Are All Inside Directors the Same Are All Inside Directors the Same? CEO Entrenchment or Board Enhancement Ronald Masulis and Shawn Mobbs Vanderbilt University & The University of Alabama

Background and Motivation Governance reforms emphasize outside directors Sarbanes-Oxley, Exchange Listings, Institutional Investors Pressured firms to decrease insider representation Little research on the role of inside directors Extensive board structure research- focuses on outside directors Two opposing theories of the role of inside directors Evidence of greater CEO influence Valuable contributors of firm-specific information Fama and Jensen (1983), Harris and Raviv (2008), Raheja (2005) Coles et al. (2008), Klein (1998) Can we distinguish between the two?

Related Literature and Research Question Outside directors differ in degrees of independence Mace (1971), Hallock (1997), Core et al (1999), Shivdasani and Yermack (1999), Hermalin and Weisbach (2003) External labor market for directorships Valuable decision management and control skills: Fama and Jensen (1983), Brickley, Linck and Coles (1999), Kaplan and Reishsus (1990) Inside directors’ differ in degrees of independence Independent Inside Directors – hold outside directorships Indicates valuable decision management and control skills Greater career opportunities apart from their current CEO Are independent inside directors (IIDs) valuable board members?

Inside Director Hypotheses Agency Perspective: Inside directors aid CEO entrenchment and extraction of private benefits of control H1 Inside directors with outside directorships (independent inside directors), are predicted to be more common in firms with less powerful or less entrenched CEOs. H2 Boards with independent inside directors are better informed and have stronger more talented inside directors. Thus, these firms should have better firm performance and stock valuation.

Inside Director Hypotheses Optimal Board Perspective: Advisory roles of inside directors enhance board decision making, which is especially important when major decisions must be made. H3 Non-CEO inside directors are predicted to be more common and to enhance firm value when Information Importance is high; specifically in firms with one or more of the following attributes (1) high growth opportunities, (2) a large, complex organizational structure and (3) highly competitive product markets. Independent inside directors are predicted to be especially valuable and frequent due to their greater independence and market recognition of their superior skills. H4 Inside directors are more valuable and more frequent when outside directors have substantial board power, such as when (1) the chairman of the board is not the CEO or (2) the board includes a large majority of independent outside directors, since there is a greater need for firm- specific knowledge in either case. Independent inside directors should be especially frequent and lead to greater firm performance in such firms.

Data IRRC Data ~ S&P 1500 firms; 1997-2003 (Panel Data) Exclude Finance and Utility Firms Firms where CEO≥64 years old; Hermalin and Weisbach (1988) Final Sample: Director observations 6,371 non-CEO inside directors 11% are IIDs Firms: 1,987 9% have one or more IIDs

Determinants of Inside Directors Firm Characteristics – Boone et al. (2007), Linck et al. (2008), Coles et al. (2008), Denis and Sarin (1999) Size, R&D, Capital Expenditures, Leverage, Business & Geographic Segments Past Performance, M&A CEO Influence Tenure, Age, Ownership, Founder or Relative is active in firm SOX Influence Methodology: Multivariate OLS, Tobit and Logit regressions Industry fixed effects Robust standard errors clustered by firm

Table 3. Determinants of Inside Directors continued…

Table 3. Determinants of Inside Directors There are differences among inside directors Independent inside directors are more likely where theory predicts insiders to bring the most value

Inside Directors and Firm Performance Decision to have non-CEO inside directors is not random Heckman (1979) – Self-Selection Model 1st stage – Probit model (Table 3 Model 3) Compute Inverse Mills Ratio Identification and IV - SOX indicator (exogenous shock) 2nd stage – Regression of performance measure Firms with inside directors Inverse Mills Ratio – control for private information Industry fixed effects, robust standard errors Controls follow Coles et al. (2006), Anderson and Reeb (2003), Fich and Shivdasani (2006) Firm Size, Business Segments, Firm Age CEO & Board Ownership, Presence of Founder or Family member Growth Opportunities, Return Volatility

Table 4. Firm Performance Regressions Firm Performance Measures Industry Adjusted Operating Performance (CF) Industry Adjusted Ln(M/B) . Controls

Table 5. Performance Regressions & Undiscovered Independent Inside Directors Outside directorships are a signal of talented executives Acquiring an outside directorships is associated with improved M/B – less agency costs (more CEO independence)

CEO Entrenchment Greater CEO influence (tenure, ownership, duality) may hinder IIDs association with performance. Underperforming firms may get more independent directors due to increased shareholder pressure.

Table 7. Performance Regressions: Firms with highly entrenched CEOs IIDs have a stronger association with firm performance and value when the CEO is less entrenched Non-IIDs may be an alternative means for CEOs to entrench themselves

Information Importance Growth Opportunities R&D, Capital Expenditures, High Tech Industry Complex firms Size, Business Segments, Geographic Reach, Firm Age Competition Board composition Greater outside representation Separate CEO and Chair

Table 8A. High R&D Activity Differences are significant at 1% level Differences are significant at 5% level Strongest effect is in High R&D

Table 8B. Performance & Organizational Complexity Principal Component Analysis Firm size Business segments Geographic reach Firm age Organizational Complexity Factor Score

Table 8C. Performance Regressions: Firms in Highly Competitive Industries When survival is most critical, independent inside directors are most valuable!

Board Monitoring Mechanisms “…unless boards are given better access to information, simply increasing board [outside] independence is not sufficient to improve governance.” Adams and Ferreira (2007)

Table 9. Performance Regressions & Board Monitoring Mechanisms Greater outside representation alone may not be sufficient! Independent inside directors appear more important than independent outside directors!

Table 14. CARs: Announcements of Outside Directorship Appointments Event Study Direct test of shareholder wealth impact Directorship appointments must be to unaffiliated firms 3-day CAR based on a one factor market model Panel A: 98 Announcements of Independent appointments Mean CAR: 1.07%** Median CAR: .6%***

Table 15. CARs: Announcements of Departures of Independent Insiders Panel A: Valuable Independent Inside directors Examine Departures 123 Announcements CARs Mean: -1.1%*** Median: -.6%* Sub-samples No Successor mentioned -1% Retirement departure -.8% Leaving for another firm -2.6% Post SOX -1.5% Panel B: Dependent Inside Director Departures No significant effect, but generally positive in sign

Robustness Alternative IID measure: IID indicator Outlier Adjustments Median regressions Winsorize data at 1% and 99% levels Endogeneity Self-Selection of inside directors (undiscovered IIDs) Treatment model (non-CEO inside directors) 2SLS IV regressions (IVs: SOX Indicator and CEO tenure) Firm Fixed Effects Qualitative results are invariant!

Conclusions Non-CEO Inside directors are heterogeneous and independent insiders can often increase firm value Outside directorships is one important mechanism for distinguishing inside directors who are more valuable to the board and shareholders Taking into account differences among inside directors and among firms can be important in: Future research on corporate boards Policy/governance reforms Inside directors are valuable to information intensive firms IIDs are more valuable than non-IIDs Independent inside directors can be as important as “independent” outside directors!

Thank you