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«Three essays on corporate boards R. Øystein Strøm A dissertation submitted to BI Norwegian School of Management for the degree of Dr.Oecon SERIES ...»

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Carter and Lorsch (2004) argue that board independence is driven by the director’s absolute rather than relative tenure, and that independence decreases rather than increases as tenure grows.8 This happens because directors become emotionally more attached to the firm and its management the longer the directors stay. Under this logic, a higher value of (2.1) means less independence rather than more. However, since (2.1) also reects the tenure of the CEO, which is irrelevant under the Carter-Lorsch hypothesis, we will alternatively use board tenure, CEO tenure, and chair tenure as proxies in our robustness tests.

A very different reason why a positive relationship between indepenA second reason for questioning the conventional independence definition in our setting is the institutional framework. The CEO of our sample firms is also a director in just one third of the cases, the CEO cannot chair the board by law, and other members of the management team are never on the board. Thus, although most directors in our sample are independent in the Byrd-Hickman sense, they may not be so according to Hermalin and Weisbach (1998).

7 Although not based on an underlying theoretical model, Westphal and Fredrickson (2001) did in fact use the fraction of directors appointed after the CEO took office as one of several independence measures.

8 Absolute rather than relative CEO tenure has also been used as an independence proxy in the strategic management literature (Finkelstein and Hambrick, 1989).


dence and performance is not found in the data is that it simply does not exist. That is, the predictions tested so far may come from theories that miss key components of the full picture. In particular, although directors provide both monitoring and advice, the Hermalin and Weisbach (1998) model only captures monitoring. This means the directors’ role as advisors is assumed to be independent of their role as monitors. Similarly, regulation mandating more independence ignores the point made by Bhagat and Black (1999, p. 264) that “Inside directors are conflicted, but well informed. Independent directors are not conflicted, but are relatively ignorant about the company”. Adams and Ferreira (2007) formalize this idea in a setting where the quality of both monitoring and advice increases with the information received from the CEO, who dislikes monitoring and likes advice. They show that if independent directors have stronger monitoring incentives than dependent directors, increased independence may hurt the stockholders. This happens because information provision is endogenous to independence: The CEO responds to increased board independence by providing the directors with less information. In fact, the value of both monitoring and advice may decrease as independence grows. Thus, an inverse or no relationship between independence and performance is consistent with a model that captures both the monitoring and advice functions of the board, recognizes the conflict between the two, and lets information provision relate endogenously to independence.

2.2.2 Information The quality of the board’s monitoring and support functions depends on the quality of the information used. Information sources that can be influenced by board design are CEO directorship, the CEO’s directorships in other firms (which we call exported CEO director), another firm’s CEO on our firm’s board (imported CEO director), and non-CEO directors holding board seats in other firms (director network).

Agency theory suggests that due to the value of independence for monitoring quality, the CEO should not be on a board which is supposed to monitor him9. In contrast, Carter and Lorsch (2004) posit that since the CEO has superior information about the firm and its environment, he should be a fully voting member in order to increase incentives for inforBecause the CEO director mechanism involves both alignment and information, it may be classified under either the alignment or the information heading. We choose the latter, but with no implicit assumption about relative importance.

2.2. THEORY, EVIDENCE, AND METHODOLOGY 31 mation production. Because the CEO is a member in about every third of our sample firms, we can explore the validity of these two competing predictions. While the CEO-chairman duality has been analyzed earlier, we are not aware of existing studies of CEO directorships.

Similarly, whereas the agency logic may suggest that the CEO should pay full attention to his firm, the information perspective would argue that the firm may benefit when the CEO is on other firms’ boards. We use the exported CEO director variable to capture this design characteristic. Perry and Peyer (2005) show that when agency costs are high, the announcement of a new outside directorship for the CEO is followed by a negative share price reaction. Correspondingly, a CEO from another firm on our board (imported CEO director) may contribute little if he is already a fully committed CEO. Also, Gilson and Kraakman (1991) argue that imported CEO directors are bad monitors because they have the same role in the principal-agent setting as the CEO they are supposed to monitor. Again, the counterargument is the information idea that the imported CEO director brings new perspectives and makes all directors better informed. The net impact of these alignment and information effects can only be determined empirically.

Just like the CEO, non-CEO directors with multiple directorships may bring back information, but may also become overstretched monitors (Ferris et al., 2003, and Fich and Shivdasani, 2006). Fama (1980) argues that the average number of outside directorships held by the firm’s directors proxies for the market value of the board’s monitoring quality. This simple measure, which is predominant in finance-based board research, is potentially problematic. Although the information benefit may be positively related to the number of directorships, the measure is noisy because it ignores the uniqueness of each seat. Also, it does not distinguish between n direct director links to just one other firm and one direct link per firm to n different firms. Moreover, the Fama measure neglects indirect links created when the firm’s director is on a second firm’s board with someone who holds a seat in a third firm.

We avoid these problems by applying an information centrality concept from social network analysis (Wasserman and Faust, 1994). This measure captures the firm’s direct and indirect links to directors in other firms, treats each seat individually, and avoids double counting. The centrality score increases with the number of direct and indirect paths from our board to other boards, and is higher the shorter the indirect path10. The 10 Network theory uses concepts such as nodes and lines. In our setting, a node is a


higher the board’s centrality score, the stronger the predicted information effect of its directors’ network.

2.2.3 Decisiveness The decisiveness mechanisms are supposed to improve the board’s effectiveness as a decision-making unit. The mechanisms we explore are board size, director gender, director age, and employee directors.

Yermack (1996) and Eisenberg et al. (1998) document that performance decreases with increasing board size. This is consistent with Gjølberg and Nordhaug (1996), who show theoretically that increased board size is valuable only when new members bring new insights. If not, larger boards take longer time to decide and make more conventional decisions than smaller boards. Thus, performance suffers when increased board size reduces creativity and decisiveness.

A larger board may also produce more diversity, which Cadbury (2002) considers a valuable characteristic. This is why public choice theory tells board designers to trade off the negative effect of longer decision time and stronger pressure on consensus against the positive impact of a wider opportunity set generated by a more diverse board (Buchanan and Tullock, 1962). Thus, the issue is not just whether board size grows, but whether it does with new directors who differ sufficiently from the existing ones.

Gender and age are potential ways to create such diversity.

firm, and a line between two firms represents a joint director in the two firms. We define geodesic g jk as the shortest path between two nodes j and k, and G as the total number of nodes. The node i is designated as ni. Using Wasserman and Faust (1994, p. 192-197), our information centrality measure is constructed in the following way: Form the G × G matrix A with diagonal elements aii = (1 + sum of values for all lines incident to ni ) and off-diagonal elements aij, where

–  –  –

The empirical evidence on how firm performance correlates with gender is scant and conflicting. Shrader et al. (1997) and Smith et al. (2006) document a negative relationship between female directors and firm performance, whereas Carter et al. (2003) find the opposite. As far as we know, age has not been studied in this setting. We will use the fraction of female directors and the variance of the directors’ age to proxy for gender diversity and age diversity, respectively.

The use of employee directors is potentially a mechanism for both alignment, information, and decisiveness. Because employees are stakeholders with contractual claims on the firm’s cash flow, the hold-up problem suggests that shared control with employees investing in firm-specific human capital may benefit owners (Hansmann, 1996 and Becht et al., 2003).

However, Williamson (1996) posits that since employees have a contractual claim, they should not be residual claimants as well. Because employees will defend their sunk human capital investments, they may oppose decisions which threaten their job security. This is the alignment dimension of employee directorships.

As for information provision, Raheja (2005) argues that inside directors may be valuable because outside directors are better monitors when firminternal information comes through several channels. Thus, employee directors may supplement the CEO as an internal information source. Employee directors may also matter for decisiveness, as the conflict of interest between owners and employees may increase decision complexity and make the board a less effective decision maker. This is why Cadbury (2002) thinks boards should be unitary.

The limited empirical evidence suggests the net effect of employee directors on owner wealth is negative. FitzRoy and Kraft (1993) and Schmid and Seger (1998) show that German firms with employee directors are less profitable than other firms. Falaye et al. (2006) find that Canadian firms where shareholding employees hold director positions in their company spend less on new assets, take fewer risks, grow more slowly, create fewer new jobs, deviate more from value maximization, have more serious cash flow problems, and are less productive. 41% of our sample firms have employee directors. We measure board-driven co-determination by the fraction of the firm’s directors employed by the firm.

To summarize, we want to investigate the following relationship beCHAPTER 2. ALIGNED, INFORMED, AND DECISIVE

tween economic performance and board design mechanisms:

–  –  –

Because the descriptive statistics will show that insider ownership by non-CEO officers and by the CEO are strongly correlated, we use only the directors’ aggregate holdings in (2.2). By removing employee directors from the proxies for independence, age diversity, network, size, and gender, we avoid multicollinearity problems and make it easier to separate the effects of shareholder–elected directors from those of employee– elected directors. On the other hand, some predictions do not distinguish between director types, such as the relationship between board size and decisiveness. We return to that issue in section 2.5 by including employee directors in the size, independence, and gender proxies. Our control variables are firm size and risk, which we measure by the log of sales revenues and the equity beta, respectively. Size is included due to its consistent correlation with observed returns in asset-pricing tests (Hawawini and Keim, 2000). Correspondingly, risk controls for the impact of cash flow uncertainty on firm value.

2.2.4 Endogenous board design mechanisms A board mechanism may be endogenously determined by other variables in our model for two reasons. First, the firm’s performance may drive its board composition. Such reverse causation occurs in the Hermalin and Weisbach (1998) model, where the board becomes less independent the better the firm performs. Similarly, Palia (2001) posits that insider ownership increases when performance grows, as equity-based compensation instruments are more often exercised when performance is strong.

Second, a board mechanism is endogenous if it is influenced by other board mechanisms in the model. An early example is Demsetz and Lehn (1985), who argue that when value-maximizing owners can freely choose

2.3. DESCRIPTIVE STATISTICS 35 their firm’s corporate governance system, equilibrium occurs when each governance mechanism’s marginal impact on performance equals zero across all mechanisms. This implies that the mechanisms are internally related and that the optimal set is determined by exogenous factors such as the firm’s industry, risk, and the stage of the business cycle. A more recent example is Adams and Ferreira (2007), where information provision by the CEO responds to exogenous changes in board independence.

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