Director Tenure Diversity and Its Impact on Governance

Debate about the ideal tenure length for directors has been reignited with the recent international proposals to limit the terms of independent directors. The underlying motivation for such proposals is to ensure that “the purpose behind the independent director rule is not lost.”[1]  While some firms already have term limits, such limits tend to be rather long.[2] Because the average length of director tenure has been increasing, practitioners and regulators have begun questioning whether there is such a thing as optimal board tenure. Firms and regulators understand and acknowledge the benefits of long tenure, such as knowledge continuity and boardroom collegiality. However, some drawbacks of long director tenure, including a loss of independence, the prevalence of routines, and the lack of agility and adaptability, have recently been raised by governance experts.[3]

The idea that tenure length may be associated with board effectiveness is not new. One of the questions explored in prior governance studies is whether board tenure length may, among the many director attributes studied,  affect the board’s ability to monitor management. While some studies hypothesize that longer tenure should result in better monitoring, since tenure length decreases directors’ susceptibility to management influence (e.g., Beasley 1996) and increases their firm-specific knowledge (Bacon and Brown 1973), other studies expect long tenure to lead to higher commitment to the status quo (Janis 1982; Staw and Ross 1980; Stevens et al. 1978) and board entrenchment, resulting in weaker monitoring (e.g., Anderson et al. 2004). Empirical results provide equally mixed evidence. While Anderson et al. (2004) find that board tenure length is positively associated with financing costs, implying weaker management monitoring and greater entrenchment, Beasley (1996) finds that tenure length decreases the likelihood of fraud, implying stronger management monitoring.

One way to consider the issue of board tenure is to further explore the idea of the optimal average board tenure, a time span that minimizes agency conflict while maximizing firm-specific knowledge, and to encourage firms to adhere to the optimal target. However, the downside of that approach is that any such target is necessarily rigid and therefore impractical to implement or maintain as a policy. Another way to tackle the issue of the best tenure length is to consider the diversity of director tenure lengths, rather than the average figure. Consistent with this argument, prior research has shown that both the characteristics (traits) and the variety (diversity) of team members’ cognitive resources are important in understanding team performance (Hoffman 1959; Hoffman and Maier 1961; Triandis et al. 1965). The importance of studying variation among board members has been further emphasized by Morck et al. (1988). Simply examining the average of a board characteristic does not capture the diversity of information sources and perspectives (Wiersema and Bantel 1992). Boards with diverse director tenure lengths may have the best of all worlds: By mixing junior and senior directors, these boards can combine benefits of both short and long director tenures and ensure knowledge continuity and continuous independence.

While empirical findings are mixed in regard to the effect of board demographic diversity, the theoretical underpinnings that allow for the possible impact of diverse director characteristics on group functioning should apply equally when the characteristic in question is tenure length. In addition to the standard arguments that apply to all forms of diversity, however, tenure diversity is unique in one respect. While the other dimensions of diversity rely on the assumption that directors with different demographic and background characteristics will cultivate divergent opinions, an assumption that has been questioned by prior research (see Harrison et al. 1998, 2002), tenure diversity does not require this assumption. While tenure-diverse board members may vary in the way they think, even without such a difference, tenure diversity offers benefits. By virtue of joining the board at different times, directors decrease the probability of group cohesiveness, the most important factor leading to group-think (Janis 1982). In fact, Wiersema and Bantel (1992) hypothesize that heterogeneous team tenure leads to new and different perspectives and prevents the “cohort phenomenon.” Studies in management literature find that team tenure diversity decreases a team’s social integration and mutual attraction (O’Reilly et al. 1989). Though a socially integrated group of team members may be desirable in other settings, it raises concerns about group-think, complacency, and an inability to monitor firm management in the board setting.

The empirical findings support the hypothesis that tenure-diverse boards are more effective at monitoring the CEO. Specifically, they appear to be more performance sensitive when replacing the CEO, are less likely to be associated with accounting restatements, are more likely to replace the CEO should a restatement occur, are less likely to overcompensate their CEOs, and generally provide less excess compensation. Despite the evidence that tenure-diverse boards are more effective at monitoring, there is no evidence that tenure diversity is associated with better future market performance and very little evidence that it is associated with better future accounting performance. The findings are consistent with prior studies, which find that increased monitoring may interfere with the board’s advisory role (Adams and Ferreira 2007).

Our study contributes to the regulatory discussions addressing the importance of term limits and board renewal. By shifting the focus to the mix of director tenure lengths, this study provides evidence that tenure diversity is an important component of effective governance. Furthermore, the evidence suggests that board renewal initiatives may not be baseless in that, at least, there is support for the notion that director tenure matters and that, in some instances, implementing term limits may result in better governance outcomes if it alters the mix of director tenure lengths.

ENDNOTES

[1] http://business.inquirer.net/36337/new-sec-rules-on-independent-directors. For example, in the Philippines, the term limits on independent directors were established as of 2012 for this reason of potentially impaired independence.

[2] Continuing the conversation: Board renewal, (PwC Center for Board Governance, Fall 2011).

[3] Canavan, July, Blair Jones, and Mary Jo Potter, 2004, Board tenure: How long is too long?, Directors & Boards, January 1.

This post comes to us from Professor Na Li at Singapore Management University and Professor Aida Sijamic Wahid at the University of Toronto’s Rotman School of Management. It is based on their recent paper, “Director Tenure Diversity and its Impact on Governance: Evidence from CEO Turnover,” available here.

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