Zombie Boards: Board Tenure and Firm Performance

The following post comes to us from Sterling Huang of the Finance Area at INSEAD.

In my paper, Zombie Boards: Board Tenure and Firm Performance, which was recently made publicly available on SSRN, I empirically investigate how board tenure is related to firm performance and corporate decisions, holding other firm, CEO, and board characteristics constant. I find that board tenure has an inverted U-shaped relation with firm value, and that this curvilinear relation is reflected in M&A performance, financial reporting quality, corporate strategies and innovation, executive compensation, and CEO replacement. The results indicate that, for firms with short-tenured boards, the marginal effect of board learning dominates entrenchment effects, whereas for firms that have long-tenured boards, the opposite is true.

The analysis relies on the assumption that some transaction costs prevent boards from fully adjusting to their optimal tenure level. But what are those transaction costs? For long-tenured boards, transaction costs could take the form of agency costs. For instance, board tenure choice may reflect the extent to which CEOs have influence over the board selection process (Hermalin and Weisbach, 1998). Further, firms with staggered boards can only replace a portion of board member each year, in which case the use of a staggered board itself introduces agency problems (Bebchuk and Cohen, 2005). For short-tenured boards, transaction costs could take the form of frictions in the labor market for directors.

Consider a board with an average tenure of four years and a maximum director tenure of five years. Suppose that the optimal tenure for this firm is nine years. In such a case, it is not possible to reach the optimal board tenure by replacing board members as a new incoming director would have a tenure of zero. While firms may bring back a former experienced board member, this has occurred only rarely since the passage of the Sarbanes-Oxley Act. In addition, a firm‘s ability to find qualified independent directors is affected by the availability of prospective directors in the local labor market (Knyazeva, Knyazeva, and Masulis, 2013) and the use of executive non-competition agreements (Garmaise, 2012).

My empirical analysis identifies nine years as the empirically observed optimal tenure using a sample of S&P 1500 firms. However, as I discuss in the paper, firms with different benefits of learning and costs of entrenchment may have a different tenure structure. Recently a number of governance reform proposals have singled out boardroom tenure as an explicit indicator for which a strict limit should be set. My paper is the first empirical analysis to focus on the effect of board tenure. The paper shows that board tenure can be positively or negatively related to firm value and corporate decisions, and that this relation varies across industries and firm characteristics, suggesting that a “one-size-fits-all” regulation may not lead to the intended outcomes.

Overall, my analysis indicates that board tenure matters as it is related to firm value and corporate policies above and beyond other commonly examined firm and board characteristics. The results highlight a time-varying trade-off between knowledge and entrenchment for board effectiveness, which should be taken into account when designing board structure.

The full paper is available for download here.

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