The bright side of co‐opted boards: Evidence from firm innovation

• Date: 01 February 2021
• Author: Xiangkang Yin,Le Vu,Lily Nguyen
• DOI: http://doi.org/10.1111/fire.12243
• Published date: 01 February 2021

DOI: 10.1111/fire.12243

ORIGINAL ARTICLE

The bright side of co-opted boards: Evidence from

firm innovation

Lily Nguyen1Le Vu2Xiangkang Yin3

1School of Business, the University of

Queensland, Brisbane, Queensland, Australia

2Centre for Global Business, Monash Business

School, Monash University, Clayton,Victoria,

Australia

3Department of Finance, Deakin Business

School, Deakin University, Burwood,Victoria,

Australia

Correspondence

LeVu, Centre for Global Business, Monash

BusinessSchool, Monash University, Clayton,

VIC3800, Australia.

Email:le.vu@monash.edu

Abstract

This study documents a positive and robust effect of co-

opted boards on firm innovation. This effect is mainly driven

by co-opted independent directors. Firms with more co-

opted independent directors are associated with lower sen-

sitivities of CEO pay and turnover to performance. It sug-

gests that co-opted boards promote innovation by insulat-

ing managers’ career concerns from innovation risk and sup-

porting incentive contracts that motivate innovation. Over-

all, our study provides new evidence on co-opted boards

benefiting firm innovation.

KEYWORDS

board of directors, citations, corporate governance, innovation,

patents

JEL CLASSIFICATIONS

G34, O31

1INTRODUCTION

A corporation’s board of directors is crucial for the proper implementation of corporate governance. However,

chief executive officers (CEOs) can exert a considerable influence on the selection of board members; they tend to

appoint new directors who share their views and perspectives on business practices (Coles, Daniel, & Naveen,2014;

Finkelstein & Hambrick, 1989;Hwang &Kim,2009). Coles et al. (2014) define co-opted directors as those directors

who join the board after the CEO assumes office and observe that co-opted directors account for nearly half of the

board. They also find that co-opted boards provide CEOs with significant insulation from performance pressures and

attribute these results to the loyalty and allegiance of co-opted boards to their CEOs. Building on these important

characteristics, we study the effect of co-opted boards on firm innovation.

We propose two competing hypotheses for the relation between co-opted boards and firm innovation. The first

hypothesis predicts that co-opted boards increase firm innovation because they can insulate managers with career

concerns from innovation risk and can support managerial incentive contracts that motivate innovation. According

Financial Review. 2021;56:29–53. © 2020 The Eastern Finance Association 29wileyonlinelibrary.com/journal/fire

30 NGUYEN ET AL.

to the career concern model (Holmstrom, 1999), managers may avoidinvesting in long-term risky innovation projects

because if they fail, this could damage their career and could increase the risk of being dismissed. Co-opted boards

should be able to provide these managers with a stronger incentive to pursue risky, value-enhancing innovation

projects, because co-opted directors are likely to be beholden to the CEO involved in appointing them to the board.

Also, the co-opted directors may pledge their loyalty by supporting the CEO even if such projects turn out to be

unsuccessful.

Furthermore, incentive contracts that motivate firm innovation should exhibitsubstantial tolerance for early fail-

ure and reward CEOs for long-term success (Ederer & Manso, 2013; Manso, 2011). This line of research thus implies

thatincentive contracts with a lower sensitivity of CEO turnover or compensation to performance can encourage man-

agers to invest in innovation projects because such contractshave a higher tolerance for failure. Co-opted boards are

more likely to support such incentive contracts since it is a way of showing their support and loyalty to the CEOs in

return for the benefits (e.g., compensations or perks receivedfrom their directorships). Indeed, Chen, Goergen, Leung,

and Song (2019) contend that higher director compensation strengthens their loyalty to the CEO, making the CEO’s

position more secure, irrespectiveof his/her performance. Moreover,Coles et al. (2014) show that firms with more co-

opted boards are related to less sensitivity of CEO turnover to performance and investment activities. These authors

interpret their results as evidence of weaker monitoring by co-opted boards. Weargue that these outcomes can also

be seen as innovation-motivating incentive contracts in the spirit of Manso (2011) and Ederer and Manso (2013). In

other words, managers with more co-opted boards are more likely to be insulated from the threat of dismissal, which

allows them to focus more on long-term, risky investment in innovation projects.

Our alternative hypothesis proposes that firms with more co-opted directors are detrimental to firm innovation.

This hypothesis is based on the argument that while the incentive contracts with a lower sensitivity of CEO turnover

(orcompensation) to performance can motivate innovation, such contracts can also be interpreted as evidence of weak

board monitoring (Coles et al., 2014). Thus, such contracts mayencourage managers to opt for a “quiet life” (Bertrand

& Mullainathan, 2003;Hart,1983), ending up with supporting managers who shirk and avoid investment in innovation

projects that are risky but turn out to be worthwhile in the long term.

We test these competing hypotheses using a sample of 1,709 U.S. firms for the 1996–2009 period. Our baseline

regression results show that co-opted boards have a positive effect on firm innovation. In terms of economic signifi-

cance, an additional co-opted director leads to 0.19 more patent counts and 0.18 adjusted patent citations per annum

for a typical firm with an average level of board size, co-opted director ratio,and patent counts and citations. These

results support the first hypothesis, wherein firms with more co-opted boards havehigher innovation outputs.

Since independence is a critical feature of directors, we categorize co-opted directors as independent and nonin-

dependent directors to examine whether these two groups of co-opted directors affect firm innovation differently.

We find that the positiveeffect of co-opted boards on firm innovation is mainly driven by co-opted independent direc-

tors. This result is consistent with Balsmeier,Fleming, and Manso (2017) who state that firms with more independent

boards have more patents and their patents elicit more citations.

We conduct several tests to examinethe robustness of our findings. Specifically, we adopt an alternative measure

of board co-option as tenure-weighted, co-opted directors as per Coles et al. (2014), include friendly board (Kang, Liu,

Low,& Zhang, 2018) as an additional control variable, or restrict the sample to innovative firms. While the effect of all

co-opted directors is relatively weak and sensitiveto variation in co-option measure and regression specifications, the

effect of co-opted independent directors remains robust and unchanged. Therefore, we focus on examining the role

of co-opted board independence in this paper,which is measured by the ratio of the number of co-opted independent

directors to the board size.

However,endogeneity is still a concern. For instance, there may be reverse causality running from firm innovation

to co-opted board independence. Toaddress the concern, we conduct two endogeneity tests. First, we follow Coles

et al. (2014) and exploitthe exchange-rule changes enacted by the Sarbanes–Oxley (SOX) Act in 2002, which requires

all listed firms to have a majority of independent directors on the board. Firms that do not have a majority of inde-

pendent directors on their boards during the period prior to 2002 (a.k.a. noncompliant firms) have to appoint new