Board Composition and Relationship‐Specific Investments by Customers and Suppliers

• Author: Kristina Minnick,Kartik Raman
• Date: 01 March 2017
• DOI: http://doi.org/10.1111/fima.12150
• Published date: 01 March 2017

Board Composition

and Relationship-Specific Investments

by Customers and Suppliers

Kristina Minnick and Kartik Raman∗

Firms aremore likely to include a supplier-customer on the board if the supplier-customer invests

more in relationship-specific assets. The results are stronger when the firm has poorer finan-

cial reporting quality or is financially distressed, as well as post-SOX. Suppliers-customers also

increase their relationship-specific investment following their appointment to the board. Direc-

torships help avoid underinvestment and mitigate contracting frictions by reducing information

risks and strengthening informal contracts with the firm.

A firm’sinvestment in assets tied to supply chain relationships are often governed by incomplete

contracts. As a consequence, the willingness to make such investments depends upon governance

mechanisms that mitigate incentiveproblems between fir ms, their suppliers, and customers. While

the literature highlights the role of mechanisms, such as vertical integration, equity ownership,

and long-term contracts, in alleviating contracting frictions along the supply chain, much less

is understood about the contribution of another prominent governance mechanism, the board

of directors, in enabling a firm’s suppliers or customers to overcome potential underinvestment

arising from incomplete contracts (Williamson, 1975; Grossman and Hart, 1986; Hart, 1988;

Hart and Moore, 1990; Dasgupta and Tao, 2000; Baiman and Rajan, 2002b; Fee, Hadlock, and

Thomas, 2006). In this study, we examine the association between the decision by a firm’s

nonfinancial stakeholder to invest in relationship-specific assets and the f irm’s choice to include

the stakeholder on the board.1

Fee et al. (2006) recognize the importance of directorships in alleviating contracting frictions

between customers and suppliers. While the focus of their study is on equity ownershipstakes, Fee

et al. (2006) find that buyers are more likely to serve on the boards of suppliers in relationships

where buyers hold an equity stake in the supplier. More recently, Dass et al. (2013) examine

why firms appoint directors from related industries (including directors from suppliers and/or

customers). Dass, Kini, Nanda, Onal, and Wang (2013) find that firms do so in order to obtain

information about industry conditions and trends from the directors, and that these directorships

enhance firm value by enabling the firm to respond better to industry shocks, manage its factors

of production more efficiently, and reduce its financial constraints.

We thank RaghuRau (Editor), an anonymous referee, Ravi Anshuman, Erik Devos, Atul Gupta, Rajkamal Iyer, Karthik

Krishnan, Shashidhar Murthy, Jim Musumeci, Venky Panchapagesan,Len Rosenthal, Anand Srinivasan, Chip Wiggins,

and seminar participants at Bentley University, the Indian Institute of Management at Bangalore, the 2014 Financial

Management Association Conference,and the 2014 Southern Finance Association Conference for helpful comments.

∗Kristina Minnick is an Associate Professor in the Finance Department at Bentley University in Waltham, MA. Kartik

Raman is a Professor in the FinanceDepartment at Bentley University in Waltham, MA.

1Throughout the paper, westate that a customer (supplier) serves on the f irm’sboard if an officer/director of the customer

(supplier) serves on the firm’s board.

Financial Management •Spring 2017 •pages 203 – 239

204 Financial Management rSpring 2017

While Dass et al. (2013) focus on the firm’s benefits from appointing a supplier-customer

to the board, these benefits could arise at the expense of the supplier-customer, thereby raising

an important question from a stakeholder’s perspective: How does the supplier (or customer)

benefit from inclusion on the fir m’s board? In addition, given that a firm would select a board

appointment from a set of multiple suppliers, what are the factors that explain why a specific

supplier is appointed to the board while other suppliers are not? Similarly, how does a customer

benefit from a board appointment? The goal of our study is to address these questions.

As shown by Williamson (1975) and others, relationship-specific investments (RSIs) under-

taken by a supplier or customer are exposed to the risk of expropriation arising from incomplete

contracts as these investments are uniquely tied to the relationship with the firm. Consequently,

we focus on the supplier’s-customer’s investment in relationship-specific assets to assess their

potential benefit from serving on a f irm’s board. Empirically, as the decision by a supplier (or cus-

tomer) to invest in relationship-specific assets and the decision by the firm to include stakeholders

on the board are likely to be jointly endogenous, our identification strategy is to use instrumental

variables with two-stage probit least squares (PLS) estimation following Maddala (1983).

In our sample, about 5% of the firms include a customer on their board, while approximately

2% of the firms include a supplier on their board. These frequencies are comparable, but higher

than those reported in Dass et al. (2013), who find that about 1.2% of f irms in their sample

appoint an actual supplier-customer as a director. As a comparison, Fee et al. (2006) report that

equity ownership stakes bybuyers are observed in 3.31% of their sample, and alliance agreements

represent about 5.09% of their sample.

At the outset, it is not apparent whether a supplier or customer is likely to serve on the firm’s

board. By sharing information with the firm, the supplier-customer faces an increased risk of the

firm misappropriating the information by behaving opportunistically (Baiman and Rajan, 2002a;

Drake and Haka, 2008). Moreover, the disclosure of proprietary information about RSIs jeopar-

dizes the supplier’s-customer’s competitive position as the information could be revealed to their

rivals either directly by the firm or could be inferred by rivals through the actions of the firm (Li,

2002; Zhang, 2002; Li and Zhang, 2008). For these reasons, a supplier-customer maybe less likely

to serve on a firm’s board if the supplier-customer invests more in relationship-specific assets.

Alternatively, sharing information on the board could enable the supplier-customer to enhance

the level of cooperation and coordination with the firm, and may also mitigate information

asymmetry with respect to the firm’s future prospects (Schoorman, Bezerman, and Atkin, 1981;

Haunschild and Beckman, 1998; Gulati and Westphal,1999; Dass et al., 2013). As a consequence,

the supplier or customer is likely to avoid underinvestment in relationship-specific assets, which,

in turn, increases the surplus available to be shared by the firm and the supply chain partner.

Furthermore, repeated boardroom interactions between the firm and the supplier-customer could

build greater trust between the transacting parties, promote interfirm cooperation, and create an

informal (relational) contract that limits opportunistic behavior by either party (Gulati, 1995;

Baker, Gibbons, and Murphy, 2002). For these reasons, a supplier-customer may be more likely

to serve on the firm’s board if the supplier-customer invests more in relationship-specific assets.

We test these possibilities using a large sample of over 18,000 customer-supplier pair years

represented by publicly traded US firms from 2000 to 2013. Following the literature, we use the

supplier’s (or customer’s) research and development (R&D) intensity and advertising intensity as

alternate empirical proxies to capture the prevalence of RSIs.

Controlling for the firm’s own level of R&D intensity (or advertising intensity) and for other

factors identified in the literature, we find that a supplier is more likely to be included on a fir m’s

board if the supplier’s level of R&D intensity (or advertising intensity) is higher than the firm’s.In

addition, we determine that a supplier invests more in relationship-specific assets if the supplier is

Minnick & Raman rBoard Composition and Relationship-Specific Investments 205

more likely to be on the firm’sboard. We find similar results for the f irm’s customers. The results

for customers are largely attributable to relationships where the customer faces a risk of hold-up

by a firm that wields relatively greater market power over the customer. Collectively, the results

suggest that the incentives of a firm’ssupply chain partner to invest in relationship-specific assets

are an important consideration in the firm’s choice of board appointments.

We conduct several tests to verify the robustness of our conclusions. First, the results are

stronger among firms that are more likely to be distressed (based on the Altman Z-score). Given

that financial distress leads to costly supply chain disruptions, as documented in Hertzel et al.

(2008), the stronger results for distressed firms suggests that board appointments of supply chain

partners help mitigate the risks of supply chain disruptions and incentivize customers-suppliers

to invest in relationship-specific assets when they otherwise might not do so.

In addition, Section 409 of the Sarbanes Oxley Act of 2004 stipulates that companies are

required to alert the Securities Exchange Commission (SEC) about material changes in operations.

Given that supply chain disruptions constitute significant changes in the firm’s operations, and

because contracting frictions within supply chains are likely to be more severe in the presence of

RSIs, we use the passage of SOX as a natural experimentto verify our conclusions. We expect the

benefits of board appointments for customers-suppliers to be more pronounced following SOX if

the potential for supply chain disruptions is detected in a timelier manner and because the risk of

being misinformed (and thereby underinvesting in relationship-specific assets) would be lower

following the enactment of SOX. Consistent with this intuition, the results are generally stronger

following SOX than they are prior to SOX.

Moreover, the results are more pronounced in subsamples where RSIs are more likely to be

subject to contracting frictions. The results are stronger in subsamples where the supplier or

customer relies more heavily on the firm, where the firm is characterized by poorer financial

reporting quality, or the firm and its supplier-customer belong to different industries. The results

suggest that including a supply chain partner on a firm’s board builds trust and strengthens

the informal relational contract between the firm and its partner thereby mitigating the fir m’s

incentive to engage in opportunistic behavior.

Weconduct additional tests to examine the timing of investment in relationship-specific assets.

The board appointment of a customer (supplier) is associated with an increase in the customer’s

(supplier’s) RSI when the customer (supplier) first joins s fir m’s board. Moreover, using an

accelerated failure time (AFT) model with time (number of years) taken to be appointed to the

board as the dependent variable, we find that it takes less time to appoint a supplier-customer

to the board when the RSI by the supplier-customer prior to the board appointment is higher.

While the potential for endogeneity makes it difficult to infer causality,one interpretation of these

results is that the firm perceives the investment prior to the board appointment as an indicator of

the likelihood that the supplier-customer will continue the investment after the appointment.

Our study is closely related to, and extends, the work in Dass et al. (2013). The result that sup-

pliers and customers avoid underinvestment, thereby benefitting from serving on a f irm’s board,

complements the findings in Dass et al. (2013) who find that the f irm benefits from including

suppliers-customers on the board by improving operating efficiency and reducing financial con-

straints. In conjunction with Dass et al. (2013), our results suggest that the appointment of a

supplier or customer to the board benefits the supply chain as a whole. Our study also brings

together the literature on transaction cost economics (Fee et al., 2006; Kale and Shahrur, 2007)

and prior research on board composition (Hermalin and Weisbach, 1988; Linck, Netter, and

Yang, 2008; Coles, Daniel, and Naveen, 2008) by recognizing RSIs bysuppliers-customers as an

important determinant of a firm’s board structure thus adding to the insights of Dass et al. (2013).