Distracted Directors

Luke C.D. Stein is Assistant Professor of Finance and Hong Zhao is a PhD candidate in Finance at the Arizona State University W. P. Carey School of Business. This post is based on a recent paper authored by Professor Stein and Mr. Zhao.

A board needs its members to be attentive to effectively fulfill its advisory and monitoring roles, but directors inevitably have outside obligations, which sometimes distract them from their board responsibilities. To minimize the possibility of directors becoming overly distracted, public firms have increasingly imposed restrictions on the outside duties that their directors may assume. In particular, firms may restrict outside board service, but this is likely to represent only a small fraction of the competition for directors’ time and attention.

Independent executive directors—i.e., those whose primary job is as an executive at an outside firm—pose a particular concern, not only because they may be especially valuable directors, but also because they are potentially more likely to be distracted, especially by events associated with poor performance at their employing firms. In Distracted Directors: Evidence From Directors’ Outside Employment, we study how the time-varying distraction of independent executive directors affects board governance effectiveness using a newly constructed dataset that links independent directors with their employers. We hypothesize that independent executive directors give priority to their jobs, allocating time and effort away from board duties when their primary employer’s performance suffers. Indeed, a director with bottom-quintile stock performance at her employer is 30% more likely to miss more than a quarter of board meetings.

In our sample, the average board has 6.8 independent directors and 1.4 independent executive directors, of whom 0.25 are distracted (by events associated with bottom-quintile employer stock returns) in any given fiscal year. We find robust evidence that distraction results in significantly lower firm performance and firm value: the distraction of one executive director is associated with a 31 basis point decrease in ROA (2.5% of sample average) and a 0.03 decrease in Tobin’s Q (1.8% of sample average) in preferred specifications.

Beyond overall performance, we also assess a variety of channels through which board distraction could affect the firm. Specifically, we look at CEO compensation, CEO turnover, earnings quality, and acquisition decisions—outcomes associated with boards’ effectiveness as monitors and advisors.

We start by considering the effect of board distraction on CEO compensation. As executives hope to extract excess compensation when board monitoring is weak, and distracted directors weaken board monitoring, we expect to observe higher CEO compensation in firms with more distracted directors; empirical evidence supports this hypothesis. All else equal, an additional distracted director is associated with a 2.2% increase in CEO total compensation, mainly in the form of equity rather than cash compensation. This is consistent with the possibility that designing appropriate equity compensation is more complicated than with cash and requires more effort from directors, so CEOs can extract excess compensation more easily in the form of equity when their board is distracted. It is also possible that additional equity compensation serves as a substitute for board monitoring in aligning executives’ incentives. We further find that these effects are more pronounced when distracted directors sit on the compensation committee, consistent with distraction leading to weaker board monitoring.

Our second measure of monitoring effectiveness is CEO turnover. We hypothesize that board distraction leads to lower turnover-performance sensitivity as it impairs the board’s ability to monitor the CEO or initiate management changes; we find evidence consistent with this hypothesis. For non-distracted boards, an interquartile decline in firm performance increases the likelihood of a forced CEO turnover by 101%; when one director is distracted, the same performance decline increases turnover likelihood by only 71%.

Another monitoring role of the board is to help ensure the quality of a firm’s financial disclosures. Consistent with the hypothesis that director distraction weakens board monitoring effectiveness and thereby encourages earnings manipulation, we find that firms with distracted boards have significantly larger discretionary accruals and more financial restatements due to irregularities. The detrimental effects of director distraction on earnings quality are stronger when distracted directors serve on the audit committee.

Besides monitoring, another important function of the board is advising management. To assess whether director distraction also impairs a board’s advisory role, we consider a firm’s M&A performance. We find that an additional distracted director is associated with a 28 basis point lower stock return during the five days around deal announcement, driven mainly by the distraction of directors who are M&A “experts”—those who have successful past M&A experience or work in the same industry as the target firm.

To provide further evidence that the relations between board distraction and firm outcomes are causal and to understand how the strength of the distraction effects varies across different environments, we examine heterogeneity with respect to several board structure and director characteristics. Since smaller boards have fewer members to cover the responsibilities of a distracted director, the adverse effects of distraction should perhaps be stronger; we indeed find even lower overall firm performance, more excess CEO compensation, further reduced turnover-performance sensitivity, and even lower M&A announcement returns for firms with small boards. We also investigate a set of director characteristics; empirical results suggest that the distraction effects are stronger for independent executive directors who are less co-opted by the CEO, who are CEOs at their employing firms, and who have shorter director tenure. These results are consistent with the idea that distraction has more adverse effects on a director’s board duties if the she serves as a particularly important monitor or advisor, or if she is particularly likely to be distracted by negative events at her employing firm.

In sum, our paper considers whether events at their employing firms distract independent executive directors from board responsibilities and thereby impair board governance effectiveness. Despite the decline in the number of executive directors after Sarbanes-Oxley, active corporate executives are still the most popular source of independent directors. The results in our paper suggest that independent executive directors indeed play an important governance role, but that their effectiveness can suffer in the face of distracting events at their employing firm.

The complete paper is available for download here.

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