Essays on Board of Direcors Exernal Connecions by Sehan Kim B.A., Applied Saisics, Yonsei Universiy, 2001 M.S., Saisics, Purdue Universiy, 2008 Submied o he Graduae Faculy of The Joseph M. Kaz Graduae School of Business in parial fulfillmen of he requiremens for he degree of Docor of Philosophy Universiy of Pisburgh 2013
UNIVERSITY OF PITTSBURGH The Joseph M. Kaz Graduae School of Business This disseraion was presened by Sehan Kim I was defended on Augus 2, 2013 and approved by John H. Evans III Alumni Professor of Accouning, Kaz Graduae School of Business Universiy of Pisburgh Jongsub Lee Assisan Professor of Finance Warringon College of Business Adminisraion Universiy of Florida Kwang June Lee Assisan Professor of Business Adminisraion Kaz Graduae School of Business Universiy of Pisburgh Disseraion Advisor: Nandu J. Nagarajan Professor of Business Adminisraion Kaz Graduae School of Business Universiy of Pisburgh Disseraion Advisor: Dhinu Srinivasan Associae Professor of Business Adminisraion Kaz Graduae School of Business Universiy of Pisburgh ii
Copyrigh by Sehan Kim 2013 iii
Essays on Board of Direcors Exernal Connecions Sehan Kim, PhD Universiy of Pisburgh, 2013 The wo essays in his disseraion sudy issues relaed o he board of direcors exernal connecions, i.e., social ies o direcors and execuives of oher firms. The firs essay examines wheher and how direcors exernal connecions affec he operaing performance of he firm for which hey are board members. Using a large sample of 393,481 direcors and execuives from 7,627 companies over he ime period from 2000 o 2010, I map he social nework of direcors and senior level execuives, and consruc a measure of direcors exernal connecions capuring how conneced an individual direcor is o direcors and execuives of oher firms. I find a posiive associaion beween he exen of direcors exernal connecions and firm performance. In addiion, I find ha firms experience efficiency gains hrough cos reducions in he presence of well-conneced direcors. Overall, my findings sugges ha direcors exernal connecions provide economic benefis o firms by increasing sales growh, lowering producion coss, and improving firm profiabiliy. The second essay invesigaes wheher direcors exernal connecions influence direcor compensaion and appoinmen. Drawing on my findings in he firs essay, I argue ha he exernal connecions of direcors are refleced in labor marke oucomes for direcors. Consisen wih prior lieraure, I find ha direcors exernal connecions are posiively associaed wih he level of heir compensaion and ha direcors wih more exensive exernal connecions earn more han hose wih more limied exernal connecions. I hen examine he impac of direcors iv
exernal connecions on direcor appoinmens. Using he subsample of direcors who depared as a direcor of one firm during he period from 2003 o 2010, I examine wheher direcors exernal connecions impac he likelihood of being seleced as a new direcor a anoher firm. I find ha he exen of a direcor s exernal connecions increases he likelihood ha he/she will obain a new direcorship a anoher firm, suggesing ha exernal connecions play an imporan role in direcor selecion process. Collecively, his disseraion provides empirical evidence ha relaional capial capured in direcors exernal connecions provides access o valuable resources and informaion o he firm, hereby enhancing is financial performance, and has significan impac on labor marke oucomes for direcors in he form of direcor compensaion and direcor appoinmen. v
TABLE OF CONTENTS Preface... xi 1.0 The Impac of Direcors Exernal Connecions on Firm Performance... 1 1.1 Inroducion... 1 1.2 Background... 8 1.3 Daa and Sample Selecion... 14 1.4 Empirical Analysis... 16 1.4.1 Variable Descripions... 17 1.4.2 Research Design... 18 1.4.3 Empirical Resuls... 21 1.5 Addiional Analyses... 26 1.5.1 Impac of Differen Types of Direcors Exernal Connecions on Firm Performance... 26 1.5.2 Indusry Analysis... 31 1.5.3 DuPon Analysis... 33 1.5.4 Robusness Tess... 35 1.6 Conclusions... 38 2.0 The Impac of Exernal Connecions on Direcor Compensaion and Appoinmen... 41 vi
2.1 Inroducion... 41 2.2 Lieraure Review... 46 2.2.1 Direcor Compensaion... 47 2.2.2 Direcor Appoinmen... 50 2.3 Daa and Descripive Saisics... 52 2.3.1 Daa and Sample Selecion... 52 2.3.2 Descripive Saisics... 53 2.4 Exernal Connecions and Direcor Compensaion... 56 2.4.1 Empirical Resuls... 56 2.4.2 Robusness Tess... 61 2.4.2.1 Decomposiion of Direcors Exernal Connecions... 62 2.4.2.2 Governance and Direcor Compensaion... 64 2.4.2.3 Addiional Tes... 67 2.5 Exernal Connecions and Direcor Appoinmen... 67 2.5.1 Empirical Resuls... 67 2.5.2 Robusness Tes... 71 2.6 Conclusions... 72 Appendix... 75 Bibliography... 79 vii
LIST OF TABLES Table 1.1. Summary Saisics of Sample Firms... 87 Table 1.2. Summary Saisics of Direcors Exernal Connecion... 88 Table 1.3. Descripive Saisics of Key Variables... 89 Table 1.4. Relaionship beween Changes in Sales and Changes in Direcors Exernal Connecions... 92 Table 1.5. Relaionship beween Changes in ROA and Changes in Direcors Exernal Connecions... 94 Table 1.6. Relaionship beween Changes in Cos of Goods Sold and Changes in Direcors Exernal Connecions... 96 Table 1.7. Relaionship beween Changes in SG&A Expense and Changes in Direcors Exernal Connecions... 98 Table 1.8. Relaionship beween Changes in Sales and Changes in Direcors Exernal Connecions by Types of Exernal Connecions... 100 Table 1.9. Relaionship beween Changes in ROA and Changes in Direcors Exernal Connecions by Types of Exernal Connecions... 102 Table 1.10. Relaionship beween Changes in Cos of Goods Sold and Changes in Direcors Exernal Connecions by Types of Exernal Connecions... 104 viii
Table 1.11. Relaionship beween Changes in SG&A Expense and Changes in Direcors Exernal Connecions by Types of Exernal Connecions... 106 Table 1.12. Relaionship beween Changes in Firm Operaing Performances and Changes in Direcors Exernal Connecions by Indusry... 108 Table 1.13. DuPon Analysis I: Relaionship beween Changes in Asse Turnover and Changes in Direcors Exernal Connecions... 109 Table 1.14. DuPon Analysis II: Relaionship beween Changes in Profi Margin and Changes in Direcors Exernal Connecions... 110 Table 1.15. Relaionship beween Changes in Sales and Changes in Direcors Exernal Connecions: Alernaive Samples... 111 Table 1.16. Relaionship beween Changes in ROA and Changes in Direcors Exernal Connecions: Alernaive Samples... 113 Table 1.17. Relaionship beween Changes in Cos of Goods Sold and Changes in Direcors Exernal Connecions: Alernaive Samples... 115 Table 1.18. Relaionship beween Changes in SG&A Expense and Changes in Direcors Exernal Connecions: Alernaive Samples... 117 Table 2.1. Summary Saisics of Direcor Compensaions... 119 Table 2.2. Summary Saisics of Direcor Deparures and Appoinmens... 124 Table 2.3. Summary Saisics of Firms, Boards, Execuives and Direcors Characerisics... 125 Table 2.4. The Relaionship beween Exernal Connecions of Ouside Direcors and Compensaion... 128 Table 2.5. Connecions and Ouside Direcors Compensaion: Subsample Analysis... 129 ix
Table 2.6. The Relaionship beween Exernal Connecions of Employee Direcors and Compensaion... 130 Table 2.7. The Relaionship beween Exernal Connecions of Ouside Direcors and Compensaion by Types of Exernal Connecions... 131 Table 2.8. The Relaionship beween Exernal Connecions of Employee Direcors and Compensaion by Types of Exernal Connecions... 133 Table 2.9. The Relaionship beween Exernal Connecions of Ouside Direcors and Compensaion afer conrolling for Governance Characerisics... 135 Table 2.10. The Relaionship beween Exernal Connecions of Employee Direcors and Compensaion afer conrolling for Governance Characerisics... 137 Table 2.11. The Relaionship beween Exernal Connecions of Ouside Direcors and Compensaion: Median Regression... 139 Table 2.12. The Relaionship beween Exernal Connecions of Employee Direcors and Compensaion: Median Regression... 141 Table 2.13. Logi Regression Analysis of Direcor Appoinmens... 143 Table 2.14. Logi Regression Analysis of Direcor Appoinmens: Alernaive Samples... 144 x
PREFACE I would like o hank he members of my disseraion commiee, John Harry Evans III, Jongsub Lee, Kwang June Lee, and especially my chairs, Nandu J. Nagarajan and Dhinu Srinivasan, for heir guidance, help and encouragemen as I complee my disseraion. I hank my wife, Sohyon, for her unwavering suppor during my pursui of his degree. I am indebed o my parens and my parens-in-law for heir uncondiional suppor and undersanding. Wihou heir love and suppor his journey would no have been possible. Finally, I appreciae he financial suppor provided by he Joseph M. Kaz Graduae School of Business and Universiy of Pisburgh. I would also like o hank Carrie Woods who provided me wih imporan adminisraive suppor hroughou he docoral program. xi
1.0 THE IMPACT OF DIRECTORS EXTERNAL CONNECTIONS ON FIRM PERFORMANCE 1.1 INTRODUCTION There is a growing belief on he par of insiuional invesors ha board of direcors, as legally he highes auhoriy in he company, are in a posiion o exer a significan impac on firm performance (Perovic 2008, p. 1373). A board of direcors serves wo main funcions, monioring managemen and providing resources. Firs, boards monior op execuives o ensure ha hey ac in good faih and bring abou firm performance ha saisfies he ineress of he owners. Second, boards provide resources in he form of advice and counsel, and bring heir experise and connecions o meeings o help managemen improve firm performance. Mos prior research seeking o undersand how boards can influence firm performance has focused on he monioring funcion. Such research has examined he condiion under which board members are more or less effecive as moniors (Baysinger and Buler 1985; Core, Holhausen, and Larcker 1999; Ferris, Jagannahan, and Prichard 2003; Fich and Shivdasani 2006; Hwang and Kim 2009, 2011; Lee, Lee, and Nagarajan 2013). This paper is abou he second funcion, he provision of resources. I explore a mechanism by which boards help improve firm performance. Connecions beween direcors in he corporae neworks can faciliae access o resources and be helpful in acquiring resources 1
from imporan elemens ouside he firm (Hillman and Dalziel 2003). While he impac of social neworks on firms economic oucomes has recenly received much aenion in academic research in finance and accouning, hese sudies have primarily focused on inra-board connecions such as he links beween chief execuive officers (CEOs) and his or her board members (Engelberg, Gao, and Parsons 2013; Liu 2010; Hwang and Kim 2009, 2011; Dey and Liu 2011; Fracassi and Tae 2012). Relaively fewer sudies have provided empirical evidence o assess he impac of direcors exernal connecions, social ies o direcors and execuives in oher firms, on firms economic oucomes. 1 In his chaper, I examine he relaionship beween he exen of direcors exernal connecions and firm performance. As he predominan heory used in he corporae governance lieraure, agency heory suggess ha direcors are responsible for effecive oversigh of corporae managers, and board effeciveness depends on a board s abiliy o perform is monioring role effecively. Coninuing research in agency heory has invesigaed he board s role in monioring managemen and sudied he effeciveness of boards in heir monioring of managemen. The lieraure finds ha links beween he CEO and board members may reduce governance qualiy and impair economic value. For example, Fracassi and Tae (2012) find ha powerful CEOs hire direcors who are socially conneced wih hem, leading o weaker monioring, and more value-desroying mergers. Chidambaran, Kedia, and Prabhala (2010) find a significan relaion beween he likelihood of fraud and CEO-board connecedness. Dey and Liu (2011) documen ha social connecions beween he CEO and board members are associaed wih lower operaing performance, lower accruals qualiy, and a higher probabiliy of resaemens. Hwang and Kim (2011) show ha 1 Ishii and Xuan (2011) invesigae he impac of social ies beween he senior execuives and direcors of he acquiring and arge firms on merger oucomes, focusing on ies across he wo merging firms. Ishii and Xuan (2011) find ha beween-firm social ies have a significanly negaive effec on he abnormal reurns o he acquirer and o he combined eniy upon he merger announcemen. 2
social ies beween he CEO and members of he audi commiee are associaed wih high levels of earnings managemen. Lee, Lee, and Nagarajan (2013) show ha poliical alignmen beween CEOs and Direcors can increase managerial enrenchmen and he likelihood of fraud. In addiion o agency heory, resource dependence heory has also influenced he corporae governance lieraure. However, in conras o he agency heory lieraure, which focuses on he board s monioring role, resource dependence heory suggess ha a board plays anoher disinc role, i.e., ha of providing essenial resources, which may be direcly relaed o firm performance (Pfeffer 1972). 2 Resource dependence heory assers ha he board s funcion as a link o he exernal environmen is imporan in ha direcors bring essenial resources in he form of advice and counsel, channels of informaion flow, preferenial access o resources, and legiimacy o firms hrough linkages o he exernal environmen (Pfeffer and Salancik 1978), and direcors also bring access o key consiuens such as suppliers, buyers, lenders, public policy decision makers, and social groups (Hillman, Cannella, and Paezold, 2000), resuling in reducing dependency beween he firm and exernal coningencies, diminishing uncerainy for he firm, lowering ransacion coss, and ulimaely aiding in he survival of he firm (Hillman and Dalziel 2003). An imporan channel hrough which direcors provide essenial resources o firms is heir exernal connecions. Direcors exernal connecions can provide channels for communicaing imporan informaion beween exernal organizaions and he firm, such as indusry rends, marke condiion and regulaory changes, and lead o shared conacs. As a resul, direcors exernal connecions are believed o affec firms decisions and firm performance. A board wih well-conneced direcors can faciliae access o resources such as capial and improved erms of 2 Peng (2004, p. 455) saes ha i [i.e., resource dependence heory] predics ha he more resource-rich ouside direcors are on he board o help bring in needed resources, he beer he firm performance. 3
conracs, link he firm o imporan sakeholders or oher imporan eniies, and aid in he formulaion of sraegy or oher imporan decisions. Moreover, direcors exernal connecions could poenially affec he flow and he qualiy of informaion available o managers, creae links among decision makers across firms, and influence he corporae decision making process, leading o beer decision making and managemen pracices, and improve firm performance. I expec ha direcors wih more exensive exernal connecions increase he abiliy of boards o bring in needed resources, resuling in a posiive effec on firm performance. While mos prior sudies using resource dependence heory o examine board effeciveness as a provider of resources have primarily focused on board human capial, such as direcors experise, experience, knowledge, skill, repuaion, and skills (Pearce and Zahra 1992; Cero, Daily, and Dalon 2001), less aenion has been paid o he associaion beween board relaional capial, i.e., direcors conacs wih and connecions o exernal eniies, and firm performance. Gelekanycz and Hambrick (1997) show ha op execuives exernal ies conribue o he shaping of he firm s sraegic conformiy o he indusry s cenral endencies and i will be beneficial o firm performance. Using survey daa from China, Peng and Luo (2000) find ha managers ies wih op execuives a oher firms and wih governmen officials have a posiive influence on firm performance. Mos recenly, Larcker, So, and Wang (2011) measure he cenraliy of firms in he boardroom nework by couning he oal number of shared direcoraes beween companies. They documen ha cenral firms earn significanly higher fuure reurns han non-cenral firms, and also find ha cenral firms experience significanly higher increases in profiabiliy compared o non-cenral firms. In his chaper, I focus on board relaional capial, capured in direcors exernal connecions and explore how he exernal connecions of individual direcors affec he operaing 4
performance of he firm for which hey serve as board members. Using a large sample of 393,481 direcors and execuives from 7,627 companies over he ime period from 2000 o 2010, I map he social nework of direcors and execuives, and consruc a measure of direcors exernal connecions. The measure capures how conneced an individual direcor is o oher direcors and execuives in he nework of firms. I find a posiive associaion beween changes in direcors exernal connecions and changes in he firm s sales revenue. This associaion holds afer conrolling for governance aribues, direcors human capial, and oher relaed firm characerisics. This suggess ha, on average, he revenue of a firm increases afer he firm brings well-conneced individuals o he board. This is consisen wih he view ha relaional capial is posiively associaed wih he provision of resources by he board, which, in urn, is posiively associaed wih firm performance. Prior lieraure suggess ha he impac of managers exernal ies on firm performance differs among firms in differen sages of a firm s life cycle (Peng and Luo 2000). Consisen wih his prior lieraure, which finds ha he impac of exernal connecions on firm performance is more pronounced among firms ha sand o benefi he mos from such resources (Larcker, So, and Wang 2011), I find ha he impac of he exernal connecions is mos pronounced among firms ha have high growh poenial and are a an earlier sage in heir life cycle. I also examine he impac of direcors exernal connecions on profiabiliy. I find a posiive associaion beween changes in direcors exernal connecions and changes in firm profiabiliy. This suggess ha he ROA of a firm increases afer he firm appoins wellconneced direcors. I hen examine wheher firms experience efficiency gains hrough cos reducions in he presence of well-conneced direcors. I find ha he exen of direcors exernal connecions is 5
negaively associaed wih cos of goods sold. Firms experience efficiency gains hrough producion cos reducions afer he firm appoins well-conneced direcors. However, he exen of direcors exernal connecions is no significanly associaed wih SG&A expenses. Overall, my findings sugges ha companies wih well-conneced boards have beer operaing performance han companies whose boards are less well-conneced, hus direcors exernal connecions provide economic benefis o firms by helping o increase sales growh, improve profiabiliy, and lower producion coss. In addiion, I invesigae he impac of differen ypes of direcors exernal connecions on firm performance. I pariion direcors exernal connecions ino professional, educaional, and oher connecions and examine heir impac on firm operaing performance. The resuls indicae ha direcors pas professional and educaional connecions have a greaer impac on firm performance han oher connecions. Furher indusry analysis shows ha he imporance of direcors exernal connecions in providing resources o a firm may vary by indusry. The impac of direcors exernal connecions on firm performance is mos significan in he regulaed and relaively smaller cusomer and supplier base indusries. In indusries wih very large cusomer and supplier bases, such as wholesale and reail indusries, direcors exernal connecions appear o have lile immediae effec on firm performance. In addiion, I examine wheher he improvemens in profiabiliy of firms wih well-conneced direcors comes from improved asse urnover, increased profi margin, or improvemen in boh. My resuls sugges ha he significan improvemens in ROA afer he appoinmen of well-conneced direcors are more driven by he improvemens in asse urnover of he firm han he improvemens in profi margin. 6
This chaper conribues o he lieraure along several lines. Firs, his paper adds o he lieraure on he role of boards by complemening agency heory wih resource dependence heory. Prior sudies have examined he role of boards of direcors, bu he focus has primarily been on he monioring funcion of he boards by examining he relaionship beween proxies for board incenives o monior and firm performance. The resource provision funcion of he boards has been less explored (Hillman and Dalziel, 2003). Resuls from his chaper provide evidence ha direcors exernal connecions may help boos he role of direcors in improving firm performance. Second, his sudy inegraes resource dependence and social nework heories. Prior resource dependence sudies focus primarily on he impac of one aspec of board capial, human capial, on firm performance. Building on social nework heory, I examine he impac of anoher aspec of board capial, relaional capial, on firm performance. This paper provides some of he firs empirical evidence ha direcors exernal connecions enhance firm performance by providing access o resources and informaion o he firm. The resuls would also shed ligh on he relaive imporance of board relaional capial o firm performance. Third, his paper also conribues o he growing lieraure on he impac of social neworks among all board members. While much of he exising lieraure on social neworks among board members has focused primarily on he CEO s social ies, less aenion has been paid o he social connecions of oher direcors. I believe ha my resuls will exend he exising lieraure ha has largely focused on a CEO s social ies. To he bes of my knowledge, his is one of he firs papers o sudy social neworks of direcors, broadening he scope of social nework lieraure beyond he CEO s social nework o include direcors social neworks. 7
Finally, his paper uilizes he mos comprehensive measure of direcors exernal connecions by examining execuives and direcors from over 7,000 companies. Prior sudies use small-samples of he 30 larges publicly raded firms in he branded food and compuer indusries (Gelekanycz and Hambrick, 1997) or of 127 surveyed firms (Peng and Luo, 2000). My measure capures several aspecs of exernal connecions including direcors employmen hisory, educaional background, and oher social ies. I also differeniae my measures from ohers by analyzing exernal connecions of each individual direcor. Relaed sudies focus on exernal connecions of CEOs (Liu, 2010) or shared direcor posiions (Larcker, So, and Wang 2011). The remainder of he chaper is organized as follows. Secion 1.2 reviews he background lieraure. Secion 1.3 describes he daa and provides descripive saisics on he exernal neworks of direcors. Secion 1.4 describes he consrucion of variables and research design, and presens empirical resuls, which are analyzed furher in Secion 1.5. Secion 1.6 concludes. 1.2 BACKGROUND The link beween boards of direcors and firm performance has been sudied from wo differen perspecives, agency heory perspecive and resource dependence perspecive. Agency heoriss argue ha a key aciviy for boards is monioring managemen and effecive monioring can improve firm performance by reducing agency coss (Hillman and Dalziel 2003). These researchers explore he monioring role of boards and examine he relaionship beween effecive monioring and firm performance (Dalon, Daily, Cero, and Roengpiya 2003; Dalon, Daily, Ellsrand, and Johnson 1998). A large number of sudies have invesigaed he characerisics of he board and examined wheher he characerisics of he board affec board 8
effeciveness in monioring managemen and firm performance. The mos widely discussed quesion regarding he characerisics of he board is how board composiion, such as he proporion of ouside direcors (Hermalin and Weisbach 1991; Mehran 1995; Klein 1998; and Bhaga and Black 2000), demographic diversiy (Erhard, Werbel, and Shrader, 2003), and size (Dalon, Daily, Johnson, and Ellsrand 1999; Hermalin and Weisbach 2003; Yermack 1996) are relaed o monioring managemen and firm performance. There is also a large and growing lieraure on direcors serving on muliple boards (Core, Holhausen, and Larcker 1999; Fich and Shivdasani 2006; Ferris, Jagannahan, and Prichard 2003). However, prior research on his opic seems sill inconclusive. In conras, resource dependence heoriss focus on he board as providers of resources and conend ha boards are chosen o maximize he provision of imporan resources o he firm (Pfeffer 1972; Pfeffer and Salancik, 1978; Klein 1998; Lynall, Golden, and Hillman, 2003). In his research, scholars examine he relaionship beween boards provision of resources and firm performance. Pfeffer and Salancik s (1978) seminal work on resource dependence heory suggesed ha direcors bring four benefis o organizaions: (a) informaion in he form of advice and counsel, (b) access o channels of informaion beween he firm and environmenal coningencies, (c) preferenial access o resources, and (d) legiimacy (Hillman, Wihers, and Collins 2009, p. 1408). Board research based on resource dependence perspecive suggess ha direcors provide advice and counsel o op managemen (Minzberg 1983; Lorsch and MacIver 1989), bring heir own experiences, knowledge, and experise o he firm (Baysinger and Hoskisson 1990), aid in he formulaion of imporan firm decisions (Judge and Zeihaml 1992; Lorsch and MacIver 1989), and enable firms o gain linkages o imporan sakeholders or oher imporan eniies (Bur 1980; Hillman, Keim, and Luce 2001). 9
Resource dependence heoriss argue ha board capial encompassing boh human capial, such as direcors experise, experience, knowledge, skill, repuaion, and skills, and relaion capial, such as direcors conacs o exernal organizaion and connecions, can bring subsanial resources o a firm. Prior empirical sudies in his area examine he relaionship beween boards capial and firm performance Pearce and Zahra (1992) find ha board composiion as measured by size of board members is posiively associaed wih fuure firm performance, suggesing ha a large board enhances a company s abiliy o undersand and respond o diverse sakeholders. Cero, Daily, and Dalon (2001) documen ha firms wih more presigious boards are likely o have lesser underpricing ha occurred in he iniial public offering, suggesing ha presigious direcors help firms overcome informaion asymmery problems ha migh oherwise deer poenial invesors. In general, board capial helps firm srenghen he linkages wih he exernal environmen by acquiring addiional access or conrol over resources so ha such board capial can posiively affec a firm s performance. Social nework heory posis ha social ies creae rus, goodwill, or expecaions of reciprociy, which enable he individual o obain he needed resources from oher (Aldrich and Cliff 2003; Coleman 1988). The lieraure in social nework heory has documened ha having broad neworks can enhance he abiliy of people o convey complex ideas o diverse audiences (Reagans and McEvily 2003). Gargiulo and Benassi (2000) find ha more effecive managers have less consrained neworks. Managers wih beer connecions end o earn more income, ge more frequen promoions, and have beer careers (Bur 1997; Granoveer 1985). Barnea and Guedj (2009) repor evidence ha connecions beween direcors and op execuives are relaed o execuive compensaion. 10
In a similar line of research, here have been numerous sudies on he inerlocking direcoraes. Levine (1972) finds he exisence of inerlocked direcoraes beween he boards of major banks and he boards of major indusrials. Mizruchi and Searns (1988) show ha inerlocking direcoraes enable firm o gain ouside funding. Gulai and Wesphal (1999) find ha formaion of alliance is posiively relaed o he number of board inerlocks. Haunschild and Beckman (1998) documen ha inerlocking board members may faciliae an exchange of imporan informaion, leading o beer firm performance. On he oher hand, Hallock (1997) observes a posiive correlaion beween CEO compensaion and inerlocked boards, and Bizjak, Lemmon, Whiby (2009) documen ha inerlocked boards play a significan role in he spread of employee sock opions backdaing. However, research on inerlocking direcoraes has provided inconclusive evidence on a link beween board inerlocks and firm performance (Mizruchi 1996). Recenly, lieraure in finance invesigaes he impac of CEO s social connecions on economic oucomes. Liu (2010) finds ha an ouside CEO candidae benefis significanly by having connecions o he board of he hiring firm. Engelberg, Gao, and Parsons (2013) documen ha CEOs wih exensive neworks of personal connecions o hose ouside he firm earn more han hose wih smaller neworks. Hwang and Kim (2009) measure social ies beween he CEO and ouside direcors a Forune 100 firms and find ha social ies have an effec on how direcors monior and discipline CEOs based on compensaion and urnover. Dey and Liu (2011) examine wheher an independen direcor s social connecions wih he firm s CEO are associaed wih he direcors monioring effeciveness. They documen ha firms wih direcors who have social and professional connecions o he CEO are associaed wih lower usefulness and reliabiliy of repored earnings numbers. Chidambaran, Kedia, and Prabhala (2010) examine 11
he relaion beween fraud probabiliy and CEO-board social connecedness. They find ha professional connecions formed due o common prior employmen decrease fraud while nonprofessional connecions due o shared educaional and non-business anecedens increase fraud probabiliy. The influence of social neworks on he provision of resources funcion of direcors has received considerable aenion hrough a series of aricles. D Aveni (1990) finds ha wellconneced managers influence crediors o suppor he exising op managemen s righ o coninue in conrol of he firm wihou supervision by he bankrupcy cours. Wesphal (1999) find ha social ies beween CEO and ouside direcors faciliae ineracion by raising he frequency of advice and counsel, leading o increase in firm performance. Carpener and Wesphal (2001) documen ha boards consising of direcors having ies o sraegically relaed organizaions were able o provide beer advice and counsel. Agrawal and Knoeber (2001) find ha poliically experienced direcors are more prevalen in firms wih greaer governmen conracs, expors, and lobbying and lawyer-direcors are more prevalen in firms where coss of environmenal regulaion are higher. Cohen, Frazzini, and Malloy (2008) find ha muual fund managers inves in firms where board members share he same educaion nework. Engelberg, Gao, and Parsons (2012) demonsrae ha firms wih connecion o capial suppliers enjoy more favorable erms of lending, improved credi raings, and superior sock price performance. Anecdoal evidence also shows ha boards connecions and experise help a sar-up company lay he groundwork for growh. For example, direcors pas professional connecions have helped win key license o build a fixed wireless nework, raised financing, and helped find sraegic parners for he venure company (Lipin 1999). 3 However, he ne economic 3 See Appendix for more deails. 12
consequences of boards social neworks on firm performance have ye o be firmly esablished empirically (Larcker, So, and Wang 2011). Only a few papers explore he impac of execuives exernal connecions on firm performance. Gelekanycz and Hambrick (1997) find ha op execuives who held board appoinmens in differen indusries, which presumably follow differen sraegic pracices, were more likely o iniiae sraegic change a heir own firm, and op execuives exernal ies enhance firm performance. I differeniae my approach from Gelekanycz and Hambrick s (1997) sudy, which focuses on he board capial of op execuives raher han ha of direcors by examining he deph of relaional capial of all board members. Also, his paper goes beyond heir sample of 30 larges publicly raded firms in he branded food and compuer indusries for 1983 1987. Using survey daa from China, Peng and Luo (2000) conduc a sudy closely relaed o Gelekanycz and Hambrick s (1997) sudy. They find ha managers ies wih op execuives a oher firms and wih governmen officials help improve firm performance. I sudy he exensive exernal connecions formed by direcors and execuives in over 7,000 U.S companies. However, Peng and Luo (2000) employ relaively small-sample survey daa of 127 responses and rely primarily on percepual measures of exernal ies. Mos recenly, Larcker, So, and Wang (2011) examine wheher he posiion of a firm in he boardroom nework formed by shared direcoraes is associaed wih fuure sock price and firm performance. They find ha cenrally posiioned firms in he boardroom nework have higher fuure sock price reurns and greaer fuure profiabiliy han non-cenrally posiioned firms. However, heir sudy focuses on shared direcor posiions raher han individual direcors exernal connecions. 13
In summary, direcors exernal connecions may play an imporan role as channels of informaion, advice, counsel, and access o essenial resources enable a firm o accomplish higher economic oucomes, which improve firm performance. 1.3 DATA AND SAMPLE SELECTION I consruc execuive and direcor neworks from BoardEx daabase provided by Managemen Diagnosics Limied, an independen privae research company specializing in collecing and classifying social nework daa on he board of direcors and execuives of US and European public and privae companies. BoardEx consolidaes in-deph informaion concerning he board of direcors and senior managemen of publicly quoed and large privae companies. The daabase conains execuives and direcors curren and pas employmen hisory (including posiions held and he sar and end daes of he posiion), educaional background (including undergraduae, graduae and professional educaion and degree informaion), oher aciviies such as memberships in general social associaions, organizaions and chariable groups. The personal biographical informaion in BoardEx daes back o as early as 1926. BoardEx covers over 435,000 direcors and execuives of over 15,000 publicly quoed and large privae companies. The coverage is spli ino over 8,250 US company boards, 2,700 UK company boards, and a furher 5,000 company boards, spli beween Coninenal Europe and he res of he world. For his sudy, I focus on US companies over he ime period from 2000 o 2010, because BoardEx s coverage prior o 2000 is no complee. Using hese daa, I consruc each individual board member s nework. 14
Financial daa are obained from COMPUSTAT. The key firm idenificaion variable in BoardEx is Company ID. Since here is no exising link beween Company ID as repored in BoardEx and idenifiers from oher commonly used daabases (Engelberg, Gao, and Parsons 2013), I creaed links beween he BoardEx daabase and COMPUSTAT and CRSP daabases in muliple seps. Following Engelberg, Gao, and Parsons (2013), I, firs, mach Company ID as repored in BoardEx wih GVKEY (S&P idenifier) by icker symbol, which is provided in he BoardEx daabase, and CUSIP which is derived from he Inernaional Securiy Idenificaion Number (ISIN) in BoardEx daabase for companies ha are currenly rading. Second, for companies in he BoardEx daabase wihou icker symbols and ISIN, I mach he company name recorded in BoardEx wih he name of a company on COMPUSTAT and CRSP using he name maching algorihm in SAS. All maches are manually checked. I also look up similar company names using similar name maching algorihms and verify such maches by checking heir informaion from various sources. I collec corporae governance variables from he IRRC and BoardEx. This resuls in he final sample of 7,627 mached companies consising of 393,481 execuives and direcors over he ime period from 2000 o 2010. Table 1.1 presens summary saisics of sample firms. I shows he number of sample firms and firm characerisics, expressed in million dollars from 2000 o 2010. I suggess ha many small firms were added o he BoardEx daabase around he fiscal year of 2003. [Inser Table 1.1] Panel A of Table 1.2 presens summary saisics on he direcors exernal connecions ha I consruc. On average, a direcor has 372.2 exernal nework connecions o all oher direcors. The direcors exernal connecions vary by ypes of direcors. An employee direcor has an average of 247 exernal nework connecions. A grey direcor (affiliaed non-execuive 15
direcors) 4 has an average of 326.8 exernal nework connecions. Independen direcors have he bigges nework connecions, an average of 417.7 exernal nework connecions. Panel B of Table 1.2 repors he average exernal connecions of direcors per firms by indusry. Indusries are defined by he Fama-French 12-indusry caegories. 5 Firms in Chemicals, Business Equipmen (which includes compuers, sofware, and elecronic equipmen), and Uiliies indusries have direcors wih relaively exensive exernal nework connecions. Financial firms have direcors wih relaively limied exernal nework connecions. [Inser Table 1.2] 1.4 EMPIRICAL ANALYSIS I begin by describing my measures for direcors exernal connecions used in he regression analyses in Secion 1.4.1. I presen my research design in Secion 1.4.2, and discuss he resuls of my analyses in Secion 1.4.3. 4 According o definiions saed in he Combined Code (2003), grey direcors have personal or commercial ies wih he firm or execuives. Such ies are inferred where he non-execuive is relaed o any of he firm s direcors, advisors or senior employee, has served on he board for more han nine years, was formerly an employee of he company or group, has received addiional remuneraion apar from direcor s fee, has any maerial business relaionships wih he company, represens a significan shareholder, or inerlocking direcors. 5 See Ken French s websie a hp://mba.uck.darmouh.edu/pages/faculy/ken.french/daa_library.hml for he definiion of he welve Fama-French indusry caegories. 16
1.4.1 Variable Descripions Following Fracassi (2008), I consruc a measure of direcors exernal connecions. The measure capures how conneced an individual direcor is o oher direcors and execuives in he boardroom neworks. The exernal connecions of a direcor r a year is defined by DEC = Pas Professional Connecions + Educaional Connecions + Oher Connecions r,, where Pas Professional Connecions represen he number of direcors and execuives whom he direcor has worked wih, or sa eiher on he board of direcors or on he op managemen group in he pas in he same company a he same ime, Educaional Connecions represen he number of direcors and execuives wih whom he direcor wen o he same school and graduaed wihin wo years wih he same undergraduae, professional, masers or docorae degree, and Oher Connecions represen he number of direcors and execuives wih whom he direcor shares membership in general social associaions, organizaions or chariable groups. A firm i s oal exernal connecions a year is he sum of exernal connecions belonging o all N board members of he firm, defined as TDEC i = DEC N, r,. r= 1 My measure of firm i s direcors exernal connecions is he average of exernal connecions belonging o N board members of he firm, defined as ADEC i, = 1 N N r= 1 DEC r,. 17
1.4.2 Research Design To examine he relaionship beween he exen of direcors exernal connecions and firm performance, I focus on he conemporaneous associaion beween changes in direcors exernal connecions and changes in firm operaional performance. I use various measures of firm performance: sales growh, ROA, cos of goods sold, and selling, general and adminisraive (SG&A) expenses. The empirical models are specified in he following equaion: SALES = α + + +, (1) i, β1 ADECi, conrol variables ε i ROA i, = α + β1 ADECi, + conrol variables + ε i, (2) COGS, (3) i, = α + β1 ADECi, + conrol variables + ε i SG&A ADEC conrol variables, (4) i, = α + β1 i, + + ε i where, for each firm i and year : ADEC = ln( ADEC ) ln( ADEC 1), i, i, i, SALES i, = ln( SALESi, ) ln( SALESi, 1 ), ROA i, = ln( ROAi, ) ln( ROAi, 1 ), COGS i, COGSi, 1 COGS = i, ln ln, SALESi, SALESi, 1 SG&A i, SG&Ai, 1 SG&A = i, ln ln, SALESi, SALESi, 1 In hese models, dependen variables are changes in financial performance measures. Using changes in financial performance measures allows for conrol of he level of financial performance measures prior o he es period, and I use a naural logarihmic ransformaion o 18
conrol for skewness in he direcors exernal connecions (DEC), alhough he resuls are similar when his ransformaion is no used. The conrol variables I use in equaions (1) hrough (4) are consisen wih hose used in prior research (Agrawal and Knoeber 2001; Barnea and Guedj 2009; Dey and Liu 2010; Engelberg, Gao, and Parsons 2013; Larcker, So, and Wang 2011). For firm characerisic variables, I include firm size, he marke-o-book raio, firm age, and leverage raio. I use a naural logarihm of oal asses as a proxy for firm size. Larger firms end o have larger boards. As a consequence, larger firms will likely have more direcors wih more exensive connecions. I use a naural logarihm of he marke-o-book raio and firm age o conrol for he presence of high growh opporuniies. The marke-o-book raio is calculaed as he marke value of equiy divided by he sum of he book value of equiy and deferred axes. Firm Age is he age of he firm (years) based on he dae in which a firm s share price firs appeared on he CRSP. The inclusion of he marke-o-book raio and firm age reflecs he fac ha firms wih high growh opporuniies and firms in an early sage of heir life cycle are more likely o benefi from he exernal connecions of heir senior execuive and board members. Thus, I expec a posiive associaion beween direcors exernal connecions and marke-o-book raio and a negaive associaion beween direcors exernal connecions and firm age. Leverage raio is compued as he fracion of long-erm deb in oal asses. To conrol for he effeciveness of monioring, I include board characerisic variables such as board size, he proporion of ouside direcors on he board, CEO and board chair dualiy, and he fracion of busy direcors on he board. Board size is he number of direcors on he board. The proporion of ouside direcors (Ouside Direcor) is calculaed as he percenage of direcors defined as independen direcors or non-employee direcors. CEOCHAIR is a dummy 19
variable ha akes he value one when CEO is serving as chairman of he board. The fracion of busy direcors (Busy Direcor) is calculaed as he percenage of direcors holding more han wo direcorships. Fich and Shivdasani (2006) find ha boards wih a majoriy of busy direcors are associaed wih weak corporae governance and operaing profis. I consruc wo inra-board social connecion variables o capure he degree of he relaional capial among he board members, 1) social ies among board members and 2) social ie beween CEO and independen direcors. Social ies among board members (Inra-Board Ties) are measured by he number of pairs of conneced direcors scaled by he number of pairs of board members. Social ie beween CEO and independen direcors (Tie o he CEO) is measured by he fracion of he independen direcors having social ie o he CEO. I also consruc four variables o capure he board s human capial, 1) indusry experience, 2) board experience, 3) graduae degrees, and 4) elie educaions. Indusry experience (IndExp) is compued as he proporion of he board members possessing he same indusry experience. Board experience (BoardExp) is defined as he sum of he cumulaive years direcors have served as a direcor scaled by he number of board members. Graduae degrees (Graduae) is he fracion of direcors holding graduae degrees such as MBA, Maser, JD, MD, or PhD degree on he board. Elie educaion (Elie) is measured by he percen of direcors who graduaed from Ivy League undergraduae schools. Finally, I include he new appoinmens of direcors o he board in he year before, ADEC as conrol variable o eliminae he lagging effec of exernal connecions of direcors i, 1 who are appoined o he board in he previous year on firm performance because I focus on he conemporaneous associaion beween changes in direcors exernal connecions and changes in firm operaional performance in his sudy. 20
1.4.3 Empirical Resuls Table 1.3 repors descripive informaion for he key variables in my sample. Panel A provides means, medians, sandard deviaions, firs quarile, and hird quarile values for he key variables in my sample. Panel B shows a simple correlaion marix for he key variables in he sample. For he univariae daa, I average across ime for each firm and hen deermine he mean for he sample by averaging across firms. Panel A of Table 1.3 shows ha on average, a firm has 372.2 oal exernal connecions, 247.4 professional connecions, 72.3 educaional connecions, and 36.3 oher connecions. In erms of board characerisics, he average firm in my sample has 8.7 direcors on board, 68.7% are independen direcors, and 17.3% are busy direcors. 61.3% of CEOs serve as he chairperson of he firm of which he or she is he CEO. The average social ies among board members is 0.155 and 18.8% of board members have social connecion wih he CEO of he firm of which he or she sis on he board. In erms of board human capial, on average, 19.8% of direcors have an specific indusry experience, hey have 14.7 years board experience, 52.2% of direcors have graduae degrees, 30.4% of direcors graduaed from Ivy League undergraduae schools. Panel B of Table 1.3 provides a correlaion marix for some of he key variables in he analysis. Direcors exernal connecions appear o bear a posiive associaion wih firm size, firm profiabiliy, and board size. In addiion, direcors exernal connecions are posiively correlaed wih board human capial variables. [Inser Table 1.3] Table 1.4 presens resuls from ordinary leas squares regressions of changes in sales revenue on changes in direcors exernal connecions. Panel A of Table 1.4 shows he resuls of regression analysis based on all direcors sample. Column (1) repors he resuls of base regression. I find changes in direcors exernal connecions a year are significanly (p < 0.01) 21
posiively associaed wih changes in oal sales revenue a year. This associaion holds afer conrolling for he governance and oher firm and board characerisic variables. This finding implies ha he addiion of direcors wih more exensive exernal connecions o he board bring increases in oal sales of he firm. The coefficien of marke-o-book raio is posiive and significan (p < 0.01), and he coefficien of firm age is significanly negaive, suggesing ha firms wih high growh opporuniies and firms in an early sage of heir life cycle are more likely o benefi from direcors exernal connecions. Column (2) adds he conrol variable, changes in direcors exernal connecions a year 1. The resuls sugges ha even afer conrolling for he addiion of direcors wih more exensive exernal connecions o he board in he year before, he relaion beween changes in direcors exernal connecions a year and changes in oal sales revenue a year is sill significanly posiive (p < 0.01). Year and Fama- French 49 indusry conrols are added in column (3) and (4). Similar o resuls in column (1) and (2), he coefficien of changes in direcors exernal connecions a year is significanly posiive (p < 0.01), indicaing ha new appoinmens of direcors wih more exensive exernal connecions o he board accrues value o he firm by boosing sales revenue of he firm. Panel B of Table 1.4 repor he resuls of regression analysis based only on he subsample of direcors who are defined as independen by he BoardEx daabase. In each column, he resuls are very similar o hose repored in column (1) hrough (4) of Panel A of Table 1.4 based on all direcors sample excep he coefficiens of changes in direcors exernal connecions of he firm for independen direcors only are slighly weaker han hose of changes in direcors exernal connecions of he firm for all direcors. Taken ogeher, his evidence suggess ha direcors exernal connecions as board relaional capial play an imporan role in enhancing firm performance by increasing sales growh. 22
[Inser Table 1.4] Nex, I examine wheher here is an associaion beween he exen of direcors exernal connecions and firm profiabiliy. Table 1.5 presens resuls from regressing changes in ROA on changes in direcors exernal connecions Panel A of Table 1.5 shows he resuls of regression analysis based on all direcors sample. Column (1) repors ha changes in direcors exernal connecions a year are significanly (p < 0.01) posiively associaed wih changes in ROA a year, indicaing ha direcors exernal connecions provide economic benefi o firms by improving profiabiliy. Similar o he resuls in Table 1.4, he resuls sugges ha conrolling for he governance and oher firm and board characerisic variables, firms wih more wellconneced direcors show higher profiabiliy han firms wih less well-conneced direcors. The resuls also sugges ha firms in an early sage of heir life cycle are more likely o benefi from direcors exernal connecions. Column (2) adds he conrol variable, changes in direcors exernal connecions a year 1. The resuls show ha he coefficien of he change in direcors exernal connecions a year 1 is no saisically significan. Afer conrolling for he change in direcors exernal connecions a year 1, he associaion beween he change in direcors exernal connecions a year and he change in ROA a year is marginally posiive (p < 0.1). Column (3) and (4) show he resul of he regression including year and Fama-French 49 indusry conrols. In he presence of boh year and indusry conrols, he resuls are very similar o hose repored in column (1) and (2). I find he coefficien of he change in direcors exernal connecions a year is significanly posiive (p < 0.01) in column (3) and he coefficien of he change in direcors exernal connecions a year is marginally posiive (p < 0.1) in column (4). The findings imply ha new appoinmens of direcors wih more exensive exernal connecions o he board help firms improve heir profiabiliy. 23
Panel B of Table 1.5 repor he resuls of regression analysis based only on he subsample of independen direcors. Consisen wih my resuls based on all direcors sample, I find a significanly posiive associaion beween he exen of direcors exernal connecions and firm profiabiliy excep specificaions conrolling he change in direcors exernal connecions a year 1, which show he posiive, bu no saisically significan associaion. Togeher, he resuls are consisen wih direcors exernal connecions providing economic benefi o firms by improving profiabiliy. [Inser Table 1.5] To examine wheher firms experience efficiency gains hrough cos reducions in he presence of direcors wih more exensive exernal connecions, I invesigae he relaionship beween he change in direcors exernal connecions and he change in cos of goods sold and SG&A expenses for he firm. Table 1.6 presens he resuls from regressing changes in cos of goods sold on changes in direcors exernal connecions. Panel A of Table 1.6 shows he resuls of regression analysis based on all direcors sample. Column (1) repors he resuls of he base regression. I find ha he associaion beween he change in direcors exernal connecions a year and he change in cos of goods sold a year is significanly (p < 0.01) negaive, indicaing ha he firm experiences produc cos reducions afer he appoinmen of new direcors o he board wih more exernal connecions. This associaion holds afer conrolling for he governance and oher firm and board characerisic variables. The resuls also sugges ha firms in an early sage of heir life cycle are more likely o benefi from direcors exernal connecions hough cos reducions. Column (2) adds he change in direcors exernal connecions a year 1 as a conrol variable. The resuls sugges ha even afer conrolling for he addiion of direcors wih more exensive exernal connecions o he board in he year before, 24