Strategic Director Appointments

• Published date: 01 September 2021
• Author: GEORGE DRYMIOTES,KONDURU SIVARAMAKRISHNAN
• Date: 01 September 2021
• DOI: http://doi.org/10.1111/1475-679X.12351

DOI: 10.1111/1475-679X.12351

Journal of Accounting Research

Vol. 59 No. 4 September 2021

Printed in U.S.A.

Strategic Director Appointments

GEORGE DRYMIOTES∗

AND KONDURU SIVARAMAKRISHNAN†

Received 1 January 2018; accepted 28 December 2020

ABSTRACT

Recent corporate governance scandals have been attributed to a lack of board

independence because of the influence CEOs have over their boards. How-

ever, CEOs can also affect board efficacy without compromising its indepen-

dence by strategically choosing directors. We offer a theoretical framework to

examine how CEOs can strategically choose director characteristics (such as

expertise and skill set) to influence the inner workings of the board. We ex-

amine how director expertise affects the board’s equilibrium voting strategies

and show that some “passivity” on the part of directors can in fact be de-

sirable equilibrium behavior. More importantly, we show that managers can

strategically appoint independent outside directors to influence board voting

in their favor. Surprisingly, contrary to what we might expect, we find that

opportunistic (principled) managers may not always appoint the least (most)

able directors to the board. We also examine whether CEOs would prefer a

“captured” board (i.e., an insider-dominated board) and show that the value

∗Texas Christian University; †Rice University

Accepted by Haresh Sapra. We thank the editor and an anonymous referee for

many helpful comments and suggestions. We also thank Anwar Ahmed, Ramji Balakrishnan,

Rafael Copat, Jonathan Glover, Haijin Lin, Nandu Nagarajan, Ethan Smith, Daniela De La

Parra Hurtado, Suresh Radhakrishnan, Naomi Soderstrom, Raghu Venugopalan, Ramgopal

Venkataraman, Rustam Zufarov, workshop participants at the University of Texas at Arling-

ton, and conference participants at the 2016 Lone Star Accounting Research Conference. An

online appendix to this paper can be downloaded at http://research.chicagobooth.edu/arc/

journal-of-accounting- research/online-supplements.

1303

© 2021 The Chookaszian Accounting Research Center at the University of Chicago Booth School of

Business

1304 g. drymiotes and k. sivaramakrishnan

of director input (i.e., the board’s advising role) and the financial markets

can discourage CEOs from pursuing such appointments.

JEL codes: D80, G34, M40

Keywords: board of directors; corporate governance; majority voting; rub-

berstamping; deferring; abstaining; director appointments

1. Introduction

Despite numerous legislative and regulatory reforms instituted over the

years, a string of recent highly publicized governance failures at such com-

panies as Volkswagen and Olympus have once again brought renewed

scrutiny on corporate governance practices. One major concern is the in-

fluence CEOs have over director appointments (Bebchuk [2003], Bebchuk

[2005], Bebchuk [2007], Bainbridge [2006], Stratmann and Verret [2012],

Drymiotes and Lin [2020]). It is not uncommon to see CEOs appointing

directors with personal or business ties (e.g., relatives, friends, or business

associates).1CEOs can, however, use their influence over director appoint-

ments more subtly by nominating independent outside directors, but strate-

gically choosing who they nominate (based on, e.g., expertise, knowledge,

experience, and skill set).

This strategic nature of director appointments has received little atten-

tion in the literature. For the most part, the literature has focused on

what makes the board effective (e.g., independence, expertise, and size).

For example, Shivdasani and Yermack [2002] find that markets associate

board independence with board efficacy, whereas Drymiotes [2007] and

Laux [2008] show that less independent directors can in some instances

make the board more efficient. DeFond, Hann, and Hu [2005], Krishnan

and Visvanathan [2008], and Dhaliwal, Naiker, and Navissi [2010] exam-

ine the impact of appointing outside directors with financial expertise on

audit committees. In contrast, in this paper, we focus on how managers can

use their power over director appointments strategically to influence board

decisions.

Specifically, we ask: What are a manager’s preferences with respect to

a director’s skill set? How does agency conflict and the manager’s poten-

tial need for advice and guidance from the board affect these preferences?

How do strategic director appointments shape equilibrium board voting

patterns and outcomes? Given a choice between appointing inside versus

outside directors, would a manager ever prefer an outside director?

We examine a setting in which a firm’s board plays both a monitoring

and advising role. The firm’s manager proposes a project for approval to

1For example, in December 2018, Tesla appointed two new independent directors as part of

a settlement agreement with the SEC. One of the named directors was Mr. Ellison, Chairman

of Oracle, who had publicly supported Elon Musk and stated that, “I’m very close friends with

Elon Musk, and I’m a big investor in Tesla” (Winkler and Higging [2018]).

strategic director appointments 1305

the board. The manager can either be a “loyal” manager who always acts

in the shareholders’ best interests and proposes positive net present value

(NPV) projects, or an “opportunistic” manager who proposes negative NPV

projects that provide him with private benefits. The manager’s type is un-

observable. The consequent adverse selection problem creates a demand

for board monitoring. Moreover, the manager faces uncertainty about the

project’s outcomes, which creates a demand for board advising.

The literature typically views boards as monolithic units that make deci-

sions based on some information (see, e.g., Drymiotes [2007] and Volker

[2008]). In our model, the board consists of three “representative” mem-

bers: the manager and two directors.2,3Each director obtains information

about the project’s outcome before casting a vote. Because this informa-

tion is imperfect, the directors may incorrectly reject high-output projects

(Type I error) or accept low-output projects (Type II error). The board

makes the approval decision according to a simple majority voting rule. To

examine strategic director appointments, we allow the manager to replace

one of the independent directors with either another insider (and thereby

“capture” the board) or a new outside independent director.

This structure allows us to analyze (i) board voting strategies and (ii) how

managers can influence board decision making by strategically choosing

director characteristics. We begin by analyzing the board’s decision-making

process. We characterize the directors’ equilibrium voting strategies as a

function of the severity of the adverse selection problem and the extent

of project-level uncertainty. We show that voting patterns such as rubber-

stamping and abstaining—that are pervasive in practice—can arise natu-

rally in equilibrium.4Perhaps surprisingly, we also find that as the agency

conflict worsens (as the prior belief that the manager is loyal decreases), the

board can, in some cases, actually make better decisions by relying on less

(i.e., by ignoring) information.

2One can think of the two directors as representing the views of the “more powerful” di-

rectors on the board that influence the votes of the other directors. For example, during an

interview (Bryant [2018]), Kevin Sharer, who was CEO of Amgen for 12 years, pointed out

that: “The other thing I learned with boards is that even though there may be 12 directors, three or four

people are always in charge. This is not a bad thing. What I mean by “in charge” is that nothing of

consequence is going to happen unless these four people agree. These four people have, in effect, collective

veto power, and that’sa little bit of a check on other directors who may be confused about what they should

be advocating for.”

3We discuss implications of having more than three directors in the concluding section.

4In his opening statement during a hearing before the Permanent Subcommittee of In-

vestigations on the role of the board of directors in Enron’s collapse (U.S. Senate [2002]),

Senator Levin noted: “The Board told the Subcommittee staff that because each of Enron’s transactions

was approved by Enron management, whom they saw as some of the most creative and talented people in

the business, and because the transactions had been approved by Arthur Andersen, a top auditing firm,

and by Enron’s lawyers and private law firms like Vinson and Elkins, by the credit rating agencies, or by

investment bankers who had a significant stake in a lot of these transactions, the Board assumed that the

transactions were OK. Now, I can see why you might rely on a company auditor or an outside attorney,

but the Board must exercise independent judgment.”