Board Independence and Long-Term Performance Sanjai Bhagat University of Colorado, Boulder & Bernard Black Stanford Law School Also, please see the articles in “New York Times,” “Chief Executive” and “CFO” in Media Clippings in the home-page:

Conventional Wisdom: n Large Company Boards should consist mostly of independent directors. n Institutional shareholders can improve corporate governance by strengthening independence of corporate boards. The Question : Will greater board independence produce better corporate performance?

This Study: First Large-Scale, Long-Time-Horizon analysis of affect of independent directors on corporate performance. n Stock price and accounting performance during for 950 large U.S. firms.

Prior Research (1) n Direct studies of corporate performance and board structure. n Conflicting results: Due to different performance measures. n None of the prior studies use multiple performance measures.

Prior Research (2) n Board Structure, CEO Replacement, Takeover Bids, and Poison Pills n Economic effect is quite small. n Ignores advisory role of boards on usual business activities.

Prior Research (3) n Share Ownership & Firm Performance n Increase in inside stock ownership correlates with improved performance up to 5 -10% ownership. n Firms with high inside ownership have less outside directors. n Hence, important to control for ownership by insiders and outside blockholders.

Research Design n Institutional Shareholder Services (ISS) : Board composition of 957 large U.S. public corporations; Data on inside, affiliated outside, and independent directors from proxy statements mailed in early 1991, and n CRSP: Stock returns during n Compustat: Accounting data during n Share ownership data from 1991 and 1988 proxy statements.

Potential Weakness of Our Research Design n Survivorship Bias: Entry into and exit from sample during sample period ( ). n For stock price performance measures, measurement periods that end/begin/include early 1991 should be free from above source of bias. n Prospective period of study ( ): No correlation between survival and board structure.

Definitions n Inside directors: Directors who are also officers (CEO, CFO) of the company. n Affiliated directors: Directors who have a significant business relationship with the company. n Independent directors: Not officers and have no significant business relationship. n DIFF = (Fraction of Independent Directors) minus (Fraction of Inside Directors) n Why DIFF is an appropriate measure of board independence?: Proponents of independent directors argue that inside directors should be replaced by independent directors.

Sample Characteristics n Table 1: Median firm has 11 board members: 7 independent directors, 1 affiliated outsider, 3 insiders (typically including CEO and CFO). n 70% of sample firms have majority- independent boards (DIFF > 0). n 6% of sample firms have majority- inside boards.

Accounting Performance Measures and Board Structure n Ratio variables (Table 2) : n Tobin’s Q (market value of assets/ replacement value of assets), n Operating Income to Sales, n Operating Income to Assets, n Sales to Assets n Sales to Employees.

· Equation 5.1: firm performance = f 1 (INDEP, CEO ownership, board size, outside director ownership, no. of outside 5% holders, log(firm size), industry performance control) · Equation 5.2: INDEP = f 2 (firm performance, CEO ownership, outside director ownership, no. of outside 5% holders, log(firm size)) · Equation 5.3: CEO Ownership = f 3 (firm performance, outside director ownership, log(firm size))

Table 5: Simultaneous Equations (3SLS) Instrumental Variables Estimates Simultaneous equations (three stage least squares) regression results for various performance variables on board independence and stock ownership for 928 large U.S. public companies for and The instrumental variables, system of equations, and performance variables Q, OPI/AST, MAR, and SAL/AST are defined in the text. Q means average Q during Q means average Q during Board and stock ownership variables are based on early 1991 data. Industry control for each regression is the mean of the dependent variable for that regression for each firm's industry group; 302 industry groups are constructed on the basis of 4-digit SIC codes from Compustat. t-statistics are in parentheses.

Bottom Line: Poorer performing firms move towards a board that consists of a greater proportion of independent directors. However, the performance of these firms does not necessarily improve. Study underscores the importance of using a broad range of variables to measure firm performance.

Stock Market Performance Variables and Board Structure n If markets are (semi-strong form) efficient, then impact of board independence on share price would occur at the time the independent board is first elected. n Measurement problems in measuring stock market based performance measures for long (several years) horizons. n Negative correlation between board independence and prior stock market performance. Subsequent stock market performance is not statistically significant.

Results persist after controlling for n Board size, n Firm size, n Stock ownership by CEO, n Stock ownership by inside directors, n Stock ownership by independent directors, n Number and size of outside 5% blockholders. n Results persist in robust regressions.

Why increased board independence may not pay off in improved performance. The Case for Inside Directors n Including insiders on the board may make it easier for other directors to evaluate them as potential CEOs. n Insiders may be better at making strategic investment decisions. (Some evidence that inside director representation on investment committees improves firm performance.) n But, senior managers could be invited to board meetings even if they are not board members. n However, interaction between senior managers (other than CEO) and other directors may be different if the managers have seats on the board, are expected to attend every meeting, must vote, and are expected to participate in discussions, than if they attend at the CEO’s pleasure.

Why increased board independence may not pay off in improved performance. The Case for Inside Directors n Tradeoff between independence and other essentials to good decisions. n Inside directors are conflicted, but well informed. n Independent directors are not conflicted, but are relatively ignorant about the company. n Tradeoff between independence and incentives. n Independent directors usually own trivial amounts of the company’s shares. n Inside directors have their human capital (and substantial financial capital) committed to their company.

A case for a modified version of the conventional wisdom that favors highly independent boards. n Incentivize independent directors through stock and stock-option ownership. (Bhagat-Carey-Elson (1999) n Institutional investors may need to put their own representatives on boards. (Legal restrictions.) n Today’s “independent” directors are not independent enough. (Board members that may be employed by a university or foundation that receives financial support from the company.) n Require directors to disclose any (social/professional/business) relationship (past or present) with the CEO.

n Heterogeneity among independent directors. Some types of independent directors are valuable, while others are not. n CEOs of companies in other industries may be too busy with their own companies. n “Visibility” directors - well-known persons with limited business experience, often holding multiple directorships and adding gender/racial diversity are not effective, on average. n Hence pushing boards for greater independence may be fruitless or even counterproductive, unless independent directors have particular attributes, which are currently unknown.