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1 February 2015 CFA Institute Journal Review

Co-Opted Boards (Digest Summary)

  1. Santosh Pokharel

Not all independent directors are effective monitors of a company’s management. Directors who are appointed after the CEO of the company takes office are not as effective monitors as directors who are appointed before the CEO takes office and are independent. Directors who are appointed after the CEO takes office have an allegiance to that CEO. As their representation increases on the board, the board’s monitoring decreases, management’s pay increases (not tied to performance metrics), and investment increases.

What’s Inside?

The authors segregate company board members into two categories: co-opted and non-co-opted. Co-opted board members are those who were appointed after the CEO of the company took office, whereas non-co-opted members are those who were appointed before the CEO’s appointment. The authors also control the two categories for level of independence. They find that co-opted board members are less effective monitors than non-co-opted independent directors.

How Is This Research Useful to Practitioners?

Board members are supposed to be effective monitors of management’s (especially the CEO’s) performance. They are generally experienced individuals who have expertise and add value to a company’s board—a decision-making body. Moreover, board members are supposed to be independent of a company’s management.

But in reality, board members, especially those appointed after the CEO of the company takes office, have some allegiance to the CEO and may be lax in effectively monitoring the CEO’s performance. With a better understanding of the composition of company boards, equity investors may want to filter out companies that have a large share of co-opted members on their board.

The authors find that boards with more co-opted members are less likely to fire an underperforming CEO, more likely to approve increases in the CEO’s pay, and more likely to approve investments recommended by the CEO. These findings generally hold true even if the board members are independent but co-opted. All of these findings have implications in terms of companies’ long-term valuations.

How Did the Authors Conduct This Research?

The authors’ main independent variable is the ratio of co-opted (or captured) board members to total board size. Other key variables are CEO forced turnover, CEO pay, CEO pay–performance sensitivity, firm’s investment, and independence of the board (defined as the proportion of independent directors on the board).

The authors test four main hypotheses regarding companies with increasingly co-opted boards: (1) the sensitivity of CEO turnover to firm performance decreases, (2) CEO pay level increases, (3) CEO pay–performance sensitivity decreases, and (4) the firm’s investment increases.

They use the RiskMetrics database to gather information about directors of S&P 500 Index, S&P MidCap 400 Index, and S&P SmallCap 600 Index firms during 1996–2010. They use compensation data from ExecuComp, accounting data from Compustat, and stock return data from CRSP. The resulting sample excludes firms incorporated outside the United States. The firms that are part of the sample have an average of $5.3 billion in sales, 10 board members, a co-option mean value of 0.47 (meaning that almost half of the board members are co-opted), and independence of 0.69. The authors’ findings indicate that co-opted directors, irrespective of whether they are independent, are sympathetic to the CEO.

Abstractor’s Viewpoint

The authors’ findings that not all independent directors are effective in terms of monitoring the performance of CEOs present new questions and scope for future research in corporate governance. If independent directors who are co-opted show their allegiance to the CEO, as the authors’ findings indicate, how can these directors still be defined as independent?

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