STANFORD CLOSER LOOK SERIES

Topics, Issues, and Controversies in Corporate Governance and Leadership

Director Networks: Good for the Director, Good for Shareholders

By David F. Larcker and Brian Tayan August 5, 2010

Board Networks

A directors social and professional network contributes to his or her qualifications as a board member. Networks are important in that they create links between individuals and organizations through which support, influence, and information are shared. For this reason, executives with a broad network tend to be highly valued as director nominees.1 Google is an example of a company with a wellconnected board. At the time of the companys initial public offering in 2004, it shared director affiliations with many successful institutions in Silicon Valley, including Apple, Cisco, eBay, Intel, and Yahoo! It was also connected to firms outside of the area, including Amazon and Wal-Mart. It is not inconceivable that these connections contributed to the companys success as both a start-up and a publicly traded corporation (see Exhibit 1). In recent years, however, much attention has been paid to the negative aspects of inter-board connections. This is because network connections have the potential to cause negative outcomes that impair economic value and reduce governance quality. For example, director networks may lead to the following: The spread of bad practices. There is considerable evidence (and informed speculation) that bad practices such as stock option backdating are transferred across companies through boardroom connections.2 Directors observing a practice at one firm may bring it to others with which they are affiliated. The spread of bad information. Incorrect information may also be shared across companies through board networks. False rumorssuch as

those of a new product launch, marketing strategy, price increase, or pending acquisitioncan cause companies to make ill-informed decisions, which destroy economic value. A reduction of director effort and attention. A well-connected director will sit on more than one board, each requiring a certain amount of time and attention. Academic research has shown that directors that sit on multiple boards (busy directors) tend to provide worse oversight. Busy boards are correlated with higher executive compensation, reduced likelihood of terminating a CEO for poor performance, and a higher likelihood of earnings manipulation.3 Collusion. Board networks may be a conduit through which firms engage in collusive activity, such as price fixing, illegal division of sales territories, and other anti-competitive behaviors. For these reasons, the Clayton Antitrust Act of 1914 prohibits shared directorships among companies that are in direct competition. At the same, not enough attention has been paid to the positive effects of board networks. Board interconnections allow for the flow of valuable information that can enhance decision making and improve economic performance. Examples include: Sharing of market information. Directors with deep networks possess considerable knowledge of industry trends, market condition, and regulatory changes. Directors that represent important affiliatessuch as customers, suppliers, or providers of capitalcan facilitate the flow of information along the supply chain, thereby improving efficiency. Sharing of management practices. Directors can

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Director Networks: Good for the Director, Good for Shareholders

deliver information about management practices and organizational improvements based on their experience at other firms. This lessens the learning curve and reduces adoption risk at subsequent firms. Negotiating information. Director connections may allow two firms to negotiate better contracts by improving trust, sharing information, and reducing information asymmetry. Professional contacts. Director networks may serve as a source of important business relationships, including new clients, suppliers, sources of capital, political connections, regulators, and director and executive referrals. These positive effects have been demonstrated through the academic literature. For example, Larcker, So, and Wang (2010) find that companies with a well-connected board have greater future operating performance and higher future stock price returns than companies whose boards are less connected. These effects are most pronounced among companies that are newly formed, have high growth potential, or are in need of a turnaround. The authors conclude that boardroom networks have an important and positive impact on the economic performance of a firm.4
Why This Matters

For more on this topic, see also: David F. Larcker, Eric C. So, and Charles C. Y. Wang, Boardroom Centrality and Stock Returns, (July 24, 2010). Rock Center for Corporate Governance at Stanford University Working Paper No. 84. Available at SSRN: http://ssrn. com/abstract=1651407. 2 John M. Bizjak, Michael L. Lemmon, and Ryan J. Whitby, Option Backdating and Board Interlocks. (February 1, 2007). Review of Financial Studies, Forthcoming. Available at SSRN: http://ssrn. com/abstract=946787; and Christopher S. Armstrong and David F. Larcker, Discussion of The Impact of the Options Backdating Scandal on Shareholders and Taxes and the backdating of stock option exercise date, Journal of Accounting and Economics, 47, p.50-58. 3 Eliezer M. Fich and Anil Shivdasani, Are Busy Boards Effective Monitors? Journal of Finance, April 2006, Vol. 61, Issue 2, p. 689724. 4 Larcker, So, and Wang (2010), loc. cit.
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David Larcker is the Morgan Stanley Director of the Center for Leadership Development and Research at the Stanford Graduate School of Business and senior faculty member at the Rock Center for Corporate Governance at Stanford University. Brian Tayan is a researcher with Stanfords Center for Leadership Development and Research. They are coauthors of the books A Real Look at Real World Corporate Governance and Corporate Governance Matters. The authors would like to thank Michelle E. Gutman for research assistance in the preparation of these materials. The Stanford Closer Look Series is a collection of short case studies that explore topics, issues, and controversies in corporate governance and leadership. The Closer Look Series is published by the Center for Leadership Development and Research at the Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. For more information, visit: http://www.gsb.stanford.edu/cldr. Copyright 2012 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.

1. Governance experts spend considerable time talking about the negative effects of board interconnections, including reduced independence, a culture of back scratching, and an old boy network. At the same time, it is important to understand that these connections can deliver tangible, positive value that benefits the organization and its stakeholders. 2. Rather than evaluate boards based on independence standards and other superficial structural attributes, more attention should be paid to how board members professional backgrounds and network of connections contribute to governance quality and shareholder value creation. Why is it so difficult for commercial governance ratings firms to incorporate this information into their analyses?

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Director Networks: Good for the Director, Good for Shareholders

Exhibit 1 Network Connections: Google Directors (2005) A subset of Googles board network in 2005, the year after its successful IPO.

eBay
Fred D. Anderson Elevation Partners (PE) Steve Jobs CEO, Apple

Pixar

Apple
Arthur Levinson CEO, Genentech William Campbell Chairman, Intuit

Amazon Intuit

Intel

Paul Otellini CEO, Intel

Google
John Hennessey President, Stanford U.

John Doerr Kleiner Perkins (VC)

Yahoo!
Jerry Yang Founder, Yahoo!

Dennis Powell CFO, Cisco

Wal-Mart

Michelle Burns CFO, Mirant

Cisco

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