Skip to main content
SpringerLink
Log in

Should Independent Board Members with Social Ties to Management Disqualify Themselves from Serving on the Board?

  • Published:
Journal of Business Ethics Aims and scope Submit manuscript

Abstract

This paper examines whether independent directors who have social ties to management (inside directors) can effectively perform their fiduciary duty to monitor management on behalf of shareholders. Ex ante, it is not clear whether social ties will enhance or obstruct the quality of board performance. Theory suggests that directors who are socially tied to management are ineffective and would make decisions favoring management. However, social ties can increase trust and information sharing between management and independent directors, improving directors’ ability and effectiveness in governing the company (Westphal, J.D.: 1999, The Academy of Management Journal 42(1), 7–24). To examine these contradicting predictions I use social network analysis and construct proxies for social ties between management and independent board members. Using these proxies, I first demonstrate that social ties are associated with higher managerial compensation. Further analyses reveal that these results are driven by social ties that include members of the compensation committee. Conversely, I demonstrate that financial reporting quality is improved when social ties exist. Specifically, I find that the likelihood of material weaknesses in internal controls and the likelihood of financial restatements are lower in companies with social ties. I further observe that this improved quality of financial reporting holds only when social ties include members of the audit committee. I conclude that ethically, socially tied independent directors should disqualify themselves from serving on compensation committees where social independence is essential. However, in tasks where collaboration with management is essential, directors with social links to each other can be of added value to shareholders.

This is a preview of subscription content, log in via an institution to check access.

Access this article

Log in via an institution

Price excludes VAT (USA)
Tax calculation will be finalised during checkout.

Instant access to the full article PDF.

Institutional subscriptions

Similar content being viewed by others

References

  • Abbott, L.J., S. Parker and G.F. Peters: 2004, ‘Audit Committee Characteristics and Restatements’, Auditing: A Journal of Practice & Theory 23 (1), 69-87.

    Article  Google Scholar 

  • Adams, R.B. and D. Ferreira: 2007, ‘A Theory of Friendly Boards’, The Journal of Finance 62(1), 217-50.

    Article  Google Scholar 

  • Agrawal, A. and S. Chadha (2005) Corporate Governance and Accounting Scandals. The Journal of Law and Economics 48: 371-406.

    Article  Google Scholar 

  • Anderson, R. and J. Bizjak: 2003, ‘An Empirical Examination of the Role of the CEO and the Compensation Committee in Structuring Executive Pay’, Journal of Banking and Finance 27 (7), 1323–48.

    Article  Google Scholar 

  • Ashbaugh-Skaife, H., D. Collins and W. Kinney: 2007, The Discovery and Reporting of Internal Control Deficiencies Prior to SOX-mandated Audits’, Journal of Accounting and Economics 44, 166-192.

    Article  Google Scholar 

  • Bebchuk, L.A. and J.M. Fried: 2004, ‘Pay Without Performance: The Unfulfilled Promise of Executive Compensation’ Cambridge, MA: Harvard University Press.

    Google Scholar 

  • Black, B., B. Cheffins and M. Klausner: 2005, ‘Why Directors’ Damages may Harm Investors’, Financial Times (January 20).

  • Boyd, B.K: 1994, ‘Board Control and CEO Compensation’, Strategic Management Journal 15, 335-344.

    Article  Google Scholar 

  • Carcello, J.V., D.R. Hermanson, T.L. Neal and R.A. Riley: 2002, ‘Board Characteristics and Audit Fees’, Contemporary Accounting Research 19(3), 365- 384.

    Article  Google Scholar 

  • Carcello, J. V., T. L. Neal, Z. V. Palmrose and S. W. Scholz: 2011, ‘CEO Involvement in Selecting Board Members and Audit Committee Effectiveness’, Contemporary Accounting Research (in press).

  • Carter B.C. and J. W. Lorsch: 2004, Back to the Drawing Board Designing Corporate Boards for a Complex World (Harvard Business School Press, Boston, MA).

    Google Scholar 

  • Certo, S. T., C. M. Dalton, D. R. Dalton and R.H. Lester: 2008, Boards of Directors Self Interest Expanding for Pay in Corporate Acquisitions?. Journal of Business Ethics 77: 219-230.

    Article  Google Scholar 

  • Chhaochharia V. and Y. Grinstein: 2007, ‘The Changing Structure of US Corporate Boards: 1997-2003’, Corporate Governance: An International Review 15(6), 1215-1223.

    Article  Google Scholar 

  • Cohen, J., G. Krishnamoorthy and A. Wright: 2002, ‘Corporate Governance and the Audit Process’, Contemporary Accounting Research 19(Winter), 573–594.

    Google Scholar 

  • Cohen, J., G. Krishnamoorthy and A. Wright (2007) The Impact of Roles of the Board on Auditors Risk Assessments and Program Planning Decisions. Auditing: A Journal of Practice & Theory 26(1): 91-110.

    Article  Google Scholar 

  • Cohen, J., G. Krishnamoorthy and A. Wright: 2008, ‘Form Vs Substance: the Implications for Practice and Research of Alternative Perspective on Corporate Governance’, Auditing: A Journal of Practice & Theory 27(2), 181-205.

    Article  Google Scholar 

  • Conyon, M. J: 2006, ‘Executive Compensation and Incentives’, Academy of Management Perspectives 20(1), 25-44.

    Google Scholar 

  • Core, JE., R.W. Holthausen and D.F. Larcker: 1999, ‘Corporate Governance, Chief Executive Officer Compensation, and Firm Performance’, Journal of Financial Economics 51, 371-406.

    Article  Google Scholar 

  • Daily, C., J.L. Johnson, A.E. Ellstrand and D.R. Dalton:1998, ‘Compensation Committee Composition as a Determinant of CEO Compensation’, Academy of Management Journal 41, 209–220

    Article  Google Scholar 

  • De Franco G. D., Y. Guan and H. Lu: 2005, The Wealth Change and Redistribution Effects of Sarbanes–Oxley Internal Control Disclosures. Working Paper, University of Toronto.

  • Doyle, J., W. Ge and S. McVay: 2007, ‘Determinants of Weaknesses in Internal control over Financial Reporting’, Journal of Accounting & Economics 44, 193–223.

    Article  Google Scholar 

  • Ettredge, M., J. Heintz, C. Li and S. Scholz: 2010, Auditor Realignments Accompanying Implementation of SOX 404 ICFR Reporting Requirements. Working Paper. Lawrence, KS: University of Kansas.

  • Fama, E.F. and M.G. Jensen (1983) The Separation of Ownership and Control. Journal of Law and Economics 26: 301-325.

    Article  Google Scholar 

  • Fich M.E. and J.L.White (2003) CEO Compensation and Turnover the Effects of Mutually Interlocked Boards. Wake Forest Law Review 38(3): 935-959.

    Google Scholar 

  • Finkelstein, S. and D.C. Hambrick (1989) Chief Executive Compensation a Study of the Intersection of Markets and the Political Processes. Strategic Management Journal 10: 121-134.

    Article  Google Scholar 

  • Fredrickson, J.W., D.C. Hambrick and S. Baumrin: 1988, A Model of CEO Dismissal’, Academy of Management Review 13, 255-270.

    Article  Google Scholar 

  • Guedj, I. and A. Barnea: 2009, Director Networks. Working Paper. Austin, TX: University of Texas at Austin.

  • Hallock, K. F.: 1997, ‘RECIPROCALly Interlocking Boards of Directors and Executive Compensation’, Journal of Financial and Quantitative Analysis 32, 331-344.

    Article  Google Scholar 

  • Hammersley, J.S., Myers, L.A. and Shakespeare, C.: 2008, ‘Market Reactions to the Disclosure of Internal Control Weaknesses and to the Characteristics of those Weaknesses Under Section 302 of the Sarbanes-Oxley Act of 2002’, Review of Accounting Studies 13 (1),141-165.

    Article  Google Scholar 

  • Hoitash, U., R. Hoitash and K. Johnstone: 2010, Internal Control Material Weaknesses, CFO Compensation, and the Moderating Effects of Corporate Governance, External Monitoring, and Firm Risk. Working paper. Boston, MA: Northeastern University.

  • Hoitash, R., U. Hoitash and J. Bedard: 2008, ‘Internal controls quality and audit pricing under the Sarbanes-Oxley Act’, Auditing: A Journal of Practice & Theory 27,105- 126.

    Article  Google Scholar 

  • Hoitash, U., R. Hoitash and J.C. Bedard: 2009, Corporate Governance and Internal Control Over Financial Reporting: A comparison of regulatory regimes’, The Accounting Review 84(3), 839.

    Article  Google Scholar 

  • Holder-Webb, L., J. Cohen, L. Nath and D. Wood: 2008, ‘A Survey of Governance Disclosures Among U.S. Firms’, Journal of Business Ethics 83, 543-563.

    Article  Google Scholar 

  • Huron: 2006, Audit Committee Research Report Analyzes Pattern of Audit Committee Composition Over a 4-Year Period from 2002 to 2005. http://www.huronconsultinggroup.com/library/Huron_AuditCommReport_Email_Version.pdf

  • Klausner, M., C. Munger, N. Munger, B. Black and B. Cheffins: 2005, ‘Outsides Directors’ Liability: Have WorldCom and Enron Changed the Rules?’, Discovery (Winter), 36–39

  • Klein, A.: 2002, ‘Audit Committee, Board of Director Characteristics, and Earnings Management’, Journal of Accounting and Economics 33 (3), 375–400.

    Article  Google Scholar 

  • Krackhardt, D (1992) The Strength of Strong Ties: the Importance of Philos in Organizations. In Networks and Organizations: Structure, Form, and Action. Nohria N, Eccles RG (eds), Cambridge, MA: Harvard Business School Press; 216–239.

    Google Scholar 

  • Krishnan, J.: 2005, ‘Audit Committee Quality and Internal Control: An Empirical Analysis’, The Accounting Review 80(2), 649-678.

    Article  Google Scholar 

  • Lambert, R.A., D.F. Larcker and K. Weigelt.: 1993, ‘The Structure of Organizational Incentives’, Administrative science Quarterly 38, 438-461.

    Article  Google Scholar 

  • Larcker, D., S. A. Richardson, A. J. Seary and İ. Tuna: 2006, Director Networks, Executive Compensation, and Organizational Performance. Working paper. Palo Alto, CA: Stanford University.

  • Li, C., L. Sun and M. Ettredge.: 2010, Financial Executive Qualifications, Financial Executive Turnover, and Adverse SOX 404 Opinions’, Journal of Accounting and Economics 50(1), 93-110.

    Article  Google Scholar 

  • Li, Y. and J. Weintrop: 2005, The Effectiveness of NYSE Guidelines to Regulate CEO Compensation through Independent Compensation Committees. Working paper. New York, NY: Baruch College.

  • Lorsch, J. W.: 1989, ‘Pawns or Potentates: the Reality of America’s Corporate Boards’, Boston: Harvard Business School Press.

    Google Scholar 

  • Main, B., G. M. O’Reilly, C. A. Ill and J. Wade.: 1995, The CEO, The Board of Directors and Executive Compensation’, Economic and psychological perspectives Industrial and Corporate Change 4, 293-332.

    Article  Google Scholar 

  • Matsumura, E. M. and J. Y. Shin.: 2005, ‘Corporate Governance Reform and CEO Compensation: Intended and Unintended Consequences’, Journal of Business Ethics 62,101–113.

    Article  Google Scholar 

  • Morck, R.: 2007, Behavioral Finance in Corporate Governance-Independent Directors and Non-Executive Chairs. Working Paper. Alberta, Canada: University of Alberta

  • Neter, J., M. H. Kutner, C. J. Nachtsheim, and W. Wasserman.: 1996. Applied linear statistical models, 4th edn. New York, NY: McGraw-Hill

  • Newman, H. and H. Mozes (1999) Does the Composition of the Compensation Committee Influence CEO Compensation Practices. Financial Management 28: 41–53.

    Article  Google Scholar 

  • Nowak, M. J. and M. McCabe.: 2003, ‘Information Costs and the Role of the Independent Corporate Director’, Corporate Governance: An International Review 11, 300-307.

    Article  Google Scholar 

  • O’Reilly, C.A. and Main, B.G. M.: 2007, Setting the CEO’s Pay: It’s More than Simple Economics’, Organizational Dynamics 36,1-12.

    Article  Google Scholar 

  • Pfeffer, J. and G.R. Salancik.: 1978, ‘The External Control of Organizations’, New York: Harper & Row.

    Google Scholar 

  • Raghunandan K. and D. Rama (2006) SOX Section 404 Material Weakness Disclosures and Audit Fees. Auditing: A Journal of Practice & Theory 25: 99-114.

    Article  Google Scholar 

  • Rodgers W. and S. Gago (2003) A Model Capturing Ethics and Executive Compensation. Journal of Business Ethics 48: 189-202.

    Article  Google Scholar 

  • Securities and Exchange Commission: 2002, Certification of Disclosure in Companies. Quarterly and Annual Reports, Release Nos. 33-8124, 34-427, IC-25722; File No. S7-21-02. Washington D.C.:SEC

  • Srinivasan, S.: 2005, ‘Consequences of Financial Reporting Failure for Outside Directors: Evidence from Accounting Restatements and Audit Committee Members’, Journal of Accounting Research 43 (2), 291-334.

    Article  Google Scholar 

  • Vafeas, N.: 2003, Further Evidence on Compensation Committee Composition as a Determinant of CEO Compensation’, Financial Management 32, 53–70.

    Article  Google Scholar 

  • Wasserman, S., and K. Faust: 1997, ‘Social Network Analysis: Methods and Applications’. New York, NY: Cambridge University Press.

    Google Scholar 

  • Westphal J.D.: 1999, Collaboration in the Board Room: Behavioral and Performance Consequences on CEO Board Social Ties’, The Academy of Management Journal 42(1), 7-24.

    Article  Google Scholar 

  • Yermack, David.: 1996, ‘Higher Market Valuation of Companies with a Small Board of Directors’, Journal of Financial Economics 40, 185-211.

    Article  Google Scholar 

  • Zhang, Y., J. Zhou and N. Zhou.: 2007, ‘Audit Committee Quality, Auditor Independence and Internal Control Weaknesses’, Journal of Accounting and Public Policy 26(3), 300-327.

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. College of Business Administration, Northeastern University, 404 Hayden Hall, 360 Huntington Avenue, Boston, MA, 02115-5000, U.S.A.

    Udi Hoitash

Authors
  1. Udi Hoitash
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Udi Hoitash.

Additional information

Data availability: Data are publicly available from sources identified in the paper.

Rights and permissions

Reprints and permissions

About this article

Cite this article

Hoitash, U. Should Independent Board Members with Social Ties to Management Disqualify Themselves from Serving on the Board?. J Bus Ethics 99, 399–423 (2011). https://doi.org/10.1007/s10551-010-0660-5

Download citation

  • Published:

  • Issue Date:

  • DOI: https://doi.org/10.1007/s10551-010-0660-5

Keywords

Search

Navigation