Do Outside Directors with Government Experience Create Value?

• Date: 01 June 2018
• Author: Le Zhang,Jun‐Koo Kang
• DOI: http://doi.org/10.1111/fima.12190
• Published date: 01 June 2018

Do Outside Directors with Government

Experience Create Value?

Jun-Koo Kang and Le Zhang∗

We examine whether outside directors with government experience add value to their firms. We

find that government directors aremore likely to miss board meetings and that their appointment

announcements are greeted more negatively. Firms with government directors also experience

poorer operating performance and more negative merger announcement returns, although their

mergers are less likely to be challenged by antitrust authorities. These adverse valuation effects

are largely alleviated when firms have large government sales, when they operate in regulated

industries, or when government directors are politically connected. Using close gubernatorial

election outcomes as a natural experiment and an instrumental variables approach to control for

endogeneity bias do not change the results.

The number of publicly listed firms that appoint former government officials as their outside

directors has increased dramatically in recent decades. For example, while in 1990, only31.47%

of our sample US public firms had former government officials on their boards, by 2007, this

number had increased to 54.53%.1However, despite the increasing presence of former government

officials on corporate boards, their role as independent directors has been called into question.

In this paper, we investigate several important issues regarding the role of government directors

(outside directors with work experience in government agencies) in US public firms and their

impact on firm value. Specifically, we examine the following issues: What motivates firms to

appoint government directors? Do government directors perform an important value-enhancing

role (the “value-enhancing view”) or do they just rubber-stamp the decisions of top management

(the “rubber-stamp view”)?

Firms may appoint government directors because they are expected to bring several benefits to

the firms. For example, government directors can provide firms with valuable connections and

privileged information about the public policy process, which can otherwise be expensive and

often difficult to obtain due to its complexity (Hillman, Zardkoohi, and Bierman, 1999). These

connections and unique information about the public policy process allow government directors

We are grateful for comments from an anonymous referee, Utpal Bhattacharya (Editor), Suman Banerjee, Stephen

Dimmock, Huasheng Gao, Dennis Gromb, Inmoo Lee, Angie Low, and Ronald Masulis, and seminar participants at

Cheung Kong Graduate School of Business, Chinese University of Hong Kong, Erasmus University, ESSEC Business

School, Hong Kong Polytechnic University, Macquarie Graduate School of Management, Nanyang Business School,

Ulsan National Institute of Science and Technology, University of Adelaide, and University of New South Wales.We also

thank conferenceparticipants at 2011 Centre for Governance, Institutions, and Organization Academic Conference,2011

International Conference on Asia-Pacific FinancialMarkets, and 2012 China International Conference in Finance. All

errors are our own.

∗Jun-Koo Kang is a Professorin the Division of Banking and Finance at Nanyang Business School at Nanyang Techno-

logical University in Singapore. Le Zhang is a Senior Lecturerfrom the Research School of Finance, Actuarial Studies

and Statistics, College of Business and Economics, Australian National Universityin Canberra, Australia.

1For example, in 2006, Lockheed Martin had 13 outside directors on its board, of whom five werefor mer government

officials, including former Under Secretary of Department of Defense Pete Aldridge Jr., former Admiral of US Strategic

Command James O. Ellis Jr.,and for mer Deputy Secretary of Homeland Security James M. Loy.

Financial Management •Summer 2018 •pages 209 – 251

210 Financial Management rSummer 2018

to facilitate sales to the government, thus helping improve firm performance. In addition, with

the contacts they acquire from working in the public sector, government directors can influence

government actions in the firm’sbest interest, a benef it that is especiallyvaluable when the actions

of regulatory agencies such as the Food and Drug Administration (FDA) and the Environmental

Protection Agency have important consequences for firm performance (Agrawal and Knoeber,

2001). Thus, according to this value-enhancing view, government directors play an important role

in firms’ decision making, particularly when fir ms have a major trading relationship with the

government or when they operate in a regulatory environment.

In contrast to the above value-enhancing view, the rubber-stamp view regards government

directors as inefficient independent directors because, compared with their counterparts in the

corporate world, they tend to have less business experience in areas such as accounting, finance,

and corporate governance, which limits their ability to effectively perform a value-enhancing

function. Several studies show that directors’ industry experience and accounting and financial

knowledge are positively related to firm performance, as they play an important role in the

decision-making and management succession processes. For example, Cust´

odio and Metzger

(2013) find that chief executive officers (CEOs) who have worked in a target industry increase

their shareholders’ wealth during takeovers. Cohen, Krishnamoorthy, and Wright (2010) show

that directors’ accounting and financial expertise is important for effective advising.

The advisory capacity of government directors can also be impaired to the extent that they

hold directorships in multiple firms. Firms that regularly deal with government agencies or have

significant procurement government contracts are likely to have strong demand for government

directors due to their ability to facilitate business with government agencies and influence govern-

mental decisions (Agrawal and Knoeber, 2001). However, the supply of government directors is

often limited, which provides retired government officials an opportunity to sit on more than one

board. For example, former US Labor Secretary Elaine L. Chao served on six different boards,

including C.R. Bard, Clorox, Columbia/HCA Healthcare, Dole Food, Northwest Airlines, and

Protective Life, before sitting on George W. Bush’s cabinet.2These overcommitted government

directors may have little time to advise firm management, resulting in lower firm performance

and value (Fich and Shivdasani, 2006).3

CEOs may hire these retired government officials because of their career concerns or other

private benefits. For example, CEOs may hire government directors because they share common

educational and social backgrounds with these directors. To the extent that socially connected

directors are friendly to CEOs, less likely to confront management, and less likely to take an

active role in disciplining management (e.g., Hwang and Kim, 2009), CEOs of firms appointing

socially connected government directors may be less constrained than those of firms appointing

nongovernment directors. Thus, the rubber-stamp view suggests that government directors’ lack

of business experience, their frequent multiple directorships, and their friendly relationships with

top management limit their ability to play an effective advising role and consequently have an

adverse effect on firm performance.4

2“Multiple seats of power: companies are cracking down on number of directorships board members can hold,” Wal l

Street Journal, January 23, 2001.

3Fich and Shivdasani (2006) find that firms with a majority of outside directors holding three or more directorships are

associated with weak corporate governance. They also find that firms with a “busy board” have lower market-to-book

ratios, lower profitability,and lower sensitivity of CEO turnover to firm performance.

4Consistent with the rubber-stamp view, the shareholder advisory firm Glass Lewis & Co. criticized American Interna-

tional Group (AIG) Inc., which was beset by bookkeeping and governance problems, for having too many government

directors (such as former US ambassador to the United Nations Richard Holbrooke and former Defense Secretary William

Cohen) on its board. Glass Lewis further claimed that AIG needed to “increase the level of business expertise, including

Kang & Zhang rOutside Directors with Government Experience 211

Using a large sample of 78,803 firm-year observations and 20,101 outside director appointments

from 1990 to 2007, we find that the presence of a government director is prevalentin many publicly

listed firms in the United States. Specif ically, we find that approximately 43% of our sample

firms have at least one government director on their board. Conditional on the presence of a

government director, one out of five outside directors is a government director.

To distinguish between the value-enhancing view and the rubber-stamp view of the role of

government directors, we perform several tests. In performing our tests, we control for potential

endogeneity bias caused by unobservable omitted firm characteristics and the endogeneity of

board composition by using firm fixed effects, an instrumental variables approach, and close

gubernatorial election outcomes. We also use an event study approach to alleviate the reverse

causality problem that the causation runs from firm performance to the presence of a government

director on the board.

First, as a director-level analysis, we examine whether directors’ attendance rate at board

meetings is different between government and nongovernment outside directors. Supporting the

rubber-stamp view,we find that government directors are more likely to have attendance problems

than nongovernment directors, especially when they hold multiple directorships or whenthey are

socially connected to the CEO. However, government directors’ attendance problems are not

likely to be severe when their firms have a major trading relationship with the government

or when they operate in regulated industries, suggesting that the role of government directors

on corporate boards varies across the product markets and regulatory environments that firms

face.

Second, as firm-level analyses, we examine the link between merger announcement returns

and the presence of government directors on the board. To the extent that a merger is a largely

unanticipated event, using announcement returns around such an event in the analysis can poten-

tially mitigate the reverse causality problem.We find that acquiring f irms that havea government

director experience significantly lower abnormal announcement returns than those without a

government director. This result supports the rubber-stamp view. However, their announcement

returns are statistically indistinguishable from those of firms without a government director when

they maintain extensive trading relationships with the government or when they operate in reg-

ulated industries. Thus, under certain circumstances, such as when the importance of a firm’s

government sales is high or when the firm operates in a regulated industry, governmentdirectors’

unique information about the public policy process and their ability to influence government pol-

icy help increase firm value, thereby offsetting the potential costs associated with having retired

bureaucrats on corporate boards. Further supporting this view, we find that mergers by acquirers

with a government director are less likely to be challenged by antitrust authorities.

As an additional firm-level analysis, we examine howthe stock market reacts to appointments of

government directors to a board. Supporting the rubber-stamp view,we f ind that the mean three-

day abnormal announcement return for firms appointing a government director is a significant –

0.56%. However, similar to the merger announcement return analysis, this negativeannouncement

effect is largely alleviated when firms with high sales dependence on the government or those in

regulated industries appoint government directors. We also examine whether the presence of a

government director affectsa f irm’soperating performance. We find that fir ms with a government

director exhibit significantly lower industry-adjusted return on assets (ROAs)than those without

a government director, particularly when firms do not have the government as a major customer

or when firms operate in nonregulated industries.

expertise in the insurance industry on its board.” (“Lifting the Lid: Ex-politicians draw scrutiny overboard roles,” Reuters

News, July 29, 2005.)