In a new paper, we explore the relationship between co-opted directors and firms’ anti-takeover provision (ATPs). We argue that the relationship can be viewed through traditional agency theory, which highlights the potential conflict of interests between firm managers and owners. Managers, as self-interested economic agents, may not always make decisions that maximize firm value but instead seek personal gains, often at the expense of shareholders. Co-opted directors, those who are appointed after a CEO assumes office, can exacerbate this agency problem. The number of co-opted directors has been rising in U.S. firms since enactment of the Sarbanes-Oxley (SOX) Act in 2002. The number of independent but co-opted directors doubled in firms that did not have a majority of independent board members at the time of SOX adoption. Currently, co-opted directors constitute about half of the board in U.S. firms.
Co-option can weaken a board’s capacity to effectively monitor managers because of their conflict of interest with CEOs. In addition, co-opted directors attend fewer meetings and engage in fewer discussions on key agendas, eroding boards’ capacity to offer essential advisory and supervisory services to managers. This provides corporate executives with more room to exercise control over the firm’s resources. Insufficient oversight combined with increased managerial discretion can lead to self-serving behaviors by executives, potentially decreasing the firm’s value. Such firms are vulnerable to hostile takeover. Since most successful takeovers are associated with the removal of top executives, incumbent managers tend to create barriers to avoid a potential takeover threat. This requires support from the board of directors. Co-opted directors are likely to be more lenient towards management in supporting the adoption of ATPs.
Co-Opted Boards and Anti-Takeover Provisions
In our paper, we analyze 5,585 firm-year observations for the period 2012–2022 and show a significant positive relationship between board co-option and the adoption of anti-takeover devices. Firms with co-opted boards have 0.8 percent more ATPs than their counterparts without co-opted boards. A 1 percent increase in the ratio of co-opted board members to total directors is associated with a 1.4 percent increase in anti-takeover index. Moreover, longer-serving co-opted members are more likely to implement defensive mechanisms against takeover threats. Regardless of whether co-opted directors are independent or not, they tend to dilute the strength of discipline from forces – like takeover threats – outside the company. Our findings underscore the pivotal role of board composition in influencing a firm’s approach to anti-takeover policies. A higher level of board co-option is associated with an increased likelihood of adopting anti-takeover devices, implying a potential internal governance deficiency in firms with co-opted boards.
We further find that the effect of co-opted boards on ATPs is more pronounced in firms where senior executives’ compensation is higher than the industry average. This suggests that managers adopt ATPs to protect themselves from external disciplines and steer firms’ resources for their benefit. In addition, the reciprocal relationship between co-opted directors and firms’ executives may lead to higher compensation for directors as well. In line with this argument, we show that the directors create a benefit, through higher compensation, by co-operating with managers to adopt more ATPs. This finding underscores the dark side of the co-opted boards. Firms with entrenched management and a significant number of ATPs are generally worth less, suggesting that management prioritizes personal interests over those of shareholders. We support this hypothesis, showing that the impact of co-opted boards on ATPs is higher in firms with low financial and market performance.
How to Mitigate the Effect
In theory. firms with strong corporate governance are less likely to be the target of a takeover threat, resulting in adoption of fewer ATPs. Good governance can, to some extent, be a substitute for market discipline because one strong governance mechanism in place diminishes the effectiveness of another mechanism. Firms with strong governance tend to be less attractive to potential hostile bidders, mitigating the need for ATPs. Supporting this proposition, we find that governance quality reduces firms’ adoption of ATPs. We further show that board gender diversity reduces firms’ ATPs. Diversity on boards is consistent with good corporate governance, and the different perspectives it provides can improve the quality of information the board receives, and the advice given to managers. In addition, female directors are more likely to hold CEOs accountable. Hence, board gender diversity mitigates agency problems between shareholders and managers by improving board dynamics, communication. and disclosure requirements.
Gender equality and board cultural diversity have a similar impact. It is likely that a gender gap threatens democracy in corporate leadership, facilitating the adoption of board quotas for women in many countries. Board cultural diversity improves firm performance by offering the board broader perspectives. In fact, we find that gender equality and board cultural diversity lead to fewer ATPs, suggesting that board gender equality and cultural diversity strengthen board capacity to reduce agency problems.
We further examine the mitigating role of executive gender diversity. There is strong evidence that female executives foster co-operative learning and better communication, leading to more effective governance. We consistently find that executive gender diversity counteracts the relationship between co-opted boards and ATPs, supporting our hypothesis that board and management diversity can deter managers from acting in their self-interest by adopting more ATPs.
Implications
From the agency theory perspective, we can argue that co-opted directors increase firms’ agency conflicts as they reduce the potential for external disciplining The connection between co-opted directors and CEOs helps expropriate shareholder value by increasing ATPs. In other words, co-opted boards increase firms’ agency costs by blocking the potential for external discipline.
Our research also has important implications for management. For instance, we find that co-opted directors help managers use firm resources for their own benefit by arranging higher compensation packages, leading to poor financial performance for the company. Hence, it is essential to be careful about appointing co-opted directors. In addition, governance quality and board and management gender diversity and equality mitigate the detrimental effect of co-opted boards. Hence, firms can improve governance by increasing board and management diversity to reduce ATPs, creating room for external forces to discipline managers.
This post comes to us from professors Mohammad Dulal Miah at the College of Banking and Financial Studies in Muscat, Oman, Rashedul Hasan at Swansea University, and Sabur Mollah at Sheffield University. It is based on their recent article, “Co-Opted Boards and Anti-Takeover Provisions in Us Firms: Do Better Financial Outcomes and Dynamic Governance Matter?” available here.