Yu-Hsin Lin *
III. D ECONSTRUCTING D IRECTOR I NDEPENDENCE
3. Function of the Board
a. The Advisory and Monitoring Roles of the Board
It is generally acknowledged that the corporate board of directors is at the apex of corporate internal control system and is responsible for final corporate decisions.16 The board not only advises the management on corporate strategy but also monitors the management. The advisory and monitoring role of the board are sometimes mixed. Before the board can give any effective advice to the management, it relies on the
management to provide information. The more information the management provides, the more effective can the board provide its advice. On the other hand, the more information the management provides, the more effective can the board monitor the management. In theory, shareholders would like CEO to share more information to the board so that the board not only can give better recommendation but also monitor more effectively. Nevertheless, in practice, the CEO faces a trade-off in sharing information with the board.
Assuming that moral hazard problem presents and that the CEO’s preferred projects are different from those of the shareholders’. In this situation, CEO would be hesitated to share firm-specific information with the board that is independent and would monitor intensely on him. As a result, the advisory and monitoring roles of the board may conflict.17 Economic theories suggest that it might be optimal for shareholders to choose a friendly board, a board that do not monitor too intensely and that the CEO is willing to share information with.18
From the theoretical reasoning above, it follows the empirical inquiries into whether more monitoring would in fact compromise advisory function and whether such tradeoff between monitoring and advising functions affects firm value. Faleye et al. (2011) find that the improvement of monitoring comes at the significant cost of weaker strategic advice and greater managerial myopia.19The study first classified board committees as monitoring and advising committees. The three monitoring committees include audit, compensation and nomination committees. The study defines a director as monitoring-intensive if he/she serves on at least two of the three principal monitoring committees and defines a board as monitoring-intensive if a board consists of a majority of monitoring intensive directors. For the quality of board advising function, the study uses acquisition performance and corporate investments in innovation as proxies. They find that firms with
monitoring-intensive boards exhibit worse acquisition performance and innovate less, which implies that more intense monitoring would compromise board advisory function.20
The question presents then be whether boards with intense monitoring and weak advising function would increase or destroy firm value. Faleye et al. (2011) find that monitoring-intensive board is associated with a statistically significant reduction of 12.1 percentage points in Tobin’s q, a proxy for firm value. Such finding
16Eugene Fama & Michael Jensen, Separation of Ownership and Control, 26 J.L.&ECON. 301, 311 (1983)
17Renee B. Adam and Daniel Ferreira, A Theory of Friendly Boards, 62 J.FIN.217, 217-220 (2007).
18Id., at 229-231. See also Andres Almazan and Javier Suarez, Entrenchment and Severance Pay in Optimal Governance Structures, 58J.FIN 519 (2003).
19Olubunmi Faleye et al., The Costs of Intense Board Monitoring, 101J.FIN.ECON.160, 170-173 (2011).
20Id.
implies an average reduction of 5.8% in a firm’s total market value, which is not trivial.21There are many possible explanations for the loss in firm value. Given the time constraints, increasing directors’ time on monitoring reduces the time available for advising. In addition, directors would perceive their primary function as monitoring and shy away from offering strategic advice. On the other hand, CEOs tend to share less information with monitoring-intensive boards, which could result in poorer board advice. 22
In sum, empirical research supports the theoretical hypothesis that the advisory and monitoring roles of the board are sometimes conflicted. And the net effect of increased monitoring is negative, especially when firms are in need of board’s advice on specific value-creating activities, such as corporate acquisitions andR&D investments or when the firm’s operations are complex where the demand for board advising is greater.23
b. Information
As mentioned, the board relies on the management to provide information in order to make an effective decision. It is even so for outside directors. Some observers are skeptic about the effectiveness of outside directors because they possess inferior information than insiders. Theoretical research shows that the
effectiveness of outsiders in both advisory and monitoring functions depends on the information environment of the firm.24
Duchin, Matsusaka and Ozbas (2010) conducted such an empirical study that test the impact of information cost on the effectiveness of outside directors. Their finding is worth noticing. They first construct
firm-specific proxies for an outsiders’ cost of becoming informed and the variables include the number of analysts who posted forecasts about the firm in a given year, the dispersion of analyst forecasts, and the analyst forecast error. These variables are based on the availability, homogeneity, and accuracy of analysts’
quarterly earnings forecasts.
So it would be reasonable to suspect that one of the reasons why prior research could not find statistically significant relations between board independence and firm performance could be that they omitted a very important variable — information cost.
25
They first estimate the relation between board independence and firm performance in general and, consistent with prior research studies, find no significant relationship between the two. However, when adding
information cost as a variable, they find significant improvement in firm performance by adding outsiders to the board when the firm’s information cost is low, and vice versa. The research suggests that the effectiveness of outside directors depends on information costs.
Then they estimate the relation between performance and board independence, conditional on information cost.
26 In addition, they find that firms do take information costs into consideration when composing their boards. Firms with higher information costs have more insiders on the boards and those with lower information costs have more outsiders on the boards. Consistent with
theoretical research, Duchin et al (2010) find empirical evidence that it may be optimal for some boards to be controlled by insiders, and recent regulations that force outsider control could be harmful to firm value.27
21Id., at 173-174.
22Id., at 175.
23Id., at 175-178.
24 Adam and Ferreira, supra note 17.
25 Ran Duchin, John G. Matsusaka, and OguzhanOzbas, When Are Outside Directors Effective?, 96 J.FIN.ECON.195, 201-02 (2010).
26Id., at 202-07.
27Id., at 211-12.
4. Social Ties as Sources of Information
Both theoretical and empirical research has showed that information is essential to the effectiveness of outside directors in both monitoring and advising function. Hence, source of information is also an important factor.
Most outside directors obtain inside information from the CEO. Theory suggests that if moral hazard problem presents where CEO’s interests is different from that of the shareholders’, CEO faces a trade-off in sharing information with the board. If outside directors are independent and monitor intensely, CEO would not be willing to share information. In that situation, outside directors lose source of inside informationand their performance will decrease. In theory, it would be optimal to have a friendly board.28 Empirical research confirmed such hypothesis. Westphal (1999) examines whether social ties between outside directors and CEO would increase board involvement and firm performance. They relied on surveys of corporate directors and CEOs to identify social ties by asking them whether they are friends or mere acquaintances. The research study shows that social ties can contribute to board effectiveness and firm performance by fostering
collaboration between CEOs and directors in the strategy-making process without reducing board control.29
5. Do Social Ties Matter?
Therefore, social ties or relationship can be a source of information for outside directors.
Although social ties could facilitate information exchange between CEO and outside directors, social ties would raise doubt on the independence of outside directors and the effectiveness of their monitoring activities.
Inspiring studies have been done to examine the impact of social ties to the monitoring function of independent directors. Studies have used different proxies to test the monitoring effectiveness of outside directors with social ties, including CEO compensation level, earnings management, and financial reporting quality. It is generally more difficult to identify the so-called “social ties”.
Recent theoretical work has presented economic models that probing into the relation between social
networks and corporate governance. Theory suggests that social connections between board members tend to impede governance effectiveness because boards would be reluctant to monitor too intensely on CEO in order to preserve their social capital. In addition, social networks can reduce the precision of information collected and used by board members in deciding resource allocation. While precise information could improve resource allocation, it could also raise the probability of detecting CEO’s siphoning of corporate assets.
Therefore, in order to preserve social connections, board members with social ties tend to reduce the precision level of information collected. 30
Subrahmanyam (2008) also presents basic empirical evidence on social network and corporate governance.
The study uses age differences, occupation, ethnicity, gender, familial relationship between CEO and board members as proxies for social networks. Empirical tests show that when boards consist of both fewer
28 Adam and Ferreira, supra note 17.
29 James D. Westphal, Collaboration in the Boardroom: Behavioral and Performance Consequences of CEO-Board Social Ties, 42 ACAD.MGMT J.7, 16-19.
30Avanidhar Subrahmanyam, Social Networks and Corporate Governance, 14 EUR.FIN.MGMT. 633, 636-45 (2008).
members who are also CEOs and greater non-Caucasian representation, firms are better governed and executive compensation is lower.Given that the majority of board members are Caucasian, research results suggest that firms are bettered governed when social networks are less likely to form in corporate boards.31 Hwang and Kim (2009) examine the social ties among board directors of Fortune 100 firms and the impact of social ties to executive compensation.32 They identify social ties by shared backgrounds, including mutual alma mater, military service, regional origin, discipline and industry, and find that the percentage of
independent boards drop from 87% to 62% when screening by shared backgrounds.33Using CEO compensation as a proxy for directors’ monitoring level, they test the impact of social ties on CEO compensation. They find that the CEOs of socially independent boards receive significantly lower
compensation than those of non-independent boards, suggesting that social ties do impair the impartiality of outside directors and diminish their monitoring function.34
Following their prior research, Hwang and Kim (2011) further examines the impact of social ties on the oversight of audit committees and, in particular, on the earnings management practice. They observe
significant social ties, as defined by shared backgrounds, between audit committee members and CEOs. They find a substantially stronger relation between abnormal accruals and the extent of an audit committee
member’s social ties to the CEO in relation to conventional ties. Their finding suggests that mutual qualities foster relationship building and that social relationship impairs the oversight ability of audit committee.35 In sum, empirical research shows that social relations between outside directors and CEOs do compromise the monitoring ability of outside directors. However, since social relations could foster information exchange which is essential for outside directors to carry out their responsibilities, social ties between outside directors and CEOs could foster board collaboration and improve board’s advisory function. Finally, whether social ties increase or decrease firm value will depend on the specific situation where each firm was at, such as a firm’s development stage and the complexity of a firm. The optimal composition of boards may vary among
different firms.
IV. CONCLUSION
This study presents Taiwan as a case that shows Asian corporations rely more on quanxi in developing
business relationship and specifically in choosing independent directors. Furthermore, most public companies in Asia are controlled by families or government and are less transparent. From recent theoretical and
empirical studies, we know that social ties could serve as a channel for access to critical information. Hence, social ties might in turn enhance the efficacy of independent directors. This article argues that in firms with controlling shareholders, quanxi or social ties, to some extent, reduce the information cost of independent directors and enhance director’s efficiency especially in tasks that inside information is essential. However, in tasks that involve personal interests, i.e. executive compensation, social ties might hinder director’s
impartiality and thus result in ineffective monitoring.36
31Id., at 647-53.
32Byoung-Hyoun Hwang and Seoyoung Kim, It Pays to Have Friends, 93(1) J.FIN.ECON.138 (2009).
33Id., at 139-44.
34Id., at 145-48.
35Byoung-Hyoun Hwang and Seoyoung Kim, Social Ties and Earnings Management9-10(May 22, 2011). Available at SSRN:
http://ssrn.com/abstract=1215962.
36Hwang and Kim, supra note 32.