The Costs of Intense Board Monitoring

by R. Christopher Small, Co-editor, for the Harvard Law School Forum, December 6th, 2010.

In our paper The Costs of Intense Board Monitoring, forthcoming in the Journal of Financial Economics, we study the effects of the intensity of board monitoring on directors’ effectiveness in performing their monitoring and advising duties. Our objectives are three-fold. First, we examine whether the quality of board monitoring is enhanced when the board is more focused on monitoring. Second, we examine whether intense monitoring is associated with weaker advising. Third, we examine how this potential tradeoff between the quality of board monitoring and advising affects overall firm value, emphasizing the role of the firm’s advising requirements in the process. We define a monitoring intensive board as one on which a majority of independent directors concurrently serve on two or more of the monitoring committees (i.e. audit, compensation, and nominating).

We study these issues using firms in the S&P 1500 indexes over 1998-2006. We test for monitoring effects by analyzing CEO turnover, executive compensation, and earnings quality. We find that the sensitivity of turnover to firm performance increases with the intensity of board monitoring suggesting that boards that are more devoted to monitoring are more likely to replace the CEO following weak financial performance. We also find improvements in earnings quality with less discretionary accruals and a significant reduction in excess executive compensation among boards with greater monitoring intensity. These results suggest that the quality of board monitoring increases when independent directors devote significant time to oversight responsibilities.

Next, we examine how this affects the quality of board advising. We first focus on a strategic event that requires significant board input by analyzing acquisitions. We find that firms with monitoring intensive boards exhibit worse acquisition performance and a longer time to deal completion. Yet acquisitions are discrete events and worse acquisition performance needs not imply generalized ineffective strategic advising. Hence, we provide further insight by focusing on corporate investments in innovation. Innovation entails the cultivation of firm-specific human capital and tolerance for experimentation and potentially costly mistakes. This requires that the CEO sees the board as supportive, which offers the implicit assurance necessary to induce him to assume strategic risks. Intense monitoring can destroy this perception, causing the CEO to focus more on routine projects with relatively safe outcomes rather than on high-risk innovation. Consistent with this, we find that firms with monitoring intensive boards innovate less, where innovation is measured using research and development investments and the quality of patents granted to the company by the U.S. Patent and Trademark Office. (continue reading… )

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