Classified Boards, Stability, and Strategic Risk Taking

Classified boards are the focus of recent shareholder activism aimed at improving U.S. corporate governance. Although critics argue that classified boards reduce directors’ effectiveness, proponents counter that they enhance corporate stability, board independence, and long-term strategic risk taking. Based on hand-collected data, this study found that stability was similar for both classified and nonclassified boards and that continuity rates for independent directors were comparable for both categories. The study found as well that companies with classified boards invested less in R&D and other company-specific capital assets. These findings were also true for companies with relatively complex operations that are often considered most likely to benefit from classified boards.Classified boards are the focus of recent shareholder activism aimed at improving U.S. corporate governance. According to Institutional Shareholder Services, 46 shareholder proposals to declassify boards received an average of 60.5 percent favorable votes in 2005; that number increased to 66.8 percent for 42 such proposals voted on by 30 June 2006. On the basis of studies that examined the stock price reaction to adoptions of classified boards and studies that analyzed the impact of classified boards on hostile-takeover activities, critics argue that classified boards harm shareholders by facilitating managerial entrenchment and reducing directors’ effectiveness. Proponents counter that classified boards enhance corporate stability, board independence, and long-term strategic risk taking. To examine these claims empirically, I used hand-collected data for a sample of 2,072 companies in the 1995–2002 period.First, I analyzed the effect of classified boards on long-term board stability, which I defined as the proportion of 1995 directors remaining on the board as of the end of 2002. For companies with classified boards, 58.9 percent of 1995 directors remained on the board as of the end of 2002, compared with 60.5 percent for companies that elected all directors annually. I obtained similar results for two categories of directors: 59.0 percent of affiliated directors and 59.5 percent of independent directors remained on classified boards, compared with 61.1 percent and 59.5 percent for nonclassified boards. None of these differences is statistically significant, which indicates that electing directors to staggered terms does not enhance board stability any more than electing all directors annually and that independent directors do not last any longer than affiliated directors on classified boards. These conclusions remained unchanged when I controlled for other factors that can affect board stability by using a multiple regression framework.Next, I examined the effect of classified boards on corporate investment in long-term, company-specific capital assets by focusing on expenditures for research and development and net investments in property, plant, and equipment (PP&E). On average, companies with classified boards invested 2.1 percent of their assets in R&D, compared with 4.3 percent for companies with nonclassified boards. Similarly, classified boards increased their net PP&E by 19.8 percent, compared with 20.6 percent for nonclassified boards. Even among companies in complex industries (e.g., pharmaceuticals, electronics, and software development) in which investment in R&D and other company-specific assets is critical for success, those with classified boards spent less on R&D and net PP&E—5.0 percent and 11.5 percent, respectively, compared with 9.3 percent and 15.5 percent for companies with nonclassified boards. Overall, these results are difficult to reconcile with the notion that classified boards enhance directors’ ability to focus on long-term strategy.Finally, I analyzed the effect of classified boards on wealth creation among companies subject to a high degree of operating uncertainty because of the complexity of their business. This group is commonly considered most likely to benefit from having classified boards; nevertheless, I found evidence contradictory to such beliefs. Regardless of how I defined operating complexity, I found that classified boards always had a negative impact on the creation of shareholder value.These results weaken some of the strongest arguments in support of classified boards. That classified boards have powerful antitakeover effects is generally accepted and has been empirically shown. Nevertheless, many proponents support classified boards because they are thought to promote corporate stability. The findings indicate that this claim is without merit and suggest that justifying classified boards on the basis of furthering stability is problematic. Rather, the current wave of shareholder activism aimed at declassifying corporate boards appears to be well justified.