In Search of Board Independence: Former Employees, Shades of Gray and Director Classifications Revisited

Abstract

In this paper, we show that a true measure of board independence requires a careful disentangling of both the functioning role of gray directors and the firm’s decision on whether to classify former employees as independent or gray. By reclassifying gray directors, we find that the likelihood of fraud significantly increases when a firm has former employees serving on its board of directors. These effects are particularly strong when these former employee directors have previously served with the current CEO, or when they assume important monitoring responsibilities by serving on the auditing and compensation committees. By contrast, we find that other “outside” gray directors are less associated with fraud. In this regard, we demonstrate that gray directors are not a monolithic group, and that there are important “shades of gray.” Given this perspective, we construct a novel measure of a board’s functioning independence. In a broad series of empirical tests, we demonstrate that while there is no significant link between the traditional measure of independence and corporate fraud, there is a strong link between our measure of functional independence and the likelihood of fraud. We also demonstrate that fraud is more likely to occur when a firm uses its discretion to classify a former employee as an independent director. We argue that this is a relevant indicator of the firm’s relative conservatism, which is shown to be negatively correlated with the likelihood of fraud.