Network connections within committees and board governance effectiveness

• Published date: 01 July 2022
• Author: Hong Zhao
• Date: 01 July 2022
• DOI: http://doi.org/10.1111/corg.12409

ORIGINAL ARTICLE

Network connections within committees and board

governance effectiveness

Hong Zhao

Department of Finance, NEOMA Business

School, Reims, France

Correspondence

Hong Zhao, Department of Finance, NEOMA

Business School, 59 Rue Pierre Taittinger,

Reims 51100, France.

Email: hong.zhao@neoma-bs.fr

Abstract

Research Question/Issue: The paper studies how network connections within board

committees affect corporate governance effectiveness.

Research Findings/Insights: Using detailed director biographical data of a large

U.S. sample, we find that firms with more connections among compensation

committee members exhibit less CEO excess compensation, and firms with more

connections among audit committee members exhibit less earnings management.

These positive effects of connections on corporate governance are more pronounced

when a committee has shorter joint tenure, when the firm's information is more

opaque, when the firm's CEO is more powerful, or when external governance is

weaker. To address endogeneity concerns, we further exploit exogenous departures

of directors and continue to find that connections among committee members lead

to more effective governance.

Theoretical/Academic Implications: Our paper's findings suggest that network

connections among directors improve governance effectiveness. This relation is

consistent with sociology views that social connections foster information sharing,

opinion exchange, and coordination. Our paper complements previous studies on

board connections that mainly focus on whether connections between boards and

CEOs impair board monitoring. Our paper also shows that director network

connection is an important board characteristic.

Practitioner/Policy Implications: Our paper's results lend support to the perspective

that director network connections can be valuable to firms. Network connection with

other board members is an important part of a director's human capital. Therefore,

hiring new directors that are connected to the incumbent members can be beneficial

to firms at least in certain settings.

KEYWORDS

board committee, CEO compensation, corporate governance, earnings management, network

connection

1|INTRODUCTION

Boards of directors form a key corporate governance mechanism.

Recent studies on boards of directors go beyond traditional character-

istics, such as size and independence, to more sophisticated aspects

such as the way a board is formed and the way it interacts with other

agents of the firm. Among these studies, a burgeoning literature

exploits the recently available data on directors' biographies and

examines how directors' social connections with firm top hierarchies

affect corporate governance effectiveness. Researchers find that

Received: 18 April 2021 Revised: 18 October 2021 Accepted: 20 October 2021

DOI: 10.1111/corg.12409

Corp Govern Int Rev. 2022;30:421–441. wileyonlinelibrary.com/journal/corg © 2021 John Wiley & Sons Ltd 421

network connections between directors and CEOs improve the

board's advising function by facilitating information dissemination

(e.g., Kang et al., 2018; Schmidt, 2015) but at the same time impair

the board's monitoring function by undermining directors' true inde-

pendence (e.g., Bruynseels & Cardinaels, 2014; Fracassi & Tate, 2012;

Hwang & Kim, 2009; Pan et al., 2020). However, these existing stud-

ies on director social connections mainly focus on connections

between directors and top executives. Little is known about whether

social connections between independent directors within a board have

any effect on governance effectiveness. Our paper aims to fill this

gap. In particular, we examine connections within the compensation

committee and within the audit committee to understand their effects

on board monitoring effectiveness.

Existing studies in sociology, management, and finance provide

two different perspectives on whether committee connections

improve or undermine the effectiveness of board governance. On one

side, it is well documented in sociology literature that people are more

willing to share information with those who they have social connec-

tions with (Cross et al., 2004; McPherson et al., 2001). Accordingly,

management and finance studies show that social connections

between individuals facilitate information transfer in security markets,

between firms, and within firms (e.g., Cohen et al., 2008; Kang et al.,

2018). Similarly, connections have been shown to foster opinion

exchange by encouraging directors to voice concerns and opposing

views on corporate strategies (Westphal & Bednar, 2005). Besides

better communication, network connections can also enhance com-

mittee coordination, giving committees a stronger voice to influence

corporate governance. Given these reasons, we expect network con-

nections between board committee members to enhance governance

effectiveness.

On the other side, committee connections could also be a gover-

nance concern. Connected directors may form groupthink, a term used

by Janis (1982) for a dysfunctional mode of decision process that

obstructs independent critical thinking and effective governance. Even

without groupthink, connected directors may lack diversity in experi-

ences and perspectives. By definition, connected directors often

attended the same schools or have worked in the same firms, so they

are likely to form repetitive functional backgrounds, which may have

negative consequences on team outcomes as shown in the manage-

ment literature (Ancona & Caldwell, 1992; Certo et al., 2006;Simons

et al., 1999). In this case, socially connected committees may deliver

less effective governance. Yet, to the degree that compensation and

audit committee's duties require specific but relatively single expertise,

the costs of directors'functional repetition canbe limited in our setting.

Given these two competing arguments on the value of committee

connections, we turn to data to empirically examine whether commit-

tee connections improve or deteriorate corporate governance. We

focus on two committees with independent directors only, namely the

compensation committee and the audit committee. Our sample con-

sists of a large set of U.S. public firms between 2000 and 2017. Using

detailed director biographical data, we identify network connections

between directors established via past employment, current employ-

ment, education, and other nonprofessional activities. For our sample

firms, 39% of the compensation committees and 37% of the audit

committees have at least one pair of connected members.

The empirical results on both the compensation and the audit

committee suggest that committee connections positively affect cor-

porate governance effectiveness. Within the compensation commit-

tee, having more connections is associated with significantly less CEO

excess compensation. This is particularly the case for equity-based

compensation, probably due to the more complicated nature of

designing equity-based compensation, which requires more informa-

tion sharing and opinion exchange. Within the audit committee, hav-

ing more connected members is associated with significantly less

earnings management. Both of these results suggest that the gover-

nance effectiveness-enhancing channel dominates. Moreover, the

positive effects of committee connection on corporate governance

are more pronounced when the committee members have shorter

joint tenure, when the firm's information is more opaque, when the

CEO has greater power at the firm, and when external governance is

weaker—all are situations that could benefit even more from connec-

tions among the independent committee members.

As board structures are endogenously chosen by firms, endo-

geneity is a common concern. To provide further evidence on the cau-

sality of our results, we exploit changes in committee connection

caused by director deaths. Using a difference-in-differences approach,

we find that compared to departures of unconnected committee

members, departures of connected members lead to a deterioration in

corporate governance: The level of CEO compensation and the mag-

nitude of earnings management significantly increase. These results

further illustrate the value of committee connection on governance

effectiveness.

Our paper contributes to several strands of literature. First, it

belongs to the growing literature that examines the effects of network

connections on financial markets and firms. Several studies show that

network connections improve information exchange between firms

and other agents in financial markets, such as banks (Engelberg et al.,

2012), mutual funds (Cohen et al., 2008), venture capitalists

(Hochberg et al., 2007), and sell-side analysts (Cohen et al., 2010).

With respect to network connections across firms, Fracassi (2017)

and Shue (2013) find that firms with socially connected executives

exhibit similar strategies in acquisitions, capital investment, and finan-

cial policy. Researchers have also examined network connections

within firms. Yet, these studies mostly focus on connections between

board of directors and managers, aiming to explain whether these

connections improve or deteriorate boards' monitoring and advising

roles (Fracassi & Tate, 2012; Hwang & Kim, 2009; Kang et al., 2018;

Schmidt, 2015; Pan et al., 2020). We extend these studies on intrafirm

connections to connections within the board of directors. Our paper

shares some common grounds with a recent study by Ke et al. (2019)

to the degree that both papers examine how social connections

improve information dissemination and opinion exchange within a

firm. Yet, our paper differs from Ke et al. (2019) in at least the follow-

ing two aspects. First, the two papers investigate two different groups

of individuals in firm top hierarchy: We focus on independent direc-

tors in compensation and audit committees, while Ke et al. (2019)

422 ZHAO