Fight or flee: Outside director departures prior to contested management buyout offers

• Date: 01 September 2020
• Author: Michaël Dewally,Matteo P. Arena,Sarah W. Peck
• Published date: 01 September 2020
• DOI: http://doi.org/10.1111/corg.12329

ORIGINAL ARTICLE

Fight or flee: Outside director departures prior to contested

management buyout offers

Matteo P. Arena

1

| Michaël Dewally

2

| Sarah W. Peck

1

1

College of Business Administration,

Marquette University, Milwaukee, Wisconsin,

USA

2

Department of Finance, Townson University,

Baltimore, Maryland, USA

Correspondence

Sarah W. Peck, College of Business

Administration, Marquette University, P.O. Box

1881 Milwaukee, WI 53201-1881, USA.

Email: sarah.peck@marquette.edu

Funding information

Marquette University

Abstract

Research Question/Issue: We investigate outside director departures prior to man-

agement buyout offers (MBOs). In these transactions, managers have both an infor-

mation advantage and incentives to make a lowball offer to shareholders. Outside

directors can safeguard against managerial self-dealing by negotiating for the best

terms for public shareholders from either management or another bidder.

Research Findings/Insights: It is typical that outside directors stay on the board

through an MBO offer as MBOs are less likely to have changes in directors—either

joining or leaving—relative to a control sample. After controlling for endogeneity as

well as firm and director characteristics, we find that outside directors are more likely

to leave when the offer is later contested. We do not find any evidence that

departing directors are replaced by new outside directors who ensure shareholders

get a higher premium nor do we find any evidence that the board acts as a public

auctioneer. We also find that outside directors are more likely to depart when the

buyout contest is longer. Our findings show that outside directors provide a weak

internal monitoring mechanism as they leave precisely when shareholders need their

expertise the most.

Theoretical/Academic Implications: Our results contribute to research that supports

the notion that outside director departures are symptomatic of board weakness. The

results of our study support the contention of other researchers that outside direc-

tors often fail to monitor managers.

Practitioner/Policy Implications: Our study offers useful information to M&A invest-

ment banking advisors and leverage buyout analysts by showing the mechanisms

under which director turnover can affect the value and the outcome of MBOs.

KEYWORDS

corporate governance, board of directors, director turnover, management buyout offers,

takeovers

1|INTRODUCTION

The role outside directors play in monitoring managers has been the

subject of extensive research. Fama and Jensen's seminal 1983 paper

launched the discussion arguing that outside directors have incentives

to monitor management to protect their reputations as decision

experts. Many studies support the notion that outside directors are

effective monitors (see, e.g., Brickley, Coles, & Terry, 1994; Byrd &

Hickman, 1992; Cotter, Shivdasani, & Zenner, 1997; Hanson &

Song, 2000; Nguyen & Nielsen, 2010; Rosenstein & Wyatt, 1990;

Received: 4 June 2018 Revised: 6 May 2020 Accepted: 7 May 2020

DOI: 10.1111/corg.12329

274 © 2020 John Wiley & Sons Ltd Corp Govern Int Rev. 2020;28:274–293.wileyonlinelibrary.com/journal/corg

Weisbach, 1988). However, some researchers question the indepen-

dence and effectiveness of outside directors given that management

largely controls the nominating process (see Arena & Ferris, 2007;

Shivdasani & Yermack, 1999). Goergen and Renneboog (2014) review

the literature and conclude that the role that independent directors

play in advocating for shareholders' interests remains unsettled. We

contribute to the research on outside directors and board dynamics

by examining director turnover prior to management buyout (MBO)

offers, a transaction where managers have an inherent conflict of

interest with shareholders.

Outside directors can play an important role by advocating for

public shareholders during the MBO contest—the “fight”hypothesis.

Yet prior research suggests there is a potential cost for outside direc-

tors who stay on the board when the MBO offer is contested. Har-

ford (2003) studies what happens to directors' future board seats and

the accompanying directors' fees after a takeover bid. He finds that

for outside directors, the direct financial impact of a completed

merger is negative. He concludes that when outside directors fail as

monitors, forcing the external control market to act for them, there is

a partial settling-up in the directorial labor market. Other researchers

have also found that outside directors bear costs when the firm faces

adverse events. Fich and Shivdasani (2007) find that outside directors

lose future board seats when there is a financial fraud lawsuit against

the firm where they serve as a director. Srinivasan (2005) finds the

reputation of outside directors is damaged when they are on boards

of firms that restate earnings. Gilson (1990) finds that outside direc-

tors lose board seats when they serve on boards of firms experiencing

financial distress. These findings suggest that outside directors are

likely to leave the board prior to the MBO offer when they think that

the offer is weak and could be contested. These directors leave to

avoid being tainted in the directorial labor market by avoiding any

involvement in a transaction in which the external control market

intervenes to correct board failings; this is the “flee”hypothesis.

Additionally, outside directors can have conflicting loyalties and

reputational concerns in these transactions. On the one hand, they

have incentives to create a reputation among the shareholders who

elect them as watchdogs against management entrenchment. Institu-

tional shareholders can vote against directors nominated to the board

when the firm's performance and corporate governance practices are

weak (see Del Guercio, Seery, & Woidtke, 2008). On the other hand,

outside directors may wish to cultivate a reputation for going along

with the managers who nominate them, as this can lead to more board

seats and higher compensation (see Brick, Palmon, & Wald, 2006;

Dah & Frye, 2017; Nguyen, 2014). We hypothesize that the tension

created by these conflicting reputational concerns is likely to cause

directors to depart, that is, flee. By avoiding controversy, they can

preserve their reputations as independent monitors while maintaining

a friendly attitude toward management.

In this study, we focus only on buyouts of U.S. firms. A cross-

country investigation would prevent us from providing the depth of

analysis we offer in this paper, as regulatory and institutional contexts

are vastly different across countries and economies in different

phases of development. First, procedurally, the parties involved in the

transactions are not uniform across regions due to differences in avail-

able sources of financing, in the impacts of debt pressure, and, in

some cases, due to the absence of private equity. Second, differences

in regulatory approval across countries are likely to significantly

impact the interaction between governance and the business rationale

for an MBO transaction (see Wright, Scholes, & Yao, 2010). However,

our results have implications for directors' incentives to stay on a

board in non-U.S. settings. Our methodology for investigating director

changes can provide guidance for researchers who study non-U.S.

buyouts.

For a sample of MBO offers from 1999 through 2016, we com-

pare both board composition and board turnover to a control sample.

We find that the boards of firms with MBO offers have a higher per-

centage of insiders. We find that while board composition is stable

during the 2 years preceding the MBO, there is considerable turnover

in the individual directors who serve on the board. About a third of

the board turns over for both samples. We also find that when there

is an MBO offer, directors are more likely to stay beyond what can be

explained as routine vis-à-vis our control sample. Thus, the MBO offer

itself does not lead to more director departures. Further, these

observed departures are more likely to occur when the MBO offer is

subsequently challenged by either shareholders or a competitive bid-

der. While outside director departures can be a form of monitoring by

signaling to a competitive bidder that the management's offer is weak,

this type of monitoring is likely to be less effective than staying on the

board and actively seeking higher offers from competitive bidders

and/or blocking management from adopting anti-takeover amend-

ments designed to discourage other bidders.

After controlling for firm and director characteristics, fixed

effects, and the endogenous relation between director turnover and

MBO-related factors, we find that outside directors provide a weak

internal monitoring mechanism as they are likely to leave precisely

when shareholders need them to ensure that the buyout offer is fair.

The results of our study support Jensen's (1993) contention that out-

side directors often fail to monitor managers.

Professional directors or those who are retired from their primary

profession are more likely to depart when the MBO offer is chal-

lenged than other types of outside directors. Professional directors

are likely to be more sensitive to protecting future board seats than

directors who are currently working and have alternative sources of

compensation. We find only weak evidence that professional directors

are more likely to depart than other types of outsiders. We do not

find any evidence that departing outside directors are replaced by

new outside directors who may have better expertise in navigating a

contentious MBO offer. Nor do we find any evidence that when

directors depart, the board they leave engages in actions to auction

off the firm to the highest bidder. Finally, we report mixed results on

our tests regarding whether outside directors depart to avoid the time

required in a buyout. The overall weight of our findings suggests that

outside directors “flee”rather than “fight”on behalf of the interests of

shareholders.

Our study makes several contributions. First, we contribute to a

growing body of research on outside director departures. Fields and

ARENA ET AL.275