Few of us would go to our auto mechanic for medical advice; we typically seek out experts with experience related to the problem we are trying to solve. Yet on average only 25% of Standard &Poor (S&P) 500 companies have independent directors with related industry experience, according to data collected by CEIBS Professor of Finance Wang Cong for the period of 2000 to 2007. How effective can an independent board director be at monitoring and advising top management of a firm without having worked in the same industry?

Prof. Wang and his co-authors explore this question in a new study that looks at the correlation between board effectiveness in fulfilling key responsibilities, including corporate financial reporting, CEO compensation, CEO turnover, and corporate acquisitions, and whether the firms’ independent directors have related industry experience. Academics have been divided into two schools of thought on this issue. Some believe that independent monitors with experience in the same industry may not be objective enough to provide adequate oversight, either because they are too empathetic to the challenges faced by senior management, or because they may share a common social network. This is called the “compromised monitor” hypothesis. On the flip side, the “expert monitor” hypothesis says that having same-industry experience makes independent directors more effective.

For their study, the researchers looked at a large cross section of firms spanning a broad range of industries. They began with the universe of firms that were part of the S&P 500 index during the years 2000 to 2007. Using the BoardEx database they collected data on the employment history of the firms’ independent directors. They obtained the industry classifications of their employers from Compustat and the Center for Research in Security Prices (CRSP) for publicly-listed companies, and Capital IQ, Orbis, Manta and Google searches for private companies. The independent directors in their sample have a total of 13,513 prior employers. Firm financial information was obtained from Compustat, stock price and returns data from CRSP, and board characteristics from BoardEx.

After analysing the data, the expert monitor hypothesis prevailed. The results show that the presence of independent directors with industry experience on a firm’s audit committee significantly curtailed firms’ earnings management. In addition, when there are a greater number of independent directors with related experience on a firm’s compensation committee there are fewer instances of excess CEO compensation. More independent directors with related experience on the full board also increases CEO turnover performance sensitivity and improved returns on acquisitions done for purposes of diversification.  

The results appear in the study titled “Industry Expertise of Independent Directors and Board Monitoring” which has been published by the Journal of Financial and Quantitative Analysis. Prof. Wang’s co-authors are Fei Xie of University of Delaware, Lerner College School of Business and Economics, and Min Zhu of City University of Hong Kong College of Business. Read the study here.