Inside directors, risk aversion, and firm performance

• Author: Rahul Bhargava,Hongchao Zeng,Arun D. Upadhyay,Sheri Faircloth
• Published date: 01 January 2017
• Date: 01 January 2017
• DOI: http://doi.org/10.1016/j.rfe.2016.12.001

Inside directors, risk aversion, and firm performance☆

Arun D. Upadhyay

a

,RahulBhargava

b

, Sheri Faircloth

b

,HongchaoZeng

b,

⁎

a

Departmentof Finance, College of Business,Florida InternationalUniversity, ModestoA. Maidique Campus, 11200S.W. 8th St, RB 247B, Miami, FL 33199, UnitedStates

b

ManagerialScience Department,College of Business,University of Nevada, Reno,1664 N Virginia St, Reno,NV 89557, United States

abstractarticle info

Articlehistory:

Received7 February 2016

Receivedin revised form 17 September2016

Accepted7 December 2016

Availableonline 12 December 2016

JEL Classification:

G32

G34

K22

Priorliterature providesmixed evidence on managerialrisk aversion. Usinga sample of 1737 large US firms from

1996 to 2005, we finda negative associationbetween the insider ratio andfirm risk. Upon further analysis, we

show thatfirms with a greater insider ratioare also likely to have moreconservative CEO compensation and in-

vestment policies. Analysisof CEO compensation policies indicates that firms with a greater insider ratio offer

lower equity based compensation, lower vega and lower total compensation to their CEOs. Also, firms with a

greaterinsider ratiotend to invest more in tangibleassets such as plant and equipmentand have lowerintangible

investments.Consistent withthese boards institutingconservative policies,we find that firms with a greaterin-

sider ratio performbetter when they operate in highly volatile environments.Overall, this study suggests that

high-insider boards are more conservativein policy initiation and that such boards are valuable in firms with

greater operatinguncertainties.

© 2016 ElsevierInc. All rights reserved.

Keywords:

Insidedirectors

Corporategovernance

Firm risk

CEO compensation

Investmentpolicy

Firm performance

Operatingvolatility

1. Introduction

The financial meltdown of 2008–20 09 refocused the attention of

both the media and regulators on the failure of corporate governance

practices in general,but specifically on corporate boards in identifying

risky investments of their firms.

1

Corporateboards are one of the most

important governance mechanisms th at shareholders use to protect

their interests (Fama & Jensen,1983).

2

Boardscan influence managerial

decisions directly by voting on investment a nd financing policies, or in-

directlyby altering the incentivestructures of top managers.For exam-

ple, boards often design manage rial compensation schemes that

encourage managers to undertake risk y projects that benefitstock-

holders. Since excessive risk-taking negatively impacts investors, it is

importantto have a board thatprovides a balance of monitoring and in-

centive systemsto prevent excessive risk takingbehaviors.

Corporatescandals of thelast two decades and subsequentregulato-

ry reforms havepushed board structurestowards more independence.

Enactmentof the Sarbanes-Oxley Act (2002)and subsequent adoption

of listing requirements by the national stock exchanges have made it

mandatoryto have a majorityof independent directors.A push towards

smaller and outsiderdominated boards from the proponents of corpo-

rate governancereforms has significantly reducedthe managerial rep-

resentation on boards (Linck, Nett er, & Yang, 2008). These changes

may have impactedthe quality of managerial evaluationand monitor-

ing effectiveness ofboards, as outside boardmembers rely on the inside

directors for valuable informa tion about a firm and its investments

(Raheja,2005; Adams & Ferreira,2007). In the absenceof managerial in-

puts, outside directors could find it difficult to evaluate the quality of

managerial decision making and ma y not design a compensation

scheme that balances growth with risktaking.

Like anygroup, the actions andeffectiveness of corporateboards are

a function of board characteristics (i.e. size and composition (Jensen,

1993)). This study examines the relation between board composition

and corporaterisk taking.Specifically, weinvestigate how a greaterrep-

resentation ofinsiders on the board is associated withfirm risk . Inside

directors share similar profe ssional backgrounds, access to firm -

specific knowledge, and motivation s to reveal information (Rahej a,

Reviewof Financial Economics 32 (2017)64–74

☆Wethank Chunlin Liu,Greg Stone, Qun Wu,conference participantsat the Academyof

Finance2013 annual meeting,and the University of NevadaReno for valuable comments

and suggestions.

⁎Correspondingauthor.

E-mailaddresses: arun.upadhyay@fiu.edu (A.D. Upadhyay),rahulb@unr.edu

(R. Bhargava),sherif@unr.edu(S. Faircloth), hzeng@unr.edu(H. Zeng).

1

See BusinessWeek 26th September 2008 and New York Times4th January 2009. In

these articles, boardsof directors are criticized for their inability to control the financial

risks oftheir firms.

2

For a detaileddiscussion on the role of corporateboards and related research,please

refer toAdams, Hermalin, and Weisbach(2010).

http://dx.doi.org/10.1016/j.rfe.2016.12.001

1058-3300/©2016 Elsevier Inc. All rightsreserved.

Contents listsavailable at ScienceDirect

Review of Financial Economics

journal homepage: www.elsevier.com/locate/rfe