Board Classification and Managerial Entrenchment: Evidence from the Market for Corporate Control

Board classification is a common corporate governance provision that staggers the annual election of directors. Critics of board classification contend that the governance arrangement moderates an incumbent manager’s exposure to the market for corporate control, motivating empirical claims that board classification is causally associated with greater principal-agent conflict and a reduction in firm value. Alternatively, board classification, like anti-takeover devices generally, may be efficient if it allows incumbent managers to deter opportunistic bidding or negotiate for higher value bids. In this paper we examine the relation between board classification, takeover activity, and transaction outcomes for a panel of firms between 1990 and 2002. Target board classification is associated with an increasing likelihood of bid hostility and a commensurate increase in the incidence of multi-bid takeover contests. While board classification alters the dynamics of takeover bidding, the expected gains to target shareholders are equivalent in bids for targets with and without classified boards. Board classification is associated with a significantly lower likelihood of receiving a takeover bid. The economic magnitude of bid deterrence is not large enough to explain the observed difference in value between firms that do and do not utilize classified board structures. Overall, our analysis provides little support for an often cited link between board classification and managerial entrenchment. 1.0 Introduction Board classification is a common corporate governance structure that staggers the annual shareholder election of director slates. In the absence of board classification all continuing and nominated directors of a corporation stand for election annually. In contrast, corporations utilizing classified board structures (also known as staggered boards) assemble directors into distinct classes (typically three) with successive annual elections occurring only for a single director class. Thus, under a classified structure, directors are elected to annual terms equal to the number of classes. Of the approximately 3,000 publicly traded firms covered by the Investor Responsibility Research Center (IRRC), a majority utilized a classified board structure at some point between 1990 and 2002. Board classification is often adopted by firms going public in U.S. capital markets. Field and Karpoff (2002) find that 36.2% of firms going public between 1988 and 1992 employed a classified board at the issue date, while Daines and Klausner (2001) find that 43% of a sample of initial offerings between 1994 and 1997 included a classification provision in their corporate charter. Despite its prominence as a corporate governance feature, recent evidence in Bebchuk and Cohen (2005) suggests that board classification is systematically associated with lower firm value. Corollary evidence presented in Faleye (2006) and Masulis, Wang, and Xie (2005) also indicates that firms employing classified boards exhibit a greater incidence of principal agent conflict. The extant literature has largely emphasized the anti-takeover properties of classified boards when motivating their adoption and maintenance. This in turn has led many to conclude that classification suppresses a firm’s exposure to the market for corporate control and is therefore a causal antecedent to agency conflict in firms that employ this governance structure. In this paper we address this inference through an examination of board classification and 1 The IRRC governance database has 10,121 total firm and year observations between 1990 and 2002 of which 5,911 observations are recorded as having a classified board structure. 2 A conventional view is espoused in Daines and Klausner (2001) who state that classified boards have “...no justification except to ward off challenges for control.”