Strategic Director Appointments

The independence of corporate boards is a serious concern to shareholders and regulators. The influence CEOs have over director appointments accentuates this concern. It is not uncommon to see CEOs appointing directors with personal or business ties (e.g., relatives, friends, or business associates). However, such appointments are likely to invite close scrutiny. CEOs can also use their influence more subtly by strategically nominating independent outside directors with certain expertise, knowledge, experiences, and skills.

Strategic director appointments have received little attention in the literature, which has tended to focus on what makes the board effective (e.g., independence, expertise, and size). In a new article, we focus on how managers can strategically use their power over director appointments to influence board decisions.

What skills does a manager prefer in a director? How do agency conflicts and the manager’s potential need for advice and guidance from the board affect this preference? How do strategic director appointments shape board voting patterns and outcomes? Would a manager ever prefer an outside director over an inside director?

We examine two roles boards typically play in organizations: monitoring and advising. Consider a board decision on whether to approve a project proposed by the firm’s manager. To the extent the manager’s incentives are unknown, there is an adverse selection problem, which creates a demand for board monitoring. To the extent project outcomes are uncertain and directors have relevant experience, there is a demand for the board’s advising role.

We consider a setting where the board consists of three “representative” members: the manager and two independent directors. Each director obtains information about the project’s probable outcome before casting a vote. If this information is imperfect, the directors may incorrectly reject high-output projects (type I error) or accept low-output projects (type II error). The board makes the decision by majority vote. To examine strategic director appointments, we allow the manager to replace one of the independent directors with either another insider (and thereby “capture” the board) or a new independent director.

With this structure, we analyze (i) board voting strategies and (ii) how managers can influence board decisions by strategically choosing director characteristics. We begin by examining the board’s decision-making process. We characterize the directors’ optimal voting strategies as a function of the severity of the adverse selection problem and the extent of project-level uncertainty. We show that voting patterns such as rubberstamping and abstaining (pervasive in practice) can arise naturally in equilibrium.

Perhaps surprisingly, we also find that as the agency conflict increases (as the prior belief that the manager acts in shareholder interests decreases), the board can, in some cases, actually make better decisions by relying on less (i.e., by ignoring) information.

More importantly, we establish that the board’s voting strategy depends on director characteristics. As a result, we offer novel insights concerning CEOs’ preferences in director appointments. Conventional wisdom suggests that CEOs who act in shareholder interests (loyal CEOs) would not only prefer outside directors but also appoint the most skilled directors possible. Surprisingly, this is not always the case. Their preferences depend on uncertainty about the project’s success. When uncertainty is low, loyal CEOs may appoint directors who are not the most qualified. Intuitively, the loyal CEO does not want the board to make a type I error (i.e., he does not want the board to reject a high-output project) – he is not concerned about type II errors. However, the directors do care about type II errors because they do not know whether the manager is loyal or opportunistic and do not want to incorrectly accept a low-output project proposed by the opportunistic CEO.

On the other hand, when uncertainty is high, the board’s advisory role becomes more valuable to the loyal manager. He is now concerned about the board making a type II error; he does not want his proposal to be incorrectly accepted should it turn out to be a low-output project. He, therefore, benefits by appointing the most qualified outside director possible.

Conventional wisdom also suggests that opportunistic CEOs appoint inside directors to capture the board and, if this is not an option, appoint outsiders with relatively low ability (e.g., someone with no industry experience). Our analysis shows that even this intuition does not always hold. Consider a case where uncertainty about a project’s output is sufficiently high that the loyal manager appoints an outside director to benefit from the board’s advisory role (as noted above). The opportunistic manager weighs private benefits against the market value of his equity stake – because appointing an insider would reveal he is opportunistic, which would adversely affect the firm’s market value. An important takeaway here is that the directors’ advisory function and market pressure drive strategic director appointments, and, in some cases, even the opportunistic CEO appoints independent outside directors.

We also examine board voting strategies when the directors share information, reach a consensus, and then vote as a single group. It turns out that the board’s equilibrium voting strategies are surprisingly similar to the directors’ strategies when they vote independently of each other, but with one important difference: The directors can now coordinate their votes. We find that, in some instances, the directors approve the manager’s proposal only when they all have information supporting it. This strategy reduces the likelihood that the board commits a type II error. A question that naturally arises here is whether the manager would want directors to reach a consensus before voting or vote independently of each other.

Surprisingly, we find that even loyal managers would sometimes like the directors to reach a consensus but vote independently at other times. The key to this finding is, once again, the board’s advisory role. When loyal managers face high uncertainty, they prefer that directors reach a consensus to minimize the likelihood of a low-output project being approved (i.e., reduce type II error) – the demand for the board’s advisory role is more pronounced. Interestingly, however, loyal managers would prefer that directors not share information when uncertainty is low. The reason is that the loyal manager has considerably more information than the directors (i.e., he knows that he is proposing a high-output project) and therefore does not benefit much from the board’s advisory role. Inducing information sharing between the directors works to his disadvantage because he has to contend with the likelihood that the board will reject his project (type II error).

We provide insight into how managers can exploit their influence over nominating directors to shape the board’s equilibrium voting strategies. We show that, in the presence of an adverse selection problem, market pressure plays an important disciplinary role by inducing self-serving managers to appoint independent outside directors – even when they can capture the board by appointing insiders. Finally, we show that managers can use their influence more subtly by nominating independent outside directors to avoid attracting attention, while still being strategic about who they nominate.

This post comes to us from professors George Drymiotes at Texas Christian University and Shiva Sivaramakrishnan at Rice University. It is based on their recent article, “Strategic Director Appointments,” available here.