Do Independent Directors Matter?

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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
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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?
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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.

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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.

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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.

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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.

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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.

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• 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))

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• 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.

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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.
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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.

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• 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.

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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.

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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.

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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.

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• 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.