Effects of Local Director Markets on Corporate Boards

The following post comes to us from Anzhela Knyazeva and Diana Knyazeva, both of the Department of Finance at the University of Rochester, and from Ronald Masulis, Professor of Finance at the Australian School of Business, University of New South Wales.

In our paper, Effects of Local Director Markets on Corporate Boards, which was recently made publicly available on SSRN, we examine how local director labor markets affect board composition and the quality of corporate governance. We document that the supply of potential directors in the local labor market strongly affects board composition of S&P 1500 companies, namely, the proportion and expertise of independent directors. For instance, in an average sample firm, a third of independent directors in S&P 1500 firms holding executive positions are employed locally.

Our empirical tests show that access to a larger local pool of prospective directors has a positive effect on the proportion of independent directors and a negative effect on the proportion of gray and inside directors found on a typical board of directors. At firms located near larger local pools of prospective directors, a significantly higher fraction of independent directors are employed locally. Overall, boards of firms located near larger pools of managerial talent include a larger percentage of independent directors who are executives from other nearby firms.

Our findings provide strong evidence of the importance of local director labor markets and the notion that distance matters in spite of technological developments that facilitate teleconferencing and other forms of information sharing over long distances. Although board meetings typically average only seven a year, the presence of directors at board meetings appears to be important for the effective execution of their oversight and advisory roles. At the margin, it appears that distance negatively affects the willingness of prospective directors to serve on boards, especially those who are full-time corporate and financial executives or holders of other professional positions, who face heavy demands on their time. Of course, firms may also benefit from selecting local outside directors to the extent that soft information about director quality cannot be fully communicated over long distances.

The analysis of our small- and medium-sized firm subsamples indicates that low visibility firms are most likely to rely on local director labor markets in their search for independent directors. Prospective directors appear more willing to accept the costs of distance in exchange for the benefits of being affiliated with the boards of large, established companies. In a similar vein, firms in more accessible locations (closer to major airports) are less constrained by local director pools due to the lower expected travel times for nonlocal directors. Further, the climate near a firm’s headquarters can also affect the strength of the local labor market constraint. Firms in areas with better climates, measured by less snowfall, more sunshine, fewer temperature extremes, and less within-year variation in weather, are likely to face fewer expected travel disruptions and shorter travel times. Thus, firms in these locations are less constrained by local labor markets as prospective directors expected lower travel costs of serving on these boards.

To corroborate the channel through which the local director pool exerts its influence on board composition, we examine the proportion of locally employed independent directors on boards and find that it similarly increases in the size of the local pool of prospective directors. In addition, we examine several dimensions of director expertise, including executive, technology, financial, academic, and legal expertise, and director education, to proxy specialized skills and abilities to perform effective monitoring and advisory roles. We find that firms located closer to a large pool of potential director talent (general managerial or specialized) have a higher proportion of independent directors with these respective types of expertise on their boards. We include a number of controls to account for the possibility that a third variable explains variation in both local labor markets and board structure.

Finally, since the local pool of prospective directors is a powerful predictor of board independence, we use it to reexamine the effect of board independence on the firm’s bottom line. We focus on small and medium-sized firms (75% of our sample), which are more likely to be limited to the local pool of prospective directors due to their low visibility or prestige. Using this supply constraint on director selection, we find board independence has a significant positive effect on firm value and operating performance, and CEO turnover and proportion of equity based pay, but it has no effect on a CEO’s total compensation per se.

The full paper is available for download here.

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