In October of 2001, the business world was roiled by revelations that the Enron Corporation, then one of the world’s largest energy companies, had for years been engaged in a massive financial fraud that allowed executives to hide enormous and ultimately crippling debts. The scandal resulted in the collapse of Enron, and sent several top executives to jail.
The Enron scandal was at the time viewed as one of the largest in the history of American business. But just a few months later, word broke of a similar scandal at New Jersey-based Tyco, where CEO Dennis Kozlowski had concocted an elaborate scheme to inflate earnings and hide losses, and just a few months after that came the collapse of WorldCom, where executives had also been cooking the books. Collectively, the scandals resulted in the loss of billions in shareholder value and thousands of jobs. Not surprisingly, lawmakers decided to act.
In July of 2002, President George W. Bush signed into law the Sarbanes-Oxley Act, a sweeping set of regulations that sought to crack down on corporate misconduct and protect investors. A major focus of the legislation was to promote “board independence”—the idea that board directors should not work for or be connected in any way financially to the companies they are supposed to be providing oversight for.
The theory underpinning board independence is obvious: Directors who are not employed by the firm they oversee and do not do business with the firm are more motivated to question any potential irregularities than those directors on the inside who might stand to gain from such behavior. After all, failing to uncover issues in a firm one is specifically hired to monitor could damage an independent director’s reputation, jeopardizing opportunities to sit on other boards. But, to hear Corinne Post and Andrew Ward tell it, even as nations worldwide moved to enact similar legislation, there was no scientific consensus backing the idea that such regulations actually worked.
Post, the C. Scott Hartz ’68 Term Professor of Management, and Ward, the Charlot and Dennis E. Singleton ’66 Endowed Chair in Corporate Governance, recently joined with two colleagues—Kris Byron of Georgia State University and François Neville of McMaster University—to remedy that. For work that was eventually published in the Journal of Management, Post, Ward and their colleagues conducted a meta-analysis of 135 different studies to finally test the theory that board independence is linked directly to better governance.
“Board independence has long been championed as this solution to curbing corporate misconduct,” Post says. “But the reality is that there has been a lot of skepticism among scholars that this kind of legislation would be effective. So we thought this would be a good way to examine the extent to which these kinds of actions can make a difference.”
The team examined evidence spanning more than 80,000 companies in 20 countries worldwide, and when their work was complete, they found their answer: Board independence can be a good thing, they say, but not in every form, and not universally.
It turns out that firms implement board independence in various ways: Some focus on ensuring that a decent proportion of all directors, overall, are independent; others concentrate on staffing the board’s audit committee (whose specific role is oversight) with independent directors; others still simply ensure that someone other than the CEO chairs the board of directors.
The team’s analyses showed that all three implementations correlate to less corporate misconduct. However, the strongest correlation among the variants of board independence was within audit committees, which are primarily tasked with overseeing financial reporting processes, regulatory compliance, and risk management.
The team also found that effect of board independence was significant and large; in fact, the board independence-misconduct relationship was about twice as significant as the relationship others have found between board independence and firm performance.
Finally—and perhaps most importantly, as nations continue to grapple with issues surrounding corporate governance and corruption—the team also noted that the extent to which board independence and CEO-chair separation may curb misconduct depends on a country’s institutions and norms. What might be considered to be corruption in the U.S., Post says, may be seen as less problematic in another country. And in these situations, even an independent board can be overpowered by inherent corruption.
“In other words,” Post says, “the mechanism of board independence doesn’t function evenly across the globe.”
In short, independent directors are most likely to curb corporate misconduct when they are on the boards’ audit committee, and when the firm they oversee is located in countries with stronger institutions and norms preventing corruption.
