On the relationship between boards and their stakeholders:
How the relationship with financial and non-financial
stakeholders influences capital structure.
Robert T. Visser
S2799979
Rijksuniversiteit Groningen
MSc BA O&MC
Abstract
Theory on stakeholders, boards of directors and capital structure was used to explain and test how the relationship between boards of directors and their financial and non-financial stakeholders affects an organization‘s capital structure. As traditional agency theory is losing its descriptive accuracy, it is being complemented with stakeholder theory. As a result, boards of directors are starting to pay more attention to stakeholders other than shareholders. Based on the literature available on capital structure and stakeholders interests, it was found that stakeholders can be grouped as either financial or non-financial stakeholders, who each have their own interests concerning capital structure and leverage. Multiple stakeholder management models were used to explain how stakeholders can influence organizational decision making. For the analysis, a dataset containing data on 155 boards of directors was used, as well as data from the annual reports of the organizations related to the boards. The results indicate that it is likely that boards of directors use different stakeholder management models when taking into account the interests of financial and non-financial stakeholders. Support was found for the hypothesis that financial stakeholders‘ interests have a positive effect on leverage, when taken into account in the work of non-executive directors on the board. It was surprising to find that non-financial stakeholders‘ interests can have a positive effect on leverage, when taken into account in the work of non-executives. Theory suggests otherwise, although there are lines of reasoning which might explain this result. No moderating effects of non-financial stakeholders‘ interests were found on the relationship between financial stakeholders‘ interests and leverage. Suggestions are made for future research, in which directions are given towards more research into the stakeholder management models used by non-executive boards of directors.
Supervisor: dr. Dennis B. Veltrop
20 June 2017
1
Abstract
As stakeholders are becoming more important in the organizational environment, traditional views on agency theory are losing their descriptive accuracy. The traditionally important shareholder as the key-stakeholder and agent of the firm has to start sharing the attention it used to receive (van Puyvelde et al., 2012). In this research, theory about boards of directors, stakeholders and capital structure will be used to explain and test how the relationship between boards of directors and their stakeholders affects the capital structure of the firm. With use of the existing literature on the influence of stakeholders on capital structure, it was possible to make a clear distinction between two separate groups of stakeholders. Financial stakeholders are stakeholders that have a direct investment in the organization, for which they expect a return (Neu, Warsame & Pedwell, 1998). Non-financial stakeholders often have no direct investments involved, and rely more on informal contracts with the organization (Cornell & Shapiro, 1984). As agency theory is accompanied by stakeholder theory, boards are now expected to deal with a range of stakeholders, who all can be seen as principals of the firm (van Puyvelde et al., 2012) and thus have interests in organizational decisions that should be taken into account by boards of directors (Freeman & Reed, 1983). Whether the sometimes contradicting interests of stakeholders are translated into organizational action, seems to depend on the stakeholder management models that are used by boards (Donaldson & Preston, 1995). Factors of influence are among others, the relative power of stakeholders and the scope of topics they are involved in by boards of directors (Pedersen, 2006; Spitzeck & Hansen, 2010).
2
Introduction
In recent years the academic interest in boards of directors has grown, especially when it comes to research topics related to the inner workings of boards of directors (McNulty & Pettigrew, 1999). There still is little understanding of the behavioral aspects of boards of directors, which is largely caused by the distant nature of these groups of ‗elites‘ (Pettigrew, 1992). In the light of corporate governance there is an ongoing discussion on the topic of boards of directors, which functions as a steward between principals and agents of the organization (McNulty & Pettigrew, 1999; van Puyvelde, Caers, du Bois & Jegers, 2012). This research will make use of the literature on stakeholder theory, corporate governance and boards of directors, in order to explore and use it to explain and test how the level of debt present in the capital structure of an organization is affected by varying stakeholders‘ interests. Considering the point of view of Freeman & Velamuri (2008), the relationship between stakeholders and the organization is one that should be characterized as one that is mutually beneficial to all parties. As long as the organization is successfully in business, both stakeholders and the organization can reap the fruits of this relationship (Freeman & Velamuri, 2008).
Considering the fact that increases in the leverage levels of an organization leads to an increase in the risk of default and eventually bankruptcy (Titman, 1984), above optimal levels of leverage will negatively affect the organizations‘ relevant stakeholders, because bankruptcy is likely to put a halt to the mutually beneficial relationship between stakeholders and firms. In addition, as varying stakeholder groups may have competing interests on the subject of leverage within the capital structure of an organization, it is still unclear whether an optimal capital structure is achievable. The fact that leverage plays a central role in this research does not imply that other financial measures of firm performance are not relevant in the context of stakeholder theory. Previous works on this topic have predominantly focused on how various individual stakeholder groups affect capital structure, but there remains a gap in the knowledge on how potentially competing interests of stakeholders on the subject of leverage are weighed and acted upon by boards of directors.
3 actions can have negative impacts that impair the interests of stakeholders groups, which might respond with counteractions that can harm the firm. This is called stakeholder activism which results from structural neglecting the interests of stakeholder groups that claim to have a stake in the firm (Rowley & Moldoveanu, 2003). Also, as CSR is becoming increasingly important in organizational environments (Harrison & Freeman, 1999), stakeholder interests are becoming a more important issue. What we do not know however, is whether and how boards translate stakeholders‘ interest into the capital structure of the organization. Huse (1998) called for more research into the relationship between boards of directors and different stakeholder groups, as we do not know how board behavior is affected by the interests of various stakeholder groups.
Traditional views on agency theory are losing their descriptive accuracy as the shareholder as the principal of the organization is accompanied by other stakeholders (van Puyvelde et al., 2012). Stakeholder management has started to play a more important role in corporate governance, as it carries the potential to add value to the organization (Donaldson & Preston, 1995; Berman, Wicks, Kotha & Jones, 1999). Proponents of stakeholder theory suggest that it should be one of the responsibilities of boards of directors to manage stakeholders and enhance corporate social/sustainability responsibility (Freeman & Reed, 1983). Depending on the stakeholder management model employed by the board, stakeholders are given varying levels of engagement in organizational decision making (Pederson, 2006; Spitzeck & Hansen). One of the relevant issues in stakeholder theory is the fact that stakeholders can have conflicting interests (Freeman & Reed, 1983), as well as it can be a difficult task to identify the relevant stakeholders as the nature of their relationship with the organization is not always clear (Wang & Dewhirst, 1992; Lewis, 2001). From a theoretical perspective it is therefore relevant to gain a better understanding of the interests of different stakeholders and how these interests can be contradictive, as well as how they are translated by the board of directors into organizational action. The capital structure literature makes a clear distinction between stakeholder groups, identifying them as either financial or non-financial stakeholders. Financial stakeholders have a direct investment in the organization, for which they expect a return (Neu, Warsame & Pedwell, 1998). Non-financial stakeholders often have a more informal relationship with an organization, with no direct investments involved and often based on more implicit ‗contracts‘ with the organization (Titman, 1984; Cornell & Shapiro, 1987; Tyteca, 1997). The differences between financial and non-financial stakeholders imply that they have different relationships with the organization based on whether or not they have invested in the organization.
4 increase in firm value through the tax benefits of debt. In short, the tax-shield on debt allows organizations to pay relatively fewer taxes and thus leave a ´larger part of the cake‘ to be divided amongst investors and shareholders (Bradley, Jarrell & Kim, 1984; Wedig, Sloan, Hassan & Morrisey, 1988). Although the effects of a tax-shield can be beneficial for financial stakeholders like banks, investors and shareholders (Bradley, Jarrell & Kim, 1984; Eriotis, Vasiliou & Ventoura-Neokosmidi, 2007), there is a downside to maintaining high levels of debt. These disadvantages are to be found in trade-off theory, which suggests that organizations will strive for an optimal capital structure in which the difference between the benefits of the tax-shield on debt and the costs of debt is maximized. The costs of debt are related to the costs of bankruptcy and financial distress, such as legal and administrative expenses, loss of customers and suppliers due to reduced trust (Alves, Couto & Francisco, 2015; Banerjee, Dasgupta & Kim, 2008). As certain stakeholders rely on their relationship with the firm, bankruptcy can induce switching costs for stakeholders in their pursuit of a new supplier, customer or employer (Titman, 1984; Titman & Wessels, 1988). Stakeholders can have competing interests on the topic of capital structure and leverage and the available literature is often aimed at describing how single groups of stakeholders affect organizational decisions on capital structure. There remains a gap that explains the interaction between the different interests of varying stakeholders, and how boards of directors translate these interests in decisions on capital structure. If one of the goals of organizations is to achieve an optimal capital structure, then how is the pursuit to achieving this goal affected by the interests of varying stakeholder groups?
In terms of research, the board of directors has proven to be a difficult subject to investigate, due to their closed nature. However, the number of articles that give a glimpse of the internal workings of these boards is growing. Topics of interest are the role, composition, behavioral dynamics and effectiveness of boards of directors (McNulty & Pettigrew, 1999; Dalton, Daily, Ellstrand & Johnson, 1998; Forbes & Milliken, 1999; Minichilli, Zattoni, Nielsen & Huse, 2012), and are intended to gain insights in the ‗black box‘ of the board of directors. The term board of directors in the literature is often used to describe boards that can consist of both internal and external directors. The board of directors has the formal authority to make decisions on strategic matters (McNulty & Pettigrew, 1999) e.g. the sources of capital used in investment activities and thus should have a strong voice in capital structure decisions. Also, they can use debt as a control measure with which they are able to keep management from self-enriching behavior as interest payments limit the free cash-flows available for overinvestment (Jensen & Meckling, 1976; Jensen, 1986). Debt can also be used as a measure to prevent takeovers by other organizations (Harris & Raviv, 1988), making capital structure a relevant measure on the topic of governance and organizational control.
5 structure of organizations, as measured in leverage. This research will provide us with more insights in how stakeholders affect capital structure decisions, and how boards function as stewards between stakeholders and the firm, by controlling and shaping managerial decisions on the topic of capital structure. With this knowledge, we will gain more insights in the roles of boards of directors in stakeholder theory, and how their relationship with financial and non-financial stakeholders affects capital structure.
6
Theory and hypotheses
Stakeholder theory
The word stakeholder has gained importance in academic literature since its first appearance in 1963 at the Stanford Research Institute. Since then, the term dramatically changed the now classical views of the organization, and the role and function of its board of directors. Following the early notions of agency theory, the board of directors serves as a mechanism that is in place to protect the needs and desires of the shareholders. Boards fulfill this role by acting as a control mechanism that monitors and corrects the behavior and decision-making of management (Freeman & Reed, 1983; Donaldson & Preston, 1995). Although this view of agency theory seems to have lost its descriptive accuracy, the general idea behind agency theory serves as a strong basis that can be integrated with stakeholder theory (Hill & Jones, 1992; Van Puyvelde, Caers, Du Bois & Jegers, 2012).
A modern definition of stakeholders in a wide sense is ―any group or person that is able to make a claim on an organization‘s attention, its resources or outputs, or may be affected by the organization‘s activities, and is in the position to affect organizational outcomes‖ (Freeman & Reed, 1983; Wang & Dewhirst, 1992; Lewis, Hamel & Richardson, 2001). As this definition suggests, stakeholders can vary between organizational contexts. This makes it hard to identify relevant stakeholders and define their relation with the organization. As a result, stakeholder management has become a tool to manage the relationships between the organization and its (key) stakeholders (Donaldson & Preston, 1995; Berman, Wicks, Kotha & Jones, 1999). As a governance mechanism between the organization and its constituents, the board of directors plays an active role in this relationship.
Berman et al. (1999) have researched the relationship between different stakeholder models and firm financial performance. Multiple models of stakeholder management can be identified, of which the
strategic stakeholder management model and the intrinsic stakeholder commitment model are the most
7 model has the most descriptive accuracy. There is insufficient evidence supporting the intrinsic stakeholder management model (Berman et al, 1999; Stavrou, Kassinis & Filotheou, 2006; Currie, Seaton & Wesley, 2009). This lack of evidence supporting the intrinsic stakeholder management model implies that the foremost motivation for organizations to engage in stakeholder management is to use stakeholders for the benefit of the organization and its investors and shareholders. Notwithstanding the fact that this relationship may be beneficial for the stakeholders, it cannot be stated that the organizational actions are based on a moral obligation towards its stakeholders‘ interests. Freeman & Raviv (2008) lead to believe that the discussion on whether an intrinsic stakeholder management model exists or doesn‘t is relevant. They propose that in a capitalistic environment, the focus should be on a relationship between an organization and its stakeholders that is mutually beneficial. They also argue that employing stakeholder management in order to make up for a faulty and unethical underlying structure of the organization surpasses the goal of stakeholder management. If society finds that the organization does not satisfactorily meets its expectations, why not take them up on their offer to help and improve the situation? The proposition is that it is not wrong to benefit from stakeholders, as long as value is created from mutually beneficial relationships that benefit society as a whole (Freeman & Raviv, 2008).
Board of directors
Since the main goal of the board of directors is to monitor, control, and intervene in the actions and decisions of the management (Daily, Dalton & Cannella, 2003), it is an effective tool that has the potential to safeguard the interests of stakeholders that have a claim on the organization. As a part of corporate governance, stakeholders are an undeniable subject of matter for corporate boards of directors (Wang & Dewhirst, 1992). In the last decades, the ―black box‖ known as the boardroom is carefully opened and researched, leading to more insights about the interplay between boards of directors and stakeholders. From a stakeholder theory perspective, we have gathered the knowledge that the modern-day board is influenced in its behavior by both environmental and organizational factors (Miller-Millesen, 2003), resulting in more variety in the agenda of the boardroom. This has led to the introduction of topics like corporate social/sustainability responsibility (CSR) (Pedersen, 2006), and more voice for a wider variety of stakeholders (Wang & Dewhirst, 1992; Henriques & Sadorsky, 1999).
8 rejecting proposals and advising management on relevant topics (McNulty & Pettigrew, 1999), implying that boards have a decisive role in capital structure decisions.
The relationship between a board of directors and the stakeholders of an organization is to be found in the stakeholder theory and corporate governance theory, and has been characterized as deceptively simple by Freeman & Reed (1983). To understand this relationship, there has to be an understanding of the basic principles of organizational relationships. Following stakeholder theory, an organization has multiple relationships with varying stakeholders, who have a legitimate stake in the organizational activities (Freeman, 2010). These relationships can be seen as a set of implicit or explicit contracts between stakeholders and the organization, in which corporate governance functions as a mechanism that ensures contractual compliance. From this perspective, the role of the board of directors can also be defined as an overseer, which ensures that the relationships between the organization and its stakeholders are mutually beneficial (Williamson, 1984; Cornell & Shapiro, 1987; Freeman & Evan, 1990).
There are different ways in which stakeholders can influence a board of directors in their decision making. Huse (1998) researched the dynamics between boards of directors and stakeholders. He found that this relationship can be seen as an open system view in which an ongoing dialogue between members of the board takes place on a formal and informal level. In conclusion, Huse (1998) found that the relationship between board and stakeholders is laden with trust, emotions and personal relationships, and can affect the board‘s agenda and behavior. As boards are becoming more stakeholder oriented (Wang & Dewhirst, 1992), it is starting to become more common practice for representatives of different stakeholder groups to take a seat on the board of directors (Byrd & Mizruchi, 2005; Hillman, 2005; White, 2006; Ayuso & Argandoña, 2007). Through this mechanism, stakeholder interests are directly represented in the board of directors. Lastly, institutional theory gives an explanation as to why boards take into account the interests of stakeholder groups in their work. Especially governmental and industrial (self) regulation creates an environment, in which the interests of stakeholders become more important. On the other hand, as a standard in an industry is set, organizations tend to mimic successful stakeholder initiatives from other companies resulting in a normative institutional environment (Luoma & Goodstein, 1999; Campbell 2007).
9 scope. The power dimension measures the level in which stakeholders are given the power and voice to participate in decision making, while the scope dimension gives an indication of the range of topics in which stakeholders are involved in the decision making process. The authors found that the power dimension can be measured on five levels ranging from no evidence of stakeholder power to a substantial
impact of stakeholder power. Also, they measured three levels of scope of participation, in the range of operational, managerial and lastly, strategic issues. This model results in a 3 x 5 matrix, and implies that
stakeholders can influence organizational decision making, depending on the power they are given or already have vis-à-vis the organization and the issues they are allowed a voice in. Pedersen (2006) builds on varying dimensions of stakeholder dialogue and engagement. The dimensions inclusion, openness,
tolerance, empowerment and transparency are all measured on a scale from low to high. On a low level of
engagement one or a select few stakeholders are included in the dialogue, which is structured on a fixed topic where one position has the priority above others and one stakeholder dominates the dialogue ass well as the decisions made, while little to no access to information about the process and outcomes of the dialogue is given. On a high level, all relevant stakeholders are included in the dialogue, which has an open character where all points of view are respected and heard in an equal manner, with full access to information regarding the process and outcomes of the dialogue. Pedersen remarks that an organization is most likely to be placed between the extremes of low and high, and it is not necessarily to be assumed that organizations that score low on these dimensions have questionable morals. As organizations can be limited in their resources, they may have to allocate these resources to fit a set of priorities. The model by Pedersen implies that filters in the dialogue process decide which stakeholders are selected for the dialogue, how stakeholder interests are weighed and how the outcomes and decisions are translated into actions. This means that intentionally or unintentionally, the decision making process can be influenced by powerful stakeholders or the firm itself (Pedersen, 2006).
Financial leverage
Considering the fact that increases in the leverage levels of an organization leads to an increase in the risk of default and eventually bankruptcy (Titman, 1984), above optimal levels of leverage will negatively affect the organizations‘ relevant stakeholders, because bankruptcy is likely to put a halt to the mutually beneficial relationship between stakeholders and firms. In addition, as varying stakeholder groups may have competing interests on the subject of leverage within the capital structure of an organization, it is still unclear whether an optimal capital structure is achievable.
10 academic and practical point of view, the capital structure of an organization has many implications, in which the leverage within an organization is often discussed. In modern literature, an important goal of the research on capital structure is maximizing the firm value, which is seen as one of the major benefits of the introduction of debt in the capital structure (Harris & Raviv, 1991). This effect is mainly caused by the fact that levered firms relatively pay fewer taxes than an all equity firm as a result of tax-shields (Ross, Westerfield, Jaffe & Jordan, 2011; Wedig, Hassan & Morrisey, 1996). The tax-shield on debt enables the organization to increase the cash flow to investors and the owners of the firm, thus creating value. However, a levered firm is not without its risks as an increase in leverage results in an increase in the probability of liquidation. This effect is caused by the fact that investors can opt for liquidation of the firm in the event of disappointing financial results (Harris & Raviv, 1990). Besides the tax considerations in capital structure theory, the level of debt present in an organization has multiple other theoretical implications. From an agency theory perspective, debt can be used as a tool to control managerial behavior as the debt repayments limit the free cash flows that are available for managerial self-indulging activities like buying corporate jets and expensive offices. As debt decreases the cash flows available to managers, leverage levels can reach a point where the free cash flows are insufficient for investment opportunities and can effectively restrict organizational growth (Jensen & Meckling, 1976; Jensen, 1986). Leverage can also be viewed as a communication tool towards the outside world e.g. Diamond (1989) and Hirshleifer & Thakor (1989) found that firms with higher debt levels are believed to be a safe investment with a good track-record of debt repayment. Thus, higher leverage can be interpreted as a good organizational reputation from the perspective of financial stakeholders. Also due to informational asymmetries between managers and investors, investors perceive the issuance of debt as a signal of a high quality investment leading to an increase of firm value due to positive reactions on the stock market (Ross, 1977). Lower leverage communicates to non-financial stakeholders that the organization is a safe party to do business with, which is especially relevant in markets involving durable and/or unique products as bankruptcy in this case implies high switching costs for the stakeholders involved (Titman, 1984). Lastly, debt is found to be used as a measure that can protect an organization from a potentially hostile takeover. If a firm finds itself in a position in which the possibility of a takeover is likely, it can protect itself by issuing additional debt with which they repurchase equity from investors. By doing this, the firm essentially buys voting rights with which they can maintain the managerial status quo and prevent a takeover (Harris & Raviv, 1988).
11 come from legal and administrative expenses that result from the additional information that is required by investors, on which they will base their decision to liquidate. Loss of customers and suppliers due to reduced trust will further reduce revenues (Alves, Couto & Francisco, 2015; Banerjee, Dasgupta & Kim, 2008). This implies that as soon as an organization starts defaulting on their repayments, the likelihood of bankruptcy increases due to increased bankruptcy costs. From this perspective, debt ratios and leverage are viewed as measures of financial risk which can lead to bankruptcy of the firm (Remmers, Stonehill, Wright & Beekhuisen, 1974; Titman, 1984). Titman (1984) made a convincing case on the influence of the capital structure on the decision to liquidate an organization. He concluded that firms that have higher levels of leverage will liquidate sooner than less levered firms. This is due to the fact that bond holders are more likely to choose to liquidate the firm to secure their investments, even though the organization is not bankrupt at that moment in time.
12 it is as a tool to control management, a method of communication to the outside world or to achieve an optimal capital structure that increases firm value.
Stakeholders
Although stakeholders can be divided into different groups (Van Puyvelde et al., 2011), the division of choice in the capital structure literature is between financial and non-financial stakeholders (Tyteca, 1997; Myers & Saretto, 2010; Kale, Meneghetti & Sharur, 2013; Myers & Saretto, 2016; Ghosh, 2016). Financial stakeholders can be defined as stakeholders that have an investment in the organization, for which they expect a return. In essence, this group of financial stakeholders consists of the shareholders, investors and creditors of the organization (Neu, Warsame & Pedwell, 1998). Non-financial stakeholders generally have no direct investments in the organization, and have a mutually beneficial relationship with the organization. Suppliers, customers and employees, as well as unions and the media can be considered non-financial stakeholders (Titman, 1984; Cornell & Shapiro, 1987; Tyteca, 1997).
Financial stakeholders. The foundation for modern capital structure literature was laid by Modigliani and
Miller (1958). Based on their work and following research, the relevancy of leverage in an organization‘s capital structure became more important as it has become clear that introducing certain amounts of debt creates value (Bradley, Jarrell & Kim, 1984). The introduction of debt in the capital structure creates value for its shareholders and investors, due to the effects of the tax-shield on debt (Ross et. al., 2011; Wedig, Sloan, Hassan & Morrisey, 1988). Therefore, shareholders‘ interests are best served with optimal debt-ratios. A recent article by Ghosh (2016) gives some insights in the influence that (investment) banks can have on capital structure. The results of this study show that organizations that have a better relationship with a bank have considerably more debt in their capital structures. It is not uncommon for organizations to have a representative of a bank on the board of directors. As the relationship between an organization and its bank becomes stronger, it is likely that there will be more debt in the capital structure. This is mostly explained due to the fact that more information is shared between the bank and the borrower (Kroszner & Strahan, 2001; Byrd & Mizruchi, 2005; Ghosh, 2016). In many countries, creditors are protected by the law which gives them varying advantages in the situation of bankruptcy of an organization. Just as any other lender of money, creditors are likely to extend their credit as long as there are no large risks of bankruptcy (Rajan & Zingales, 1995). Following this line of reasoning, it would be in the creditors‘ interest if an organization maintains higher leverage levels.
13 & Kim, 1984). This reasoning is closely related to trade-off theory, which has a focus on optimal capital structures. Trade-off theory acknowledges the benefits of debt caused by the tax-shield. However, trade-off theory warns us that there can be a downside to having too much debt in the capital structure (Harris & Raviv, 1991). At a certain point, an organization can become so heavily levered that the costs of bankruptcy outweigh the benefits of the tax-shield on debt. The costs of debt are related to the costs of bankruptcy and financial distress, such as legal and administrative expenses, loss of customers and suppliers due to reduced trust (Alves, Couto & Francisco, 2015; Banerjee, Dasgupta & Kim, 2008). The bankruptcy costs are partially invoked by investors as they have the option to vote for liquidation of the organization in order to safeguard their investment, or at least a part of it. Investors will require the production of information on which they can build their decision to liquidate, imposing additional costs on the organization as it will need to allocate resources to the production of this information (Harris & Raviv, 1990). This clearly implies that investors as financial stakeholders can cross the line when it comes to levels of leverage, although in general they have an interest in higher leverage levels. Lastly, debt can be used by shareholders and the board of directors as a means to control managerial behavior. As debt requires repayments and interest payments, it decreases the free cash-flow available to managers, effectively keeping them from overinvesting and pursuing luxurious lifestyles and empire building (Jensen & Meckling, 1976; Jensen, 1986).
Non-financial stakeholders. The relationship between non-financial stakeholders and the capital structure
14 The second line of reasoning suggests that implicit and explicit contracts with stakeholders have an effect on the capital structure of the organization. Cornell & Shapiro (1987) found that the inclusion of the interests of stakeholders other than stockholders has implications for capital structure. It implies that the organization should be viewed as a collection of claims, held by different stakeholders. Cornell & Shapiro make a clear distinction between explicit claims, such as contracts and agreements with stockholders and creditors, and implicit claims that have no legal binding. They suggest that implicit claims by stakeholders can affect capital structure e.g. when an organization produces unique or durable products, they make the implicit promise that the buyer will be able to keep using the product in the future. By making a promise that will take place in the future, an organization can create value, as long as it fulfills its promises. However, stakeholders will want to see evidence that the company will indeed be able to keep providing the services and replacement parts that are needed to keep using the product. Following this line of reasoning, firms will have to signal that the risk of bankruptcy is low by maintaining lower levels of leverage in their capital structure (Cornell & Shapiro, 1987; Barton, Hill & Sundaram 1989).
15 knowledge in order to find a job elsewhere. Through technology advancements, media as a non-financial stakeholder (Tyteca, 1997) is beginning to play a more influential role in the business environment. The news that is reported by media can have both positive and negative influences on an organization, depending on how the message is communicated towards, and received by the public. The media are not necessarily third parties, but can also be a publication that stems from the organization itself, think about public annual reports (Collison, Lorrain & Power, 2003). Through the dissemination of news, media can affect the reputation of an organization (Cennamo, Berrone, Cruz & Gomez-Mejia, 2012), and through this, media has a measurable effect on financial performance measures i.e. return on assets (Deephouse, 2000). Also, reputation affects the sources and costs of debt e.g. the accessibility to public debt versus bank debt. As it takes a considerable amount of time to build a strong reputation through the media, while a reputation can be destroyed with one harmful publication (Campbell, 2007), it can be assumed that the media has a negative effect on leverage (Johnson, 1997; Anderson, Mansi & Reeb, 2003). Unions and works councils are groups of non-financial stakeholders that are formed for the protection of labor, and increase the bargaining power of the labor force. In a same way, works councils are legislatively mandated in many European countries which have access to corporate information and have a voice in decision making (Campbell, 2007). The relationship between unions and councils, and the organization influences leverage through bargaining power. E.g. as a heavily levered firm has a higher risk of default, a workforce with high bargaining power will be able to put it into default by means of a strike (Simintzi, Vig & Volpin, 2009). Also, leverage is a known to be used by management to improve the bargaining power of the organization vis-à-vis the unionized workforce. As default of the firm is not in the best interest of the workforce, increased leverage creates a situation with increased risk of default, thus can decrease the probability of a unionized strike (Myers & Saretto, 2010; Myers & Saretto, 2016). In summary, it can be assumed that a good relationship between the organization and its unionized workforce will lead to lower leverage.
Hypotheses
decision-16 making (Spitzeck & Hansen, 2010). Also, the shape of the dialogue and the filters used in the dialogue between the organization and its stakeholders are likely to influence whether or not the interests of financial and non-financial stakeholders are translated into the capital structure of the firm.
As the interests of financial stakeholders become more important to the board of directors, it is likely that the firm will become more heavily levered, as this can increase value for the shareholders and creates investment opportunities for investors. A good relationship between debt-financers and the firm will increase leverage as more information is shared, creating opportunities for debt-financing. Shareholders, banks & investors, and creditors all have an interest in higher levels of leverage, as the introduction of debt results in higher returns for the financial stakeholders. Financial stakeholders are therefor expected to strive for an optimally balanced capital structure. Based on this reasoning we formulate hypothesis 1a (H1a).
Hypothesis 1a (H1a): There is a positive relationship between financial stakeholders‘ interests within
boards of directors and the level of leverage within a firm.
Model 1
H1a. Direct effects model (financial stakeholders)
17
Hypothesis 1b (H1b): There is a negative relationship between non-financial stakeholders‘ interests within
boards of directors and the level of leverage within a firm.
Model 2
H1b. Direct effects model (non-financial stakeholders)
As stakeholder theory is gaining more ground, the shareholders and investors have to share in the attention they receive from the organization. Boards of directors are no longer solely in place to act in the interests of the financial stakeholders of the firm, and instead take into account the interests of other non-financial stakeholders in their job as overseer of the firm. The literature that was reviewed in this section describes a positive effect of financial stakeholders‘ interests on leverage, while the effects of the interests of financial stakeholders‘ interest on leverage are described as negative. We therefore hypothesize that non-financial stakeholders moderate the effect of the interests of non-financial stakeholder within a board of directors on the level of leverage within a firm (Hypothesis H2).
Hypothesis 2 (H2): The positive relationship between financial stakeholders‘ interests within boards of
directors and the level of leverage within a firm is moderated by the negative effect of non-financial stakeholders‘ interest within boards of directors on the level of leverage within a firm.
Model 3
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Methods
Sample and data
As it has proven to be difficult to access boards of directors for research purposes, a secondary dataset which originates from an online tool for self-evaluation by boards of directors in the Netherlands was used. The tool that was used for the collection of this data consists of an online survey which has been extensively tested and validated in order to improve the overall quality of the questionnaire. In order to overcome the problems involving gaining access to boards of directors, steps that were recommended in earlier studies by Leblanc & Schwartz (2007) and Westphal & Stern (2007) have been followed in the data collection by the creators of the questionnaire. The dataset was standardized, as the data derived from the participating boards of directors is confidential for anonymity reasons.
The current focus of the research for which the online tool is used, is on boards operating within the context of NPOs, specifically social housing agencies and educational institutions, resulting in a dataset that primarily consists of NPOs. In total, the dataset contains standardized data on 155 boards of directors. The data that was used from the dataset included measurements on the extent to which non-executive directors take the interests of varying stakeholders into account in their work. Also, data on board specific characteristics such as tenure and board size were used from the dataset.
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Measures
Factor analysis A descriptive factor analysis on the stakeholders‘ interests variables showed support for
the division into two groups, although the non-financial stakeholder item suppliers was factored with the financial stakeholders creditors, shareholders and investors. Factor analysis was performed on eight stakeholder variables. The items measured the extent to which non-executive directors take the stakeholders‘ interests into account in their work as non-executives. Although the suppliers are grouped among the financial stakeholders, we will base our further analysis on the literature that was discussed previously. Suppliers in the literature do not fit the description of financial stakeholders, who generally have a direct investment in the organization. Also, the literature on non-financial stakeholders state that the interests of suppliers are in line with those of non-financial stakeholders (Titman, 1984; Cornell & Shapiro, 1987; Tyteca, 1997). What can be concluded from the factor analysis is that boards of directors make a clear distinction between two groups of stakeholders when it comes to taking into account the interests of various stakeholders.
Table 1
Factor analysis stakeholders
Construct and item wording SL
20
Independent variable: non-financial stakeholders. The degree in which the interests of non-financial
stakeholders are considered by a board of directors is measured with an online survey tool. The tool measures the amount in which the interests of varying groups of stakeholders are being considered by the non-executive members of the participating boards of directors. Specific examples of such stakeholders are employees, suppliers, customers, works-council and media. This combination of items is often used by researchers to define non-financial stakeholders (Myers & Saretto, 2010; Kale, Meneghetti & Sharur, 2013; Myers & Saretto, 2016; Windsor, 2009; Tyteca, 2007; Collison, Lorraine & Power, 2003), albeit not necessarily in this current configuration. In order to construct the independent variable non-financial
stakeholders, a combination of the items employees, suppliers, customers, works-council and media was
made and tested for internal consistency, which delivered a Cronbach‘s Alpha of .71
Individual board members will give a rating on a 1-7 Likert-type scale, stating to what extent do individual non-executive directors take non-financial stakeholder X‘s interests into account in their work as non-executives . The Likert scale ranges from 1 to 7; 1 meaning that the interests of this stakeholder group is not considered in the work of a board member, and 7 meaning that the interests of the stakeholder group are often considered in the work of the board member. The construct is measured on an aggregated group-level (board-level) of analysis, in order to make comparisons between the participating boards of directors.
Moderating variable: financial stakeholders. As well as the previously described independent variable,
the construct for the moderating variable ‗financial stakeholders‘ is measured by the online tool for board self-evaluations. The degree in which the interests of financial stakeholders are considered by a board of directors is once again a construct that consists of multiple items that are measured by the online tool. The groups of stakeholders that are considered in this construct are the following items: shareholders, lenders, and creditors. Once again, these items are measured on a 7 point Likert-type scale ranging from 1 (interests of financial stakeholders not considered in the work of board members) and 7 (interests of financial stakeholders are often considered in the work of the board members). As well as the previous independent variable, the data for this variable comes from the 155 boards of organizations that voluntarily participated in the research as a part of their self-evaluation process.
The variable financial stakeholders will be constructed by the combination of the following three items; shareholders, lenders, and creditors. Again, these items are originally coded on a 7 point Liker-type scale. The new construct was tested for internal consistency with a Cronbach‘s Alpha of .78. The construct is measured on an aggregated group-level (board-level).
Dependent variable: leverage. The data for this variable will be gathered from secondary sources, namely
21 organizations have participated in this research, annual reports were selected accordingly. E.g. if a board of organization X has participated in February 2015, the annual reports from 2014 for that organization was used for data gathering, assuming the books are closed on 31st of December. By working this way, the probability that data from years in which the board that participated was actually active in its relevant composition was increased. Data was gathered for the relevant year (Y0) and the previous year (Y-1). As the measurement for this variable is the level of leverage present within the organization, the variable will be constructed according the mathematical equation with which leverage can be measured. Current textbooks and literature describe multiple ways in which leverage can be measured. Variations can be found in the use of market- or book values, or long-term debt versus total debt (Dambolena & Khoury, 1980; Frank & Goyal, 2009) The particular measurement for leverage in this instance can be formulated as; [(Total assets – Total equity) / Total assets] or; [Total debt / Total assets] (Berger, Ofek & Yermack, 1997). This ratio is often used in literature to define leverage (Remmers, Stonehill, Wright & Beekhuisen, 1974; Faulkender & Petersen, 2006; Jegers & Verschueren, 2006). Essentially the data needed for this variable can be retrieved from the balance sheets that are discussed in the relevant annual reports. Of particular interest are the data that describe the assets, debt and equity of the organization; fixed and current assets, long-term debt and current liabilities, and the equity present within the organization. The final product of this variable is a ratio that describes the amount of debt that is present within the capital structure of the relevant organization, or in other words; it shows how levered the organization is.
Ultimately, this construct will show the proportionate amount of debt that is present in the organization. As the amount of debt is unlikely to exceed the total amount of assets, the product of this variable will be a proportionate figure that ranges between 0 and 1; 0 meaning that there is no debt present in the capital structure, and 1 meaning that the entire firm is financed with external financing from financial stakeholders. Every measure in between 0-1 shows the proportionate amount of debt that is present in the capital structure.
Control variables. As the measured independent variables in this research are in itself not sufficient to
predict the outcomes of the independent variable, control variables were included in the model. The control variables that were included in the model are the board characteristics tenure and board size. Also a measurement of return on assets was added as an independent variable. These control variables are known to explain variance in the dependent variable leverage.
22 variable for board size was simply measured by counting the number of board members in a board of directors during the relevant year. As board size increases, boards will put more pressure on managers to pursue positive financial performance for which larger free cash flows are necessary (Berger, Ofek & Yermack, 1997). In order to free up cash flows, boards can decide to reduce the level of debt in the capital structure (Harris & Raviv, 1991; Jensen & Meckling, 1976; Jensen, 1986). Also, as larger boards are able to monitor more actively than boards which are smaller in size, there is less need to restrict the cash flows available to manager. The increased oversight will make it possible to closely monitor managerial actions and behavior, effectively preventing them from overinvesting (Berger, Ofek & Yermack, 1997). As directors‘ tenure on the board increases, leverage will decrease due to the ability of managers to influence board members (Anderson, Mansi & Reeb, 2004), this effect can be caused by the fact that trust is built between management and the boards. Based on these lines of reasoning, it should be expected that the control variables board tenure and board size will have a negative effect on leverage.
Another factor that partially explains the amount of debt present in the organization is the profitability of the organization as measured in return on assets (ROA) (Berger, Ofek & Yermack, 1997; Frank & Goyal, 2009). ROA is measured as the ratio of net income before taxes divided by total assets or; [net income / total assets] (Stonehill et al., 1974). As organizations become more profitable, the costs of financial distress become relatively lower leaving more room for debt in the capital structure. Also, as organizational profits increase, the organization will aim to shield their profits from taxes by issuing more debt in order to reap the benefits of the tax-shield on debt (Stonehill et al., 1975; Titman & Wessels, 1988; Frank & Goyal, 2009). Based on this line of reasoning it can be expected that ROA has a positive effect on leverage.
Analysis
23
Results
The exploratory descriptive statistics for the variables are shown in table 2. The table shows the correlations of the variables that are used to build the models shown in table 3. The correlation table shows multiple significant correlations between variables. In total there are 155 observations that are taken into account in the analysis. However, there was a small amount of data missing for some of the variables, as some of the questions in the online questionnaire were left unanswered. This may be due to the fact that these boards did not have a relationship with certain financial or non-financial stakeholders.
Table 2 Correlations of variables Variables 1 2 3 4 5 1. Board size 2. ROA .05 3. Board Tenure -.10 .01
4. Financial Stakeholders Interests .06 -.05 .00
5. Non-Financial Stakeholders Interests .12 .18* .01 .50**
6. Leverage -.17* .04 -.03 .22** .17*
Note: N = 155. *p < .05. **p < .01.
There are significant positive relationships between non-financial stakeholder interests and ROA (r = .18, p < .05.), financial stakeholder interests (r = .50, p < .01.), and leverage (r = .17, p < .05.). The variable financial stakeholder interests shows a significant relationship with leverage (r = .22, p < .01.). Furthermore, the correlation table shows that leverage is negatively correlated with board size (r = -.17, p < .05). From this we can state that leverage is positively influenced by the level in which financial- and non-financial stakeholders‘ interests are taken into account by a board of directors in their work. Also, the table shows that the size of a board of directors negatively affects leverage.
24 significant explanations. Model 1 shows the influences of the control variables on the dependent variable. Models 2 and 3 show the results for the direct effects model for hypothesis 1a and hypothesis 1b. In model 2 the independent variable financial stakeholders’ interests is introduced to show the direct effects of this variable on the independent variable. This relationship is significant and positive (Model 2, b = .23, p < .01). Model 3 shows the results for the second direct effects model with the non-financial stakeholders’
interests variable. This model does also bring forth new significant findings, although they are not in the
expected direction (Model 3, b = .19, p < .05). Less significant results are found in model 4, which takes into account both independent variables. In this model, no significant results are shown for the effects of the independent variable non-financial stakeholders’ interests However, there is a significant finding in model 4 showing an effect of financial stakeholders‘ interests on leverage (Model 4, b = .19, p < .05).
Table 3
Results of Multiple Regression Results on Leverage: Test for Moderation Effect
Model 1 Model 2 Model 3 Model 4 Model 5
Board size -.17* -.19* -.20* -.20* -.20* ROA .05 .08 .02 .07 .06 Board Tenure -.05 -.05 -.04 -.04 -.04 Financial Stakeholders Interests .23** .19* .18† Non-Financial Stakeholders Interests .19* .11 .12 Financial Stakeholders x Non-Financial Stakeholders .05 R² .03 .09 .07 .10 .10 ΔR² .03 .06 .04 .07 .00 Observations (%) 153 147 152 146 146
Note: Standard errors are shown in parentheses. Standardized regression coefficients reported in table.
†p < .10.
*p < .05. **p < .01.
26
Discussion
With this research we aimed to gather more insights in how the interests of financial and non-financial stakeholders are translated by boards of directors into the capital structure as measured in leverage of an organization. We measured the extent to which boards take the interests of various stakeholder groups into account in their work, and how this affects leverage. Although the main focus in stakeholder and governance theory currently is on non-financial CSR related performance measures, we plead that leverage is an important financial measure that affects all stakeholder groups. The risk of default and bankruptcy increases as leverage increases, a situation that is not beneficial for most stakeholder groups, as they will incur varying levels of costs associated with a bankruptcy (Titman, 1984). Although financial and non-financial stakeholders have different interests on the topic of leverage, it is not in either one‘s best interest if an organization goes bankrupt.
Our findings show little support for the hypotheses, with the exception of hypothesis H1a in which we hypothesized that as boards of directors take the interests of financial stakeholder in higher regard, leverage would increase. Our results show that as the extent to which boards consider financial stakeholders‘ interests in their work increases, a significant increase of leverage can be measured. These results are in line with the findings of Wedig et al. (1988), Kroszner & Strahan (2001), Byrd & Mizruchi (2005), and Ghosh (2016) who found that adherence to financial stakeholders‘ interests leads to higher levered capital structures. In the direct effects model including the variable non-financial stakeholders’
interests, we found a significant positive increase in leverage as boards take their interests into higher
27 measured in ROA (Stonehill et al., 1975; Tyteca, 1997) and board tenure (Berger, Ofek & Yermack, 1997) on leverage were not significant.
As non-financial stakeholders consist of multiple stakeholder groups, it is possible that there are conflicting interests between the stakeholder groups that are not taken into account in the analysis (Freeman & Reed, 1983). Titman (1984) might have another explanation as to why the results differ from the hypothesized relationships. Titman assumes that non-financial stakeholders like customers, employees and suppliers face high switching costs when an organization goes bankrupt, and therefore have an interest in lower leverage (Titman & Wessels, 1988). The organizations in our sample are predominantly not for profit educational institutions and social housing corporations, which are public services (partially) funded by the government. These services have a homogenous character, implying low switching costs for customers (Lee, Lee & Feick, 2001). Following the same line of reasoning, suppliers are expected to face high costs in the durable goods industry, as they often have to make firm-specific investments, and therefore have an interest in lower leverage in their customers‘ capital structure. Relating to our sample, it might be possible that the suppliers in these homogenous industries have little to no interest in the leverage levels of their customers. In European countries including the Netherlands, workforce unions have started to lose members (van den Berg & Groot, 1993; Vandaele & Leschke, 2010). This means that unions in the Netherlands have lost bargaining power vis-à-vis the organizations that employ their members. It is possible that due to this development, it is no longer relevant to suggest that unions affect leverage, at least in environments where unions lose their strength. Although works councils are widespread in Western European countries (Campbell, 2007), it is not likely that they would influence leverage for the same reasons that go for the other non-financial stakeholders. This means that due to the homogeneous nature of the products and services offered by the organizations in our sample, non-financial stakeholders have no interests in the leverage of the firms and therefor the results show insignificant and contradictive findings for our hypothesis (Hypothesis H1b.).
28 empowerment and transparency, all of which can be measured on multiple levels of engagement (Pedersen, 2006). The fact that certain stakeholders‘ interests are in high regard within boards, does not necessarily imply that all relevant stakeholders are included in decision making in the same manner. Also, it could very well be the case that discussions between varying stakeholder groups and boards have a different character, ranging from an open discussion to a more closed nature. Building on this line of reasoning, Spitzeck & Hansen (2010) state that stakeholder governance knows two dimensions: power and scope. If stakeholders have a lot of influence in corporate decision making, the level of power is high. It is possible that non-financial stakeholders of the organizations in our dataset score low on the power dimension. This would indicate that they do not participate or are taken into account in decision making by the board. Scope refers to the range of topics in which stakeholders are involved in by organizations. There exists a possibility that the non-financial stakeholders are not involved or considered in decisions relating to capital structure and leverage (Spitzeck & Hansen, 2010).
Relating to the research questions that were developed earlier, we can state that boards employ a strategic stakeholder model (Donaldson & Preston, 1995) when it comes to capital structure decisions, of which comparable results were found by Berman et al. (1999). Stakeholder management in this model is a means to an end, in which the main purpose is to benefit from the relationship with stakeholders, and create value for the firm. Although any concrete statements on employed stakeholder management models cannot be made, the findings of this research provide some indications. Using the model by Spitzeck & Hansen (2010), the results show that non-financial stakeholders score low on both the power and scope dimensions. This implicates that non-financial stakeholders in the context of this research have no power in decision making activities on the topic of capital structure. The absence of non-financial stakeholders‘ power on this topic indicates a narrower scope of topics in which these stakeholders are involved. The results on financial stakeholders show that they have some power in decisions on capital structure, which in turn implies that financial stakeholders‘ interests are taken into consideration in a broader scope of topics. Following the model by Pedersen (2006) we can state that the stakeholder dialogue between boards of directors and financial stakeholders takes place on a higher level. The dialogue between boards of directors and non-financial stakeholders might take place on a lower level, or these stakeholders may entirely be excluded from the dialogue surrounding capital structure decisions (Pedersen, 2006).
Limitations and strengths
29 this research was specifically aimed on NPOs in the Netherlands, little consideration of the literature surrounding NPOs and their related capital structure and stakeholder theories was taken. Furthermore, the dataset containing the data on boards of directors was anonymized by standardizing the data. Because of this, it has not been possible to make additional statements on the level to which boards take varying stakeholders‘ interests into account in their work. Although the dataset has proven to be a valuable source for data concerning board of directors, it was not possible to gather additional data concerning the relationship between the participating boards of directors and their stakeholders. This has caused a restriction in the ability to further analyze the relationship between boards and their stakeholders, and the stakeholder management models that boards employ in their dialogue with the varying stakeholders. Even though the dataset primarily consists of non-profit organizations, it does give some valuable insights on how the theory applies on NPOs. From this we can propose that more research on the effects of non-financial stakeholders‘ interests on leverage levels in NPOs is advisable. From such research we can learn a lot about the relationship between NPO boards of directors and their stakeholders, as well as how capital structures of NPOs are affected by their stakeholders. One of the major strengths of this research is the fact that the data is derived directly from the board of directors of the participating organizations. It gives valuable insights in how boards of directors translate the interests of different stakeholders in the capital structure and how this affects leverage. Also, by reviewing the literature, it was possible to gain a theoretical understanding of the shared interests that stakeholder groups can have.
Implications and directions for future research
Although the results did not support the hypothesis that non-financial stakeholders‘ interests moderate those of financial stakeholders, we did contribute to the existing literature by reviewing the interests of non-financial stakeholders on the topic of leverage. As literature in the capital structure research often divides stakeholders into financial and non-financial stakeholders, we were surprised by the lack of articles that group stakeholders based on their interests, in order to test how their interests affect capital structure. Following the work of Titman (1984), we found that non-financial stakeholders have an interest in lower levels of leverage in firms. This line of reasoning assumes that these organizations operate in highly specific industries, incurring switching costs on non-financial stakeholders in scenarios in which the risk of bankruptcy is high.
30 in the capital structure of the organizations in our sample. Our results add to the existing literature as we learned that the interests of financial stakeholders are taken into account by the board of directors into capital structure decisions, leading to higher leverage. Where most of the literature focuses on separate financial stakeholder groups e.g. banks or investors, we found that the interests of these stakeholders combined are generally in line with each other on the topic of leverage levels. Notwithstanding the fact that contradictive interests among financial stakeholders may arise when an organization starts to default and faces bankruptcy (Titman, 1984). Future research could aim to find other explanations as to why non-financial stakeholders might have an interest in the leverage that is present within an organization, besides the fact that they could incur high switching costs as they operate in highly specialized markets. Another interesting line of research could aim to map how boards of directors engage different financial and non-financial stakeholders by employing the articles of Pedersen (2006) and Spitzeck & Hansen (2010). Such research will offer important insights in the dialogue between financial and non-financial stakeholders and boards of directors. Could it be that a different model of stakeholder management is used for financial stakeholders in comparison to non-financial stakeholders? (Donaldson & Preston, 1995; Berman et al., 1999). And is the model used by boards of directors dependent on board characteristics such as age, board size and sex for example?
Practical implications
31
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