The Supply of Corporate Directors and Board Independence *

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The Supply of Corporate Directors and Board Independence



Anzhela Knyazeva1, Diana Knyazeva2, and Ronald Masulis3



We thank Bernard Black, Christa Bouwman, Qianqian Du, Kose John, Jason Kotter, Rafael LaPorta, John Long, Vikram Nanda, Subrata Sarkar, George Serafeim, Cliff Smith, Jerry Warner, Toni Whited, Wanli Zhao, and conference and seminar participants at the 2009 European Financial Management Symposium on Corporate Governance and Control, 2009 Financial Management Association Annual Meetings, 2010 Asian Financial Management Association Meetings, 2010 Australasian Finance and Banking Conference, 2011 SFS Cavalcade, University of Michigan, 2011 Frontiers of Finance Conference at ISB Hyderabad, 2012 American Finance Association Annual Meetings, Dartmouth College, and University of Queensland for valuable comments. The authors gratefully acknowledge the financial support of the William E. Simon Graduate School of Business Administration and the Financial Markets Research Center at Vanderbilt University.


William E. Simon Graduate School of Business Administration, University of Rochester, Rochester, NY 14627, USA, phone: 585-275-3102, e-mail:


William E. Simon Graduate School of Business Administration, University of Rochester, Rochester, NY 14627, USA, phone: 585-275-3211, e-mail:


Corresponding author. Australian School of Business, University of New South Wales, Sydney, NSW 2052, Australia, phone: +61 2 9385 5860, fax: +61 2 9385 6347, e-mail:


The Supply of Corporate Directors and Board Independence


We explore the relations between board independence and key board decisions, CEO incentives and firm performance, using a framework that circumvents major endogeneity concerns common in research on corporate boards. Our approach is to exploit the strong impact of local director labor markets on corporate board structure to examine whether firms can more easily attract independent directors to their boards when a larger pool of prospective directors (executives of other firms) is located near a firm’s headquarters. Empirically, firms close to large pools of local director talent have more independent boards and more local independent directors. Proximity to local pools of specialized expertise - academic, legal, financial, technological or similar growth experience - is associated with greater board representation of such directors. Local labor markets are less important for well established, highly visible firms. Using local director pools as an instrument for board independence in small and medium-sized firms, we reexamine the effects of board independence on firm value, operating performance and CEO incentives. Empirically, we find that board independence has a positive impact on firm value and operating performance, and increases CEO pay for performance sensitivity and CEO turnover-performance sensitivity.



1. Introduction

Recent research on the role and effectiveness of boards of directors has emphasized the optimal choice of board composition, and the potential importance of board independence and expertise (e.g., Adams and Ferreira, 2007; Coles, Daniel and Naveen, 2008; Boone et al., 2007; Raheja, 2005). One stream of research focuses on independent director representation on the board and concludes that the nature of a firm’s investment opportunities affects its demand for outside directors with particular attributes to enhance a board’s advisory and monitoring roles. Another stream of research emphasizes private benefits of control and CEO influence over board nominations to explain the degree of board independence. Common themes in the board of directors literature are the need for CEO monitoring and advice. Yet, the empirical evidence supporting this proposition is mired in controversy due to endogeneity concerns. We circumvent these concerns by exploring an important overlooked question, namely the role of the local labor market in affecting the supply of directors to firms and how it influences board composition. Specifically, we investigate whether a firm’s ability to recruit qualified independent directors to its board is significantly affected by the local supply of prospective directors, holding demand side characteristics constant.

We conjecture that the local labor market for prospective directors has an important bearing on board appointment decisions because prospective directors have substantial demands on their time and serving on the boards of local firms entails lower time costs. Empirically, we find that the local supply of potential directors near a firm’s headquarters has important effects on board structure and independent director representation, even after controlling for demand related determinants of board design found in earlier research. Firms located in the vicinity of larger pools of prospective directors have a higher percentage of locally employed independent



directors and higher independent director representation on their boards. As a consequence, firms constrained by a limited local pool of qualified prospective directors rely more heavily on gray directors and insiders for their board appointments. The size of the local pool of active executives also has a particularly strong effect on a firm’s proportion of outside directors with executive experience. Interestingly, we do not observe a mechanical effect between the depth of the local director pool and overall board size, suggesting that the primary impact of local labor markets is on the composition of the board and not board size. Furthermore, firms located near major universities, law firms, technology firms, and financial institutions have higher percentages of outside directors with academic, legal, technological and financial expertise, respectively, on their boards of directors.

Our main results establish a significant role for the supply of prospective directors in explaining board composition. We refine our initial analysis by looking at various subsamples of firms that are more likely to be constrained by local director supply. We further reexamine the main relations around the imposition of regulatory constraints on board composition – Sarbanes-Oxley and stock exchange listing rules, which serve as an additional source of exogenous variation in board independence. Given these results and the general stationarity of headquarters locations, we use the local supply of prospective directors to predict the level of board independence and then use it to reexamine the relation between board composition and firm value, performance, CEO compensation and turnover incentives.

The availability of local director talent is relevant for a firm’s board selection process for several reasons. First, the ability to hire non-local directors is reduced by their higher costs of attending board meetings, including obvious transportation costs as well as their higher time and energy costs spent traveling to board meetings far from their home offices. Such opportunity



costs can be considerable for directors with full-time positions in distant locations. Second, it is more costly for non-local directors to acquire soft information about the quality of managerial decision making and performance. Thus, more remotely located directors must expend much greater effort to oversee managers effectively from a distance.

Existing evidence finds a nontrivial impact of distance in a variety of situations where monitoring has substantial value. For example, Lerner (1995) argues that proximity to a venture capitalist’s (VC’s) office affects its willingness to invest in a firm or join a firm’s board since it is generally less costly to oversee local firms than more distant ones. Bengtsson and Ravid (2011) argue that the VC’s proximity to a portfolio firm facilitates soft information transfers and lowers monitoring costs and they find that proximate VCs offer entrepreneurs less harsh incentive contracts, with fewer investor-friendly contingent rights to cash flows. Masulis et al. (2011) find that foreign independent directors, who are far removed from a firm, are less likely to attend board meetings and boards that include them are more likely to offer excessive CEO compensation and restate earnings as a result of financial misreporting and exhibit significantly poorer firm performance. Coval and Moskowitz (1999) present evidence of local investment bias among mutual fund managers and evidence that they earn higher abnormal returns on nearby investments, while Bae et al. (2008) illustrate the information advantage of local stock analysts in forecasting earnings. Ivkovic and Weisbenner (2005) show that local investment bias is present among individual investors, while earlier work by Brennan and Cao (1997) and Kang and Stulz (1997), among others, suggests that information costs being a positive function of distance to an investment can partially explain these investor preferences. DeYoung, Glennon, and Nigro (2008) find that defaults on small business loans increase with distance, particularly at banks that do not use credit scoring (‘hard information’ based underwriting approach).



While there are several reasons why firms may want to recruit independent directors locally, qualified directors are a scarce human resource and locating a willing candidate can be time consuming. For example, replacing a director following an unexpected departure takes a considerable amount of effort and time (on average 185 days, according to Nguyen and Nielsen (2010)). Moreover, an average senior executive holds less than one outside board seat, suggesting a reluctance by executives to become overcommitted with outside board responsibilities (Perry and Peyer, 2005; Ferris et al. 2003). If the local market for prospective directors is thin, firms may be unable to obtain the desired number of experienced independent directors in the local market.

Given the weaker director reputation benefits that smaller, less established firms offer, as well as the greater challenges faced by outside directors traveling to firms in less accessible areas, such firms are likely to face greater difficulties in attracting qualified independent experts to their boards. Given the limited supply of local director talent (especially independent directors with specialized expertise) combined with the high costs of attracting non-local independent directors and assuring their active board participation, firms may appoint fewer independent directors or fewer directors with specific expertise to their boards. Thus, we hypothesize that the availability of prospective independent directors in the local labor market affects a firm’s choice of board structure and that this effect is much stronger for small and medium-sized firms. Moreover, the proportion of local directors among independent directors is expected to decrease with firm size. This hypothesis is also tested holding constant a firm’s demand for independent directors with specific skills, which is a function of the costs and benefits a firm realizes from intensive oversight and advisory services of these independent directors.



The above discussion motivates our main empirical predictions, which are specified below. First, firms located near larger pools of prospective directors are expected to have a higher fraction of independent directors on their boards, holding other factors constant. Based on the Guner et al. (2008) and Linck et al. (2008b) findings that most outsiders come from non-financial executive or similar industry backgrounds, we focus on the pool of current executive officers at nearby firms as the primary source of prospective directors likely to be easiest to recruit. Further, firms located near larger local executive pools should draw a higher proportion of independent directors with executive expertise, especially from nearby firms, all else equal.1

While the median independent director is a Main Street executive, other common career paths for outside directors include executive positions at financial institutions and legal or non-corporate backgrounds such as academia, politics, government service, non-for-profits etc. Averaging Linck et al.’s (2008b) annual samples, directors with executive experience account for over forty percent of independent directors (with retired executives accounting for another twenty-five percent), financial directors – ten percent, lawyers – seven percent, academic directors – four and a half percent, and the remainder – under ten percent. Holding other factors constant, a firm’s proximity to these specialized types of director talent is expected to have a positive effect on the presence of independent directors with such expertise sitting on a firm’s board.

Further, we examine firm and industry characteristics that can affect the extent to which board composition is reliant on the local director labor market. Qualified prospective directors have opportunity costs of joining a company’s board. A prospective director is more likely to


We also assess whether local labor market constraints are less binding for firms that are more readily accessible due to their proximity to a major airport. The presumption is that prospective directors will be expected to bear lower travel costs and thus will be willing to travel further to join a firm’s board. As a consequence, these firms could be less constrained by local labor markets.



accept a board appointment at a company with more visibility, which offers greater director reputation benefits. We therefore expect directors to be more willing to assume distance-related costs of joining boards of larger, more established firms. Since potential directors have limited time to serve on outside boards and realize greater reputation benefits from serving on boards of larger firms, they will be more reluctant to serve as directors on smaller firms. Thus, firms with less visibility are expected to face greater hurdles in attracting non-local directors, forcing them to rely more heavily on the local labor market as a primary source of independent directors.

The prior analysis raises an important question as to whether we effectively control for a firm’s overall demand for independent directors and those with specific expertise in our analysis of the supply effects of local director pools. Our primary approach is to incorporate as controls the determinants of a firm’s choice of board composition documented in existing studies of boards. Following Coles et al. (2008), Denis and Sarin (1999), Linck et al. (2008a) and related work, we include the following control variables: firm size, growth opportunities, firm age, intangible assets, R&D intensity, monitoring by institutional investors, the extent of takeover defenses, the strength of managerial ownership incentives, and CEO tenure. To account for unobservable time-invariant differences in demand for outside directors or specific types of outside director expertise, we include industry fixed effects. We also incorporate time fixed effects to account for aggregate trends in demand for board independence and director expertise. Furthermore, for several tests we exploit the relatively greater demand for particular types of outside director expertise in certain industry sectors, such as knowledge intensive and high tech industries and regulated industries.

Next, we examine whether there is a measurable change in the relation between board composition and local director markets following an exogenous shock to board composition due



to recent governance reforms that place greater priority on board independence. On the one hand, as the proportion of independent directors on boards increases to comply with these laws and regulations, firms are likely to search the local labor pool for prospective directors more intensively. On the other hand, an exogenous increase in aggregate demand for independent directors could lead many firms to exhaust local labor markets and thus, be forced to pursue a regional or nationwide search.

Finally, if local labor markets have a significant effect on board characteristics, while firm location is largely predetermined and thus independent of later corporate decisions, we can use the exogenous variation in local director market conditions to achieve a more powerful experimental design for examining the empirical association of board composition with firm value and other outcomes. We focus on the subsample of small and medium-sized companies, represented by the bottom 75% of the S&P 1500, where local labor market conditions are most likely to serve as a constraint on a firm’s ability to attract independent directors. Given that we show that local labor pools of potential directors significantly affect board composition, the implications of this supply side effect are very important to explore.

Our main findings are as follows. Firms located near larger pools of prospective directors have a higher proportion of independent directors on their boards. The effect is strongest for small and medium-sized firms that may come to rely more heavily on local director markets for board members due to their lower visibility and prestige. Further, firms in locations that are less readily accessible by air are more reliant on local director pools due to complicated logistics of attending meetings and otherwise being an active outside director. We also find support for the conjecture that firms in locations with worse climates (defined as having a lower percentage of sunshine, more snow days, higher temperature extremes, and higher temperature variability



throughout the year) are more constrained by local director pools. Our results are consistent with the prediction that weather, an arguably exogenous factor, influences a qualified nonlocal director’s willingness to join the firm’s board (due to weather-related transportation delays and a less comfortable living environment). Further, firms with access to deeper local labor markets for particular types of expertise have a higher proportion of such experts on the board.

Finally, we examine the relation between board independence and firm performance and value in a two-stage setting using the local director pool as an instrument for board independence. Consistent with the theoretical predictions about the monitoring role of an independent board, we confirm the hypothesized positive effects of board independence on firm performance and valuation. We also find that more independent boards have a higher proportion of incentive pay in total pay, and all else equal, greater CEO turnover-performance sensitivity.

Our findings contribute to the extensive literature on corporate boards (see, e.g., Rosenstein and Wyatt, 1990; Yermack, 1996; Yermack, 2004; Guner et al., 2008; Fich, 2005; Linck et al., 2008a; Boone et al., 2007; Masulis and Mobbs, 2011; Brickley et al., 1994). While these prior studies focus on the demand for independent directors (or particular types of independent directors), we examine the supply of potential directors in the local labor market and show that it is an important determinant of board structure.

This study is related to a recent strand of literature that explores the implications of geography for monitoring. Distance and remote location have been linked to reduced effectiveness of information collection, monitoring and advising and to lower institutional ownership and analyst following (Loughran and Schulz, 2005, 2006; Almazan et al., 2008; Kedia et al., 2008; John et al., 2011; Becker et al., 2011; Coval and Moskowitz, 1999, 2001; Ivkovic and Weisbenner, 2005; Malloy, 2005; Bae et al., 2008; Landier et al., 2007). John and



Kadyrzhanova (2009) find that firms are less likely to adopt takeover defenses in areas with good governance and that good governance is only beneficial if local peers’ governance is good as well. Bouwman (2011) finds that individuals are more likely to be appointed to boards if they previously held a board seat in (i) the same geographic area, (ii) the same industry, (iii) a similar size firm, (iv) a firm with a common director, or (v) a well performing firm. Fich (2005) finds that executive expertise is valued when individuals are selected for board appointments. Guo and Masulis (2012) use the changes in listing requirements around the Sarbanes-Oxley reforms to examine the effect of board independence on CEO turnover and subsequent firm performance following CEO firings.

Our study examines the impact of the density of local labor markets for prospective directors with specific types of expertise on the quality and composition of boards, a critically important corporate governance mechanism. Two recent papers examine the proximity of existing directors to headquarters. Wan (2008) shows that current board members living close to headquarters are better informed and realize higher returns on inside trades, however, they are less effective as monitors and are associated with lower firm value. Alam et al. (2011) report that firms with lower asset tangibility and capital intensity have more local directors and they find that local directors reduce the performance sensitivity of managerial pay and turnover.

Our analysis differs in several important ways from this prior literature. We do not examine how independent directors’ geographic distance from the firm affects CEO compensation structure or turnover or value. Instead, we evaluate the role that the pool of potential directors in a firm’s vicinity plays for the structure of the board and the ability to attract different types of outside expertise, and demonstrate a supply effect on board composition.



Besides documenting the overall importance of local director markets for board composition, we isolate firm characteristics that increase its dependence on the local pool of director talent.

2. Data Sample

The sample includes Compustat / CRSP firms with available RiskMetrics data on board characteristics and takeover provisions, 13f data on institutional holdings, and Execucomp data on CEO characteristics and share ownership. Compustat/CRSP firms covered by governance databases are larger than firms in the entire universe of public and private companies. Financial firms (6000-6999), regulated utilities (4900-4999), small firms with total assets under $20 million, foreign firms, and firms headquartered outside the continental US are excluded. The sample period is 1996-2006, and unless otherwise specified, the final sample includes 1,661 firms. In several tests, sample selection criteria are modified for robustness. Where director titles are required to identify executive experts, the sample period starts in 1998 due to availability of primary titles in RiskMetrics. Measures of academic, legal, and financial expertise and director education are based on BoardEx data beginning in 2002 and ending in 2008. Geographic coordinate data is obtained from the 2000 Census and climate data is obtained from the National Climatic Data Center.

Explanatory Variables Board characteristics

Following prior work, the main measure of board composition is board independence, defined as the proportion of the board represented by independent (non-gray) outside directors. Gray directors are outside board members with familial or business ties to a firm or its senior



management, which create conflicts of interests that can compromise a board’s major functions.2

Robustness tests also consider inside directors, defined as the proportion of firm officers on the board. For a representative sample firm, the board is comprised of 9 directors, of whom 65% are independent, 14% are gray, and 21% are officers (including the CEO).

Local independent directors are independent directors employed at companies located within a sixty-mile radius of the sample firm, as a fraction of independent directors holding corporate jobs. For the average firm in our sample, about a third of independent directors are identified as holding executive positions, of which a third are employed at local firms.

Director expertise contributes to a board’s ability to effectively monitor and advise the CEO (Fich, 2005; Adams and Ferreira, 2007; Raheja, 2005). Director expertise is measured by the proportion of executive, financial, technology, and academic experts among outside board members. Executive experience is defined as being a current chief executive officer, chief financial officer, chief operating officer, or inside director on another firm’s board.3 We also

distinguish between directors with and without more specialized business expertise in R&D intensive, high-tech, or growth firms. Financial, legal, and academic expertise is determined based on the executive positions a director holds or held in the recent past, as reported in BoardEx. Detailed definitions are shown in Appendix A. Summary statistics for the main variables are presented in Table 1.


Gray directors are identified by RiskMetrics based on firm proxy statements and disclosures of related transactions. Examples include executives of professional service providers; customers; suppliers; former employees of the firm or subsidiaries; designees under an agreement with a group, directors designated by a significant shareholder, majority holders; family members of executives; recipients of the firm’s gifts; and interlocking directors (a director and executive of our firm sits on another board that has an executive and director who also sits on our board). With regards to former employees, according to NYSE listing standards, former employees can be reclassified as independent rather than gray directors after three years. Excluding the few such cases from the independent director definition does not affect our results (the average proportion of independent directors declines by a tenth of a percent and the main result continues to hold).


Identification of directors with executive expertise is based on current executives within the RiskMetrics S&P 1500 universe of companies during our sample period, which does not cover very small or privately held firms. Compared to their peers at large firms, executives of small firms are less likely to be invited to join corporate boards, so excluding them should have little effect on our empirical results. As a way of evaluating the effect of excluding this group of executives, we also use a more comprehensive executive expertise measure drawn from the BoardEx database.



[Table 1] Characteristics of local director labor markets

We construct several variables to characterize the availability of prospective directors in the vicinity of a firm’s headquarters. According to Guner et al. (2008), the most common outside director career is an executive role at another nonfinancial firm, followed by finance and non-corporate backgrounds. Similarly, in Linck et al. (2008b) non-corporate directors with nonfinancial executive backgrounds are significantly more prevalent than financial, nonprofit, consultant or academic backgrounds.

Thus, our main measure of the local pool of prospective directors (local director pool) is the density of nonfinancial firms located within a sixty-mile radius of the sample firm.4 Logs are

used to address the right skewness of the densities. Since executives of direct competitors are unlikely to be asked to join the board due to competitive concerns about the release of proprietary information and anti-trust liability (price fixing), we exclude firms in the same four-digit SIC industry. In robustness tests, we expand the local pool definition to include firms in the same industry, use a hundred-mile radius, include firms from Alaska, Hawaii, and Canada, and, to account for the possibility that large firms are the primary source of directors, exclude small firms from the local director pool.

In addition to looking at the size of the local pool of potential executive expert directors, we consider prospective directors with other backgrounds that serve as a source of specialized expertise. Specifically, we examine the log of the number of (i) financial institutions in the firm’s vicinity, as a source of financial experts; (ii) academic institutions, defined as nationally ranked


This measure implicitly assumes that prospective directors holding top positions at other firms are generally concentrated at a firm’s headquarters, which seems plausible, and the number of top executives available to serve on outside boards is comparable across firms. To address the possibility that firms of different size supply varying numbers of prospective directors, we redefine local director pools to contain only large companies in a robustness test in Table 5 and find our results are robust to this alternative pool measure.



business schools and universities listed in U.S. News and World Report, as a source of directors with academic backgrounds and advanced degrees; (iii) main offices of law firms, as a source of legal expertise; and (iv) high-tech and R&D firms, as a source of technology experts.

We use firm headquarters locations reported in Compustat. Geographic coordinates are obtained from the US Census (2000) Gazetteer. Headquarters locations are generally chosen in the early life of a firm, many years prior to the board composition choices we examine, and typically for reasons unrelated to demand for a particular board structure. Thus, we treat firm location as predetermined and use the concentration of organizations’ headquarters in the firm’s vicinity as a source of exogenous variation. Headquarters locations are likely to be most relevant for the hiring of independent directors and the cost of managerial oversight and board activity. In the robustness section, we perform sensitivity tests that examine the influence of infrequent headquarters relocations.

Control variables

We use various controls to capture the costs and benefits of independence and firm-specific demand for independent directors. Complex firms are expected to have a greater need for advice from skilled outside experts (Boone et al., 2007; Coles et al., 2008; Linck et al., 2008a). Similar to prior work, our main proxy for complexity is firm size. Some tests also use the degree of a firm’s business and geographic diversification, measured by the number of industry segments and a foreign segment indicator, respectively.

Although independent directors have fewer conflicts of interest than insiders, they also have less firm-specific knowledge (Fama and Jensen, 1983). For growth firms, firm-specific knowledge is crucial and the cost of transferring it to outsiders is high, which results in fewer outsiders on the board (Coles et al., 2008; Linck et al., 2008a). We use sales growth, R&D



intensity, and intangible assets (and to some extent, the standard deviation of returns) to proxy growth options and the importance of firm-specific information.

Other controls reflect governance mechanisms that could either substitute for or complement board monitoring. The Gompers et al. (2003) G Index of takeover defenses is a commonly used measure of a key external governance mechanism. For robustness we use a classified board indicator as an alternative measure. Institutional ownership captures monitoring by institutional blockholders (and to an extent, institutional investor preferences regarding governance). When managerial and shareholder interests are aligned through higher CEO ownership, the need for board monitoring is expected to decrease (Raheja, 2005). CEO characteristics may also affect optimal board composition. More influential CEOs with longer tenure may require greater board monitoring (Raheja, 2005). Alternatively, if tenure is a function of ability, CEOs with longer tenure should require fewer outside experts on the board. Firms with older CEOs nearing retirement may add inside board members to facilitate internal succession (Linck et al., 2008a; Hermalin and Weisbach, 1998). Since some governance mechanisms could be chosen simultaneously with board composition or independence, the coefficient estimates on these other governance measures need not indicate causal relations with board composition. Our findings are not affected when these potentially endogenous controls are omitted. In some robustness tests, we add indicators for firms located in large and medium-sized cities, based on the US Census (2000), to capture the special character of large population and business concentrations. All specifications include three-digit SIC industry and year fixed effects to capture industry and temporal variation.



In the latter portion of our analysis, we use two-stage least squares to reevaluate the relation between board independence and important firm decisions and outcomes (total CEO pay, the proportion of incentive pay in total pay, CEO turnover, firm value, and operating performance) and deal with endogeneity concerns common in prior work. In the first stage, we predict the level of board independence by the size of the local director pool, our measure of interest, as well as industry median board independence (in the spirit of the John and Kadyrzhanova (2009)) and large and medium-sized city indicators. These variables affect board independence, but do not directly influence firm outcomes. We demonstrate the relevance of geographic predictors of board structure in the main board independence regressions (first stage estimates and identification statistics are reported). In the second stage, firm performance and other variables are regressed on predicted board independence and a set of controls.5 The

analysis excludes the top quartile of S&P 1500 firms based on total asset size, for which local director markets are less likely to be a binding constraint, to focus on the remaining small and medium-sized companies, which represent about 3/4ths of S&P 1500 firms. Since observations for a given firm can be autocorrelated, we use robust standard errors clustered at the firm level. 3. Empirical Results

As a first step before turning to our multivariate analysis, we examine descriptive evidence pertaining to our main premise that firms with access to larger local director markets draw a larger proportion of independent directors locally. As seen from Fig. 1, companies near larger local pools of prospective directors have a higher average proportion of locally employed


One might be concerned that local director markets are capturing underlying variation in economic conditions, and therefore, affecting firm value directly. Conceptually, geographic pools in the area of the firm’s location should not be directly related to individual valuations given the predetermined nature of firm location, the few headquarters relocations and, since the choice of initial location is made early in a firm’s life for reasons such as access to suppliers, customers, and skilled labor, and not to secure prospective directors. To address this concern empirically, in unreported tests we control for firm headquarter state in valuation regressions and obtain similar results; we also include first-stage instruments in valuation regressions and find they are jointly insignificant; this mitigates potential concerns about direct effects or validity of exclusion requirement.



independent directors. Further, the proportion of locally employed independent directors with identifiable corporate positions is three times greater for companies in the top quartile of local director pools compared to companies in the bottom quartile.

Main results

Our multivariate analysis begins with an examination of the association of local director markets and the percentage of independent directors on the board, controlling for other firm characteristics. In Table 2, OLS estimates show that board independence has a strong association with the local supply of prospective directors. In column I, a larger local pool of prospective directors is associated with greater board independence, after controlling for industry and year fixed effects. This finding supports the hypothesis that board governance is affected by the size of the prospective director pool in a firm’s vicinity.

[Table 2]

Controls for various firm characteristics (size, growth, ROA, age, risk, asset tangibility, R&D intensity, institutional ownership, and the G index) and CEO characteristics (ownership, age, tenure) that could affect shareholder demand for board independence are included in columns II and III. The main effect remains unchanged in significance and the parameter estimates on the local director pool fall only marginally in size.

Fig. 2 summarizes economic magnitudes of the determinants of board independence from one standard deviation changes in each determinant. The local director pool effect is larger in magnitude than the individual effects of sales growth, risk, ROA, and CEO characteristics. It is comparable in size to the effects of asset tangibility and size and has roughly half the impact of CEO ownership or the G index. Consistent with Coles et al. (2008), Denis and Sarin (1999), and Linck et al. (2008a), large firms, which tend to be more complex, rely more on outside directors.



Young, high growth firms have fewer independent directors, consistent with such firms having a greater need for firm-specific inside knowledge. Consistent with Coles et al. (2008), R&D intensive firms have a higher fraction of independent directors on the board. Monitoring by institutional investors appears to complement board oversight, although we are careful to interpret the relation as indicative of association rather than causality. Firms with managers protected by more extensive takeover defenses tend to have greater board independence, consistent with the corporate control market acting as a substitute for a board monitoring and disciplining its managers. Higher managerial ownership lowers the need for oversight by independent directors.

Which firms are most dependent on local director markets?

The relation between local director labor markets and board composition could vary based on firm visibility. Directors, especially those holding full-time jobs, internalize the costs of service on nonlocal boards, including transportation costs and opportunity costs of time spent traveling to and from an average of seven board meetings a year, plus the expected additional costs of their time and reputation if the firm faces serious legal or financial difficulties. Prospective directors might be less willing to join the boards of nonlocal firms if such firms have low visibility, since reputational and career growth benefits are likely to be smaller than opportunity costs of their time. Small firms on average pay their directors less (Linck et al., 2008b; Brick et al., 2006; Linn and Park, 2005). Small firms are also more likely to face financial difficulties and be unable to obtain financing in the event of a cash shortfall. In turn, Vafeas (1999) finds no effect of firm size on the number of board meetings, so a director’s normal time commitments for being on these boards appears to be roughly similar.



On the other hand, a prospective director interested in reputation building, career growth, and additional board appointments is more likely to overlook travel costs and accept a nonlocal board appointment if the firm is large, established, or otherwise highly visible. Intuitively, a board appointment to a more prominent firm carries with it greater reputational benefits. Since large firms tend to be more complex and given that performing board functions entails substantial learning about firm practices, service on a larger firm’s board offers the director potentially greater gains in expertise and a more valuable network of contracts. Although small firms could theoretically compensate for the smaller reputational benefits of serving on their boards by paying independent directors more, existing evidence does not appear to support this possibility since smaller firms pay their directors significantly less.6 It follows that potential

independent directors should be more willing to accept board seats at larger, higher visibility firms, even when they are located further away. Thus, we predict that larger, more established firms are more likely to overcome local labor market constraints and succeed in a national search.

Firm size, firm age, and NYSE listing may all raise a firm’s profile and attractiveness to potential directors.7 Univariate evidence on local hiring of independent directors by firm

categories is presented in Table 1B. Low visibility firms have significantly more locally employed directors among independent board members holding executive positions at other firms. This finding also holds more generally to all outside directors (independent as well as gray directors) and the subgroup of gray directors. Our evidence on mean distance between the firm and outside directors’ full-time position is also consistent with this argument. Based on


Further, for robustness we add a control for director pay, which does not eliminate the local director pool effect (Table 5, Panel B, column VIII). Also, in an unreported test we do not find a significant relation between local director pools and director pay.


Boards of small recently formed firms may also have a greater presence of venture capitalists, and venture capitalists’ board positions were shown to be affected by distance and location (Lerner, 1995).



univariate tests, high visibility firms have the luxury of tapping a wider, national director pool, while low visibility firms are constrained by the local supply of prospective directors.

Multivariate evidence on how the local director pool affects board independence is presented in Table 3. In initial tests presented in Panel A, the local director pool has an economically strong and statistically significant effect on board independence for smaller, younger firms, firms with few blockholders, and non-NYSE listed firms, i.e., firms with less overall visibility, but it is not significant for large, well established firms. Since these visibility proxies are correlated, we repeat the analysis using a combined visibility measure derived from a principal components analysis. We obtain similar results.

In summary, local director pools affect board independence at firms with low to moderate visibility (roughly three-quarters of the sample). High visibility firms do not appear constrained by the local supply of director talent. Intuitively, firm visibility is a plausible source of variation in the willingness of prospective directors to bear the costs of distant board meetings and as a consequence, it captures the extent to which a firm is constrained to search locally for prospective directors. In addition, we examine a proxy for the economic activity level of the region a firm is located in, on the assumption it is easier to attract directors if a firm’s location is in a state experiencing relatively high levels of business activity, which could offer prospective directors valuable synergies and networking benefits, offsetting the disutility of serving on nonlocal boards. We use an indicator that equals one if total corporate assets of public firms located in the state exceed the national median, and zero otherwise. All else equal, we find reliance on a local director pool is stronger in states with low levels of business activity, as measured by low overall assets under corporate control.



Table 3, Panel B exploits variation in the relative difficulty of attracting nonlocal directors due to varying air travel accessibility and the overall attractiveness of a firm’s headquarter location. Similar to John et al. (2011), we use distance to the closest airport as a proxy for direct transportation costs. We use sixty- and thirty-mile thresholds to identify firms that are located “far from airports”. We expect such firms to rely heavily on local director talent. Indeed, we find that firms located away from major airports are more dependent on local director pools, whereas firms headquartered close to airport hubs are not significantly affected by local director labor market conditions.

We also examine a more exogenous measure of board desirability that is unlikely to be related to economic factors affecting the firm’s or a prospective director’s opportunity set. Specifically, nonlocal director willingness to join a board is likely to be higher when it is in an attractive location. Metrics based on climate at the firm’s main location seek to capture its geographic attractiveness to a prospective nonlocal director, who might travel there for board meetings or on other occasions to monitor the firm. Inclement weather conditions are also more likely to result in travel delays and less pleasant traveling conditions, holding distance constant.

Empirically, we find that firms in areas with bad climates (measured using sunshine, snowfall and temperature extremes) are more constrained by local director markets. All else equal, local director labor supply does not significantly constrain firms in locations with good climates. The evidence is consistent with the notion that considerations related to the attractiveness of the firm’s location, in this case, typical weather in the area, impact local director labor market constraints.

In the last set of tests, reported in Table 3, Panel C, we reevaluate the relation between local director pools and board independence in the aftermath of governance reforms



Oxley (SOX) and governance rules in exchange listing requirements). More stringent board governance standards, including a majority of independent directors and independent director representation on key committees, could force non-compliant firms to expand their director search beyond their local director pools to accommodate this regulatory shock in the post-SOX period. We also note that this later period has the benefit of more advanced information and communications technology, which could make it easier to employ more distant directors who could more easily acquire firm-specific information over longer distances. However, we find that local director pools remain a significant, albeit smaller, factor in the appointment of independent directors, even as noncompliant firms increase board independence in the post-SOX period. Alternative measures of local director talent

Next we examine the sensitivity of our main findings on board independence to variable definitions, sample selection criteria, and additional controls. Alternative definitions for the local director pool variable are examined in Table 4. Our main measure of the local pool of prospective directors includes executives at US firms located within a sixty-mile radius of the firm in question. We expand the definition to a hundred-mile radius in column I. In column II, we define the local director pool more narrowly to only include other firms with headquarters in the same county. In column III, we use a thirty-mile radius around the firm’s headquarters. Canadian firms are added to the pool in column IV. The local director pool coefficient remains positive and significant and retains its economic magnitude.8

[Table 4]

Our measure of the local pool of prospective directors includes executives from local firms of varying sizes. However, firms may prefer to hire independent directors with executive


 At the 5% level in the case of hundred-mile radius or county based definitions, at the 8% level in the case of the thirty-mile radius, and at the 1% level when Canadian firms are included 



experience at larger firms, or at least similar size firms. As a sensitivity test, we measure the director pool with only firms of similar or larger size in column V. It is possible that all firms prefer directors with experience at medium to large-size firms. In column VI, the local director pool measure excludes small firms.9 Our main coefficients remain positive and significant.

Our main measure of prospective director supply excludes firms in the same industry.10

In column VII, the local pool measure includes nonfinancial firms from all industries, including the firm’s own industry. Coefficient estimates are similar to the earlier results. While our main local directors pool measure only includes Main Street executives, in columns VIII-IX we expand the local pool definition to include prospective directors from financial firms with and without executives from the firm’s own industry. In column X, we decompose the local director pool into two variables depending on whether it is below or above the sample median to allow for different effects on board independence. The local director pool effect remains positive and significant. The difference in these two coefficients is not statistically significant (not shown), consistent with board independence having a linear relationship with the local directors pool measure.

Proportion of inside and gray directors on the board and other board characteristics

In Table 5, Panel A, we supplement our previous findings on the proportion of independent directors by examining the proportion of gray directors and inside directors on the board. In column I, we test the possibility that firms with weak local director markets rely more heavily on gray directors. These types of directors may not be as effective in their role as


We exclude firms with assets below hundred million, which approximately corresponds to the first and second quintiles of assets in the full sample of nonfinancial firms (including firms with missing governance data) for our sample period.


A small minority of independent directors hold executive positions at another firm in the same industry (among independent directors with executive positions, only 2% work for a firm in the same four-digit SIC industry and just 3.5% - in the same three-digit SIC industry). This is likely due to concerns about potential conflicts of interest that may arise over proprietary information or strategic motives involving competitors.



monitors, but they may offer valuable advisory services and be easier to recruit. We find that the proportion of gray directors is decreasing in the local director pool. In column II, the fraction of inside directors is decreasing in the size of the local director pool.

We also investigate whether the local director pool affects board size. Specifically, we check whether proximity to a larger local pool of prospective directors leads firms to add more independent directors (resulting in larger board size) or the substitution of independent directors for inside or gray directors (resulting in no change in board size). In column III, board size is not significantly related to the local director pool, suggesting that firms near larger local director pools substitute independent directors for gray and inside directors, but have little influence on overall board size. Finally, in columns IV-VI, we reproduce the preceding analysis in the subsample of small and medium-sized firms. The effects remain qualitatively similar.

Further robustness analysis

The effects of alternative sample selection criteria, variable definitions, and controls are analyzed in Table 5, Panel B. Since the fraction of independent directors is a proportion bounded between zero and one percent, we regress our control variables on a logit transformation of board independence (logarithm of the ratio y/(1-y), where y is board independence expressed as a proportion; see, e.g., Maddala (1983)). Estimates from this specification are reported in column I. While the coefficients differ from the earlier regressions based on an untransformed dependent variable, the local director pool coefficient retains its sign and significance. To account for the possibility that location in a big city is correlated with board structure, we exclude firms in the top ten metropolitan areas and firms located in California, Illinois, Massachusetts, and New York (columns II and III, respectively). In column IV, we lag the local director pool one period to mitigate simultaneity concerns. In columns V-VIII, we control for a classified board, dual class



shares, business segments, foreign segments, NYSE listing, and a quadratic term on firm size, as well as substituting market value for book value as a measure of firm size.11 In unreported tests,

we redefine board independence to exclude directors with 5% or greater stakes, cluster errors both by firm and by year, and add Alaska and Hawaii firms (a handful of observations) to the sample. The local director market effect remains statistically and economically significant.

Several other alternative explanations for the local director pool effect are considered in Table 5, Panel C. Geographic clusters of same-industry firms (columns I-II) do not explain variation in independent director representation. Similarly, the effect cannot be attributed to differences in population density (columns III-IV), upper-income households (column V), households with older members drawing retirement income (column VI), or college education per capita (column VII), suggesting that our local director pool measure is not a proxy for omitted variation in the size, socio-economic class, or age profile of the area population. Without inferring causality, we also control for director pay (column VIII), which similarly does not change our main results. Accounting for variation by state in economic conditions (profitability, investment opportunities, and unemployment) and governance practices (average board independence) also does not explain the local director pool effect, which retains significance and economic importance (columns IX-XI).

Consistent with other work on location, we use Compustat data on current corporate headquarter locations. Pirinsky and Wang (2006) find that relocations of headquarters are


Allowing for a quadratic firm size specification, the linear term becomes negative and the quadratic term enters with a positive coefficient: as small companies grow, they are able to meet their expertise needs internally, but as firms continue to expand and their complexity increases, they are less able to rely on internal expertise and appoint more independent directors. In another robustness check (not reported), inclusion of a linear and quadratic market value terms, or replacing market value terms with equity market capitalization does not affect the results.



infrequent.12 Although relocations of corporate headquarters are rare, we directly examine the

robustness of our results to this issue by excluding firms from the sample that changed their locations based on their historical headquarters locations obtained from the 1996–2004 editions of Compact Disclosure. In the last two columns, we eliminate firms reporting acquisitions of more than five or one percent of total assets in a given year, respectively, which could lead to a merger related location change. After applying these sample restrictions, the sample size falls, but our basic findings do not change materially. As this robustness analysis yields very similar results, we retain our main measure of location and local director pools in subsequent tests. Executive expertise

The prior analysis of board characteristics focuses on the proportion of outside directors on a firm’s board. While the proportion of independent directors is an indicator of the degree of board oversight, it is not a sufficient metric of the quality of such oversight or a board’s ability to provide expert advice to management. Outside directors with executive experience are crucial to shareholder wealth creation (see, e.g., Fich, 2005), and executives of other local firms comprise a significant proportion of independent directors and of the local pool of prospective directors. Thus, we next explore the importance of the local pool of potential executive directors.

If firms look to local executives as a primary source of outside director expertise, the fraction of executives among a board’s independent directors is expected to be positively associated with the size of the local pool of executives. The effect is observed in column I of Table 6, Panel A. It supports the notion that the local nature of director appointments has


Even if managers could affect a firm’s location choice, it is not clear why CEOs facing less board scrutiny would want to locate away from other firms. Hubris may in fact dictate proximity to peer firms. Potential CEO preferences for locations in a big city should be captured by the big city indicator. Moreover, firm relocations are rare. Pirinsky and Wang (2006) identify 118 relocating firms in 1992-1997 (for comparison, the full sample included 4,000-5,000 firms per year). Our analysis of historical locations based on Compact Disclosure confirms this: the overwhelming majority of firms does not relocate; some move to a different city, but remain within sixty miles of the old location; and exceedingly few firms relocate more than sixty miles away.



implications for the level of expertise on the board, and not only for the presence of outside directors. By establishing a link to outside executive experts, this analysis further highlights the channel through which the local pools of executives affect independent director recruitment. The relation of independent director executive expertise with the pool of potential executives from similar-size or larger local firms is even stronger (column II). We obtain similar findings for the proportion of executives among all outside directors (columns III-IV). The result remains qualitatively similar when we draw executive expertise data from BoardEx13, in order to also

include executives of small publicly listed firms and privately held companies (column V). [Table 6]

We have seen that board representation by independent directors and those with managerial expertise increases with the density of the local director pool, consistent with our hypothesis that local labor markets are important in determining board structure. In our next test we look at the representation of local executive experts on the board to test the channel through which the local director pool affects a firm’s board composition. Univariate evidence in Fig. 1 suggests that firms located near larger local director pools of executives have a higher proportion of locally employed executive directors. Consistent with the univariate evidence, the multivariate test in column I of Table 6, Panel B shows that the proportion of independent directors with executive positions at other local firms is increasing in the depth of the local director pool of executives. Similarly, the proportion of local directors among outside (independent and gray) directors is increasing in the local director pool of executives (column II). The proportion of local gray directors alone is positively related to the size of the local director pool (column III).


A greater proportion of directors with executive experience are identified using BoardEx data for the sample of boards since BoardEx lists executive affiliations at smaller firms, outside of S&P1500, as well as at privately held (unlisted) companies. The proportion of executive experts among outside directors using BoardEx data rises to over sixty percent.



Further, average distance to an independent director’s primary employer is decreasing in the depth of the local pool of prospective directors (column IV). We reproduce the tests for small and medium-sized firms in columns V-VIII. The results are largely similar, except for gray directors, where the coefficient turns insignificant, possibly due to a small overall size of the sample of gray directors with executive positions. Overall, firms located near larger director pools can more readily recruit executives of nearby firms to serve as outside board members. This finding supports the hypothesis that local director markets affect director appointments and board independence.

Next, we consider the effect of firm size on the decision to appoint local independent directors. Univariate evidence in Table 1B indicates that the proportion of locally employed directors among independent directors with identified executive jobs is at least a third higher for smaller firms, relative to larger firms. The difference is statistically significant. Consistent with this univariate evidence, we find in multivariate analysis that the proportion of independent directors who are local executives is highest for small firms (column I of Panel B). Also, R&D intensive firms appear to be more likely to hire local directors, consistent with distance interfering with timely firm-specific information acquisition required by such firms.

We have seen that small firms draw more heavily on local directors. A related question is which types of firms deliver local director talent. We conjecture that large firms supply more prospective directors with executive expertise. In unreported univariate evidence, we find that officers of large firms are on average twice as likely to hold outside local directorships. This finding is confirmed in the multivariate analysis in Table 6, Panel C. The proportion of executives with outside board seats at other local firms is higher for larger firms, even after controlling for large firms’ possible tendency to be situated near larger local director pools



(column I).14 Consistent with this, executives of large firms are more likely to sit on the boards

of other local firms and on average hold more local directorships (columns II-III). Overall, large firms appear to serve as net suppliers of outside directors with executive expertise to smaller local firms (even beyond the direct effect of large firms having more officers).

Retired executives, classified as directors over sixty who have previously held an executive position, comprised about twelve percent of independent directors, based on Table 1. These retired executives generally secure directorships while they are active executives at nearby firms and then they are reappointed after retirement. Using our sample from RiskMetrics, more than four fifths of outside directors classified as retired were active executives earlier when they were first appointed an outside director. This suggests that our local director supply measure also applies to retired executives. In an unreported test, we find that the proportion of independent directors who are retired executives that come from local companies is positively related to the size of the local director pool.

Specialized board expertise

Corporate boards require more than general managerial experience from their independent directors; they also require individuals with specialized knowledge and skills to advise the board and CEO (see, e.g., Linck et al., 2008b). Similarly, given the heavy time demands on major classes of potential directors, firms can be expected to first approach local candidates with such expertise to be directors. Thus, firms can be forced to forego certain valuable types of director expertise, such as academic, technical, legal, or financial, when there is


Compared to all directors, insiders tend to hold fewer concurrent board appointments, presumably due to the demands of their main job, however, their board appointments are disproportionately concentrated among local firms. At an average firm in our sample, 31% (14%) insiders hold a concurrent appointment at another (local) firm. The average number of appointments at other (local) firms in our sample is 0.45 (0.17) per insider. Local firms are defined based on headquarters locations within a sixty-mile radius of the firm. When all directors (inside, gray and independent) are considered, the average number of appointments at other (local) firms in our sample is 0.65 (0.08) per director. Figures are based on an inside director’s concurrent independent or gray director status on the board of another firm as reported by RiskMetrics.



limited local supply of expertise. However, if specialized expertise is viewed as essential for corporate boards, representation of such experts on the board could be less sensitive to local labor market conditions, as firms would search more widely for potential director experts. Further, demand for such experts is likely to be related to firm characteristics reflecting the nature of its investment opportunities, expenditures on technology, asset characteristics, uncertainty, and of course, a firm’s industry, and thus these firms’ choices of directors are likely to be less sensitive to geographical conditions.

To empirically investigate the demand for independent director expertise, we examine subgroups of firms that have similar needs for particular types of director expertise. We then examine the relations of particular types of expertise available in local director markets to the expertise found in the firm’s current group of independent directors. After controlling for major firm characteristics that act as a proxy for a firm’s demand for outside directors with specific knowledge and skills, we expect the supply of local director expertise to be positively related to the overall level of this expertise found among a firm’s independent directors.

[Table 7]

In Table 7, Panel A, we focus on the specialized professional expertise of outside directors gained from their current and prior work experience. We first examine the presence of outside directors with academic work experience, termed academic experts. Besides having fewer potential conflicts of interest than seasoned industry veterans, academic directors can add specialized skills and knowledge and state of the arts perspectives gained from their fields of expertise to help address a firm’s strategic and operational challenges. Indeed, we find that having a firm’s headquarters near a number of major universities is positively associated with the proportion of outside directors having academic positions. In an unreported test, we obtain



similar results when we use top tier business schools.15 In columns II-III, we allow for the

possibility that R&D intensive firms are more reliant on academic directors. We find that R&D intensive firms located near major academic centers include a higher proportion of academic directors on their boards.16

In Table 7, Panel B, we examine the local availability of legal and financial experts. Consistent with a local labor supply effect, we find that a board’s overall legal expertise is positively related to the local density of the main offices of major law firms, a proxy for the local supply of prospective directors with legal experience. The effect is concentrated among regulated firms (financials and utilities), which arguably require a greater degree of legal and regulatory expertise on the board. In contrast, we find in unreported tests of unregulated firms that proximity to law firms is not significantly related to legal expertise on the boards.

In the last column we investigate the financial expertise of outside directors in relation to the local availability of these types of experts. Outside financial experts are valuable for all corporations as members of audit committees and to provide independent advice to top management on a firm’s financial health, capital structure, and payout decisions. At the margin, we find the density of financial institution headquarters in a firm’s vicinity, which serves as a measure of the availability of potential local directors with this type of expertise, has a positive effect on the presence of financial experts on corporate boards.

We next consider directors with technological and R&D expertise in relation to the local availability of prospective directors with those attributes (measured by the local pool of executives and outside directors in R&D intensive and high tech firms). In Table 7, Panel C, we


Major business schools are based on U.S. News and World Report business school rankings.


In unreported tests, we find that unlike R&D intensive firms, less R&D oriented firms located near major academic centers do not have a higher percentage of academic directors.



see that consistent with our hypothesis about local supply effects, the proportions of outside directors with technology and R&D expertise are both increasing in the size of the local pool of such prospective directors. Our main definition of high tech industries follows Baginski et al. (2004) and includes pharmaceuticals; computer software, hardware, and electronics; and R&D services. In untabulated tests, we also include chemical, telecommunications and media firms as high tech industries and expand the definition of director technological experience to include those fields. The results remain very similar. Finally, the fraction of independent directors with experience at firms in a similar growth phase increases in the local pool of potential directors with such expertise (defined as the same quartile of growth opportunities, measured by market-to-book ratios). Overall, a limited supply of local candidates with experience in firms with similar growth patterns raises the faction of independent director with these traits on the board.

Finally, Table 7, Panel D examines the relation of firm proximity to major academic institutions and outside director educational qualifications. The proportion of outside directors with advanced graduate and professional degrees is increasing in the density of nearby major universities. Breaking down advanced degrees into different types, we observe that boards have more outside directors with MBAs, other masters degrees, and doctoral degrees when they are located near more major universities or business schools (the effect on law degrees is not statistically significant). To the extent that educational credentials proxy for director expertise, this evidence further supports the conclusion that a firm’s ability to recruit outside experts to its board is positively affected by the density of the local pool of academically qualified candidates.



4. New evidence on how board independence affects CEO incentives and firm performance A number of prior studies report evidence that greater representation of outside directors on boards lead to gains in shareholder wealth (e.g., Gompers et al., 2003; Cremers and Nair, 2005; Bebchuk and Cohen, 2005; Masulis and Mobbs, 2011; Yermack, 1996; Rosenstein and Wyatt, 1990; Brickley et al., 1994). However, many well known researchers have raised concerns about endogeneity of board composition and the challenges in attributing causation to the observed board independence-firm performance relation (e.g., Adams et al., 2010; Boone et al., 2007; Coles et al., 2008; and Bhagat and Black, 2002).

We summarize the major criticisms of the existing evidence on the effects of board independence below. First, an omitted variable bias can arise when certain omitted characteristics correlated with firm value are also correlated with board independence. For example, growth firms, which tend to have higher valuations, may appoint more insiders due to the high costs of conveying proprietary information to outside directors, whereas mature firms, which tend to have lower valuations, may appoint more outsiders to overcome agency conflicts. Unless the relation is properly identified, the resulting confounding effect can dominate the direct effect of board independence. Second, a reverse causality concern can arise when well performing firms, which have fewer agency problems, have less need for outside director monitoring, whereas poorly performing firms need more outsiders on the board (see, e.g., (e.g., Coles, Daniel and Naveen, 2008). Alternatively, in line with the arguments in Yermack (2004), outside directors seeking to build their reputations might be drawn to top performing firms.

Endogeneity concerns cast doubt on the ability of OLS estimation to establish causation. A recent study by Nguyen and Nielsen (2010) seeks to address this endogeneity concern by looking at market reactions to sudden director deaths, a type of unexpected exogenous shock to