How Independent are Independent Directors?

As a corporate governance researcher, I tend to see principal-agent relationships everywhere. One that has received a lot of recent attention is the one between directors and shareholders. One of the good things to come out of the recent corporate scandals has been a greater push for board independence. The Wall Street Journal has a good piece in today's paper on how the definitions of what makes an "independent" director may not do a great job of defining independence. Here's a snippet:

The New York Stock Exchange and the Nasdaq Stock Market imposed the rules in the past 18 months to boost the number of directors who have no interest in overseeing the companies they serve beyond looking out for shareholders. But a review of 150 corporate filings by The Wall Street Journal highlights how exceptions and qualifiers in the rules have, in the view of some critics, limited their effectiveness.

Coca-Cola Co. counts billionaire Warren Buffett as an independent board member, even though he heads a company that does tens of millions of dollars of business with the soft-drink giant. Citigroup Inc. deems two directors independent, even though they have children employed by the financial giant. At BB&T Corp., in Winston-Salem, N.C., an attorney whose law firm works for the financial-services holding company heads the board committee that sets executive pay -- one of about 20 instances of "independent" directors employed by the public companies' outside law firms.

The rules, which cover companies listed on the NYSE and Nasdaq, were in part a response to fraud scandals at Enron Corp. and other companies that highlighted the risks of directors with financial relationships to their companies. Critics see such ties as potential conflicts, because directors might be tempted to allow their own financial interests to override shareholders'.

For the whole article, click here (subscription required).

A very timely and creative related academic piece "Back Door Links Between Directors and Executive Compensation", by Larcker, Richardson, Seary, and Tuna just showed up on the SSRN. In it, they define a measure of "back door influence" that extends the definition of director interlocks (where director A sits on the board of director B's company and director B sits on the board of director A's company) in a very interesting way. Their measure is similar to the "degrees of separation" game where you try to see how many connections you must make to link any actor to Kevin Bacon (click here for the Oracle of Bacon at the University of Virginia). A direct interlock would indicate one degree of separation. If the directors are not directly interlocked, but instead both sit on a third company's board, they have two degrees of separation. If they sit on two unrelated boards that share a third director, they have three degrees of separation, and so on.

Interestingly they find that

"... CEOs at firms where there is a relatively short back door distance between inside and outside directors or between the CEO and the members of the compensation committee earn substantially higher levels of total compensation (after controlling for standard economic determinants and other personal characteristics of the CEO and the structure for board of directors)..."

Click here for the abstract.

UPDATE: Welcome to all the folks from Professorbainbridge.com -- thanks for stopping by.