Using panel data on U.S. public firms, we document a positive effect of board independence on corporate innovation. This effect is concentrated in firms that are larger in size, in the non-technical industries, facing less product market competition, and using more debt, where managers are more likely to be excessively risk averse. We establish causality of board independence on innovation using a difference-in-difference approach that exploits an exogenous shock to board composition, namely, the mandate of a majority of outside directors on company boards by NYSE and NASDAQ in response to the passage of Sarbanes-Oxley Act in 2002. We further examine incentive compensation as a possible mechanism. We show that firms with more independent boards use more equity-based compensation, especially stock options, to promote managerial risk-taking.
Innovation is widely viewed as a critical driving force of economic growth (e.g., Romer, 1990; Segerstrom, 1991). Innovation at the firm level is constrained by an agency problem that derives from the discrepant attitudes toward risk between the managers of a company and its shareholders, often known as managerial conservatism. Managers, whose personal wealth disproportionately hinges on the performance of the firm they run, tend to prefer projects with less volatile cash flows to reduce the risk of compromising their wealth or losing their jobs (Jensen and Meckling, 1976; Amihud and Lev, 1981; Smith and Stulz, 1985; Hirshleifer and Thakor, 1992; Gormley and Matsa, 2016). They hence have little incentive to innovate because innovation is a generally very risky endeavor (Holmstrom, 1989). Welldiversified shareholders, in contrast, tend to prefer risky projects because the value of their stockholdings increases with the riskiness of cash flows of the company they invest in, due to the option-like property of equity investments. To promote innovation, it is essential to overcome this conflict of interests. An independent board, with a majority of outside directors, is a major governance mechanism designed to mitigate conflicts of interest between managers and shareholders. The literature has shown that outside directors are active monitors and play a role in curtailing managerial pursuit of private benefits and encouraging efforts (e.g., Brickley and James, 1987; Duchin, Matsusaka and Ozbas, 2010; Wintoki, Linck and Netter, 2012; Schwartz-Ziv and Weisbach, 2012; Knyazeva, Knyazeva and Masulis, 2013). There is little evidence, however, about whether an independent board is also effective in aligning the risk preference of the managers with shareholders and hence ameliorating the managerial tendency to underinvest in innovation. In this paper we attempt to fill this gap. Unlike most other types of agency problems, managerial conservatism is a “hidden, silent killer” that is very difficult to discern as “the dangers of playing it safe aren’t sudden, obvious, and dramatic” (Sundheim, 2013, pp.5-6). When it comes to investment decisions, managers have the power to decide whether to invest in routine projects or risky innovative projects.