Heterogeneity in expertise and incentives of board members

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Heterogeneity in expertise and incentives of board members*
Anzhela Knyazevaa
Diana Knyazevab
Charu Rahejac
This version: October 14, 2009
Abstract We examine the differences in expertise and incentives of directors in corporate boards within firms. Directors exhibit a considerable amount of heterogeneity in experience, number of outside board appointments, and equity incentives. First, we identify firm and industry characteristics that determine firms’ choice of heterogeneous boards. Second, we examine the relation between board heterogeneity and firm outcomes after controlling for other measures of board composition, size, and expertise levels. In the full sample, firms with heterogeneous boards exhibit lower valuations, all else given, suggesting a role for focus in director appointments. Firms with heterogeneous boards also have lower incentive CEO compensation and higher total pay, lower cash holdings, higher dividends, and higher leverage. Keywords: board characteristics, director heterogeneity, monitoring
* We thank Anup Agrawal, Daniel Ferreira, Shane Heitzman, Jonathan Karpoff, Sanjog Misra, Shawn Mobbs, Bruce Resnick, Bill Schwert, Cliff Smith, Jerry Warner, and seminar participants at the University of Alabama for helpful suggestions. a University of Rochester, William E. Simon Graduate School of Business Administration, Rochester, NY 14627. E-mail: [email protected] Phone: 585-275-3102. b University of Rochester, William E. Simon Graduate School of Business Administration. E-mail: [email protected] c Wake Forest University, Babcock Graduate School of Management. Winston-Salem, NC 27104 E-mail: [email protected]

I. Introduction A corporate board of directors of a corporation performs the critical function of
monitoring and providing advice to top management on key corporate decisions. A subject of great interest among practitioners and financial economists has been in understanding how the structure of board affects its effectiveness. For example, papers in the literature examining board monitoring effectiveness have considered the effect of board independence, board size, proportion of equity ownership by the board and proportion of directors with outside board memberships on firm valuation and discrete board tasks (see, e.g., Weisbach (1988), Rosenstein and Wyatt, 1990; Yermack, 1996; Yermack, 2004; Fich, 2005; Fich and Shivdasani, 2006, among others). Other papers have also considered board effectiveness in advising management by considering board size and proportion of specific types of directors (e.g., Coles, Daniel and Naveen (2008), Agrawal and Knoeber (2001) among others).
Despite the large body of literature on corporate boards, financial economic theory and empirical analysis of board has focused on the proportion of directors of a certain type (such as the proportion of independent directors) as a source of heterogeneity in the board and have not considered the process of how directors interact in a board individually. Yet, one feature that distinguishes director decision making is that directors monitor firms as a group and they need to reach an agreement to be able to monitor and advice management. Differences among directors in skill or experience can either enhance board effectiveness by increasing information to the board, or it can make it more difficult for the board to make decisions because of individual director preference or perspective. Further, individual directors share benefits of reputation and ownership in firm value gains, but acquiring and evaluating information poses a cost of time to individual board members leading to possible free riding among directors.

Group dynamics have first order effects on decision making by management and director teams. Yet, there is a lack of understanding of the implications of dispersion (diversity) in member skill sets and incentives for firm performance and financial policies. This paper attempts to fill the gap by examining the implications of diversity in director characteristics for the performance of board monitoring and advisory functions, as they relate to firm value and key corporate decisions. Differently from existing work, we study within-board heterogeneity in director characteristics. Rather than focus on averages of director characteristics such as outsider presence or experience, we examine dispersion in director incentives to monitor management and in director experience within a firm. We find that heterogeneity within a board affects the performance of the board as a group in the exercise of its monitoring and advisory tasks.
The research agenda is threefold. First, we characterize the extent of heterogeneity within boards along dimensions associated with measures of board members’ incentive to monitor and ability to advise management. Our main measures for incentive to monitor are director ownership in the firm and the number of outside appointments (number of outside appointments measure reputational incentives). We measure a director’s ability to give advice based on the experience of directors in other industries.
Second, we identify firms and industries factors that are associated with heterogeneous boards. Several recent papers in the literature such as Linck, Netter, and Yang (2007), Boone, Karpoff, Field and Raheja (2007), and Lehn, Patro, and Zhao (2006), and Dey (2008) show that the choice of board structure is related to the specific firm and industry characteristics. Similarly, we study the extent to which the dispersion in monitoring and advising incentives are chosen optimally based on the needs of the firm and the industry. We study firm and industry characteristics such as firm complexity, growth opportunities, product-market competition and

CEO influence. We use previous work on board’s monitoring and advising function to drive the hypotheses for board heterogeneity.
Third, we examine the relation between board heterogeneity and firm value and firm decisions that may be associated with firm value. We analyze two main alternative implications of greater board heterogeneity. On the one hand, heterogeneous boards could face conflicts of interests and higher coordination costs among the different board members which could make it difficult for board members to monitor and give advice. On the other hand, greater heterogeneity has the potential of improving the flexibility of the board and the quality of information to the board, both in its ability to advise top management on a range of corporate decisions and to monitor the CEO’s investment decisions. We note that costs and benefits of heterogeneity in directors’ monitoring incentives and heterogeneity in directors’ ability to give advice may be independent of one another as monitoring and advisory functions may require different skills from board members.
Our main findings are as follows. First, corporate boards exhibit a considerable amount of heterogeneity in the areas of ownership stakes, and reputational incentives and director experience. Second, firm and industry characteristics appear to affect the choice of extent of board heterogeneity. Determinants of heterogeneity in board members’ incentives and heterogeneity in director experience differ. Third, we find that even after controlling for firm and industry characteristics, heterogeneity in director monitoring incentive and ability to give advice has a significant effect on firm value and key firm decisions that cannot be explained by board composition, size, and expertise levels. Heterogeneity in monitoring incentives is associated with lower firm value, which underscores the benefits of focus in director appointments. We also find less incentive pay in managerial compensation in firms with more heterogeneity among directors

in their incentive to monitor. Further, boards with considerable dispersion in director reputational incentives assume more debt, possibly partly offsetting the weaker internal monitoring efforts undertaken by such boards.
Consistent with the arguments presented in Klein (1998), Adams and Ferreira (2008a), and Coles et al. (2008) among others, we find that director’s ability to give advice is an important factor affecting firm value. Heterogeneity in director industry expertise is associated with lower firm value, which underscores the benefits of focus among directors to advice firms effectively. We also find that heterogeneity in directors’ ability to give advice is associated with lower cash holdings, lower investment levels and less incentive pay in managerial compensation. Jensen (1993), and Yermack (1996) argue that improved communication and ability of board members to share their information is associated with improved firm performance. Westphal and Bednar (2005) argue that demographic homogeneity among directors increases the likelihood that directors will express their concerns in board meetings. To the extent that similarity among board members allows board members to communicate effectively, our results show that similarity among board members results in a more cohesive board, thus improving board effectiveness.
Several caveats apply. As in other board studies, evidence on the relation between board heterogeneity and firm valuation mostly applies to associations rather than causal relationships, all else given. Further, the empirical tests of the two alternative predictions (conflicts of interest and increase in coordination costs versus effective monitoring and improvement in the quality of information) will show the larger of the two effects. Thus, for example, while it is possible that there are benefits due to improvement in the quality of information in more heterogeneous boards, our negative results suggest that the costs of coordination may be higher than the benefits

of heterogeneous boards. Finally, as a number of governance variables are correlated, one has to be mindful of potential collinearity concerns, so we attempt to address them in sensitivity checks.
The remainder of the paper is organized as follows. Section two overviews related literature on within-group heterogeneity and board governance and formulates the main testable predictions. Section three discusses the sample, variables, and methodology. Section four presents empirical results. Section five concludes. II. Related literature and testable predictions Related corporate governance literature on boards
As stated previously, most of the literature on corporate board has a focus on the levels (not the dispersion) of various director characteristics. Studies have focused on both the ability and incentive for directors to monitor management as well as the ability of the board to give advice to management.
Studies focusing on director incentives to monitor have considered the effects of director ownership, the number of outside directorships, as well as the ability of directors to acquire future directorships. Yermack (2004) studies the structure of director incentives and documents significant pay-performance sensitivity for outside directors. Kaplan and Reishus (1990) find that top executives of companies that reduce their dividends are about 50% less likely to receive additional outside directorships than are top executives of companies that do not reduce their dividends. Beasley (1996), and Fich and Shivdasani (2007) find a decrease in the number of additional directorships for directors involved in companies with financial fraud. Adams and Ferreira (2008b) find that even relatively small incentives such as meeting fees (the average per meeting fee in 2003 dollars is $1,000) increase director involvement in firms and the likelihood of directors attending board meetings.

In addition to performance incentives, other studies have considered how the number of outsider board memberships affects director incentive to monitor. Fich and Shivdasani (2006) examine the busyness of outside directors and find lower market-to-book ratios, lower profitability, and lower sensitivity of CEO turnover to performance in firms where the majority of outsiders on the board hold three or more directorships. They conclude that directors who hold multiple seats have less incentive to monitor management. Ferris, Jagannathan, and Pritchard (2003) also examine busy outside directors but do not find adverse effects on committee duties or fraud litigation. Masulis and Mobbs (2008) find a higher valuation in firms where insider directors hold outside board seats.
In terms of director background and the ability to give advice, several existing papers examine the implications of specific experts on boards and find that experts influence firm decisions. Kroszner and Strahan (2001) focus on the implications of bankers on boards. Guner, Malmendier, and Tate (2008) analyze directors with financial expertise. They find that the presence of commercial bankers on boards increases the size of loans and decreases investment to cash flow sensitivity whereas the presence of investment bankers is associated with more frequent outside financing and larger public debt issues. However, bankers on boards are also associated with worse stock and earnings performance after acquisitions as banker directors need not act in the interest of shareholders. Klein (1998) studies the professional background of directors and finds that firms select directors based on their own specific requirements, and Agrawal and Knoeber (2001) find a greater incidence of politically experienced directors in larger firms, firms reliant on sales to the government, exports, and lobbying and a greater fraction of legal experts on boards of larger firms and firms facing costly environmental regulation. In a related study of director expertise, Fich (2005) finds that markets react favorably

to appointments of executive experts (managers of other firms) to boards of directors. Papakonstantinou (2007) documents positive effects of board industry experience on performance. Existing work has also used industry expertise among other board characteristics (see, e.g. a study of earnings timeliness in Bushman, Chen, Engel, and Smith (2004) and an analysis of the effects of Sarbanes Oxley in Duchin, Matsusaka, and Ozbas (2008)).
Adams and Ferreira (2008a) consider board diversity by studying the effects of women on boards. They find that gender-diverse boards are associated with greater CEO turnover sensitivity to stock performance and that directors receive more equity-based compensation in firms with more gender-diverse boards. However, they find that average effect of gender diversity on firm performance is negative, suggesting an overall cost to forcing companies to have a more diverse board. Testable predictions Determinants of board heterogeneity
The first part of our tests focuses on the firm, industry, management, and state characteristics that predispose firms towards more heterogeneous boards. We follow previous work on board structure such as Hermalin and Weisbach (1988), Yermack (2004), Boone et al. (2007), Linck, et al. (2008), Coles et al. (2008), and Lehn et al. (2008) to develop our hypotheses and add controls for factors that may affect board changes.
Heterogeneity in board member incentive and expertise can affect the board’s coordination costs in evaluating managers and ability of the board to formulate guidance on investment opportunities and key corporate decisions. Further, to the extent that agency conflicts exist and oversight of managerial decisions imposes individual costs on board members, heterogeneity in director incentives may serve to either disrupt board monitoring by increasing

coordination costs or, alternatively, help the board by increasing the amount of information to the board or providing incentive for individual directors to gather information. (A more detailed review of the existing theoretical literature on coordination costs and collective action problems with agent heterogeneity follows in the next subsection.) Below we identify several testable predictions about firm and industry characteristics expected to shape the firm’s need for advisory (information provision) and monitoring (CEO oversight) roles of the board and, by consequence, the choice of a homogeneous or heterogeneous board.
First, in terms of board monitoring, Fama and Jensen (1983), Lehn et al. (2004) and Boone et al (2007) argue that larger and more complex companies have higher information requirements and different directors with specific knowledge to help oversee manager’s performance. Based on these studies, we expect larger and more complex firms to require more heterogeneity in director incentive for boards to monitor effectively. Further, in terms of board advice, Klein (1998), Agrawal and Knoeber (2001), Adams and Ferreira (2008a), Adams and Mehran (2003), and Coles et al. (2008) argue that the need for advice increases with firm complexity. This would imply that senior managers of larger and more complex (diversified) companies would benefit from boards with more heterogeneity in director experience for advice.
At the same time, large and complex organizations face agency concerns and coordination difficulty. This means that these firms may require less heterogeneous boards to monitor and provide advice to help offset the coordination difficulty in these firms. The empirical tests below will help determine whether larger and complex companies require less heterogeneous boards because coordination costs are high in these firms, or whether such firms require more heterogeneity because of firm complexity.

Second, the difficulty of information acquisition by board members may affect board heterogeneity. In the board literature, Coles et al. (2008), Lehn et al. (2004), and Linck, et al. (2008), argue that boards of companies with significant growth opportunities and information asymmetries require higher levels of information to the board for monitoring and greater need of advice to the CEO. To the extent that heterogeneity of board member information sets increases the cost of formulating and communicating advice to the CEO (coordination costs), firms with significant growth options (e.g., technology firms) and high information asymmetries (intangible assets) are expected to suffer the most from this cost and are therefore the most likely to form boards with a homogeneous experience profile that can invest resources in specialized advice. In contrast, in firms with lower information asymmetries and fewer growth options, focus in director experience may be less important relative to the flexibility of skills and advice delivered by a more heterogeneous board.
Third, the company’s operating environment is expected to have an effect on the costs of carrying out the board’s supervisory and advisory functions. Demsetz and Lehn (1985) propose that noisiness of the firm’s business environment will affect monitoring costs. Uncertainty in the firm’s business environment (cash flow risk and competitive product markets) could add to the benefits of a heterogeneous board with diverse member expertise and skill sets that would aid the company’s adjustment to evolving industry conditions. However, Raheja (2005) and Harris and Raviv (2007) show that companies operating in noisier environment can benefit from lower coordination costs among board members to increase the efficiency of decision-making in the board. Firms facing significant volatility and industry competition may therefore form homogeneous boards that will focus fully on core business strengths to keep the firm afloat and ahead of competing companies. We will distinguish between these two possibilities empirically.

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Heterogeneity in expertise and incentives of board members