Why 9 Years Is a Lucky Number for Board Director Tenure and Effectiveness

A paper recently presented at the annual meeting of the American Accounting Association in Anaheim, California investigates the tenures of outside directors of more than 2,000 corporate boards during a 13-year period and finds them to be, on average, close to the level that yields the optimum in company market value.

The study, by Sterling Huang of the INSEAD Business School, finds the relationship between board tenure and firm value to be in the shape of an inverted U that reaches a peak at about nine years. In other words, other relevant factors being equal, the value of companies rises as the average tenure of their outside board members increases to nine years after which it falls off by as much as 10%. The pattern holds whether average tenures of boards are primarily the result of director turnover or simply the passage of time and whether the tenures of board colleagues are relatively diverse or similar.

As it turns out, this high point at nine years is not far from the actual corporate mean for outsider board tenure, which the study finds to be 8.35 years.

But there is still plenty of opportunity for investor grumbling, given that board-tenure averages among the more than 2,000 companies making up the study sample ranged all the way up to 31 years, almost four times the optimal level.

To gauge corporate value, Huang used a standard measure called Tobin’s Q, which is a ratio of two variables – roughly, the company’s market value (that is, its stock price multiplied by the number of stocks issued) divided by an amount equal to what it would cost to replace the firm’s assets. Since market value reflects investors’ assessment of the company, a high value for Tobin’s Q reflects investor approval of a firm and optimism about its prospects.

After attaining a peak when average board tenure reaches nine years, Tobin’s Q goes into decline as tenure increases, falling by about 10% by the time the average reaches 24 years, assuming other major financial, structural, and governance factors affecting firms’ market value are held constant.

Huang sees the inverted-U shape his research uncovers as reflecting a tradeoff between two factors — knowledge accumulation and independence. As directors acquire firm-specific knowledge early in their tenure, the result is better firm performance, but this continues, he finds, only up to some threshold level of board tenure beyond which learning gains are less than independence losses. In the words of the study, “for firms with short-tenured boards, the marginal effect of board learning dominates entrenchment effects, whereas for firms that have long-tenured boards, the opposite is true.” Eventually, “as tenure continues to advance, boards become ‘zombie boards’ as their oversight declines and firms engage in more value-destroying activity.”

In addition to investigating how the tradeoff between knowledge and entrenchment affects overall firm value, as measured by Tobin’s Q, the study probes whether a similar inverted-U pattern prevails in specific corporate policies and decisions. Huang finds this to be the case with respect to merger-and-acquisition performance, financial-reporting quality, readiness to replace CEOs, and strategic persistence and innovation but not in preventing opportunistic backdating of CEO option grants.

For example, “firms with very short- or very long-tenured board make suboptimal acquisition decisions, though for different reasons. For a short-tenured board, a lack of knowledge about the business makes it less effective in selecting an acquisition target. As tenure advances, learning allows the board to make better acquisition decisions, as suggested by the market’s reaction to acquisition announcements, but only up to some threshold level of tenure, beyond which familiarity with management weakens the monitoring capacity of the board, leading to inefficient investments that are less well-received by the market.”

A major challenge of the study was to ascertain that it was board tenure that affected firm performance, and not vice-versa — that is, high average board tenure was not just a reflection of the trouble poorly performing firms might have in attracting new directors. To probe this possibility, Huang analyzed the response of investors to the sudden deaths of directors, reasoning that significant stock movements in the immediate aftermath of the deaths would strongly suggest that causality ran from directors to performance and not the opposite way. The results not only suggested the former to be the case but provided confirmation of nine years as a significant dividing line: sudden deaths that move average board tenure towards nine years attract a three-day mean abnormal announcement return of plus 1.038%, while those that move board tenure away from nine years observe a mean abnormal announcement return of minus 1.429%.

The study also provides evidence that one size does not fit all companies when it comes to board tenure. Building on earlier research, Huang extracts from his sample firms with greater advising needs and those with greater monitoring needs. In the former group, consisting of companies with complex operations and many intangible assets, “board members likely require more time to acquire the knowledge needed to advise on the appropriate strategy,” and the optimal length of average board tenure turns out to be about 11 years. In contrast, among firms with great monitoring needs, such as those covered by few stock analysts or with weak shareholder power, “the marginal costs of entrenchment may quickly dominate the marginal benefits of leaning,” and firm value reaches a maximum at an average board tenure of about seven years.

The sample for the study consisted of companies in the S&P 1,500 during the period 1998-2010, a total of 2,158 firms that yielded 13,989 firm-years of data. For about 85% of the sample, outsiders constituted a board majority, and average board size (outsiders plus insiders) was 9.2 directors.

Surprisingly, the effect of board tenure on firm performance has been only sparsely studied, a striking contrast to the vast literature on the effects of diversity. As Huang writes at the outset of the paper, explaining his choice of subject, “Anecdotal evidence suggests that long board tenure is negatively associated with firm performance, and that shareholders are concerned about boards with long tenure. However, empirical evidence on how board tenure affects corporate decisions and firm performance is scarce.”

The paper, entitled “Zombie Boards: Board Tenure and Firm Performance,” was among hundreds of scholarly presentations at the American Accounting Association meeting, which drew more than 3,000 scholars and practitioners to Anaheim, CA from August 3 to 7. The AAA is a worldwide organization devoted to excellence in accounting education, research, and practice. Journals published by the AAA and its specialty sections include The Accounting Review, Accounting Horizons, Issues in Accounting Education, Behavioral Research in Accounting, Journal of Management Accounting Research, Auditing: A Journal of Practice & Theory, and The Journal of the American Taxation Association.

Read: https://aaahq.org