A Survey of Recent Evidence on Boards of Directors and CEO Incentives
Recent corporate governance research reports several major developments. First, researchers have made important progress in adapting statistical methodologies and experimental designs to facilitate causal inference about how governance mechanisms affect firm performance and valuation. The internal governance mechanisms studied include board composition and structure and CEO financial incentives. One key question explored here is how do independent boards and particular types of independent directors affect firm strategic decisions and its performance. This article reviews much of this rapidly accumulating new evidence.
Many studies focus on board independence (having an independent director majority) and document positive causal relationships with firm performance and valuation measures. Large proportions of independent directors on board nominating, audit and compensation committees are also beneficial. These studies also investigate the effects on other key decisions such as M&A transactions and new director nominations. Most importantly, these studies explore the economic channels that lead to these positive firm outcomes. Some studies also uncover serious deficiencies with the definition of independent directors, which overstates actual board independence.
Several studies find that nearby pools of executives serve as a major source of director talent and affect a firm’s board composition, proportion of independent directors and their expertise and experience. Multiple studies find that independent director experience can improve firm outcomes, while other characteristics such as CEO social ties, busyness or being over 65, can weaken them. The same experience or characteristics in affiliated outside directors have no significant effects.
A recent stream of studies explores the effects of firms exogenously losing an experienced independent director’s services due to death or illness or when holding multiple directorships, a director becomes distracted by major events at another board. Researchers find firms with distracted independent directors experience significant declines in firm performance, while similarly distracted affiliated directors have no such effects.
A growing body of research examines how board gender diversity affects firm performance and value, but the conclusions remain mixed and controversial. However, one recent study conditioning on firms with overly aggressive CEOs finds that gender diversity of independent directors improves performance and reduces risk-taking.
Several studies examine whether institutional investor monitoring of boards improves their performance and diligence. Researchers find that when institutional investors are exogenously distracted by major valuation changes elsewhere in their portfolios, this leads to weakened director and board monitoring, which in turn causes declining board and firm performance.
One noteworthy study analyzes the effects on a firm of having executive directors, who serve as independent directors at other companies. Such outside appointments give executive directors greater visibility and independence from the CEO. Researchers find that these directors positively affect home firm performance and M&A profitability.
Other researchers investigate how CEO financial incentives affect firm operating performance and share value. Some studies focus on the interplay between director and CEO powers and incentives. Several studies of independent boards document improved CEO incentives by ensuring more accurate financial statements, stronger pay for performance sensitivity, greater forced turnover to performance sensitivity and requiring long-term investment in firm equity. In contrast, other studies argue that CEOs can control director access to firm information, use firm resources to coopt directors and influence director nominations, thereby undermining actual board independence.
It is well known that CEOs are typically under-diversified given their large firm shareholdings and their human capital’s high correlation with firm performance. CEOs also seek to avoid being fired, which is more likely after a takeover or debt covenant violation. These threats act to discipline CEO performance, but also make CEOs even more risk averse than outside shareholders. Researchers have exploited several quasi-natural experiments to assess the effects of CEO risk aversion on firm risk-taking.
Researchers document that new state anti-takeover statutes that discourage takeover bids, lead to reduced market pressure on CEO performance. This allows CEOs risk aversion freer reign, and firms then increase less profitable, risk reducing M&A deals. When senior executives pledge their shares to obtain personal loans, this raises their risk exposure to margin calls for more collateral after stock price declines. Researchers find following such pledging that firm risk-taking declines. When new regulations reduce the voting rights of pledged shares, executives reduce pledging, and firm risk-taking then rises.
Most existing board evidence is U.S.-centric. However, several international studies explore whether shareholders benefit from different types of regulatory required internal corporate governance reforms. They report that stronger board and audit committee independence improves stock valuation.
In summary, unlike earlier research that suffered from serious endogeneity issues, current research finds substantial evidence that board independence leads to better manager incentives and enhances shareholder wealth.