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Do%20Independent%20Directors%20Matter?

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Large Company Boards should consist mostly of independent directors. ... DIFF = (Fraction of Independent Directors) minus (Fraction of Inside Directors) ... – PowerPoint PPT presentation

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Title: Do%20Independent%20Directors%20Matter?


1
Board Independence and Long-Term Performance
Sanjai Bhagat University of Colorado, Boulder
Bernard Black Stanford Law School Also,
please see the articles in New York Times,
Chief Executive and CFO in Media Clippings
in the home-page http//bus.colorado.edu/faculty/
bhagat
2
Conventional Wisdom
  • Large Company Boards should consist mostly of
    independent directors.
  • Institutional shareholders can improve corporate
    governance by strengthening independence of
    corporate boards.
  • The Question

Will greater board independence produce better
corporate performance?
3
This Study First Large-Scale, Long-Time-Horizon
analysis of affect of independent directors on
corporate performance.
  • Stock price and accounting performance during
    1985 - 1995 for 950 large U.S. firms.

4
Prior Research (1)
  • Direct studies of corporate performance and board
    structure.
  • Conflicting results Due to different
    performance measures.
  • None of the prior studies use multiple
    performance measures.

5
Prior Research (2)
  • Board Structure, CEO Replacement, Takeover Bids,
    and Poison Pills
  • Economic effect is quite small.
  • Ignores advisory role of boards on usual business
    activities.

6
Prior Research (3)
  • Share Ownership Firm Performance
  • Increase in inside stock ownership correlates
    with improved performance up to 5 -10 ownership.
  • Firms with high inside ownership have less
    outside directors.
  • Hence, important to control for ownership by
    insiders and outside blockholders.

7
Research Design
  • Institutional Shareholder Services (ISS) Board
    composition of 957 large U.S. public
    corporations Data on inside, affiliated outside,
    and independent directors from proxy statements
    mailed in early 1991, and 1988.
  • CRSP Stock returns during 1985 -1995.
  • Compustat Accounting data during 1985 -1995.
  • Share ownership data from 1991 and 1988 proxy
    statements.

8
Potential Weakness of Our Research Design
  • Survivorship Bias Entry into and exit from
    sample during sample period (1985 -1995).
  • For stock price performance measures, measurement
    periods that end/begin/include early 1991 should
    be free from above source of bias.
  • Prospective period of study (1991-1995) No
    correlation between survival and board structure.

9
Definitions
  • Inside directors Directors who are also officers
    (CEO, CFO) of the company.
  • Affiliated directors Directors who have a
    significant business relationship with the
    company.
  • Independent directors Not officers and have no
    significant business relationship.
  • DIFF (Fraction of Independent Directors) minus
    (Fraction of Inside Directors)
  • Why DIFF is an appropriate measure of board
    independence? Proponents of independent
    directors argue that inside directors should be
    replaced by independent directors.

10
Sample Characteristics
  • Table 1 Median firm has 11 board members 7
    independent directors, 1 affiliated outsider, 3
    insiders (typically including CEO and CFO).
  • 70 of sample firms have majority-independent
    boards (DIFF gt 0).
  • 6 of sample firms have majority-inside boards.

11
Accounting Performance Measures and Board
Structure
  • Ratio variables (Table 2)
  • Tobins Q (market value of assets/ replacement
    value of assets),
  • Operating Income to Sales,
  • Operating Income to Assets,
  • Sales to Assets
  • Sales to Employees.

12
  • Equation 5.1 firm performance f1 (INDEP,
    CEO ownership, board size, outside director
    ownership, no. of outside 5 holders, log(firm
    size), industry performance control)
  • Equation 5.2 INDEP f2 (firm performance,
    CEO ownership, outside director ownership, no. of
    outside 5 holders, log(firm size))
  • Equation 5.3 CEO Ownership f3 (firm
    performance, outside director ownership, log(firm
    size))

13
  • Table 5 Simultaneous Equations (3SLS)
    Instrumental Variables Estimates
  • Simultaneous equations (three stage least
    squares) regression results for various
    performance variables on board independence and
    stock ownership for 928 large U.S. public
    companies for 1988-1990 and 1991-1993. The
    instrumental variables, system of equations, and
    performance variables Q, OPI/AST, MAR, and
    SAL/AST are defined in the text.
  • Q 88-90 means average Q during 1988-1990.
  • Q 91-93 means average Q during 1991-1993.
  • Board and stock ownership variables are based on
    early 1991 data.
  • Industry control for each regression is the mean
    of the dependent variable for that regression for
    each firm's industry group 302 industry groups
    are constructed on the basis of 4-digit SIC codes
    from Compustat. t-statistics are in parentheses.

14
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15
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16
Bottom Line Poorer performing firms move towards
a board that consists of a greater proportion of
independent directors.However, the performance
of these firms does not necessarily
improve.Study underscores the importance of
using a broad range of variables to measure firm
performance.
17
Stock Market Performance Variables and Board
Structure
  • If markets are (semi-strong form) efficient, then
    impact of board independence on share price would
    occur at the time the independent board is first
    elected.
  • Measurement problems in measuring stock market
    based performance measures for long (several
    years) horizons.
  • Negative correlation between board independence
    and prior stock market performance. Subsequent
    stock market performance is not statistically
    significant.

18
  • Results persist after controlling for
  • Board size,
  • Firm size,
  • Stock ownership by CEO,
  • Stock ownership by inside directors,
  • Stock ownership by independent directors,
  • Number and size of outside 5 blockholders.
  • Results persist in robust regressions.

19
Why increased board independence may not pay off
in improved performance.
  • The Case for Inside Directors
  • Including insiders on the board may make it
    easier for other directors to evaluate them as
    potential CEOs.
  • Insiders may be better at making strategic
    investment decisions. (Some evidence that inside
    director representation on investment committees
    improves firm performance.)
  • But, senior managers could be invited to board
    meetings even if they are not board members.
  • However, interaction between senior managers
    (other than CEO) and other directors may be
    different if the managers have seats on the
    board, are expected to attend every meeting, must
    vote, and are expected to participate in
    discussions, than if they attend at the CEOs
    pleasure.

20
Why increased board independence may not pay off
in improved performance.
  • The Case for Inside Directors
  • Tradeoff between independence and other
    essentials to good decisions.
  • Inside directors are conflicted, but well
    informed.
  • Independent directors are not conflicted, but are
    relatively ignorant about the company.
  • Tradeoff between independence and incentives.
  • Independent directors usually own trivial amounts
    of the companys shares.
  • Inside directors have their human capital (and
    substantial financial capital) committed to their
    company.

21
A case for a modified version of the conventional
wisdom that favors highly independent boards.
  • Incentivize independent directors through stock
    and stock-option ownership. (Bhagat-Carey-Elson
    (1999)
  • Institutional investors may need to put their own
    representatives on boards. (Legal restrictions.)
  • Todays independent directors are not
    independent enough. (Board members that may be
    employed by a university or foundation that
    receives financial support from the company.)
  • Require directors to disclose any
    (social/professional/business) relationship (past
    or present) with the CEO.

22
  • Heterogeneity among independent directors. Some
    types of independent directors are valuable,
    while others are not.
  • CEOs of companies in other industries may be too
    busy with their own companies.
  • Visibility directors - well-known persons with
    limited business experience, often holding
    multiple directorships and adding gender/racial
    diversity are not effective, on average.
  • Hence pushing boards for greater independence may
    be fruitless or even counterproductive, unless
    independent directors have particular attributes,
    which are currently unknown.
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