Do Outside Directors Monitor Managers? Evidence From Tender Offer Bids

Abstract

Examining 128 tender offer bids made from 1980 through 1987, we categorize outside directors as either independent of or having some affiliation with managers, and find that bidding firms on which independent outside directors hold at least 50% of the seats have significantly higher announcement-date abnormal returns than other bidders. However, the relationship between bidding firms' abnormal stock returns and the proportion of board seats held by independent outside directors is nonlinear, suggesting it is possible to have too many independent outside directors. All results are lost if the traditional inside-outside board classification method is used.

Full text

Journal of Financial Economics 32 (1992) 195-221. North-Holland
Do outside directors monitor managers?
Evidence from tender offer bids*
John W. Byrd
Forr Lewis College, Durango. CO 81301. USA
Kent A. Hickman
Gonzaga Unirersity. Spokane, WA 99258. USA
Received April 1991, final version received October 1991
Examining 128 tender offer bids made from 1980 through 1987. we categorize outside directors as
either independent of or having some affiliation with managers, and find that bidding firms on which
independent outside directors hold at least 50% of the seats have significantly higher announce-
ment-date abnormal returns than other bidders. However, the relationship between bidding firms’
abnormal stock returns and the proportion of board seats held by independent outside directors is
nonlinear. suggesting it is possible to have too many independent outside directors. All results are
lost if the traditional inside-outside board classification method is used.
1. Introduction
In publicly-traded corporations, the board of directors is charged with pro-
tecting and promoting the interests of shareholders. The board has the legal
authority to ratify and monitor managerial initiatives, evaluate the performance
of top managers, and reward or penalize that performance. Most corporate
Correspondence to: John Byrd. 64 Oak Valley Drive, Durango, CO 81301. USA.
*We thank Hugh Haworth of the SEC for providing a copy of the tender offer database. We
appreciate the comments on earlier drafts of the paper provided by Michael Jensen (the editor), Jon
Karpoff. Roberta Romano, Stuart Rosenstein, Dennis Sheehan (the referee), Jeffrey Wyatt, and
workshop participants at Texas A&M University, the University of Oregon, Washington State
University. the University of Arizona, and Arizona State University, especially Barry Baysinger,
Saeyoung Chang. Larry Dann, Michael Hertzel, Michael Hopewell, Marilyn Johnson. Scott Lee.
Scott Lummer, Wayne Mikkelson, Helena Mullins, George Racette, Richard Smith. Thomas Turk,
and Wanda Wallace. John McDowell and Danny Cooper provided valuable research assistance.
Much of the work on this paper was done while the authors were at Washington State University.
0304405X. 92,$05.00 C 1992-Elsevier Science Publishers B.V. All rights reserved

196 J. Byrd und K. Hickmrm. Do outside dirrc~tors monitor munuqrrs?
boards include some of the firm’s top managers as well as directors from outside
the firm. The inside directors provide valuable information about the firm’s
activities, while outside directors may contribute both expertise and objectivity
in evaluating the managers’ decisions. The corporate board, with its mix of
expertise, independence, and legal power, is a potentially powerful governance
mechanism.
The outside directors’ monitoring of managers has been seen as the most
important function of the corporate board [Winter (1977) and American Law
Institute (1982)]. It is argued that only outside directors can ask the difficult
questions ‘which even a fully conscientious management may not face directly
because of an unconscious pride of authorship’ [Winter (1977, p. ZSS)]. The
importance of outside directors is not universally accepted. however. Some
observers question whether outside directors add to the economic discipline
already imposed on managers by product and factor markets, the managerial
labor market, the market for corporate control, and alternative internal gover-
nance controls such as auditing, bonding, and ownership structure.’ Even if
boards do not merely duplicate other governance mechanisms. critics suggest
that managers inherently dominate the board by choosing the outside directors
and providing the information they analyze [Mace (1986) and Patton and Baker
(1987)].
Empirical studies have not resolved the debate about the importance of
corporate boards, and particularly outside directors, in protecting shareholder
interests. Few studies have directly examined the relationship between the
presence of outside directors and the shareholder wealth effects of managerial
decisions, and only recently have researchers substantiated the monitoring role
played by outside directors. In a study of the banking industry, Brickley and
James (1987) find that the presence of outside directors tends to reduce manage-
rial consumption of perquisites. Weisbach (1988) finds that the higher the
proportion of outsiders on a board, the more likely it is that the board will
replace the firm’s chief executive officer after a period of poor corporate per-
formance. Rosenstein and Wyatt (1990) provide direct evidence that shareholder
wealth is affected by board composition: they document a positive stock price
reaction at the announcement of the appointment of an additional outside
director.
Our study provides additional evidence on the importance of corporate
boards by examining the association between the presence of outside directors
and the returns to shareholders of bidding firms in tender offers. Boards
are virtually certain to be involved in takeover attempts; in fact, legal commen-
tators state that reviewing acquisition proposals put forth by management is
a duty of the board [Koontz (1967) and Weiss (1991)]. Acquisitions are major
‘See Hart (1983). Fama (1980). Manne 11965). Jensen and Ruback (1983). and Jensen and
Mcckling (1976) for discussions of these control mechanisms.

J. Bvd und K. Hickman. Do outside directors monitor munugers.? 197
investments that may alter the strategic direction of the firm. so they certainly
affect the welfare of the shareholders whom the directors represent. The threat of
shareholder lawsuits provides a further incentive for directors to review pro-
posed acquisitions.
Outside directors may be particularly adept at monitoring acquisition [Bacon
(1985)]. They may manage firms that have been involved in acquisitions, and
they are likely to be more objective in evaluating the costs and benefits of an
acquisition than the managers proposing the takeover. They may also have
special information about the target firm’s industry or the target firm itself
which is relevant to the acquisition. The objectivity and business acumen of
outside directors is particularly important in monitoring the acquisition process
when managers’ empire-building ambitions or executive pride conflict with
shareholders’ interests.’ Existing evidence confirms that acquisitions enhance
the value of some bidding firms, while reducing that of others. Studies using data
from the 1970s and 1980s find that the distribution of bidder abnormal returns is
centered near zero, with approximately equal numbers of firms falling above and
below the mean.’ The fact that abnormal returns are often negative suggests
either that bidding firms overestimate a target’s worth or that tender offers are
motivated by goals other than shareholder wealth maximization. If outside
board members have any influence in corporate decisions, it may be revealed in
the acquisition process.
In examining the role of corporate directors, we use the director classifica-
tion procedure developed by Baysinger and Butler (1985), which distinguishes
between inside directors, affiliated outside directors, and independent out-
side directors. The independent outside directors represent the monitoring
component of the board. Boards in which independent outside directors
hold at least half the seats can block a proposed acquisition, and such
boards will approve fewer unprofitable acquisitions than other boards.
Moreover, independent directors may influence the acquisition process even
when they lack veto power over board decisions; as more directors voice
their concerns over a proposed acquisition, the likelihood of swaying the
decision increases. We therefore expect a positive association between acquisi-
tion profitability and the proportion of independent outside directors on the
board.
The quality of board oversight depends on the directors’ incentives to monitor
managerial activities. Fama and Jensen (1983) and Ricardo-Campbell (1983)
argue that outside board members who hold multiple directorships have
ZBaumol(1959), Marris (1964). and Rhoades (1985) discuss the tendency of managers to increase
the firm beyond its optima) size. Executive pride or hubris is central to Roll’s (1986) theory regarding
the low profitability of takeovers to bidders.
‘See. for example. Jensen and Ruback (1983). Dodd (1986). Bradley. Desai. and Kim (1988).
Jarrell, Brickley. and Netter (1988). and Loderer and Martin (1990).

198 J. Byrd und K. Hickman. Do ourside direcrors moniror mmugers.’
a greater incentive to monitor corporate decisions on behalf of all shareholders
because these directors have made a significant investment in establishing
reputations as decision experts. While opposing a proposed acquisition may
jeopardize a director’s position on the bidder’s board, the cost of supporting
a decision detrimental to shareholders could be still greater, because it would
reduce the value of the director’s reputational capital in the marketplace for
decision experts. The more directorships an individual holds, the greater his or
her incentive to oppose unprofitable acquisitions.
In addition, equity ownership by nonmanagement board members creates
an incentive for those directors to more actively oppose unprofitable activities
in order to protect their financial stake in the firm [Jensen and Meckling
(1976)]. Jensen and Meckling argue that as managerial ownership of the
firm’s stock increases, the interests of managers and outside shareholders
become more closely aligned. As the objectives of these two groups converge,
fewer acquisitions will be proposed for motives other than shareholder wealth
maximization. However, this alignment of the interests of shareholders and
managers may be limited to relatively low levels of managerial stock owner-
ship. Stulz (1988) provides a model in which high levels of managerial stock
ownership are harmful to shareholders because managers become insulated
from some corporate governance mechanisms, such as the market for corporate
control.
Using a sample of 128 tender offer bids by 111 firms, we find that the average
announcement-date abnormal return is significantly less negative for bidding
firms on whose boards at least half the seats are held by independent outside
directors. In cross-sectional piecewise regression tests, we find a curvilinear
relationship between the proportion of independent directors on the board and
the bidding firms’ announcement-date abnormal returns. This relationship is
positive over most of its range, but is significantly negative when independent
directors hold a very high proportion of board seats. The curvilinear relation-
ship is not affected when other variables which may influence the profitability of
an acquisition are added to the regression model; examples of such variables
include director stock ownership, the number of other directorships held by
bidding firm directors, the terms of the tender offer, and the relatedness of the
bidder and target. Furthermore, this relationship is unique to independent
outside directors. Reestimating the regression models using a piecewise board
composition variable based on the proportion of outside directors on the board
(both independent and nonindependent) yields no significant statistical relation-
ship between board composition and the acquisition announcement abnormal
returns. Interestingly, differences in abnormal returns are not apparent if
the traditional two-way (inside-outside) classification of directors is used, sug-
gesting that studies of board composition relying on the inside-outside
classification may have missed important empirical relationships because they
misspecilied the director categories.

J. Byrd and A’. Hickmun. Do oursIde directors monifor managers? 199
Our results are consistent with the hypothesis that independent outside
directors monitor firm decisions on behalf of shareholders during the acquisi-
tion process. However, our findings do not support the claim that shareholders
are necessarily better off with a board comprised entirely of independent outside
directors. In fact, the results suggest that it is possible to have too many
independent outside directors. Baysinger and Butler (1985) argue that corporate
boards have a variety of responsibilities which require a diverse set of talents to
satisfy. Emphasizing one area of expertise, such as managerial monitoring, may
reduce the board’s overall effectiveness. Our results are consistent with such
a multifaceted view of the role of the board of directors in corporate decision-
making.
In the next section we describe the board classification procedure. In sec-
tion 3, the sample selection process is described and characteristics of the sample
are presented. Our empirical results are presented in section 4, and section 5
contains a summary and our conclusions.
2. Classification of directors
The traditional two-way classification scheme of ‘insider’ (corporate em-
ployee) or ‘outsider’ (nonemployee) directors fails to consider potential conflicts
of interest when directors are not full-time employee but have affiliations with
the firm. We therefore follow the director classification procedure developed in
Baysinger and Butler (1985). Depending on affiliations and transactions noted
on the bidder’s proxy statement, directors are placed into one of three catego-
ries: inside directors, affiliated outside directors, or independent outside direc-
tors. Inside directors are typically corporate officers or retirees and members of
their families. Affiliated outside directors are not full-time employees of the firm
but are associated with it in some way. This class includes investment bankers,
commercial bankers that have made loans to the firm, lawyers providing
services to the firm, consultants, officers and directors of the firm’s suppliers and
customers, and interlocking directors. Independent outside directors have no
affiliation with the firm other than their directorship, and include private
investors, business executives, academics, and decisionmakers from the public
sector.
3. The sample
3.1. The sample selection process
Our sample consists of 128 acquisition bids made by 111 firms during the
period 1980-87. To compile the sample, we began with a list of all tender offers
field with the U.S. Securities and Exchange Commission (SEC) from 1980
J.F.E. -C

200 J. Bwd and K. Hickman. Do outside direcrors monifor managers.’
through 1988.’ The final sample includes all bidders from the list that satisfy the
following five criteria:
1. Both the bidder and the target were listed on the New York or American
Stock Exchange at the time of the bid. and the bidder did not already own
a controlling interest in the target.
2. The tender offer bid was registered with the SEC between January 1, 1980
and December 31, 1987.
3. The tender offer was announced in the Wall Street Journal, and there were no
conflicting news announcements for the day preceding through the day
following the bid announcement, such as a change in dividends or earnings,
a proxy fight, or the award of a large purchase contract, a feature on the
bidder in the ‘Heard on the Street’ column for a matter other than the tender
offer, or a report that the target had made a counter offer for the bidder.
4. Each bidder had daily stock returns on the Center for Research on Security
Prices (CRSP) Daily Returns File for at least 210 trading days preceding the
bid announcement date.
5. A proxy statement for the annual shareholders’ meeting immediately before
the bid announcement was available either in the Q-file Corporate Microfile
or from Bechtel Information Services.
The requirement of NYSE or AMEX listing imposes an implicit minimum
size standard, which helps ensure that the acquisition is material to the bidder.
We exclude observations in which the bidder already holds a controlling interest
in the target in order to avoid problems of investor anticipation of the acquisi-
tion. Eliminating bids with contemporaneous news announcements makes it
possible to attribute the announcement-date abnormal return solely to the
acquisition offer rather than to some other corporate event.
3.‘. Descriptise statistics of the sample
Table 1 presents a time profile of the sample showing the number of tender
offers made in each year, 1980-87, by board type. In panel A, firms are classified
as having independent boards (at least 50% independent outside directors) or
nonindependent boards (less than 50% independent directors). Of the 128
tender offers, 45 are made by firms with independent boards. Panel B classifies
boards using the traditional inside-outside procedure. Using this method, 105
“We are grateful to Hugh Haworth of the SEC’s Office of Economic Analysis for prowding this
data.

J. Byrd and K. Hickman. Do outside direcrors moniror managers? 201
Table I
Tender offer bids classified by year and board type for 128 tender olTers by 1 I I firms, 1980-87.
Panel A Independent boards’
Number of bids with board composition of
Year Less than 50%
independent directors 50% or more
independent directors Year
total
1980 9 6 15
1981 12 7 19
1982 16 2 18
1983 9 4 13
1984 I2 8 20
1985 10 7 17
1986 7 8 15
1987 8 3 11
Total 83 45 128
Panel B. Outside-direcror-dominated boardsb
Year
Number of firms with board composition of
-
Less than 50% 50% or more
outside directors outside directors Year
total
1980 1 14 15
1981 3 16 19
1982 -l
; 16 1s
1983 9 13
I984 5 I5 20
1985 4 13 17
1986 7 13 15
1987 2 9 11
Total 23 105 128
“Directors are identified according to affiliations listed in the proxy statement immediately
preceding the tender offer. Independent outside directors have no affiliation with the firm or its
managers other than their directorship. For details of the categorization procedure, see the text or
Baysinger and Butler (1985).
“Outside directors are all directors who are neither current nor former employees of the firm (but
who may have some business affiliation with the firm).
bids (82% of the sample) have boards with at least 50% of total seats held by
outside directors.
Table 2 presents summary statistics on sample firm boards of directors.
Where available, we include comparable statistics from other studies. The
average bidding-firm board has 12 directors, of whom 38% are classified as
inside directors. 23% as affiliated outside directors, and 39% as independent
outside or monitoring directors, (When directors are divided into just two
classes - ‘insiders’ and ‘outsiders’ - we find that the average proportion of

Table 2
Summary stattsttcs for board characteristics of bidding tirms in tender offers ~tth comparisons to
other studies for I28 tender offer bids by I I I tirms. 19YO-87.
Mean Median Standard
deviation Comparable
means
Board size (number of directors) 12.1 12.0 3.7
Inside directors ( o 0 )’ 37.5 36.0 15.9
AAliated outside dtrectors f”,,, Y 13.3 21.8 13.3
Independent outside directors ( o,~Y 39.2 39.4 IS.1
Total outside directors ( ‘%) 62.5 64.0 15.9
Inside dtrector stock ownership (“,O) 10.9 2.0 16.7
Affiliated outside stock ounership (“4,)’ 3. I 0.0-t x.5
Independent outside stock ownership (%)I 2.0 0.08 6.1
Outside director stock ownership (O/O ty 4.1 0.3 9.7
Other directorships” 2.6 2.-t I.3
_______- _____~_.
“As reported tn Worn Ferry (1987).
13”.13.5b,1 I’
13b
31h
26b
67’.57b.63d
8.8’
3.0*
-.___._
bAs reported m Baysinger and Butler (1985).
‘As reported in Singh and Harianto (1989).
‘As reported in Drieghe (19861.
‘Dtrectors are categortzed according to the affiliations for each director found in the proxy
statement immediately preceding the acquisition bid.
‘Director stock o\+nership is the percentage of the common stock of the bidding firm held by all
directors in a particular director category.
%Outside director stock ownership is the percentage of the common stock of the bidding firm held
bv all outside directors.
hOther directorships ts the aberage number of directorships held by outside directors. excluding
the seat held on the bidding firm’s board.
outsiders on boards of sample firms is 62%. which falls within the range of
outsider representation reported in other studies.) Seven observations (by six
different firms) had no affiliated outside directors, and three sample firms had no
independent outside directors. One firm, Clabir, had no outside directors of
either type. Our sample has a higher proportion of independent outside direc-
tors and a lower proportion of inside directors than were found by Baysinger
and Butler (1955). who document an increase in independent directors and
a corresponding decrease in inside directors during the 1970s a trend which our
data suggest continued into the 1980s.
Inside directors of bidding firms held, on average, 11% of their firm’s common
stock. This finding is similar to the inside ownership stake of 8.8% found by
Singh and Harianto (1989). The average stock ownership of all outside directors
is 40/b, with independent outside directors holding just under 2% and affiliated
outside directors holding just over 2%. For all three director types, the mean
ownership stake exceeds the median, indicating that the distribution of stock
ownership is skewed to the right. In our sample the total ownership of common
stock by all board members is 15%, on average, which is larger than the 10.6%
mean board ownership stake reported by Merck, Shleifer. and Vishny (1988) for

directors of Fortune 500 firms in 1980. This difference in the ownership of stock
by directors may be due to the inclusion of smaller firms in our sample. Finally,
outside directors hold 2.6 other directorships. on average. which is similar to the
number reported by Drieghe (1986). (This number does not include the seat held
on the sample firm’s board.)
A comparison of independent boards and other boards (not shown in table 2)
revealed only one significantly different characteristic: the ownership of stock by
inside directors. As a group, inside directors on independent boards held 6% of
company stock. on average, compared with 13% held by all inside directors on
nonindependent boards. These values are different at the 1% level of significance
(r-statistic of 2.49). This result arises in part because nonindependent boards
have more inside directors. When ownership is computed on a per director
basis, inside directors on nonindependent boards continue to own a larger
fraction of shares than their counterparts on independent boards (3.2% versus
1.9%) but the difference is no longer statistically significant (r-statistic of 1.58).
In table 3, we present summary statistics about the tender offer bids and the
bidding and target firms. The mean market value of the bidding firms’ common
stock 30 days before the tender offer announcement is S1,592 million
(median = $861.5 million) and ranges from S20 million to S11.8 billion. The
mean market value of the target firms’ common stock 30 days before the tender
offer announcement is 5.570 million (median S207 million) and ranges from $4
million to $7.25 billion. The average ratio of target size to bidder size is 0.68,
with a median value of 0.30. On average, bidding firms are attempting to acquire
firms of about two-thirds their own size in terms of equity value. Over the
sample period the mean value of the relative size of the target to the bidder
increased from 0.32 in 1980 to 1.24 in 1987: that is, the observations from 1987
involved bidders that, on average, were smaller than the targets they pursued.
Bidding firms with independent boards were, on average, smaller than other
sample firms and pursued proportionately smaller targets. The average ratio of
target size to bidder size for bidders with independent boards is 0.44, compared
with 0.81 for bidders with nonindependent boards. These values are statistically
distinguishable at the 2.5% level (c-statistic of 2.23).
The total amount of the bid, as reported in the first WalI Street Journal
announcement, averaged 5569.4 million dollars. The average bid premium
offered by bidding firms, computed using the target’s share price 30 days before
the bid announcement and the bid price at the first announcement, was 44%.
[This is somewhat larger than the average bid premium of 30% for takeovers in
the 1980s reported by Jarrell, Brickley, and Netter (1988)]. The bid premium
decreased over the sample period from an average of 51% in 1980-82 to
40% in 1985-87, although these values are not statistically different from
each other at conventional significance levels (t-statistic = 1.62). The bid pre-
mium differed significantly between firms with and without independent boards:
firms with independent boards offered an average premium of 35.5%, compared

x4 J. Byrd and K. Hickmun. Do ourside dirrcrors moniror muntrgrrs.’
Table 3
Summary statistics of the sizes of the bidding and target firms, the bid premium offered. and the
industry affiliation in 128 tender offer bids by I1 1 tirms. 1980-87.
Variable Mean Standard
Median deviation
Market value of bidder common stock (Smillions)”
Market value of common stock
target (Smillions)”
Ratio of to bidder”
target
Total value of the bid (Smillions)b
Bid premium (%)’
1.592 862 1779 -._*
570 207 1.083
0.68 0.30 1.08
569 250 896
44 40 34
‘The market value of bidder and target common stock is measured 30 days before to the
announcement of the tender offer bid in the Wall Streer Journal.
“The total value of the bid is the bid price in the first Wall Street Journal announcement of the bid
times the number of shares sought. In the case of an offer to exchange stock, the bid price is replaced
by the bidder’s stock price the day before the announcement times the exchange ratio of the offer.
‘The bid premium is calculated as the difference between the bid price and the price of the target’s
shares 30 days before the announcement, all divided by the piice of the target’s shares 30 days before
the announcement. In the case of an offer to exchange stock. the bid price is replaced by the bidder’s
stock price the day before the announcement times the exchange ratio of the offer.
with 48.6% for firms with nonindependent boards. These values are statistically
distinguishable at the 1% level (t-statistic of 2.47).
Of the 128 bids, 116 were cash offers, and in 93 the bidder eventually
gained control of the target. Ninety-eight bids were the first offer for the
target. The sample includes firms from 84 different four-digit SIC codes,
with the most frequent bidder SIC code (1311, petroleum production) appearing
in eight tender offers. The related industry groups of petroleum refining
and natural gas production and distribution account for another 12 bids.
Included in the sample are bidders from 66 different three-digit SIC codes
and 34 different two-digit SIC codes. Twenty-seven tender offers involved
bidders and targets with the same four-digit SIC code. These are cases of
bidders attempting to expand within their own industry: petroleum production
and refining (SIC 1311 and 2911) each account for three of these 27 offers.
At the three-digit SIC code level, 39 proposed acquisitions were between
firms with the same SIC code, and 43 involve firms whose three-digit SIC codes
are within one digit of each other. Fifty-four tender offers are between firms in
the same two-digit SIC code. Horizontal acquisitions are equally prevalent
among firms with independent boards and other boards. Similarly, we find no
evidence that firms with executive-dominated boards are more likely to make
diversifying tender offers. These data, which are not tabulated, suggest that the
sample is not dominated by a particular industry or a particular type of
acquisition.

J. Bwd und K. Hickmun. Do ourslde directors moniror monugers’ 205
4. Empirical results
4.1. A bnormd returns
We measure the impact of the acquisition decision on the bidding firm’s
shareholders by calculating the abnormal return on the bidding firm’s common
stock at the announcement of the tender offer. Data from the CRSP daily
returns file and the value-weighted market index are used to estimate market
model parameters for each observation. The estimated market model para-
meters, ;i and Bi* for firm i are ordinary least squares (OLS) estimates using
the 100 nonoverlapping continuously-compounded two-day returns from the
200-day estimation period beginning on day - 209 (that is, 209 trading days
before the announcement date, which is designated as day 0). The abnormal
return, ARi,, for firm i over the two-day interval t is the difference between the
actual continuously-compounded return for firm i over the two-day interval t,
Ri,, and the expected return for that two-day period based on the estimated
market model parameters and the continuously-compounded value-weighted
market return, R,,, over the same two-day interval, or
ARi, = Ri, - ii - P^iR,, . (1)
Significance tests involving the abnormal returns are based on the following
Z-statistic for the two-day event window (days - 1 and 0, or the announcement
date and the trading day immediately preceding):
(2)
where N is the number of observations in the sample. var(ARi*) is defined as
1
’ (3)
where V,? is the residual variance from firm i’s market model regression, f?m is
the mean of the continuously-compounded two-day market returns over the
200-day estimation period, and a and b represent the beginning and ending
two-day periods for the estimation period. The Z-statistic in expression (2) is
asymptotically unit normally distributed.
Table 4 reports the average response of the bidder’s stock price to the
announcement of a tender offer bid. The two-day announcement period includes
day 0, the date of the Wall Street Journal announcement of the bid, and day - 1,

Average two-day risk-adjusted
ahnormal return
Skrndard dcvialion
Minimum
Median
Maximum
Z-stnlistic: H,: Mean = 0.0’
Number of ohservalions
Number negorive
- I.X6%”
4.15u/u
- 14.651%
- 1.X3”/”
12.36%
- 7.Y7”
x3
60’
Boards with 11 leut 50%
independenl direclors
- O.O7”/“b
4.98%
- 12.35%
- 0.12%
I I .97%
~ 0.61
45
26’
All bidding lirmr
~ 1.23”/u
4.44?”
- 14.65%
- l.%“/u
12.36%‘”
- 6.7X’
I?X
X6

the trading day immediately preceding the announcement date. The third
column of table 4 shows that the average two-day announcement-date abnor-
mal return for the entire sample is - 1.23%, which is statistically different from
zero at all standard levels of significance (the Z-statistic is - 6.78). [This is
similar to the average return of - 1.10% to successful bidders in tender offers
during the 1980s reported by Jarrell, Brickley, and Netter (1988).] When the
sample is categorized according to the independence of the board of directors.
we find that the 83 bid announcements involving firms with nonindependent
boards have a statistically significant average two-day abnormal return of
- 1.86%, while the 45 announcements by firms with independent boards have
an average return of - 0.07%. These values are different at the 5% level
(t-statistic = 2.13). Of the firms with nonindependent boards, 60 of the 83 bids.
or 72%, had negative abnormal returns; among firms with independent boards.
58% had negative abnormal announcement-date returns. These proportions.
72% and 58%, are statistically different at a significance level of 10%. Our
results not only support the hypothesis that the shareholder wealth effects of an
acquisition bid will, on average, be more favorable when independent directors
hold at least half the seats on the bidder’s board, they are consistent with the
claim that shareholder interests are better served by independent boards of
directors.
The results in table 4 are based on the three-way director classification
procedure developed by Baysinger and Butler (1985). Using the more typical
two-way classification scheme (table 5) yields no significant difference between
inside- and outside-dominated boards. Inside-dominated boards are those in
which executives of the firm hold more than 50% of all seats. In outside-
dominated boards, nonexecutives hold at least 50% of all seats. As shown in
table 5, bid announcements involving firms with inside-dominated boards have
a statistically significant average two-day abnormal return of - 0.99%. while
the outside-dominated board group has an average return of - 1.28%. These
returns are not statistically distinguishable from each other, although both are
statistically different from zero at the 1% level. This evidence, when combined
with the results from table 4, supports the theoretical contention of Baysinger
and Butler (1985) that the affiliations of outside directors can affect their
monitoring incentives. Our findings also suggest that important relationships
may be missed if the simple inside-outside classification scheme is used.
4.2. Cross-sectional regression models
A series of regression models is used for cross-sectional analysis. Shareholder
wealth effects at the announcement of the acquisition bid are regressed on
explanatory variables including board independence, the fraction of board seats
held by independent directors, director stock ownership, other directorships,
and a set of control variables. Separate stock ownership variables are included

208 J. Byrd and K. Hickmun. Do ours& drrecrors moniror managers?
Table 5
Two-day risk-adjusted abnormal stock returns for bidding firms at the first announcement of
a tender offer bid for 128 bids by 11 I firms. 1980-87. with boards classified using the inside-outside
classification scheme.
Inside-director-
dominated boards” Outside-director-
dominated boards All bidding firms
Average two-day risk-adjusted
abnormal return
Standard deviation
Minimum
Median
Maximum
Z-statistic: H,: Mean = 0.0’
Number of observations
Number negative
- 0.99%b
5.30%
- 10.69%
- 1.01%
12.36%
- 2.70d
23
12’
- 1.28?/ob
4.25%
- 14.65%
- 1.39%
11.97%
- 6.22a
105
74’
- 1.23%
4.44%
- 14.65%
- 1.28%
12.36%
- 6.78’
128
86
‘Outside directors are neither current nor former executives of the firm (or members of the families
of current or former executives).
?he mean values for the two board categories are not statistically different at any standard level
of significance (f-statistic = 0.24).
‘The null hypothesis being tested is that the mean two-day abnormal return equals zero.
dSignificant at the I% level.
‘The proportions of negative returns for the two board categories are statistically different at the
10% level (t-statistic = 1.69).
for inside, affiliated outside, and independent outside directors. In addition,
piecewise regression models are used to further investigate the relationship of
the acquisition announcement abnormal stock returns to the presence of inde-
pendent outside directors. The control variables reflect the results of past studies
which suggest that bidder abnormal returns may be influenced by the medium of
exchange [Travlos (1987)], the presence of multiple bidders [Bradley, Desai, and
Kim (1988)], and whether the bidder and target are from related industries
[Merck, Shleifer, and Vishny (1990)].
Table 6 presents coefficient estimates from several cross-sectional OLS re-
gression models. In each model, the dependent variable is the two-day risk-
adjusted announcement-date abnormal return expressed in percent. The
explanatory variables include two board composition variables as well as
continuous and dummy variables for the stock ownership of each category of
director. The explanatory variables are defined as follows:
Independent Board = 1 if independent outside directors hold at least 50% of all
board seats, and 0 otherwise;
Fraction lndependent Directors = number of independent directors divided by
total number of directors on the board;
Inside Stock Ownership = fraction of the bidding firm’s outstanding voting
shares (and options exercisable within six months) owned by executives (or
former executives) holding seats on the board;

J. Byrd and K. Hickmun. Do oursrtle directors monitor munagers? 209
Aflliated Outside Stock Ownership = fraction of the bidding firm’s outstanding
voting shares (and options exercisable within six months) owned by affili-
ated outside directors;
Independent Outside Stock Ownership = fraction of the bidding firm’s outstand-
ing voting shares (and options exercisable within six months) owned by
independent outside directors;
Inside Ownership Dummy = 1 if Inside Stock Ownership > 0.002 (0.2%), and
0 otherwise;
Afiliated Outside Ownership Dummy = 1 if Afiliared Outside Director Owner-
ship 2 0.002 (0.2%), and 0 otherwise:
Independent Outside Ownership Dummy = 1 if Independent Outside Director
Ownership > 0.002 (0.2%), and 0 otherwise.
Other Directorships = average number of other directorships held by outside
board members;
Offer Terms = 1 if the bid is entirely for cash, and 0 otherwise;
Competing Bid = 0 if the sample firm’s bid is the first bid for the target, and 1 if
there is another bid outstanding when the sample firm enters its bid; and
Within One Three-digit SIC = 1 if the three-digit SIC codes of the bidder and
target are within one digit of one another, and 0 otherwise.
In models 1 and 2 the board composition variable is the dummy variable
Independent Board. In both models, the Independent Board variable has the
predicted positive sign and is significant at the 2% level. This result is consistent
with the data shown in table 4. The coefficient estimates imply that the expected
return to shareholders of bidding firms with independent boards is about two
percentage points higher than for other firms.
We examine the importance of the distinction between independent and
affiliated outside directors by replacing the Independent Board variable with
a board composition variable based on the traditional inside-outside classifica-
tion of directors. The explanatory power of the model is reduced when the
Independent Board variable is replaced by a dummy variable which equals one if
outside directors (affiliated and independent) hold at least 50% of all seats
and zero otherwise. In no case is this alternative board composition variable
significant at the 10% level. These results are not tabulated.
In models 3 and 4 the continuous board composition variable, Fraction
Independent Directors, replaces the dummy variable. The coefficients are positive
as predicted, but not statistically significant at conventional levels (the r-statistic
of 1.63 in model 4 corresponds to a p-value of 11%). Moreover, there is no
change in the regression results when this variable is replaced by a board
composition variable measuring the fraction of total board seats held by outside
directors (affiliated and independent). These results are surprising given the
significant relationship of the Independent Board dummy variable to announce-
ment-date abnormal returns found in models 1 and 2. We investigate these
results further in table 7.

210
i:
3
I

J. Bvd rrnd K. Hickman. Do oursrde direcrors moniror managers? 211

In no models are the coefficients of the continuous ownership variables (Inside
Stock Ownership. AJiliated Outside Stock Ownership, and Independent Outside
Stock Ownership) statistically significant. The lack of significance of inside Stock
Ownership differs from Lewellen, Loderer, and Rosenfeld’s (1985) finding of
a positive association between managerial ownership and the cumulative stock
price adjustment over the entire acquisition process.
When the continuous ownership variables are replaced by their dummy
variable analogues we find statistically significant coefficients for both inside
and independent outside director ownership, consistent with the Jensen and
Meckling (1976) prediction that stock ownership helps align the interests of
managers (and directors) with those of shareholders. The results reported
in table 6 are for dummy variables with separation points of 0.2% for all
director categories. Although the same breaking point is used to construct
all three ownership dummy variables, the three variables differ considerably.
This breaking point represents the 16th percentile of inside ownership, so
the Inside Ownership Dummy variable distinguishes between almost no aggre-
gate ownership by managers and at least some low level of ownership. For
both types of outside directors, the breaking point of 0.2% represents approxi-
mately the 65th percentile ofthe ownership distributions, so the dummy variable
indicates the effect of relatively large outside director holdings. This pattern
of results for the ownership dummy variables is robust over a range of
breaking points (from 0.12% to 1.25% for the Inside Ownership Dummy and
from 0.15% to 0.55% for the Independent Outside Ownership Dummy). Diagnos-
tic tests indicate that the dummy variable results might be affected by several
influential observations. Rather than discarding these observations, we reesti-
mate the regression models usin g a robust regression technique, iteratively
reweighted least squares (IRLS), that is more efficient than ordinary least
squares (OLS) when the distribution of the error terms has heavier-than-normal
tails [Hamilton (1992)-J. The IRLS results confirm the OLS results; that is, in
regressions which deemphasized observations with large residuals, the coeffi-
cient estimates and significance levels did not differ substantially from the
original OLS results.
The variable Other Direcrorships is negatively signed but is not statistically
significant in any of the models. The regression models also include three control
variables which describe characteristics of the acquisition bid. The coefficient
estimates for the control variables confirm the results of previous studies. As in
other studies. cash offers are associated with a higher stock price reaction than
noncash offers. Similar to the findings of Bradley, Desai, and Kim (1988) the
Competing Bia’ coefficients are negatively signed, although not statistically
significant, indicating that shareholder wealth is reduced when a bidder enters
an ongoing bidding contest. The coefficients on the Within One Three-digit SIC
variable are positive, as in Merck, Shleifer, and Vishny (1990), suggesting that
shareholders benefit from acquisitions within the same industry.

J. Byrd and K. Hickman. Do outside directors monitor managers? 213
While the results shown in table 6 verify that independent boards benefit the
shareholders of bidding firms during the acquisition process, they provide no
statistically significant evidence that those benefits accrue continuously as the
proportion of independent outside directors increases. In other words, the
relationship of the announcement-date abnormal returns to the proportion of
independent outside directors may be nonlinear. We test for a nonlinear rela-
tionship by separating the board composition variable, Fraction Independent
Directors, into the following piecewise variables:
Fraction Independent Directors (to 0.4) = Fraction Independent Directors if
Fraction Independent Directors is less than 0.40, = 0.40 otherwise;
Fraction Independent Directors (0.4 to 0.6) = 0 if the Fraction Independent
Directors is less than 0.40, = (Fraction Independent Directors minus 0.40) if
the Fraction Independent Directors is between 0.4 and 0.6, = 0.20 other-
wise;
Fraction Independent Directors (ouer 0.6) = (Fraction Independent Directors
minus 0.60) if the Fraction Independent Directors is greater than 0.6, = 0
otherwise.
The turning points of 0.40 and 0.60 maximized the explanatory power of the
full model. Using this method, the sum of the piecewise variables equals the
original variable, Fraction Independent Directors.
Table 7 presents the results from several linear piecewise regressions. In all
models, the coefficient for the Fraction Independent Directors (0.4 to 0.6)
variable is positive and statistically significant, while the coefficient for Fraction
Independent Directors (over 0.6) is negative and statistically significant. In no
model is the coefficient for a low proportion of independent outside directors
statistically significant. Fig. 1 presents these results graphically, using coefficient
estimates from model 1. Replacing the single board composition variable with
its piecewise analogues increases both the F-statistic and R’ of otherwise
comparable models. The results presented in table 7 indicate that a simple linear
model does not describe the relationship between the acquisition announcement
abnormal returns and presence of independent directors as accurately as a piece-
wise model.’
This nonlinear relationship supports the contention of Baysinger and Butler
(1985) that there is an optimal mix of inside, affiliated outside, and independent
outside directors. When independent directors hold 40-60% of board seats we
‘As an alternative to the piecewise board composition variables we estimated a second-degree
polynomial model. In all cases the first-order term is significantly positive. while the squared term is
negative. albeit not statistically significant. The inflection point of these quadratic functions ranged
from 0.50 to 0.55 (from 50% to 55% independent outside directors).

I.!.

J. Byrd und K. Hickmun. Do outside dirrcrors mom~or managers.? 215

E
2 -1.5
e,
z -2
2 -2.5
,” z -3
* -3.5
-4
-4.5
-5-C : : : : : : : : : : : : : ; : I
C 2 0 IA
3 _ c R ;i: 4 2 s z C
In g g 2 3 m
F I-- z
2’ 6 6 6 6 6 6 j 6 6 c’ j 1 j c=’ j j
Fraction of Independent Outside Directors
Fig. 1. The relationship between the fraction of independent outside directors and the acquisition
announcement abnormal returns implied by the piecewise linear OLS regression presented in
table 7, column I. of abnormal returns regressed on board composition, director stock ownership,
and control variables for 128 bids by 111 firms, 1980-87.
find evidence consistent with monitoring. Within this range, there is apparently
a sufficient critical mass of independent outside directors to effectively oversee
managerial activities. When independent outside directors hold only a small
proportion of board seats (less than 35540%) we find no evidence of monitoring.
At the other extreme, we find that returns to shareholders decrease as the
proportion of board seats held by independent outside directors increases
beyond 60%, suggesting that it is possible for a board to have too many
independent directors.
We test the robustness of the piecewise board composition results by chang-
ing the turning points used to compute the variables and by examining the
model for influential observations. The results are unchanged in terms of signs
and statistical significance for lower turning points from 0.20 to 0.45 and upper
turning points from 0.50 to 0.70. We find no evidence of influential observations
using the procedures suggested by Belsley, Kuh, and Welsch (1980). Results from
iteratively reweighted least squares estimations provide additional confirmation
regarding the robustness of the ordinary least squares results.
The explanatory power of the model is reduced when the piecewise variables
based on independent outside directors are replaced by similar variables based
on inside directors or all outside directors. These results, which are not
tabulated. provide additional evidence that important relationships may be
missed if the traditional inside-outside director classification method is used.

J. Byrd and K. Hickman. Do ortmde direcrors mmutor managers.” 217
The pattern of results for director stock ownership is identical to that shown
in table 6. The coefficients of the continuous ownership variables are not
statistically significant, but coefficients for both the inside and independent
outside ownership dummy variables are positive and statistically significant.
These dummy variables distinguish between almost no aggregate ownership by
particular director groups and at least some low level of ownership. Therefore,
the significant positive coefficients on these variables indicate that shareholders
benefit from director stock ownership, but that these benefits do not necessarily
increase as that ownership stake grows. We also examined the relationship of
the announcement-date abnormal returns to managerial and independent out-
side director ownership using two alternatives to the dummy variable approach.
Neither linear piecewise ownership variables nor a quadratic function provided
evidence of a curvilinear relationship. Moreover, neither alternative improved
the explanatory power of the model.
As in table 6, the Other Directorship coefficient is negatively signed but is not
statistically significant. The control variables follow the same pattern as in
table 6. Cash offers and proposed acquisitions of firms in related industries
enhance the expected returns to shareholders, while entering an ongoing bidding
contest for a target is associated with lower abnormal returns.
4.3. Ecidence of monitoring or learning by independent boards
Eighteen firms appear twice in our sample, with four of these firms changing
board categories from the first to the second acquisition offer. The evidence from
these duplicate observations suggests that all boards, but particularly indepen-
dent boards, improve their ability to distinguish between good and bad acquisi-
tions. Of the 18, 1 I (or 61%) experienced higher abnormal returns in response to
their second tender offers (although these higher abnormal returns were not
necessarily positive). We find that the announcement-date abnormal returns for
the second bid are 1.4% higher, on average, than for the first bid. The six sample
firms with independent boards at the time of their second bid had an average
increase in their announcement-date return of 3.5%, while the average increase
for sample firms with nonindependent boards was only 0.4%. Five of these six
firms (or 83%) had either a positive stock price response to their second bid or
an increase from their first bid. Eight of 12 firms with boards dominated by
nonindependent directors at the time of the second bid experienced either
a positive stock price response to their second bid or an increase from their first
bid. Given the small number of observations, these proportions (83% and 58%)
are not statistically distinguishable.
From the time of the first to the second bid, three firms changed from
a nonindependent board to an independent board. All three firms had positive
responses to their second tender offer announcements (two of the three earlier
offers were met with negative announcement-date stock price reactions).

A single firm changed its board from independent-director-dominated to nonin-
dependent-director-dominated. Both of this firm’s offers were met with negative
abnormal returns. with the stock price reaction to the second bid being slightly
more negative. Although the small number of firms changing board categories
makes statistical testing difficult. these results are generally consistent with the
contention that independent boards provide better oversight during the acquisi-
tion process than other boards.
4.4. Itrcl~~ptdtwt director ttloriitoritlg or tturnagrriiil quulit~.?
While our results are consistent with the hypothesis that independent boards
monitor managers, they are also consistent with an alternative explanation-the
managerial quality hypothesis - which involves no such monitoring. Suppose
that there are good and bad managers. Good managers make value-enhancing
acquisitions. These CEOs also dress up their firms’ boards with independent
directors. Bad managers. on the other hand, sometimes choose tender offer
targets for reasons besides shareholder wealth maximization, and they appoint
their cronies to the board. If investors can distinguish managerial quality, then
the average abnormal returns to acquisitions announced by high-quality man-
agers will exceed the average abnormal returns to acquisitions announced by
lower-quality managers. Although independent directors play no monitoring
role, the association of independent boards with good CEOs creates an appar-
ent relationship between board independence and the shareholder wealth effects
of tender offers. In fact. managerial quality determines both the composition of
the board of directors and the quality of the acquisition.
We test the managerial quality hypothesis by examining the relationship of
two measures of preacquisition firm performance to the acquisition announce-
ment abnormal stock returns and board independence. If our performance
measures are indicative of managerial quality and the managerial quality
hypothesis is correct, then managers offirms with better performance will make
better acquisition decisions. Moreover, after controlling for managerial quality,
board of director independence should explain very little of the remaining
cross-sectional variation in the announcement-date stock returns.
Following previous studies, we measure managerial performance by examin-
ing abnormal stock returns [Murphy (1985), Weisbach (1988)] and Tobin’s
Q-ratios [Merck, Shleifer, and Vishny (1988), Lang. Stulz, and Walkling (1989),
and McConnell and Servaes (1990)]. Both measures are computed using data
from the three-year period immediately before the tender offer announcement,
adjusted for industry performance. Usin, 0 either the cumulative abnormal re-
turns or the Q-ratios, we find no statistically significant difference between the
acquisition-date abnormal returns of the high- and low-performing firms.
(We have not tabulated these results, although the results and a description
of the methodology used to compute them are available from the authors.)

Furthermore, the proportion of independent to nonindependent boards does
not differ significantly between the high- and low-performance groups. These
results hold if the performance measures are based on one. two, or three years,
and if no industry adjustment is made. We do find that among the higher-
performing firms, those with independent boards have significantly higher
acquisition announcement abnormal returns than high-performing firms with
nonindependent boards; this result is significant at the 10% level.
Adding the performance measures as explanatory variables to the regression
models presented in tables 6 and 7 adds nothing to the explanatory power of
those models. The board composition variables remain significant, and in no
case are the coefficients on the performance measure variables statistically
significant. Overall, these findings provide no support for replacing the monitor-
ing interpretation of our results with an interpretation based on managerial
quality.
5. Summary and conclusions
In this study, we examine the association between characteristics of the board
of directors of bidding firms and the shareholder wealth effects of tender offer
bids. We document that less-negative returns to shareholders are associated
with boards of directors in which at least half the members are independent of
firm managers. Our evidence is therefore consistent with the claim that indepen-
dent boards benefit shareholders. We find evidence of a nonlinear relationship
between the fraction of independent directors on a board and the shareholder
wealth effects of tender offer bids. Although this relationship is positive over
most of its range, it is negative when the fraction of independent directors is
extremely high (over 60%). This result is consistent with the contention of
Baysinger and Butler (1985) that all categories of board members - managers,
affiliated outside directors, and independent outside directors - play an impor-
tant role in guiding the firm. Interestingly, our results are not consistent with the
contention that shareholders will be best served by a board comprised entirely
of outside directors. Emphasizing the monitoring role of independent outside
directors could harm shareholders by making the board less effective in its
decisionmaking and advisory roles. Overall, our evidence suggests a richer
model of board involvement in corporate decisionmaking than has typically
been assumed.
Our findings are sensitive to the method of classifying directors. We use the
three-way classification procedure developed by the Baysinger and Butler
(1985) which identifies directors as insiders, affiliated outsiders, or independent
outsiders. Had we used the conventional inside-outside categories, we would
have found no significant association between board of director composition
and the shareholder wealth effects of tender offers. This suggests that important

relationships may have been missed in studies that rely on the two-way classi-
fication scheme.
In our regression tests, we find evidence that shareholders benefit when
managers and independent outside directors own at least a small fraction of the
bidding firm’s common stock. This evidence is consistent with hypotheses that
ownership structure affects firm value [Jensen and Meckling (1976)].
In general. our results contribute to the emerging understanding of the value
of the corporate board. They suggest that one useful approach to this issue is to
examine the association between the composition and characteristics of the
board and the shareholder wealth effects of board-level corporate decisions such
as greenmail payments, golden parachute adoptions, and poison pill plans. It
will be interesting to see whether the cross-sectional variation in shareholder
returns due to these events is explained by attributes of the board of directors.
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