How Valuable are Independent Directors? Evidence from External Distractions

Ronald Masulis is Scientia Professor of Finance at University of New South Wales Australian School of Business, and Emma Jincheng Zhang is a lecturer in banking and finance at Monash University. This post is based on their recent article, forthcoming in the Journal of Financial Economics.

In our article, How valuable are independent directors? Evidence from external distractions, which was recently accepted for publication in the Journal of Financial Economics, we provide new evidence on the value of independent directors by exploiting exogenous events that seriously distract independent directors.

Agency theory predicts that independent directors are valuable (Fama and Jensen, 1983). Yet, empirical assessments of the value of independent directors are decidedly mixed, leaving the value of independent directors an important unsettled question in the literature (Bhagat and Black, 1999; Gordon, 2007; Adams et al., 2010). While some studies find a positive relation between board independence and corporate outcomes (e.g., Cotter et al., 1997; Dahya et al., 2008; Aggarwal et al., 2009), others find no relation (Bhagat and Black, 2002) or changing relations depending on a firm’s information environment (Duchin et al., 2010). Recently, several studies have questioned the usefulness of independence as a primary director characteristic, with alternative director traits being proposed as superior measures of board quality, such as director co-option (Coles et al., 2014).

Hermalin and Weisbach (2003) conclude from these conflicting empirical results that sharper experimental designs largely free of endogeneity concerns are needed. Our study aims to improve the identification of independent director effects by exploiting major external distractions that individual independent directors can face. External director distractions provide a sharp experimental setting to isolate the value of independent directors for several reasons. First, they are exogenously triggered, temporary, and can occur more than once. These features help to rule out alternative explanations for our findings. Second, a distracted independent director simply stops supplying the same level of advisory and monitoring services previously provided, yet she is usually not replaced. This rules out alternative explanations related to expectations about the characteristics of replacement directors. Third, director distractions are economically important and the severity of a distraction’s impact varies with its duration and the relative importance of a director’s roles. This allows us to undertake additional tests in the cross section to further validate and isolate the roles and benefits of independent directors.

The external distractions we study fall into two fundamental categories, namely personal and professional. Personal distractions include major illness/injuries as well as winning major national or international awards. Professional distractions include challenges faced at another firm where the independent director concurrently sits on the board. These firm-level challenges include both events that reflect negatively on board performance (i.e., declines in industry-adjusted firm performance, financial misconduct investigations and financial distress) and events that generally have no negative performance implications (i.e., M&A deals, divestitures, CEO illness/injuries and CEO turnover). To minimize endogeneity concerns, we require that the firm where the distraction occurs has no major economic connection with the subject firm, and that the independent director plays an important role at the event firm where the professional distraction occurs. We treat the roles of the director at the event firm to be important if: (1) the independent director is an officer-director at the event firm, (2) the independent director is a committee chair with oversight responsibilities for the corporate event at the event firm, or (3) the event firm experiencing the distracting corporate event is relatively prestigious compared to other firms where the director concurrently sits on the board.

Our initial sample consists of S&P 1500 firms over the 2000–2013 period. If the distraction period represents a majority of the subject firm’s fiscal year (or at least a quarter of the fiscal year in the case of a major illness/injury), we consider this firm-director-year as “preoccupied” (or just “distracted” hereafter). About 21.9% of independent directors are preoccupied in a typical sample year by a combination of distracting events, and a typical independent director-firm observation is preoccupied about once every 4.5 years.

As a first step in our analysis, we test whether our selected exogenous distractions shift an independent director’s attention away from their normal board responsibilities. We find that preoccupied independent directors attend fewer meetings, trade less frequently in the firm’s stock and resign from the board more frequently, indicating a director’s declining firm-specific knowledge and a reduced board commitment. We next exploit these exogenous shocks to director attention to assess the value of independent directors to a firm. We find that firms with more preoccupied independent directors have declining firm valuation and operating performance and exhibit weaker M&A profitability and accounting quality. The negative effects of distracted independent directors are stronger when these directors are non-coopted (following the Coles et al., 2014 definition) and when the subject firm requires more director attention (proxied by firm opacity). We find that accounting quality suffers mainly when distracted independent directors sit on the audit committee, while acquisition profitability suffers primarily when distracted independent directors have prior acquisition experience. We conduct several sensitivity tests and conclude that our results are robust. These findings show that independent directors are valuable firm monitors and advisors, especially when they play key board roles or have critical expertise.

This study makes several important contributions to the literature. First, we exploit director distractions as an exogenous shock to the level of monitoring and advising supplied by independent directors. Under this clean experimental setting, we find persuasive evidence that board independence increases shareholder wealth. Our findings highlight the fact that not all independent directors are fully engaged, and only non-distracted independent directors consistently add value. Second, this study contributes to the literature on busy directors. Recently, Falato et al. (2014) use deaths of directors and CEOs as a natural experiment to generate exogenous variation in the attention of independent directors sitting on multiple boards. Our study substantially expands the range of distractions that exogenously reduce a director’s time and attention. Third, our study contributes to the literature studying the link between director independence and information cost. In our study, distractions serve as a shock that temporarily increases the information acquisition cost of an affected director and thereby makes her more reliant on information provided by management. We find that a rise in director-level information acquisition costs leads to negative corporate outcomes.

Fourth, we take into account that firm outcomes can be affected by the duration of a distraction, the relative importance of the other firm to the distracted director (to capture an independent director’s incentives to reallocate attention), the importance of the roles these distracted independent directors play at the subject firm, and the fraction of the board they represent. Fifth, we assess the firm-level effects of distractions to affiliated (i.e., gray) outside directors. We find that distractions to affiliated directors do not have significant effects on firm value or other key corporate outcomes. These results further support the conclusion that it is primarily independent directors, not all outside directors, who are effective monitors. Thus, independent directors and affiliated outside directors should not generally be aggregated or treated as having equivalent effects. Lastly, we highlight the time-varying nature of independent director attention, which causes director effectiveness to vary over time.

The complete article is available for download here.

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