Do Diverse Directors Influence DEI Outcomes?

Joseph Pacelli is Associate Professor at Harvard Business School. This post is based on a recent paper by Professor Pacelli, Professor Wei Cai, Professor Aiyesha Dey, Professor Jillian Grennan, and Professor Lin Qiu. Related research from the Program on Corporate Governance includes Politics and Gender in the Executive Suite (discussed on the Forum here) by Alma Cohen, Moshe Hazan, and David Weiss; Will Nasdaq’s Diversity Rules Harm Investors? (discussed on the Forum here) by Jesse M. Fried; and Duty and Diversity (discussed on the Forum here) by Chris Brummer, and Leo E. Strine.

Do diverse boards foster more diverse workforces? Currently, women make up 28% of U.S. boards, and women of color, 6%. Over 1,300 directors joined their boards before the turn of the century and 40% of them are now nearing retirement. As the old guard steps down, there is a huge opportunity, now more than ever, to create more gender-balanced and diverse boards, especially as U.S. corporations face mounting pressure from various stakeholders to do so. Is it not essential, then, to determine how board diversity may, or may not, impact the internal dynamics of firms? As supporters of diversity in all forms often point out, “diversity is a fact, equity, a choice, inclusion, an action, and belonging, an outcome.” This quote highlights the challenges companies face in trying to ensure every employee can reach their full potential.  In our recent study, we examine whether diversity at the highest echelons of management encourages diversity across all levels of a company.

We focus on the depth and breadth of diversity-related initiatives, thus allowing us to assess whether greater board diversity generates trickle-down effects.  Specifically, we examine whether greater board diversity is associated with more diverse workforce hiring, more equitable pay practices, and more inclusive corporate cultures. To establish causal linkage between diverse boards and firms’ DEI practices, we introduce a novel regression discontinuity (RD) identification strategy that allows us to observe firms that quasi- randomly lie on either side of a fixed threshold. We supplement the RD analyses with existent identification strategies stemming from shifts in the supply of directors, state legislation mandating gender diversity, and social movements promoting racial and gender equality.

We propose and test three distinct channels through which diverse boards can promote work-place DEI practices within a firm. First, we adopt a broad view of diversity and predict that cognitively and demographically diverse boards can bring in a wider range of knowledge, skills, perspectives, and approaches to problem solving that improves decision-making. Next, we hypothesize and test whether specific dimensions of board diversity, related to under-represented groups (such as female and non-white directors), directly impact diversity initiatives within the firm. The second channel, labeled the “homophily” channel, is predicated on the tendency of individuals to associate, interact, and bond with others who possess similar characteristics and backgrounds. Unlike homophily, which stems from identity formation through intra-group social connections, the third channel, which we label as the “allyship” channel, occurs when a person in a position of privilege and power seeks to operate in solidarity with another marginalized group.

By using complementary empirical strategies, we can examine each hypothesized channel in detail.  First, to test a broad view of diversity, we exploit the discontinuous probability of placing a diverse director on the board as a function of close-call, local political elections. We find that diverse government representation is associated with the subsequent appointment of diverse directors to local companies, and that there is a discontinuous jump in board diversity as a function of the diverse politicians vote share. This quasi-experimental variation is the basis for our RD design. Usually, we don’t know the counterfactual (the “what ifs” or alternate endings of a situation). Our framework, however, allows us to look at the firms in a jurisdiction where a diverse candidate, like Martha McSally, wins and compare them to firms in a jurisdiction where a diverse candidate, like Sarah Buxton, loses. We compare these firms across a number of characteristics, including governance and performance, and they are statistically indistinguishable. Importantly, though, the boards of these firms become more diverse in the two years after a diverse candidate is victorious in a close-call election. We exploit this additional diversity to establish causal estimates.

Second, to test the homophily and allyship channels of board diversity, we examine recent law changes that focus on gender diversity on boards.  We study the impact of the staggered adoption of legislation with gender quotas or gender-related disclosure requirements, also commonly referred to as “comply or explain laws.” Once we verify that, on average, the firms located in treated states increase the percent of female directors on the board, we then examine the potential consequences of greater gender diversity on the inner workings of the firms. This focus on gender diversity allows us to test the homophily and allyship channel in a causal setting, and as such, complements the previous identification strategies that focus on our broad-based measure of board diversity.

Our analyses focus on a sample of S&P 1500 firms over the period between 2008 through 2020 and collect data on directors and their skills, employee pay, salary gaps, corporate culture, and ESG ratings. Our first set of tests focuses on the “depth” of diverse talent, and we repeatedly find statistically significant increases in the representation of under-represented groups (URGs) at the manager and staff level when board diversity improves. This is consistent with the trickle-down effect that diversity practices at the top cascade through the rest of the organization. When we evaluate the three channels through which board diversity influences the representation of diverse talent – cognitive diversity, homophily, and allyship – we find some support for all three channels. We find that the broad-based board diversity measure is statistically significantly associated with increased diversity at all depths and occurs in the cross-section and within-firm over time. The statistical significance for female homophily occurs at the manager rather than the staff level. For non-white homophily, we find support at both the manager and staff level. The evidence on allyship suggests women are stronger allies for non-white employees than non-white employees are for women. Focusing on the point estimates from the RD strategy, we observe that a one standard deviation increase in our broad-based measure of board diversity is associated with a 9.3% increase in the representation of URG employees in the two-year window after the event. When we extend our analyses to salary gaps, the evidence is consistent with no improvements.

Our second set of findings focus on the breadth of diversity by extending our analysis from formal practices like hiring and compensation to the informal ones, like corporate culture.  We find that greater broad-based board diversity is significantly associated with a higher number of stars for Glassdoor’s five-star rating system for company culture. This is also consistent with other metrics evaluating employees’ perceptions of management and designation as a “Best Place to Work.” Finally, based on textual analysis of Glassdoor’s employee reviews, we find that the employees perceive the culture to be more community-oriented when the board is more diverse.

Our final set of tests explores the ongoing debate about whether popular ESG ratings systems actually capture these improvements in the internal workings of firms, and we find discrepancies among the popular rating agencies (e.g., Sustainalytics, Refinitiv, KLD).  Our findings suggest that asset managers looking to incorporate gender and racial equity into their investment decision-making should look beyond the check-box approaches to ESG ratings. Overall, our study makes multiple contributions to literature on board diversity and how culture is an important channel through which corporate governance operates.

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