Board of directors with similar backgrounds can hurt a company’s bottom line

January 17th, 2019

COLUMBIA, Mo. – When picking a board of directors, shareholders naturally seek individuals with the best pedigrees—those who attended the best schools and worked at prestigious companies. But it turns out that this strategy can backfire when members of the board share similar backgrounds.

In a first-of-its-kind study, a researcher at the University of Missouri has found that boards of directors with shared education, employment history and family background are correlated with several negative characteristics, including lower market values and more frequent financial misrepresentation.

“Other studies have looked at the ties between boards and CEOs, but I wanted to see how the internal ties between directors might influence their decision making,” said Matthew Souther, an assistant professor of finance at MU’s Robert J. Trulaske, Sr. College of Business. “I found that shareholders are ultimately the ones to bear the cost of a closely connected board.”

Souther examined closed-end funds, which are investment funds that are traded like stocks, for three main types of connections. For an education connection, directors had to attend the same college or university. Employment ties consisted of working at the same employer at the same time, while family connections required that directors be related. While employment and education connections do not guarantee an outside relationship, prior research has shown that shared backgrounds can create social bonds and shared lines of thinking.

Educational connections were found to be the most frequent by far. About 40 percent of the boards studied contained educational connections, and more than 7 percent of directors within the same boards shared those connections. In total, nearly 51 percent of boards had at least one connection between directors, and the effects of these connections were clear.

“While independent directors had a positive effect on fund values, connected directors had an almost equal effect in the opposite direction,” Souther said. “Each additional connection between directors was associated with a 0.88% decline in the value of the fund. Financial misrepresentations were also more frequent when connected directors were present, along with higher compensation for the board and higher expenses charged to shareholders.”

Souther said these findings could be explained by a lack of dissent among connected board members, decreasing the likelihood that a questionable decision would be overruled. He said these findings are especially important because federal law currently only mandates levels of board independence, but does not consider the backgrounds of directors they consider “independent.” The boards studied fell within the independence requirements but still exerted a negative influence on the funds, indicating that perhaps current laws do not adequately protect shareholder interests.

The study, “The effects of internal board networks: Evidence from closed-end funds,” was published in the Journal of Accounting and Economics.