Were Non-Independent Boards Really Captured Before Sarbanes-Oxley?

A central question in the corporate governance literature concerns the impact of boards on performance. Some studies support the view that governance structures endogenously arise as optimal solutions to the contracting environment of the firm. Many studies support an opposing view that governance structures can be captured by CEOs in ways that reduce monitoring, promote rent seeking by executives, and exacerbate corporate wrongdoing.

Papers in this latter vein generally support Sarbanes-Oxley era reforms that changed corporate governance and mandated independent boards of directors. However, clean evidence on the average effect of requiring independent boards is limited and contested, and basic questions remain unanswered. Did governance structures before SOX lead to detrimental agency costs? Are shareholders better off with the regulations? Do corporate boards even affect the performance of firms?

In a new working paper, available here, I examine these questions by taking a new approach that exploits the implementation of the law. In short, the independent board mandates defined independence such that some directors could reclassify from non-independent to independent. The effect of this definition is that while some firms—“treatment” firms—were required to change the membership of the board to meet the requirement, other firms—“placebo” firms—complied not because their directors changed, but because the classification of their directors changed. Importantly, the social and economic relationship between the CEO and director are largely unchanged for reclassified directors. As such, the reclassifications made boards at placebo firms more independent legally, but not economically.

The relative performance of the two groups after the rule was introduced likely depends on the reasons for a board’s original composition. If the non-independent board was optimal, the placebo firms should perform better, all else being equal, because they avoided any changes while treatment firms moved away from the optimal board structure. Conversely, if the board structure imposed agency costs and was not optimal to begin with, then the placebo firms should perform relatively worse.

My main tests show that placebo firms significantly outperformed treatment firms following the introduction of the independent board rules. I also show that the specific conditions that determine whether a firm is defined as a treatment firm or placebo firm are effectively random. This gives the estimated performance advantage of placebo firms a causal interpretation and implies that treatment firms performed worse because their boards were changed. In other words, the mandated governance policies impeded the conduct of firms targeted by the regulations. Indeed, this argument is made in plain language in SEC filings by firms around the passage of rule.

The question is why the replacement of inside (non-independent) directors with independent directors is harmful for these firms. Aside from monitoring incentives, these director types differ in the expertise they bring to the board. Typically, inside directors have significant knowledge about the firm that independent directors do not. Recent research has indicated that the value of this knowledge can be large.[1] Moreover, new directors take time to adjust to the operating environment of the firm. The cost of this adjustment and the value of firm specific knowledge for board members is, in part, what this paper tests. The main tests indicate that the value of firm-specific knowledge on the board is indeed large.

If independent directors at treatment firms have less knowledge about the firm and want to monitor it more closely than the outgoing “inside” directors they replace, then investment policy can be affected. In particular, greater monitoring should discourage acquisitions with agency conflicts and opaque R&D, while reduced firm-specific knowledge makes it harder for the board to evaluate intangible and risky investments like R&D.[2] Showing how investment policies vary based on board structure has been challenging for the literature on governance, however. The test design here overcomes that challenge. Consistent with the intuition above, I show that the fraction of investment going to R&D and acquisitions after the rule change is 28.3 percent higher for placebo firms than comparable treatment firms.

The paper also contributes to the widespread debate about whether to view board independence, and board structure more broadly, as optimized, irrelevant, or captured. This debate has continued for at least 25 years but has not abated as evidence has accumulated. I add to this discussion with one of the cleanest tests to date, where the central findings support an “optimized” viewpoint.

However, the existence of reclassifications is partially consistent with the view that boards can become entrenched and that some changes are just window dressing. This highlights how much the meaning of “independence” can vary, something discussed by Cohen, Frazzini, and Malloy (2012), Coles, Daniel, and Naveen (2014), and Houston, Lee, and Shan(2016).[3] My paper also supports the window dressing view: Rules can attempt to force the board to change, but a CEO can find ways to reduce the changes that are made against his wishes. As my findings make clear, legal changes are not equivalent to economic changes.


[1] E.g. Masulis and Mobbs (2011).

[2] E.g. Coles, Daniel, and Naveen (2014), Duchin, Matsusaka, and Ozbas (2010), and Linck, Netter, and Yang (2008).

[3] These papers make the point that board members can be selected who are independent but also supportive of (or beholden to) executives.

This post comes to us from Donald Bowen, a visiting assistant professor at Virginia Polytechnic Institute’s Pamplin College of Business. It is based on his recent paper, “Were Non-Independent Boards Really Captured Before SOX?” available here.