Nominal versus Real Board Independence

In this paper, we investigate whether a regulation that mandates a greater proportion of outside directors on a corporate board results in a more independent board. Instead of taking the fraction of outside directors directly as the measure of board independence, we define it as the nominal independence level. The real independence level of the board is determined by both the nominal independence level and the length of the relationship between board members and the CEO. We assume that the real independence between a board member and the CEO decreases over time as long as the board member stays on the board. In our dynamic model, the board both monitors and advises the CEO, and the CEO decides whether to replace one of the directors in each period. The CEO’s tradeoff is between the possibly higher board expertise introduced by new directors versus the lower board real independence obtained by retaining the same directors. In our model, the higher the nominal independence level of the board, the more reluctant the CEO is in replacing existing directors. The resultant longer tenure of outside directors makes the CEO even less willing to replace them. Regulations that mandate higher nominal independence can have the unintended consequence that they lower both the real independence and the expertise of the board of directors in the long-run.