Directors’ Ties to Non-CEO Executives: Information Advantage or Entrenchment?

Understanding factors that facilitate or inhibit boards’ ability to monitor the chief executive officer (CEO) is central to corporate governance. In a recent paper, we analyze how informal relationships between directors and non-CEO executives (hereafter, internal ties) affect board effectiveness.

This overlooked dimension of corporate boards may improve board performance by creating an alternative channel through which valuable information can flow to the board. Social ties between directors and executives may increase the likelihood of information sharing because social connections often lead to more frequent interactions and, more importantly, foster trust between the connected parties. As a result, directors with ties to non-CEO executives may have unfiltered access to firm-specific information, enabling them to verify information supplied by the CEO, gain more profound insights into the firm’s operations, ask penetrating questions, and obtain soft information about the CEO’s ability and fit with the firm. Hence, internal ties might enhance board effectiveness and ability to reign in the CEO by facilitating valuable information sharing.

Alternatively, internal ties may hurt boards’ monitoring ability if such connections are used by the CEOs to perpetuate their power in the boardroom. This prediction is consistent with prior academic research that shows that ties between independent directors and CEOs are associated with lower board monitoring leading to a reduction in firm value. If internal ties are similar to director–CEO ties, then entrenched CEOs may hire friendly directors connected to executives in order to shift board composition toward their preferences, or they can hire executives with ties to directors as favors to board members. Because directors connected to non-CEO executives could feel beholden to the CEO, they might side with the CEO’s decisions even if they are not optimal. Hence, internal ties may reduce the monitoring effectiveness of the board and promote CEO entrenchment.

To examine the impact of internal ties on board’s monitoring ability, we rely on a large sample of firms covered by the BoardEx database. We identify a director as connected if he and a non-CEO executive have worked together in the past at a different firm, or if both executive and director currently serve on the board of another firm. We document that 24 percent of firms have at least one internal tie during the years 2001 to 2015.

We start our analysis by examining factors influencing a firm’s choice to appoint connected directors. We document that firms with powerful CEOs are less likely to add directors with ties to non-CEO executives. This result indicates that powerful CEOs may resist the appointment of connected directors to limit alternative channels of information to the board. We proceed to analyze how internal ties affect boards’ decisions related to CEO turnover, acquisitions, and financial reporting.

If internal ties enable boards to have timelier and more detailed information about CEOs’ actions, decisions, and ability, then boards with such ties will be more likely to identify poorly-performing CEOs and terminate their employment faster. In contrast, if internal ties promote CEO entrenchment, then boards with internal ties will be more lenient toward CEOs, resulting in longer CEO tenures. We find that boards with connected directors are more likely to terminate CEOs for poor performance. This suggests that internal ties provide information to these boards, allowing directors to better perform their duties. Importantly, we document that the benefits of having access to firm-specific information are more valuable in firms with higher information asymmetry and when connected directors have greater influence in the boardroom.

Our analysis of acquisition decisions provides further support for the conjecture that internal ties improve board effectiveness. We find that firms with internal ties are less likely to engage in acquisitions that generate large shareholder losses and are more likely to make acquisitions that lead to large gains. These results suggest that internal ties can improve board monitoring without compromising on boards’ ability to advise CEOs.

We complete our study by examining the impact of internal ties on financial misconduct. This setting allows us to provide direct evidence on how boards’ access to position-specific information can improve board monitoring. We take advantage of the unique role played by the chief financial officer (CFO) in financial reporting and examine the propensity of firms with internal ties to engage in financial wrongdoing. We find that the presence of connections between directors and the CFO reduces the probability of class action lawsuits related to the financial reports and the likelihood of issuing earnings restatements. This result is more pronounced when the CFO is likely to be pressured into earnings manipulation by a powerful CEO.

Overall, in contrast to the extensive prior literature that documents negative effects of director–CEO ties on board monitoring, we show that connections between directors and non-CEO executives enhance board effectiveness. We attribute these results to social ties facilitating information transfer between outside directors and non-CEO executives. Our findings are particularly important in the current governance landscape where CEOs often serve as sole insiders, thereby increasing information asymmetry between boards and CEOs.

This post comes to us from professors Udi Hoitash and Anahit Mkrtchyan at Northeastern University. It is based on their recent article, “Directors’ Ties to Non-CEO Executives: Information Advantage or Entrenchment?” available here.

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