The market for independent directors

• Date: 01 November 2018
• Author: Lei Chen,Frank Moers
• DOI: http://doi.org/10.1111/corg.12240
• Published date: 01 November 2018

ORIGINAL MANUSCRIPT

The market for independent directors

Lei Chen

1

|Frank Moers

2

1

School of Accounting, Collaborative

Innovation Center for Accounting Function

Extension and National Governance Capacity

Improvement, Southwestern University of

Finance and Economics, Liutai Avenue 555,

Wenjiang District, Chengdu 611130, China

2

Maastricht University School of Business and

Economics, Tongersestraat 53, Maastricht

6211LM, The Netherlands

Correspondence

Lei Chen, Associate Professor, School of

Accounting, Collaborative Innovation Center

for Accounting Function Extension and

National Governance Capacity Improvement,

Southwestern University of Finance and

Economics, Liutai Avenue 555, Wenjiang

District, Chengdu 611130, China.

Email: leichen@swufe.edu.cn; leichen.

swufe@foxmail.com

Funding information

the National Natural Science Foundation of

China, Grant/Award Number: 71502143

Abstract

Manuscript Type: Empirical

Research Question/Issue: Using the US setting from 1996 to 2006, we examine

how the market for independent directors responds to increasingly stringent scrutiny.

Research Findings/Insights: Despite the unambiguous increase in the demand for

independent directors (with financial expertise) since 2000, independent directors

(with financial expertise) have not expanded their board seats but reduced them.

Incumbents are more likely to depart from firms that are costly to advise and monitor,

but only post‐2000. Meanwhile, we document an influx of new directors to the labor

market. These new directors are more likely to be hired by firms that are costly to

advise and monitor post‐2000 and are more likely to be financial experts so that

the increased demand can be satisfied.

Theoretical/Academic Implications: We provide evidence that the demand–supply

framework adequately captures the market for independent directors. In particular,

rather than the demand effect simply dominating the supply effect for a particular

group of directors, the demand is fulfilled by opposing supply effects of different

types of directors, specifically incumbents versus new entrants.

Practitioner/Policy Implications: Policy makers should not underestimate the (dis)

incentives that directors have to provide services to the market when initiating future

governance reforms (e.g. writing the limit on the number of directorships held by

directors into best practice/law). Firms, especially ones that are costly for directors

to advise and monitor, are encouraged to explore effective ways to retain valuable

directors and prepare thorough succession plans whenever the supply of directors

is expected to shrink.

KEYWORDS

corporate governance, directorship portfolio adjustments,independent directors, monitoring and

advising costs, sarbanes–oxley act

1|INTRODUCTION

As I understand it, Sarbox dictates that I not Chair any

committee due to the size of my holdings, not be on the

compensation committee because of the loan I once

made to the company, not be on the governance

committee, and it even dictates that some other board

member must carry out the perfunctory duties of the

Chairman. What's left is liability and constraints on

stock transactions, neither of which excite me.

(An excerpt from the resignation letter by the former

chairman Jim Clark of Shutterfly, 2007)

The literature examining the market for directors has proliferated.

In particular, researchers focus on whether board appointments are

Received: 17 January 2017 Revised: 29 June 2017 Accepted: 18 March 2018

DOI: 10.1111/corg.12240

Corp Govern Int Rev. 2018;26:429–447. © 2018 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 429

associated with the effectiveness of directors' monitoring of the man-

agement or with directors' friendliness toward the management (e.g.,

Bouwman, 2011; Coles & Hoi, 2003; Eminet & Guedri, 2010; Ertimur,

Ferri, & Stubben, 2010; Harford, 2003; Helland, 2006; Lel & Miller,

2015; Levit & Malenko, 2016; Marshall, 2010; Zajac & Westphal,

1996). Using the US setting during the period 1996–2006, our paper

aims to shed light on an important issue that is overlooked by previous

studies, that is, how the market for independent directors responds to

increasingly stringent regulations and enhanced public scrutiny. Our

analyses are performed within a demand–supply framework. Since

the demand for independent directors, especially for those with

financial expertise, has increased unambiguously due to regulatory

requirements (see Section 2.1), we focus on the supply side of the

market, in which the changes appear to be less straightforward at

first sight.

Our first analysis examines a key attribute of the market for inde-

pendent directors: the busyness of directors. We follow the previous

literature and use “busyness”to refer simply to the number of board

seats that an independent director has (see Core, Holthausen, &

Larcker, 1999; Ferris, Jagannathan, & Pritchard, 2003; Fich &

Shivdasani, 2006) rather than the workload involved in the board

service. We find that the busyness of independent directors does

not change during the period from 1996 to 1999. However, as scru-

tiny from the stakeholders escalates, independent directors start to

reduce their number of directorships after 2000 to assure that the

workload and risk involved in the board service are within their own

capacity (time) constraint. The same pattern can be observed if two

board‐level variables are examined: board capital and the percentage

of busy directors. Having established that independent directors

become less busy after 2000, we next perform a directorship portfolio

analysis, which compares independent directors' departures with the

average independent directorships held by each director across differ-

ent time periods. We document that after 2000 (especially after

2002), when public scrutiny intensifies, the firms that independent

directors drop are more costly to monitor and advise than the firms

that they keep. The third analysis starts with an examination of the

changes in the composition of the director pool. Independent directors

in general reduce their number of board seats after 2000 on the one

hand, but firms' demand for independent directors unambiguously

increases due to various mandates on the board structure on the other

hand. We demonstrate that the gap between the decreased supply

and the increased demand is filled by an increased number of directors

who newly enter the market. We also examine the appointments of

those new directors and find that after 2002 they are more likely to

sit on the boards of firms that are costly to monitor and advise. This

implies that the vacancies created by the departure of incumbent

directors tend to be filled by directors who are new and are willing

to take more risk to gain a foothold in the market. We further find

that, among all independent directors, financial experts reduce their

external directorships, meaning that the supply of independent direc-

tors with financial expertise decreases. This result is logical, because

these directors are most likely to be confronted with the increased risk

associated with the regulatory change and public scrutiny. However,

the demand for such financial experts actually increases as a result

of the regulatory requirements. It turns out that unseasoned new

directors are more likely to have financial expertise after 2002 so

that the gap between the demand and the supply of financial experts

can be satisfied.

Our paper contributes to the literature in two ways. First, several

papers explicitly or implicitly adopt the demand–supply framework to

examine the market for directors. For instance, Knyazeva, Knyazeva,

and Masulis (2013) find that board independence is contingent on

the depth of the local talent pool. In the Chinese setting, Giannetti,

Liao, and Yu (2015) find that individuals with foreign experience are

scarce and that not all firms with a similarly high demand for directors

with foreign experience can be satisfied; as a result, the firms that are

able to hire directors with foreign experience enjoy performance

improvements. Linck, Netter, and Yang (2009) conclude that, due to

the Sarbanes–Oxley Act 2002 (SOX), firms increase directors' com-

pensation and insurance, work them harder, and hire more indepen-

dent directors and directors who are financial experts. Adding to this

literature, we provide strong evidence that the demand–supply frame-

work adequately captures the (changes in the) market for independent

directors. In particular, we not only show the trend towards a reduced

number of board seats per independent director but also document an

influx of directors who are new to the market. Further, we show that

incumbent independent directors who are financial experts decrease

their directorships and that the new entrants to the market are more

likely to be financial experts to offset this decrease in the supply. Thus,

rather than the demand effect simply dominating the supply effect for

a particular group of directors, we show that the demand is fulfilled by

opposing the supply effects of different types of directors, that is,

incumbents versus new entrants.

Second, our study deepens the understanding of director turn-

over, especially the role played by non‐financial incentives.

Researchers argue that power, prestige, reputation, career concerns,

and implicit incentives have a huge effect on the supply of indepen-

dent director services available to a firm. For instance, Fich (2005)

and Yermack (2004) find that greater visibility of larger firms is associ-

ated with a greater likelihood of obtaining additional directorships.

Fich and Shivdasani (2007) and Srinivasan (2005) document that direc-

tors suffer from labor market penalties once their firms become

involved in financial fraud. Fahlenbrach, Low, and Stulz (2013) report

that outside directors are more likely to leave the firms that will per-

form poorly or disclose adverse news for reputational concerns.

Masulis and Mobb (2014) show that busy independent directors dis-

tribute their effort unequally according to the directorship's relative

prestige. We advance the literature by showing that a particular

non‐financial disincentive, specifically the cost of monitoring and

advising, has become a crucial determinant of independent director

departures in the period when scrutiny is high but not in the period

when scrutiny is low.

The above‐documented restructuring of the market for indepen-

dent directors manifests unintended consequences of intensified

regulatory monitoring and public scrutiny. Policy makers should not

underestimate the (dis)incentives that directors have when initiating

future governance reforms. Firms, especially ones that are costly for

directors to advise and monitor, are encouraged to explore effective

ways to retain valuable directors and prepare thorough succession

plans whenever the supply of directors is expected to shrink.

430 CHEN AND MOERS