USC Marshall School of Business

Corporate reformers love the idea of an outsider-dominated board of directors—and have legislation like the Sarbanes-Oxley Act to back them up. "Because outside directors are independent from management, they are believed to be willing to stand up to the CEO to protect shareholder interests," explain researchers including USC's John G. Matsusaka and Oguzhan Ozbas.

But does the value of outside impartiality outweigh a lack of insider knowledge? Working in partnership with former Marshall PhD student Ran Duchin (now an Assistant Professor at the University of Michigan), Matsusaka and Ozbas set out to determine if independence matters for boards, and—beyond that—when it is likely to matter.

Three views of board regulations informed the team's research:

• Window-dressing. Skeptics argue that managers might appoint allies who, while technically independent, won't improve the board's performance at all.
• Entrenchment. Proponents of this view assume that managers who cannot get around regulations will appoint outside directors, and improve board performance as its independence grows.
• Optimization. Those who take this position argue that managers play off the inherent weaknesses and strengths of inside and outside directors—and that an artificial push for outside directors weakens the board's general effectiveness.

But Duchin, Matsusaka and Ozbas discovered the success or failure of an outsider-dominated board actually hinged on a single variable. "Our main finding is that outside directors do appear to have a material effect on performance," they say, "but the direction of the effect depends on how costly it is for those directors to become informed about the firm. Consistent with recent theoretical research, we find that outside directors are associated with significantly better performance when their cost of acquiring information is low, and are associated with significantly worse performance when their cost of acquiring information is high."

The Bottom Line: An outside director might actually hurt a board's performance if the acquisition of corporate knowledge comes at a high price.

John G. Matsusaka and Oguzhan Ozbas are professors of Finance and Business Economics in the USC Marshall School of Business.