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Independence in the board: benefits but also costs

It has passed a long time since independent directors started to be required in public firms` boards by legislators, regulators, and stock exchanges norms. A certain number of independent directors need to be appointed, and certain committees need to be composed by independents also, (at least the Audit Committee, but sometimes also the Nomination or Compensation Committees, etc).

Some firms try nevertheless to push the model to its own limit, when the only insider is the Ceo, the rest of directors being independents, (let`s call these boards full independent boards, or FIB). Would you say this is a reasonable structure? Although it might seem clear the answer is not, there have been no rigorous studies in the matter until recently.

In July 2014, Olubunmi Faleye from NorthEastern University at Boston, published an article on the matter, (1), and we will try to expose his main conclusions in what follows. As an advance, Faleye recommends boards to include some additional managers, and not only the Ceo. Let`s see why.

FIBs may be smaller than boards including other managers, so that efficiency is increased; agency costs are better controlled with independents; and if their number rises, as in FIBs, independent directors can easily cope with the regulatory increase in oversight obligations and also provide external expertise or resources, (Resource Dependence Theory, (2)). Let`s stop here as for the benefits from independents.

But excluding other managers might harm board effectiveness also. First, by closing the normal and cheapest path for information to flow from lower ranks, and secondly, by damaging the Ceo succession process and/or learning curve for those below the Ceo, (that when eventually promoted will lack the previous exposure to the board activities and its discussions on strategy, etc, so that they will face a tougher adaptation period).

Results are obtained as follows:

  1. Out of a sample (USA) provided by Riskmetrics, Faleye finds that FIBs show lower operating profits and depressed stock values, (when compared with non FIB firms). ROA and Tobin`s Q are the variables used in this part.
  2. Then he tries to search evidence for different channels through which this effect can be derived. He tests several thesis:
    1. The hypothesis that directors simply don`t have access to firm specific information seems to gain support. The effect is higher in firms where projects are difficult to monitor by outsiders and where the advise needs are lower, (so that independence adds lower value).
    2. The hypotheses that new Ceos not having had access to the Boards previously initially commit certain missteps that a FIB could have avoided also receives support, (tests suggest that underperformance due to this fact prevails for two years).

A question arising from these results is why do some firms create FIBs instead of choosing a more balanced structure, if the effects are as negative as Faleye`s research shows. Faleye reaches also an empirical answer; FIBs will be imposed in firms where the Ceos are strong enough to have a decision power over the board structure, so that, while simulating doing things in favor of the shareholders` interest, Ceos really pursue their own benefit thanks to being the only nexus between firm and board, thus also reducing challenges to his job from lower ranks.

The article is very useful in that it presents evidence from the costs of Fully Independent Boards, (where the only Manager being a director is the Ceo), so that it allows to think that although independence provides benefits, it also provides costs, so that firms shouldn`t take the independence part of their boards beyond the point where costs surpass benefits.

 (1) Faleye, Olubunmi, The Costs of a (Nearly) Fully Independent Board (August 26, 2014). Available at SSRN: http://ssrn.com/abstract=2487230

(2)   http://202.154.59.182/ejournal/files/Resource%20Dependence%20Theory.pdf

 

Thanks: I thank Jean Florent Rérolle for providing the reference to this article in Twitter,  

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