Kyonghee Kim, Elaine Mauldin, and Sukesh Patro
Outside Directors and Board Advising and Monitoring Performance
Journal of Accounting and Economics | Volume 57, Issues 2-3 (Apr 2014), 110-131

The effort and performance of directors on the boards of public corporations are generally examined from the twin perspectives of monitoring and advising company management. Recent research on corporate boards examines whether the board's effectiveness at monitoring tasks comes at the cost of its performance in advising tasks and vice-versa. While some recent empirical evidence supports such a view (Faleye-Hoitash-Hoitash JFE 2011), a commonly held opposing view is that the incremental efforts made in carrying out one type of task can have positive spillover effects in performing the other type of task. For example, to advise the CEO on optimum dividend policy the director needs to develop a proper understanding of the firm's investment opportunity set, but such understanding is likely to help the board in better monitoring the CEO's performance and compensation (Brickley-Zimmerman JAE 2010). In Kim-Mauldin-Patro (JAE 2014), we contribute to this discussion by examining whether the performance of the board in fulfilling its monitoring duties is achieved at the cost of performance in advising tasks.

A distinct focus on the advising versus the monitoring performance of the board in governance research not only derives from a separate interest in each but also from the existing measures of board structure. Outside directors contribute primarily to the monitoring function because they are independent of management and inside directors contribute primarily to the advising function because they have more firm-specific knowledge (Lehn-Patro-Zhao FM 2009; Linck-Netter-Yang JFE 2008). Constraints on board size imply that greater monitoring strength accruing from board independence will come at the cost of reducing the board's advising capacity. We focus on an aspect of board structure that has received relatively scant attention in the empirical literature on boards and that is likely to capture both advising and monitoring capabilities of outside directors - their tenure. We focus on tenure because the central challenge for outside directors in performing both monitoring and advising roles is to overcome problems arising from information asymmetry between themselves and firm management. The firm-specific and management-specific knowledge that can overcome these problems is likely to increase with the tenure of outside directors through a variety of avenues including more board and committee meetings attended, likely increased committee assignments, greater experience with the firm's strategies and policies, and greater within-firm deal-level experience. Because such knowledge acquisition can help reduce information asymmetry and attenuate informational conflict between the board and management, we hypothesize that outside director tenure will have a positive impact on the performance of the board.

While the above arguments are applicable for most advising tasks and monitoring tasks, there are certain specialized monitoring tasks where they may not apply. Specifically, the specialized monitoring task of ensuring the quality of financial reporting requires particular functional expertise and experience, requirements that are not met through increased firm- and management-specific knowledge alone. Because efficacy in financial reporting monitoring demands a high level of technical detail and knowledge of accounting standards and concepts, internal control concepts, and auditing processes, it is likely that the financial expertise of outside directors, rather than their tenure, has a positive impact on this monitoring task. Thus, we hypothesize that the tenure of outside directors has a positive impact on advising tasks and generalized monitoring tasks such as compensation monitoring but not on specialized monitoring tasks such as financial reporting monitoring.

Data and Design

We use detailed Morningstar data on directors for a sample of about 14,000 firm-years from 2003 to 2008 to test our hypotheses. Because tenure is likely affected in mechanical ways or in ways that are not reflective of gaining firm-specific knowledge, we use the residual from the following regression as our primary independent variable (Outside Tenure):   text{Raw Outside Tenure}_t =  alpha +  beta_1  text{Inside Tenure}_t+ beta_ 2  text{Firm Age}_t : - :1 :     + :  beta_3 :  text{IRisk}_{t,t-2}+ beta_4  text{Altman Z}_{t-1}+ beta_5  text{ROA}_{t-1}+ epsilon Inside Tenure, the average tenure of inside directors, accounts for director turnover associated with changes in top management (Hermalin-Weisbach RJE 1988). Firm Age, accounts for mechanically shorter director tenure in younger firms. Idiosyncratic risk (IRisk) captures the impact of firm-specific volatility on director tenure. We expect greater volatility leads to higher levels of director turnover and shorter tenures. The modified Altman's Z-Score, accounts for board changes associated with weak financial performance (Hermalin-Weisbach RJE 1988). Because Altman-Z may not fully capture the impact of firm performance, we also include the firm's return on assets (ROA) to incrementally capture performance. To properly isolate the impact of tenure, we include a comprehensive set of other board characteristics in all our analyses. These include, the supervisory and financial expertise of outside directors, a measure of the skill of outside directors (based on the number of other directorships held and tenure in these positions), and board size and independence.

Outside Director Tenure and Board Advising

For advising performance, we examine the acquisition and investment decisions of the firm because these are characterized as typical advisory functions of the board. While acquisitions may reflect the firm's need for growth and strategic recombination, a substantial part of the literature on acquisitions examines other causative factors arising from agency motivations and managerial hubris. Under this view, a manager who wants to maximize compensation is likely to make acquisitions more frequently and/or undertake larger deals. If boards are able to differentiate value-increasing acquisitions from those merely aimed at increasing firm-size, higher advising performance will be reflected in fewer and smaller acquisitions, and in deals with positive announcement returns and post-acquisition performance (Gompers-Ishii-Metrick QJE 2003). As Table 1 shows, we find that Outside Tenure is negatively associated with the likelihood, frequency and relative size of acquisitions, and positively associated with acquisition announcement returns. We find weaker evidence that tenure has a positive impact on post-acquisition returns (untabulated). In robustness tests, we find no support for the potential alternative explanation that firms bring on new directors in anticipation of acquisitions. Table 1 also shows that longer outside director tenure is associated with smaller amounts of over- or under-investment. Overall, these results suggest that firms are more selective when making acquisition and investment decisions as outside director tenure increases.

1: Outside Director Tenure and Board Advising
Acquisition Acquisition Acquisition Announcement
Likelihood Frequency Ratio Return Abnormal
Outside Tenure (t) –0.032** –0.060** –0.033** 0.003** –0.067**
Outside Skill (t) –0.016 0.108** 0.035*** 0.000 –0.405**
Inside Tenure (t) –0.007** –0.007 –0.008** 0.000 –0.042**
Outside Supervisory (t) 0.066 –0.022 –0.131*** –0.021*** 0.045
Outside Financial (t) 0.227*** 0.250 –0.294** –0.024*** –0.367
Board Independence (t) 0.140 0.148 –0.186 0.021 –0.387
Board Size (t) –0.017 0.011 –0.006 –0.000 0.011
Inverse Mills Ratio - - 0.685** –0.004 -
Constant t –2.302** –3.032** –0.841** 0.021 8.264**
Year, Industry, Control Variables are included
Observations 13,736 13,736 951 951 11,750
Non-zero obse 951 951 951 951
Pseudo/Adj. R2 0.0749 (p<0.01) (p<0.01) (p<0.01) 0.1279

Outside Director Tenure and Board Monitoring

For monitoring performance we examine CEO compensation monitoring and financial reporting monitoring. Table 2 shows that excess CEO compensation, i.e., after accounting for the impact of normal economic determinants, decreases as Outside Tenure increases, suggesting that outside directors' knowledge about the firm and the manager acquired over time enables them to limit managerial rents. For financial reporting

Finally, we use the firm's operating performance as a summary measure of board performance in both advising and monitoring. Pooled OLS regressions show that Outside Tenure is positively associated with operating performance measured by annual industry-adjusted return on assets, return on equity, net profit margin and asset turnover ratio measured in the subsequent year. Because of a potential reverse causality issue wherein outside directors leave firms that have impending performance declines, we use an instrumental variable (IV) approach to re-estimate the relation between director tenure and firm performance. We use outside director age as the instrumental variable. Director age and director tenure are highly correlated, not only mechanically but also because general labor market trends suggest that older workers are less likely to change their job. Importantly, research finds little or no association between age and performance in a meta-analysis of 380 empirical studies, and a small negative association between age and executive functions across 34 empirical studies (Ng-Feldman JAP 2008; Rhodes PA 2004). Related to directors, Ferris-Jagannathan-Pritchard (JF 2003) suggest that any positive effects from director experience increasing with age may be offset by older directors having less energy, posing a last period risk, and viewing directorships as lucrative part-time jobs for their retirement years. Consistent with the OLS results, we find that IV estimation yields a positive and significant association between outside director tenure and firm performance (not tabulated here).

2: Outside Director Tenure and Board Monitoring
Excess, CEO Comp (t+1) Discretionary,Accruals (t+1)
Outside Tenure (t) –0.010** 0.058***
Outside Skill (t) 0.014 0.155
Inside Tenure (t) –0.005** 0.050**
Outside Supervisory (t) 0.012 –0.835
Outside Financial (t) –0.051 –1.418**
Board Independence (t) 0.325** 0.356
Board Size (t) –0.007
Constant –0.237*** 3.799**
Year Effects Yes Yes
Control Variables Yes Yes
Observations 10,295 12,638
Adjusted R2 0.0221 0.0437

Conclusion

Throughout our analysis, we test for the potential non-linear impact of director tenure (Vafeas JBFA 2003) but find no significant evidence. Overall, our results make two contributions. First, they show that outside director tenure, a board characteristic that has heretofore received scant empirical attention, is an important dimension of the advising and monitoring capability of the independent board. Second, they provide additional insights on the dual roles of the board, advising and monitoring, and thus add to recent work that emphasizes distinctions and competition between the two roles (Faleye-Hoitash-Hoitash JFE 2011). While our financial reporting monitoring results suggest some support for the