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The impact of changes in firm performance and risk on director turnover

Sharad Asthana
Department of Accounting, College of Business, University of Texas-San Antonio, San Antonio, Texas, USA, and

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Steven Balsam
Department of Accounting, Fox School of Business, Temple University, Philadelphia, Pennsylvania, USA
Abstract
Purpose The purpose of this paper is to show that director turnover varies in predictable and intuitive ways with director incentives. Design/methodology/approach The paper uses a sample of 51,388 observations pertaining to 13,084 directors who served 1,065 firms during the period 1997-2004. The data are obtained from RiskMetrics, Compustat, Execu-Comp, CRSP, IBES, and the Corporate Library databases. Portfolio analysis, logit, and GLIMMIX regression analysis are used for the tests. Findings The paper provides evidence that directors are more likely to leave when firm performance deteriorates and the firm becomes riskier. While turnover increasing as firm performance deteriorates is consistent with involuntary turnover, directors are also more likely to leave in advance of deteriorating performance. The latter is consistent with directors having inside information and acting on that information to protect their wealth and reputation. When inside and outside director turnover is contrasted, the association between turnover and performance is stronger for inside directors. Research limitations Since data are obtained from multiple databases, the sample may be biased in favor of larger firms. The results may, therefore, not be applicable to smaller firms. To the extent that the story is unable to differentiate between voluntary and involuntary director turnover, the results should be interpreted with caution. Originality/value Even though extant research has looked extensively at the determinants of CEO turnover, little has been written on director turnover. Director turnover is an important topic to study, since directors, especially outside directors, possess a significant oversight role in the corporation. Keywords Company performance, Risk analysis, Employee turnover, Directors Paper type Research paper

I. Introduction In contrast to the plethora of literature on executive, primarily CEO, turnover, little has been written on director turnover. Yet directors, especially outside directors, possess a large and increasing oversight role in the corporation[1]. Consequently director turnover is an important topic to examine. Further the literature on CEO turnover cannot simply be applied to non-CEO directors as directors, in particular outside directors, have different incentives from CEOs. For example, while CEOs receive the bulk of their remuneration and prestige from their position, outside directors, who
Review of Accounting and Finance Vol. 9 No. 3, 2010 pp. 244-263 # Emerald Group Publishing Limited 1475-7702 DOI 10.1108/14757701011068057

The authors are thankful for comments and suggestions from an anonymous reviewer and workshop participants at the American Accounting Association National Conference 2008, Lehigh University, Louisiana State University, University of Texas-San Antonio, and York University.

often have full-time positions, quite possibly as CEOs of their own corporations, and are likely to hold other directorships, only receive a small portion of their remuneration from one directorship. Consequently they may be more willing to leave voluntarily if they perceive a potential smudge to their reputation from the directorship. This may arise from problems that exist or they anticipate will exist from the corporation. Our results derived from cross-sectional analyses over the years 1997-2004 show that directors, both inside and outside, behave in a rational manner and act as if they are concerned with their reputations. That is, they are more likely to leave their positions when the company is having financial problems or they expect it to have problems. In particular, we find they are more likely to leave when performance has deteriorated, and the firm has become riskier, for example, has a higher probability of bankruptcy. While both of these findings are consistent with increases in involuntary turnover, we also find stock returns lower and risk higher in the year after director departure, a finding we attribute to directors having inside information and voluntarily departing prior to poor performance. These findings hold after controlling for other factors that we believe may be associated with director departure, for example, director age, tenure and gender, and firm size. We then examine whether inside director turnover differs from that of outside (both independent and gray[2]) directors. When contrasted to outside director turnover, we find that inside directors are more sensitive to firm performance and risk in deciding to leave their positions. This finding is consistent with inside directors being more likely to quit than outside directors for a given deterioration in firm performance and increases in firm risk. While higher turnover after a deterioration in performance is consistent with inside directors being more likely to leave the firm involuntarily, that does not appear to be the case when inside directors leave in advance of a deterioration of performance[3]. Rather we attribute the latter finding to inside directors having better inside information on the future performance of the firm and being more likely to act on it. We attribute the inside directors higher sensitivity to firm performance and risk to be a function of the inside director being less diversified than an outside director. That is, both the inside directors wealth and human capital are tied to his or her position with the firm. This paper continues with a brief review of the literature on turnover in section II, which is followed by the development of our hypotheses in section III. Section IV discusses our model, while section V discusses the sample. Section VI discusses our empirical results. We conclude with a summary of results. II. Previous literature Previous studies show that CEO turnover is associated with prior (Benston, 1985; Coughlan and Schmidt, 1985; Warner et al., 1988; Weisbach, 1988; Puffer and Weintrop, 1991) and future (Huson et al., 2004) performance, board composition (Weisbach, 1988; Perry, 1999), CEO stock ownership (Denis et al., 1997), equity compensation (Balsam and Miharjo, 2007), and availability of replacements (Parrino, 1997). In contrast there are few papers that look at director turnover (Gilson, 1990; Yermack, 2004; Srinivasan, 2005; Fich and Shivdasani, 2007). Gilson (1990) looks at a sample of 111 publicly traded firms that either filed for bankruptcy or restructured their debt between 1979 and 1985, finding few outside directors remained on the board when the firm emerged from bankruptcy or completed its restructuring. Yermack (2004) examines turnover among outside directors of the Fortune 500 between 1994 and 1996, showing that turnover is associated with director

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age, gender, membership in the compensation committee, CEO turnover, and stock market returns. Srinivasan (2005) examines outside director turnover in 409 companies that restated their earnings from 1997 to 2001, finding (1) that turnover in these firms is significantly above average and (2) that turnover is associated with being on the audit committee, performance, CEO turnover, director age, tenure, number of other directorships, and whether or not the director sold stock during the restatement period. Fich and Shivdasani (2007) examine outside director turnover in a sample of 113 firms facing shareholder class action lawsuits finding, surprisingly, that outside directors in these firms do not experience abnormally high turnover although they appear to experience a significant decline in other board seats held. We extend their research as follows. First we look at a broader sample of companies over a longer time period, confirming the general results of Srinivasan (2005) and Yermack (2004). Second we examine a more complete set of variables, a set that not only incorporates the corporations past performance but also its future performance, finding results consistent with directors having inside information and using it in determining whether or not to continue on the board. Third we examine and find performance differentially affects the departure decisions of inside and outside directors. Finally, we also use a more refined measure of non-routine director turnover, i.e. we exclude retirements that are mandated by firm policies regarding director age and tenure. III. Development of hypotheses Our first hypothesis pertains to the effect of corporate performance on director turnover. To be precise, we look at the impact of corporate performance and changes in corporate performance on director turnover. While the prior literature showed turnover inversely related to the level of performance (Benston, 1985; Coughlan and Schmidt, 1985; Warner et al., 1988; Weisbach, 1988; Puffer and Weintrop, 1991; Yermack, 2004; Srinivasan, 2005), we decided to also examine changes in corporate performance for the following reason. At the time the director joined the board, the corporation was performing at a certain level and the director willingly joined the board given that information. Similarly each time the director agrees to run for reelection he/she does the same implicit calculation, implicitly trading off the time commitment and risks of serving on the board against the benefits of doing so. Consequently, changes in performance should impact the directors decision to remain on the board[4]. In particular, we expect directors are more likely to resign their posts when the firm performance declines, i.e. they do not want to be associated with a losing firm. Alternatively, they may be more likely to be forced from the board by shareholders or step down in response to investor demand for change when the firm performance declines. Both lead to the same empirical prediction: H1. The likelihood of director turnover is inversely related to the level and/or change in current firm performance.

Directors are officially classified as insiders by the Securities and Exchange Commission, and as such, may have access to information that allows them to predict the firms future performance. If the director feels that corporate performance will decline in the future he or she is more likely to decide to leave the firm. Our second hypothesis is H2. The likelihood of director turnover is inversely related to the level of/change in future firm performance.

We also expect director turnover to be greater when risk is high or increases, as the potential for negative outcomes is greater; and when those negative outcomes occur directors may be sued. More so, not only they may be sued, but also the directors may wind up paying money out of their own pockets. While relatively infrequent in the past, as Black et al. (2006) found only 13 such cases over a 25-year period ending in 2005, there have been some high-profile cases in recent years where directors have had to pay. For example, Young (2005) reports that Eleven former board members of WorldCom Inc. agreed to pay $20.2 million out of their own pockets, while Smith and Weil (2005) report that Ten former Enron Corp. directors agreed to dig into their own pockets to pay $13 million. More recently, five former outside directors of Just for Feet paid $41.5 million to settle a lawsuit (Lattman, 2007). Lattman (2007) citing a Towers Perrin survey also notes potential directors are concerned about personal liability. Consequently our third hypothesis is: H3. The likelihood of director turnover is positively associated with the level of/ increases in current firm risk.

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Analogous to performance, directors may resign because the future risk of the firm is anticipated to be high or increasing. Consequently our fourth hypothesis is: H4. The likelihood of director turnover is positively associated with the level of/ changes in future firm risk.

Our focus in our first four hypotheses is on examining how economic factors affect director turnover. We now examine whether those factors have a differential effect on inside vs outside director turnover. Because of their diversification, e.g. they are not dependent upon the directorship for the majority of their income; outside directors may be more willing than corporate insiders to voluntarily relinquish their posts if they believe that being associated with the firm will negatively impact their reputation. This would be consistent with the finding of increased outside director turnover for firms with earnings restatements found in Srinivasan (2005). However, insiders also have incentives to resign if remaining with the company poses a risk to their reputation and wealth. It is well known that corporate executives, in this case, inside directors, are under-diversified, i.e. a disproportionate amount of their human capital and wealth is tied to the performance of their employer. Consequently poor performance by their employer will not only affect their reputation, but also their wealth. Thus they may be more likely to resign from the board. Our explicit assumption is that when the inside director leaves the board, he or she also leaves his or her position with the company. Unless the executive retires he or she will take, perhaps not immediately, a position with another company. Thus, the cost to the executive is not what he or she was making prior to resigning, but the difference between that amount and his or her next position, i.e. his or her opportunity cost. However, given that firms with poor/declining performance are less likely to pay bonuses and if they are in financial distress, even impose pay cuts, he or she may actually receive a raise upon leaving the company. Further once the inside director leaves the company he or she is free of ownership requirements increasingly imposed upon top executives and may dispose of his or her stake in the company. Ultimately the director has a decision to make, continue on the board or resign/decline to stand for re-election. As noted above, for inside directors the choice is even more significant, as our presumption is that if he or she resigns from the board he or she also relinquishes his or her full-time position with the firm. In making the decision the director trades off the benefits provided by continuing on the board against the cost of

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doing so. The benefits include pecuniary benefits, such as the compensation associated with being a director[5], as well as non-pecuniary benefits, such as, the prestige of being a corporate director. The costs incorporate the time commitment associated with serving on the board, as well as the potential costs to the directors reputation from serving on this particular board. In this paper, we can only examine the effects of some of these costs and benefits on director turnover due to data constraints. For example, while we can measure director compensation with some degree of precision, we cannot measure the non-pecuniary benefits the director gets from serving on the corporations board. Further while we can measure director compensation, we cannot measure its importance to the director without knowing the magnitude of his or her other income and wealth[6]. Consequently, while we anticipate that the relationships between turnover and changes in firm performance and risk may differ between inside and outside directors, we do not predict which group of directors will have a stronger relationship. That is, as discussed above, outside directors may be more likely to leave when performance declines or risk increases because they only depend on the directorship for a portion of their income. In contrast under-diversified inside directors may decide to leave because they depend on their position for the majority of their income. Consequently, while our empirical model tests for these differences, we do not make a prediction at this point. H5. The association between turnover, performance, and risk differs between inside and outside directors.

IV. Model To test the first four hypotheses we begin with the following models which include variables representing past and future performance and risk, as well as a set of control variables likely to affect turnover. We test the impact of the level of performance/risk and change in performance/risk separately, as when we include them in the same model we observe very high multicollinearity. To test hypothesis five we modify the models to incorporate interaction terms for director type, i.e. inside vs outside, with our performance and risk variables: Director turnovert 0  1 Market returnt  2 Market returnt1  3 Probability of bankruptcyt  4 Probability of bankruptcyt1  5 Absolute discretionary accrualst  6 Absolute discretionary accrualst1  7 Director aget 8 Gendert  9 Director tenuret  10 Director has full-time positiont  11 Number of other directorshipst  12 Poor director attendancet  13 Director remunerationt  14 Executive opportunity costt 15 New CEOt  16 High-tech industryt  17 Litigation-prone industryt  18 Sizet " 1

Director turnovert 0  1 Market returnt  2 Market returnt1  3 Probability of bankruptcyt  4 Probability of bankruptcyt1  5 Absolute discretionary accrualst  6 Absolute discretionary accrualst1  7 Director aget 8 Gendert  9 Director tenuret  10 Director has full-time positiont  11 Number of other directorshipst  12 Poor director attendancet  13 Director remunerationt  14 Executive opportunity costt 15 New CEOt  16 High-tech industryt  17 Litigation-prone industryt  18 Sizet " where the dependent variable, director turnover, is discrete and takes the value of 1 if year t is the directors final year and zero otherwise. The independent variables, which are discussed below, and are more formally defined in Table I, can be classified into those that reflect firm performance and risk, director characteristics and compensation, and other control variables. A. Test variables Firm performance. We use market returns as our proxy for firm performance, which we measure for both the year of and the year after departure. In model (1) we use industryadjusted (two-digit SIC code) performance, whereas in model (2) we use the change in performance. To be more precise, to control for differential lengths of service, we measure the change in performance between the directors first year of service and year t and convert the change into annualized percentages. Under hypothesis one we expect directors to be more likely to leave after a poor/decline in performance, while under hypothesis two we expect directors, who are in possession of inside information to be more likely to leave in advance of a decline in performance. Our expectation based upon these hypotheses is that the level and change in returns (past and future) will be negatively associated with turnover. Firm risk. To measure firm risk we use two variables, probability of bankruptcy and the absolute value of discretionary accruals, which we also measure in the level and change form. Probability of bankruptcy is a common measure of risk and we use the formulation from Zmijewski (1984). Discretionary accruals are a measure of earnings manipulation. If a firm resorts to earnings management it may indicate there are problems with the firm or at least problems with their accounting system that put directors at risk. To measure discretionary accruals, we use the cross-sectional version of the Jones (1991) model as in Defond and Jiambalvo (1994). We then take the absolute value of discretionary accruals as in Bergstresser and Philippon (2006). Based upon hypotheses three and four, we expect directors to be more likely to resign when risk is high/risk increases. Empirically, we thus expect director turnover will be positively associated with changes in each of these variables. 2

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Variable Director turnover Insider

Definition Dichotomous variable with value of 1 if this is the directors last year on the job; and 0 otherwise Dichotomous variable with value of 1 if the director is an employee of the firm; and 0 otherwise Implies the value minus the median value for the two-digit SIC code industry for that year (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value) Implies annualized relative increase from the first year as director (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value) With dividends market return during the current fiscal year Zmijewskis measure of financial distress Absolute value of discretionary accruals from the crosssectional version of the Jones (1991) model deflated by total assets at the beginning of the fiscal year

250

Levels model

Changes model

Performance variable Market return Measures of firm risk Probability of bankruptcy Absolute discretionary accruals

Control variables: director characteristics Director age Directors age Director gender Dichotomous variable with value of 1 if the director is a female; and 0 otherwise Director tenure Years as a director of the company Director has full-time position Dichotomous variable with value of 1 if director holds a fulltime position outside the firm; and 0 otherwise. Value set to zero for inside directors Number of other directorships Number of other company boards as director Poor director attendance Dichotomous variable with value of 1 if the director failed to attend at least 75 percent of the board/committee meetings; 0 otherwise Compensation variables Director remuneration Value of cash retainer, plus per meeting fee times number of meeting, plus estimated value of stock and options granted to the director during the fiscal year (in $000) deflated by number of board meetings Residual from regression of log of total direct compensation of inside director on contemporary return on assets, market return, log of revenues, age, and gender. Value set to zero for inside directors Dichotomous variable with value of 1 if a new CEO took over in the current year; and 0 otherwise Dichotomous variable taking the value of one if the firm is in SIC codes 3,570 through 3,579; 4,800 through 4,899; or 7,370 through 7,379 Dichotomous variable taking the value of one if the firm is in SIC codes 2,833 through 2,836; 3,570 through 3,577; 3,600 through 3,674; 5,200 through 5,961; 7,370 through 7,374; or 8,731 to 8,734 Logarithm of revenue

Executive opportunity cost

Other control variables New CEO High-tech industry Litigation-prone industry

Table I. Variable definitions

Size

Inside vs outside directors. To test hypothesis five, i.e. examine whether inside and outside directors respond differentially to performance and risk, we interact each of the performance and risk variables in models (1) and (2) with an indicator variable taking the value of one if the director is an insider and zero otherwise. If there is a difference in sensitivity between the two groups the coefficients on these interactions will be statistically different from zero (recall from above, we do not make directional predictions for hypothesis five). B. Control variables We divide our control variables into three categories, director characteristics, director compensation, and other controls. We include the following director characteristics which potentially could influence turnover independent of firm performance and risk: age, gender, tenure, whether the director has a full-time position outside the firm, how many other directorships he/she holds, and an indicator variable taking the value of 1 if the director failed to attend at least 75 percent of board meetings. We partially control for director age and tenure by excluding turnover caused by firm policies on age and tenure in position; however, we do not have these data for all firms, nor do all firms have such policies[7]. Consequently we expect turnover to be positively associated with director age in our sample for two reasons. First, some firms may have informal policies that we fail to identify, and second, even without these policies, directors like executives are more likely to retire as they get older. Ex ante we do not predict an association between turnover and director tenure, as while tenure is positively associated with age, long tenure may lead to entrenchment. We include a gender indicator variable as there is research indicating that the appointment of women to the board is not random, e.g. they are more likely to be appointed to the boards of high-performing firms (Farrell and Hersch, 2005). If that were the case, their pattern of turnover might also differ from that of their male counterparts. We also believe that whether the director has a full-time job may affect turnover. Consequently, we include it as a control variable in our model. A director with numerous directorships may, in the current environment, be advised to cut back on the number of boards he/she sits on; consequently, we include the number of board positions as a control variable. Our last measure of director characteristics is attendance. Given poor attendance is likely caused by other demands on his/her time and/or health issues, we feel a director with poor attendance is more likely to leave the board. We include two variables for director compensation: director remuneration, which represents the compensation received by outside directors, and executive opportunity cost, which represents our estimate of the premium received by inside directors over other executives with similar characteristics. Our expectation is the higher compensation the less likely the director is to leave (or at least voluntarily leave) the board. Our other control variables include the existence of a new CEO, indicator variables for whether the firms industry is considered high technology, litigation prone, and whether the firm has a Big 4/5 auditor, and firm size. We include an indicator variable for the existence of a new CEO for two reasons. First in the governance literature, evidence suggests, for example Hermalin and Weisbach (1998) and Shivdasani and Yermack (1999), that outside board members serve at the discretion of the CEO. So the new CEO may ask for or directors may offer to resign or not stand for re-election. Second with respect to executives, Fee and Hadlock (2003) find that the probability that a non-CEO leaves office is elevated around CEO dismissals. Consistent with this, Yermack (2004) finds that director turnover is greater if the appointing CEO is no

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longer in office. Thus, we expect a positive association between the new CEO indicator variable and director turnover. We define High-Tech Industries as an indicator variable taking the value of one if the firm is in SIC codes 3,570 through 3,579; 4,800 through 4,899; or 7,370 through 7,379, as in Balsam et al. (2003), expecting turnover to be greater for growth firms operating in dynamic industries (Henderson et al., 2006). We define Litigation-Prone Industries as an indicator variable taking the value of one if the firm is in SIC codes 2,833 through 2,836; 3,570 through 3,577; 3,600 through 3,674; 5,200 through 5,961; 7,370 through 7,374; or 8,731 through 8,734 (Francis et al., 1994). Finally, we include size (logarithm of revenue) as a catch all variable measuring both the scale and complexity of the firm. V. Sample and data One of the problems with either executive or director turnover is determining whether the departure is forced or voluntary. Corporations and the departing executive/director have incentive to make the departure appear amiable, even when it is not. Consequently, press releases cannot always be relied on to make that distinction (Weisbach, 1988; Warner et al., 1988; Denis et al., 1997). Researchers have developed algorithms (e.g. Huson et al., 2001) to distinguish voluntary from forced executive turnover. The Huson et al. algorithm, which is based upon keywords from the press release, the timing of release, and the age of the executive, does not transfer well to directors as directors departures are much lower key, i.e. most directors depart quietly at the end of their elected term. Few directors resign during their term, and when they do, they are news. An example is the following headline from the Wall Street Journal article (McBride, 2006) XM satellite director resigns after expressing cost concerns, which discusses the abrupt resignation of director Pierce Roberts[8]. Given the paucity of comparable disclosures, and the lack of a pre-existing algorithm to separate involuntary from voluntary turnover, by necessity our turnover sample will include directors who voluntarily resigned or elected not to stand for re-election, and those who were forced from their position. This of course, will add noise to our analysis, making it harder to find our hypothesized relationships. We were, however, able to purchase a customized dataset from RiskMetrics providing information on firms with mandatory retirement ages or maximum tenure policies, and we eliminate turnover due to these factors from our analysis[9]. In addition, we report additional analysis that tries to separate involuntary and voluntary director departures. We obtain our data from a variety of sources, including RiskMetrics, Compustat, Execu-Comp, CRSP, and IBES, as well as a custom database purchased from The Corporate Library. Table II summarizes our sample selection procedure, while Tables III-V provides a distribution by director type, year, and industry. As can be observed from Table II, we began with a total of 152,837 director-year observations. We lose data as not all firms are on, or have sufficient RiskMetrics, ExecuComp, CRSP, or IBES data. We delete as involuntary, retirements due to the mandatory policies discussed above. We delete observations where the director leaves more than one directorship in the same year, as it is likely those departures are driven by director specific, e.g. age or infirmity, rather than the firm-specific factors examined here. We also delete firms in the financial (SIC codes 6,000-6,999) and regulated (4,000-4,999) sectors. Missing data and observations lost in estimating director turnover[10] restricts our final sample for our levels model to 51,388 observations. Differencing further reduces the sample for the change model to 38,304 observations. Tables III-V provides information on sample distribution by director type, year, and industry. Table III shows that in 33,191 of our observations the director is considered

Procedure Data available on 2006 director database Less firms not available on Execu-Comp Less firms not available on CRSP Less involuntary departures Less multiple resignations Less firms in the financial and utility sector Less missing data Less observations lost in estimating director turnover Note: The final sample pertains to 1,065 unique firms

Observations lost

Observations remaining 152,837 117,516 94,249 93,672 93,300 74,281 64,472 51,388

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Table II.
Sample selection

(35,321) (23,267) (577) (372) (19,019) (9,809) (13,084)

Type Independent Insider Linked Total

Total observations 33,191 10,823 7,374 51,388

Unique directors 8,358 2,870 1,856 13,084

Table III.
Sample distribution: distribution by director type

Fiscal year-end 1997 1998 1999 2000 2001 2002 2003 2004 Total

Total observations 5,103 5,924 6,379 6,686 6,959 6,952 6,782 6,603 51,388

Independent 3,081 3,565 3,933 4,223 4,544 4,601 4,584 4,660 33,191

Type of director Insider 1,189 1,365 1,420 1,481 1,440 1,415 1,334 1,179 10,823

Linked 833 994 1,026 982 975 936 864 764 7,374

Table IV.
Sample distribution: distribution by fiscal-year

independent, in 10,823 observations the director is a insider, and in 7,374 observations the director has some non-employment link to the firm that compromises his/her independence. Since many directors serve on more than one board, we also provide data on the number of unique directors. Whereas about 64 percent of the directors in our sample are considered independent of the firm they comprise 65 percent of our director firm year observations. About 14(14) percent of our directors (observations) have non-employment links to the firm, whereas about 22(21) percent of our directors (observations) are insiders. The final sample contains 1,065 unique firms and 13,084 unique directors. Table IV shows the sample appears to be fairly evenly spread across our sample period. Table V shows there does appear to be some deviation between the sample and population (ExecuComp) proportions. In particular, service companies appear to be under-represented, while manufacturing companies appear over-represented, when compared to the population.

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Industry 1. Agriculture, forestry, and fishing 2. Mining 3. Construction 4. Manufacturing 5. Wholesale 6. Retail 7. Services 8. Other Total

Sample observation 57 2,664 316 33,055 2,285 5,692 7,400 178 51,388

Sample (%) 0.11 5.18 0.61 63.82 4.45 11.08 14.40 0.35 100.00

Population (%) 0.32 4.84 1.29 57.47 4.03 10.29 21.26 0.50 100.00

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Table V. Sample distribution: distribution across industries

Notes: The industry classification is based on Dopuch et al. (1987) and includes the following SIC codes: Agriculture, Forestry, and Fishing 100-999; Mining 1,000-1,499; Construction 1,5001,999; Manufacturing 2,000-3,999; Wholesale 5,000-5,199; Retail 5,200-5,999; Services 7,0008,999; Others <100 and >8,999

Table VI provides some descriptive statistics for the variables used in our empirical model after winsorizing the variables at 1 and 99 percent. The mean for Director turnover is 0.1065, which indicates that the average director tenure is between 9 and 10 years. The mean market-adjusted return, which is adjusted for the median return in its two-digit SIC code, is 0.0242.
Variables Director turnover Performance variables Market returna Measures of firm risk Probability of bankruptcya Absolute discretionary accrualsa Director characteristics Director age Director gender Director tenure Director has full-time position Number of other directorships Director is an insider Poor director attendance Director compensation variables Director remuneration Executive opportunity cost Other control variables New CEO High-tech industry Litigation-prone industry Size Mean 0.1065 0.0242 0.0460 0.0166 58.6405 0.0958 5.6174 0.6093 0.8432 0.2095 0.0226 13.7193 0.0038 0.1142 0.0893 0.3241 7.3334 Median 0 0 0 0 59 0 6 1 0 1 0 9.3835 0 0 0 0 7.2396 Standard deviation 0.3085 0.2469 0.1386 0.1899 8.6566 0.2943 2.5396 0.4879 1.2689 0.4070 0.1485 18.1343 0.6454 0.3181 0.2852 0.4681 1.3539

Table VI. Variable distribution

Notes: See Table I for variable definitions. Only statistics for levels are reported. Changes are suppressed for the sake of brevity; athe means are different from 0 since the industry adjustments are done with median values and not mean values; n 51,388

In terms of firm risk, we observe that the probability of bankruptcy (industryadjusted) for our sample firms is just under 5 percent. Absolute discretionary accruals (industry-adjusted) are about 1.66 percent of total assets. Looking at director characteristics, the average director age is just under 59, average director tenure is almost six years, and about 10 percent of directors are female. A total of 61 percent of outside directors have full-time positions. The average number of other directorships is slightly less than one. Addressing our other control variables the fraction of firm year observations with a new CEO is 11 percent, close to 9 percent are in high-technology industries and over 32 percent are in litigation-prone industries. VI. Empirical analysis We begin with some portfolio analysis in Tables VII and VIII. Table VII partitions the sample into high and low based upon medians of our performance and risk measures, examining how turnover differs in a univariate sense. In general, we observe that turnover is higher for the firms with the lower (greater) performance (risk). For example, when market return in the year of change is above the median, director turnover is just under 10 percent, whereas when market return is below the median, director turnover is almost 11.5 percent, a difference which is significant at the one percent level. The only time we do not see a difference is for discretionary accruals in year t 1. Table VIII reverses the partitioning scheme, grouping firm year observations based upon whether the director left or stayed with the firm. As expected,
Attribute Market return (t) Market return (t 1) Probability of bankruptcy (t) Probability of bankruptcy (t 1) Absolute discretionary accruals (t) Absolute discretionary accruals (t 1) Mean turnover for High portfolio Low portfolio 0.0988 0.1009 0.1163 0.1156 0.1171 0.1072 0.1148 0.1126 0.0979 0.0985 0.0971 0.1057 Difference 0.0160*** 0.0117*** 0.0184*** 0.0171*** 0.0200*** 0.0015 t-statistics 5.89 4.28 6.76 6.27 3.27 0.53

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Table VII.
Notes: See Table I for variable definitions. High (low) portfolios are formed by selecting values greater than or equal to (less than) the median. Only statistics for levels are reported. Changes are suppressed for the sake of brevity; ***significant at 1 percent level; n 51,388 Portfolio analysis: portfolios formed on independent variables

Attribute Market return (t) Market return (t 1) Probability of bankruptcy (t) Probability of bankruptcy (t 1) Absolute discretionary accruals (t) Absolute discretionary accruals (t 1)

Mean value of attribute Director left Director stayed 0.0420 0.0340 0.0760 0.0768 0.0221 0.0178 0.0220 0.0180 0.0424 0.0446 0.0159 0.0143

Difference 0.0200*** 0.0160*** 0.0336*** 0.0322 0.0062** 0.0035

t-statistics 5.61 4.44 17.00 15.76 2.29 1.24

Table VIII.
Notes: See Table I for variable definitions. Director status is coded as left if the director left the board and stayed otherwise. Only statistics for levels are reported. Changes are suppressed for the sake of brevity; **significant at 5 percent level; ***significant at 1 percent level; n 51,388 Portfolio analysis: portfolios formed on dependent variable

RAF 9,3

we observe that the performance (risk) is greater (lesser) for directors that stay with the firm. For example, the industry-adjusted market return is 4.2 percent if the director left and 2.2 percent if he/she remained with the company, again a difference that is significant at one percent. Overall the results in Tables VII and VIII, which are descriptive in nature, are consistent with directors taking into account firm performance and risk when deciding whether to remain with the company. A. Primary model In Tables IX and X we show the results for the levels (model 1) and changes (model 2) models side by side. Since our dependent variable is discrete, we use logistic regressions[11]. Both models are highly significant, with pseudo R2 of 17 and 13 percent, respectively. In general, the results of the models are comparable. The empirical results strongly support
Variables Intercept Performance variables Market return (t) Market return (t 1) Measures of firm risk Probability of bankruptcy (t) Probability of bankruptcy (t 1) Absolute discretionary accruals (t) Absolute discretionary accruals (t 1) Director characteristics Director age Director gender Director tenure Director has full-time position Number of other directorships Poor director attendance Director compensation variables Director remuneration Executive opportunity cost Other control variables New CEO High-tech industry Litigation-prone industry Size Observations Pseudo R-square Wald Chi-sqr Prob > Chi-sqr Exp. sign ? ? ? ? ? ? Levels 4.0307*** 0.1749*** 0.1602*** 1.0368*** 0.1825* 0.1428* 0.0357 0.0349*** 0.0258 2.0213*** 0.1959*** 0.0629*** 0.5922*** 0.0030*** 0.0648*** 0.2559*** 0.3466*** 0.0281 0.0730*** 51,388 0.1707 3389.5858 <0.0001 Changes 6.1273*** 0.2571*** 0.3265*** 10.4972*** 0.8711 0.1746*** 0.1409*** 0.0640*** 0.2026*** 1.3480*** 0.2297*** 0.1377*** 0.2690** 0.0001 0.5433*** 0.2518*** 0.1088* 0.0032 4.6106** 38,304 0.1302 1828.1779 <0.0001

256

Table IX. Analysis of factors affecting director turnover (dependent variable director turnover)

Notes: See Table I for variable definitions. Levels imply the value minus the median value for the two-digit SIC code industry for that year (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value). Changes imply annualized relative increase from the first year as director (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value); *significant at 10 percent level; **significant at 5 percent level; ***significant at 1 percent level; significance levels are one-sided for variables with directional expectations; two-sided otherwise

Variables Intercept Insider Performance variables Market return (t) Market return (t)*insider Market return (t 1) Market return (t 1)*insider Measures of firm risk Probability of bankruptcy (t) Probability of bankruptcy (t)*insider Probability of bankruptcy (t 1) Probability of bankruptcy (t 1)*insider Absolute discretionary accruals (t) Absolute discretionary accruals (t)*insider Absolute discretionary accruals (t 1) Absolute discretionary accruals (t 1)*insider Observations Pseudo R-square Wald Chi-sqr Prob > Chi-sqr

Exp. Sign ? ?

Levels 4.0257*** 0.0423 0.1080* 0.2979** 0.1397** 0.0996* 0.8659*** 0.7956** 0.2276* 0.2349 0.2451*** 0.4868** 0.0305 0.0326 51,388 0.1714 3408.4625 <0.0001

Changes 6.2321*** 0.1761*** 0.1918*** 0.3348*** 0.2926*** 0.1604* 9.8292*** 2.7807* 0.0376 0.2425 0.1891*** 0.0784* 0.1540*** 0.0636 38,304 0.1321 1850.9798 <0.0001

Changes in firm performance and risk 257

Notes: See Table I for variable definitions. Levels imply the value minus the median value for the two-digit SIC code industry for that year (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value). Changes imply annualized relative increase from the first year as director (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value); *significant at 10 percent level; **significant at 5 percent level; ***significant at 1 percent level; significance levels are one-sided for variables with directional expectations; two-sided otherwise. Estimates for control variables are qualitatively similar to those in Table IX and are not reported for the sake of brevity

Table X.
Effect of director independence on turnover (dependent variable director turnover)

hypothesis one, showing that turnover is inversely related to both the level (model 1) and change (model 2) in firm performance at the one percent level of significance[12]. The empirical results for hypothesis two also show that turnover is inversely related to both the level and changes in future firm performance. That is, we examine the association of director turnover with both the level and the change in market performance in the year after departure, finding a strong inverse association, again significant at the one percent level. This is inconsistent with the findings of Huson et al. (2004) who find that firm performance improves after CEO replacement. One explanation for this divergence in results, which will be examined further in the next section, is that the relationship differs between CEO and other, mainly outside, directors. While the association between contemporaneous performance and turnover could be the result of either voluntary or involuntary turnover as directors are more likely to be asked to step down/aside when the firm is not performing well, the association between subsequent performance and turnover is more likely to be voluntary and consistent with directors having inside information and using that information to decide on whether to stay on the board[13, 14]. The empirical results also support hypothesis three, showing that turnover is positively related to the level and change in firm risk. We observe that for the probability

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258

of bankruptcy, the association with the probability of bankruptcy is significant at the one percent level in both models, while for absolute discretionary accruals it is significant at the 10 percent level in the levels model and the 1 percent level in the changes model. In contrast the results for hypothesis four are weaker than those of the first three hypotheses. We observe marginal (10 percent level) significance between director turnover and the probability of bankruptcy in year t 1, but no association between director turnover and the change in the probability of bankruptcy between years t and t 1. We also find mixed results for absolute discretionary accruals. We do not observe an association between the probability of turnover and the level of absolute discretionary accruals, but do find a strong (1 percent level) association between the probability of turnover and changes in absolute discretionary accruals between years t and t 1. Overall the results for hypothesis four are mixed. Turning to our control variables we find, as did both Yermack (2004) and Srinivasan (2005), that turnover increases with director age, although we find it decreases with director tenure. The latter finding could be caused by the positive correlation between director age and tenure. However, dropping either age or tenure does not affect our primary results. Yermack (2004) also finds turnover for female directors to be lower than that of their male counterparts, a finding we are unable to confirm. That is, in the levels model the coefficient on the gender variable is insignificantly different from zero, while in the changes model it is actually positive and significant. We observe that when a director has a full-time position he/she is less likely to leave his/her directorship, whereas directors who have other board positions are also less likely to leave the board in question. Consistent with our expectations we find that directors whose attendance is poor are more likely to leave the board. Also as expected we find that both director remuneration and executive opportunity cost are inversely related to turnover, although the coefficient on director remuneration is not significantly different from zero in the change model. Consistent with Srinivasan (2005) we find a positive and significant effect of a new CEO on director turnover. We also find a positive association between director turnover and our high-technology indicator variables, but not for the company being in a litigation-prone industry. Finally we see that firm size is positively associated with director turnover. B. Model incorporating differential sensitivities for inside and outside directors Table X presents the results for the models which allow for a differential association between director turnover and changes in firm performance and risk between inside and outside directors. We do so, by adding a level variable for taking the value of one if the director is an insider and zero otherwise, and by adding interactions for each of our performance and risk variables with that indicator variable. The coefficients can thus be interpreted as follows. The coefficient on the performance/risk variable itself represents the relationship between the variable and turnover for outside directors, the coefficient on the interaction between the variable and insider represents the incremental effect for insiders, and the sum of the coefficient on the variable and the coefficient on the interaction represents the relationship for insiders. For brevity Table X does not include the results for our control variables. The first thing we observe is that the unconditional turnover for inside directors is higher than it is for outside directors (significant at 1 percent level) in the changes, but not the levels model. With respect to our performance variables, we find the incremental association with market return for inside directors to be negative and statistically significant at 5 percent for the levels model and 1 percent for the changes model. With respect to future performance, the incremental associations are marginally

(10 percent level) stronger in both models. Consequently we conclude that inside director turnover is more sensitive to contemporaneous and future performance. With respect to our risk measures, we only observe an incremental effect for the current level/change in risk. That is, the interaction between insider and the probability of bankruptcy is significant at 5 percent in the levels model and 10 percent in the changes model, as are the interactions between insider and absolute discretionary accruals. As in Table IX we find weak results for risk in year t 1, whether it be for outside or inside directors. Consequently we can only conclude that inside director turnover is more sensitive to contemporaneous risk and change in risk. C. Research limitations and additional analysis Since data are obtained from multiple databases, the sample may be biased in favor of larger firms. The results may, therefore, not be applicable to smaller firms to the same extent as they do to the large firms. To the extent that we are unable to differentiate between voluntary and involuntary director turnovers, our results should be interpreted with caution. However, to confirm that our results are driven by voluntary (and not involuntary) director turnover, we conduct the following additional test. If directors are fired for poor performance, it is reasonable to assume that the insider directors will be the first to be fired and then the outside directors. Thus, using this pecking order, we exclude all director turnovers when there are one or more insider turnovers for the same firm in the same year under the assumption that these have a higher likelihood of being forced departures/firings. The new results are reported in Table XI. For levels, the results are qualitatively similar to our findings in Table IX. For the changes regression, we gain significance on Probability of Bankruptcy(t 1) and lose significance on Absolute Discretionary Accruals(t 1). To the extent we are able to purge out fired directors, the findings from Table XI give us confidence that our conclusions hold for voluntary director turnover. Another possibility is that directors with shares may have been (illegally) selling shares using inside information prior to exiting the firm which may have been the reason for his/her forced removal. To control this, in an untabulated extension, we did look for any suspicious/abnormal director trading activity prior to the directors departure/earnings disclosure. We did not find any significant results. The more effective the corporate governance of the firm, the more likely are the directors to be fired consequent to poor performance. In additional analysis, we use the G-INDEX from Gompers et al. (2003) to control for the strength of corporate governance. Our results do not change significantly. VII. Summary and conclusions In this paper we have provided evidence that director turnover is influenced by a series of economic factors. In doing so, we confirm and extend the findings of Srinivasan (2005) and Yermack (2004). Our primary contributions are that by examining a broader sample over a more recent time period we show that not only do directors respond to performance and risk when deciding to continue as a director, they also appear to utilize the inside information they possess about the future performance of the firm. Further, we provide some evidence that turnover of inside and outside directors appear to respond to differentially to these performance. In particular, we find that inside director turnover is more sensitivity to contemporaneous and future performance, as well as contemporaneous risk. To some extent the observed inverse relationship between turnover and performance/ risk could be consistent with involuntary turnover. However, the inverse relationship with

Changes in firm performance and risk 259

RAF 9,3

Variables Intercept Performance variables Market return (t) Market return (t 1) Measures of firm risk Probability of bankruptcy (t) Probability of bankruptcy (t 1) Absolute discretionary accruals (t) Absolute discretionary accruals (t 1) Observations Pseudo R-square Wald Chi-sqr Prob > Chi-sqr

Exp. sign ?

Levels 8.7737*** 0.2877** 0.3635*** 1.9163*** 3.1297*** 0.0703** 0.0004 39,480 0.2365 3537.1011 <0.0001

Changes 8.9889*** 0.0686** 0.2041*** 14.3670*** 14.5147*** 0.1256** 0.0599 31,747 0.1554 1876.430 <0.0001

260

Table XI. Additional controls for involuntary turnover (dependent variable director turnover)

Notes: See Table I for variable definitions. Levels imply the value minus the median value for the two-digit SIC code industry for that year (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value). Changes imply annualized relative increase from the first year as director (for the performance and risk variables; for director characteristics, compensation variables, and other control variables, we use the unadjusted value); *significant at 10 percent level; **significant at 5 percent level; *** significant at 1 percent level; significance levels are one-sided for variables with directional expectations; two-sided otherwise. Estimates for control variables are qualitatively similar to those in Table IX and are not reported for the sake of brevity. Only turnovers that are voluntary are retained. Any turnover is deemed to be involuntary if there are one or more insider turnovers for the same firm in the same year

future performance could also be consistent with directors in general, and insiders in particular, using their inside information to jump ship ahead of declines in performance.
Notes 1. Consistent with the extant literature an outside or independent director does not work for the firm, nor have other links that would compromise his or her independence. The latter two are commonly known as inside and gray-linked directors. 2. Even though they may not be independent, gray directors do not face the same diversification issues as inside directors. 3. It is possible, however, that they are dismissed based upon inside information that allows outside board members to predict future firm performance. 4. In addition, as noted by Darrough and Rangan (2005) among others, levels regressions are more susceptible to correlated omitted variable bias. 5. Inside directors do not normally receive fees for serving on the board. 6. To some extent we control for this factor by including variables representing the outside directors other sources of income, i.e. full-time position and other directorships. 7. In sensitivity analysis we exclude all directors past the age of 70 and find it has no effect on our results. 8. We were able to locate a few other examples. For example, Tharp (2003) reported that Andrea Van de Kamp was forced from the Disney board for taking stands against then CEO Michael Eisner and Tejada (1997) reports that when Jesse L. Upchurch resigned as

9.

10. 11.

12. 13.

14.

director of Tandy, he claimed he was being penalized for criticizing the CEOs performance. Unfortunately we do not have this data on all the firms in our sample. For those firms we simply assume there is no mandatory retirement policy for directors. Any noise as a result of this assumption will simply make it harder for us to find our hypothesized relationships. As reported in note 7, in sensitivity analyses we exclude all directors aged 70 and older, finding it has no effect on our results. To identify a director as departed, we require one year of subsequent firm data, where we observe that he/she is no longer on the board which also reduces our sample. To control for the econometric issues that may arise from the pooling of multiple executives from a single firm over a period of years, we also use the SAS procedure Glimmix. Glimmix controls for both firm and time fixed and random effects in a logistic setting. In general, our results, while differing in the level of significance, are consistent whether we use the logit or Glimmix procedures. Both Yermack (2004) and Srinivasan (2005) found director turnover inversely related to past firm performance. Evidence of directors having and using inside information to make decisions is also found in a recent study by Ravina and Sapienza (2006), who use abnormal returns earned on insider trades to document that outside as well as inside directors possess inside information. One alternative explanation for this finding is that firm performance declined due to director departure. While plausible, there is no evidence of this in the literature and Fich and Shivdasani (2007) find a positive market reaction to director resignation announcements.

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Weisbach, M.S. (1988), Outside directors and CEO turnover, Journal of Financial Economics, Vol. 20, pp. 431-60. Yermack, D. (2004), Remuneration, retention, and reputation incentives for outside directors, Journal of Finance, Vol. 59, October, pp. 2281-308. Young, S. (2005), Ex-WorldCom directors reach pact, The Wall Street Journal, Vol. 21, March, p. A6. Zmijewski, M.E. (1984), Methodological issues related to the estimation of financial distress prediction models, Journal of Accounting Research, Vol. 22, Supplement, pp. 59-82. Further reading Balsam, S., Bartov, E. and Marquardt, C. (2002), Accruals management, investor sophistication, and equity valuation: evidence from 10-Q filings, Journal of Accounting Research, Vol. 40, pp. 987-1012. About the authors Sharad Asthana is an Associate Professor in the Department of Accounting, College of Business, University of Texas-San Antonio. He received his PhD in Accounting from the University of Texas at Austin in 1995 after 13 years experience as a senior manager and CEO. He has published 24 articles in journals, such as The Accounting Review, Contemporary Accounting Research, Auditing: A Journal of Practice and Theory, Journal of Accounting and Public Policy, International Journal of Accounting, Auditing and Performance Evaluation, Journal of Business Research, Journal of Pension Economics and Finance, International Journal of Auditing, and Journal of Information Systems, among others. He has been inducted into the Deans Research Honor Roll for outstanding research in 2003 and 2004 and was awarded the Teacher of the Year Award in 2001 and 2002 for excellence in the classroom. Sharad Asthana is the corresponding author and can be contacted at: sharad.asthana@utsa.edu Steven Balsam, Professor of Accounting and Senior Merves Research Fellow at the Fox School of Business at Temple University, obtained his PhD from the City University of New York (Baruch College) in 1991. His research interests are executive compensation, earnings management, and capital markets. In addition to writing a book for World@Work, Executive Compensation: An Introduction to Practice and Theory, and an AICPA self-study course, Accounting for Stock Options and Other Stock-Based Compensation, he has published articles in academic journals, including The Accounting Review, Journal of Accounting Research, Journal of Accounting and Economics, Contemporary Accounting Research, Journal of the American Taxation Association, Journal of Accounting and Public Policy, Journal of Accounting, Auditing and Finance, and Accounting Horizons; and practitioner journals including the Journal of Accountancy. He is also a member of the editorial boards of the Journal of Accounting and Public Policy and The International Journal of Accounting. He has been widely quoted in the media and has given expert witness testimony on executive compensation to the United States Senate Committee on Finance. Prior to coming to Temple University he taught at Baruch College and the University of Rochester. Before entering academia he was a Certified Public Accountant working for the international accounting firm of Ernst & Young.

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