The effects of board independence on busy directors and firm value: Evidence from regulatory changes in Sweden

• Date: 01 January 2020
• Published date: 01 January 2020
• Author: Reda M. Moursli
• DOI: http://doi.org/10.1111/corg.12301

ORIGINAL ARTICLE

The effects of board independence on busy directors and firm

value: Evidence from regulatory changes in Sweden

Reda M. Moursli

Department of Business Administration, Lund

University School of Economics and

Management and the Knut Wicksell Centre for

Financial Studies, P.O. Box 7080, SE‐220 07

Lund, Sweden

Correspondence

Reda M. Moursli, Department of Business

Administration, Lund University School of

Economics and Management and the Knut

Wicksell Centre for Financial Studies, P.O. Box

7080, SE‐220 07 Lund, Sweden.

Email: reda.moursli@fek.lu.se

Abstract

Research Question/Issue: This paper examines the impact of changes in board

independence on the market valuation of Swedish firms. I exploit an exogenous

change to the rules of corporate governance in 2005, which requires large firms to

have majority independent boards, as a quasi‐experimental setting.

Research Findings/Insights: I use a regression discontinuity design and a difference‐

in‐differences approach to capture the reaction of the market to the new governance

rules, taking advantage of the fact that only large firms are required to comply with

the code. The results indicate that (a) the market reacts negatively to the enactment

of the new governance rules and (b) target firms that complied with the independence

requirement witnessed larger decreases in their market valuation compared with the

rest of the firms in the sample. The busyness of independent directors is a potential

explanation for the estimated negative effect of the increased board independence

on the market valuation of target firms. For instance, I find that independent directors

in target firms experienced a larger increase in their busyness compared with their peers

in nontarget firms. This increase in busyness is also more pronounced for independent

directors of complying target firms.

Theoretical/Academic Implications: The findings of this paper are in line with the-

oretical models that find that imposing quotas on the number of independent direc-

tors might not be optimal for all firms.

Practitioner/Policy Implications: This paper identifies board busyness as an impor-

tant consequence of requiring board independence in the Swedish context. The

results of the paper have implications for corporate governance policies that impose

quotas on board independence without limiting board busyness, especially when the

supply of directors is limited.

KEYWORDS

Corporate governance, board composition, director independence, corporate governance codes,

shareholder value

Received: 8 October 2018 Revised: 11 July 2019 Accepted: 12 July 2019

DOI: 10.1111/corg.12301

Corp Govern Int Rev. 2020;28:23–46. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg

23

1|INTRODUCTION

In recent years, the concept of good governance practices has formed

the basis for a wave of governance codes such as the influential 1992

Cadbury Report in the United Kingdom, the 2002 Sarbanes–Oxley Act

(SOX) in the United States, and the European Commission's 2003

Guide to Corporate Governance Practices in the European Union.

From these codes, it appears that regulators share similar views regard-

ing board independence in that a larger fraction of independent direc-

tors is encouraged, if not mandated. In 2005, a Corporate Governance

Code was enacted in Sweden (hereafter, “the code”) that requires large

firms to have majority‐independent boards. In principle, independent

directors are expected to improve the monitoring of management

(Hermalin, 2005) and contribute their expertise to improving firm per-

formance (Adams, Hermalin, & Weisbach, 2010). However, requiring a

majority‐independent board might not be optimal for every firm, as

argued by Adams and Ferreira (2007) and Raheja (2005). Moreover,

on the basis of empirical evidence, an understanding of the effect of

board independence on firm valuation is often limited by endogeneity

issues and the absence of a consensus in the literature regarding the

direction of this relation (Agrawal & Knoeber, 1996; Bhagat & Black,

2000; Bhagat & Bolton, 2009; Hermalin & Weisbach, 1991).

This paper investigates the effect of imposing a majority‐

independent board on firm's market valuation, measured using Tobin's

Q. I take advantage of the exogenous shock to board independence in

Sweden caused by the enactment of the code in 2005, which man-

dates that in large public firms, a majority of the board members must

be independent.

1

The Swedish code defines independence relative to

not just the firm and the management but also vis‐á‐vis the largest

owners. On the basis of a sample of 4,432 director‐year observations,

I measure board characteristics and aggregate them at the firm level,

resulting in a final sample of 256 firms and 512 firm‐year observations

from 2004 to 2005.

I use a regression discontinuity (RD) design to compare firms

around the threshold of compliance set by the code, defined as a mar-

ket capitalization above 3 billion Swedish krona (SEK). In such a set-

ting, differences in the market valuation of firms right above and

below the cutoff can be attributed to the enactment of the code. To

capture the change in the market valuation of firms, I use the differ-

ence in the natural logarithm of Tobin's Q from year‐end 2004 to

year‐end 2005, labeled Δln(Tobin's Q). I find that target firms experi-

enced a larger decrease in Δln(Tobin's Q) than did nontarget firms. This

result indicates that the market responded negatively to the indepen-

dence requirement after the code entered into effect in 2005. My sec-

ond finding is that boards are busier in target firms than in nontarget

firms. In fact, independent directors in target firms experienced a

higher increase in their levels of busyness in 2005 compared with

independent directors in nontarget firms. One explanation for this is

that independent directors are hired from a limited pool of directors,

which increases board busyness.

Using both an instrumental variable and a difference‐in‐differences

approach, I find that target firms that comply with the code experience

a larger decrease in firm value than do noncomplying firms. Complying

target firms also appear to have more busy independent directors

postcompliance than do noncomplying firms. The latter findings sup-

port the idea that requiring firms to have majority‐independent boards

has a causal effect on board busyness and shareholder wealth.

Specifically, the stronger decrease in Δln(Tobin's Q) for complying tar-

get firms suggests that the negative market reaction is more pro-

nounced for the majority‐independent board requirement compared

with the hiring of individual independent directors per se.

The contributions of this study are twofold. First, I contribute to a

growing literature that exploits regulatory changes in corporate gover-

nance to identify the causal effects of board independence on firm

outcomes. This study uses a quasi‐experimental setting where the pol-

icy change is exogenous. By contrast, studies of the relation between

board structure and firm performance often suffer from severe

endogeneity issues. As reported by Hermalin and Weisbach (1998),

causality can move in the opposite direction, where better performing

firms choose better corporate governance practices or changes in

board structure in response to previous bad firm performance.

2

In recent years, a growing literature has exploited regulatory

changes in corporate governance to identify causal effects of board

characteristics on firm outcomes. These exogenous shocks to gover-

nance offer quasi‐experimental settings where the causal relation

between changes to the board and firm performance can be investi-

gated within a RD design (recent examples include Cunat, Gine, &

Guadalupa, 2012; Iliev, 2010). In a study closely related to mine, Black

and Kim (2012) investigate the effects of a regulatory change in 1999

in South Korea mandating that large firms have a majority‐

independent board and an audit committee. They find that an increase

in board independence is associated with large gains in share price and

firm value. Their setting is perhaps closest to mine, especially as both

studies focus on countries with relatively small financial markets.

However, I find that the Swedish market reacted differently to board

independence compared with the Korean market.

Differences between my findings and those of Black and Kim

(2012) can be explained by the different economic contexts preceding

the adoption of the codes. The South Korean corporate governance

reforms in 1999 followed the East Asian financial crisis in 1997 and

1998. Several studies find that weak corporate governance had a sig-

nificant impact on the negative performance of South Korean firms

before the crisis (Joh, 2003) and during the crisis (Baek, Kang, & Park,

2004; Johnson, Boone, Breach, & Friedman, 2000; Mitton, 2002).

Mitton (2002) finds that firms with more transparent accounting dis-

closure, higher outside ownership, and lower corporate diversification

experienced significantly better stock performance during the crisis.

Baek et al. (2004) show that chaebol firms with high ownership con-

centration and firms with controlling shareholders whose voting rights

exceeded ownership rights experienced larger equity drops and worse

stock performance than did firms with larger foreign equity ownership

and better disclosure quality.

3

In Sweden, before the enactment of the new code in 2005, there

was no major market shock that led to market‐wide financial instabil-

ity or firm underperformance. The reforms of corporate governance

practices in Sweden in 2005 continued a process that started in the

MOURSLI

24