO's status and board size are important factors influencing the functioning
of board informal hierarchy.
Practitioner/Policy Implications: The results have important implications for
researchers and policymakers. The findings show that the informal hierarchy among
directors can shape managerial behavior and guide boardroom interactions. The
results also suggest that improving formal governance mechanisms can enhance
boardroom interactions by moderating the effects of informal hierarchy in the con-
text of China.
KEYWORDS
corporate governance, board informal hierarchy, CEO status, China, stockprice crash risk
1|INTRODUCTION
Stock price crash (i.e., a large drop in stock price) risk has drawn much
attention from regulators, policy makers, corporate executives, and
investors. Many studies have also investigated the causes and conse-
quences of stock price crash risk (hereafter crash risk). Studies show
that the hoarding of bad news by managers is the major cause of stock
price crashes (Chen, Hong, & Stein, 2001; Hutton, Marcus, &
Tehranian, 2009; Jin & Myers, 2006). Specifically, managers have
incentives (such as concerns about career and compensation) to con-
ceal bad news from investors. When the amount of bad news reaches
a threshold level, managers are forced to release it all at once to the
Received: 13 May 2018 Revised: 8 April 2019 Accepted: 9 April 2019
DOI: 10.1111/corg.12282
Corp Govern Int Rev. 2019;27:341–357. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 341
market, causing a stock price crash: a large drop in the stock price (Jin
& Myers, 2006). Research has identified various formal governance
mechanisms, managerial characteristics, and firm attributes associated
with crash risk (see review by Habib, Hasan, & Jiang, 2018). Although
several studies have focused on formal governance mechanisms, little
theoretical or empirical work has examined how the informal hierarchy
among directors, a very important aspect of boards, may influence
crash risk.
A long tradition of research in sociology shows that members of
a group tend to sort into an informal hierarchy that has profound
impacts on their interactions and behavior (Gould, 2002; Magee &
Galinsky, 2008). Research on boards also suggests that directors on
a board tend to implicitly sort into an informal hierarchy based on
their influence and competence (He & Huang, 2011; Magee &
Galinsky, 2008; Overbeck, Correll, & Park, 2005). Studies show that
a clear informal hierarchy among directors increases managerial
coordination on various corporate issues (He & Huang, 2011; Magee
& Galinsky, 2008). Specifically, a clear informal hierarchy reduces
confusion, frustration, and destructive conflicts in the boardroom,
thus increasing the efficiency of boardroom interactions (He &
Huang, 2011).
In this study, we propose that a clear informal hierarchy reduces
conflicts among directors on a board, which increases the possibility
of managerial coordination of bad‐news hoarding activities and the
likelihood of future crash risk. Furthermore, we suggest that informal
hierarchy is less influential on larger boards because directors on these
boards find it difficult to recall their rank order in the hierarchy
(Finkelstein & Mooney, 2003; He & Huang, 2011). Therefore, we the-
orize that the positive effect of informal hierarchy on future crash risk
is weaker for firms with larger boards.
In addition, because higher status actors in a hierarchy tend to
set the tone for group discussions and act as a communication cen-
ter by providing influential opinions (He & Huang, 2011; Zhu, Ye,
Tucker, & Chan, 2016), we argue that directors are more likely to
coordinate with the CEO on information hoarding activities when
the CEO has a higher status. Thus, we propose that a CEO's status
can strengthen the positive relationship between informal hierarchy
and future crash risk. Following He and Huang (2011), we measure
the informal hierarchy among directors based on the number of
board appointments held by them. Using a large sample of Chinese
listed firms between 2004 and 2014, we find strong support for
our theoretical predictions.
This study makes important contributions to research on stock
price crash. Whereas prior studies have focused on firm characteris-
tics and formal governance mechanisms in examining antecedents of
stock price crash, our study advances a relatively novel sociological
perspective by highlighting the important impacts of informal hierar-
chy among directors on stock crash risk. In explaining how informal
hierarchy among directors increases the hoarding of bad news by
executives, a known antecedent of stock crash risk, this study also
enhances our understanding about deeper causes of stock crashes.
Further, our study contributes to research on boards of directors.
Although there is increasing interest in boards of directors, the
majority of studies have adopted either an economics perspective
or a psychological perspective. Among limited studies adopting a
sociological perspective, only a few (He & Huang, 2011; Johnson,
2004) have examined the effect of informal hierarchy among direc-
tors. Our study extends sociological studies on boards by explaining
how information hierarchy among directors influences a critical out-
come —namely, stock crashes —that has not been examined by
prior sociological studies on boards. Finally, our study contributes
to research on board informal hierarchies. Whereas prior studies
(He & Huang, 2011; Magee & Galinsky, 2008) have focused on the
benefits of informal hierarchy among directors, our study shows
how it can negatively influence corporate decisions by increasing
stock crash risk.
2|THEORY AND HYPOTHESES
2.1 |Informal hierarchies on corporate boards
A hierarchy represents a rank order (explicit or implicit) among mem-
bers of a group based on deference, power, and status (Blader & Chen,
2012; Finkelstein, 1992; He & Huang, 2011; Huberman, Loch, &
Önçüler, 2004). Those higher on the hierarchy are likely to have a
higher status than those lower on the hierarchy (Zhu, Ye, Tucker, &
Chan, 2016). Because people of a higher status are more likely to
act as a communication center and set the tone for discussions, those
higher in the hierarchy tend to express more opinions and receive
more credit for their work in the group (Gould, 2002; Humphrey,
1985; Jetten, Hornsey, & Adarves‐Yorno, 2006). In contrast, those
lower in a hierarchy tend to receive less attention from group mem-
bers, are perceived to be less competent, and are more likely to con-
form to other members in decision making (Gould, 2002; He &
Huang, 2011; Ridgeway & Johnson, 1990). In general, people higher
in a hierarchy tend to have a stronger influence on decision making
(Zhu, Ye, Tucker, & Chan, 2016).
The development of a hierarchy among individuals is nearly inev-
itable (Blader & Chen, 2012; Magee & Galinsky, 2008). A hierarchy is
not only established formally within a group but can also be devel-
oped informally. Indeed, a large body of research suggests that an
informal hierarchy tends to develop within a group rapidly and spon-
taneously (for a review, see Magee & Galinsky, 2008). One reason is
that individuals can make inferences and judgments about others'
power and competence based on only seconds of observations.
Therefore, hierarchical differentiation typically emerges among
individuals in most social groups and can shape the entire group's
interactions. For example, there is evidence that individuals can
form informal hierarchies based on their gender, personality, and
even speaking styles (Berger, Fisek, Norman, & Zelditch, 1977;
Fragale, 2006; Magee & Galinsky, 2008; Ridgeway, Boyle, Kuipers,
& Robinson, 1998).
Corporate boards are groups of individuals who interact socially.
Research on boards shows that directors tend to form an informal
hierarchy among themselves (He & Huang, 2011), and directors higher
342 JEBRAN ET AL.
To continue reading
Request your trial