Board Composition and Firm Value — Lessons from Lawyer-Directors

The following post comes to us from Charles K. Whitehead, Professor of Law at Cornell Law School.

Within the standard framing, directors monitor managers in order to help align shareholder-manager interests and minimize the agency costs that arise within public companies. A principal goal has been to reinforce director independence in light of the conventional wisdom that independent directors are the most effective monitors. Directors, however, are more than just agency-cost-reducers. As managers, they also bring to bear different perspectives and judgments that are important in formulating business strategies. In addition, their training, expertise, and experience in problem-solving are valuable in managing a business, as well as their knowledge of markets and practices that may be less familiar to firm executives.

The board’s managing function has been under-evaluated by law and finance academics. In our working paper, Lawyers and Fools: Lawyer-Directors in Public Corporations, my co-authors, Lubomir Litov and Simone Sepe, and I offer new insight into how boards operate. Specifically, we analyze the effect on firm value of directors with legal training (“lawyer-directors”) who sit on the boards of public, non-financial corporations.

Two principal claims arise from our analysis: First, we argue that board composition—and the training, substantive skills, and experience that directors bring to managing a business—can be as or more valuable to the firm and its shareholders than current requirements that focus on director monitoring and independence. For some firms, alternatives to traditional monitoring can increase firm value more efficiently than the standard construct. Second, we argue that, beyond internal agency costs, external factors can shape the board and its organization. Which directorial skills are optimal will be affected over time by, among other factors, changes in the firm’s operating environment.

More specifically, our study finds that, on average, having a lawyer on the board leads to an overall decline in firm risk-taking and a 9.5 percent increase in firm value; when the lawyer is also an insider—a non-independent director—that increase rises to 10.2 percent. The result was an almost doubling in the percentage of public companies with lawyer-directors from 2000 to 2009. We also analyze the firm characteristics that are likely to result in having a lawyer-director; the effect of lawyer-directors on litigation, CEO compensation, and board integrity; and the channels through which lawyer-directors are likely to cause a drop in corporate risk-taking.

Our results caution against a one-size-fits-all approach to the board, such as current requirements that focus predominantly on a director’s independence and initiatives to break up the dual CEO-chairman role. Restricting the ability of shareholders, directors, and others to order their own affairs and adjust to changes in the environment may impose a less-flexible, less-efficient model of corporate governance on organizations with different needs and characteristics.

The full working paper is available for download here.

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