Outside Directors, Politics, and Firm Performance

Abstract

A substantial number of outside directors have experience in non-business arenas, especially in government and in the private practice of law. Moreover, for most of these directors, the entirety of their experience is outside of business. We propose a political role for such directors and argue that they are selected, at least in part, because of their value in enlisting government favors or forestalling government constraints. To assess this possibility, we analyze the backgrounds of the 3,220 directors of 264 large U.S. manufacturing firms. We also compile a novel dataset that contains detailed measures of the importance of politics to firms. We have three main findings. First, we find that outside directors with political and legal backgrounds appear to be chosen, at least in part, because of this experience. Second, we find that such directors are more common on the boards of firms for which politics is more important. Both findings are consistent with a political role for these outside directors. Third, we explore the possibility that recent findings showing a negative relation between firm performance and both board size and the proportion of outside directors could be driven by politics. Specifically, politics may lead simultaneously to larger and more outsider oriented boards and to poorer firm performance. We assess this possibility by including, first, the incidence of directors with political or legal backgrounds and, second, our measures of the importance of politics in regressions that find this negative effect of board size and composition on firm performance. Although our results are modest, the added political variables are typically negatively related to firm performance and the addition of these variables weakens the effect of both board size and board composition on firm performance. This is evidence consistent with politics underlying the negative relation between board size and composition and firm performance. Overall, this paper provides empirical evidence on an important, but neglected, role of corporate boards and provides a rational explanation of the otherwise puzzling negative relation between firm performance and both board size and the proportion of outside directors.