In theory, a board of directors protects the rights of shareholders. Independent directors are supposed to be just that—independent—free to dissent from a decision of the majority. The reality is more complex. Directors are tied to one another by business and social connections, and their behavior often has as much to do with their relationships with one another as their concern for the company.
"Boards are populated by living, breathing people who have their own interests, and understanding the makeup of the board is very important," says Tarun Khanna, the Jorge Paulo Lemann Professor at Harvard Business School.
Scholars have studied how boards work, but very little is known about the decisions and performance of individual directors. Boards are black boxes, with debates going on behind closed doors that rarely spill out into public. It is next to impossible to know which board members are dissenting from the party line and which are following the majority.
“In the United States you know this happens, but you don't get to observe it." —Juan Ma
Khanna and HBS doctoral student Juan Ma, however, discovered data shedding light on this opaque phenomenon in an unlikely place—China. In 2001, the country transitioned to independent boards and passed a unique law requiring board members of publicly traded firms to reveal when they dissent from the majority opinion, along with an explanation for their decision.
"China is the only country we know of that requires this information. This provides us a very rare opportunity to monitor the performance of individual board members," says Ma. "In the United States you know this happens, but you don't get to observe it."
In a recent working paper,Independent Directors' Dissent on Boards: Evidence from Listed Companies in China, Ma and Khanna found that the social ties of the directors had much more influence on their likelihood to dissent than firm performance.
Social ties can be difficult to measure. Traditionally, researchers have attempted to get a handle on this subjective factor by noting connections such as directors who come from the same city or attended the same school. But that fails to capture the richness of social relations that transcend such formal connections.
In place of those markers, Ma and Khanna used a different proxy of looking at which chair appoints a director, assuming that a social tie must exist between the two. Then they measured how the voting behavior of that director changed when the chair who appointed him or her left the board as a measure of how that tie affects dissent. They found that after the chair left, board members were 58 percent more likely to dissent than before.
Dissent goes up even more significantly in the 60-day period anticipating the breaking of the social tie, by the chair departing, the board member departing, or both. In the two months before the end of the relationship, dissent goes up 74 percent. In fact, 27 percent of all dissent occurred in that 60-day period, even though the average director's tenure was about four years. "They see there is less of a problem to rock the boat when they are leaving," speculates Ma.
By contrast, when Ma and Khanna measured the effects of firm performance on likelihood of dissent, they found a much lower correlation. A one unit increase in the ratio of a firm's market value to assets value increased the likelihood of dissent by 22 percent. "Social ties are a better predictor of dissent than firm performance," concludes Ma.
Dissent Punished By Markets
The importance of this dissent is even more significant given the consequences it has on both the directors and their firms. One might expect that dissent would be perceived as a good thing, showing that independent directors are doing their jobs protecting the interests of shareholders. In fact, Ma and Khanna found the opposite.
The stock market punished firms where dissent was evident, with an average drop in share price of 0.97 percentage point on days in which dissent was announced. The directors themselves were also punished--there was an average drop of more than 10 percent in those board members' annual income, and 26 percent less likelihood of staying on the director job market over those who didn't dissent.
"In a sense, dissent is a sign of a healthy board, but that's not how the market interprets it," says Khanna. "The caveat," he adds, "is that prices on the Chinese stock exchanges don't always move the way we'd hope they would in response to fundamentals." The negative effect on individual and firm performance, however, makes the dissent by directors more significant since they are bucking the majority over their own better interests. "But people do because they feel strongly about it."
Ma and Khanna caution against applying the results of the Chinese data too broadly. The country is a unique case, with most of its companies owned by either the state or large families, and lacking checks and balances such as shareholder voting and class action lawsuits that, in the United States and Europe, can help control companies' actions.
"You are never sure whether any findings from the Chinese dataset will apply in New York," warns Khanna. "Nevertheless, it is better than not having any findings at all."
Although the data may not be directly applicable to the United States or other countries, it provides a valuable look into corporate boards and points the direction for future research in those countries. In a sense, this data pulls open the black box of boards of directors, shining some sunlight on what happens inside.