Director Appointments—Is It “Who You Know”?

Ralph A. Walkling is Christopher and Mary Stratakis Professor in Corporate Governance and Accountability and Founder of the Center of Corporate Governance at Drexel University Lebow College of Business. This post is based on a recent paper by Professor Walkling; Tu Nguyen, Assistant Professor of Finance at University of Waterloo; and Jie Cai, Associate Professor of Finance at Drexel University Lebow College of Business.

The best way to get on a board, is to be on a board.
(Old adage)

A pillar of modern corporate governance for U.S. public firms is shareholder representation by the board of directors. Shareholders, however, are generally unable to nominate the directors who will represent them in the boardroom. Instead, the incumbent board nominates new directors, who are almost always subsequently elected. The characteristics of director additions are the foundation of a firm’s evolving governance structure, yet we know little about how boards select their new members. In contrast to most other markets where supply and demand meet in marketplaces, the director labor market typically operates in opacity. Companies never advertise vacancies and candidates do not submit their applications, while anecdotal evidence suggests that boards often recruit new members through personal connections.

The appointment of directors already connected to the board is controversial. First, selecting directors through board networks can be efficient. Boards only act as a whole and not as individuals and tend to seek consensus (Bainbridge, 2002). Cooperation and coordination are essential. Appointing unknown directors requires a steeper learning curve as new directors are assimilated into the team. In addition, past association certifies connected directors. Thus, appointing colleagues you trust can reduce uncertainty and lower coordination costs. Further, a potential director appointee will also want to join a board she feels comfortable with and trusts. Having a prior relationship with incumbent directors help to foster such trust for the candidate and the board. The coordination hypothesis argues that appointing a connected director increases firm value, particularly in complex situations.

On the other hand, adding a new director with prior connection to the incumbent board can reinforce the homogeneity of the board. McPherson, Smith-Lovin, and Cook (2001) argue that people with similar background and mindset are naturally more likely to form and retain social ties, which they term “homophily.” New directors selected from the board network, therefore, are more likely to share a similar view or approach to many issues as the incumbents. Such boards can become blind sighted to certain risks or opportunities. By appointing a connected director, the firm misses an opportunity to bring in fresh perspectives and new skills that the incumbent board lacks or might not even be aware that they need. The homophily hypothesis, therefore, argues that appointing a connected director reduces firm value, in particular for firms in a complex environment.

Finally, the selection process can be influenced by the CEO, the very person the board is supposed to monitor. Even without direct CEO involvement, new members of the board are often appointed by directors coopted by the CEO. Exacerbating the situation is the fact that individuals nominated to the board are almost always elected and thereafter are quite difficult to be involuntarily removed. The agency hypothesis argues that board appointment of connected directors, in particular those connected to the CEO or co-opted directors, represents cronyism, perpetuating existing power in the boardroom at the expense of shareholders.

This paper aims to provide comprehensive evidence on the prevalence and consequences of director recruitments from the networks of their board members. Specifically, we examine both direct (first degree) and indirect (second degree) connections in a sample of 9,923 board appointments from 2003 to 2014. Direct connections are people with whom the incumbent board or CEO has worked with in director and/or executive capacity. Indirect connections are those who have worked with or been on the same board with one of the direct connections. That is, they have direct ties to the direct contacts, hence a second degree connection.

Our results indicate a significant and dramatic role for connections in director appointments. Unconditionally, a typical board has a first-degree connection to just over half a percent of all the directors listed in BoardEx, but nearly 30% of all new directors appointed to a board have such a connection. [1] Unconditionally, an average board has a first and second degree connection to about 18% of all directors tracked by BoardEx. In contrast, we find that over 75% of new director appointments are selected from the incumbent boards’ first or second degree network. For S&P 500 firms, 94% of the director nominees are selected from the pool of individuals with first or second degree connections to the incumbent board, yet these directors represent only 26% of all directors tracked by BoardEx. To put it differently, only 6% of all S&P 500 director nominees are selected from unconnected directors who represent on average 74% of the potential talent pool.

We also find support for both the agency and coordination hypotheses, but little evidence for the homophily hypothesis. The price reaction to connected appointees is significantly positive in complex firms and firms in competitive industries, where coordination is likely to be most important. Conversely, the price reaction to connected appointees is significantly negative in those situations where agency problems are already indicated. These price reactions to appointments are confirmed by votes for connected directors in the subsequent board elections.

It is conceivable that an appointment of a director with ties to incumbent board is associated with certain governance or firm characteristics of the appointing firm and that shareholders react to the underlying issues rather than the appointment itself. To address this endogeneity issue, we use the deaths of executives or directors in a firm’s network as exogenous shocks to the network. Depending on firm needs, companies may seek new directors with certain skills or characteristics. When such skills or characteristics are not available in the network of incumbent directors, the firm has to look outside of the board network. These death events, therefore, represent exogenous shocks to the availability of connected candidates and can lead to appointment of unconnected directors. We then use the network damage caused by these death events as an instrument for the firm’s subsequent appointment of a connected director. In the analyses of stock market reaction and shareholder votes, we confirm our results using the instrumented likelihood of appointing a connected director as the main independent variable.

Our research contributes to the literature in several ways. First, we provide comprehensive evidence of the importance of social connections in director appointments in a large sample study. This evidence sheds new light on how boards select director nominees and establishes a benchmark against which the importance of other factors influencing director selection can be compared. Second, we illustrate the benefit and harm of appointing a connected director. Connections enhance board coordination, which benefits complex firms and firms facing a more competitive environment, but connections can also help entrenched management to perpetuate their control of boards. Market price reactions and subsequent shareholder votes in director elections are consistent with these arguments and reward or punish such appointments accordingly. These results contribute to the broad literature of social networks and corporate governance, as well as the ongoing debate of shareholder access to director nomination.

The full paper is available for download here.


1A board is connected to an outside individual if at least one member of the board is connected to this individual.(go back)

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