I recently did a review of studies published between 2008 and 2018 that explored independent directors who sit on the boards of for-profit corporations. I am going to discuss what I learned from these studies and highlight three key takeaways on director independence.
What is an independent director?
An independent director is “free from conflicts of interests that might compromise her ability to solely act in the interest of the firm” (Larcker & Tayan 2016, p.58). This definition is broad, and reflects the intuition that independent directors should not be distracted from their fiduciary duty towards the firm.
In Canada, various regulatory texts refer to director independence and offer slightly different definitions. The Toronto Stock Exchange (TSX) requires that a corporation has at least two independent directors. It specifies in its Company Manual that a director is independent if she “is not a member of management and is free from any interest and any business or other relationship which in the opinion of the Exchange could reasonably be perceived to materially interfere with the director’s ability to act in the best interest of the company” or if she “is a beneficial holder, directly or indirectly, or is a nominee or associate of a beneficial holder, collectively of 10% or less of the votes attaching to all issued and outstanding securities of the applicant.” The TSX offers bright-line rule to determine whether a director is independent. In particular, an individual who has been employed by the company, or its affiliates, within the last three years is not independent, nor is a person who has had a material business relation with the firm (TSX Company Manual 2018).
Besides the Company Manual of the TSX, other regulatory texts refer to director independence. National Instrument 52-110: Audit Committees, last revised in 2015, requires that an audit committee has three members, all of whom must be independent. Here independence refers to them having “no direct or indirect material relationship with the issuer”. NI 52-110 goes on to provide specific instances of directors who would not be independent, such as a director who was employed by the firm within the last 3 years.
Further, National Policy 58-201: Corporate Governance Guidelines, issued in 2005, includes recommendations for director independence: the chair of the board of directors should be independent, as should be the majority of the directors on the board, all the directors of the nominating committee (responsible for nominating new directors) and all the directors of the compensation committee (responsible for setting executive pay).
Companies are required to disclose information about director independence, as per National Instrument 58-101: Disclosure of Corporate Governance Practices. For example, firms must report whether the chair of board, as well as the majority of directors, are independent, and must give the identity of independent and not-independent directors. Both National Policy 58-201 and National Instrument 58-101 define director independence in the same way as National Instrument 52-110.
Research highlights that director independence is an ambiguous concept; it is affected not only by employment or business relations that a director may have, or by their family ties. Instead, director independence is also influenced by a director’s social relations. Hwang and Kim (2009) stress the importance of a director’s social circle for independence considerations. They document that fewer boards are independent when using an independence criterion that includes a director’s social relations in addition to their employment/business and family relations. Directors who have social ties and meet outside of the boardroom are also more influential over the board (Stevenson & Radin 2009).
Why should firms have independent directors?
Independent directors, by virtue of their independence, are able to put the interests of the corporations and its stakeholders ahead of their own interests. From this perspective, they make for good monitors of the firm. More specifically, independent directors are useful for evaluating the performance of the firm’s executive team and for overseeing the firm’s disclosures. For instance, when boards are more independent, R&D expenditures are less manipulated (Garcia Osma 2008), and material weaknesses in internal controls are more quickly remediated (Goh 2009).
This being said, being free from conflicts of interests is not sufficient for monitoring the firm. Monitoring also requires knowledge, in particular knowledge about the firm’s industry, its operations and strategies, as well as about practices such as executive pay setting and auditing. Independent directors are not, by definition, unknowledgeable: Ravina & Sapienza (2010) document that independent directors are knowledgeable about the firm, even though they are less knowledgeable that the firm’s management.
Directors may need a particular kind of knowledge, that which is appropriate for the matters which directors are called on. Kroll et al (2008) document that when directors have the appropriate expertise for acquisitions and monitor, firms enjoy superior outcomes during corporate acquisitions. This expertise for acquisitions that independent director can have is most useful when the entire board is independent from management (MacDonald et al 2008).
A firm’s information environment plays a role in whether directors can accumulate particular expertise: when it is less costly for the director to acquire information, an independent director can arguably learn more readily. In such circumstances, firms perform better when independent directors are added to the board (Duchin et al 2010).
The board does not just monitor the firm; it also provides advice to senior management. Providing advice, like monitoring, requires knowledge. Research, however, cautions that monitoring and providing advice may not be activities that easily complement one another. Boards that monitor intensively (and terminate CEOs when firm performance is poor, prevent excessive CEO compensation, etc) are poor at offering advice: firms with such boards do poorly when acquiring other firms, and do not innovate well. Complicating things for director independence is the fact that boards that monitor intensely are also those that have a majority of independent directors (Faleye et al 2011). Director independence and advice functions then may not go well together.
What firms select independent directors?
Not all firms are required to have a board filled with only independent directors. As such, there is a large variation among firms in the proportion of the directors who are independent.
Director independence serves some firms better than others. To start, it matters whether the firm has access to independent director. Firms tend to recruit more independent directors when they are closer to a larger pool of local directors (Knyazeva et al 2010).
Next, the firm’s economic environment matters. Linck et al (2008) document that firms with high growth opportunities, high R&D expenditures, and high stock return volatility have smaller and less independent boards, while large firms have bigger and more independent boards. If a more independent board monitors managers more severely, without necessarily having the appropriate expertise to do so, then managers may face a higher chance of being fired. A series of studies indeed show that firms whose boards have more independent directors tend to fire their managers faster (Hwang & Kim 2009, Knyazeva et al 2010, Faleye et al 2011). To prevent termination, managers may hesitate to take on risk (Balsmeier et al, 2017); yet, taking on risk may be what they should do in environments with lots of growth options. As such, director independence can be counterproductive. Consistent with this conjecture, Balsmeier et al (2017) document that firms that transition to more independent boards concentrate more on crowded and familiar areas of technology; while they receive more patents, these patents are not more highly cited or more uncited. In other words, these firms avoid risky behavior when it comes to innovating.
A firm’s corporate governance is also relevant for director independence. Link et al (2008) find that boards are more independent when insiders are better able to extract private benefits and when CEOs are more influential over the board. Ferreira et al (2011) show that boards are more independent when stock prices are less informative. These findings suggest that when a firm’s other governance mechanisms make for a weak monitoring environment, independent directors, who are strong monitors, are more useful. Independent directors thus appear to represent a governance mechanism that is a substitute for other governance mechanisms (e.g., outsider, influence-free CEOs, stock price informativeness).
This brief review of studies published during the last 10 years on director independence highlights three key takeaways.
First, director independence is not enough: in order for independent directors to be effective monitors, they need to be knowledgeable about the company, its environment, and its transactions. Directors have an easier time becoming knowledgeable in environments where the costs of information acquisition are lower.
Second, director independence can be counter-productive: independent directors who are good monitors tend to give less good advice. As such, it is important to know what matters more for a particular firm: a board that monitors or a board that offers advice.
Third, what matters, in terms of director independence, to a particular firm depends on its societal circumstances (e.g., is there a pool of local directors from which to recruit?), its economic environment (e.g., is it growing fast and does it have to innovate?), and its governance situation (e.g., does it have an influential CEO, or an informative stock price?). The governance situation in particular is crucial in that director independence is but one element of a rich set of mechanisms that are relevant for the firm’s governance. Director independence cannot be considered in isolation, and must be understood in its larger context.
Balsmeier B, L Fleming, G Manso (2017) Independent boards and innovation. Journal of Financial Economics 123 (3): 536-557.
Duchin R, JG Matsusaka and O Ozbas (2010) When are outside directors effective? Journal of Financial Economics 96 (2): 195-214.
Faleye O, R Hoitash, U Hoitash (2011) The costs of intense board monitoring. Journal of Financial Economics 101 (1): 160-181.
Ferreira D, MA Ferreira, CC Raposo (2011) Board structure and price informativeness. Journal of Financial Economics 99 (3): 523-545.
Garcia Osma B (2008) Board Independence and Real Earnings Management: The Case of R&D Expenditure. Corporate Governance: An International Review 16 (2): 116–131
Goh BW 2009 Audit Committees, Boards of Directors, and Remediationof Material Weaknesses in Internal Control. Contemporary Accounting Research 26 (2): 549–579
Hwang B-H and S Kim (2009) It pays to have friends, Journal of Financial Economics 93 (1): 138-158
Kroll M, BA Walters and P Wright (2008) Board vigilance, director experience, and corporate outcomes. Strategic Management Journal 29: 363–382.
Knyazeva A, D Knyazeva, and RW Masulis (2010) The Supply of Corporate Directors and Board Independence. Review of Financial Studies 26 (6): 1561–1605.
Larcker D and B Tayan 2016 Corporate Governance Matters. Old Tappan, New Jersey (USA): Pearson Education.
Linck JS, JM Netter, and T Yang (2008) The determinants of board structure, Journal of Financial Economics 87 (2) 308-328.
MacDonald ML, JD Westphal and ME Graebner (2008) What do they know? The effects of outside director acquisition experience on firm acquisition performance. Strategic Management Journal 29 (11): 1155–1177
Ravina E and P Sapienza (2010) What Do Independent Directors Know? Evidence from Their Trading. Review of Financial Studies 23 (3): 962–1003
Stevenson WB and RF Radin, 2009, Social Capital and Social Influence on the Board of Directors. Journal of Management Studies 46 (1): 16–44
Photo adapted from Ricky Leong