RESEARCH Business Industry
MANAGEMENT
Putting outsiders on corporate boards not necessarily beneficial

Mark Reutter, Business Editor
(217) 333-0568; mreutter@uiuc.edu

9/1/02

CHAMPAIGN, Ill. — With executive self-dealing and accounting scandals rocking the corporate world, the push is on to make boards of directors more independent. No less than the New York Stock Exchange has drawn up principles of corporate governance calling on boards to have a majority of "outside" directors without ties to management.

A problem with this approach is that there is little evidence suggesting that appointing more outside directors actually improves corporate performance, according to a survey of academic research by a professor of finance at the University of Illinois at Urbana-Champaign.

In the forthcoming article, Michael S. Weisbach concludes that "there does not appear to be an empirical relationship between board composition and firm performance."

Rather, the announcement of the appointment of outside directors typically results in a bounce in a company's stock price. This suggests to Weisbach that outside directors play a psychological role in reassuring stockholders that their money is being vigilantly guarded.

The article, to be published in the Federal Reserve Bank of New York’s Economic Policy Review, was co-written by Benjamin E. Hermalin, a business professor at the University of California at Berkeley.

"Outside directors are often thought to play the monitoring role inside boards," the authors noted, but whether outsiders act as monitors is unclear, especially if there are few incentives to encourage them to actively question management. Indeed, "a reputation as a director who does not make trouble for CEOs" can be of equal or greater value to an outside director.

Outside directors, however, do play a more active role in firing CEOs than do boards dominated by "insiders" (company officers) who are beholden to the current regime. In fact, it is typically a company in crisis that appoints outside directors and gets a new CEO.

Board size also affects firm performance. Boards with a large number of directors are negatively correlated with company value, suggesting to the authors that "small boards do a better job of monitoring management." Similarly, directors who receive pay or stock incentives "tend to have a professional rather than a personal relationship with the CEO and thus are relatively more independent."

The number of outside directors does not have a discernible impact on CEO pay, another
hot-button issue in how corporate America is run. Citing various studies in the late 1990s, Weisbach and Hermalin noted that CEO pay increases whether or not outsiders are appointed to a board, and especially rises if the board contains "outside" directors who also are CEOs.

Their article is titled "Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature."