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.