Nishant Dass, Omesh Kini, Vikram Nanda, Bunyamin Onal, and Jonathan Wang
Board expertise: Do directors from related industries help bridge the information gap?
The Review of Financial Studies, Volume 27, Issue 5 (May 2014), 1533-1592

Boards of directors play a central role in corporate control and decision-making, attracting both media and regulatory attention. Less evident perhaps is the advisory function of boards, where the industry expertise and connections of individual directors can enhance the quality of strategic advice provided to management. Firms may choose directors who can help alleviate uncertainty in the economic environment and lower transactions costs in dealing with external entities. We argue that directors drawn from a firm's supply-chain industries, with their related industry knowledge and expertise, can be particularly valuable.

In a large sample of publicly-listed firms, we find that about 60% of firms have had a director who is also an officer or a director of another firm in their supply chain industries; we denote these directors as “directors from related industries” (“DRIs”). These directors can bring potentially valuable knowledge about their own industries as well as facilitate the firm's access to contacts in those industries. This knowledge helps the firm overcome information challenges such as anticipating industry conditions and trends, thereby facilitating better management of its factors of production and protecting it against demand or supply shocks. By providing information about supply chain industries, DRIs can also improve the board's ability to monitor by narrowing the information gap between the board and the firm's management. We build on these arguments by investigating the following questions:

Why do some firms choose to have DRIs?

To answer this question, we propose and empirically validate the following hypotheses: Information-related hypothesis. Firms that face a significant information challenge with respect to their supply chain will benefit more from the industry expertise, knowledge, and networks of DRIs. For instance, innovative firms may favor DRIs since they require specialized inputs and the demand for their output is harder to predict. In addition, the lack of other sources of information and the strength of economic links between the firm's industry and its supply chain industries will increase the demand for DRIs. We find that the prevalence of DRIs at firms is consistent with this hypothesis. For instance, Table 1 reports the top-5 and bottom-5 industries, when ranked by the percentage of firms with at least one DRI on the board. It suggests that firms operating in industries that face the largest (smallest) information challenges are the most (least) likely to utilize the services of DRIs.

1: Industries ranked by the prevalence of DRIs (over the sample period 1990-2005)
Top 5 Number of firms in Percentage of firms
SIC description the given industry with at least one DRI
Biological not diagnostic 1,063 78.65%
Computer storage devices 319 62.07%
Advertising agencies 108 73.15%
Electrical instruments 496 61.09%
In vitro/vivo diagnostics 656 66.16%
Bottom 5 Number of firms in Percentage of firms
SIC description the given industry with at least one DRI
Newspapers 283 17.67%
Savings 770 10.78%
Poultry 112 5.36%
Home health care 209 8.61%
Electric housewares 104 10.58%

Further, consistent with the information-related hypothesis, we find that characteristics such as R&D intensity, patent grants, patent citations, and the differentiated nature of an industry's products increase the likelihood, while characteristics such as stock price informativeness reduce the likelihood of having DRIs on the board.

Market structure hypothesis.
It will be easier for firms with greater market share to attract DRIs because these firms are likely to be relatively more important as sources of information and network connections for the firms from which the DRIs are drawn. Further, common ownership to reduce coordination and/or contracting costs with potential/actual suppliers and customers is more likely to receive antitrust scrutiny in concentrated industries. Hence, firms in concentrated industries may, at least partially, achieve the same objective by appointing DRIs. Consistent with the market structure hypothesis, we find that the likelihood that a firm has DRIs is increasing in its market share and industry concentration. We also find that the presence of DRIs is greater in industries with higher degrees of vertical integration. This result suggests that DRIs can alleviate the high coordination costs and contractual frictions that are likely present in these industries.
Conflicts of interest hypothesis.
Having DRIs on the board also has a potential downside arising from conflicts of interest. For instance, DRIs from current or potential customers/suppliers may influence the firm's management to improve the prices/terms negotiated or garner new business for their affiliated firms. Our evidence is consistent with this hypothesis. Specifically, it is uncommon for DRIs to come from the current customers/suppliers of the firm. Further, it is rare for the DRIs' affiliated firms to eventually become customers/suppliers of the firm. Finally, the likelihood of DRIs being present is higher when the firm is less vulnerable to DRIs' attempts to promote their affiliated firms.

Does the presence of DRIs contribute to firm value/performance?

We next turn to the second question by examining the impact of DRIs on firm value and performance. We find that the presence of DRIs appears to improve firm value and performance. For instance, the presence of a DRI is associated with a 5.5% higher ROA. The stock market reaction upon the appointment of a DRI to the board is also positive—e.g., the risk-adjusted abnormal return over a three-day window centered around the announcement of a DRIappointment is 2.5%.

Clearly, not every firm will benefit from having DRIs. Consistent with the informational benefits of having DRIs, we find that their effect on the firm's value is stronger for firms operating in more innovative environments and those with less informative stock prices. Further, the impact of DRIs on firm value is stronger for firms with greater market share, which is consistent with the notion that these firms are less influenced by the DRIs' conflicts of interest and that the presence of DRIs can enable dominant firms to foreclose their rivals from critical inputs/outlets. Finally, the value impact of DRIs is only significant when the CEO is also the Chairman, which is consistent with powerful CEOs being less affected by the conflicts of interest that arise due to the DRIs trying to benefit their affiliated firms.

What are the channels through which DRIs benefit the firm?

We address the third question by examining some specific channels through which DRIs can add value to the firm. We find that the information/expertise of DRIs helps firms: (i) respond better to industry sales shocks, (ii) alleviate financial constraints, and (iii) shorten their cash conversion cycle primarily through better management of inventories. For example, the presence of a DRI is associated with a cash conversion cycle that is shorter by at least 21 days and an inventory conversion period that is shorter by 18 days.

On a cautionary note, not every firm can hope to benefit by having DRIs on its board. There are several costs associated with having DRIs and these may outweigh their potential benefits. First, when DRIs are from actual or potential suppliers and customers, there is reason to be concerned about conflicts of interest. Second, DRIs can be a potential source of proprietary information leakage to rival firms. Finally, bringing in a DRI comes at the cost of excluding another potential director, who can add value along other dimensions (e.g., by providing political connections or financial expertise).

Not an AFA President.... ...but the editor of this jagazine. We ran out of volunteers, and felt it was just fair to expose ourselves, too.

Not an AFA President.... ...but the publisher of this jagazine. Ivo's picture was funnier than Bhagwan's.