Effect of Board Composition on Firm Bankruptcy: An Empirical Study of United States Firms

By Rauterkus, Andreas; Rauterkus, Stephanie et al. | International Journal of Management, June 2013 | Go to article overview
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Effect of Board Composition on Firm Bankruptcy: An Empirical Study of United States Firms


Rauterkus, Andreas, Rauterkus, Stephanie, Munchus, George, International Journal of Management


Prior to the enactment of the Sarbanes-Oxley Act of 2002 in the United States publicly traded company Board of Directors enjoyed relative freedom regarding their role in firm's success and or failure. Fraud and other types of corporate wrongdoing for example by WorldCom led to one of the largest bankruptcy filings in the United States. The focus and aims of this paper examines the role of board composition, in particular with respect to insiders, on a company's probability to file for Chapter 11 bankruptcy protection. We used a sample of 33 firms that filed for Chapter 11 bankruptcy in 2001 and 33 non-distressed (control) firms matched by size and industry. We examined four specific board characteristics on the probability of restructuring. They are (1) low equity ownership by directors, (2) large number of directors serving on the board, (3) large percentage of inside directors, and (4) the existence of a chief executive officer who serves as chairman of the board o directors. These factors were found to be positively related to the probability that the firm firms for Chapter 11 bankruptcy protection. The main factor was the large number of inside directors of the board. The results demonstrated a link between financial distress and board composition in the research literature that supports the Jensen (1993) prediction of the relation between firm failure and ineffective corporate internal control systems. The findings in this study support the action taken the New York Stock Exchange by implementing Section 303 A of the NYSE Company Manual. This further suggests more disclosure on the part of the directors and an expanded role of more outside directors and fewer inside directors.

Introduction

In the aftermath of incidents of fraud and other types of corporate wrongdoing as in the case of WorldCom, which ultimately led to one of the largest bankruptcy filings in the U.S. at the time, investor confidence suffered substantially1 This sequence of events, coupled with the Sarbanes-Oxley Act of 2002, led the New York Stock Exchange (NYSE) to propose dramatic new guidelines related to corporate governance for its listed companies. These guidelines, which are detailed in Section 303 A of the NYSE Listed Company Manual, focus primarily on corporate boards of directors and the need for director independence.2 These rules, similar to those proposed by the Cadbury Committee in the wake of numerous corporate scandals in the United Kingdom, can be viewed as a resurrection of the admonitions of Jensen (1993) which nearly a decade earlier warned of the dangers of ineffective corporate internal control systems.3

According to Jensen (1993), effective corporate internal control systems are one force that is capable of mitigating the agency problem between managers and shareholders. Others include the takeover market, legal, political and regulatory systems and the product and factor markets.

Further, due to the legal acceptance of anti-takeover measures and certain regulatory restrictions, the takeover market is no longer as effective as it was in the 1980s, forcing inefficient firms to delay exit until financial distress forces liquidation. As evidenced by the crippling of the takeover market, government regulation imposes more government intervention in the capital markets than is economically feasible. Finally, the product and factor markets effectively drive inefficient firms out of the market, but require a substantial amount of time.

These weaknesses of alternative corporate control forces leave internal corporate control systems as the most feasible force to resolve the agency problems that develop between firms and shareholders. However, evidence of the failure of internal corporate control systems can be seen in the activity of the control market, corporate restructurings and financial distress. In order to make these systems more effective, it is first important to understand the structural weaknesses of internal corporate control systems that lead to their failure.

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