Jwrr.al of t inancial kconomro 4-i 11997) 239 250

Inside directors, board effectiveness, and shareholder wealth

Stuart RosenstcirP*, Jeffrey G. Wyattb

We investigate whether ins&z managers are added to corpara~c bc~rds for et5eiency Dr entrenchment purposes. Our e&:lmination d inside director appointments finds that the stock-market reaction to the annou ncemenl is significantly negative when inside direc- lors own less than 5% of the fir n’s common stock, sigrtifbntly pc&ive when their ownership level is berwecn 5% and 25%. and insignificantly di&renl from ZCTO when ownership exceeds 25%. These results suggest that the cxpaacd benefits of an inside director’s expert knowledge clearly outweigh the expected costs of managerial emrench: mcnt only when managerial and outside shareholder interests are closely aligned.

&rwdr: Corporate povcmancc; bard of directory: l&&z directors; Ownership struelure IEL cfa~G@ttitm: G32: G34: LZZ

The average corporate board has several inside managers as directors. This condition invites skepticism about the ability of 1 hard to IX independent in appraising managerial petformance. The charge of a board of directon,

We thank James &id&y. John Byrd. Ronnie Cia~~on. Mark Cmrr. Daniel Ddi. Raymond Goman. Robert Harris. Lloyd H&r. David Leonard, Anil Shivdasuu Mkbael Weisbach. and ezspe&Uy Jcrold Warner (she editor) ad Robert Parrino {the refcrc+), for beipfui armm~~~ts and suggfdom. and Maureen l%rrisb lor rrsurcb as&ancc Jeffrey Wyatt gratefuRy acknowkdges support from Miami University tbrougb Wrrrmei teaearcb funds and a ressucb leave for Fall 1992.

OMU4OSXj97~S15~ <c, 1997 Elsevicr S&ma S.A. All rights curved Pll s0304405x9700004-4

230 S. Rosenstein. J.G. W~ttJJoumal oj Financiot Economics 44 (1997) 229-250

however, is not only to monitor managerial behavL)r but also to ratify material corporate decisions and endorse corporate strategies. Inside managers are an important source of firm-specific information, and their inclusion on the board can lead to a more effective decision-making process (Fama and Jensen, 1983). Inside managers are also added to corporate boards to be evaluated as potential CEOs by other board members (Hermalin and Weisbach, 1989). Whether inside managers are added to corporate boards to enhance board dfectiveness or to entrench incumbent management teems is an open empirical question.

This paper examines the stock-market reaction to appointments of inside managers to corporate boards. Though Rosenstein and Wyatt (1990) find a positive stock-market reaction to the appointments of outside directors, their evidence does not imply that the appointment of an insider is harmful to sharehoiders. If corporations adjust board composition to respond, in the interests of shareholders, to new challenges, then inside director appointments may afso increase shareholder wealth. Our examination also investigates &ether the governance mechanisrms of inside ownership and board com- Qtiocb have nr~ inLc;nce on the stock-market reaction to inside director appointments.

Inside ownership plays an important role in the corporate governance litera- ture. Jensen and Meckling (1976) assert that inside ownership by managers is a powerful incentive for ensuring that the interests of managers and outside shareholders are do&y rdigned. Thus, for MS with sizable proportions of inside ownership, inside directors are likely to be appointed with shareholders in mind mitigating the negative consequences of managerial entneadunent. However, Merck et al. (1984l) maintain that, at high levels of inside ownership, insiders may have the voting power to secure their jobs and design their own compensation pa&ages In their study ofthe relation between firm performance andinsideomershipbyboardmembcrs,thelyfiadevidcnceco~s~twithtbt hypothesis that inside ownersbiphascostsaswellasheaeBts,Tbishypotheais suggests that, at high kve#s of inside ownership, some inside director appoiat- merits may reflect management’s freedom from market discipline rather than an ei%rt to alter board composition in a way that benefits outside sharehohkrs. Consequently, we expect that the stock-price efkets of insider appointments will vary across levds of inside ownership, and that the ‘most positive efR2cts eouki occur at moderate rather than high inside ownership levels.

The corporate governance literature also indicates that the composition of a board of directors is an important element in protecting the interests of shareholders, espe&My in transactions where the interests of managers and outside sha&okkrs may diverge. For example, Weisbach (1988) finds that aCEOofapoorlyperfbrmingsrmism~likeZytobe~iithefirm has a majority of outside directors. Sriekley et al. (1994) report a stock-price reaction to the adoption of poisota pills that is positive when the proportion

S. Rosenstein. J.G. Wyan~humal of Finatkial Economics 44 11997) 229 -250 231

of outside directors is greater than 0.50. and negative when the proportion of outside directors is less than 0.50. Further, Byrd and Hickman (1992) find that the shareholders bf firms bidding in tender offers are best served when the proportion df outside directors is close to 0.60. Consistent with this finding, Mace (1986) and West (1985) report that many CE& believe that the most effective boards are those that have a balance’ of inside and outside directors

If a balanced board is beneficial, then adding an inside manager to an outsider-dominated board will enhance shareholder wealth. At the other ex- treme, the apg>oiatn\ent of an insider to an insiderdominated board will be of little consequer;ce, 01 confirm that assertive outside monitoring is being avoided. Thus, we predict a positive relation between the stock-price effects of inside director appointments and the proportion of outside directors However, in subsequent tests, we also investigate the possibiIity that the relationship between abnormal returns and the proportion of indepe&nt directors is nonlinear. under the assumption chat any negative consequences of the appointment of an insider will be most pronounced at the point where the balance of power between insiders and outriders shifts.

Our examination of 170 inside director announcements that are not con- taminated by other iaformaiion finds that the average stock-market reaction is essentially zero. However, the average stock-prirx reaction is sigaifieaatly nega- tive when inside directors 06 ,. Iess than 5% of the fimt’s common stock. significantly positive when the iuside ownership level is between 5% and 25%, and insignificantly different from zero when inside owaersbip exceeds 25%. In addition, at moderate levels of inside ownership, ranging from 5% to 25% of the firm’s common stock, we find a positive relation oetween the stock-price &xts and the proportion of outsiders on the board. Interestingly, at both low and high levek of inside ownership, tbe stock-market reaction is unrelated to the propor- tion of outside directors.

Our interpretation of the stock-market reaction to appointments of inside managers to corporate boards is as follows. At low levels of inside owner- ship. the market infers that the Bddition of an inside director is likely to be an attempt to entrench existing management. either the incumbent CEO or a han- dpicked successo r. At moderate levels of inside ownership, where managerial interests are dosely aligned with those of the outside shareholders, the expected beuehts of the specialized knowledge provided by an inside manager outweigh the expected costs of incmased managerial entrenchment. In this situation. the move toward a bahnoed board is bend&t, with d new in&h being mofe

valuable to an outsider-dominated board. At high levels of inside ownership, where insiders may have t?te voting power to insulate themselves from the scrutiny of outsiders, it appears that either the costs of the appointments of&et the benefits, or our tests are not powerful enough to detect a stock-market reaction.

232 S. Rosenstein. J.G. IQattiJournal of Ftnunhtl Economics 44 11997) 229- 250

In the next section, we describe the data used to test’the economic hypotheses. Methods and results of our event study are presented in Section 3. In Section 4, we use regression analysis to examine simultaneously the relation between the stock-market reaction, ownership structure, and board composition. In the refu-ession analysis, we also add variables that measure CEO succession, firm performance, and size. Section 5 contains our conclusions.

We outline the sample selection procedure in the following subsection. We describe the sample firms and the board composition and ownership character- istics of the sample firms in subsequent subsections.

2. I. Sample selecrion procedure

WI: ~::*fi~t~‘;r ‘.*&e lirrctti, ajaJbistitr v*~~oisapraentorformeremplo~ of the firm. Our sample of 170 inside director announcements is drawn from the “Who’s News” section of the WaN Street ./auraaf ( WSI) between 1981 and 1985. Announcements involving the appointment of one or more inside directors and no outside directors are included in the sample. Further, all of the firms are listed on either the New York Stock Exchange (NYSE) or American Stock Exchange (ASE) and have returns reported on the Center for Research in Security Prices (CRSP) d&y stock mturns data base.

Tbe Annou ttcememt Date (AD) is the day tbe annouruztinent appears in tbe WAX which is often tbe first public disclosure of the board’s nominee. Although shareholders ostensibly ‘eiect’ candidates who have been ‘nominated’ by the board ofdirectors, ordinarily shareholders merely ratify the board’s selection of aboardmember.

Roard appointments often coincide with regular board meetings, wben an- nouaccments regarding eamin@cs, dividendr~ and other matters are made. We tw the following procedure to obtain announcements that are uncontaminated by explicit information. Announeemen ts are eliminated if:

(l)l%CWbO%NttWS-Mtkk6XXltiS~abOUtanothrraMporate pasoand~omefgg,orodrcractivity.Many~appointmentsartmade inoonjuacrioawithpnnnationsor~atop~tiveE3hiredFnmtoutPide the firm. Tbis elimination step results in an initial data set of 476 observations.

(2) The firm is mentioned in the Wall Street .kamuf index over tbe 3day period covering the day before through tbe day after tbe announcement (AD 1,AD + 1) lor any other reason, ineluding earnings and dividend announa+ merits. This elimination step ieaves 187 observations.

(3) There are any missing returns over the period (AD 170, AD + i 70). Miss- ing returns may indicate a halt in trading occasioned by a major event such as

S. Rosenstein. J.G. &atf; Joumol of Financial Economics 44 (IYY7) 229-250 233

Table 1 frequency of announcements by year for a sample of 170 noncontaminated announaments ol the

appointment of an inside director to tbe board of a NYSE or ASE corporation as reported in the Wall Sfreet JoomaJ ‘Who’s News” section over the period 1981-1985

1981 1982 1983 1984 1985 TOtA

Frequency 06) 28 (16.4) 35 (20.6) 37 (21.8) 45 (26.51 2s (14.71 170(100.0)

‘Newsdpromoj;iorrsdthendircctorsorothcrdfioMsdo~(#~ppuriatheannou~nl. Na otbcr newi about tbe directors or the firm. in&ding earning or d&&a&. appears in tk announcement c r in th T Wall Street Juurd J&r over the period from the day before to the day after the annon-t

merger or bankruptcy, and may result in changes to the board. Executing this step eliminates two observations.

(4) The proxy statement preceding the announcement is not availa& in the Q-Fifes. Observing this step eliminates 15 observations’

Table I shoti the frequency of announcemen ts by year and reveals that the frequensies are reasozabiy uniform across years. To determine tbe size of the sample firmq we measure the market value of each firm’s common equity as of two days before the WS I announcemen t (AD-2). Tab& 2 indicates a broaj range of market values of co. lmon equity among sample firms, ranging from 5237 million to SlQ15 billion. Mean and median market v&es of S804.9 million and $330.6 million, respectively, are quite similar to those from Rosen- stein and Wyatt’s (1990) noncontaminated outside ditector sample ($867.4 million and s299.6 million, respectively).

2.2. Cbmcteristics ofneu~~ qpointed directors

The WSJ annou ncement often states if a newly appointed director replaces an existing member of the board, leaving the rite of the board intact, or if the new appointment represents an expansion of the board. When the WSJ announce- ment omits this information. we determine tbc effect of the appointment on the

‘We find that tlr i&rmation in 46 (27.1%) dour WSJ armou- tshadbuadixdosedintk preabdiag pxy ,suuemcmt. For tbesc obwvations, wr ccnnpa~ rest&s ttxiag tk prrviourly &fined WSJ an-t date with results For which tk -lda~hdefiaedasIheproxy mailing date and tbc following trading day. and ako to a xampk m which tkc annoueammti are aen:ttul. la both tbc cent study and in subxequcnt rrgrrsriocri we tind that nmtts are net quatiudrdyckanebdbyuEingtbcproxy~~bLcEndth:~tradi~~drlckw~crscs where the &XI d-n appeared in the proxy statanat Woweve:. kv& Oc significance across su~int~ewn(studyandiatht~anmonpwrormcad~thtWSIdrtcu;tbc evenIdatebrnllan wuacencats. We condude that at IeaS smx market pxrtkipank3 ma13 10 Ibe W.SJ an-t even when the inknation has been pnviously disclosed.

234 S. Rosenstrin. J.G. l+att!Journal of Financial Economics 44 (1997) 229 250

Table 2 Statistics describing the distribution of market values of common equity for a sample of 170 noncontaminated’announcements of the appointment ofan inside director to the hoard of a NYSE or ASE corporation as reported in the Wall Street J(mrna/ “Who’s News”‘&tion over the period 1981- 1965

Market values (S millions)

Mean 804.86 b!a.lian 330.511 S:andard deviation 1433.38 Minimum 2.31 Maximum IOf 53.36

‘News of promotions of these directors or other officers do not appear in the announcement. No other news about the directors or the firm, including earnings or diCdends. appears in lbe announcement or in the \+‘rlf/ S~V-I Joumu! ir&n oter the period from the day befonz to the day .fter- tbc En*’ sttncement.

size of the board by examining proxy statements. Because our UrnpIe includes only annouucements where an inside director is named to a board, the propor- tion of insiders on a board can be increased in two ways. Firs& if the announce- ment results in expansion in the size of the board, the proportion of insiders will increase. Eighty-two (48.2%) of the announcemen ts in our sample result in board expansion% !Secon& if the newly appointed director replaces an existing outside director, the proportion of ins&s on the board will also increase. In our sample, 26 (15.3%) announcements involve the replacement of an outsider by an insider (Panel A of Table 3). Sixty-two announcemen ts (36.5%) are replacements of one insider by another. These announcements result in no elmup in the SLr of the board or its composition, but they are still noteworthy because the occasion of a replacement is an opportunity to appoint either an inside manager or an outsider.

WC observe that one insider is appointed in 152 (89.4%) cases, while two insiders are appointed in the mmaining 18 (10.6% j. Announcements for two insiders may su t a valuecnhancing succession contest or an attempt by the incumbent CEO to ‘pack’ the board with insiders. All but two of the new directors in the entire sample are current empioyees.

We attempt to differentiate among the new directors’ positions within firms, finding that 21 (12.4%) appointments involve presidents or chief operating ofkers (COOS), 46 (27.1%) are subsidiary or division CEOs, and 103 (60.6%) are viceprkdents (Panel B of Table 3) Panel C of Table 3 shows that 95 (55.9%) of the new directors have been with the firm for at least five years and 42 (24.7%) have been with the firm for one year or tess. It is conceivable that some of these new employees have been brought in at the board’s behest

S. Rosenstein. J.G. Wyait 1 Journal o/Financial Economics 94 (1997) 229.25il 235

Table 3 Characteristics of a sample of 170 nonconraminated’ announcements of the appointment of an inside drrector to the board of a NYSE or ASE corporation as reported in the Wdl Street Jwrnal ‘Who’s News” section over tbe period 1981-1985

A. Ellkct of the akou ncement on the exlslmg board

Replacerinsider Reptacesoutsidct Expands board

Total

8. Appoinmems of insiders by position within the Cm

Presi&nt or cm Subsidiary or division CEO vice-praident

TOLsl

C. New inside dimcms’ tenure umkin the firm

slyear 2-4 yaws 25yeats

Tolal

n (%I)

62 (36.5) 26 t 15.3) 82 m-21

170~100.0)

(I (%)

21 112.4) 46t27.1)

103 160.6)

17ofltm.O)

A PA)

42 (24.7) 33 (19.41 95 (55.9)

no (Kno)

‘NearsoCpranotionsoflbcvdirranrscnolhcrdfiacrrdomc~iarhcasmnraaarmt. No other news about tk direclors ur the Arm. indwiing ea37iings or divide&s. appears ia the atmoMcrment or in Ihe Wdi Street Jownd Me \ ova Ibt p&xi from the day before (0 Ibe day after the anaounanunt

and are expected to function as virtual outsiders in monitoring the firm’s pXfOfTM~~.

2.3. Data OR ownership struck .tnd board composition

We believe that board composition before the annnunament is important in determining the stuck price reaction to the announcement of an inside director appointment. We create three categories to classify directors. I&SC categories are: insider, gray outsider, and independent outsider. Using proxy statements, we classify past or present employees of the firm as insiders. Gray outsiders include famiiy members of insiders, attorneys whose firms represent the firm, investment or commercial bankers whose firms have relationships with the firm, consultants to the firm, and directors who personalily or through their employers have substantial business dealings with the firm We classify a director as an

236 S. Rosenstein. J. G. Wyotr/Journai of Finunciol Economics 44 (1997) 229 -250

Table 4 Characteristics of variables describing board composition, ownership structure, the imminence of CEO succession, and prior performance for a sample of 170 norrcontaminated’ announcerrmnts of the appointment of an inside director to the board of a NYSE or ASE corporation as mported in the Wall Street Jounml “Who’s News” section over the period 1981- 1985

A. Percem ownership by directors and other large blockholders

Mean Med. Sd dev.

lnsidets 8.24 I.98 13.45 Gray out8idersb 0.88 0.00 4.15 In dependent outsiders 3.66 0.16 8&t other block- 8.52 0.00 13.38

Total 2I.30 15.12 21.10

B. Board composition hefore the announcemerit

Mean Med. Std. dev. -.

Insiders 4.35 4 2.41 LI.,, mtu3r. .- 1.9’ I t.tM independent oucsrders 5.711 6 3.04

Total I I.10 IO 4.02

Min.

0.01 0.00 O.f@ 0.00

0.03

Min.

I 0 a

4

Max.

63.9 1 41.00 52.99 79.10

97.33

Max.

I3

2i

33

C. CEO suazssion vatiabks

M-It Med. Std. dev. Min. M&%X. -

CEO’s age 57.90 58 7.29 38 76

n (%) I) (%)

CEO‘s tenure subsequent I;3)ears >3ycsn 10 the aRnou-I 65 OK2%t 105 (61.8%)

n (%I n (%)

CEO’S tenure as or the <syears r5yan an-t 77 (45.3%) 93 (547%)

D. Stock price performance in the prior performance periodd

Mean MCd. Std. dev. Min. Max.

Prior pe- - a.0033 - O.thI3 I 0.2414 - 0.398 0.7657

*Ncwooipnrrnotiomol(brsedindorsorotheroliicnsdocrDo(~rinthean~~l NoothnacwsaboutthcdirrcronortheBrm,iadudingeorniagordivida#ialppearsia1Bc Pnnoun*taartorinthcWpnStnrtlarrnal~xovatbcperiodlromthedrykCoretotbe6y afiertkaanoruaawnt’ bOutside direuors who may bare some relationship with the firm other than their pot&oar as dimctonordrudrdkrr ~?fOXy-tSdeaoce-ochertbon managementafuidincto!swhohoidatws% ofttselimfsshal?a. ‘PriOOperforrrullais~wonafa~re(urnsovrrtbcpcriod~~170drrsbeFwctbe amlormmmen1datearrdestdillg21dapheforr!theanrunttKemen tdate(AD17O.A~ZtkAtmomtal ntum is as the firm’s market-adjusted return on day AD-t. 48.8% of the cumulative returns are positive.

S. Rosenstein, J. G. Wyrrtr / Journal qf Fi ttanciaiEcorwmics 44(1997)229-250 237

independent outsider if the director’s only business relationship with the firm is as a director and he has no family relationship with any top manager. Substan- tial shareholders, as noted in the proxy statements, who have no other reSation- ship to the firm are also classified as indepe&ent outsiders.

We use the proxy statements to obtain information about share ownership among directors and other hoiden of 5% or more of the firm’s stock. Panel A of l-able 4 shows the distributions of shares heId, by owner types. Holdings by inside directors average 824% of each sample firm’s common sto& although the median is just 1.98%. Holdings by gray outsiders (mean =0.88%, median = 0.00%) and Mqendent outsiders (mean = 3.66%, median = 0.16%) are much lower. Owuemhip by other blockholders who are not on the board averages 8.52% of the firm’s common stock; however, the distribution is highly skewed with a meducr of 0.00%.

Panel B of Table 4 shows that the average board has 11 .I0 members, with 4.35 insiders, 0.97 gray outsiders, and 5.78 i&epe&ent outsiders. These numbers on board composition ate similar to those found in Weisbach (1988). We ahio note that the overall proportion of indepuubt outsiders in the sample is 51.8% before and 47.6% after the anno UQcemeQts. 1-t out- siders numeGcally dominate 103 (60.1%) boards More and 88 (51.8%) after the almoll maeme~ts. Hence, 15 an- ts result in a shift ia nume&al domination from independcat -utsi&s to insiders. in the event stlrdy, we examine the stock-market reaction for these 15 cases+ under the assumption that the negative consequences of inside direcUr appointiits win be most pronoumxd when the proportion of insiders imxases fromlessthantogreater than 50%.

We also helieve that the ~ofCEOsucce&onand6rmperformance may be dated to wealth 4dikcts associated with inside director appointments. Pad C of Table 4 presents statistics on the CEO’s agp, tenure subsequent to the insider annou Qcement,andteaureasdtht! -t,PanelDofTabIe 4 describes the distribution of abnormal returns over the 1 soday trading period ending 21 days before the announcement (AD-170, AD-21).

3, Eve.M~-d

We describe the methods for measuring abnormal returns in the following subsection.Wetsenprescatresultsforthtfunsampkandforsubsampltseat- egor+zedbyinsideownershipandboardaqX&on b&rethean-t

3.1. Etwadymetlto&

We examine abnormal returns over the 191-trading-day period beginning 170 days before the announcement and ending 20 days after the announcement

238 S. Rosenstein. J.G. Wyatt/Journal of Financial Economics 44 (1991) 229-2.50

date (AD-170, AD + 20). We then divide the total event-time period into the prior performance period, which ends 21 days before the announcement date (AD-l 70, AD-21), and the event period (AD-20, AD -t 20). Our analysis focuses on the two-day announcement period starting the day before the announcement is made (AD-l, AD). Abnormal returns over this two-day period represent changes in firm value resulting from the unanticipated reaction to the aanounce- merit of an inside director appointment.

We measure abnormal returns using the market-adjusted returns method, with the CRSP equaJJy weighted index serving as the market index (see Brown and Warner, 1985). This method is used to ensure that abnormal returns in the prior performance period, which are used as explanatory variables in subsequent cross-sectional regressions, are independent of announcement-period abnormal returns. If we were to use, for exampk, the alpha from the market model as a measure of prior performance, anaounce- ment-period abnormal re!ums would JX negatively related to prior perfor- mance, evfql if the true relation iq zerl Event study results u&g the market LKI&) or tne sizc-atlljusted returns method are essentially identical to those rcpod.

For tests over the two-day announcement period (AD-J, AU), we cumulate abnormaJ returns in the prior pcrlormance pried into 75 two-tradingday abnormal returns to obtain estimates for the standard deviation oJ‘ each secur- ity’s return. la addition to the traditional r-statistic, cl. that uses the prior performance period standard deviation to standardize abnormal returns, we account for potential variance shifts on the annou~~xmtn t date by using a ‘standardized cross-saztional’ statistic tz (see bti et al, 1991). We also use a nonparametric statistic, tlr that compares the ranks of abnormaJ returns over the two-day interval (AD-l, AD) to the ranks of abnormal returns over the 75 two-day priods in the prior ~3erformamze period (Corriulo, 1989). Signi& cance tests using f2 and 13 an essentially identical to those using tl. and arc not lqxmeb

To gain insights into how inside ownership and board composition before the annou ncements atkct the stocJ+market reaction to insider appointments, we examine abnormal returns for s&samples based on these variables. Jnside ownership is dassified using Mar& et aJ.‘s( 1988) categories of less than 5%, 5% to 25%. and greater than 25% inside ownership. Board composition is cJassified using Weisbach3 (MB) categories of Jess than 40%. d&60%, and gteater than 60% in&pendent outside directors.

3.2. Event study resvlLr

FuJJ-sampk results are pracnted in the lower right-band corner of TabJe 5. For the entire sample, tJte average abnormal return is essentially zero (abnormaJ

S. Rosenstein. J.G. &OII: Journal o/Financial Economics 44 (1997) 229.-250 239

Tatle 5 Aver;* abnormal returns (AARs) and test statistics over tk two-day annou noanent period for a sample of 170 noncontaminated’ annou acements of the appointment of one or more inside director& to tk board of a NYSE or ASE corporatic& as reported in the Wall Street Jamd’Whok News” section over the period 1981-1985. Tk subsampbzs are categorized by the percentage of inside ownership and perccatage of imlcpenht, outside dircdors before tk announcement. T-statisti& rtc in parentbesis. Tk numkrs in brackcfs repremt tk number of obscrvstions in

encb ategoty and tk nwnber of positive obscfvations m each ategory, rcspccfivdy

Inside -hip

Pcmntagc of indejmcknt ouIsifiedimors hdoretk < 5% -1 (4

<40%(l) o.OiJ12 10.14) 115.7)

40-60%’ (2) - Mosfi {- 1.31) c47.24)

> 60%’ (3) ‘- O.fm~ (- Ll9V [Sl.l8]

Mpnmw=d - o.fxx5 iadrpcndcatoutside 4 - zo7)c dilccIm [I 13.493

S--25%’ (a)

O.OOO).s (0.38) [15.8]

0.0130 t1.31t [l7.10]

0.0382 t3.06P 17.71

0.0127 (2.39f, [39.25]

> 25% K-1

0.0082 f - 0.29) [ll.S]

0.0011 ( - 0.081 c5.23

- 0.0023 f-0.19) v-11

O.fX61 I - 0.34) I@.81

Allkwlsof inside oyntmhip

OstO28 to.161 [41.2aJ

- OmM I - 0.20) w. Ml

- 0.0039 (- l.Oll W.W

- o.oaJ9 ( - 0+65) [lXX82]

240 S. Rosenstein. J.G. WyattiJoumul o/Finonciol Economics 44 (1997) 229.-250

return = - o.ooo9, I* = - 0.65). This result suggests that, on average, there is no benefit or signal associated with the appointment of an inside director. We conclude that any gain in board effectiveness or efficiency is countered by the potential costs of managerial entrenchment.

The right-hand column of Table 5 indicates that abnormal returns for all levels of inside ownership are not significantly different from zero for the three groups based on the percentage of independent outside directors. However, the bottom row of the table shows that abnormal returns are significantly negative for inside ownership of less than 5% (abnormal return = - O.ooS5, 11 = - 2.07). signillcantly positive when inside ownership is between 5% and 25% (abnormal return = 0.0127, tl = 2.39) and insignificantly different from zero when inside ownership exceeds 25% (abnormal return = 0.0051, 1, = - 0.34). Further, the hypothesis that the abnormal returns are jointly equal across ownership groups is rejected at the 0.05 level. A posteriori tests indicate that the average abnormal return for the low-ownership grou; (less than 5%) is diRerent than the average abnormal ri*tum for tbe moderate-ownership group 0 )- ::“l’u

Table 5 fur&r reveals that the dilkrences in abnormal returns across inside ownership kvck arc statistically significant at the 0.10 kvel for balanced boards (Row 2) and at the 0.01 level for boards with greater than 60% outsiders (Row 3). These results appear to indicate that adding an insider to an outsider-dominated board is more consequential to the firm (or less anticipated) than adding an insider to a board already amtmlkd by insiders

With respect to dilkmnces across the three groups based on the per- centage~ of imkpmdcnt outside directoK abnormal returns are signi6cantly different from each other only for the level of inside ownership between 5% and 25% (Column B of Tabk 5). This result suggests that, when the interests of managers and outside shareholders are well aligned through moderate inside ownership, the move toward a balanced board is ben&cial, with a new insider being more valuabk to a board numerically dominated by out- siders.

We also address the conjecture that any negative consequences associated with the appointment of an insickr will be most pronounced at the point where the balance of power shifts from outsiders to insiders. Wbik not reported in the taMe, we tind that abnormal returns are insignifkantly dill&at from zero lot the 15 cases wbem the percentage of insiders increases from kss than to greater than SO?4 (abnormal return = - O.QO27, tl = - 0.18). In addition, we find no sign&ant difkrence in atiormal returns regardless of whether the inside appointment is a replacement for an inside or outside director, or an expansion of the board. We continue this investigation in the next section where we use multiple regression to test simultarkously the relation between abnormal cc- turns inside ownership and board composition.

S. Rosenstein. J.G. ~vatr~Jouma1 of Financial Economics 44 (1997) 229-250 241

4. c-1 relpesciolt aaalysi5

Regression analysis allows us to test for separate individuai effects and nonlinear relations in our model, and to add control variables to our mode). The following subsections describe our choice of variables and present the results.

4. I. Variable seleciim

In addition to in+e ownership and board composition. our regmssion analysis allows us to .\ccount for CEO s-ion, firm performance, and firm size. We examine CEO sucGession because insiders may be added ‘to corporate boards to provide for an orderly succession to CEO. We anticipate that the stock-price reaction to these appointments may differ from thoS where suc- cession planning is not the motive. Firm performance is included in the regres- sions because poorly performing firms may add insiders to reduce the fikdihood of criticism and remediaf action by outside directorq2 while well-performing firms may reward valuable inside managers with board seats- Controlling for size is importanl in this study bar;au* the prop0rtiorr ul it&k ownership is correlated with our proxy foi firm size (p = - 0.39).

4.1.1. Onwemhip mriables Table 6 presents four regressio,t models. For each regression, the dependent

variabk is the two-day abnormal return. Regression 1 uses the full sample of i 70 appointments and a dummy variable speci6cation to categorize low (less than S%), moderate (5% to 25%), and high (greater than 25%) levels of inside ownership as in the event-study (Table 5). Regmssions 23, and 4 use subsamples based on the three kvek dinside ownership. These s&samples are analyzed in order to explore whether the relation between board cornposiTion an 4 abnormal tetums is d&rent for the three keels of inside ownership.

In Regression 1, the dummy variable INOWNit5 takes on a value of one for the 113 sampie firms where inside directors as a group hold less than 5% of the common stock. The dummy variabk iNOWNko25 takes on a value of one for the 39 sample firms where inside directors hold between 5% and 25% of the 6mfs common stock, and the variable INOWN@ takes on a value of one for the 18 sample 6rms where insiders hold more than 25% of the 6rmS stock- In this regression, the intercept is suppressed to permit in&sion of all three inside ownership dummy variabks; hence, r-&i&s test *he hypothesis that the dummy variable coefficient is equal to zero.

2For P dbEusion of this conjectutc, see tk muncttabk dixussion en the roe of corporate boards in the h.wnal of Applied Corpmue finat& 2.5 (3) Fall t9%!, pp. 58-77.

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244 S. Rosenstein. J.G. WyatriJmrnal t$Financial Economics 44 (1997) 229- 250

4. I. 2. Board composition In Table 6, the independent variable PEROUT is defined as the proportion of

independent outside directors on the boird before the announcement, less the average proportion across all firms in the sample being analyzed. A quadratic specification is used to determine if abnormal returns are most pronounced when the ‘balance of power’ between inside and outside directors shifts.

In addition, we include a dummy variable that takes on a value of 1 if more than one director is appointed (MULTj. For these 18 announcxtnents, the decrease in the proportion of outsiders on the board is greater, ceteris paribrrs than when only one inside +ector is appointed.

4.1.3. CEO succession In examining the influence of CEO succession on the wealth effixts associated

with inside direetor appointments, we believe that the variable of interest is the imminence of sueeession. Our ex ante measure of the imminence of suaxssion is the CEO% age as of the previous proxy statement, kss the average age of all C EOS s tire tinqie h& auqzed tCEOAGE). Pane) C of Table 4 shows that the average CEO in the sample is 57.9 years old. Whik not reported in Tabk 4. we observe that CEOs are 64 years of age or older in 35 (20.6Ohj cases.

An interaction term between CEOAGE and the variabk denoting muRipk appointments (NULL) is added to determine if multipk appointments are treated difkrently lor okkr CEOs. This variabk may capture the positive implications of a competition to repkee the CEO. Alternatively, it may indkate the negative e&ets of an attempt to *pack’ tbe board with insiders during tire CEO’S remaining tenure.

We also attempt to measure ex psz the imminence of CEO suaxssion, recognizing that the CEO’s age may not capture this construct. We assume that, when an inside director an mmcement is made, the market amesses the likeli- hood and timing ofa CECYs departure and possibk suecession by the new inside director.

‘The ex pr variables include dummy variabks that take on a value of I if the CEO both resigns and kaves the board within three years of the announcement (CEOLEFTj, if the CEO resigns and remains on the board for at kast three years after the announeemen t (CEOBD), and if the new inside direotor becomes CEO within 3 years of the announoemen t (DIRCEO). Panel C of Tabk 4 shows that 65 (38.2%) CEOs have stepped down within three years of the announee- ment. of these, 25 (14.7%) remain on the board.3 In 16 (9.4%) eases, the new director becomes CEO within three years

S. Rosenstein. J.G. Wjwtt/ Journal of Financial Economics 44 (IYY?) 229 --250 245

41.4. 0th~ variables We estimate firm performance prior to the announcement. The variable

PRIPERF is defined as, the cumulative market-adjusted return over the period (AD-170, AD-21’). Panel D of Table 4 shows that prior performance, on average, is close to zero. The average cumulative abnormal return is - 0.38%, and 48.8% of the cumulative returns are positive.

Finally, the variable LNS’IZE is measured as the natural logarithm of the ratio of the market value of a firm’s equiiy and the average equity value for firms in the sample being analyzed. We use weighted least-squares qression to account for hcteros~tedasticity across firms, with each observation weighted by the inverse of the standard deviation of two-day abnormal returns over the prior peiformance period.

4.2. Regression resuh

Tabk 6 presents four regression models, which include independent variables for board composition. inside ownership, CEO success~ ‘on, and several control variables. We discuss the regressions as a group, focusing on each type of i&pendent variable individually.

4.2. I. tlwvmdp and board cwnlJasilirur in Table 6, the regression res&s mirror the univariate tests on inside owner-

ship and board composition presented in the event study (Table 5). In Regres- sion 1, the coefkient of INOWNSto25 (O.Oi46, t = 2.46) is sign&antly positive, while the coeftidents of INOWNM (- 0.039, I = - 1.09) and INOWNgtZS (OIMl76, f = 0.8zt) are insigmficantly d’lTerent from zero. In addition, the hypoth- esis that the 4xefkknts of the three inside ownership variables 8ce equal is reject4 at the 0.01 level.

Adding further support to the event study results, the boar&composition we&ients are not significantly different from zero in any regression except R~~~x&uI 3, which uses the subsample based on moderate Levels of inside ownership. In Regression 3, abnormal returas are positively related to the proportion of im@en&nt outside directors at the 0.10 ievel (coe&ient of PEROUT = 0.0721, t = 200, p-value = O.OSS: In a regreuioa faot presented) that omits (PEROUT)2, the coefB&nt of PEROUT is significantly positive at

deparme mte is 27.0%. whik krr CECh 63 year+ of age or youngx the mle is 12L2%. a enl difterence at rhf ‘0.01 led. The departure rate for younger CEO5 is &se to the actual mw d&out 12Y~ report4 by Warner d al. (lS88) for top vt changes, and is Jylch lower tban CEO umiover rates reported in smdies oftinacid di&ms(Gilson, 1989,52%. proxy contests (tkA&o and DeAlgeb. l%39.30%). and negotiated black tmdes (Uy and HoMenres+ I!%% 45%b Hencctitappeanthat~dthcinsidaappoinrmentsiaoursunpkarenot~~witb dramaticcorpomrcevcnts

246 S. Rosenstein. J.G. Wyatt/Journal of Finuncial Economics 44 (1997) 229-250

the 0.05 level. The results suggest that, at moderate levels of inside ownership, the benefits of the new director’s specialized knowledge outweigh the potential costs of entrenchment, especially when the insider is added to an outsider- dominated, board.

4.2.2. CEO succession With respect to CEO succession, for the full sample (Regression I) the ex post

CEO successian variabks as a group are significant at the 0.05 level. Further inspection of the subsampk regressions reveals that the ex post suazession ~~ariabks as a group are signifkant at the 0.05 level only in Regression 2 where inside ownership is less than 5%. In Regression 2, abnormal returns are negatively related to the CEO’s age (coeflkient of CEOAGE = - O.UOlO, t = - 2.31). suggesting that at low levels of inside ownership, the appointment of one inside director by an older CEO is associated with an attempt at entnn&ment. This result is consistent with the ‘horizon problem’ hypothesis in Dechow and Sloan (1991), which states that CEOs are more likely to engage in CdIt~~fTICh:b~I~t ATi?.‘T;tzj 7 . tbley ~kpro;i~h retirement. An altermative explanation is that the appointment of an insider signals to outside shareholders that a valuable CEO will soon be stepping down.

Regression 2 also reveals that tht coc&ient on CEOLEFT, which takes on a value Oc one for observations where the CEO both Raves the firm and the board within three years of the announcement, is marginally positive. The ctxfhcknt on CEOBD, which takes on a value ofcme when the CEO resigns as head of the firm and stays on as a director, is insignitkantly negative. The test that these two coetR&nts are jointly equal is rejected at tbc 0.01 kval. This result is consistent with the notion that an objective appraisal of the new CEO’s performance by other board members is likely to be inhibited by the pmsence of the incumbent CEO. Alternatively, this result may indicate that appointments that appear to temporarily increase the proportion of in&k directors arc viewed more positively than those that result in a pennammt inmase.

Regression 2 further indicates that for low inside ownership firms, tbe coeRic- icnt on DIRCEO, which takas on a value of one when the new inside director becomes CEO within three years, is signScantly negative. While this result su that the likelihood of perpetuation of the present management team is viewed negatively, an ahemative intcrpmtation is that the announcement sig- nals that a valuabk CEO is pknning to step down.’

We investigate the throng negative reactions associated with the firms, in the low-ownership group, where the CEO remains on the board after stepping

‘The co&Went dDHtCE0 is ah siwtfy negative at the @IO level in lkgmsion 4. However, we hesitate to interpwt this msuk as DIRCEO takes on a V&BC of otte fur only two thns in &ii

*mpk.

S. Rosenstein, J.G. Wptt/Joumal of Financial Economics 41q (1997) 229-250 247

down as CEO (CEOBD = 1) or the new director becomes CEO within three years of the appointment (DIRCEO = 1). Wall Street Journal index citations indicate that of the 23 firms in one or both categories, 10 either are in financial distress or have reported losses during the year of the insider appointment. Although these announcementsare uncontaminated by other news, several have large negative announcement-period abnormal returns (for example, Roper Corp. (CEOBD = 1 and DIRCEO = 1). -0.1049; Armco Steel (CEOBD = tlq -0.0834, Navistar (CEOBD = 1). - 0.0515; Pan Am Corp. (DIRCEO = I), -0.0512). Apparently, these anno uncements am being taken as signals that management is attempting to insulate itself from the scrutiny of outside direc- tors or that managerkl change is being resisted in these poorly performing companies. Alternatively, the large negative returns may reflect the difkulty that these ailing firms have in recruiting outside guidance.

4.2.3. prior perfonnonc~ The subsampk regressions also indicate that the relation between abnormal

returns and prior performance (PRIPERF) is signifkant only for the moderate and high ownership s&samples. In Regressions 3 and 4, abnmnal returns are positively related to prior performance at the 0.05 level. These results suggest that, for firms where managers ate firmly in control through their inside owne&ship, the appointment of an inside dkector is a signal to outside shareholdm of managerial continuity for strongly performing fimq but that serious change for the better is not likely for poorly pe&rrning firms

4.2.4. .Smmmy ofaabsaqle reqpvssion evideme Regreskns 2-4 suggest that ownership structure is a central factor in deter-

mining whether the appointment of an inside director is viewed as entrenching incumbent management or improving managerial e&kncy. In the low inside ownership group. where agency problems are presumably greater &au those that exist at higher levels of inside ownership. wealth efkts are related to the imminence of CEO suazession or some other characteristic proxied by the CEO’s age, as well as to the ex post succession variabks as a group. We conclude that inside director appointments that appear to eutrench management are

negatively, rega@ess~.of board composition wore the announcement. In the moderate inside ownership group (525%), where inside ownership reduces agency probiems hetween managem and outside sharehokkrs, it ap- pears that a balance of inside and outside directors is desirable. with a new insider being more valuable for a board that is outsiderdominated.

4.3. Aiidiriosial s~~cations .

Regressions similar to those in Table 6 were run by addrng or substituting other independent variables or functional forms. For example, with respect to

248 S. Rosenstein. J.G. l++aotrfJoumal of Financ-ial Economics 44 (1997) 229-250

ownership structure, piecewise linear or continuous specifications do not ex- plain as much variation in abnormal return.; 3s the dummy variable specifica- tion presented in Table 6. Alternative measui& of managerial ownership, such as holdings by all directors as a group, yield simiiar though weaker results to those presented. In addition, variables measuring ownership by outside direc- tors and 5% or greater blockholdings by outside shareholders, as reported in proxy statements, are not significant in addition to or as substituter for our inside ownership variables.

We find, for the full sample, no relation between board composition and abnormal tetums, using numerous dummy variable and piecewise linear speci- fications. In addition, dummy variables that account for whether the inside appointment is a rep)aaxnent for an inside or outside director, or an expansion of the board, are not significant. Finally, we find no significance for a dummy variable that takes on a value of 1 for the 15 observations where numerical domination shifts from outsiders to insiders. Thus, we cannot detect a kvel of board composjliun JL which the stock-market reaction indicates a shift in cnntrq;.

With respect to CEO succession, the CEO’s tenure as of the announcement is also considered. Tenure may give some indication of the CEO’s power relative to the rest Oc the board under the assumption that CEOs consofidate power only afker some time in &ice. Panel C of Table 4 shows that, for 93 (54.7%) firms, the CEO has beld that position for at least 5 years’ We find, however, that tenure is not sigalficaatiy related to abnormal returns, either in addition to or in pIace of CEOAGE. Finally. neither the new director’s position within the firm nor his tenure is significantly related to the wealth e&c& of inside director appointments

This paper examines the stock-market reaction to appointments of inside managers to corporate boarda Our examination of 170 noncontaminated inside director anao tllxmmtstthat thePveragestoek-marka -isdoseto zero. This result is in contrast to evi&mce on outside ditector announoemeDts. Using similar event-study m&to& and sampliig director annormazments over the same time period, Rtmmtcio and Wyatt (1990) find a positive stock-market reaction to outside director appointments.

The stockpric2 e&cts of i r appointments, however, vary significantly amiss Iweb of inside ownerships The average stock-price reacbon is sietly

sIu~ roost proxy staltmeots give the CEO’sexact ~~NUC, a sizable minority simply state that tbcCM)&aokcnia~prcacntposicionforfi~ormanyears

S. Roserutein. J.G. Wyatt j/ Journal o/Financial Economics I I (1997) 22% 250 249

negative for firms whose inside directors own lebs Char 5% of the firm’s common stock and significantly higher and positive when th own between 5% and 25%. Further, the relation between stock-price effect and firm characteristics such as board composition and the imminence of CEO succession is quite different for the two inside ownership groups. In the low-ownership group, board composition before the announcemen t is not a factor, but the stock-price e&cts itre negatively related to the CEO’s age. This result suggests that an older CEO may appoint an inside director to help protect him from the scrutiny of outsiders during bis remaining years with the firm.

In the moderalc4wnership group (5-Z%), where &her agency problems betwm sharehokicrs and managers are low or where management is firmly in control, CEO s-ion variables are unrelated to valuation e&c&. In tbese firms, the stock-market reaction to the addition of an insider is positiveiy related to both the proportion of outside directors on the board and the firm’s prior performance. These resufts suggest that managerial ownership dominates board composition as ata ef%ctive toof for aligning managerial and &a&o&r inter- ests. In conclu&n, the benefits from the expert knowledge supPried by a new inside director outweigh the costs associated with managerial entrenchment oaly when managerial and outside shareholder interests are dosely aligned.

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