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E-MailPhilip G. Berger is the Wallman Family Professor of Accounting at the University of Chicago, Wei Cai is an Assistant Professor of Business at Columbia University, and Lin Qiu is an Assistant Professor of Management at Purdue University. This post is based on their recent paper.
Both the academic and practitioner spheres have embraced culture as a critical factor in determining a wide range of organizational outcomes. Culture generally impacts how people communicate and interact with each other. Firms experience this same phenomenon: recent research suggests that the cultural background of executives has a lasting effect on how they communicate with other key players. These actors include the capital market, employees, and importantly, the board of directors. Although interactions with boards of directors often determine an executive’s course of action and thus significantly impact firms, the crucial effect of culture on these interactions remains rather nebulous.
We argue that the proximity between the CEO’s and the directors’ cultural backgrounds plays a critical role in shaping the CEO-board relationship. In this study, we examine dynamic CEO-board cultural proximity – how the CEO-board cultural proximity evolves over the years after a new CEO joins the company and the implications of this evolution on corporate governance. Our definition of CEO-board cultural proximity builds off of the cultural dimensions constructed by Hofstede (2010). We hypothesize that these dimensions shape CEO-board dynamics through implicit bias and may evolve over CEO tenure. People who share the same cultural background have similar hidden assumptions, group norms, and values, reducing the need for explicit communication. These shared traits underlie the homophily phenomenon, which drives social networks, political alignment, and even friendship. In this way, culture serves as an implicit contract and an often-overlooked element of intra-firm relationships.
Although the importance of culture is well-established, the difficulty of constructing a comprehensive and accurate measure of culture has resulted in a dearth of research on this issue. Many prior studies have studied culture in a multinational setting, yet these settings have considerable endogeneity concerns. Results can be driven by unobservable factors associated with different countries, including the language, legal system, economic environment, and institutional environment. We attempt to overcome these obstacles by constructing a more granular measure of CEO-board cultural proximity. With a large sample of CEOs and directors from S&P 1500 companies, we measure CEO-board cultural proximity using both the first and last names at the firm-year level. Using both first and last names creates a more thorough profile of cultural background, as it can capture multi-country origin. The United States, as an immigrant country with substantial variation in cultural backgrounds, serves as an ideal setting in which to observe these dynamics. This setting allows us to examine the effect of cultural heritage while holding constant other factors such as language and the legal system.
We first find that the CEO-board cultural proximity increases over time after a new CEO takes office. Compared with the year when the CEO initially assumed the position, the CEO-board cultural proximity increases by 11.5% of the standard deviation of the cultural proximity measure’s distribution by the end of her third year, and it increases by 13.9% of the standard deviation of the measure’s distribution by the end of her sixth year. This effect grows even stronger as the CEO’s tenure approaches eight years. We find that this CEO-board dynamic is robust when the CEO turnover is exogenous, i.e., turnover due to the prior CEO’s death, poor health conditions, or natural retirement, thus mitigating the concern that an omitted factor drives this change. Finally, we control for existing CEO-board networks, and results remain robust.
The significant growth in cultural proximity is in stark contrast with relative stability of percentage of outside directors. The Sarbanes-Oxley Act relies on the idea of an “outside director,” a director not strictly affiliated with the firm, as a measure of board independence. However, our findings suggest that the current regulatory approach overlooks a key dynamic underlying CEO-board interactions. Culture implicitly shapes interactions along several dimensions, and culture appears to be significantly evolving within organizations during a CEO’s tenure.
We then examined the driving forces behind this evolving CEO-board cultural proximity. How does the CEO manage to increase the cultural alignment between the CEO and the board? One possibility is that cultural proximity could be the result of the board’s decreased uncertainty surrounding a CEO’s ability after several years. We refer to this idea as the “CEO-power channel.” A second possibility, which we refer to as the “entrenchment channel,” involves mediocre CEOs entrenching themselves and inefficiently gaining excess power over the board. Ultimately, the evidence suggests that successful CEOs, proxied by ROA performance, gain more bargaining power as their tenure increases and can therefore influence board composition to a greater extent.
Having found evidence that this dynamic exists, we finally explored how exactly this cultural rapprochement affects organizational outcomes. Corporate strategic decisions, such as mergers and acquisitions, require substantial coordination between the CEO and the board of directors. The possible effects of decreased implicit board independence may be more complex than they initially seem. On one hand, increased cultural proximity may improve coordination between the CEO and the board due to reduced information friction and enhanced communication (Van den Steen 2010). On the other hand, it may also increase the tendency towards groupthink, which could lead boards of directors to avoid conflict and quickly accede to decisions without critical evaluation. We find, on average, that CEO-board cultural proximity is associated with better decision-making. However, for firms with weak governance, greater cultural proximity is associated with worse M&A performance. These results suggest that cultural proximity promotes coordination when corporate governance is strong, but it may raise groupthink concerns when corporate governance is weak.
This study makes several contributions. First, we enrich the literature surrounding the cultural heritage of executives by examining the interaction of cultural backgrounds rather than studying each one in isolation. Additionally, using both first and last names in our analysis of heritage acknowledges the complexity of an individual’s cultural identity. We encourage future studies to embrace this approach. Second, we contribute to a deeper understanding of the dynamic CEO-board relationship. Many prior studies focus on an explicit measure of board independence, the percentage of “outside directors,” while we use culture as a more implicit measure. Given the importance of culture in determining a wide range of organizational outcomes, including culture in analyses of independence is crucial.
Our research findings emphasize the importance of considering the impact of cultural proximity in corporate governance for both researchers and practitioners. Although greater cultural proximity can boost communication in firms that have strong governance, it can pose challenges for firms with weaker governance. By comprehensively examining these dynamics, our study contributes to organizations’ understanding of CEO-board relationships and offers insights to help shape them effectively.
The full paper is available for download here.
