Corporate boards are charged with the critical tasks of assessing top management performance and making compensation and dismissal decisions.  Moreover, boards serve as a valuable source of advice and counsel to top management.  While board members tend to be highly talented individuals, they make decisions collectively as a group.  The quality of board decisions is, therefore, likely to be materially influenced by group dynamics.  While the topic of group dynamics has been extensively studied by social psychologists, the finance literature contains little evidence on its impact on firm value.  In a recent article titled “Director Overlap: Groupthink versus Teamwork,” we assess the empirical importance of group dynamics in the context of corporate boards.

We focus on two aspects of group dynamics — groupthink and teamwork – that arise from the same construct of board structure, what we term as “director overlap.”  Overlap captures the extent of common service by the board of directors.  Higher values imply greater time spent together by directors in board service.  Greater overlap among directors can lead to greater cohesiveness of the group, which in turn can result in groupthink (negative synergies) or in better teamwork (positive synergies).

What is groupthink? Janis (1971, 1972) defines it as a mode of thinking where the group attempts to minimize conflict and achieve consensus without critical evaluation of alternative viewpoints and by ignoring or discouraging dissenting opinions.  According to Janis, group cohesiveness and context (such as decision complexity and external threats from the environment) make groupthink more likely.  Janis uses several case studies – including the Bay of Pigs invasion – to illustrate how groups of smart individuals can still make bad decisions if susceptible to such group dynamics.  Groupthink has been blamed for other high-profile failures, such as the Challenger space shuttle disaster, the collapse of Enron and WorldCom, as well as for the global financial crisis of 2008-09. Nobel laureate Robert Shiller attributes the failure of the U.S. Federal Reserve to forecast the financial crises to groupthink.  By extension, corporate boards, even if they include highly talented individuals, will still make costly mistakes if they suffer from groupthink.  Greater cohesiveness of the board can, therefore, be harmful for firms by promoting groupthink.

Greater cohesiveness, however, can also have an offsetting effect in terms of promoting more effective teamwork.  Malenko (2014), for instance, argues that costly communication between directors is a critical problem in board decision-making. Intuitively, greater overlap among board members can facilitate better communication.  This, in turn, can lead to better teamwork and more effective decision-making.  Westphal (1999) notes that “friendship ties among group members lead to higher levels of task-related communication and mutual assistance by enhancing interpersonal trust.”  Pick and Merchant (2012) highlight this conflicting role of cohesiveness by noting that high cohesion and friendship among board members can lead to groupthink, but low cohesiveness can lead to destructive conflict among board members.

Based on this discussion, we develop hypotheses regarding the types of firms that are hurt more by groupthink versus those that benefit more from teamwork.  In dynamic environments, the costs of poor decisions will be relatively large.  Such environments are more likely to require that the board consider (or even develop) and critically evaluate multiple alternatives and carefully pick the best of those alternatives.  But boards that are subject to groupthink “limit [their] discussions to a few alternative courses of action (often only two) without an initial survey of all the alternatives that might be worthy of consideration” (Janis, 1971).  Thus, greater groupthink should be particularly damaging for firms in dynamic environments.  This leads to our first hypothesis: Greater director overlap will have a more negative effect on firm value for dynamic firms.

We also focus on the positive aspects of director overlap, namely teamwork.  Higher director overlap implies that directors have spent more time together on the board.  As a result, coordination and communication costs among board members is lower. Coordination and communication costs are likely to be more significant in complex firms, such as firms that are large, and those that operate in multiple product markets.  In such firms, overlap is likely to be more beneficial.  For example, Coles, Daniel, and Naveen (2008) argue that more complex firms require greater advice from their boards.  Directors have to communicate with each other effectively to decide the best strategy for the firm.  Greater overlap helps directors to communicate with each other more effectively.  This leads to our second hypothesis: Greater director overlap will have a more positive effect on firm value for complex firms.

To test our hypotheses, we first construct three proxies for overlap to capture the extent of common service of the board: Board Intra-connections, Board Tenure, and Board Stability.  Board Intra-connections is a measure of the average years of common service among the outside directors.    Board Tenure is the sum of all outside directors’ tenure divided by board size, and Board Stability is the number of outside directors that have served more than nine years divided by board size.  Board Overlap is a factor score estimated using these three variables, with higher values implying greater board cohesiveness.

We next construct four proxies for firms facing more challenging environments.  For ease of exposition, we term these as our Dynamism proxies since our measures capture the extent to which the firm’s industry conditions are changing quickly.  Our proxies are: (i) Industry Growth (sales); (ii) Industry R&D; (iii) Industry Mergers (as measured by the merger frequency; Harford, 2005); and (iv) Industry Fluidity.  Hoberg et al. (2014) argue that a firm’s fluidity score captures changes, threats, and external pressures in the firm’s product market due to actions and tactics of competitors. Firm Dynamism is a factor score based on these four variables.  Greater values of this score indicate firms in more dynamic industries. Firm Complexity is computed as a factor score (as in Coles et al., 2008) based on firm sales, number of business segments, and leverage.

We test our hypotheses using board data for a large cross-section of firms (S&P 1500 firms) for a long time-period (1996-2018).  In keeping with much of the corporate governance literature, we use Tobin’s q as a measure of firm value.  This is the sum of the market value of equity plus book value of debt divided by the book value of assets.

Consistent with our two predictions, the effect of overlap on firm value is more negative in firms facing a dynamic market environment and more positive in complex firms.  Additionally, we show that the negative effect of groupthink is more pronounced in firms that have more insulated boards (fewer board connections) and more control by the CEO on board agenda (CEO/chairman duality and prior to the 2003 Exchange-mandated executive sessions of the board).  Interestingly, we do not find that gender diversity mitigates the negative effect of groupthink.

We believe that endogeneity is not a significant concern in our study.  First, boards face significant adjustment costs.  Firms have very limited low-cost tools to drive refreshment to reduce overlap or instead to increase overlap on the board.  Second, our inclusion of firm fixed-effects in all the regressions controls for any firm-level omitted variables that are time invariant.  Third, we use industry-level, rather than firm-level, values of dynamism.

Our results have implications for a number of current governance debates.  For example, several commentators have called for term limits for directors.  In our context, the idea is that groupthink is more likely when the board is overly cohesive, which in turn is more likely when the same set of directors stays on the board together for a long time.  Our findings that groupthink is detrimental to firm value in dynamic firms and that teamwork is advantageous in complex firms suggest that setting term limits for directors may be desirable for dynamic firms and detrimental in complex firms.  Likewise, our findings have implications for other organizational choices, such as the use of a staggered board (rather than yearly director elections) and rules specifying a mandatory retirement age, that would affect director groupthink and teamwork.

This post comes to us from professors Jeffrey L. Coles at the University of Utah, Naveen D. Daniel at Drexel University, and Lalitha Naveen at Temple University. It is based on their recent paper, “Director Overlap: Groupthink versus Teamwork,” available here.