Do Independent Directors Cause Improvements in Firm Transparency? (Digest Summary)

It is generally believed that an increase in the proportion of independent directors on a firm’s board improves a firm’s transparency, which supports the hypothesis that independent directors need transparency to undertake their duties. Two directions of causality between board structure and the proportion of independent directors are considered. Transparency may be increased as a result of actions of independent directors. But it can also be argued that transparency and, therefore, board independence are highly dependent on such firm characteristics as size, growth opportunities, and business environment. The authors’ findings suggest that requiring firms to increase the proportion of independent directors leads directly to increased corporate transparency because of the fact that independent directors need transparent information to exercise their role.

The authors’ findings show that the level of correlation between independence of board members and corporate transparency is determined by a number of factors, including (1) level of independence of the audit committee, (2) information processing cost, and (3) degree of managerial entrenchment. For example, a firm that has a relatively independent audit committee, low information processing cost, and low degree of managerial entrenchment will have a strong positive relationship between independence of board members and corporate transparency.

In addition, the authors find that noncompliant firms that remove inside and gray directors maintain the same number of independent directors. The remaining independent directors may have a greater ability to address any information transparency issues owing to the removal of inside control on the board.

To test the hypothesis that the proportion of independent directors causally determines corporate transparency, the authors use an exogenous factor (a shock) to alter the proportion of independent directors and test how a firm’s information flow responds to this exogenous factor. They use the regulation issued by the NYSE and NASDAQ in 2003 that requires most listed companies to have a majority (more than 50%) of independent directors on their board as the shock factor.

The authors use a sample of 1,846 firms and compile data on board independence and corporate transparency, among others. They define an independent board member as an outsider with no material relationship to the firm. To quantify corporate transparency, they use the bid–ask spread of a firm’s stock price, with the rationale that higher corporate transparency and informational flow result in a lower bid–ask spread.

The issue of corporate governance is currently capturing attention (Professor Jean Tirole recently won the Nobel Prize in Economics, and some of his seminal work was in this area). The authors’ research adds to the existing body on corporate governance; they try to delve deeper into the issues of how, and if, independent directors can improve corporate transparency. Their findings support the hypothesis that an independent board is more transparent than a less independent board. What is new and useful in this article is the finding that firms deliberately try to alter their corporate transparency to suit the informational demand of directors.