Determinants of board independence and size
in U.S. corporate boards: 2007-2013
Version: Draft
Student name: Dennis van der Horst Student number: 10867821
Date: 22/06/2015
Education: MSc Accountancy and Control, variant Accountancy
Institution: University of Amsterdam, Faculty of Economics and Business Supervisor: Dr. Alexandros Sikalidis
Statement of originality
This document is written by Student Dennis van der Horst who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Abstract
This paper examines the relation between firm characteristics and two measures of board structure – board independence and board size. Board independence is defined as the proportion of outside directors on the board and board size as the number of directors on the board. The relation is tested using models developed by Linck et al. (2008). The sample consists of U.S. firms from 2007 to 2013. Based on theoretical work is predicted that firm complexity, costs of monitoring and advising, ownership incentives, and CEO characteristic are important determinants of board independence and size. The findings of this paper provide empirical evidence that … explain board structure. This is consistent with the notion that board structure is governed by the trade-off between information acquisition and processing costs and the benefits from monitoring and advising. Uniform requirements on board structure may therefore be suboptimal, one size does not have to fit all. Restrictions on board structure do not necessarily enhance firm value.
Table of contents 1. Introduction………..p. 5 2. Literature review and hypotheses……….p. 11 2.1 The firm as a nexus of contracts………. p. 11 2.2 Agency theory……….. p. 12 2.3 Board of directors structure……….. p. 16 2.4 Hypotheses………. p. 17 3. Research methodology………. p. 24 3.1 Sample selection……… p. 24 3.2 Research design……….. p. 24 3.3 Descriptive statistics……… p. 26 4. Results……….. p. 27 4.1 Univariate analysis……… p. 27 4.2 Multivariate analysis……… p. 27 4.3 Robustness tests………. p. 27 5. Conclusion………..p. 28 References……….. p. 29
1. Introduction
Financial capital is a key factor of production and it leads to complex contracting relationships between owners and managers1 (Armstrong et al., 2010). When structuring these contracting arrangements, divergent interests among owners and managers create a demand for monitoring and bonding mechanisms that help alleviate various agency conflicts (Jensen and Meckling, 1976). The information environment plays a central role both in determining the extent of these agency conflicts and in designing the mechanisms to mitigate them (Armstrong et al., 2010). More specifically, the fact that not all contracting parties have the same knowledge before and/or after the contracting has been arranged either creates or aggregates agency conflicts. In general, management has the best firm-specific information followed by the supervisory board and they are in turn followed by shareholders.
Shareholders are the owners of the firm2. They supply equity capital and hold the ultimate control rights. However, shareholders are usually not involved in day-to-day activities of the firm. These responsibilities are therefore delegated to the supervisory board who again delegate most decision rights to management. This delegation of decision rights to management is consistent with the argument of Jensen and Meckling (1995) that decision rights are allocated most efficiently if they are allocated to the party that has the best information about the decisions that need to be made. The supervisory board remains responsible for monitoring and advising management on behalf of the shareholders.
According to Shleifer and Vishny (1997) corporate governance deals with how shareholders make sure managers get them their money back. It deals with the agency problem: the separation of ownership and control. So, corporate governance ensures that the interests of management and shareholders are aligned. There are two possible agency conflicts that corporate governance can solve (Armstrong et al., 2010). First, there could be a conflict between shareholders and management while the interests of shareholders and the supervisory board are aligned. This means the supervisory board really acts on behalf of the shareholders. The second possibility is that the interests of management and the supervisory board align but are in conflict with those of shareholders. This means the supervisory board acts in the best interest of management. 1 The relationship between owners and managers is not the only relationship that is caused by the provision of financial capital. Besides governance contracting there is also debt contracting. However, the focus of this paper is on governance contracting. 2 In this paper the terms ‘firm’, ‘organization’, ‘enterprise’ and ‘company’ are used interchangeably.
There are several mechanisms that companies could employ to mitigate agency conflicts. Examples are monitoring by the supervisory board, shareholders and analysts, incentive payment, financial reporting3 and regulation4. However, Jensen and Meckling (1976) argue that no governance structure is likely to eliminate agency conflicts fully. Thus, even in the best governed firms agency conflicts will appear. Armstrong et al. (2010) note that in reality different types of corporate governance structures can be observed and that it is not expected that a single type will become dominant. Heterogeneity in the combinations of corporate governance mechanisms firms use is logical, because the best corporate governance structure is dependent on the characteristics of the individual firm.
Heterogeneity cannot only be observed in combinations of corporate governance mechanisms, but also in the way corporate governance mechanisms are applied. Firms differ in how their supervisory board is structured. Board size5 and systems vary between countries. The U.S. has a one-tier board system in which management and the supervisory board together form one board called the board of directors. The directors in the board of directors can be divided in three types (Hermalin and Weisbach, 2003). Directors are either classified as insiders, linked or outsiders. Insiders are executive directors who are currently employed fulltime by the firm. A linked board director is a non-executive director who is a relative of the CEO, a former employee of the firm, a person that has a long-standing relationship with the firm, or a director in an interlocked board6. Outsiders are non-executive directors who do not have any business ties with the firm aside from their board membership.
The most effective proportion of outside directors in boards7 (frequently called ‘board composition’ or ‘board independence’ in the academic literature) is a question that has received much attention from scholars (e.g., see Coles et al., 2008; Duchin et al., 2010; Raheja, 2005). The advantage of outside directors is that they are expected to be more independent and objective than inside directors in boards8 (Bushman et al., 2008). Outside directors are expected to be more independent, because they do not have to report to the firm’s CEO and for their living they do not depend on the firm (Larcker and Tayan, 2011a). In addition, outside directors
3 Financial reporting cannot only solve conflict between owners and managers, but is also valuable in contracting
relationships between the firm and debt providers, suppliers, customers, regulators, auditors and tax authorities. 4 Corporate governance mechanisms that make sure that management maximizes the return of shareholders are discussed more elaborately in Section 2. 5 Board size is defined as the number of directors on the board. 6 A board is interlocked if an inside director is director on the board of a non‐inside director’s firm. 7 From now on referred to as ‘outside directors’. 8 From now on referred to as ‘inside directors’.
could bring valuable knowledge and skills to the board which can improve firm value. The disadvantage of outside directors is that they are possibly less informed about the firm than inside directors. There is a trade-off between inside and outside directors. Some argue that most directors should be outside directors. Jensen (1993) even argues the CEO should be the only inside director.
Empirical evidence on the effectiveness of outside directors is mixed. Byrd and Hickman (1992), Brickley et al. (1994), and Borokhovich et al. (1996) found a positive relation between board independence and firm value9. In addition, Rosenstein and Wyatt (1990) found that investors appreciate the addition of an outside director to the board. The stock price increased significantly around the announcement date. The stock price responded negatively when an inside director who owned a small amount of stock was appointed, but not when the inside director owned a large amount of stock. Apparently investors consider equity ownership to be a corporate governance mechanism that mitigates the risks associated with the appointment of an inside director. On the other hand, Bhagat and Black (1999), Coles et al. (2008) and Duchin et al. (2010) suggest that adding inside directors on the board may improve firm performance for some firms. Lehn et al. (2009) argue that the advocates of boards that consist of a certain proportion of outside directors underestimate the costs those boards incur for ensuring outside directors have adequate information. The academic consensus is that there is no ‘one size fits all’ about what proportion of outside directors leads to the highest firm performance (e.g., see Hermalin and Weisbach, 2003; Armstrong et al., 2010).
According to Corporate Board Member and PricewaterhouseCoopers LLP (2008) board size is related to firm size. In their database of U.S. corporate boards, firms with annual revenues of less than $10 million had on average seven directors on their board while firms with annual revenues of more than $10 billion had on average twelve directors on their board. The advantage of large boards is that they have more resources to fulfil their monitoring and advising roles (Larcker and Tayan, 2011a). There are more board directors with more diverse experience available, which gives greater opportunities for specialization and committees. The downside is that large boards are more costly (both in compensation and coordination) and they can suffer from slow decision making and free-riding behaviour. As with board independence, there is a trade-off regarding board size between small and large boards. Lipton and Lorsch
9 When discussing literature in this paper terms as ‘firm performance’ and ‘firm value’ are used interchangeably.
(1992) propose to limit board size to ten directors and argue a board should have eight or nine directors.
Empirical evidence on the relationship between board size and firm value is mixed. Yermack (1996) examined this relation with a sample of large U.S. firms and found an inverse association between board size and firm value (measured by Tobin’s Q). Factors such as firm size, industry and growth opportunities have been controlled for. In addition, Yermack (1996) found that shareholders responded favourably to announcements of smaller board size. Coles et al. (2008) argued that Yermack (1996) did not take into account all factors that influence the relationship between board size and firm value. The authors repeated the analysis of Yermack (1996) and one of the extra variables they included was firm complexity. The reasoning behind this was that complex firms (measured among dimensions such as scope of operations, firm size and leverage) could benefit more from a large board then ‘simple’ forms. The empirical results confirmed this hypothesis: board size and firm value are negatively correlated for simple firms, but positively correlated for complex firms.
Scholars have identified a trend in U.S. board structure: board independence steadily increases over time while board size decreased during the 1990s and remains stable since the 2000s (e.g., see Huson et al., 2001; Linck et al., 2008; Lehn et al., 2009; Duchin et al., 2010). In their sample of industrial manufacturing firms that survived from 1935 to 2000, Lehn et al. (2009) found that the percentage of inside directors10 decreased steadily from 50% in 1945 to less than 20% in 2000. The sharpest decrease in the percentage of outside directors occurred in the period 1975-2000. Board size has been stable between 1955 and 1985 at fourteen directors per board. Between 1985 and 2000 this number decreased to eleven directors per board. Linck et al. (2008) used a more comprehensive sample with as much as 7,000 firms of all sizes, ages and industries. They found that in 1990 the percentage of outside directors was about 60-65% and this had increased to about 70% in 2004. Board size for large firms fell during the 1990s from eleven directors per board to nine and in 2004 it was again close to eleven directors per board. According to Spencer Stuart11 (2014) the average board has about eleven directors, a number that is stable for ten years. The percentage of outside directors continues to increase: 84% is independent in 2014. 10 Lehn et al. (2009) did not have adequate information to measure the proportion of outside directors. 11 Spencer Stuart is one of the world’s leading executive search firms. The firm is privately held and has offices in 30 countries. Since 1986 Spencer Stuart publishes its U.S. board index in which the latest data and trends in board composition, board practices and director compensation are examined among S&P 500 companies.
In this paper is investigated what has determined board independence and board size in U.S. corporate boards in the period 2007-2013. The following research question has been formulated: what are the determinants of board independence and board size in U.S. corporate boards in the period 2007-2013? It is interesting to find out which factors affect board independence and size and how these factors have evolved over time (Hermalin and Weisbach, 2003). Can the same factors as in prior research explain the increase in board independence or is the increase due to some other factors?
This research takes a similar approach as Lehn et al. (2009) and Linck et al. (2008). It takes the perspective that the optimal board structure of a firm depends on the costs and benefits of monitoring and advising while taking into account the firm’s characteristics and other corporate governance mechanisms. This paper tests how two measures of board structure (board independence and board size) relate to firm characteristics. Prior literature indicates that firm complexity, costs of monitoring and advising, ownership incentives, and CEO characteristic are important determinants of board independence and size (e.g., see Bushman et al., 2004; Boone et al., 2007; Coles et al., 2008; Linck et al., 2008; Lehn et al., 2009). This paper found a strong relation between firm characteristics and board structure. Therefore uniform requirements on board structure may be suboptimal. Restrictions on board structure may not necessarily enhance firm value in every situation.
According to Linck et al. (2008) there are two explanations for the determinants of board structure. It might be that board structure develops as an efficient response to the firm’s contracting environment and is a solution to the agency problem. Alternatively, the board structure is not the solution to, but rather the result of agency problems. For example, Jensen (1993) and Bebchuck and Fried (2005) argue that the CEO has so much influence on the board composition that the board of directors is ineffective in monitoring and advising. Throughout this paper will be assumed that boards are structured based on the idea to maximize shareholder wealth. However, this does not mean that all the findings of this paper are incompatible with the alternative explanation that boards are structured at the pleasure of the CEO. [In a later version of this paper an example of such a finding from this paper will be given. In addition a conclusion will be drawn about the general consistency of the findings with one of the two explanations.]
Linck et al. (2008) argue that although the impact of corporate board structure on firm behaviour is one of the most debated issues in corporate finance today, little research is done on the determinants of board structure. Armstrong et al. (2010) believe that the trend that the proportion of outside directors increases warrants further investigation by accounting
researchers. Especially, how this trend relates to changes in the corporate information environment over time is deemed to be important. In addition, McConnell (2003) calls for more research into outside directors. This paper aims to contribute to the literature by responding to all these calls for research.
Besides, research into the determinants of board structure is also relevant from a regulatory perspective. According to Linck et al. (2008) regulation has had a direct impact on board structure. After the Sarbanes-Oxley Act (SOX) of 2002 the trend of falling board size that emerged in the 1990s, reversed. In addition, board independence increased in the post-SOX period. However, post-SOX did not mandate a certain board size or a majority-independent board12. It only required that the audit committee is composed entirely of independent directors. Linck et al. (2008) found that although most of the determinants of board structure are more or less similar in the pre- and post-SOX period there are also differences. This research sheds light on what happened to board size and independence after the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) of 2010 and how the determinants of board structure developed from 2007 to 2013. Similar to SOX, Dodd-Frank does not mandate a certain board size or a majority-independent board. On the other hand Dodd-Frank stipulates that shareholders or groups of shareholders (with three percent or more of a company’s shares for at least three years) are allowed to nominate directors on the company proxy (up to 25 percent of the board).
This paper is structured as follows. In Section 2 relevant literature on the firm as a nexus of contracts, the agency theory and board structure is reviewed. Based on this literature review the hypotheses are developed. Section 3 describes the research methodology and the data set. The hypotheses are empirically tested in Section 4. Last but not least, in Section 5 concluding remarks are provided.
12 The listing requirements of the NYSE and NASDAQ mandate majority‐independent boards since 2003.
Additionally, the rules of the NYSE require the audit, nominating/corporate governance and compensation committee to be composed of outside directors only. The rules of the NASDAQ are similar, but more flexible.
2. Literature review and hypotheses
This section consists of three subsections. In the first subsection the idea of the firm as a nexus of contracts is discussed briefly. This contractual view of the firm explains why firms exist. The logical next step is to review the agency theory. With their agency theory Jensen and Meckling (1976) extend the theory of the firm and enhance the definition of the firm. In this part is also explained why there are boards of directors. In the third subsection is first discussed what boards of directors do. Next, an extensive review of papers that have looked at determinants of the proportion of outside directors and board size is provided. Based on this review hypotheses are developed.
2.1 The firm as a nexus of contracts
Watts (1992) argues that it is difficult to define what a firm is. It depends on what point the writer tries to make. It aids to the understanding of what a firm is to compare organizing production in firms to organizing production via markets. Alchian and Demsetz (1972) define a firm as when two individuals produce cooperatively in any other way than via the market13. Whether production takes place via the market or via the firm is determined by contracting costs. Firms exist when the contracting costs via the firm are lower than the costs of contracting via the market (Coase, 1937)14. This contractual view of the firm sees the firm as the nexus of contracting relationships that together form the firm. These contracting relationships are with parties that are part of the firm’s environment (for example shareholders, suppliers, employees, customers, etc.). According to the contractual view, firms are legal fictions, which means that firms are treated as individuals in the court of law.
Watts (1992) provides an overview of hypotheses that have been put forward in the academic literature to explain why contracting costs could be lower in firms than in the market. First, there is the hypothesis of economies of scale in contracting. This hypothesis argues that it is often cheaper to have one employment contract opposed to writing a contract for every
13 Alchian and Demsetz (1972) provide an example of a lumberman and a cabinetmaker. If the lumberman
decides to employ the cabinetmaker to produce cabinets with the wood he chops, one can speak about production via a firm. If the lumberman instead sells his wood to the cabinetmaker, there is production via the market. The difference is that within a firm, there is production without a specific transaction in the market. The employee has a long‐term employment contract and the owner is compensated for the risks taken with the residual claim on the firm’s cash flows. 14 To continue with the example of the lumberman and the cabinetmaker. For the lumberman contracting costs in the market include finding a cabinetmaker to sell his wood to, determining the sell price, writing a contract for the sale, etc.
single transaction via the market. A different explanation is that firms capture the benefits of team production and at the same time minimize the costs of shirking. A team of people can do more than individual people. However, working in a team also generates costs. It is less easy to determine individual effort and output than in the case of individual production. A firm can solve this situation by assigning someone to monitor the team. The monitor can in turn be motivated by making him or her the residual claimant of the firm’s cash flows.
Thirdly, post-contractual opportunism is a reason to organize production via firms. If one of the two parties in a market transaction invests in a specialized asset the other party has an incentive to extract the benefits from the party that invested in the specialized asset. Mechanisms that prevent a party from expropriating rent (for example courts of law, reputation, etc.) are costly. Integrating the two parties into one firm might be cheaper. Knowledge costs can also explain the existence of firms. The creation of a firm allows for the generation of knowledge. If several market participants are combined into one firm, information can be shared and bundled. Randomness is cancelled out if information is aggregated. The alternative to creating knowledge internally is buying it from outside the firm. Only if the cost of buying the knowledge outside the firm is higher than generating it internally the existence of a firm can be explained with the knowledge costs hypothesis.
The last hypothesis is called the evolution of firms. Customers prefer firms that deliver products at the lowest price given a certain quality. The firms that survive are the ones that ask the lowest price while covering their costs. Contracting costs are part of these costs. The firms that survive have minimized contracting costs, their mere existence proves that contracting via firms can be cheaper than contracting via the market.
2.2 Agency theory
Jensen and Meckling (1976) extend the theory of the firm with the agency theory (frequently called the ‘principal-agent theory’ in the literature). Central in the agency theory is the agency relationship. There are two parties in the agency relationship. The principal engages an agent to perform some service on its behalf and this involves delegating decision-making authority to the agent. In return for providing the service the agent receives compensation from the principal.
If both the principal and the agent are rational, it can be expected that the agent will not always act in the best interest of the principal. There is an asymmetry of information in the principal-agent relationship. The agent generally has more information about its own actions than the principal, this gives the opportunity for moral hazard. To prevent the agent from
exploiting its information advantage the principal will design appropriate incentives for the agent by incurring monitoring costs. Alternatively, the principal can pay the agent to incur bonding costs to signal to the principal that their interest are aligned. According to Groenewegen et al. (2010) monitoring and bonding costs are two sides of the same coin: if one of the two increases the other one should decrease. Jensen and Meckling (1976) argue that in most agency relationships there will be positive monitoring and bonding costs and even if monitoring and bonding activities are optimized there will still be some residual welfare loss. Agency costs are defined as the sum of:
(i). the monitoring expenditures by the principal, (ii). the bonding expenditures by the agent, (iii). the residual loss.
In short, the agency theory describes the structure of the relationship between two parties in a situation involving cooperative effort. Jensen and Meckling (1976) stress the generality of the agency problem. This is closely related to their critique on Coase (1937) and Alchian and Demsetz (1972). Jensen and Meckling (1976) argue that the problem of agency costs and monitoring exists in all contracts of the firm with its environment and not only in cases of joint production.
The agency theory provides a useful framework to study the tension of the separation between ownership and control. The problem with this separation is the agency costs caused by the contractual arrangements between the owners (principals) and management (agents) of a firm (Jensen and Meckling, 1976). Shleifer and Vishny (1997) explain the essence of the agency problem in the situation of separation of ownership and control. Owners and management clearly need each other. The shareholders want to make a good return on their funds and need the skills of the managers to generate it for them. The managers on the other hand need the shareholders’ funds in order to make investments which allows them to execute their business plan. The agency problem in this situation is that shareholders cannot be sure that the managers put their funds to good use (investing) instead of spending it for personal purposes. This means there is information asymmetry between shareholders and managers.
Jensen and Meckling (1976) were not the first to study the problem of the separation of ownership and control. Already in 1776, Adam Smith described the tension between owners and managers of firms: “The directors of such [joint-stock] companies, however, being the managers rather of other people's money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to
consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.” (Smith, 1776, p. 700).
One might wonder with all these agency costs what the logic behind separating ownership and control is. Fama and Jensen (1983) touched this issue. In their research they tried to explain the survival of organizations that separated ownership and control. Fama and Jensen (1983) found that the separation between ownership and control is not only common in large corporations, but can also be observed in for example professional partnerships and non-profits. They conclude that the separation between ownership and control survives for two reasons. First, because of the benefits of specialization and second, because of an effective common approach to controlling the agency problems caused by the separation of ownership and control.
The answer to the agency problem is corporate governance. Shleifer and Vishny (1997, p. 738) used the following definition of corporate governance: “Corporate governance deals with the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment”. The concept of corporate governance is broad, but can be divided into internal and external corporate governance mechanisms (Bushman and Smith, 2001). Examples of internal mechanisms are managerial incentive plans, the internal labour market and monitoring by the board of directors (Bushman and Smith, 2001; Huson et al., 2001). Examples of external corporate governance mechanisms are monitoring by shareholders and analysts, competition in the product market, the external labour market, regulation and the takeover market (Bushman and Smith, 2001; Huson et al., 2001).
The simple answer to the question why boards of directors exist is that they are a product of regulation (Hermalin and Weisbach, 2003). To have some kind of board is a requirement to become incorporated and also stock exchanges have certain requirements for boards. These requirement differ per stock exchange, but in general mandate the board of directors have a certain amount of members, committees and outside directors. However, this cannot be the only reason that boards of directors exist. Organizations that are not (yet) incorporated and listed also have boards of directors. In addition, there are no stories of companies that lobby for removing the regulation that mandates having a board of directors.
However, instead of regulation, boards of directors can also be regarded as an internal corporate governance mechanism. Boards of directors aim to align the interests of shareholders with management. Hermalin and Weisbach (2003) argue that the explanation that boards of
directors exist because they are a market solution to a contracting problem inside an organization is a more plausible explanation than a regulatory-based one. In addition, establishing a boards of directors makes other corporate governance mechanisms more feasible. Take for example incentive payment. The idea of incentive payment is to contractually provide management with strong incentives to only take actions that are in the interest of the shareholders. This begs the question who is going to provide these incentives and who ensures that the incentives are structured optimally (Hermalin and Weisbach, 2003). Shareholders are in most companies to diffuse and uninformed to set managers’ compensation, a boards of directors can solve this problem and set managers’ compensation on behalf of the shareholders. A related and interesting issue is how shareholders can be sure that outside directors are properly incentivized to perform their monitoring role objectively. Inside directors are conflicted in their incentives to monitor, because their benefits are closely correlated to the benefits of the CEO15. What restrains outside directors from colluding with the inside directors and expropriate shareholders’ capital? Fama and Jensen (1983) are the first to share their thoughts on this issue. They came with the hypothesis that outside directors have incentives to develop or protect their reputation as experts. Typically, outside directors are managers of other corporations or have important roles in complex organizations. Outside directors use their directorship to signal that they are experts. Fama and Jensen (1983) argue that the signal is credible when direct payments to outside directors are small, but when the reputation loss is substantial if the firm fails.
Yermack (2004) empirically tested the hypothesis of Fama and Jensen (1983) and is one of the first to examine the most direct incentives of outside directors – compensation and ownership. Yermack (2004, p. 2282) found: “statistically significant evidence that outside directors receive positive performance incentives from compensation, turnover, and opportunities to obtain new board seats. Together these incentives provide outside directors serving in their fifth year with wealth increases of approximately 11 cents per $1,000 rise in firm value.”. The findings of this research are a bit in contrast with the expectations of Fama and Jensen (1983). It is indeed through that signalling expertise (which increases the likelihood of obtaining new directorships and provides an incentive of 4 cents per $1,000 increase in
15 However, Drymiotes (2007) shows that in some situations less independent boards (which means a lower
proportion of outside directors) are more effective in monitoring. Drymiotes (2007) argues that putting more inside directors on a board is a commitment device which prevents outside directors from shirking their monitoring efforts ex post, after the productive efforts of management.
shareholder wealth) is a strong incentive, but rewards from compensation and ownership also play an important role in motivating outside directors.
2.3 Board of directors structure
The board of directors plays an important role in aligning the interests of managers and shareholders. According to Armstrong et al. (2010) this is the main reason why a significant part of the research in the area of governance focuses on board characteristics and decision-making. Notwithstanding the amount of research, Hermalin and Weisbach (2003) argue that theory about board of directors is in its infancy and that empirical work has filled the vacuum in theory. The empirical work tries to answer one of the following three question:
1. How do board characteristics such as composition or size affect profitability? 2. How do board characteristics affect the observable actions of the board? 3. What factors affect the makeup of boards and how do they evolve over time?
This paper seeks to answer question three. It examines which firm characteristics explain board independence and board size and how these determinants changed over time. What is the impact of the trends in board structure discussed earlier. A good starting point is to explain what boards of directors do (Adams et al., 2010). What is their function? The literature identified two broad functions: advising and monitoring (Fama and Jensen, 1983; Coles et al., 2008; Linck et al., 2008; Lehn et al., 2009; Armstrong et al., 2010). Advising entails assisting senior management in decision-making (Linck et al., 2008). This role requires a board with both firm-specific and general expertise (Armstrong et al., 2010).
Monitoring means scrutinizing management with the purpose of guarding the shareholder against harmful behaviour (Linck et al., 2008). Monitoring requires not only that the board is skilled and knowledgeable, but also that they are independent. Inside directors have more firm-specific information than outside directors, but generally lack independence. The benefits for inside directors are closely related to the success of the CEO and that impairs their objectivity. The optimal board composition depends on the costs and benefits of monitoring and advising given the firm’s characteristics (Linck et al., 2008). Coles et al. (2008) note that different board directors have different roles. They argue that inside directors have other functions than outside directors. It is the task of inside directors to formulate the strategy and to transfer firm-specific information to outside directors.
Adams et al. (2010) point out that the role of board directors has changed over time. Descriptive studies from the 1980s and 1990s suggest that board directors were passive with respect to their monitoring function (e.g., see Demb and Neubauer, 1992). More recent
descriptive studies report a shift in this passivity (e.g., see MacAvoy and Millstein, 1999). MacAvoy and Milstein (1999) conclude that during the 1990s board directors evolved from being ‘managerial rubberstamps’ into independent directors that fulfil their monitoring role actively. The finding of Huson et al. (2001) that CEO turnover increased during the 1990s supports this view.
2.4 Hypotheses
Consistent with existing literature, four hypotheses will be developed based on firm characteristics.
Firm complexity
It is expected that there is a relation between the monitoring and advising functions of boards and firm complexity (Linck et al., 2008). According to Fama and Jensen (1983) the complexity of a firm’s operations determines the way it is organized. Fama and Jensen (1983) argue that outside directors are experts and they bring in skills and knowledge the firm can benefit from. Complex firms can benefit more from appointing outside directors and this should result in more independent and larger boards (Linck et al., 2008). Bushman et al. (2004) expect that high organizational complexity increases the potential for moral hazard, because it makes the actions of the managers less transparent. That should lead to a higher proportion of outside directors. On the other hand, the high complexity of a firm increases the firm-specific knowledge that is required from directors. This makes being a director more expensive for outsiders which should lead to a lower proportion of outside directors.
Bushman et al. (2004) argue that predictions about the relation between board size and firm complexity can also go in both ways. On the one hand, boards that are smaller have lower coordination costs and less free-riding behaviour among directors. On the other hand, larger boards have more resources available for monitoring and advising. Adams and Mehran (2012) found that larger boards add value in complex firms. Using a sample that consisted entirely of banks (which are all considered to be complex) they found that board size and firm value were positively associated.
Complexity can be measured along many dimensions. For example, firm size, leverage, number of segments, age, and geographic concentration (e.g., see Bushman et al., 2004; Boone et al., 2007; Coles et al., 2008; Linck et al., 2008; Lehn et al., 2009). Lehn et al. (2009) measure firm complexity with firm size and argue that if firm size increases the potential for agency conflicts increases with it. Therefore they expect that larger firms will have a higher proportion
of outside directors as a way to decrease the agency conflict. Their findings confirm their expectation, insider representation decreases in firm size. Lehn et al. (2009) also expect a direct relation between board size and firm size. Larger firms have more and more diverse activities than small firms. Therefore larger firms have greater advisory needs and more demand for information than smaller firms, this requires a larger board. They found that board size increases in firm size.
Bushman et al. (2004) measure firm complexity with industry and geographic concentration. As discussed earlier in this section, they did not have unambiguous predictions about how board independence and board size relate to firm complexity. The results of Bushman et al. (2004) indicate that firm complexity does not significantly impact the proportion of outside directors and board size.
Boone et al. (2007) measured firm complexity with firm size, firm age and number of business segments. They refer to this view as the scope of operations hypothesis and expect that all three of their firm complexity measures are positively related to the proportion of outside directors and board size. It is argued that as a firm grows or survives (the reasoning is that a firm gets more complex when it grows older) the demand for specialized board services increases and new board members are necessary for monitoring. This would increase both the size and independence of the board. Boone et al. (2007) looked at a sample of IPO firms. They found that most of measures for firm complexity are significantly and positively related to the proportion of outside directors and board size. Only the relations between firm age and board size and number of business segments and board independence were not significantly positive.
Coles et al. (2008) also used three measures of firm complexity. These are similar to Boone et al. (2007) the number business segments and firm size, but instead of firm age they included the proportion of debt in the capital structure or leverage. Coles et al. (2008) hypothesized that all these measures were positively related to the proportion of outside directors and board size. They confirm their hypothesis and found that complex firms have larger and a higher fraction of outside directors on the board.
Linck et al. (2008) used four measures of firm complexity. The three measures Coles et al. (2008) used (number of business segments, firm size, and leverage) and conform Boone et al. (2007) also firm age. However, it was not clear from the research of Boone et al. (2007) if firm complexity increases with firm age when the firm is already mature. Therefore the square of firm age is included to test if the relation between board structure and firm age is nonlinear. Linck et al. (2008) found that almost all measures of firm complexity are
significantly and positively related to board independence and board size. Only the relation between the square of firm age and board independence was not significant.
Conform Linck et al. (2008), to proxy for firm complexity four measures are used. These measures are the number of business segments, firm size, leverage, and firm age. This leads to Hypothesis 1:
Hypothesis 1: Complex firms have larger boards and a higher proportion of outside directors
than simple firms.
Costs of monitoring and advising
Armstrong et al. (2010) expect that firms with greater information asymmetry between management and the outside world have a lower proportion of outside directors. The firm-specific knowledge that outside directors need is costly to obtain. Information acquisition and processing cost increase with information asymmetry. It is costly for outside directors to develop firm-specific expertise from their general expertise (Linck et al., 2008). Appointing additional directors gives more information to the board, but at the same time coordination and compensation costs increase and the free-rider problem becomes mere severe. This trade-off turns more negative for firms with greater information asymmetry, because in these firms information is more costly to obtain.
Lehn et al. (2009) argue that the costs of monitoring and advising are also higher for high-growth firms. An inverse relation between the proportion of outside directors and a firm’s growth opportunities is expected. In high-growth firms, outside directors either make decisions with less information available to them or they face increased costs of acquiring this information compared to firms with low-growth opportunities. In addition, high-growth firms need a faster decision-making process than firms with low-growth opportunities. Outside directors slow the decision-making process, because it takes time for them to obtain firm-specific knowledge. Lehn et al. (2009) expect also that the board size is smaller in high-growth firms. First, similar to firms with greater information asymmetry the costs of monitoring increase with a firm’s growth opportunities. Second, firms with growth opportunities generally
operate in a more volatile business environment. Corporate strategy has to change more frequently in such environments and the larger the board the more costly these changes are16. One can also argue that outside board directors are necessary in firms with great information asymmetry and high growth opportunities. In these firms there is more opportunity for managers to consume private benefits (Boone et al., 2007; Lehn et al., 2009). Monitoring is more costly in firms with greater information asymmetry and higher growth opportunities, but the net benefits of monitoring increase with the availability of private benefits to managers. Therefore, one could expect that the proportion of outside directors to be higher in these firms. However, Lehn et al. (2009) expect that inside ownership of equity is a substitute governance mechanism for outside directors on the board in firms with greater information asymmetry and higher growth opportunities. Ownership incentives are discussed in the next section. To control for the effect of the availability of private benefits to managers, the firm’s free cash flow is added as an independent variable to the regression model for board independence. This proxy is conform Boone et al. (2007) and Linck et al. (2008). According to Jensen (1986) free cash flow leads to agency conflicts, because managers have the incentive to use the money for their own gain, in particular when there is more cash than profitable investment opportunities.
Lehn et al. (2009) proxied for high growth opportunities with two measures: the market-to-book value of assets (MTB assets) and the ratio of PPE to the book value of total assets (PPE ratio). They found that high growth opportunities are significantly negatively related to board independence and board size. Linck et al. (2008) used three measures to proxy for the costs of monitoring and advising: the market-to-book ratio of equity (MTB), the level of R&D spending, and the standard deviation of stock returns. They argued that the first two measures are standard measures. The standard deviation of stock returns is a good proxy for information asymmetry according to Fama and Jensen (1973). Linck et al. (2008) found significant negative relationships between their proxies and board independence and board size.
Coles et al. (2008) include a measure for R&D intensity in their analysis to proxy for firms in which boards firm-specific knowledge is important. They expected a higher fraction of inside directors in R&D-intensive firms, but this was not reflected in their results. Boone et al. (2007) argued that monitoring costs are affected by the uncertainty of the firm’s operating environment. If the firm operates in a noisy environment, there will be less monitoring, because the costs are higher. Boards tend to be smaller and with a lower proportion of outside directors.
16 Kole and Lehn (1999) examined how board structure was impacted by a change in the business environment.
They found that the board size of U.S. airline companies decreased after the industry was deregulated. Deregulation made the business environment less stable and more volatile.
Boone et al. (2007) include four variables to measure the costs of monitoring. The market-to-book ratio of equity, a measure of high R&D expenditure, the variance of the firm’s daily stock return and the CEO’s share ownership. They refer to this view as the monitoring hypothesis and expect that all four of their measures are negatively related to the proportion of outside directors and board size. The reasoning behind including the variable for the CEO’s share ownership is that if the CEO holds a lot of shares this indicates that the monitoring costs are high. Usually CEO’s own shares to mitigate the agency problem that is caused by a costly monitoring environment. The variables for the monitoring hypothesis have a mixed impact on board composition. Some of the measures are significantly negative, others are not significant or even significantly positive.
Conform Linck et al. (2008), to proxy for the costs of monitoring and advising three measures are used. These measures are the market-to-book ratio of equity, the level of R&D spending and the standard deviation of stock returns. This leads to Hypothesis 2:
Hypothesis 2: Firms with higher costs of monitoring and advising have smaller boards and a
lower proportion of outside directors than firms with lower costs of monitoring and advising.
Ownership incentives
Equity ownership by management is an internal corporate governance mechanism and a substitute for monitoring by the board of directors. It aligns the interests of shareholders and management. In her theoretical paper, Raheja (2005) argued that when these interests are aligned, boards will be less independent and smaller. As discussed earlier, Rosenstein and Wyatt (1990) found that a firm’s stock price responded negatively when an inside director who owned a small amount of stock was appointed, but not when the inside director owned a large amount of stock.
Boone et al. (2007) argued that it might be the case that board structure is the result of a negotiation between the CEO and the outside directors on the board. This implies that the CEO had influence on the outside directors. Boone et al. (2007) included two variables to measure the influence of CEO: the CEO’s job tenure and the CEO’s stock ownership. Three variables were included to measure constraints on the CEO’s influence: outside directors’ stock ownership, whether or not a venture capital investor was present at the time of the IPO, and the reputation of the firm’s investment banker at the time of its IPO. Boone et al. (2007) refer to this view as the negotiation hypothesis and expected that board independence is negatively
related to the first two of their measures and positively to the latter three. The results provide strong support for the negotiation hypothesis, most of the variables are statistically significantly related to board independence and have the predicted signs.
Linck et al. (2008) used two measures to proxy for ownership incentives. For insider incentive alignment the percent of a firm’s shares held by the CEO was used and for outsider incentive alignment the average percent of a firm’s shares held by each non-executive director was used. Linck et al. (2008) expected that board independence and board size are negatively related to CEO ownership and positively to outside director ownership. They found that, consistent with their hypothesis, CEO ownership was negatively related to board independence and board size. Surprisingly, outside director ownership was also negatively related to board independence and board size. A possible explanation for this unexpected finding is that when outside directors on average have strong ownership incentives, fewer outside directors are needed.
Conform Linck et al. (2008), to proxy for ownership incentives two measures are used. These measures are CEO ownership and outside director ownership. This leads to Hypothesis 3:
Hypothesis 3: The proportion of outside directors and board size decreases with CEO
ownership and increases with outside director ownership.
CEO characteristics
According to Hermalin and Weisbach (1998) a CEO’s influence on board structure depends on his perceived ability. In addition, they argued that board independence declines during the CEO’s tenure and board independence increases with poor performance. Faleye (2007) explained that a CEO’s reputation is build up gradually, but can be lost very easily. Reputable CEO’s are therefore not so likely to engage in activities for private benefits. Agency problems are less severe and the firm can do with less corporate governance mechanisms. Raheja (2005) on the other hand suggested that board independence increases with a CEO’s influence. When a CEO has more influence it is more difficult to overturn him and therefore more outside directors are necessary to counterbalance the powerful CEO.
Both Hermalin and Weisbach (1998) and Faleye (2007) suggested to measure a CEO’s perceived ability by firm performance and CEO tenure. As it takes time to establish a reputation for good performance the longer the CEO tenure, the more opportunities the CEO has had to work on his reputation. Also, if the CEO would not have been a good performing CEO the
internal control system should have eliminated him already. Linck et al. (2008) used firm performance, CEO age, and CEO tenure to proxy for a CEO’s perceived ability. For all measures a negative relation with board independence was hypothesized. They found that a CEO’s perceived ability was significantly negatively related to the proportion of outside directors.
Conform Linck et al. (2008), to proxy for CEO characteristics three measures are used. These measures are firm performance, CEO age, and CEO tenure. This leads to Hypothesis 4:
Hypothesis 4: The higher a CEO’s perceived ability the lower the proportion of outside
3. Research methodology
3.1 Sample selection
The research method employed in this paper is database research. The sample will consist exclusively of U.S. firms. First, board data are retrieved from RiskMetrics. Data are available from 2007 up to and including 201317. The database covers firms included in the S&P 1500 index. In line with other papers in governance research, financial institutions and utility companies18 will be excluded from the sample (e.g., see Linck et al., 2008; Adams et al., 2010), to make the findings of this paper comparable to other papers. This sample is matched with information from other databases. For accounting information the Compustat Monthly Updates – Fundamentals Annual database is used, for the number of segments the Compustat Monthly Updates - Segments (Non-Historical) database is used, and stock return data is taken from CRSP.
3.2 Research design
The following regression models are estimated to test the hypotheses of the relation between firm characteristics and board structure:
BoardSize = β0 + β1LogMVE + β2Debt + β3LogSegments + β4FirmAge +
β5FirmAge2 + β6MTB + β7R&D + β8RETSTD + β9CEO_Own + β10Director_Own + Industry Dummies + Year Dummies + ε (1)
BoardIndep = β0 + β1LogMVE + β2Debt + β3LogSegments + β4FirmAge + β5FirmAge2
+ β6MTB + β7R&D + β8RETSTD + β9CEO_Own + β10Director_Own +
β11FCF + β12Performance + β13CEO_Age + β14CEO_Tenure +
Industry Dummies + Year Dummies + ε (2)
where MVE = Market value of equity.
17 The U.S. Securities Act of 1933 lays out the reporting requirements for public companies in their SEC filings.
The following is expressed about the disclosure of boards of director affiliation: pursuant to Item 470(a) of Regulation S–K, firms must disclose whether each director is ‘‘independent’’ within the definition prescribed by the exchange on which the firm’s shares are traded (Armstrong et al., 2010).
18 More specifically, firms with SIC codes between 4900 and 4999 or 6000 and 6411 are excluded from the
Debt = Long-term debt/Total assets.
Segments = Number of business segments in which the firm operates. FirmAge = Number of years since the firm was first listed on CRSP. MTB = Market value of equity/Book value of equity.
R&D = R&D expenditures/Total assets (if missing, set to zero).
RETSTD = Standard deviation of monthly stock returns over the preceding fiscal year. CEO_Own = Percent of firm’s shares held by the CEO.
Director_Own = Average percent of firm’s shares held by each non-executive director. FCF = Free cash flow = Ratio of operating cash flow less preferred and equity dividend payments to the book value of assets.
Performance = Average Earnings Per Share over the two preceding fiscal years. CEO_Age = CEO’s age.
CEO_Tenure = Number of years that the CEO has served as CEO.
All these empirical proxies of theoretical constructs are conform Linck et al. (2008). Except for FCF which is conform Coles et al. (2008) and Performance. Linck et al. (2008) measured Performance using the average industry-adjusted return on assets over the two years preceding the proxy date. However, according to Larcker and Tayan (2011b) Earnings Per Share is the most common performance metric to measure the performance of employees.
An important issue in governance research is endogeneity (e.g., see Hermalin and Weisbach, 2003; Adams et al., 2010). Endogeneity is an estimation problem and it means that there is a correlation between a variable and the error term. In the area of governance research the issue with endogeneity is that there is no reason to suppose that board structure is determined exogenously (Adams et al., 2010). For example, consider two firms, one with a large board and one with a small board. If the financial performance of the firm with a small board is higher it is easy to conclude that a smaller board leads to higher financial performance. However, it is important to also consider why a firm at some point chose for a board with a certain size. It could be that past financial performance influenced the current board size. Endogeneity is a problem when the goal is to uncover causal relationships. The goal of this paper is to understand what determines board independence, therefore endogeneity issues apply to this research.
Several methods are employed to deal with endogeneity issues. First, year and industry dummies are included in the model. Second, since board structure is relatively persistent (which might reduce the independence of the year-to-year firm-level observations in the dataset) one
of the robustness tests is to include only observations from every third year (2007, 2010, and 2013).
The OLS specification used in this paper board assumes strict exogeneity (Linck et al., 2008). This means that it is assumed that the errors are independent from all past and future values of the independent variables. This might not be reasonable, because for instance past board structure could affect current and future performance.
3.3 Descriptive statistics
TO DO:
1) Table with summary statistics on firm, ownership and board variables. 2) Correlation matrix.
4. Results
4.1 Univariate analysis
To explore the relations between board structure and various subsamples of firms univariate analyses are performed. These subsamples are created based on firm characteristics. The results of the univariate analyses provide an initial assessment of the hypotheses.
TO DO:
1) split sample for independent variable with median – see Coles et al. (2008).
4.2 Multivariate analysis
4.3 Robustness tests
1) Board structure is relatively persistent. Therefore questions can be raised about the independence of year-to-year firm-level observations. To solve this the regressions were performed again, but then only observations from every third year were included.
2) Linck et al. (2008) found that the board structure of small, medium and large firms was dramatically different. There the board determinants were examined across firm size.
3) Measure the impact of including financial institutions and utility companies in the sample.
5. Conclusion
To know the factors that determine board composition, is key to understanding the role of boards in corporate governance (Hermalin and Weisbach, 2003).
To summarize….
Limitations:
1) Endogeneity, robustness tests.
2) Shortcomings of independence standards (p. 144 – Larcker and Tayan (2011a)
3) The OLS specification assumes strict exogeneity which might be not reasonable, but it is not accounted for.
Policy recommendation
- Regulation does not necessarily improve corporate governance. Refer to the conclusion of Lehn et al. (2009).
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