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No Return on Independence

It's a recurring theme in CE's own hallmarks of good corporate governance-a good board is an independent board. But will board independence pay off on the bottom line? The authors attack the premise that board independence plays a critical role in company performance. And a new study supports their view.

The primary responsibility of the board of directors is to represent-some would say protect-the interests of the shareholders. But their effectiveness in doing so has been subject to intense criticism. The essence of the argument is that too many contemporary boards are comprised of members who are not independent of firms’ management.

The two culprits cited are “inside” directors and “affiliated” directors, with the common theme that these types of directors are unlikely to provide a dispassionate evaluation of a CEO’s performance. Many observers believe that inside directors, as employees of the firm who usually report to the CEO on a day-to-day basis, are unlikely to be critical of the CEO.

And similar doubts are often voiced about affiliated directors, who have close personal and/or professional relationships with the CEO or the firm. What constitutes an “affiliated” or “6b” director is set forth in SEC Regulation 14A, Item 6(b), and includes former employees, as well as those with family ties or business relationships with the firm. Such relationships, some observers suggest, may also temper directors’ ability to offer objective criticism. As a result, most critics argue that boards of directors should be largely comprised of members who are not firm employees and who are not engaged in close personal and/or professional relationships with the CEO or the firm. In short, boards of directors should be independent.


None of this would be of any consequence except that the independence of the board of directors is widely believed to affect corporate performance. John Biggs, CEO and chairman of TIAA-CREF, one of the largest U.S.-based institutional investor funds, is a resolute proponent of the view that “…those [companies] with able and qualified independent directors…will eventually outperform companies that do not have such boards.”

The perspective that board independence matters is widely, and sometimes aggressively, held. In addition to the SEC requirement that affiliated directors be identified in proxy materials, major stock exchanges have guidelines concerning the service of independent directors on nominating, compensation, and audit committees.

Without a shadow of a doubt, however, it is the activist institutional investor community that has been the vanguard of corporate governance reform. These institutional investors hold some 50 percent Of corporate equity. Moreover, these groups,€. primarily private and public pension funds, in concert with the academic community, are persuaded that the independence of the board is related to corporate financial performance-and some 40 years or more of examination have not settled the issue.

This should be easy: All we need is some measure of board independence and another for financial performance to determine if, in fact, companies with higher proportions of independent directors also have better financial performance. Yet, in past efforts that’s been easier said than done. Drawing on decades of research, attempts have been made to summarize the relationship between board composition and corporate performance with uniform, if less than satisfying, results. The relationship has been described as “vexing,” “contradictory,” “mixed,” and “inconsistent.”

Beyond the technical issues (e.g., sample size-number of companies in the study-sampling error, reliability, range restriction, use of confidence intervals rather than statistical significance), this set of hypothetical studies would almost certainly have been conducted in various venues, at different times, with firms of various sizes, while relying on a myriad of different measurements of board independence and corporate financial performance. Furthermore, a review of the studies examining board independence/financial performance relationships reveals no fewer than nine ways to measure what constitutes an “outside” director. Similarly, there are no fewer than 10 ways to define an “affiliated” director. There are also “interdependent” directors, or directors appointed to the board during the current CEO’s tenure. The measurement of corporate financial performance is even more challenging. Should we rely on accounting returns-ROA, ROI, ROE, ROS, and profit margin? If so, which? And for one year? A three-year average? A five-year average? Or maybe market returns would be a more appropriate?

A meta-analysis, a relatively new technique designed to facilitate combining separate studies to reach a responsible summary of their results, offers a more effective approach. This method addresses both the technical issues mentioned earlier, and also allows the direct comparison of studies relying on different measurements. Professors John E. Hunter and Frank L. Schmidt, the acknowledged gurus of meta-analysis, assert that the “conflicting” results that often result from narrative reviews-the prior method of choice-are often artifactual. That is, there is no actual relationship underlying such results. Reliance on narrative reviews, as opposed to meta-analysis, say Hunter and Schmidt, may lead to “terrible errors” in review studies.

The meta-analytical technique was recently used to analyze the board independence/corporate financial performance question for more than 40 years of data, for 159 studies, and for more than 40,000 companies. The results are easily interpreted: There is no relationship between the independence of the board of directors and corporate financial performance-none whatsoever.

This result does not turn on the size of the organization, nor on the method of rating financial performance. From entrepreneurial companies to those in the Fortune 500, there’s no evidence of a board independence/financial performance relationship. And whether relying on accounting or market-returns, there is no such relationship. Lastly, the various measurements of board independence are not at issue.


As noted earlier, the often posited relationship between an independent board and corporate financial performance is intuitively appealing. “Think about it: No one questions that the CEO’s performance matters a great deal to corporate performance,” reported Robert A. G. Monks and Nell Minow, presidents of Institutional Shareholder Partners and Institutional Shareholder Services, respectively. “And the board is charged with hiring the best CEO it can find, helping the CEO set goals and priorities for the long-term viability of the corporation, monitoring his or her accomplishments against those goals and, if necessary, replacing him or her in a timely manner. How can board performance not matter to corporate performance?”

True, but therein lies the problem. While we don’t doubt for a moment that board performance is a critical factor in corporate performance, we would argue that the common notion of “board independence” is a poor proxy for board performance. Moreover, the evidence sustains that view. For example, Coca-Cola was among those with the lowest scores for board independence in Business Weeks “The Best and Worst Boards.” It was also noted that compensation policies and benefits at Coca-Cola are “the sort of golden goodies that some believe promote board passivity and pro-management bias.” This is the same Coca-Cola that was No. 2 for the 100 largest companies in the Wall Street Journal Shareholder Scorecard for 10-year average returns to shareholders.

Clearly, some boards are better than others. What’s not clear is that the independence of the board is remotely related to the quality of the board or the performance of the company.

Dan R. Dalton is dean and Harold A. Poling chair of strategic management at the Kelley School of Business, Indiana University. Catherine M. Daily is associate professor of strategic management at the Kelley School f Business, Indiana University. Both Dalton and Daily are widely published in the area f corporate governance. This article is based, in part, on the original study published in the Strategic Management Journal (1998, Vol. 19, No. 3).


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