CLOSER LOOK SERIES: TOPICS, ISSUES, AND CONTROVERSIES IN CORPORATE GOVERNANCE

CGRP-08
DATE: 08/05/10

DIRECTOR NETWORKS:
GOOD FOR THE DIRECTOR, GOOD FOR SHAREHOLDERS
BOARD NETWORKS

A director‟s 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 is 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 well-connected board. At the time of the company‟s
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 company‟s 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.

1
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
Professor David F. Larcker and Brian Tayan prepared this material as the basis for discussion. Larcker and Tayan
are co-authors of the book Corporate Governance Matters. The Corporate Governance Research Program is a
research center within the Stanford Graduate School of Business. For more information, visit:
http://www.gsb.stanford.edu/cldr/cgrp/.

Copyright © 2010 by the Board of Trustees of the Leland Stanford Junior University. All rights reserved.
Director Networks: Good for the Director, Good for Shareholders, CGRP-08 p. 2

 The spread of bad information. Incorrect information may also be shared across companies
through board networks. False rumors—such as those of a new product launch, marketing
strategy, price increase, or pending acquisition—can 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 affiliates—such as customers, suppliers, or providers of capital—can
facilitate the flow of information along the supply chain, thereby improving efficiency.

 Sharing of management practices. Directors can 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,

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. 689-724.
Director Networks: Good for the Director, Good for Shareholders, CGRP-08 p. 3

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

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?

4
Larcker, So, and Wang (2010), loc. cit.
Director Networks: Good for the Director, Good for Shareholders, CGRP-08 p. 4

Exhibit 1
Network Connections: Google Directors (2005)

A subset of Google‟s board network in 2005, the year after its successful IPO.

Source: Board Member Magazine Director Database.