External Networking and Internal Firm Governance

In our paper, External Networking and Internal Firm Governance, forthcoming in the Journal of Finance, we use panel data on S&P 1500 companies to identify external network connections between directors and CEOs. We observe network connections stemming from shared external board seats, prior employment in other firms, education, or charitable and leisure activities. We test whether these ties affect firm policies and performance.

A well-functioning board of directors provides both valuable advice to management and a check on its policies. An effective director should not just rubber stamp management’s actions, but should take a contrarian opinion when management’s proposals are not in the interest of the firm’s shareholders. Thus, it is important to identify director characteristics which affect their ability or willingness to bring valuable new information into the firm and to properly perform their monitoring role. Our results suggest that having directors with external network ties to the CEO may undermine the effectiveness of corporate governance.

We find that firms in which a high percentage of independent directors have external network ties to the CEO make more frequent acquisitions than firms with fewer CEO-director connections. Moreover, these acquisitions destroy shareholder value on average, particularly in firms which also have weak shareholder rights. More generally, we find that firm value measured by Tobin’s Q improves when independent directors with ties to the CEO leave the board. To confirm the direction of causality, we use director deaths and retirements as a source of exogenous changes to board composition and CEO-director ties: we find that firm value significantly improves when directors with network ties to the CEO die or retire and the improvement is significantly stronger than the change in value when directors without ties to the CEO die or retire. Consistent with weaker monitoring in firms with many CEO-board connections, firms with more powerful CEOs are more likely to appoint new directors with pre-existing network ties to the CEO. That is, more powerful CEOs exploit their heightened bargaining power over the selection process to shape the board according to their preferences.

Though our results provide clear evidence on the consequences of CEO-director ties for shareholders, they provide less insight into the motivation of connected independent directors. One possibility is that connected directors agree to serve on the board to expedite the CEO’s agenda and are complicit in the value-destroying decisions which result. Connected directors may realize that certain policies proposed by the CEO are not in the shareholders’ interest, but are reluctant to oppose them for fear of losing valuable external social ties or future career opportunities. Another possibility, however, is that close ties between the CEO and the board and resulting similarities in backgrounds and experiences increase the extent to which the board and management engage in “groupthink” while determining firm policies (Janis, 1972). Directors may be more willing to give the benefit of the doubt to management when they have a closer relationship with (or more trust in) the CEO. An attractive aspect of this story is that it does not require the directors (or CEO) to consciously disregard shareholder interests. Instead, failure to gather sufficient information or to adequately consider all alternatives might result from common cognitive biases.

Regardless of which motives dominate, our results have important implications for the corporate governance debate. We find evidence that external governance mechanisms can substitute for weak internal governance. The negative reaction to merger bids among firms with many network ties between independent directors and the CEO and the reduction in Tobin’s Q are strongest in firms with weak shareholder rights. We also ask whether the governance reforms mandated by SOX have had a significant impact on the prevalence of CEO-director ties which fall outside the scope of the formal definition of independence. Romano (2005), for example, argues that reforms mandating increased board independence are window-dressing since firms can circumvent the requirements by hiring directors who satisfy the statutory requirements for independence, but who are nonetheless captured by the CEO. We split our sample into firms which were compliant with the SOX mandate of at least 50% independent directors at the end of the last fiscal year to end prior to passage of the legislation and firms which were not. Confirming the patterns in Duchin, Matsusaka, and Ozbas (2007), we find a sharp increase in board independence beginning in 2002 and continuing through 2005. We also see convergence in the percentage of independent directors among firms which were compliant with SOX prior to its passage and firms which were not. On the other hand, we see no pattern in the percentage of independent directors with network ties to the CEO over time: the frequency of such directors on the board and the rate at which they are added to boards stay roughly constant throughout the sample period. Thus, network ties between independent directors and the CEO remain an important issue for optimal board composition and corporate governance design.

Finally, we ask whether there is any relation between the prevalence of CEO-director network ties and a firm’s likelihood of participating in the TARP program during the financial crisis of late 2008. We find higher percentages of connected independent directors among the TARP companies at the end of our sample period (2007). On average, 38.6% of independent directors in TARP-participating banks have network ties to the CEO, compared to an industry average of 13.6% and our overall sample average of 15%. Likewise, 30% of directors in General Motors have such connections, compared to an industry average of 2.28%. Though merely suggestive, this evidence implies that board composition should be a continuing target of regulatory reforms. Moreover, future academic research on the implications of director independence for corporate policies should consider carefully the deviation between the economic notion of independence and the types of director which fulfill statutory independence requirements.

The full paper is available for download here.