In our paper, Industry Expertise on Corporate Boards, which was recently made publicly available on SSRN, we propose and study a measure of board industry expertise. The question of who should sit on corporate boards has attracted significant academic and regulatory efforts in recent years. For example, on December 16, 2009, the U.S. Securities and Exchange Commission (SEC) released final proxy disclosure enhancement rules. Among other directives, these rules require registrants to “disclose for each director and any nominee for director the particular experience, qualifications, attributes or skills that qualified that person to serve as a director.” A prominent feature of these disclosures has been an emphasis on related industry experience. In its first proxy filing under these rules, Hewlett-Packard stated that director Marc L. Andreessen “is a recognized industry expert and visionary in the IT industry” who has “extensive leadership, consumer industry and technical expertise” through his positions at and service on the boards of public and private technology companies. Other major firms making similar claims include Coca-Cola Co., Wal-Mart Stores, and Bank of America.
Of all requisite competencies, industry expertise is perhaps the most important attribute for board members because it equips directors with a deeper understanding of the risks and opportunities in a specific industry and also enhances directors’ knowledge of the regulatory environment and key industry players. These points are well understood by practitioners. The consulting firm McKinsey & Co. states in a 2006 report: “…in our work with boards we find that too many simply lack directors who have industry expertise to participate effectively in shaping strategy… [W]e believe that on a board of, say, a dozen directors, a litmus test of strategic energy is the presence of at least three or four members who have deep industry expertise in the core business and market conditions the company faces” (Carey and Patsalos-Fox, 2006). Similarly, 40% of respondents in a recent survey of S&P 500 firms identified industry expertise as a desired background for director candidates, second only to financial expertise at 42% (Spencer Stuart, 2011). Nevertheless, there is a conspicuous void in the literature concerning the impact of this board attribute. We aim to fill this gap by examining whether, how, and in what circumstances directors’ industry expertise enhances board effectiveness.
We employ comprehensive biographical data from BoardEx to construct a measure of board industry expertise based on the employment histories of independent directors for a sample of 1,528 unique firms over 2000-2009. We find that firm value is significantly higher when industry experts serve on the board. In particular, the presence of an industry expert independent director is associated with an increase of 4.6% in firm value. We also find a robust positive and statistically significant association between board industry expertise and corporate innovation measures such as R&D investments, patents granted by the U.S. Patent & Trademark Office (USPTO), and patent citations. Yet, our results show that board industry expertise has no effect on acquisition outcomes. These results suggest that industry expertise enhances board effectiveness by facilitating organic investments in corporate innovation rather than through improved acquisition performance.
Facilitating innovation requires the board to monitor differently than it otherwise would because innovation involves the exploration of novel ideas that are subject to higher probabilities of failure. Therefore, to motivate CEOs to take on risky projects and innovate, boards should be tolerant of short term failures as well as provide a compensation structure that incentivizes risk taking. Our findings suggest that board industry expertise is associated with monitoring decisions that are consistent with motivating innovation. Specifically, we find that board industry expertise significantly lessens the sensitivity of CEO dismissal to firm performance,both in terms of operating profitability and stock market returns. We also find that board industry expertise is associated with a significant increase in stock option awards and a significant reduction in cash-based pay.
Overall, this paper demonstrates the significance of industry-specific skills in board effectiveness, especially in value creation and when corporate innovation is a significant value driver.
The full paper is available for download here.