Should Independent Directors Have Term Limits? the Role of Experience in Corporate Governance

By Dou, Ying; Sahgal, Sidharth et al. | Financial Management, Fall 2015 | Go to article overview

Should Independent Directors Have Term Limits? the Role of Experience in Corporate Governance


Dou, Ying, Sahgal, Sidharth, Zhang, Emma Jincheng, Financial Management


We examine the role of independent directors with extended tenure in board-level governance, monitoring decisions, and advising outcomes. These directors exhibit a higher level of commitment as they attend more board meetings and take more committee memberships. Firms with a higher proportion of these directors have lower chief executive officer (CEO) pay, higher CEO turnover-performance sensitivity, and a smaller likelihood of intentionally misreporting earnings. These firms also restrict the expansion of resources under the CEO's control as they are less likely to make acquisitions, while the acquisitions they do make are of higher quality. Efforts to impose term limits on directors may, therefore, be misguided.

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Shareholder advisory firms and regulators increasingly view lengthy experience as a negative attribute for independent directors. Independent directors with extended tenures, subsequently referred to as experienced directors, are seen as ineffective in fulfilling the roles of monitoring management and setting firm strategy. The Financial Reporting Council in the United Kingdom does not consider a director who has been on the board for longer than nine years to be an independent director. (1) The implication is that directors become entrenched and aligned with managers after an extended period and are, therefore, unable to monitor them adequately. In the United States, the National Association of Corporate Directors (NACD), an advisory organization that publishes best practice procedures in boardrooms, recommends tenure limits of 10 to 15 years when evaluation procedures are not in place (NACD, 2005). Director term limits have also been seen as a way to bring fresh thinking and ideas onto the board, avoiding stagnation in strategic decision making (Young, 2011). A survey by Heidrick and Struggles (2007) polling 2000 of the largest US firms found that 22% of the 660 respondents imposed term restrictions on directors, more than doubling the 9% in 2001 when the survey was previously conducted.

Despite concerns that experienced directors exacerbate the manager-shareholder agency problem (Jensen and Meckling, 1976), nearly 60% of the Standard & Poor's 1500 (S&P 1500) firms in our sample from 1998 to 2013 have an independent director who has been on the board for longer than 15 years. According to a recent analysis by Guaranteed Minimum Income (GMI) Ratings for the Wall Street Journal, among Russell 3000 companies, nearly 34% of the total independent directors have had a tenure of 10 years or longer. (2) There are at least three reasons why having experienced directors on the board may actually be optimal for firms. First, given their long tenure, most experienced directors have worked with multiple CEOs, which should help them better assess the ability of the current chief executive officer (CEO). Only 10% of directors with tenure longer than 15 years in our sample were hired during the current CEO's term. In addition, over the course of their term, experienced directors will have built up significant financial stakes in the company, aligning their interests with that of the shareholders. A 1% increase in underlying stock increases wealth by $13,318 for a median director with a tenure greater than 15 years, but only $4,382 for those with a shorter tenure. Moreover, just as a long, successful tenure is seen as increasing a CEO's bargaining power (Hermalin and Weisbach, 1998), longer tenure periods should also buttress the position of the directors, helping them to balance the CEO's influence when it is time to make decisions in the boardroom.

In this paper, we examine whether tenure limits are an optimal solution to the potential agency problems caused by experienced directors using an unbalanced panel data set of S&P 1500 firms from 1998 to 2013. To isolate the contribution of experienced directors, we define an experienced director as one with more than 15 years of experience. …

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