When asking a busy person can backfire

Assistant Professor of Finance Luke Stein and his co-author considered directors on the boards of public companies and asked if there’s a difference between the times when they are likely to do a good job and the times when they're likely to do a bad job.

By Jane Larson

Directors on the boards of public companies are expected to advise the CEO, monitor the quality of financial statements, and lend their expertise to making acquisitions successful. Especially sought-after for director positions are executives actively working at other companies because of the knowledge and networks they can bring to a board.

It’s a big job, and researchers have sometimes found that when directors get busy with other boards, at least one of the companies in whose boardrooms they sit can suffer.

Assistant Professor of Finance Luke Stein and W. P. Carey graduate Hong Zhao, now of the NEOMA Business School in France, knew most prior research focused on retirees, professionals, and others serving on multiple boards.

“Hong and I considered not only who’s a busy person … but the same person that’s busy sometimes, and sometimes they’re not,” Stein says. “Rather than think about who’s an effective director or who’s not, let’s take a given person and ask if there’s a difference between the times when that person is likely to do a good job and the times when that person is likely to do a bad job.”

In their paper published this year in the Journal of Corporate Finance, Stein and Zhao broke new ground by looking at the estimated one-third of directors who are full-time executives at other companies and by quantifying what happened when their employer’s poor performance distracted them from their part-time board duties.

The pair culled their data from a database of public firms between 1996 and 2016 and found 8,169 executives who served on other firms’ boards, for a total of 39,099 director years of service. For each director year, they calculated the stock performance of the director’s employer during the board firm’s fiscal year. When employer firms performed in the bottom quintile, the researchers found the executives were more likely to miss board of directors meetings. Because directors do much of their monitoring and advising at these meetings, the researchers used meeting attendance to measure distraction.

Overall, the research found that compared with similar firms without distracted independent executives on their boards, the average firm with a distracted one saw its return on assets slip 2.7% and its market value fall about 6%. More detailed results also helped explain what may have driven these negative effects:

  • Because boards negotiate pay packages with CEOs, the researchers reasoned that a distracted executive director can’t bargain as hard or delve as deep into complex equity compensation as an undistracted one. They found that having an additional distracted director increased CEOs’ equity compensation 3.6%.
  • Boards must pay attention to the firm’s performance, and if it slips, they can evaluate a CEO’s explanations of what happened and whether he or she should stay on. The research found that given the same level of poor performance, the CEO is less likely to be fired when a director is distracted.
  • Boards are responsible for making sure the firm puts out high-quality financial statements. The researchers found that firms with distracted executives as directors take higher discretionary accruals — one way of managing earnings to look more favorable — and make more financial restatements due to accounting irregularities than do firms without distracted ones.
  • Boards help monitor, advise, and negotiate mergers and acquisitions. The research found that deals announced by firms without distracted executives as directors were more successful, in terms of stock returns around the announcement date, than deals done by firms with distracted ones.

The negative effects were exacerbated when distracted independent executive directors served on relevant committees, such as compensation or audit. These effects also kicked in when boards were small, with fewer than nine members to share the work, or when the experience of committee members wasn’t diversified.

The research has implications for CEOs, stockholders, and directors, Stein says. CEOs should be thoughtful about serving on outside boards and about how much time they could devote to those duties when things get busy at their employer. For their part, stockholders should be cautious about voting for the most prestigious, likely-to-be-busy executives as directors and should consider the diversity of experience of those they vote for, especially on small boards. Directors should have good procedures in place to ensure effective communication so they can be aware and step in when one of them is distracted.

Though the research focused on the ill effects of distraction, Stein suggests it shows that when they are not distracted, executives who serve as directors make strong contributions to overall performance and the other indicators. “My preferred interpretation is on the flip side,” he says. “If these are the bad things that happen when the people are distracted, what I’m really learning is about the good things that people do when they’re not distracted.”

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