What Do Independent Directors Know?

This post comes from Enrichetta Ravina of Columbia Business School and Paola Sapienza of the Kellogg School of Management.

In our paper What Do Independent Directors Know? Evidence from Their Trading which was recently accepted for publication in the Review of Financial Studies, we take a first look at the question of whether independent directors have enough information to monitor the company’s executives by analyzing their trading behavior in the company stock. The independence of directors is a key focus of recent regulatory changes. A criticism of this focus is that if executives want to act against the interest of the shareholders, they can simply leave directors in the dark. We indirectly measure the level of inside information independent directors collect while serving on the board by comparing the market-adjusted returns associated with their trades to those associated with the executive officers’ trades.

Using a comprehensive sample of reported executives’ and directors’ transactions in U.S. companies from 1986 to 2003, we find that executive officers earn higher abnormal returns than the market, when they make open market purchases, and that the independent directors do as well. We find that the difference between the returns earned by executives and independent directors is relatively small at most of the horizons analyzed. The results are robust to the inclusion of firm fixed effects in the regression, which allows us to compare officers and independent directors of the same firm, and to control for time-invariant, firm-specific characteristics that might affect returns, as well as individuals’ incentives and constraints. The results are also robust to using a variety of alternative specifications (e.g., controlling for the size of the transaction and stock holdings in the firm, the firm’s size, and book-to-market, and past return volatility). In addition, we find that the excess return earned by executives in the best governed firms (using the Gompers, Ishii, and Metrick Governance Index) are low and indistinguishable from zero, where as the excess return in the worst governed firms is 21%. The independent directors earn less than the executives at all governance levels. However, the gap in excess return between executives and directors is larger in the firms with the weakest governance, while it disappears for firms with the best governance.

To study whether independent directors are also informed in bad times, we analyze their trading performance when they make open market sales. To increase the power of our tests, we focus on the return from sales in two situations when trading is more likely to be driven by information rather than diversification motives: bad news (i.e., events in which the firm is experiencing a substantial market-adjusted drop in stock price) and earnings restatements. In both cases, we find that independent directors and executives outperform the market. These results are consistent with the hypothesis that independent directors are informed ahead of the market in critical situations.

Overall, these results suggest that independent directors are informed about the firm. The full paper is available for download here.

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