investment and a positive association with pay-performance sensitivity.
investment and a positive association with pay-performance sensitivity.
Electronic copy available at: http://ssrn.com/abstract=1699272
Co-opted Boards
Jeffrey L. Colesa, Naveen D. Danielb, Lalitha Naveenc
September 10, 2013
Forthcoming, Review of Financial Studies
Abstract We argue that not all independent directors are equally effective in monitoring top management. Specifically, directors who are appointed by the CEO are likely to have stronger allegiance to the CEO and will be weaker monitors. To examine this hypothesis, we propose and empirically deploy two new measures of board composition. Co-option is the fraction of the board comprised of directors appointed after the sitting CEO assumed office. Consistent with Co- option serving to measure board capture, as Co-option increases board monitoring intensity decreases: turnover-performance sensitivity diminishes; pay level increases but without a commensurate increase in pay-performance sensitivity; and investment in hard assets increases. Further analysis suggests that even independent directors who are co-opted are less effective monitors. Non-Co-opted Independence––the fraction of the board comprised of independent directors who were already on the board before the CEO assumed office––has more explanatory power for monitoring effectiveness than the traditional measure of board independence. JEL Classifications: G32; G34; K22 Keywords: Corporate governance; Board co-option; CEO entrenchment; Board composition; Board independence __________________________________________________ a W. P. Carey School of Business, Arizona State University, Tempe, AZ., 85287, USA, jeffrey.coles@asu.edu bLeBow College of Business, Drexel University, Philadelphia, PA., 19104, USA, nav@drexel.edu cFox School of Business, Temple University, Philadelphia, PA., 19122, USA, lnaveen@temple.edu The authors are grateful to an anonymous referee, Renee Adams, Christa Bouwman, Vidhi Chhaochharia, Rachel Diana, Dave Denis, Diane Denis, Ben Hermalin, Yan Li, Antonio Macias, David Maber, John McConnell, Darius Palia, Raghu Rau, David Reeb, Oleg Rytchkov, Partha Sengupta, Mike Weisbach (the editor), Jun Yang, and seminar participants at Case Western Reserve University, Lehigh University, Northeastern University, Purdue University, Rutgers University, the Securities and Exchanges Commission, Villanova University, the 2008 American Financial Association meeting, the 2008 Conference on Corporate Governance and Fraud Prevention at George Mason University, the 2008 Financial Management Association meeting, the 2008 Summer Research Conference at Indian School of Business, the 2010 Weinberg Center for Corporate Governance Conference at the University of Delaware, the 2011 SFS Finance Cavalcade, and the 2011 Finance Down Under Conference at the University of Melbourne for helpful comments.
Electronic copy available at: http://ssrn.com/abstract=1699272
1
- Introduction
The board of directors of a corporation is meant to perform the critical functions of
monitoring and advising top management (Mace (1971)). Conventional wisdom holds that
monitoring by the board is more effective when the board consists of majority of independent
directors. The empirical evidence on the connection between board independence and firm
performance, however, is mixed and weak, as is the evidence on the relation between board
independence and other organizational and governance attributes, such as managerial
ownership.1
One potential reason for the paucity of consistent, significant results is that many
directors are co-opted and the board is captured. In practice, CEOs are likely to exert
considerable influence on the selection of all board members, including non-employee directors.
Carl Icahn, activist investor, asserts quite directly (Business Week Online, 11/18/2005) that
“…members of the boards are cronies appointed by the very CEOs they’re supposed to be
watching.” Likewise, Finkelstein and Hambrick (1989) allege that CEOs can co-opt the board
by appointing “sympathetic” new directors. Hwang and Kim (2009) suggest that CEOs favor
appointees who share similar views or social ties or because there is some other basis for
alignment with the CEO.
Reflecting similar concerns about board capture, subsequent to the Sarbanes Oxley Act of
2002 (SOX) NYSE and Nasdaq adopted listing requirements that substantially reduced the direct
influence of the CEO in the nominating process. Nonetheless, CEOs are likely to continue to be
able to exert some influence on the board nomination process. At the very least, they approve
the slate of directors, and this slate is almost always voted in by shareholders (Hermalin and 1 See Coles, Daniel, and Naveen (2008), Adams, Hermalin, and Weisbach (2010), and Coles, Lemmon, and Wang (2011), for example.
2
Weisbach (1998), Cai, Garner, and Walkling (2009)).2
In this paper, we propose and implement two new measures of board composition, which
we term Co-option and Non-Co-opted Independence. Co-option is meant to capture board
capture. Non-Co-opted Independence, on the other hand, is meant to refine the traditional
measure of board independence as a proxy for the monitoring effectiveness of the board.
We define Co-option as the ratio of the number of “co-opted” (or captured) directors,
meaning those appointed after the CEO assumes office, to board size. The idea is that such co-
opted directors, regardless of whether they are classified as independent using traditional
definitions, are more likely to assign their allegiance to the CEO because the CEO was involved
in their initial appointment. Our measure is meant to reflect the additional behavioral latitude
and managerial discretion afforded a CEO when that CEO has significant influence over some
directors on the board. A related interpretation of Co-option is that it captures the disutility to
the board from monitoring the CEO. Along these lines, Hermalin and Weisbach (1998), in their
model of CEO bargaining with the board, specify director utility as a function of, among other
things, a distaste for monitoring (κ in their model), which for a director is reflected in a “… lack
of independence, at least in terms of the way he or she behaves” (p. 101). Co-option can be
thought of as capturing director aversion to monitoring and lack of independence aggregated to
the board level. Intuitively, Co-option reflects what the CEO can get away with.
Co-option ranges from 0 to 1, with higher values indicating greater co-option and board
capture and greater insulation of the CEO from various efficiency pressures. In our sample,
mean Co-option is 0.47, indicating that on average nearly half of the directors on a board joined
the board after the CEO assumed office. 2 Of course, CEO influence on the nomination process is substantially lower in the relatively few instances where directors are put up for election by dissident shareholders in proxy fights.
3
We predict that a CEO who has co-opted a greater fraction of the board will be less likely
to be fired following poor performance, will receive higher pay, will have lower sensitivity of
pay to performance, and will be able to implement preferred or pet projects even if they are
suboptimal from a shareholder-value perspective. Our findings generally are consistent with
these hypotheses.
First, we find that the sensitivity of forced CEO turnover to firm performance decreases
with co-option. For example, our parameter estimates indicate that CEO-turnover-performance
sensitivity is attenuated by about two-thirds for a one-standard-deviation increase in Co-option.
Second, we find that CEO pay levels increase with board co-option. Of course, higher pay being
associated with higher co-option is not symptomatic of entrenchment if it is compensation for
higher risk borne by the CEO through higher pay-performance sensitivity. Additional evidence,
however, suggests that this is not the case: we find that the sensitivity of CEO pay to firm
performance is generally unrelated to board co-option and even is negatively related to co-option
in some specifications. Finally, we find that investment in tangible assets (the ratio of capital
expenditure to assets) increases with co-option. This is consistent with the idea that CEOs who
have co-opted the board can invest in ways they otherwise would not. For example, in the
absence of effective board monitoring, executives are likely to satisfy their preferences for scale
and span of control, preferences that arise in larger firms for reasons of higher compensation,
control over more resources, and enhanced stature in the industry and community (Jensen
(1986)). Overall, the evidence on turnover, pay, and investment is consistent with the idea that
co-option reduces the monitoring effectiveness of the board.
In all specifications we control for the proportion of independent directors on the board
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