Does the Market Value Professional Directors?

Aida Sijamic Wahid is Assistant Professor of Accounting at University of Toronto Rotman School of Management; Kyle T. Welch is Assistant Professor of Accountancy at George Washington University School of Business. This post is based on a recent paper authored by Professor Wahid and Professor Welch.

Professional directors, as often defined by academics and practitioners, are independent directors whose only vocation consists of serving as corporate directors on one or more boards. Such directors hold no other full-time employment. Currently, over 84 percent of corporate boards include at least one professional director. Since the 1970’s academics across disciplines have argued that professional directors enhancing corporate governance (e.g. Eisenburg 1975, Barr 1976, Gilson and Kraakman 1991, Fram 2005, Pozen 2010). Many argue that specialized labor on boards will lead to higher quality and more rigorous governance as more dedicated directors have fewer competing commitments (e.g. Fram 2005, Pozen 2010, Bainbridge and Henderson 2013). These arguments seemed to have gained currency in practice as the portion of boards composed of professional directors has increased over the last decade. In addition, a survey conducted in 2004 found that around 67 percent of directors asked were in favor of appointing professional directors to improve board quality (Felton 2004).

The only empirical evidence examining the effectiveness of professional directors comes from director surveys which offer conflicting views on the value of professional directors (Larcker and Miles 2011, Felton 2004). Despite the arguments in favor of professionalization of corporate boards, the suggested positive relationship between professional directors and the quality of governance is not straightforward. Economic theory suggests that professional directors may be less independent. A professional director’s vocational prestige, social status, and income depend mainly on retaining the directorships. Consistent with this notion, a survey of CEOs finds that CEOs view a professional director’s primary aim to be the preservation of their board seat (Sonnenfeld et al., 2013). Corporate directorships are also lucrative [1] and the prospect of losing power and income by being removed from a board could act as a perverse incentive to rubber-stamp management’s proposals and appease the executives. It is also possible that professional directors do not channel the additional time available to them into more rigorous monitoring. Ultimately, it is an empirical question whether professional directors are more or less valuable than other independent directors.

Since directors are tasked with protecting shareholder interests, we begin by examining how equity-market participants respond to firms’ appointment of professional directors. Our director-level analysis compares market reactions to appointments of professional directors with the reaction to appointments of other independent directors (non-professional independent directors). We use a subset of director appointments which are announced via press releases by filing 8- forms with the SEC, alerting the investors to a material event. Using the subset of director appointments which occur outside of the regular nomination/election cycle provides a distinct advantage as such appointments usually contain no or little other confounding information.

We find cumulative abnormal returns surrounding professional director appointments are negative and significantly lower than returns from the appointment of non-professional independent directors. Although the majority of boards have at least one professional director (~84 percent), this result could still be attributable to firm type; i.e. it is plausible that strongest boards do not appoint professional directors. Consequently, we repeat the analysis holding the firm constant and find similar results, suggesting that firm characteristics do not drive the reaction. The negative market response might also be driven by director-specific attributes—that is, professional directors might be of lower quality or different. We repeat the analysis with a matched sample of directors, where the matched sample is formed by matching directors on demographic characteristics (e.g. age, gender), the level of busyness (as measured by the number of board seats) and vocational/educational characteristics (e.g. prior functional work experience, education). We find consistent results, suggesting that ability, qualifications, and other observable characteristics of directors do not seem to drive the negative market response.

To explore professional directors perceived monitoring ability, we repeat the above analysis while separating the firms into two subgroups: firms with low and high monitoring needs, as proxied by three different agency-cost measures (high leverage, low efficiency, and low insider ownership). We find that the negative market response is driven by the group of firms that experiences high agency cost. The concentration of negative market reaction to the appointment of professional directors only within the subset of companies requiring high monitoring suggests that investors view professional directors as less effective monitors.

In addition to the director-level analyses, we conduct firm-level tests to measure board effectiveness, measured in terms of firm performance, CEO performance-turnover sensitivity, pay-performance sensitivity, the likelihood of M&A transactions, and market response to the announcement of M&A transactions. The firm-level analyses show that boards with a higher proportion of professional directors are significantly less CEO-performance-turnover-sensitive and exhibit lower pay-performance sensitivity. Such firms are also more likely to engage in acquisition activity; when they do so, they exhibit significantly lower stock returns surrounding the transaction announcement measured over one- and three-day windows. We also find that boards with a higher proportion of professional directors exhibit lower Tobin’s Q and lower efficiency, as measured by sales turnover; we find no such difference in profitability.

To our knowledge, this is the first study to examine the consequence of professional directors empirically. Given the increased professionalization of corporate boards, it is important to determine whether appointing professional directors enhances or degrades boards’ ability to monitor the CEO and protect shareholder interests. Our study contributes to the ongoing regulatory debate about both, what constitutes director independence and also, whether imposing limitations on directors’ responsibilities and commitments is warranted. Further, this study shows that director incentives may be an important determinant of boards’ monitoring effectiveness. In that sense, this paper answers the call for further research into incentives of independent directors (Bebchuk and Weisbach, 2010, Brickly and Zimmerman, 2010). By not treating independent directors as homogenous, this study also contributes to the stream of literature that examines the board composition and characteristics that produce better and worse governance outcomes.

 

The complete paper is available for download here.

Endnotes

1Median compensation amounts to $240,000 for outside directors at Fortune 500 companies (Towers Watson, 2014)(go back)

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