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E-MailStefano Bonini is Assistant Professor of Economics at Stevens Institute of Technology. This post is based on a recent paper by Professor Bonini; Kose John, Charles William Gerstenberg Professor of Banking and Finance at NYU Stern School of Business; and Justin Deng and Mascia Ferrari, both of NYU Stern School of Business.
A growing number of countries, such as UK and France, have adopted tenure-related guidelines or tenure restrictions for independent directors. Most countries adopt a comply-or-explain approach to regulating tenure recommending a maximum tenure for a corporate director between nine and twelve years. In the United States however, where explicit limits are absent, a recent survey by GMI Ratings, the leading independent provider of global corporate governance and research, shows that 24% of independent directors in Russel 3,000 firms have continuously served in the same firm for fifteen years or more.
We argue that long-tenured directors are superiorly skilled individuals who provide tangible value added to their firms. An extension of tenure length allows directors to accumulate information about past events in the firm and about responses to exogenous market shocks that help firms weather crises and discontinuities. In support of the view that the effectiveness of one independent director is also the result of a long build-up process, William George, a Harvard Business School professor and independent director, stated: “When directors are truly independent of the companies they serve, they generally lack the […] knowledge about the industry or business […]. [O]f the nine boards I served on as an independent director I had industry-specific knowledge in exactly none of them.”
Research on independent directors usually adopts as the main dependent variable the average tenure across independent board members (e.g., Vafeas 2003; Huang 2013). Given that multiple regulation changes have increased the fraction of independent board members that now represent 70% to 80% of the board, average board tenure measures significantly confound the effect of a single long tenure that is diluted by the majority of board members who experience shorter tenures. This view is aligned with best practice recommendations compiled by Institutional lnvestor Services (ISS, a shareholder activist group) (2017): “While investors in the past have focused on average board tenure, they are beginning to pay attention to individual director tenure as well, particularly for directors serving in board leadership roles like lead director or key committee chairs.” Our research focuses on the puzzling phenomenon of extremely long tenures that do not occur board-wide, but are specific to a single director. Switching the focus to individual, abnormal tenures allows us to isolate the strongly beneficial effects on firm performance that increase in the single director tenure and level off after a surprisingly long period. Differently, the average tenure of independent board members does not increase firm value and in some specifications, appear to have a negative impact on firm performance and firm stability.
The positive effects documented in our paper raise two important questions: first, how do LT directors affect performance? Second, what determines long tenure?
The first question deals with the nature of independent directors, who protect firm stakeholders by monitoring the firm, its management, and the external environment (ICGN 2014). In this respect, the directors’ task is crucially related to the quality and amount of information the director can gather and process. Our tests confirm that long-tenured directors can gather and store valuable information that they share with other independent board members, generating a moderate-to-null sensitivity of the firm performance to the opaqueness of the outside information environment. Also, superior information translates into a significantly lower external litigation risk as documented by a set of tests on the likelihood of LT firms to be defendants in security class action lawsuits. This protection effect is robust to alternative specifications of the litigation risk variable.
Addressing the second question requires looking at observable individual factors, but, more importantly, finding proxies for unobservable characteristics. We show that not all board members are equally likely to become long-tenured directors. Personal characteristics and the market perception of traits and skills positively impact the probability of one individual becoming a long-tenured director. Directors with a high-quality education, such as graduate degrees and degrees from Ivy League colleges, are significantly more likely to evolve into LT directors, compared with other independent board members. However, unobservable skills may still explain their long association with a firm. Looking at contemporaneous board directorships at the time of the first appointment in the firm in which a director eventually becomes a LT board member, we show that ex-ante these individuals held a substantially larger number of board appointments than did other directors. This suggests that firms at large recognized these candidates’ superior qualities and competed for their services. Consistent with the market’s ability to identify skilled directors, we document superior performance of firms in which LT directors hold appointments as independent, but not long-tenured, directors.
Our findings have several normative implications. First, consistent with Katz and McIntosh (2014), we posit that board-wide term limits may be detrimental to the board itself, the company, and the shareholders, in particular if such limits force valuable directors off the board. This is in line with ISS (2017) that states: “term and age limits, as they have been typically applied, may not be the solutions, because they force the arbitrary retirement of valuable directors.” Second, our results show that LT directors are disproportionately more likely to be nominated as Lead Independent Directors (LID), a role that has become increasingly relevant in listed companies, following a set of regulation changes in the U.S. stock market. Since firms recognize the value of LT directors and leverage on it by appointing LT directors as LID, an unconditional tenure limit would negatively affect the effectiveness of the LID function and ultimately weaken the governance of companies.
The complete paper is available for download here.
