Does Board Size Matter?

This paper uses minimum board size requirements to assess whether large boards reduce firm performance. Since 1976, the legally required minimum size of German supervisory boards increases from 12 to 16 directors as firms pass 10,000 domestic employees. Board sizes increase sharply at this threshold, indicating that the mandate is binding for many firms. Using a regression discontinuity design around the threshold and a difference-in-differences analysis around the law’s introduction, we find robust evidence that forcing firms to have large boards lowers performance and value. At the threshold, operating return on assets drops by 2-3 percentage points and Tobin’s Q by 0.20-0.25, with similar declines for treated firms after the law’s introduction. Firms just above the threshold also generate lower acquisition announcement returns than firms just below, suggesting that large boards undertake worse acquisitions. 1 Jenter is at the London School of Economics & Political Science and CEPR. Schmid is at Hong Kong University. Urban is at Erasmus University Rotterdam. This paper has benefited from comments and suggestions by Ralf Elsas, Daniel Ferreira, Juanita Gonzales-Uribe, Moqi Groen-Xu, Mikael Homanen, Daniel Metzger, Francesc Rodriguez Tous, and seminar and conference participants at Cass Business School, IE Business School, London Business School, the London School of Economics, Nova School of Business and Economics, Universidad Carlos III de Madrid, the University of Edinburgh, the European Summer Symposium in Financial Markets (ESSFM) 2018, the 2018 Society for Financial Studies (SFS) Cavalcade, and the Third CEPR Annual Spring Symposium in Financial Economics. We thank Lennart Ebner, Georg Radmann, and Theresa Spickers for outstanding research assistance. 1 Almost all large firms have a board of directors that plays a central role in their governance. Boards select, monitor, evaluate, compensate, and replace the firm’s top executives (American Bar Association, 2009), but also advice and guide them (Adams and Ferreira, 2007). Due to governance failures and scandals, policy makers and regulators around the world have been concerned about the effectiveness of corporate boards, and governance codes in many countries include prescriptions on board size and independence (Adams, 2017). There is, however, a dearth of evidence that large boards harm firms. Because board size is endogenous, drawing conclusions from observed empirical correlations between firm performance and board size is difficult. This paper uses regulatory minimum board size requirements to assess whether large boards reduce firm performance. German corporations have a two-tier board, with a management board that runs the firm and a supervisory board that represents shareholders and – in larger firms – employees. The supervisory board hires, advises, and monitors the management board. Since 1976, the legally required minimum size of the supervisory board is 12 directors for firms with 2,00110,000 domestic employees, 16 directors for firms with 10,001-20,000 domestic employees, and 20 directors for firms with more than 20,000 domestic employees. Using two research designs on data from two distinct time periods, we find robust evidence that forcing firms to have large boards is detrimental to their performance. The first analysis uses a panel of German firms from 1987 to 2016 and a regression discontinuity design to compare firms just below the 10,000 domestic employees threshold to firms just above.1 Performance declines at the threshold: the reduced form estimates show a drop in operating return on assets (ROA) of 2 3 percentage points. Taking into account the increase in the probability of having a large board (defined as ≥16 directors) at the threshold, the two-stage least squares (2SLS) estimates link large boards to a 7 8 percentage point drop in ROA. Tobin’s Q also declines at the threshold, with a drop of 0.20 0.25 in the reduced form and of 0.5 0.8 in 2SLS. In addition, firms just above the threshold have lower acquisition announcement returns than firms just below, consistent with large boards approving worse acquisitions. The second research design is a difference-in-differences analysis around the introduction of the board size requirement in 1976. The analysis compares changes in firm performance from before to after the law’s introduction of treated firms (>10,000 employees) to control firms (≤10,000 employees). Depending on the measurement window and the control firms chosen, treated firms’ ROA declines by 1.2 2.9 percentage points relative to control firms. Treated firms’ Tobin’s Q declines by 0.12 0.15 compared to control firms. Hence, despite the different time periods and research designs, the estimates from the difference-in-differences analysis in the 1970s are in line 1 We do not use the 2,000 employee threshold because employee codetermination changes at that level (see Section 1.1). We do not use the 20,000 employee threshold because there are too few observations around it. 2 with the reduced-form estimates from the regression discontinuity analysis for 1987-2016. This evidence supports the hypothesis that forcing firms to have large boards reduces firm performance and value. Theory suggests that increasing the number of directors has both costs and benefits (Raheja, 2005; Harris and Raviv, 2008). On the one hand, boards’ capacity for monitoring and advising increases with board size, simply because there are more people to draw on. A larger group also pools more information and allows for greater diversity of backgrounds and viewpoints. On the other hand, large boards may underperform because of frictions in group decision making (Lipton and Lorsch, 1992; Jensen, 1993). At some point, the benefits of more directors are outweighed by free-riding, slower decision making, and coordination and process problems. Lipton and Lorsch (1992) recommend limiting board size to ten people, with a preferred size of eight or nine, while Jensen (1993) conjectures that boards beyond seven or eight are unlikely to function effectively and are easier for the CEO to control. The prior literature has mostly found a negative correlation between board size and firm performance. Yermack (1996) documents that board size is negatively related to profitability and firm value in a sample of US firms, and interprets this result as “consistent with theories that small boards are more effective. ” Similar negative correlations have subsequently been found for many other countries and time periods (Conyon and Peck (1998) for Denmark, France, Italy, the Netherlands, and the UK; Eisenberg, Sundgren, and Wells (1998) for Finland; Mak and Kusnadi (2005) for Malaysia and Singapore; Loderer and Peyer (2002) for Switzerland; De Andres, Azofra, and Lopez (2005) for a pooled sample of 10 OECD countries; Bennedsen, Kongsted, and Meisner Nielsen (2008) for Denmark; and Guest (2009) for the UK). The evidence is not completely unequivocal, with some studies finding insignificant correlations (de Jong et al. (2005) for the Netherlands; Black, Jang, and Kim (2006) for Korea) and some positive ones (Kiel and Nicholson (2003) for Australia; Adams and Mehran (2005) for US banks). Overall, however, the evidence suggests that board size is negatively correlated with profitability and firm value (Hermalin and Weisbach, 2003). Interpreting this evidence is more of a challenge. Shareholders and executives endogenously choose the size of the board, which implies that unexplained cross-sectional differences in board size are due to unobserved differences in firm, owner, or executive characteristics (Hermalin and Weisbach, 1998, 2003; Raheja, 2005; Boone et al., 2007; Coles, Daniel, and Naveen, 2008; Harris and Raviv, 2008). If, as seems likely, these unobserved characteristics also affect firm performance, negative correlation between board size and performance is not causal. The list of omitted variables likely to affect both board size and performance is long. For example, diversified firms tend to have large boards, because boards often grow when firms make