The determinants of corporate board size and composition: An empirical analysis

Abstract

Using a unique panel dataset that tracks corporate board development from a firm's IPO through 10 years later, we find that: (i) board size and independence increase as firms grow and diversify over time; (ii) board size—but not board independence—reflects a tradeoff between the firm-specific benefits and costs of monitoring; and (iii) board independence is negatively related to the manager's influence and positively related to constraints on that influence. These results indicate that economic considerations—in particular, the specific nature of the firm's competitive environment and managerial team—help explain cross-sectional variation in corporate board size and composition. Nonetheless, much of the variation in board structures remains unexplained, suggesting that idiosyncratic factors affect many individual boards’ characteristics.

Introduction

Corporate boards are the focus of many attempts to improve corporate governance. Shareholder advocates such as Institutional Shareholders Services, Inc. and the Council of Institutional Investors have called for US corporations to have smaller boards with greater outside representation, sentiments echoed by the National Association of Corporate Directors and The Business Roundtable.¹ Institutional investors such as TIAA-CREF have issued specific recommendations for how boards should be structured and run. Some of these recommendations were codified into law via the Sarbanes-Oxley Act of 2002, including, for example, a requirement that boards have audit committees that consist only of independent outside directors. The movement toward specific board guidelines, typically calling for greater outside representation, is also a characteristic of the Codes of Best Practice issued in many countries (see Denis and McConnell, 2003).

Yet despite the importance of corporate boards and the widespread call for their reform, financial economists have reached few definitive conclusions about the forces that drive board size and composition. This paper examines these forces empirically. To structure our tests, we group existing theories about corporate boards into three non-mutually exclusive testable hypotheses, which are summarized in Table 1.

The first hypothesis, which reflects the views of Fama and Jensen (1983), Coles, Daniel, and Naveen (2007), and Lehn, Patro, and Zhao (2005), implies that board structure is driven by the scope and complexity of the firm's operations. We call this the scope of operations hypothesis. The second hypothesis is that board size and composition are determined by the specific business and information environment in which the firm operates. We call this view—which borrows from ideas expressed by Demsetz and Lehn (1985) and Gillan, Hartzell, and Starks (2004), and is modeled by Raheja (2005) and Harris and Raviv (2007)—the monitoring hypothesis. The third hypothesis, reflecting work by Hermalin and Weisbach (1998) and Baker and Gompers (2003), implies that board composition results from a negotiation between the firm's CEO and its outside board members. We call this the negotiation hypothesis.

As illustrated in Table 1 and developed further in Section 2, each of these hypotheses yields testable predictions about the forces that shape board size, composition, or both. We test these predictions using hand-collected data from a panel of 1,019 firms that went public between 1988 and 1992, which we track for periods of up to 10 years. Our tests exploit the panel nature of the data and control for the endogeneity of board size and composition.

Our dataset differs from those of previous empirical investigations into corporate boards because it focuses on young companies. This presents both advantages and disadvantages. One advantage is that the data address a concern voiced by Hermalin and Weisbach (2003) that most research on corporate boards has been limited to large, established companies. A second advantage is that the 10-year data period allows us to measure the evolution of corporate boards as firms mature. A third advantage is that, as Baker and Gompers (2003) argue, the time surrounding the initial public offering is a particularly rich setting for studying board issues because it is a time of significant change in the firm's governance. Also, as Gertner and Kaplan (1996) point out, firms undertaking a public offering are more likely to choose value-maximizing governance features than already-public firms because the selling insiders directly bear the financial effects of such features. A disadvantage of our data, however, is that it excludes firms that have been public for more than 10 years. If the forces that drive board structure differ between young and old firms, our results might not generalize to firms that have been public for a long time. Lehn, Patro, and Zhao (2005) study firms that survive a long period of public trading.

Our results provide at least some support for all three hypotheses. In particular:

(i) Measures of the scope and complexity of the firm's operations—including firm size, firm age, and the number of the firm's business segments—are positively related to both board size and the proportion of independent outsiders on the board. This indicates that as companies grow, boards grow in response to the increasing net benefits of monitoring and specialization by board members.

(ii) Board size is positively related to measures of the private benefits available to insiders—including industry concentration and the presence of takeover defenses—and negatively related to proxies for the cost of monitoring insiders, including the market-to-book ratio, the firm's R&D expenditure, the return variance, and CEO ownership. This is consistent with arguments forwarded by Gillan, Hartzell, and Starks (2004), Raheja (2005), and Harris and Raviv (2007) that board size reflects a tradeoff between the firm-specific benefits of increased monitoring and the costs of such monitoring. Contrary to these arguments, however, we find no evidence that the proportion of independent board members is related to the costs and benefits of monitoring.

(iii) The proportion of independent outsiders is negatively related to measures of the CEO's influence—including the CEO's share ownership and job tenure—and positively related to constraints on such influence, including the ownership of outside directors, the presence of a venture capitalist, and the reputation of the firm's investment bank at the time of its IPO. This supports Hermalin and Weisbach's (1998) theory that corporate boards reflect the outcome of a negotiation between the CEO and outside board members. Furthermore, the evidence indicates a significant degree in persistence in the bargaining outcome, as the CEO's bargaining power at the time of the IPO helps explain board composition even several years after the IPO.

Overall, these results indicate that board size and composition vary across firms and change over time to accommodate the specific growth, monitoring, and managerial characteristics of the firm. Even considering all three hypotheses together, however, our empirical tests leave much of the cross-sectional variation in board size and composition unexplained. Thus, while economic hypotheses help explain board structure, there remains a large idiosyncratic or unexplained component to board structure.

The rest of this paper is organized as follows. In Section 2 we discuss related research on corporate boards and develop the three hypotheses about board size and independence. Section 3 describes the characteristics of corporate boards at the time of the IPO for our sample of 1,019 firms going public from 1988–1992, and describes the evolution of these firms’ boards and ownership structures over the next 10 years. Section 4 describes our empirical procedures to test the three main hypotheses, and Section 5 reports the results. Section 6 examines the economic importance of the effects we measure, and Section 7 concludes. In Appendix A we report on several sensitivity tests that probe the robustness of the results with regard to our empirical methods and choice of proxies.