The Independent Board Requirement and CEO Connectedness

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday January 16, 2012 at 9:16 am
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Editor’s Note: The following post comes to us from E. Han Kim, Professor of Finance and International Business at the University of Michigan, and Yao Lu of the School of Economics and Management at Tsinghua University.

In our paper, The Independent Board Requirement and CEO Connectedness, which was recently made publicly available on SSRN, we investigate unintended consequences of the independent board requirement.  Following highly publicized corporate scandals in 2001 and 2002, firms listed on the NYSE and NASDAQ are required to have a majority of independent directors. The intent is to better protect shareholders by making boards more independent from managerial influence and thereby more effective monitors. However, the majority requirement represents a ceiling on the percentage of dependent directors a firm may have.

If board composition is endogenous, the quota may trigger reactions by firms affected by the regulation. Board composition is but one of many facets of governance. Imposition of a quota on one governance mechanism may spillover to other governing bodies as firms find ways to counteract it. This paper attempts to identify the spillover effects, analyze their consequences, and answer several questions: How do CEOs react to a regulation that may reduce their influence over the board? How do the reactions, if any, manifest in the softer side of governance, namely, CEO connectedness with other key players in governing the firm? How do the spillover effects impact the regulatory intent?

We identify significant increases in the fraction of top executives appointed during the current CEO’s tenure at firms affected by the regulation and that the newly appointed top executives are more connected to their CEOs through pre-existing network ties than those at unaffected firms. These findings suggest affected CEOs surround themselves with more handpicked top executives to strengthen their connectedness in executive suites, which strengthen their internal influence and thereby make up for the loss of influence over the board caused by the regulation.

Closer CEO connectedness in executive suites seems to negate the regulatory intent. For the affected firms with insufficient capacity to increase the CEO connectedness, the regulation leads to more effective board monitoring and greater shareholder value. However, for firms fully capable of responding to the regulation via strengthening the CEO connectedness, our estimates suggest the unintended consequences more than offset the intended benefits, weakening the overall efficacy of monitoring and lowering shareholder value.

These findings imply the level of board monitoring evolves over time as a function of various firm-level factors within legal boundaries. Unless the relevant firm-level factors change, the level of monitoring remains unchanged. The board regulation perturbs the balance by mandating a majority of independent directors. Such intervention can lead to harmful unintended consequences if the affected firms are able to counteract the mandate, for example, by changing the composition of executive suites.

The central message our findings yield for policy makers is that regulating one specific internal governance mechanism is risky. Rather than targeting specifics, it may be better to encourage a closer alignment of director self-interest with shareholder value through director compensation and/or liabilities. Facilitating outside shareholder attempts to exert pressure for better monitoring and fostering competition in the market for corporate control will also help, as they will force management put greater emphasis on what is good for shareholders.

The full paper is available for download here.

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