The Changing Board of Directors: Board Independence in S & P 500 Firms

By Lee, Sharon K.; Carlson, Loring R. | Journal of Organizational Culture, Communications and Conflict, January 2007 | Go to article overview

The Changing Board of Directors: Board Independence in S & P 500 Firms


Lee, Sharon K., Carlson, Loring R., Journal of Organizational Culture, Communications and Conflict


ABSTRACT

With the enactment of the 2002 Sarbanes-Oxley Act, more attention has turned to the composition and size of corporate boards of directors. With the new regulations, we have seen an increase in the number of independent board members and a decrease in the average size of boards. This study of S & P 500 firms shows that firms with the most independent boards in the sample perform significantly better than firms with less independent boards. Also, the inverse relationship between board size and firm performance, found in earlier studies using samples before the new regulations, is not found using our recent sample. With the overall increase in independence levels, it appears that boards have become more objective and efficient in their monitoring of management, irrespective of board size.

INTRODUCTION

Stricter regulations concerning boards of directors have brought about significant adjustments in the structure, practices, and sizes of boards. The Sarbanes-Oxley Act of 2002, the SEC, NYSE, NASDAQ, and AMEX have created more rules and guidelines in an attempt to restore investor confidence in that monitoring body, the corporate board of directors. Several regulations are still pending but corporations have scrambled to comply with relatively new rules and guidelines. In order to rebuild investor confidence, one focus of study is board independence. The directors are responsible for ensuring that management acts in the best interests of the shareholders. Many corporations have made board changes to increase the independence of their board composition. Sixty-four percent of Standard & Poor's Super 1,500 companies currently "have boards that are at least 2/3 independent, as compared with only 57% of that group just last year" [IRRC, 2003, p.14].

Many believe that independent directors would be more likely to monitor and perhaps challenge management if needed. The presence of outside or independent directors may decrease agency costs experienced by most firms, and should increase the overall performance and value of the firm. Individuals affiliated with the corporation may make decisions that promote their own best interests rather than shareholder wealth. The Sarbanes-Oxley Act of 2002 has specifically addressed the independence of audit committees, and under the pending governance changes at the NYSE, NASDAQ, and AMEX, boards are to have at least a majority of independent directors. In addition, these regulations may require total independence of audit, compensation and nominating committees.

Several studies have addressed the question of outside directors and their effect on firm performance, but the findings are mixed [Hermalin and Weisbach (1991), (2002)]. Dahya and McConnell (2002) study firms that recently increased their board's independence and find that those boards are significantly more likely to replace the CEO after a record of poor firm performance.

Included in the new guidelines are some stricter definitions of what constitutes an "independent" director. Due to the guidelines set forth in Sarbanes-Oxley, the NYSE, AMEX, and the NASDAQ have proposed strict independence definitions, but they all vary. In this study, we adopt the "independence" definition set forth by the Investor Responsibility Research Center which is stricter than that of the exchanges. For example, the NASDAQ states that if the severance of an employee was at least three years ago, then he/she can be considered an "independent" board member.

The IRRC does not consider a board member "independent" if he/she is:

1. a former employee of the company or of a majority-owned subsidiary,

2. a provider of professional services to the company or an executive,

3. a customer of or supplier to the company, unless the transaction occurred in the natural course of business,

4. a designee under a documented agreement between the company and a group, such as a significant shareholder,

5.

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The Changing Board of Directors: Board Independence in S & P 500 Firms
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