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Hiring Cheerleaders: Board Appointments Of “Independent” Directors

By Harvard Law School Program on Corporate Governance

(Editor?s Note: This post comes to us from Lauren Cohen and Christopher Malloy of the Harvard Business School, and Andrea Frazzini of the Graduate School of Business at the University of Chicago)

In our recent working paper entitled Hiring Cheerleaders: Board Appointments Of “Independent” Directors, we test the hypothesis that boards appoint independent directors who, while technically independent according to regulatory definitions, nonetheless may be overly sympathetic to management. Rather than adopting the typical approach in the literature, which seeks to relate measures of board independence (e.g., increases in the number of independent directors on a board) to future performance of the firm, we investigate a subset of independent directors for whom we have detailed, micro-level data on their views regarding the firm prior to being appointed to the board. We use these track records to compare the roles of optimism (i.e., hiring a cheerleader for management) versus skill (i.e., hiring an objective and able observer) in the board appointment process.

The agents we examine are former sell-side analysts who end up serving on the board of companies they previously covered. Unlike former CEOs or other senior executives who sometimes end up on corporate boards, for whom past performance attribution is complicated by the fact that firm performance is difficult to disentangle from individual performance, sell-side analysts can be easily assessed. We can explicitly compute measures of skill/ability and optimism by examining the composition and stock return performance of analysts? past buy/sell recommendations, coupled with the accuracy of their earnings forecasts. In doing so we find evidence that boards appoint overly optimistic analysts who exhibit little in the way of skill in terms of evaluating the firm itself, other firms within the firm?s industry, or other firms in general. In particular, board-appointed analysts issue significantly more positive recommendations on companies for whom they end up on the board of directors; both relative to the other stocks they cover, and relative to other analysts covering these stocks. The magnitude of this result is large: 80.4% of these recommendations are strong-buy or buy recommendations, compared to 56.9% for all other analyst recommendations. By contrast, we find little evidence that board-appointed analysts? recommendations are more profitable, or that their earnings forecasts are more accurate. Finally, when predicting the probability of a board appointment, optimism on the firm is a strong predictor of appointment while accuracy is not. Taken together, these results challenge the conventional view that appointing independent directors necessarily adds objectivity to the board of a firm.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on October 28, 2008 (boomark / email).