Boards of directors were heavily blamed by many for not nipping the Enron, WorldCom and other corporate scandals in the bud. Depending on who was doing the criticizing, directors were at worst complicit or at best ignorant and complacent as corrupt chief executives and their greedy/intimidated minions ran amok with the companies’ finances.
The Sarbanes-Oxley reform legislation that followed picked up on the clamor. The rules now insist that at least one member of the audit committee be “financially sophisticated,” a term defined loosely as someone who, by virtue of professional experience, can understand financial statements and generally accepted accounting principles.
“The idea was that somehow this would make the board better able to monitor and detect potential fraud,” says Wharton finance professor Geoffrey Tate. In concentrating on sharpening the monitoring role of boards of directors, however, the reformers have overlooked potential conflicts that arise from the advisory role that directors also play, says Tate, co-author of a new paper titled, “The Impact of Boards with Financial Expertise on Corporate Policies.”
Banker-directors are known to influence and at times even help initiate company actions on undertaking new debt or issuing equity to make new acquisitions.
Tate and his co-authors, Ulrike M. Malmendier, professor of finance at Stanford University, and A. Burak Guner, a research associate at Barclays Global Investors in San Francisco, studied the role of company directors who are commercial or investment bankers and concluded that these “financial experts on corporate boards do not necessarily improve shareholder value.”
In their study — which looked at biographical and other data from Forbes 500 companies from 1988 to 2001, a period that ended just before the 2002 enactment of Sarbanes-Oxley — “what we found is that often the desire to act in the interests of the bank seems to trump the interests of the company’s shareholders,” Tate said in an interview.
Examining data for as many as 14 years enabled the researchers to base their conclusions on firmer ground — observations of variations within each firm — than if they had relied only on comparisons among firms. “Bank executives on the board not only qualify as financial experts (and therefore might be expected to increase in quantity following the new regulations), but also have a unique channel through which they can affect firm policies: their bank,” the authors write.
While the Sarbanes-Oxley law requires the financial expert on the audit committee to be an independent director, it’s possible for that director eventually to shed his or her independence and for that person’s bank to start doing business with the company, Tate says.
Bankers of all stripes have been prevalent on company boards long before the corporate reforms. Along with lawyers, they also constitute one of the largest groups of professionals serving as corporate directors, according to Tate. That’s not necessarily a bad thing. At least one study has found that “the presence of directors with a CPA, CFA, or other finance experience on audit committees translates into lower frequency of earnings restatements,” Tate and his co-authors say in their paper.
Larger Loans Not Justified
Their impact as corporate financial advisors is another matter, the researchers suggest.
“Our main finding is that commercial bankers serving on corporate boards help reduce the sensitivity of investment to the firm’s cash flows by increasing its access to loans, particularly through the director’s bank. However, the potential benefits do not accrue to the firms that are likely to be financially constrained. Instead, bankers on the board increase financing to firms that have good credit and minimal financial constraints, but that also have poor investment opportunities, suggesting that banker-directors act in the best interests of creditors,” the authors write. In fact, they add, firms they identified as financially constrained received significantly less attractive loan prices.
In examining the size of loans made to companies, the researchers found that loans made by a syndicate that included the banker-director’s bank were on average $552 million larger than loans obtained by companies that had no commercial banker on their boards. Proving their point further, that differential dropped to $187 million in cases where the banker-director’s bank was not part of the syndicate.
The larger loans were not justified by subsequent operational performance, according to the authors. Return on assets and return on equity generally worsened when the loans came from the banks of banker-directors. Similarly, “the impact of investment banker-directors on the board is associated with more frequent outside financing, larger public debt issues — as well as poorer firm performance after acquisition.”
In studying bond issues by companies, the researchers found that the presence of an investment banker on a company’s board was associated with a deal size that on average was $21 million larger. And the presence of investment bankers on the board tended to cut underwriting fees — but only when a bank other than their own was involved in the deal.
Also, on average, $1 invested in an acquiring company that had an investment banker on its board was worth 97 cents three years after the acquisition, the study notes. It was worth $1.12 for companies without an investment banker on its board. Profitability over the three years of companies with an investment banker on their board also dipped below that of companies without an investment banker on their board.
Typical of the phenomenon was IVAX Corp., of Miami, a maker of asthma drugs and one of the companies studied by Tate and his co-authors. At IVAX, the number of mergers increased and share values began a decline after the company put an investment banker on its board in 1991. Merger activity fell when the banker left the board in 1996. Share values slid sharply for a couple more years before recovering.
The directors’ motivations are harder to pin down, Tate says, noting that “a lot of things were not technically possible” to determine. While companies with investment bankers on their boards did worse after acquisitions, there wasn’t enough data to know in all cases whether the bankers actively facilitated the acquisition. In the same vein, it’s possible that companies with good credit but poor investment opportunities undertook new debt as a tax shield at the behest of banker-directors. The researchers found little evidence that bankers were making loans as part of a systematic strategy to increase the firm’s leverage.
“To some degree we are left with this ambiguity in not being able to pin down the motivation,” Tate says. “Are the bankers actively taking advantage of their position or simply doing a bad job in their advisory role?”