After a corporate spin-off, members of the parent firm’s board are often installed on the board of the divested firm. But what does it mean for a newly created company when board members from its parent still exert that level of control?
Knowledge@Wharton recently interviewed Wharton Management professor Emilie Feldman about her new paper, “Dual Directors and the Governance of Corporate Spinoffs,” which explores that question.
An edited transcript appears below.
A complicated question:
My research investigates what happens when companies appoint what I call dual directors following corporate spin-offs. Let me take a step back and talk about what these deals actually are.
A spin-off occurs when one company issues shares in an existing division to its shareholders, which results in the creation of a new company. So you have the divesting firm, which is the parent company, and the divested firm, which is the spin-off company. In reading the legal regulations about these deals, what I’ve found is that parent companies are actually allowed to appoint their own directors to serve simultaneously on the boards of their spin-off firms: dual directors. I look at the implications of that for the performance of each of the two companies.
What I find is that these directors are positively associated with the average performance stock market returns of the two companies together, in general. But in situations where the spin-off firm makes a large share of its sales to the parent company, dual directors are negatively associated with spin-off firm performance, but positively associated with parent firm performance. So we have an average positive effect overall, but a divergent distributional effect when we look at spinoffs where there’s a sales relationship between the spin-off firm and the parent firm.
“There’s a dark side to this story in the sense that the dual directors create the potential for opportunism on the parent firm’s part.”
Key takeaways of the research:
There are two key takeaways that I get out of the research, both really interesting. One is about the prevalence of these directors.
About 60% of the parent/spin-off firm pairs in my sample shared at least one dual director in the effective year of the spin-off. That’s a really high percentage, much higher than any other proportion of director interlock between two companies than exists in regular American corporations. What’s interesting also is that even as you proceed a few years after the completion of the spin-off — let’s take three years after the spin-off as the example – 35% of the companies still share these dual directors, which is still a really high number relative to what we see among other companies in terms of sharing common directors.
I think that just the prevalence of this phenomenon, and being able to identify this, is a really unique contribution of this study. No one’s looked at this phenomenon before.
The second key takeaway that I would raise is the idea of power. I was talking before about this positive average effective versus this divergent distributional implication, by which I mean that the parent firm does well, whereas the spin-off firm does poorly following the completion of these spin-offs. What it really boils down to is a question of power. If you think about a firm that undertakes a spin-off, the parent firm is established. It has its management team. It has its reputation. It has its position in the market. It has existing business practices, relationships with other companies and stakeholders. This company is pretty well-situated.
Not so for the spin-off firm. These companies are created completely from scratch. They have to start everything from the beginning. They have to get their management team. They have to build their reputation. They have to build an analyst following. They have to establish their own business practices. So on average, in general, the parent company is more powerful than the spin-off firm to begin with.
So, when you have one of these dual directors, in most cases, they’re not really going to have any motivation to take advantage of the spin-off firm or do things to benefit the parent firm at the spin-off firm’s expense. They have power, the parent firm has power over the spin-off firm, and that mutes the effect that dual directors will have on the spin-off firm. That’s why we see a positive average effect. In some situations, these dual directors might even help the spin-off firm in terms of establishing itself as a new company. That’s the positive average effect.
However, in situations where the parent firm is a big buyer of the spin-off firm’s output, that puts the parent company in a position of even greater power over the spin-off firm. Not only is [the parent firm] more established in the marketplace than the spin-off firm, but also the spin-off is basically dependent on the parent company as a buyer for its output. That puts the dual directors in a position where they have both the ability and the motivation to take actions at the spin-off firm’s expense to benefit the parent firm. Once the power dynamic shifts to the point where it favors the parent firm even more significantly than it does the spin-off firm, this is when we start to see the cost to the spin-off firm, which benefits the parent company. This divergent distributional implication that I was talking about, where the parent firm benefits at the spin-off firm’s expense, only happens when there’s a situation where there’s a sales relationship between the two companies.
Larger implications for the companies:
I would say that there are implications for the parent and spin-off firms that are involved in these deals. There are also implications more from a regulatory and societal standpoint. So I’ll take each of these in turn.
Starting with the companies that are involved in spin-off, I think that the implication for parent companies is that dual directors can be a really useful tool with which to manage their relationships with spin-off firms. The parent firm has the right to place these dual directors on the boards of their spin-off firm, and that gives them the ability to somehow control or shape the relationship [and] the spin-off firm’s actions in a way that it wouldn’t have the ability to do if it just did the spin-off and that company was off on its own, independent. The implication is that parent firms can proactively use these directors to manage their ongoing relationships with spin-off firms.
"Regulators need to be mindful of how dual directors might be misused in situations of high sales dependence between the spin-off firm and the parent firm."
However, there’s a dark side to this story in the sense that the dual directors create the potential for opportunism on the parent firm’s part in situations where there is this sales relationship. So the dark side is that, yes, dual directors can be a useful tool, but they can also be used for evil, rather than for good, and allow the parent firm to take advantage of the relationship with the spin-off firm. So I don’t know that I would say that we want to advise parent companies to use dual directors to take advantage of their spin-off firms, but it’s certainly an implication that comes out of the research.
Continuing in this vein, the opposite implications are true for the spin-off firms. On the one hand, these dual directors can be really useful tools with which to ease the separation process of creating a new company from scratch, building up these relationships I was talking about earlier. However, the spin-off firm needs to guard against the opportunism that I was mentioning in terms of the parent firm potentially taking advantage of the spin-off firm, especially in situations where there is sales dependence between the spin-offs and the parent companies.
Larger implications for regulation and the business community:
The second implication has to do with more of a regulatory or a societal perspective. There are two points to bring up here. The first one is that we need to think about how we classify independent directors. Dual directors are independent in the governance sense of the term — they’re independent of the management of the spin-off firms. That normally would be viewed by regulators as a good thing, because they’re free from any bias, free from any sort of taint of being associated with the existing management of the spin-off firm.
However, for dual directors, even though they’re classified as independent, it’s a funny situation because they’re not really independent in the sense that, first of all, they originate from the parent company. Obviously, there’s a relationship between the parent and the spin-off firm from before the deal, so that’s a question mark into the independence. The second is that they may have a great deal of familiarity with the spin-off firm from its days as a subsidiary within the parent company, so the independence gets called into question there as well.
We hear a lot in the press and popular media from regulators about how we want independent directors as a marker of good corporate governance. That’s completely fine. That’s all well and good. But there are gray areas, let’s say, in terms of how we see this with dual directors, so I think that that’s a regulatory implication that’s worth noting.
The second regulatory implication that goes hand and hand with this is the idea that when we think about this positive average effect of dual directors on the average performance of the parent and spin-off firms together, that’s really masking this different effect that we see for the parents and spin-off firms individually. Yes, we have a positive average effect, meaning dual directors are good on average. But in situations when we have high sales dependence, we actually have sort of a redistribution of value from the spin-off firm to the parent firm. And that’s not really getting picked up in the overall data.
So from a regulatory standpoint, maybe we do want to allow dual directors as a tool to manage relationships between parent and spin-off firms. They’re beneficial on average and that’s fine. But one has to be careful or mindful of the situation in which we see this high sales dependence, because again that opens up the possibility of opportunism, and that’s sort of hidden by the average effect. Regulators need to be mindful of how dual directors might be misused in situations of high sales dependence between the spin-off firm and the parent firm.
There are three really useful and interesting avenues for future research that I’d like to pursue in this.
The first area that I’d like to consider is what happens when dual directors leave the boards of parent and spin-off firms. There are three ways that this could happen. One is that the dual directors could break the dual directorship by departing from the parent firm’s board and just staying on the spin-off firm’s board.
The second would be that the dual director could leave the spin-off firm’s board and stay on the parent firm’s board, breaking the connection between the two companies. Or third, the dual director could leave both boards at the same time. My hunch is that there are very different reasons for each of these types of departures, and therefore, there are going to be very different performance implications and management implications, probably operational implications, for the two companies.
“What it really boils down to is a question of power.”
For example, if you have the dual director leaving the parent firm’s board and staying on the spin-off firm’s board, that might mean that the spin-off firm has finally reached a state of maturity where it’s able to function on its own and it doesn’t need that connection anymore. Or, if the dual director leaves the spin-off firm’s board but stays on the parent firm’s board, maybe the implication is something like the parent firm no longer needs the oversight or the management of the relationship with the spin-off firm. I’m really curious to dig more into these three types of departures, and to think about what their potential implications might be for the two companies, and then to test that empirically.
The second avenue that I’d like to pursue in this research is trying to understand more about the dual director’s personal characteristics. I was mentioning before that when we think about these dual directors, especially in the context of independence, there are connections in terms of the fact that they are serving on both companies’ boards, but really originated with the parent firm. I’m curious to dig deeper into that issue. Are these directors typically managers of the parent firm? What kinds of personal characteristics do they have? What is their work experience? What is their professional experience? And why might the parent firm want to apply that experience to the spin-off firm by appointing them to its board? Even further, what are the dual directors’ financial incentives? They’re obviously getting paid by both companies. They’re obviously owning shares of stock in both companies since they serve on both firms’ boards. Directors all get paid for their board service and have ownership stakes in the companies that they serve on. I’m curious to see a bit more about where these directors’ incentives lie.
This is really one of the novel things about this study: It’s really the first to consider what’s happening to the parent and spin-off firms together at the same time as opposed to treating the two companies completely independently once the spin-offs are complete. By looking more at these financial incentives, I can pull apart some of these implications for understanding how these two companies work together.
The third avenue that I’d like to pursue in my research is an even more general issue. I’ve been talking about dual directors as managing ongoing relationships between the parent and the spin-off firms. And that’s a really interesting empirical context in which to do that, this context of corporate spin-offs. But I would imagine that there are other professional situations where we do see — or we might want to see — overlapping directorships. One that immediately comes to mind is a buyer/supplier relationship, in general, of two companies that are not necessarily linked by a spin-off. You could imagine a dual director being a really useful tool to manage that kind of relationship.
Another example might be a technological ecosystem, where we see relationships between various companies that are participating in the same technological ecosystem. If you think about a smartphone, consider the producer of the chip and the producer of the glass that goes on the front. Dual directors could be a really useful tool with which to manage the overlapping relationships between companies that need to work together to put certain products or services together for consumers to use. So I’d like to try to broaden the lens of my research a little bit to look at other contexts in which these dual directorships or similar types of phenomena might be a useful mechanism to manage those types of relationships.