CEOs as outside directors

In our paper Why do firms appoint CEOs as outside directors? which was recently accepted for publication in the Journal of Financial Economics, my co-authors Rüdiger Fahlenbrach and Angie Low, and I investigate in detail the role of outside board members who are CEOs of U.S. public companies. Using data from 1988 to 2005 on more than 10,000 firms, we try to answer two questions. First, what determines whether an outside CEO or another person is appointed director? Second, do outside directors who are CEOs create value for minority shareholders?

Appointments of outside CEOs to boards are highly sought after by companies. Large, well-known companies tend to have active CEOs as outside members on their boards. For instance, the 2008 board of Procter and Gamble has four outside directors who are CEOs. Surprisingly, we find that the typical firm in our sample does not have any outside CEO on its board. Direct compensation is not used to equate the supply and the demand for CEO outside directors – they do not receive more direct compensation than other board members who attend the same meetings. We argue that the high demand for their services as outside directors allows CEOs to take their pick of board seats, and they will naturally choose boards that offer them the best total package for the amount of effort required and for the risk involved. We find that CEOs are most likely to join boards of large established firms that are geographically close, pursue similar financial and investment policies, and have comparable governance mechanisms to their own firms. CEO directors are also more likely to join firms which already have other CEO directors on the board. These findings are consistent with a prestige factor, indicating that CEO directors are more likely to accept additional directorships if such positions provide them with benefits such as added prestige or networking opportunities.

We find that the stock market reacts more favorably to the appointment of a CEO outside director than to the appointment of a non-CEO outside director when the firm currently has no outside CEO on its board. Such a positive market reaction is consistent with two hypotheses. Because of their current position, CEOs have an unusual amount of authority and experience. Therefore, once appointed, a CEO outside director could be valuable to the appointing firm because she can monitor and advise the incumbent management in a way that the typical outside director is not able to. We call this hypothesis the performance hypothesis. It is also possible that if a firm succeeds in recruiting a CEO to its board, it shows to the outside world that a business leader whose human capital is especially reputation-sensitive thinks highly enough of the firm to join its board. We call this hypothesis the certification hypothesis. Such certification could have value for the appointing firm even if the CEO outside director has little tangible impact on the firm after her appointment since the appointment might primarily certify the current market value of the firm.

We further test whether there is support in favor of the performance hypothesis by investigating changes in the firm’s operating performance upon appointment of a CEO director. To address endogeneity concerns, we use a matched-firm approach, a difference-in-difference approach, and an instrumental variable approach. We fail to reject the null hypothesis that the appointment of a CEO outside director has no impact on operating performance except in the case of interlocks where the appointment is followed by significantly poorer performance. Next, we examine whether CEO directors are associated with better board decision-making. First, we find little evidence of improved CEO turnover decisions, but we find some evidence that interlocks make the CEO more comfortable in her position. Second, firms with CEO outside directors do not make better acquisitions, where the quality of an acquisition is measured by the firm’s abnormal return at the time of the acquisition announcement. Finally, we find no evidence that CEO outside directors affect how the appointing firm’s CEO is compensated.

Overall, our findings are consistent with the following interpretation. The appointment of a CEO outside director helps certify the appointing company and its management, but it does not lead to measurable improvements in operating performance or corporate policies. With the certification hypothesis, CEO outside directors differ from other directors because their status and reputation enable them to credibly certify the firms that appoint them. CEO outside directors may be sought after by many firms, but they choose strategically their board seats in large, mature firms that they seem to understand, perhaps because they are worried about damage to their reputation should they be involved with a failing firm. Our results on the determinants of CEO director appointments confirm this matching process. It could be that the CEO outside director has no impact on operating performance or corporate policies, perhaps because CEO directors are simply too busy with their day job to use their prestige, authority, and experience to have a substantial impact on the boards they sit on.

The full paper is available for download here.