Christopher S. Armstrong, John E. Core, and Wayne R. Guay
Do independent directors cause improvements in firm transparency?
Journal of Financial Economics | Volume 113, Issue 3 (Sep 2014), 383-403

Independent directors, as outsiders to the firm, must acquire and process a substantial amount of firm-specific information to effectively perform their advising and monitoring duties. Independent directors are less effective when the corporate information environment is opaque, and when there are significant costs to acquire and process detailed information about their firm's operating, financing, and investing activities. Although prior research has made some progress in understanding the correlation between board independence and corporate transparency, this research does not test for a causal effect of board structure on transparency. Specifically, the results in this prior literature do not discriminate between two competing explanations for a positive correlation between transparency and board independence. One possibility is that corporate transparency is dictated mainly by exogenous firm characteristics, and that firms are able to appoint a higher proportion of independent directors when transparency happens to be greater. A second possibility is that firms can make choices that improve transparency, such as attracting analysts to the firm and committing to certain disclosures, which can make it easier for independent directors to become informed about the firm's activities.

NYSE and Nasdaq regs require majority independent directors

Our objective is to determine whether and how corporate transparency adapts to the informational demands of a particular board structure. Our research design relies on regulations that mandated substantial increases in the proportion of independent directors for some firms but not others. Specifically, we use regulations issued in 2003 by the NYSE and Nasdaq that required most listed corporations to have a majority (more than 50%) of independent directors on their boards. In general, firms were required to comply with these regulations by the earlier of: (1) the listed firm's first annual shareholder meeting after January 15, 2004; or (2) October 31, 2004. Some firms already had a majority of independent directors on their boards and therefore complied with these new regulations at the time they were issued. Other firms, with boards consisting of a majority of inside or non-independent directors, were required to add more independent directors, remove some inside directors, or some combination of the two.

In our sample, the firms that were not in compliance with the majority board independence rule (as of 2000) have a 45% increase in the mean proportion of independent directors (from 40% to 58% independent directors), whereas firms that were already in compliance experienced virtually no change in their proportion of independent directors during the same period.

1: Panel A: Board characteristics for compliant and non-compliant firms
Compliant Non-Compliant
Mean Median Mean Median
Number of Directors (2000) 9.15 9.00 8.03 8.00
% Independent Directors (2000) 72% 71% 40% 43%
Min. Required % Change Independent Directors (as of 2000) 0% 0% 22% 18%
Actual Change in % Independent Directors (from 2000 to 2004) 2% 2% 18% 17%
Our sample is 1,396 (453) firms that were compliant (non-compliant) with the 2003 NYSE and Nasdaq board independence regulations as of 2000. The first two rows reflect the firms' situation as of 2000. The last row shows the actual change in the percentage of independent directors by the end of 2004.

We use a model of board structure to identify the expected change in proportion of independent directors based on the minimum change that firms would have to make to their board structure, if any, to comply with the exchange requirements. We then use the predicted change in the proportion of independent directors (over a four-year period from roughly 2000-2004) to identify the effect of this exogenous change in board structure on changes in a variety of information-related variables.

Table 1 also provides descriptive statistics on how firms alter their initial board structure to comply with the exchange listing requirements. Because compliance is based on the ratio of independent directors to board size, a non-compliant firm can comply by decreasing board size (and removing inside or gray directors) or increasing board size. We find that 145 of the non-compliant firms reduced the size of their board. These firms went from an average of 9.89 directors to 7.88 directors—an average decrease of 2.01 directors. This average overall reduction in board size was the result of adding 0.98 independent directors, but removing 1.63 inside directors and 1.36 gray directors. We also find that 308 of the non-compliant firms increased the size of their board from 7.14 to 8.35 directors, on average. This average increase in board size was the result of adding 2.01 independent directors, and removing 0.28 inside and 0.52 gray directors. Overall, there is substantial cross-sectional variation in how firms adjust the size and composition of their boards to comply with the regulations.

How can public information assist independent directors?

We emphasize that our predictions and tests focus on public measures of corporate transparency. One might question whether independent directors could instead resolve their information disadvantage vis-a-vis management using private rather than public channels. For example, independent directors have access to internal budgeting information, reports, and informal communication with managers. It seems unlikely, however, that outside directors rely solely on information supplied by, and filtered through, managers (Adams-Hermalin-Weisbach (JEL 2010), Armstrong-Guay-Weber (JAE 2010)). Although managers will be forthcoming in sharing certain types of information with independent directors, they are not likely to share information that is detrimental to their own interests. Thus, managers are expected to be forthcoming only with information that is relatively unhelpful to independent directors with monitoring.

In light of this concern, independent directors seek financial reporting systems and public information channels that aid their monitoring activities. Bushman-Chen-Engel-Smith (JAE 2004) note that public disclosures can carry greater credibility than private communications, in part, because these disclosures are subject to SEC rules and enforcement, litigation, and oversight by auditors and other stakeholders. Information intermediaries such as analysts and the business press scrutinize public disclosures. Analysts can also uncover distortions in these disclosures (Miller (JAR 2006)). Other governing entities, such as blockholders and institutional investors, use public disclosures to monitor managers' strategic decisions. Further, because publicly-released erroneous information imposes costs on managers, public information channels enhance the credibility of private information that managers share with directors. For example, a public management forecast of earnings enhances the credibility of non-public budgets that underlie the forecast. We conclude from these arguments and prior literature that public measures of corporate transparency are likely to play an important role in governance.

Do firms alter their information environment to assist?

Using board structure data for a broad sample of 1,849 firms, we find that bid-ask spreads (a common proxy for information asymmetry), decreases following an exogenous increase in the proportion of independent directors. The typical 18 percentage point average increase in the proportion of independent directors following the 2003 rule translates to roughly a 6% decrease in information asymmetry. We also explore some of the potential channels through which transparency may be altered to satisfy the informational demands of the board. Specifically, we examine variables related to management forecast frequency and precision, accrual quality, analyst following and consensus, shareholder base, and auditor fees. Our evidence suggests that an increase in the proportion of independent directors results in increases in the frequency of management forecasts and analyst following (with marginally significant evidence of increases in management forecast precision, analyst forecast consensus, and institutional following). We also find that auditor fees, a proxy for commitment to stringent internal controls and higher quality financial reporting, are somewhat larger at firms that are required to increase the independence of both their full board and their audit committee.

Are entrenched managers less likely to improve transparency?

We also explore several predictions regarding cross-sectional variation in the relation between increases in board independence and corporate transparency. For example, although a board with a majority of independent directors likely requires a more transparent information environment than an insider-dominated board to govern effectively, management may not willingly relinquish control over the board. One way for management to limit the monitoring efficacy of independent directors—particularly those who are new—is to withhold information or otherwise resist efforts by directors to elicit increased transparency. To explore this possibility, we test whether the increase in corporate transparency is muted for firms where managers are likely to be entrenched. Using insider ownership and the proportion of independent directors appointed during the current CEO's tenure as proxies for entrenchment, we find that when management is likely to be entrenched, management forecasts become less precise, and to some extent less frequent, following the mandated increase in board independence. However, we find no significant mediating effects of management entrenchment on the relations between the change in board independence and changes in our other measures of corporate transparency.

Our other cross-sectional analyses examine whether the relation between increases in board independence and corporate transparency varies with audit committee independence, information processing costs, and whether firms operationalize their compliance with the board structure regulations by adding new independent directors (thereby increasing board size) as opposed to removing non-independent directors (thereby decreasing board size). Our findings indicate that information asymmetry declines more for firms that increase their board size (by adding new independent directors), as well as for firms that are required to simultaneously increase the independence of their audit committee.

Do changes in transparency precede or follow board changes?

Finally, we explore the lead/lag relation between changes in transparency and changes in board independence. We partition our sample of non-compliant firms into those that complied early and those that complied late in the sample period, and find some evidence consistent with improvements in transparency both preceding and following compliance with the board independence regulations.


Collectively, our results suggest that firms can and do alter certain aspects of corporate transparency to facilitate the informational demands of independent directors. These results generally support the inferences in a large body of financial reporting and disclosure literature arguing that corporate transparency is endogenous with respect to management and/or board actions. At the same time, our findings also highlight the importance of acknowledging the simultaneous relation between board independence and corporate transparency, and we suggest that caution be exercised when interpreting results that take board independence or corporate transparency as exogenous rather than both being jointly and simultaneously determined.