In Search of Board Independence: Former Employees, Shades of Gray and Director Classifications Revisited
61 Pages Posted: 17 Aug 2016 Last revised: 12 Jul 2019
Date Written: November 3, 2016
Former employee directors bring unique aspects to firm governance. While they have valuable firm-specific knowledge, their connections to current management often compromise their ability to serve as effective monitors. Consistent with this viewpoint, we find that the presence of former employee directors is associated with increased litigation risk. Our subsequent tests demonstrate that this positive relation is more pronounced when the former employee is 1) tied to current management, 2) holding critical monitoring position, and 3) replacing an outside director. We further highlight that the discretion in asserting the independence of former employee directors provides key insights into the firm’s relative reporting conservatism and its true desire for independence. Notably, we find that litigation is more likely to occur when boards aggressively classify a former employee as an independent director. Building upon these key findings, we demonstrate that measures of a board’s functioning independence should incorporate both the varying roles played by its gray directors and its decision on whether to classify former employee directors as independent or gray.
Keywords: functioning independence, former employees, gray directors, shades of gray, cooling-off period, reporting conservatism, corporate fraud, CEO turnover
JEL Classification: G28, G3, G01, K40, K41
Suggested Citation: Suggested Citation