Board Structure, Director Expertise, and Advisory Role of Outside Directors

Jun-Koo Kang is Canon Professor at Nanyang Technological University. This post is based on a paper forthcoming in the Journal of Financial Economics by Professor Kang; Sheng‐Syan Chen, University Chair Professor at National Chengchi University; Yan-Shing Chen, Associate Professor at National Taiwan University, and Shu-Cing Peng, Assistant Professor at National Central University.

Despite the fact that the effects of board structure and director expertise on firm performance and policies are central questions in the literature on boards of directors, evidence on these questions is mixed, due largely to the endogenous nature of board structure. We also have limited evidence about the channels through which director expertise affects firm value and the circumstances under which firms can benefit from the advisory role of directors with relevant expertise without losing monitoring efficiency.

In this paper, we use a trade policy shock that affects corporate demand for qualified directors as an exogenous source of variation in board structure to provide new evidence on these important questions. Specifically, we use U.S. Congress’ grant of Permanent Normal Trade Relations (PNTR) status to China in 2000 as a quasi-policy shock to corporate demand for outside directors with China-related experience (hereafter “directors with China experience”) and investigate how such a shock affects U.S. firms’ board structure, board advisory role in investment decisions involving Chinese firms, and the assessment of directors with China experience in the stock market and the director labor market.

The passage of PNTR, which permanently sets U.S. duties on Chinese imports at normal trade relations (NTR) levels, provided U.S. firms with new business opportunities by eliminating investment uncertainty in China and increasing their incentives to exploit China’s cheaper labor and growing markets by shifting operations to China or by establishing new business relationships with Chinese firms. However, U.S. firms entering the Chinese market face significant challenges due to fundamental differences in language, legal and political landscape, and customer preferences from those in the U.S. To overcome their lack of knowledge about the social norms and regulatory environment in China and to develop a network in China, U.S. firms entering the Chinese market may have strong incentives to appoint directors with China experience, as they can help firms make informed decisions on China-related investments.

We examine this value-enhancing role of directors with China experience using U.S. manufacturing firms from 1996 to 2011 as the sample and NTR gap 1999 as the measure of the extent to which an industry is influenced by the passage of PNTR. NTR gap 1999 is the difference between the non-NTR rate to which tariffs would have risen if the annual NTR rate had not been renewed and the NTR tariff rate set by PNTR in 1999, the year prior to the passage of PNTR. We predict U.S. industries facing a high NTR gap 1999 to be associated with greater investment uncertainty in China and thus to be influenced more heavily by the passage of PNTR. Consistent with this prediction, our difference-in-differences analysis shows that the proportion of directors with China experience on the board increases significantly more for U.S. firms in high-NTR gap industries than for those in low-NTR gap industries after the passage of PNTR. The results are robust to using the ratio of imports from China by U.S. firms to U.S. domestic absorption in 1991 as a measure of the importance of the passage of PNTR for U.S. firms, and the Smoot-Hawley-based non-NTR tariff rate in 1990, which did not change much compared to the value initially set in 1930, as an instrumental variable for NTR gap 1999.

Next, to examine whether directors with China experience increase U.S. firms’ value and operating performance, we focus on investment decisions in which these directors are expected to perform an important value-enhancing advisory function. We find that U.S. firms with a higher proportion of directors with China experience on the board realize higher three-day cumulative abnormal returns around announcements of investments involving Chinese firms than other firms. They also experience a larger improvement in post-investment long-term operating performance. To mitigate confounding effects of board structure endogeneity, we conduct instrumental variable regressions of announcement returns and long-term operating performance where we instrument the proportion of directors with China experience by the number of immigrants from China in the state in which the firm is headquartered. We find that our main results continue to hold.

We also examine how the appointments of these directors are perceived by the stock market and how they are rewarded in the director labor market. We find that the market’s ex-ante assessments of director appointment announcements are more positive for directors with China experience than for directors without such experience. Additionally, we find that after the passage of PNTR, directors with China experience obtain more directorships than directors without such experience. Thus, the unique role and expertise of directors with China expereince in implementing a firm’s value-enhancing strategies are assessed positively by the stock market and the director labor market.

Finally, we examine whether the value-enhancing role of directors with China experience is different between the directors who reside in the U.S. (Resident directors) and those who reside in foreign countries (Nonresident directors). We find that compared to U.S. firms that do not have any directors with China experience on the board, those with a higher proportion of Resident directors with China experience realize higher abnormal returns around announcements of investments involving Chinese firms and better post-investment operating performance, while those with a higher proportion of Nonresident directors with China experience do not. We also find that Nonresident directors with China experience are more likely to be absent in board meetings and that firms with a higher proportion of such directors are more likely to engage in financial restatements. However, we do not find such results for Resident directors with China experience. Thus, the value-enhancing effect of directors with foreign experience comes mainly from local directors.

Our study provides important insights into how a firm adjusts board composition in response to changes in market demand for director experience induced by a change in trade policy and how an outside director’s advisory functions help create value for firms that seek to expand into foreign markets. Our research also highlights the importance of appointing local directors with foreign experience to avoid the loss of monitoring efficiency that results from hiring foreign directors.

The complete paper is available here.

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