The Costs of Intense Board Monitoring

In our paper The Costs of Intense Board Monitoring, forthcoming in the Journal of Financial Economics, we study the effects of the intensity of board monitoring on directors’ effectiveness in performing their monitoring and advising duties. Our objectives are three-fold. First, we examine whether the quality of board monitoring is enhanced when the board is more focused on monitoring. Second, we examine whether intense monitoring is associated with weaker advising. Third, we examine how this potential tradeoff between the quality of board monitoring and advising affects overall firm value, emphasizing the role of the firm’s advising requirements in the process. We define a monitoring intensive board as one on which a majority of independent directors concurrently serve on two or more of the monitoring committees (i.e. audit, compensation, and nominating).

We study these issues using firms in the S&P 1500 indexes over 1998-2006. We test for monitoring effects by analyzing CEO turnover, executive compensation, and earnings quality. We find that the sensitivity of turnover to firm performance increases with the intensity of board monitoring suggesting that boards that are more devoted to monitoring are more likely to replace the CEO following weak financial performance. We also find improvements in earnings quality with less discretionary accruals and a significant reduction in excess executive compensation among boards with greater monitoring intensity. These results suggest that the quality of board monitoring increases when independent directors devote significant time to oversight responsibilities.

Next, we examine how this affects the quality of board advising. We first focus on a strategic event that requires significant board input by analyzing acquisitions. We find that firms with monitoring intensive boards exhibit worse acquisition performance and a longer time to deal completion. Yet acquisitions are discrete events and worse acquisition performance needs not imply generalized ineffective strategic advising. Hence, we provide further insight by focusing on corporate investments in innovation. Innovation entails the cultivation of firm-specific human capital and tolerance for experimentation and potentially costly mistakes. This requires that the CEO sees the board as supportive, which offers the implicit assurance necessary to induce him to assume strategic risks. Intense monitoring can destroy this perception, causing the CEO to focus more on routine projects with relatively safe outcomes rather than on high-risk innovation. Consistent with this, we find that firms with monitoring intensive boards innovate less, where innovation is measured using research and development investments and the quality of patents granted to the company by the U.S. Patent and Trademark Office.

Finally, because both monitoring and advising can contribute to overall firm value, we focus on value creation (as measured by Tobin’s q) to provide evidence on the net effect of intense board monitoring. We find that firm value is significantly lower when the board monitors intensely. This suggests that the negative advising effects dominate the monitoring improvements on average. It also suggests differential effects based on firm-specific advising requirements since companies with high advising needs should suffer greater value losses if their board is monitoring intensive. Consistent with this, we find that the reduction in acquisition performance, corporate innovation, and firm value is greater for firms with stronger advising requirements.

Our results have important policy implications. Our findings of improved monitoring provide an empirical basis for recommendations of increased independent director involvement in oversight duties. However, the deterioration in advising quality associated with intense monitoring suggests that an exclusive focus on board monitoring can be detrimental. Thus, there is the need to balance directors’ monitoring and advising duties in the design of value-maximizing governance structures. More importantly, our results on the different effects of intense board monitoring on firms with high and low advising requirements challenge the one-size-fits-all approach often favored by regulators, shareholder activists, and the popular press. We hope that our results will encourage a more nuanced consideration of relevant factors as firms design their governance structures to maximize value.

The full paper is available for download here.