The Influence of Corporate Governance on Investor Reactions to Layoff Announcements

Pouder, Richard, Cantrell, R. Stephen, Kulkarni, Subodh P., Journal of Managerial Issues

Researchers in strategy often use agency theory to explain problems arising from the separation of ownership and management in corporations. These so-called agency problems occur when managerial activities fail to maximize shareholder value. For example, managers might implement strategies that promote their own long-term interests rather than the interests of shareholders. Efforts to attenuate agency problems focus on adopting governance practices that seek closer alignment of shareholder and manager interests (Fama and Jensen, 1983). Agency theory proposes that the board of directors monitors managers and constrains implementation of inefficient strategies (Zahra and Pearce, 1989). Strategies ratified by the board that represent shareholder interests should be positively associated with shareholder value (Baysinger and Butler, 1985).

Shareholder activists base their movement for corporate governance reform on principles of agency theory (Lorsch, 1996), arguing that agency-based corporate governance practices increase shareholder value. Through their collective influence, activist groups have brought about significant changes in governance practice. However, the impact of these changes has not consistently improved shareholder value in all strategic contexts, suggesting that research in this area should focus on individual strategies.

While often mentioned in accounts of poor governance (e.g., Byrne, 1997; Lear and Yavitz, 1997), a strategy unexplored in the research literature is layoffs -- the most commonly used form of organizational downsizing (Cameron, 1994). Business Week reports, "Rarely a week passes without the announcement of yet more cutbacks, in what has become the most unsettling and disruptive event in corporate America. . . In [1994's] first quarter, employers announced an average of 3,106 cut-backs per day" (Byrne, 1994: 61). Layoffs can cut costs and promote more efficient use of labor resources. On the other hand, they can have considerable negative psychological, social, and economic effects. Perhaps most obvious is the emotional trauma and economic hardship that laid-off employees must endure. Less obvious are unanticipated costs such as employee lawsuits, loss of innovation and productivity among survivors, additional consulting fees, hiring full- or part-time workers to fill unforeseen employee gaps, and negative rep utation effects that make it difficult to hire qualified employees (Banham, 1995; Cameron et al., 1991; Falter-mayer, 1992). Because shareholders are removed from the managerial decisions that determine the ultimate costs of layoffs, they have turned to governance practices as a means of aligning managers' decisions with their interests.

Empirical research on the performance implications of layoffs generally focuses on the impact of layoff announcements on shareholder wealth (e.g., Chadwell and Filbeck, 1994; Chadwell and Webb, 1996; Lee, 1997; Palmon et al, 1997; Ursel and Armstrong-Stassen, 1995; Worrell et al., 1991). However, no study to date incorporates the effect of governance practices on shareholder wealth in the context of layoff announcements. Effort in this direction seems to be useful given the simultaneous rise and importance of the governance movement and corporate layoffs. This study examines the impact of governance practices advocated by activist groups on shareholder value in the strategic context of layoffs. We draw from three conceptual perspectives to explore an empirical link between characteristics of governance and the market's assessment of managerial decisions to lay off employees. First, we use strategic management's proposition that managerial strategy influences firm performance. Second, as noted, agency theory is the basis for assuming that better governance practice influences the choice of strategies that maximize shareholder value. Third, we use capital market theory to capture investors' evaluation of a firm's layoff strategy on future performance. As for specific improvements in governance practice, we investigate the following, which are widely advocated by activist groups: (1) higher proportions of outside directors on corporate boards, (2) consolidated shareholdings by institutional investors, and (3) greater stock ownership by board members (Brown, 1996; Byrne, 1997). The following question guides the study: Do governance practices recommended by activist groups influence shareholder anticipation offuture performance in announced layoffs?

Prior empirical research reveals that governance influences performance in some strategic contexts, yet not in others. Research studies focusing on the performance implications of governance across strategic settings persistently resist orderly findings, making generalizations difficult (for example, see reviews by Dalton et al, 1998; Johnson et al., 1996; Zahra and Pearce, 1989). We therefore extend prior work in governance into a new strategic context and examine its implications for shareholder wealth using a conceptually integrated framework. This article specifically tests the idea that strong corporate governance is likely to increase wealth effects associated with the announcement of a layoff.

The remainder of this article is organized as follows. First, we review relevant research on layoffs and governance. In the following sections we develop hypotheses for each governance practice, describe empirical methods, and discuss our findings. Finally, we present our conclusions and their implications.

LAYOFFS, SHAREHOLDER WEALTH, AND GOVERNANCE

Many research studies investigate the relationship between layoff announcements and shareholder returns. Worrell et al. (1991) and Ursel and Armstrong-Stassen (1995) find a significant negative share price movement following layoff announcements. Chadwell and Filbeck (1994) examine market response to layoff announcements in firms that suffered extreme losses in market value and also find a significant negative share price movement. Lee (1997) compares stock price reactions to layoff announcements in U.S. and Japanese firms over the period 1990-94, and similarly finds a significant negative effect. These findings are consistent with the popular belief that the stock price of firms announcing layoffs typically conveys negative information to the market (Cascio, 1993).

Most studies on the stock market's reaction to layoffs actually consider two types of layoffs: those used as a stand-alone strategy and those that are part of a broader organizational restructuring (Cameron, 1994; Cascio, 1993; Lee, 1997; Palmon et al., 1997; Worrell et al., 1991). When layoff announcements mention that a layoff is used in conjunction with one or more other downsizing strategy, the market's reaction will be affected by the layoff as well as the other strategies. Evidence exists showing significant abnormal returns when each of the following are announced as a stand-alone strategy: sell-offs (Hirschey and Zaima, 1989), plant closings (Blackwell et al., 1990), and early retirement programs (Davidson et al, 1996). These findings raise an important issue about layoffs that are announced together with other forms of downsizing. Anticipated wealth creation due to the layoff cannot be separated from the market's reaction to the announcement. This has the effect of confounding the market's evaluatio n of the loss of human assets by including the loss or reconfiguration of other assets.

In this study, we use the more restrictive interpretation of layoffs. Our sample includes only layoff announcements that do not make reference to layoffs used in conjunction with another downsizing strategy. For example, we exclude announcement of layoffs resulting from a firm's sale or closing of manufacturing plants, or from internal consolidation. The layoffs in our sample may therefore be biased toward firms …

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Publication information: Article title: The Influence of Corporate Governance on Investor Reactions to Layoff Announcements. Contributors: Pouder, Richard - Author, Cantrell, R. Stephen - Author, Kulkarni, Subodh P. - Author. Journal title: Journal of Managerial Issues. Volume: 11. Issue: 4 Publication date: Winter 1999. Page number: 475. © 1999 Pittsburg State University - Department of Economics. COPYRIGHT 1999 Gale Group.

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