In the paper, Governance in Executive Suites, which was recently made publicly available on SSRN, my co-author (Yao Lu) and I analyze the interplay between governance in executive suites and board monitoring. We find an exogenous shock increasing board independence weakens governance in executive suites. The empirical proxy for the strength of governance in executive suites is based on the governance mechanism identified by Landier et al. (2009), wherein dissenting executives steer CEOs towards more shareholder friendly decisions through “an efficient implementation constraint that disciplines the decision-making process.”
The level of dissent in executive suites is measured by the depth of connections a current CEO has developed with other top executives through personnel decisions. The measure is based on two metrics: (1) the fraction of top four non-CEO executives appointed during a current CEO’s tenure (FTA), and (2) the newly-appointed executives’ pre-existing network ties to the CEO. Most CEOs are highly engaged in appointment decisions of their top lieutenants; hence, a newly-appointed executive is more likely to share similar preferences with, and may be beholden to, the current CEO than executives appointed during a previous CEO’s tenure. When a CEO has more of his own appointees with whom he is connected through pre-existing network ties, his internal influence increases through “social influence.” The exogenous shock we use to analyze the effects of a change in board monitoring is the mandate for NYSE and NASDAQ listed firms to have a majority of independent directors by October 31, 2004. Although this regulation was promulgated around the same time as the enactment of the Sarbanes-Oxley Act (SOX) of 2002, it is distinct and under separate purview from the SOX.
Whether CEOs will be more or less connected to their top executives in the aftermath of the shock depends on which governing arm has the effective control over non-CEO top executive personnel decisions, the board or the CEO office. In a typical corporate organizational chart, the board is on the top and has the power to appoint or dismiss CEOs; hence by extension, it may also influence personnel decisions of other top executives. However, the board meets only a few times a year and its independent directors work on a part-time basis. They have limited access to pertinent information and rely heavily on management as their primary source of information. In contrast, CEOs work full time with employees at their disposal to perform the necessary footwork to make their case to their boards. Thus, the CEO office has an advantage by controlling the information channel. This advantage is especially important in personnel decisions, which often require non-public information on why some executives are replaced, the qualifications of their potential replacements, and the synergies each candidate can bring to the remaining executives. Thus, actual control over top executive appointment decisions may differ from that indicated by the organizational charts.
We find the board regulation significantly increases CEO connectedness in executive suites; more top executives are appointed during a current CEO’s tenure and more of them are pre-connected to the CEO. These findings are based on difference-in-differences estimation using the regulatory shock on board independence. The variation comes from the pre-regulation board composition; firms without a majority of independent directors prior to the regulation are the treatment group. To mitigate bias due to differences between treatment and control groups, we use propensity-score matched samples and report results based on both matched and unmatched samples. The evidence is robust to possible confounding effects due to the SOX and other events; executive and/or CEO turnovers; heterogeneity in the degree of the shock; or major structural changes. The results also are robust to alternative measures of CEO connectedness and sample construction, and to outliers.
Does the closer CEO connectedness soften monitoring by the newly independent board? The closer connectedness may help CEOs to control more effectively the information channel to the board and put up a more united front to impede monitoring by newly independent boards. However, if the closer CEO connectedness is the result of executive turnovers caused by newly independent boards demanding new blood in executive suites, for example, it is unlikely to weaken the monitoring.
We investigate how CEO connectedness impacts the efficacy of monitoring CEOs by exploiting cross-sectional variation in pre-existing conditions among treated firms. Due to differences in firm characteristics, some firms’ optimal dissent in executive suites may be lower than others. For such firms, FTA—our proxy for the inverse of dissent—will be high prior to the regulatory intervention. Hence, a higher pre-regulation FTA implies weaker governance in executive suites at the time of the shock, providing more targets for corrective measures by the newly independent board. A higher pre-regulation FTA also means less capacity to increase FTA post-regulation because FTA is bounded at one, making the regulation more binding. Thus, we predict if the closer CEO connectedness counteracts newly independent boards, pre-regulation FTA is positively related to regulation-related improvements in monitoring of CEOs. The proxies for the efficacy of monitoring are CEO compensation, CEO pay-for-performance sensitivity, and the likelihood of forced CEO turnover for poor performance.
We find when pre-regulation FTA is high, CEO compensation decreases and the likelihood of CEO dismissal for poor performance increases. In contrast, when pre-regulation FTA is low, CEO compensation increases and the likelihood of CEO dismissal for poor performance does not change. These findings suggest greater board independence enhances the efficacy of monitoring CEOs only when governance in executive suites is weak prior to the regulation, which limits the ability to further increase CEO connectedness.
How do the regulatory impacts on CEO connectedness affect shareholder value? We conjecture if closer connectedness is achieved by giving higher priority to building a more closely aligned team of executives than to finding the best combination of experience and talent, it will hurt firm performance. However, closer connectedness in executive suites has advantages. It may help expedite decision-making and implementation processes by making coordination easier, resulting in more timely and efficient outcomes. That is, the increase in CEO connectedness may be a double-edged sword with both benefits and deleterious effects .
We find a significant positive relation between pre-regulation FTA and the regulatory impact on Q. When pre-regulation FTA is equal to one, the regulation-related changes in Q are greater, on average, by 1.042 than those for firms with zero FTA. In sum, when governance in executive suites is weak prior to the regulation, the shock in board independence enhances the efficacy of monitoring CEOs and increases shareholder value. But when the governance is already strong, the impacts are significantly less favorable.
Our findings challenge the presumption that mandated independent boards are good for all firms. This neither contradicts, nor supports, previous studies on how board independence is related to the strength of board oversight or to firm performance. Rather, our evidence demonstrates that regulating board structure can have undesirable spillover effects. The evidence of harmful effects is not new; Larcker, Ormazabal, and Taylor (2011) and Ahern and Dittmar (2012) document harmful effects of regulatory interventions in corporate governance. Our contribution is to identify a specific channel used to circumvent the regulation—strengthening CEO connectedness in executive suites. More broadly, our evidence illustrates that when policy makers regulate one aspect of governance, some firms shift other aspects of governance to circumvent the regulation. Thus, when regulators contemplate improving a specific governance mechanism, they should not focus solely on the impact on the intended target. They also should carefully consider indirect impacts on other governing bodies.
The full paper is available for download here.