When corporate directors serve together on multiple boards, the chief executive officers tend to earn more money and enjoy longer tenures. Such mutual interlocks are plainly good for the bosses. But are they good for shareholders? Not necessarily.

By Eliezer M. Fich and Lawrence J. White

n the recent wave of corporate scandals, from Enron to Tyco, poor corporate governance structures have clearly been a contributing factor. The tales of excess compensation, poor capital allocation, and, occasionally, outright theft, have shone a harsh spotlight on the relationships between chief executive officers and the boards of directors. Too frequently, directors – who are supposed to represent the shareholders – have acted in ways that enrich CEOs and other favored executives while impoverishing common shareholders.

On many boards, two (or more) directors serve together on a different company’s board. For example, General Motors Corp.’s April 2002 proxy revealed that the GM board had two mutual interlocks: CEO John F. Smith, Jr., and Director George M.C. Fisher were also directors on the board of Delta Air Lines, Inc.; and Smith and Director Alan G. Lafley were also on the board of the Proctor & Gamble Co. (where Lafley is the CEO). We dub these associations “mutual interlocks.” And in a sample of 366 large companies, 87 percent had at least one mutual interlock in 1991.

Director interlocks have clear consequences for shareholders. Our empirical analyses show that CEO compensation tends to increase and CEO turnover tends to decrease when the CEO’s board has one or more pairs of board members who are mutually interlocked with another company’s board. Why? On the one hand, mutual interlocks could be an indication of and a contributor to CEO entrenchment, from which higher compensation and lower turnover naturally follow. On the other hand, mutual interlocks may indicate the strengthening of important and valuable strategic alliances. And the higher CEO compensation and lower turnover may be a just reward for orchestrating such alliances. We believe that the first interpretation is more accurate.


Director Interlocks

Researchers from several disciplines have been looking into interlocks for several decades. And at first it appeared that interlocks were a sign of weakness. In one of the earliest such U.S. studies, economist Peter Dooley in 1969 found that less-solvent firms were likely to be director-interlocked with banks. Later studies also reported that firms with high debt-to-equity ratios, or that had an increased demand for capital were likely to have interlocks. The reason: Financially stressed firms may seek to add bank officers to their boards to receive more favorable consideration. Or banks may demand board seats so they can monitor firms more closely.

Organizational behavior experts have examined the extent to which a board is an instrument of management interests. Some have argued that companies use board interlocks as a mechanism to improve contracting relationships, or to reduce the information uncertainties created by resource dependencies between firms. This stream of research suggests that the composition of boards, including interlocks, is largely determined by the efforts of CEOs to influence the selection of new directors so that they are responsive to that particular CEO’s interests.

Financial economists have examined interlocks as well. Kevin Hallock of the University of Illinois found that CEOs serving in employee-interlocked firms earn higher salaries than they otherwise would. Nevertheless, existing research has not documented a connection between director interlocks and total CEO compensation. And in our survey of previous studies, we did not find any associations between interlocks of various kinds and firm performance. That leads us to believe that interlocks aren’t designed to serve a firm’s strategic goals, and don’t serve them in practice.


Compensation and Turnover

Several recent studies have examined the relation between top executive compensation and board composition. And they report mixed results. For example, some authors have found a positive association between CEO compensation and the percentage of outside directors on the board. Other studies have found no relation between a board majority of outside directors and top management compensation. The level of incentive-based executive compensation appears to be positively connected with firm performance, and incentive-based compensation appears to be used more extensively by outsider-dominated boards.
“After poor firm performance, CEOs are more likely to be dismissed if the board of directors has a majority of outsiders.”

Other scholars have found an inverse relation between the probability of a top management change and prior stock price performance. After poor firm performance, CEOs are more likely to be dismissed if the board of directors has a majority of outsiders. Empirical analyses indicate that the probability of top management turnover is reduced if the top executives are members of the founding family or if they own higher levels of stock. Executive turnover is also negatively related to the ownership stake of officers and directors in the firm and positively related to the presence of an outside blockholder. Other studies have found that the likelihood of CEO departure is inversely associated with both the dollar value of stock option compensation in relation to cash pay and the amount by which a CEO’s compensation is higher than would be expected from comparisons with the compensation of other CEOs. But thus far, no study has considered the possible effects that boards with mutual director interlocks have on CEOs’ total compensation and turnover.


The Data

We looked at CEO compensation and CEO turnover for 452 industrial firms, first compiled by NYU Stern professor David Yermack. These firms were drawn from Forbes magazine’s lists of the largest 500 U.S. companies in categories such as total assets, market capitalization, sales, or net income. The data set includes all companies meeting this criterion at least four times during the 1984-1991 period. Compensation data were collected from the corporation’s SEC filings. Directors who were full-time company employees were designated as “inside” directors. Individuals closely associated with the firm – for example, relatives of corporate officers, or former employees, lawyers, or consultants, or people with substantial business relationships with the company – were designated as “gray” directors. All the rest were designated “outside” directors. We also drew on the data assembled by Kevin Hallock, who analyzed 9,804 director seats held by 7,519 individuals in 1992. We took as our final data set the 366 industrial firms for the 1991 proxy season that appeared in both the Yermack and the Hallock data sets. (Utility and financial firms were excluded from the study because government regulation may lead to a different role for directors.)

In order to examine how director interlocks may affect CEO compensation, we used a measure of total remuneration that included salary and bonus, other compensation, and the value of option awards when granted. We believe that this sum is a more accurate measure of what boards intended to pay, which could be different from what CEOs earn, since CEOs often exercise options early, thereby sacrificing a significant portion of the award’s value.

As an estimate for CEO turnover, we used a dependent variable that was set equal to one if a CEO leaves office during the last six months of the current fiscal year or the first six months of the subsequent period. In order to control for retirement-related voluntary departures, we included in the analysis the CEO’s age. Turnover events occurred in 9.0 percent of the sample (thirty-three firms).


Considering Interlocks

The key explanatory variable of this study was the number of mutual interlocks on the firm’s board. While two boards can be interlocked if they share one director, they are mutually interlocked if they share at least two directors. For any given board, a director could be part of more than one pair of mutual interlocks, so it is quite possible that a board may have a greater number of mutual interlocks than directors. In our sample of industrial firms, board sizes ranged from four to 26, with an average of 12.18. The number of mutual interlocks ranged from zero to 42, with an average of 12.15.

Other independent variables used in the study were based on their likely relevance and effects on CEO compensation and CEO turnover, as established by other authors. As in numerous other studies, Tobin’s Q (the market value of assets divided by the replacement cost of assets) was used as a proxy for the growth opportunities of the firm.

Table 1 presents descriptive statistics of the key variables in this study and their correlation with the number of board director interlocks. As seen, the mean number of directors who are CEOs of other firms is 1.94. This result is similar to that reported by James Booth and Daniel Deli, who found the mean to be 1.87 for 1989-90 data. The mean number of outside directors serving on the board was 6.94, which is also consistent with the previous literature.


Two Hypotheses

If the CEO dominates the selection process of directors to the board, and if the CEO is in fact filling the director positions with sympathetic members, then we would expect a positive association between the fraction of these favorable board members and the compensation of the CEO. In other words, our first hypothesis stipulates that boards with a larger number of mutual director interlocks will pay a higher compensation package to the CEO. Our second hypothesis states that there is an inverse association between the presence of mutual interlocks and the likelihood of CEO departure.

What do the results show? The correlations reported in Table 1 suggest the existence of a relationship between the number of mutual director interlocks and the compensation of the CEO. It is not surprising that larger boards have more interlocks and that a preponderance of interlocks appears to be positively connected with outside directors and with directors who are CEOs of other organizations. Mutual director interlocks appear to be curtailed by close ownership and governance structures. Our results show a negative and significant correlation between this variable and the indicators for CEO-as-founder and for non-CEO chairman.

Since director interlocks could just be indicators of strategic power relationships between firms at the highest level, it cannot be automatically concluded that CEOs and interlocked directors exploit networks of board memberships for their personal gain simply because these multiple board affiliations exist. In fact, CEOs could be rewarded with additional compensation and long job durations for successfully establishing mutual interlocks that serve the strategic goals of the firm.

But the data show a significant negative relationship between the number of mutual interlocks and the number of “gray” directors, many of whom could represent companies that have supplier or customer relationships with the company. This negative relationship reinforces our skepticism as to the likelihood that the mutual interlocks serve the strategic goals of the firm.

Extra Compensation

To test our first hypothesis, we ran an ordinary least square regression to estimate the effect that mutually interlocking boards have on the total compensation of the CEO. These calculations took into account factors such as interlocks, firm size, tenure of the CEO, firm performance, and stock ownership of the CEO. The results of this estimation are presented in Table 2. As expected, the number of mutual director interlocks is found to be significant and positively associated with total compensation. This finding suggests that the links created by the mutual interlocking relations between boards actively benefit the CEO. In other words, with the aid of mutual interlocks, CEOs are able to extract significantly larger compensation packages from their firms. The robustness of this result is upheld through further investigations of the components of the CEO’s pay package.

When we repeated the analysis using the natural log of only the sum of the CEO’s salary and bonus as the dependent variable, the coefficient for mutual directors was positive and significant. That suggests that even just the sum of the CEO’s basic salary and bonus tends to increase as a consequence of the mutual director interlocks. In fact, we found that a mutual interlock adds an average of $143,000 (approximately 13 percent) to the average CEO salary and bonus.

The evidence presented in Table 2 is in line with the view that mutual interlocks may indeed assist the CEO in extracting lucrative remuneration packages from the firm. The networks and traffic of influences created by mutual interlocking directorships have probably been utilized by CEOs in exerting control over the majority of board members. This finding suggests that directors may not be making decisions that benefit the firm’s shareholders the most. Mutually interlocking directorships could be weakening the control mechanisms put in place to ensure that directors fulfill their fiduciary duty and act in the best interest of the shareholders.

When we ran other regressions with these data we found that stock option compensation appears not to be judiciously used by boards in compensating their CEOs in the presence of mutual interlocks. We believe this reflects cronyism and weakens the board’s monitoring function. This interpretation is consistent with the view of academics and corporate governance activists who perceive interlocks generally as corrupt. Thus, although other studies find that markets react favorably to the adoption of stock option plans to compensate top executives, we find that stock options can be misused if the board’s monitoring activities are weakened by interlocks.

Other results in these regressions are consistent with the previous literature. We found that CEO pay is inversely related to the fraction of equity held by the CEO. And as economists Sherwin Rosen, Clifford W. Smith, Jr., and Ross L. Watts have found in other studies, we find that large companies and firms with greater growth opportunities pay more to their CEOs. A company’s net-of-market stock return was found to have a positive and significant association with total CEO compensation, consistent with previous studies.


CEO Turnover

To test our second hypothesis, we investigated whether the presence of mutual interlocking directorships decreases the board’s ability to monitor the CEO, thereby decreasing the likelihood that the CEO will depart. We analyzed the data, including CEO and company characteristics that should be associated with the probability of turnover. Michael Jensen and Kevin Murphy have suggested that one obvious CEO feature likely to affect the turnover process is age. To control for this influence we included the CEO’s age in the estimation. And to control for firm performance, we included the firm’s current and previous year stock returns net-of-market as well as the current period return on assets. Further control variables included proxies for growth opportunities (the ratio of research and development {R&D} over sales), the ratio of long-term debt to total assets, company size, and the fraction of common stock held by the CEO or his immediate family.

Table 3 presents coefficient estimates for the CEO turnover model. And the results are as hypothesized: The coefficient on the mutual interlock variable is negative and significant as predicted, implying that the presence of mutual board interlocks is inversely associated with the probability of CEO turnover. We interpret this result to indicate that mutually interlocking directorships weaken the monitoring power that the board has over the chief executive. Further, mutual interlocks contribute to the possible entrenchment objectives of the CEO. This result is in agreement with the notion that boards are ineffective in controlling the CEO, who is likely to control the nomination and selection process of the directors.

These results are consistent with other theories and research on CEO turnover. As previous studies have noted, we found that CEOs are less likely to leave office if they own a large fraction of equity in the firm or if company performance is strong. And we found that age is positively associated with the probability of CEO turnover. Firm size, as proxied by the natural log of the firm assets, does not appear to play a role in the likelihood that the CEO leaves office.



Academics and the popular press have suggested that corporate boards are ineffective in monitoring CEOs, since CEOs frequently dominate the director selection process. Boards filled with CEO-sympathetic director appointees are likely to overcompensate and undermonitor the chief executive. Our view is that the mutually interlocking directorships that are prevalent among firms are responsible for the production of sympathetic directors. These directors have the opportunity to pay and re-pay each other favors because of their multiple board memberships and may well be doing so in league with the CEOs who nominated them.
“Interlocking directorships weaken the monitoring power that the board has over the chief executive.”

Our results indicate that the power alliances created by directors with multiple memberships are used by self-serving CEOs to extract handsome remuneration packages from firms and to strengthen their entrenchment. Boards that overcompensate and undermonitor the CEO are not fulfilling their fiduciary duties to the shareholders. As a result, board mutual interlocks weaken the firm’s governance structure, promote cronyism, and exacerbate the firm’s agency problems.

The results reported here indicate that it is at least plausible that mutual director interlocking relationships between different corporate boards might affect the voting patterns and decisions that these boards make on other matters besides CEO compensation and turnover.

Overall, our research suggests that inter-board relationships should be more closely scrutinized to determine whether these relationships encourage decisions that enhance shareholder wealth or instead facilitate empire building by self-serving CEOs. If, as we suspect, the latter is the case, then closer monitoring – private and/or public – of boards is needed.

Eliezer M. Fich, Stern Ph.D. 2000, is visiting assistant professor of finance at the Kenan-Flager Business School at the University of North Carolina. Lawrence J. White is Arthur E. Imperatore professor of economics at NYU Stern.

This article is adapted from an article that appeared in the Fall 2003 Wake Forest Law Review.