Managerial response to constitutional constraints on shareholder power

• Date: 01 July 2017
• Author: Jinyong Zyung,Brian L. Connelly,Wei Shi
• Published date: 01 July 2017
• DOI: http://doi.org/10.1002/smj.2582

Strategic Management Journal

Strat. Mgmt. J.,38: 1499–1517 (2017)

Published online EarlyView 26 October 2016 in WileyOnline Library (wileyonlinelibrary.com) DOI: 10.1002/smj.2582

Received 3 September 2015;Final revision received12 August 2016

MANAGERIAL RESPONSE TO CONSTITUTIONAL

CONSTRAINTS ON SHAREHOLDER POWER

BRIAN L. CONNELLY,1WEI SHI,2,*and JINYONG ZYUNG3

1Raymond J. Harbert College of Business, Auburn University, Auburn, Alabama,

U.S.A.

2Kelley School of Business, Indiana University, Indianapolis, Indiana, U.S.A.

3Jesse H. Jones Graduate School of Business, Rice University, Houston, Texas,

U.S.A.

Research summary: We examine whether top managers engage in misconduct, such as illegal

insider trading, illegal stock option backdating, bribery, and nancial manipulation, in response

to the presence, or absence, of governance provisions that impose constitutional constraints

on shareholder power. Within the agency framework, shareholders typically oppose governance

provisions that limit their power because those provisionscould undermine shareholder inuence

and increase agency costs. However, when shareholders support provisions that constrain their

power, managers could respond positively by refraining fromself-interested behavior in the form

of managerial misconduct. Wend this to be especially true in industries where these governance

provisions are particularly relevant to managers and in scenarios where CEOs do not also serve

as board chair.

Managerial summary: In recent years, shareholders have become central to organizations and

the managers who run them. Shareholders and managers establish a rapport with one another,

such that the behavior of one affects the behavior of the other. One of the most consequential

decisions shareholders can make pertains to the reach of their inuence: They can choose to

impose strict governance over rms they own or they can allow for constitutional constraints

that limit shareholder power. When they act in the mutual interest of managers by allowing such

constraints, we nd that managers respondin kind by refraining from bad behavior,such as illegal

stock options backdating, insider trading, and nancial manipulation. This is especially true in

industries and scenarios in which shareholder pressure is most relevant to managers. Copyright

© 2016 John Wiley & Sons, Ltd.

INTRODUCTION

The prevailing wisdom of agency theory sug-

gests that shareholders should prevent rms from

adopting corporate governance provisions that pro-

tect top managers against shareholder inuence

(Bebchuk, Cohen, and Ferrell, 2009; Mahoney

Keywords: social exchange theory; agency theory; consti-

tutional limit provisions; managerial misconduct; corpo-

rate governance

*Correspondence to: WeiShi, Kelley School of Business, Indiana

University, 801 West Michigan Street BS 4020, Indianapolis, IN

46202, U.S.A. E-mail: ws7@iu.edu

Copyright © 2016 John Wiley & Sons, Ltd.

and Mahoney, 1993). Corporate governance pro-

visions are arrangements that top managers pro-

pose that inuence their working relationship with

the rm’s directors and shareholders and the rm’s

vulnerability to takeover (Danielson and Karpoff,

1998). Commonly investigated provisions are poi-

son pills and golden parachutes (Choi, 2004; Davis,

1991), but there is a less glamourous, though

equally important, set of governance provisions

that imposes constitutional constraints on share-

holder power (Bebchuk, 2005). Agency theorists

widely pan any provisions that limit shareholder

inuence as being damaging to rm value (e.g.,

1500 B. L. Connelly, W. Shi, and J. Zyung

Bertrand and Mullainathan, 2003; Gompers, Ishii,

and Metrick, 2003; Mahoney, Sundaramurthy, and

Mahoney, 1997), which helps explain why stock

prices often fall when rms adopt such provi-

sions (Datta and Iskandar-Datta, 1996; Mahoney

et al., 1997).

Top managers, however, see things differently.

Governance provisions that limit shareholder inu-

ence are important to top managers because they

provide managers with job security and offer man-

agers the discretion of making decisions that they

believe are in the best interest of the rm and all

its stakeholders (Kacperczyk, 2009). From the man-

agers’ perspective, shareholders are self-interested

when they do not allow rms to have governance

provisions that limit shareholder inuence. That is,

top managers perceive shareholders that preclude

shareholder constraints as being motivated mainly

by a desire to extract value from the rm, even if it

is to the detriment of managers or other stakehold-

ers or comes at the expense of creating long-term

value for the rm (Ambrose and Megginson, 1992).

Conversely, when shareholders afford top managers

the limitations on shareholder inuence managers

desire, they are likely to view shareholders posi-

tively and see them as partners in creating rm value

(David et al., 2010). Therefore, in this study, we

argue that executives may infer shareholder moti-

vation by whether or not shareholders provide them

constitutional limits on shareholder power.

To build understanding about the relationship

between managers and shareholders, it is useful to

consider how research on social exchange theory

(Blau, 1964; Konovsky and Pugh, 1994; Masterson

et al., 2000) can inform what we know of agency

relationships. Scholars have found social exchange

to be foundational to a range of corporate gov-

ernance relationships (Westphal and Zajac, 2013).

For instance, top managers establish exchange rela-

tionships with boards, analysts, and managers at

other rms (Wade, O’Reilly, and Chandratat, 1990;

Westphal and Clement, 2008; Westphal and Zajac,

1997). We extend this logic by examining social

exchange in agency relationships. A key principle

underlying social exchange is norms of reciprocity,

which are dened as “the interest motive of the dyad

partners” (Uhl-Bien and Maslyn, 2003: 514). In

the social exchange between shareholders and man-

agers, top managers infer shareholder motivation

when those managers are afforded, or not afforded,

the constitutional limits to shareholder inuence

that they desire. Establishing such a norm for the

exchange relationship induces reciprocal behavior

on the part of managers (Bosse and Phillips, 2016;

Bosse, Phillips, and Harrison, 2009; Cohen et al.,

2007).

We investigate this possibility in the context of

behavior that is surreptitiously self-interested: man-

agerial misconduct (Cheng and Lo, 2006). Recipro-

cating with overt forms of self-interested behavior

(e.g., extracting personal value through legal and

visible means) could have negative public conse-

quences for managers, but covert self-interested

behavior allows managers to extract personal value

from the rm without necessarily drawing the ire of

shareholders. For example, managers could engage

in illegal insider trading (Cheng and Lo, 2006), ille-

gally backdate stock options (Wiersema and Zhang,

2013), inappropriately book revenue or improperly

value assets (Marcel and Cowen, 2014), or not dis-

close material information to improve the appear-

ance of the company’s performance (Arthaud-Day

et al., 2006). We nd that managers are, in fact,

more likely to engage in managerial misconduct

in the absence of governance provisions that limit

shareholder inuence. Moreover, we introduce

two key boundary conditions to the negative

relationship between these governance provisions

and managerial misconduct, one pertaining to the

industry in which managers operate and another

pertaining to who holds the position of board chair.

Our study offers several potential contributions

to management theory and practice. First, we

challenge the received wisdom about corporate

governance provisions. We develop an understand-

ing of governance provisions from the managers’

perspective that rounds out the shareholders’ per-

spective that dominates the corporate governance

literature (Coates, 2000; Mallette and Fowler,

1992). Whereas prior work has focused on the

economic costs of allowing corporate governance

provisions (Mahoney et al., 1997; Sundaramurthy,

1996), we offer a more nuanced perspective that

accounts for the hidden costs of not allowing

them (Coates, 2000). Second, we develop theory

that is specically oriented toward governance

provisions that constitutionally limit shareholder

power. Prior research has focused mainly on

takeover-contingent governance provisions, but

in the current golden age of shareholder activism

(Goranova and Ryan, 2014) it is increasingly

important to consider governance provisions that

could hinder activism. Third, we take strides toward

integrating research on social exchange theory into

Copyright © 2016 John Wiley & Sons, Ltd. Strat. Mgmt. J.,38: 1499–1517 (2017)

DOI: 10.1002/smj