Fal Eye 2017

Rev Quant Finan Acc
DOI 10.1007/s11156-017-0635-z
ORIGINAL RESEARCH
Industry expertise on corporate boards
Olubunmi Faleye1 • Rani Hoitash2 • Udi Hoitash1
Ó Springer Science+Business Media New York 2017
Abstract Recent surveys indicate that industry expertise is the most sought-after director
qualification. Yet evidence on the value of such expertise is limited. This paper shows that
firms that are difficult for non-experts to monitor and advise are more likely to appoint
industry expert directors. Such appointments also depend on the supply of industry-ex-
perienced candidates in the local director labor market. Board industry expertise reduces
R&D-based real earnings management and increases R&D investments. The increase in
R&D spending is value-enhancing: firms with industry expert directors receive more
patents for the same level of R&D, their R&D spending is associated with lower volatility
of future earnings, and their value is higher. Finally, industry expertise is associated with
CEO termination and pay incentives that encourage R&D investments.
Keywords Director qualifications Industry expertise Real earnings

management R&D
JEL Classification G34
1 Introduction
On December 16, 2009, the U.S. Securities and Exchange Commission (SEC) released
final proxy disclosure enhancement rules requiring companies to ‘‘disclose for each
director and any nominee for director the particular experience, qualifications, attributes or
& Rani Hoitash

rhoitash@bentley.edu
1
D’Amore-McKim School of Business, Northeastern University, 360 Huntington Av., Boston,
MA 02115, USA
2
McCallum Graduate School of Business, Bentley University, 175 Forest St., Waltham, MA 02452,
USA
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O. Faleye et al.
skills that qualified that person to serve as a director.’’1 Since then, an emphasis on prior
experience in the firm’s industry has been a prominent feature of these disclosures (see,
e.g., 2011 proxy filings of Symantec Corp., Coca-Cola Co., and Hewlett-Packard). Simi-
larly, a 2012 survey of directors identified prior industry experience as the most highly
desired qualification in director nominees (PricewaterhouseCoopers LLP 2012). Never-
theless, the academic literature has only recently begun to evaluate the role of industry
expertise in board effectiveness. We aim to extend this literature by studying the effect of
industry expert directors on the extent and quality of corporate investments in research and
development (R&D) projects.
Several issues surrounding R&D investments have received significant attention in the
accounting literature, including the value-relevance of these investments (Aboody and Lev
1998), capitalizing versus expensing them (Kothari et al. 2002), using R&D as a tool for
real earnings management (Baber et al. 1991; Bushee 1998), and the association between
narrative R&D disclosures and earnings performance (Merkley 2014). A basic foundation
for these issues is that R&D is fundamentally different from other types of investments
because it involves current expenditures in expectation of highly uncertain but possibly
substantial future profits. It also imposes significant costs on executives through the cul-
tivation of firm-specific human capital that can encourage ex post hold up (Jensen 1993).
Since these same characteristics often incentivize managers to underinvest in R&D pro-
jects, an understanding of mechanisms that attenuate managerial myopia in R&D spending
remains a major topic in the literature. This paper proposes board industry expertise as one
such important mechanism.
The board of directors is ultimately responsible for the functioning of the firm, with the
dual task of monitoring and advising top management (Fama and Jensen 1983; Jensen
1993). Thus, an effective board is pivotal in ensuring that executive actions maximize the
firm’s long-term value. Prior research shows that such effectiveness depends on the ability
of directors to obtain and process information about the firm, its industry, and top exec-
utives (Harris and Raviv 2008; Adams and Ferreira 2007). This is especially so in the case
of R&D projects because of the significant asymmetry between what executives know
about the firm’s R&D investment opportunity set and what directors can ordinarily be
expected to know.
Industry expertise reduces this internal information asymmetry because it provides a
deeper understanding of the risk and reward profiles of the firm’s industry. In addition, it
enhances directors’ connections to key industry players, which increases their access to
relevant information about the nature of innovation opportunities in the industry (Faleye
et al. 2014).2 This combination can enable industry expert directors to provide better
oversight of management’s choices in R&D spending and to create the institutional
environment and incentive structures that encourage executives to overcome myopic
behavior in R&D investments.
Industry expertise can also facilitate better board advising that fosters investments in
R&D projects. First, it increases the ability of directors to provide better counsel in
identifying, evaluating, and exploiting R&D opportunities. This reduces managerial risk
1
U.S. SEC, 17 CFR Parts 229, 239, 240, 249 and 274. Release # 33-9089, p. 29.
2
Such connections also potentially enhance incoming R&D spillover because the exposure of industry-
experienced directors to other executives in the industry and their intimate knowledge of industry dynamics
can improve a firm’s ability to benefit from technological advances at other industry firms (see, for example,
Bernstein and Nadiri 1988; Chen et al. 2013; Jaffe 1986). We are grateful to an anonymous referee for
pointing this out.
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aversion in R&D investments by diminishing the ex ante riskiness of such projects. In

addition, source credibility theory (Birnbaum and Stegner 1979) suggests that decision-
makers are more likely to accept advice from perceived experts. This implies that direc-
tors’ industry expertise can increase the CEO’s willingness to seek board input and act on
such advice when offered, thereby facilitating better information exchange with directors
and more effective strategic decision-making.
Nevertheless, industry expertise need not translate into better board performance and
can hinder the effectiveness of directors in monitoring and advising management. First,
familiarity with industry norms can blind directors to changing industry dynamics and
opportunities to reinvent the industry through groundbreaking and potentially disruptive
innovation since it may be easier for outsiders to recognize such opportunities. Second,
board industry expertise implies that the professional backgrounds of directors and top
executives are similar. This similarity can foster inefficiencies that hinder effective
strategic decision-making, for example, by discouraging alternative viewpoints and
approaches. The psychology literature (e.g., Janis 1972; McCauley 1989) suggests that
similarities in the backgrounds of group members can reduce the quality of group decisions
via groupthink. Thus, a board on which directors and top executives share similar industry
backgrounds may produce suboptimal decisions because of internal pressures for confor-
mity. Finally, the CEO and other top executives bear the primary responsibility for strategy
formation and execution. These executives are industry experts by definition and are
arguably more familiar with the firm’s operations. Thus, the industry expertise of directors
may not confer additional benefits in identifying and executing profitable R&D
investments.
We study these issues using firms in the S&P 1500 indexes over 2000–2009. Using
measures of board industry expertise based on the employment histories of independent
directors, we first examine the matching of industry expert directors to firms based on
the hypothesis that observed board composition reflects the demand and supply of
different types of directors. Our tests show that firms that are more difficult for non-
experts to advise and/or monitor are more likely to appoint industry expert directors. As
indicated by prior studies, such firms include R&D-intensive firms (Raheja 2005; Linck
et al. 2008), firms with greater growth opportunities (Fahlenbrach et al. 2010), and
those in industries where industry effects explain less of the stock returns of individual
firms (Parrino 1997). We also find that industry expert directors are more prevalent at
firms that are located near a local pool of potential industry experts, which is consistent
with Knyazeva et al. (2013) who show that board composition reflects the pool of
candidates in the local director market. In contrast, industry expert directors are less
likely as CEO equity ownership increases. To the extent that equity ownership increases
the CEO’s influence on board composition, this is consistent with the notion that
powerful CEOs dislike knowledgeable monitors. Other firm and board characteristics,
including firm value, firm size, corporate diversification, CEO tenure, and CEO–
chairman duality are not significant.
We approach the question of whether industry expertise enhances the board’s ability to
attenuate myopic behavior in R&D spending from several angles. First, we focus on what
is probably the most flagrant manifestation of this behavior, that is, the decision to cut
R&D spending in order to meet short-term earnings goals. Using the methodology of
Bushee (1998), we find that firms with industry expert directors are less likely to cut R&D
spending when doing so would have allowed them to meet their earnings goal. As a
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complement to this test, we adopt the framework of Gunny (2010) and examine abnormal
reductions in R&D spending among firms that could reverse an earnings shortfall by
cutting R&D expenditures. Our results show that board industry expertise is negatively
associated with abnormal R&D reductions among these firms.
These results suggests that industry expertise enhances the board’s ability to curtail
myopic investment behavior specifically designed to meet an earnings goal. Yet we rec-
ognize their limited nature since the vast majority of firms are not typically in situations
where they must choose between cutting R&D spending and reporting an earnings
shortfall. Thus, we examine the effect of board industry expertise on R&D investments in
the general population of firms. Our tests show that board industry expertise is associated
with a significant increase in R&D investments, both in the full sample and among firms
that invest in R&D. We acknowledge the difficulty of interpreting this result as causal and
perform additional tests to aid in identifying the effects of industry expert directors. In
particular, we perform an instrumental variable two-stage least squares (2SLS) regression
analysis using two instruments for board industry expertise. The first is the number of
same-industry firms whose headquarters are located in the same three-digit postal ZIP code
as the focal firm’s headquarters. This is based on the finding of Knyazeva et al. (2013) that
the local pool of potential directors is a strong determinant of board composition. The
second is an industry-level variable that measures information acquisition costs for firms in
each industry, using proxies proposed by Duchin et al. (2010). Diagnostic tests confirm the
strength and validity of these instruments and the second stage regression shows that board
industry expertise has a positive effect on R&D investments. Various additional tests
confirm this conclusion.
Although prior research (e.g., Sougiannis 1994; Lev and Sougiannis 1996) suggests
that R&D expenditures enhance long-term firm value, it is not clear that increased R&D
spending is always desirable because such spending may simply represent wasteful
overinvestment that increases the riskiness of future earnings.3 We perform several tests
to evaluate this. First, we show that board industry expertise reduces the earnings
riskiness of R&D spending, that is, the positive relation between R&D spending and the
volatility of future earnings (Kothari et al. 2002) is weaker among firms with industry
expert directors. This suggests that board industry expertise reduces the riskiness of a
firm’s R&D projects but may also mean that such projects are routine investments whose
payoffs are more certain. Therefore we evaluate the effect of board industry expertise on
patents to provide an insight into the quality of R&D projects facilitated by industry
expert directors. We find that, conditional on the same level of R&D spending, board
industry expertise is associated with a significant increase in patents received from the
U.S. Patent and Trademark Office (USPTO). Finally, firm value (as measured by Tobin’s
q) is significantly higher when industry experts serve on the board of directors but only
among firms that invest in R&D.
Xue (2007) and Manso (2011) show that the board must make different executive
compensation and turnover choices in order to attenuate managerial myopia in R&D
activities because these activities involve the exploration of novel ideas that are more
likely to fail. Such choices include a commitment to job security and compensation con-
3
Consistent with this possibility, Chan et al. (2015) find that reductions in R&D spending are associated
with positive long-term excess stock returns. Their result suggests that maturing firms optimally cut R&D
investments in response to declining investment opportunity sets. See also Chambers et al. (2002).
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tracts that generate higher pay–performance sensitivities. Thus, we conclude our tests by
examining whether industry experts influence board monitoring in a manner consistent
with these arguments. We find that board industry expertise increases pay–performance
sensitivity and is associated with a significant increase in the ratio of stock option awards to
total CEO pay and a corresponding reduction in the ratio of cash-based pay. It is also
associated with a reduction in the likelihood of forced CEO turnover when the firm suffers
a short-term decline in performance. In all, our results suggest that industry expert directors
influence the board to make monitoring choices designed to reduce myopic behavior in
R&D investments. Importantly, these results are more pronounced in R&D firms, further
suggesting that industry expert directors are more valuable at such firms.
This paper makes several important contributions. First, we complement recent studies
that examine the value of board industry expertise in specific settings. Cohen et al. (2014)
and Wang et al. (2014) both show that audit committee industry expertise is associated
with higher quality financial reporting while Wang et al. (2014) further show that industry
expertise on the compensation committee is associated with reduced excess pay. Dass et al.
(2014) focus on directors’ experience in customer and supplier industries as opposed to the
firm’s industry, which is the definition of industry expertise usually referenced in practi-
tioner discussions and adopted in this paper. They show that such expertise has a positive
effect on firm value, especially when information problems are more severe. We extend
these studies in several ways. Our results on the factors that explain the appointment of
industry expert directors are new. Our results on the role of these directors in curtailing
myopic behavior in R&D are also new, as are the linkages we establish between industry
expertise and the quality of R&D projects as well as the monitoring choices that encourage
such investments. Our results also contribute to the broader question of director assign-
ments on corporate boards. Specifically, we find that the effect of industry expert directors
on compensation incentives is confined to firms where these directors serve on the com-
pensation committee.
Second, we contribute to the literature on managerial myopia and real earnings man-
agement (Baber et al. 1991; Roychowdhury 2006; Gunny 2010). This literature finds that,
in certain cases, managers cut R&D investments to meet short-term accounting goals. Our
results show that well-informed directors with prior experience in the firm’s industry help
mitigate this behavior. We also show that industry expert directors are associated with
increased R&D spending and that this increase is more consistent with value-maximization
rather than wasteful overinvestment. Relatedly, Xue (2007) and Manso (2011) show that
boards require compatible compensation contracts and CEO termination strategies in order
to motivate investments in R&D. We extend these studies by showing that industry
expertise is a specific type of director qualification that facilitates such strategies.
Third, we extend the literature on the dual role of directors as advisors and monitors.
While some studies find that certain features complicate the board’s ability to simulta-
neously perform its advising and monitoring duties (Adams and Ferreira 2007; Faleye et al.
2011), others argue that monitoring and advising can coexist (Brickley and Zimmerman
2010). We contribute to this debate by identifying industry expertise as a specific board
feature that enhances both monitoring (reduced real earnings management, CEO com-
pensation, and turnover) and advising (in terms of broader investments in R&D and the
quality of such investments).
Finally, our findings have practical implications for boards seeking to appoint new
directors. Our results suggest that one size does not fit all and that industry expert directors
can benefit certain firms more than others. Specifically, directors with industry experience
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appear to be valuable mainly at firms for which R&D investments are important value
drivers.
2 Sample and data
2.1 Sample construction
Our initial sample consists of all firms in the S&P 1500 indexes, excluding financial firms
and utilities because of regulatory oversight that can limit their boards’ role. As described
below, we use BoardEx data to construct measures of board industry expertise for these
firms. We start our sample in 2000 since BoardEx provides limited coverage prior to that
year. We obtain data on other board attributes from Institutional Shareholder Services
(RiskMetrics), accounting data from Compustat, stock return data from the Center for
Research in Security Prices (CRSP), and CEO compensation data from ExecuComp. Our
final sample includes firms in the intersection of these databases, consisting of 9078 firm-
year observations for 1528 unique firms over 2000–2009.
2.2 Main variables
Our variable of interest is board industry expertise. To construct this variable, we first
create a comprehensive record of the employment history of each independent director
using data from BoardEx. Next, we identify the primary standard industrial classification
(SIC) code of each director’s current and previous employers using data from Compustat.
Past studies often use two-digit SIC codes to construct industry-adjusted variables (De-
chow, Sloan, and Sweeney 1995); control for industry fixed effects (Hoitash et al. 2009);
and measure industry competition (DeFond and Park 1999) and specialization (Dunn and
Mayhew 2004). Thus, we define a director as an industry expert if the firm where he is a
board member shares the same two-digit SIC code with at least one firm in his employment
history. We aggregate this at the board level to create three measures of board industry
expertise: the proportion of industry experts relative to the number of independent direc-
tors, the number of industry experts, and a binary variable that equals 1 if at least one
independent director is an industry expert, 0 otherwise.4
U.S. laws prohibit individuals from concurrent service as directors and/or officers of
competing firms. While the legal definition of competitors need not coincide with two-digit
SIC code industries, this nevertheless raises the possibility that industry expert directors are
older, more experienced directors such as retired CEOs since retired executives are allowed
to serve as directors of erstwhile competitors. To mitigate this concern, we create four
variables that control for the experience and age of directors. These are the fraction of
independent directors who are retired CEOs of other firms, the fraction who are active
CEOs of other firms, and average age and board tenure of independent directors.
In addition, we control for other variables that likely affect board effectiveness. These
include board size, which we measure as the natural log of the number of directors, board
independence (the fraction of independent directors), and board ownership (fraction of
outstanding shares owned collectively by all directors). Others are CEO duality (equals 1 if
4
For most tests, we report results using the first measure to conserve space. All results are comparable when
using the other two measures.
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the CEO serves as board chair, 0 otherwise), and CEO ownership (fraction of outstanding
shares owned by the CEO).
We also construct measures of firm characteristics, including firm size (natural log of
market capitalization), growth opportunities (the annual percentage change in sales),
corporate diversification (combined number of business and geographic segments), return
on assets (ROA, defined as the ratio of operating income before depreciation to total
assets), and leverage (the ratio of total assets to liabilities). Table 1 presents summary
statistics for these variables.
Table 1 Summary statistics for main variables

Mean Median 25th percentile 75th percentile Standard deviation
Board size 9.237 9.000 8.000 11.000 2.278

Independent directors 6.778 7.000 5.000 8.000 2.234
Board independence 0.732 0.750 0.636 0.857 0.152
Board industry expertise 0.568 1.000 0.000 1.000 0.495
%Board industry experts 0.189 0.125 0.000 0.333 0.227
#Board industry experts 1.239 1.000 0.000 2.000 1.508
Board ownership 0.087 0.034 0.014 0.100 0.128
CEO ownership 0.034 0.012 0.005 0.029 0.067
CEO duality 0.615 1.000 0.000 1.000 0.487
Busy board 0.202 0.000 0.000 0.000 0.401
Board age 65.685 65.667 62.714 68.545 4.681
Board tenure 7.969 7.369 5.322 9.929 3.812
Active CEO directors 0.500 0.000 0.000 1.000 0.784
Retired CEO directors 0.479 0.000 0.000 1.000 0.766
Total assets 5677.091 1530.443 633.137 4274.151 12,935.793
Market capitalization 8102.831 1693.931 700.613 5028.845 25,631.637
Tobin’s q 2.027 1.644 1.264 2.342 1.232
Corporate diversification 6.011 6.000 3.000 8.000 3.368
Growth opportunities 0.093 0.077 -0.011 0.172 0.208
Return on assets 0.143 0.138 0.093 0.191 0.090
The sample consists of 9078 annual observations for 1528 firms between 2000 and 2009. Board size is the
number of directors. Independent directors are directors with no business or personal relationship with the
firm or any of its employee-directors. Board independence is the percentage of independent directors.
Industry experts are independent directors with prior or current work experience in a firm that operates in the
same two-digit primary SIC code as the focal firm. Board industry expertise equals 1 if the board has at least
one industry expert, 0 otherwise. %Board industry experts is the ratio of industry experts to independent
directors. #Board industry experts is the number of industry experts. Board ownership is the proportion of
outstanding shares owned by all directors. CEO ownership is the proportion of outstanding shares owned by
the CEO. CEO duality equals 1 if the CEO also serves as board chair, 0 otherwise. Busy board equals 1
when a majority of independent directors serve on three or more boards, 0 otherwise. Board age is the
average age of independent directors. Board tenure is the average tenure of independent directors. Active
CEO directors is the number of directors who are active CEOs of other companies. Retired CEO directors is
the number of directors who are retired CEOs of other companies. Total assets and market capitalization are
in millions of dollars. Corporate diversification is the sum of reported geographical and business segments.
Growth opportunities is the 1-year percentage change in sales. Return on assets is the ratio of operating
income before depreciation to total assets
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3 The appointment of industry expert directors
Appointments of directors result from a matching process in which a firm’s need for
specific board expertise are balanced against the qualifications and preferences of available
board candidates. Thus, in attempting to understand the effects of board industry expertise,
we first focus on how the characteristics and preferences of industry experts intersect with
firm and board attributes to balance the supply and demand for these directors.
The literature has long recognized that the board’s main functions are to monitor and
advise management. This implies that a firm’s demand for specific types of directors
depends on its need for board advising and monitoring coupled with the perceived ability
of potential candidates to provide such advice and monitor management. Adams and
Ferreira (2007) and Harris and Raviv (2008) both argue that the effectiveness of directors
as advisors and monitors depends on their ability to obtain and process information about
the firm and its internal/external environments. Industry expertise can improve the profi-
ciency of directors in both tasks. First, it enhances their ability to obtain information by
providing a better understanding of the relevant criteria for measuring, evaluating, and
improving performance in the industry. Second, the professional connections that come
with prior industry experience provide greater access to the network of industry executives,
which increases exposure to the information present in such networks. Thus, industry
expert directors can obtain information faster and at a lower cost. They are also better-
positioned to process such information because their prior experience in the firm’s industry
affords them greater insight into the firm’s operations. These considerations suggest that
the demand for industry expert directors is higher at firms with greater advising and/or
monitoring needs.
Klein (1998) and Coles et al. (2008) suggest that complex firms have greater needs for
board advice because the complexity of their operations increases the need for outside
experts whose skills complement and extend the expertise of top executives. They also
propose that complexity increases with firm size and scope of operations. Similarly,
Fahlenbrach et al. (2010) argue that high growth firms have higher needs for board
advising to assist them in exploiting their growth opportunities. Thus, we expect the
demand for industry expert directors to increase with firm size,5 the extent of firm
diversification, and growth opportunities.
Prior studies on board composition such as Raheja (2005) and Linck et al. (2008) show
that higher project verification costs increase the need for directors who are well familiar
with the firm’s operations to serve as monitors because it is easier for such directors to
obtain and process the information needed for effective oversight. Higher project verifi-
cation costs also increase the need for directors with specialized insight into the firm’s
operation because they are likely better-positioned to assist in selecting appropriate
strategies. In general, the pecking order for familiarity with the firm’s operations is
employee directors, industry expert directors, and other outside directors. This suggests
that the demand for industry expert directors increases with project verification costs and
decreases with the number of employee directors. Following the literature, our proxies for
project verification costs are R&D intensity (ratio of R&D spending to sales) and the level
5
Our prediction for firm size based on organizational complexity notwithstanding, it is plausible that
smaller firms have a greater need for industry expert directors because they may be less able to have this
required expertise internally. Thus, the effect of firm size on the demand for industry expert directors is
unclear.
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of intangible assets. We expect the likelihood of appointing an industry expert director to

increase with each.
Conversely, the information advantage of industry expert directors is less important if
information about the firm is available from easily accessible sources. In particular, Parrino
(1997) suggests that firms operating in industries in which industry effects mostly explain
the stock returns of individual firms can more easily benchmark the performance of their
top executives against other firms in the industry. This reduces the information gap
between directors and top management and thus lowers the need for industry expert
directors. We measure industry homogeneity using the proxy of Parrino (1997), defined as
the mean partial correlation between each firm’s stock returns and an equally weighted
industry index. We expect the likelihood of appointing an industry expert director to
decline with this variable.
Anecdotal evidence suggest that CEOs dislike board monitoring and therefore prefer
weaker monitors. Given that industry experts are better informed about the firm and may
thus be better monitors, we expect the demand for industry expert directors to decline with
CEO power. Frequent proxies for CEO power in the literature include CEO duality, CEO
tenure, and CEO ownership. Thus, we hypothesize that the likelihood of appointing
industry expert directors is lower when the CEO is board chair and also declines with CEO
tenure and equity ownership.
The preceding discussion focuses on the demand for industry expert directors. We now
consider the supply of these directors. We propose that this is dependent on the potential
pool of such directors and their preferences for specific types of firms. Knyazeva et al.
(2013) show that firms mostly draw independent directors from areas close to their
headquarters because directors prefer to serve on the boards of local firms due to the
relatively lower time costs involved in such commitment. Thus, we expect the supply of
industry expert directors, and the likelihood of appointing one, to increase with the number
of same-industry firms located near each firm. Our proxy for this is the number of firms in
the same two-digit SIC code as the focal firm whose headquarters are located in the same
three-digit postal ZIP code as the firm’s headquarters.
An important benefit of board service is the prestige that such service confers on an
outside director. This suggests that the supply of outside directors is higher for firms
perceived to enhance the prestige and/or reputation of directors. Since larger firms are
typically perceived as more prestigious than smaller ones, we expect industry expert
directors to prefer larger firms to smaller firms, thus implying that the supply of industry
expert directors increases with firm size.
Finally, the social psychology literature (e.g., Berscheid 1985) shows that individuals
are attracted to others of similar attitudes and backgrounds and prefer joining groups whose
existing members share a similar background to theirs. Consistent with this, Fahlenbrach
et al. (2010) find that outside CEOs are more likely to join boards with other outside CEOs
while Faleye et al. (2015) show that the likelihood of an entrepreneur director joining a
board increases with the number of other entrepreneurs currently on that board. These
studies suggest that industry expert directors are more likely to join boards that have other
industry experts.
We test our hypotheses in two complementary ways. First, we analyze the decision to
appoint an industry expert director. This allows us to examine factors that influence the
appointment of each individual industry expert director. However, it does not permit an
analysis of the level of board industry expertise because it only considers the flow of
industry experts. For this reason, we estimate additional regressions relating measures of
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the level of board industry expertise to the firm, board, and CEO characteristics discussed
earlier.
Our appointment tests use a sample of 2045 appointments of outside directors from
2003 to 2009 as reported in BoardEx. Of these, 461 (22.5%) qualify as industry experts at
the appointing firm while the remaining 1584 do not. We estimate logit regressions where
the dependent variable equals 1 if the appointee is an industry expert, 0 otherwise. Table 2
shows results of these regressions. In the first column, we focus on director attributes as a
means of characterizing industry expert directors relative to other outside directors. Two
results stand out from this regression. First, industry expert directors serve on more boards
at the time of their appointment, which is consistent with survey results that they are highly
sought-after. Second, industry expert directors are more likely to be retired CEOs. This is
intuitive because being retired reduces the likelihood that the appointment violates antitrust
laws that prohibit interlocking directorships among competitors. In addition, these former
executives are no longer burdened with the demanding duties of their offices and are thus
able to devote needed time to board responsibilities. Other personal characteristics are not
significant.
The second column of Table 2 introduces firm, board, and CEO attributes. It shows that
the likelihood of appointing an industry expert director increases with R&D intensity. An
increase of one standard deviation in the ratio of R&D to sales increases the probability of
appointing an industry expert director by 3.1% points when other variables are evaluated at
their sample means. Similarly, the likelihood of appointing an industry expert director
increases with growth opportunities as measured by realized sales growth; the probability
of such an appointment increases by 2.6% points for an increase of one standard deviation
in sales growth. Other firm characteristics, including firm size, scope of operations, the
ratio of intangible to total assets, and Tobin’s q are insignificant.
Column (2) of Table 2 also shows that the probability of appointing an industry expert
director increases with the number of nearby same-industry firms. An increase of one
standard deviation in the number of such firms increases the likelihood of appointing an
industry expert director by 3.1% points. In contrast, industry expert directors are less likely
to be appointed by firms in industries where information about firms is more easily inferred
from industry stock returns. Finally, industry expert directors are more likely to join boards
whose current members include other industry experts. Other board characteristics are
generally insignificant in predicting the appointment of industry expert directors.
Columns (3)–(5) of Table 2 present results of our firm-level regressions. They show that
each significant variable in the appointment regression is also significant in the firm-level
test. These variables are R&D intensity, sales growth, number of nearby same-industry
firms, and industry stock return homogeneity. Thus, not surprisingly, variables that
influence the appointment of individual industry expert directors also play significant roles
in determining the level of board industry expertise. Yet a few other variables provide
additional insights into the issue of why some boards include industry experts and others
do not. In particular, high CEO equity ownership reduces the probability that a firm has
industry expert directors. To the extent that high CEO equity ownership is indicative of
greater CEO power, this is consistent with the notion that powerful CEOs prefer less
informed directors as monitors. Similarly, the probability of a firm having industry expert
directors declines with the number of employee directors on the board, which is consistent
with the argument that employee directors can substitute for industry expert directors.
Overall, these results suggest that the interplay of firm and industry characteristics as
well CEO and director preferences determine the level of board industry expertise. Some
firms do not have industry expert directors because the nature of their operations does not
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Table 2 Industry experts on boards

Dependent (1) Appoint (2) Appoint (3) At least 1 board (4) #Board (5) %Board
variable expert expert expert experts experts
Sample New New Full sample Full sample Full sample
appointments appointments
Director age 0.010 (1.06) 0.011 (1.12) – – –

Doctoral degree 0.162 (0.89) 0.042 (0.20) – – –
Active CEO -0.176 0.212 (1.05) – – –
(-0.94)
Retired CEO 0.485*** 0.658*** – – –
(2.65) (3.29)
Current 0.165*** 0.181*** – – –
directorships (3.28) (3.32)
Firm size – -0.051 -0.011 (-0.20) -0.002 -0.011
(-0.75) (-0.10) (-0.20)
R&D intensity – 2.446** 8.148*** (5.54) 0.884*** 8.148***
(2.27) (7.51) (5.54)
Intangible assets – -0.326 0.600 (1.64) 0.141 (1.21) 0.600 (1.64)
(-0.77)
Growth – 0.946** 0.708*** (3.60) 0.180*** 0.708***
opportunities (2.48) (3.40) (3.60)
Corporate – -0.029 -0.001 (-0.05) 0.001 (0.22) -0.001
diversification (-1.38) (-0.05)
Tobin’s q – -0.106 0.011 (0.19) 0.013 (0.77) 0.011 (0.19)
(-1.34)
Proximal industry – 0.018*** 0.035*** (4.38) 0.010*** 0.035***
firms (3.08) (6.31) (4.38)
Industry – -3.673* -8.136*** (-4.73) -4.656*** -8.136***
homogeneity (-1.67) (-5.31) (-4.73)
Board size – -0.967** 0.655** (2.31) 0.170* (1.67) 0.655**
(-2.34) (2.31)
CEO duality – -0.129 -0.113 (-1.04) -0.040 -0.113
(-0.88) (-1.10) (-1.04)
New CEO – 0.088 (0.49) -0.012 (-0.15) -0.003 -0.012
(-0.12) (-0.15)
CEO tenure – 0.012 (0.68) -0.008 (-0.75) -0.002 -0.008
(-0.58) (-0.75)
CEO ownership – 0.984 (0.71) -3.130*** (-2.97) -1.705*** -3.130***
(-3.09) (-2.97)
Employee – -0.041 -0.233*** (-3.44) -0.093*** -0.233***
directors (-0.40) (-3.29) (-3.44)
Other industry – 0.369*** – – –
experts (6.55)
Sample size 2045 1755 6596 6596 6596
123
O. Faleye et al.
Table 2 continued
Dependent (1) Appoint (2) Appoint (3) At least 1 board (4) #Board (5) %Board
variable expert expert expert experts experts
Sample New New Full sample Full sample Full sample
appointments appointments
Pseudo R2 0.109 0.161 0.151 0.042 n.a.
The dependent variable in columns (1) and (2) equals 1 if a newly appointed outside director is an industry
expert, 0 otherwise. The dependent variable in column (3) equals 1 for firm-years with at least one industry
expert director, 0 for others. In columns (4) and (5), the dependent variables are the number and fraction of
industry experts on the board, respectively. Columns (1)–(3) are logit models, (4) is a negative binomial
model, and (5) is a fractional logit model. Doctoral degree equals 1 if the newly appointed director holds the
Ph.D., M.D., or other doctoral degrees, 0 otherwise. Active CEO and retired CEO are indicator variables for
appointees who are current or retired CEOs of other firms. Current directorships is the number of other
outside boards on which the appointee serves before the current appointment. Firm size is the natural log of
the market value of equity. R&D intensity is the ratio of R&D expenditures to sales. Intangible assets is the
ratio of intangible assets to total assets. Growth opportunities is the annual percentage change in sales.
Corporate diversification is the sum of geographical and business segments. Tobin’s q is the book value of
assets minus the book value of equity plus the market value of equity, divided by the book value of assets.
Proximal industry firms is the number of firms in the same 2-digit SIC code as the focal firm whose head
offices share the same 3-digit ZIP code with the firm. Industry homogeneity is the mean partial correlation
between each firm’s stock returns and an equally weighted industry index. It proxies for the extent to which
information about member firms is easily inferred from industry stock returns. Board size is the natural log
of the number of directors. CEO duality equals 1 if the CEO serves as board chair, 0 otherwise. New CEO
equals 1 if the CEO is in his first year, 0 otherwise. CEO tenure is the number of years since appointment as
CEO. CEO ownership is the percentage of outstanding shares owned by the CEO. Employee directors is the
number of directors who are employees of the firm. Other industry experts is the number of industry experts
on the board prior to the current appointment. In columns (1) and (2), all variables (apart from personal
characteristics of the appointee) are measured as of the year preceding the appointment. All variables in
columns (3)–(5) are 1-year lags. Regressions include year and two-digit SIC code fixed effects. Test
statistics based on robust standard errors clustered at the firm level are shown in parentheses. Statistical
significance is indicated by ***, **, and * for 1, 5, and 10%, respectively
demand the specialist skills of industry experts while others do not have them because their
CEOs dislike such directors and own enough equity to have power over board composition.
Still others do not have industry experts because they are located away from a sufficiently
large pool of such directors. In the next section, we turn our attention to the question of
whether and how these directors affect board effectiveness in curtailing managerial myopia
in R&D investments.
4 Board industry expertise and R&D myopia
4.1 R&D-based real earnings management
Prior studies such as Graham et al. (2005) and Bhojraj et al. (2009) suggest that reducing
R&D spending to satisfy an earnings benchmark is a major manifestation of managerial
myopia in R&D investments. Therefore we begin our analysis by focusing on situations
where executives are able to meet short-term earnings goals by forgoing R&D investments.
Prior studies (e.g., Cheng 2004; Bushee 1998; Barber et al. 1991) define such cases as firms
whose pre-tax earnings fall short of a benchmark by an amount that can be bridged by
123
reducing or eliminating R&D spending. Following Cheng (2004), we classify firm-years

that satisfy the following two conditions into this category:
Pre-tax incomei;t þ R&D expendituresi;t \Pre-tax incomei;t1 þ R&D expendituresi;t1
ð1Þ
Pre-tax incomei;t þ R&D expendituresi;t [ Pre-tax incomei;t1 ð2Þ
These conditions define firms as susceptible to R&D-based earnings management when

their earnings before taxes but after R&D decline relative to the immediately preceding
year by an amount that can be reversed by reducing R&D.6 Similar to Cheng (2004), we
also classify firms as suspect if they report a ‘‘small’’ loss, that is, if they satisfy the
following condition:
0:01\Pre-tax incomei;t =Market value of equityi;t1 \0: ð3Þ
Finally, we follow Bushee (1998) and proxy for real earnings management in this
sample using an indicator variable that equals 1 if a suspect firm cuts its R&D spending
relative to the prior year (i.e., R&Di,t - R&Di,t-1 \ 0), 0 otherwise. As in prior studies, a
sizeable minority (48%) of these firms do so. We expect board industry expertise to
diminish this behavior.
The above procedure provides a simple scheme for identifying firms that reduce R&D
investments under circumstances where such reduction is more likely than not
attributable to an attempt to avoid reporting an earnings shortfall. Yet it implicitly assumes
that prior year R&D spending sufficiently approximates current year R&D investment
opportunity set. Since this is not necessarily so, we employ an alternative but comple-
mentary framework as a robustness check. Specifically, we estimate each firm’s R&D
opportunity set using Eq. (1) of Gunny (2010, 863). This model predicts normal R&D
expenditures as a function of prior year R&D spending, internally generated funds, growth
opportunities, and firm size, and is estimated separately for each year and two-digit SIC
industry in Compustat. We use residuals from the model to measure abnormal R&D
spending, with negative values indicating reductions in R&D investments relative to the
firm’s investment opportunity set. Since we expect industry expert directors to reduce the
likelihood of managing reported earnings by reducing R&D spending, we multiply the
residual by -1 to facilitate sign consistency between results using this proxy and those
using our first proxy.
Table 3 presents results of regressions of both variables on board industry expertise and
control variables suggested by prior work such as Gunny (2010) and Bushee (1998). The
dependent variable in columns (1)–(3) is an indicator variable that equals 1 when a suspect
firm reduces R&D spending, 0 otherwise. Our measure of board industry expertise in
column (1) is the proportion of industry expert directors. It is negative and significant at the
1% level. The coefficients imply that an increase of one standard deviation in the per-
centage of industry experts is associated with a decline of 5.4% points in the likelihood of
cutting R&D when other variables are evaluated at their sample means. Columns (2) and
(3) present similar results when we measure board industry expertise using the number of
6
As in prior studies (Bushee 1998; Cheng 2004; Gunny 2010), we do not focus on analysts’ forecasts
because real activities earnings management occurs throughout the year, before managers know the final
forecasts of earnings.
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O. Faleye et al.
Table 3 Board industry experts and R&D-based real earnings management

Dependent (1) Cut (2) Cut (3) Cut (4) (5) (6)
variable R&D R&D R&D Abnormal Abnormal Abnormal
R&D R&D R&D
Sample Suspect Suspect Suspect Suspect Suspect Suspect
firms firms firms firms firms firms
%Board -0.984*** – – -0.027*** – –

industry (-2.78) (-3.09)
experts
#Board industry – -0.126** – – -0.004*** –
experts (-2.33) (-3.67)
Board industry – – -0.536*** – – -0.008**
expertise (-2.63) (-2.47)
Firm size 0.376*** 0.372*** 0.373*** 0.001 (0.43) 0.001 (0.38) 0.000 (0.34)
(4.91) (4.88) (4.89)
Leverage -0.220 -0.236 -0.128 0.005 (0.53) 0.005 (0.44) 0.008 (0.72)
(-0.50) (-0.53) (-0.30)
Tobin’s q -0.098 -0.101 -0.117 0.003 (0.81) 0.002 (0.79) 0.002 (0.62)
(-1.20) (-1.26) (-1.43)
DR&Dt-1 0.461* 0.465* 0.455* 0.031*** 0.031*** 0.030***
(1.85) (1.86) (1.84) (3.22) (3.24) (3.20)
DIndustry R&D -1.396 -1.385 -1.432 -0.029 -0.028 -0.030
intensity (-0.88) (-0.87) (-0.92) (-0.68) (-0.66) (-0.70)
Distance to -0.111* -0.117* -0.115* -0.002** -0.002** -0.002**
earnings goal (-1.80) (-1.80) (-1.81) (-2.51) (-2.51) (-2.54)
Negative 0.695*** 0.691*** 0.642*** -0.021*** -0.021*** -0.023***
income (3.29) (3.26) (3.06) (-3.13) (-3.14) (-3.22)
Free cash flow -0.343 -0.284 -0.268 -0.016 -0.015 -0.013
(-0.59) (-0.49) (-0.46) (-0.58) (-0.53) (-0.48)
DCapex -0.001** -0.001** -0.001** -0.000 -0.000 -0.000
(-2.20) (-2.30) (-2.29) (-0.78) (-0.86) (-0.86)
DSales -0.154 -0.153 -0.157 -0.003** -0.003** -0.003**
(-1.53) (-1.51) (-1.52) (-2.12) (-2.17) (-2.20)
Board size 0.436 (1.00) 0.711* 0.594 (1.37) 0.008 (0.83) 0.016* 0.012 (1.33)
(1.70) (1.86)
Board 1.244* 1.460* 1.302* 0.017 (1.07) 0.024 (1.49) 0.016 (1.03)
independence (1.69) (1.94) (1.77)
CEO duality -0.010 -0.000 0.014 (0.08) 0.002 (0.71) 0.002 (0.72) 0.003 (1.00)
(-0.06) (-0.00)
CEO ownership 0.801 (0.85) 1.015 0.769 (0.82) -0.030 -0.024 -0.026
(1.10) (-1.31) (-1.05) (-1.12)
Active CEO 0.088 (0.79) 0.079 0.097 (0.89) 0.001 (0.51) 0.001 (0.37) 0.001 (0.57)
directors (0.73)
Retired CEO -0.004 -0.006 -0.005 0.000 (0.20) 0.000 (0.16) 0.000 (0.21)
directors (-0.04) (-0.06) (-0.05)
Observations 860 860 860 866 866 866
123
Table 3 continued
Dependent (1) Cut (2) Cut (3) Cut (4) (5) (6)
variable R&D R&D R&D Abnormal Abnormal Abnormal
R&D R&D R&D
Sample Suspect Suspect Suspect Suspect Suspect Suspect
firms firms firms firms firms firms
Pseudo/ 0.149 0.147 0.147 0.105 0.105 0.095

Adjusted R2
Suspect firms are firms whose pre-tax earnings decline relative to the immediately preceding year by an
amount that can be reversed by reducing current year R&D expenditures. The dependent variable in columns
(1)–(3) equals 1 if a suspect firm reduces R&D spending relative to the previous year. Each is a logit model.
The dependent variable in columns (4)–(6) is abnormal R&D reduction, calculated as -1 multiplied by
residuals from a regression estimated over all Compustat firms that predict normal R&D based on Eq. (1) of
Gunny (2010). Each is estimated using OLS. %Board industry experts is the ratio of industry experts to
independent directors. #Board industry experts is the number of industry experts. Board industry expertise
equals 1 if the board has at least one industry expert, 0 otherwise. Firm size is the natural log of market
capitalization. Leverage is the ratio of long-term debt to total assets. Tobin’s q is the book value of assets
minus the book value of equity plus the market value of equity, divided by the book value of assets.
DR&Dt-1 is the difference in R&D from t - 2 to t - 1. DIndustry R&D intensity is the change in the ratio
of industry R&D to industry sales from t to t - 1. Distance to earnings goal is the difference in earnings
before taxes and R&D from t to t - 1 divided by R&D at t - 1. Negative income equals 1 if net income for
the year is less than zero, 0 otherwise. Free cash flow is cash flow from operating activities less average
capital expenditures over the preceding 3 years, divided by current assets. DCapex and DSales are the
change in capital expenditures and sales from year t to t - 1, respectively. Board size is the natural log of
the number of directors. Board independence is the percentage of directors who are unaffiliated with the firm
beyond being directors. CEO duality equals 1 if the CEO serves as board chair, 0 otherwise. CEO ownership
is the proportion of outstanding shares owned by the CEO. Active CEO directors is the number of directors
who are current CEOs of other firms. Retired CEO directors is the number of directors who are retired CEOs
of other firms. Each regression includes year and two-digit SIC code fixed effects. Test statistics based on
robust standard errors clustered at the firm level are shown in parentheses. Statistical significance is indi-
cated by ***, **, and * for 1, 5, and 10%, respectively
industry expert directors and the indicator variable that equals 1 if the board has at least
one industry expert director, respectively.
Columns (4)–(6) present results of regressions where the dependent variable is abnormal
R&D reduction. They show a negative relation between each measure of board industry
expertise and the level of reduction in R&D spending relative to estimated R&D oppor-
tunity set. The coefficients in column (4) imply that an increase of one standard deviation
in the percentage of industry expert directors lowers abnormal reduction in R&D spending
by 70 basis points.
These results suggest that firms that are able to reverse an earnings shortfall by reducing
R&D spending are less likely to do so when industry experts serve on the board. This
supports the hypothesis that the knowledge and expertise of directors with prior experience
in a firm’s industry allow such directors to provide better oversight of management that
minimizes the likelihood and extent of myopic behavior in R&D investments.
4.2 Board industry expertise and broad-based R&D investments
The preceding section shows that industry expert directors curtail myopic behavior when a
firm faces a choice between missing an earnings goal and reducing R&D. Though of clear
significance, this result may not generalize to the full population of firms because the
123
O. Faleye et al.
majority of companies are not normally in situations where they can reverse an earnings
shortfall by reducing R&D spending. In addition, such a choice is only an issue because
U.S. accounting rules require expensing R&D expenditures. Yet there are other reasons
why managers may exhibit myopia in R&D investments. We discussed these in the
introduction and hypothesized that industry expert directors are well-positioned to coun-
teract them. In this section, we evaluate this hypothesis by examining the effect of industry
expert directors on R&D investments in our full sample.
Table 4 shows results of regressions of R&D spending on our measures of board
industry expertise and control variables suggested by prior work (Baysinger and Hoskisson
1990; Hall and Ziedonis 2001; Xue 2007) as well as the other board structure control
variables described earlier in Sect. 2. The dependent variable in each regression is the ratio
of R&D expenditures to sales. As usual in the literature, we set this variable to zero if
Compustat reports R&D as missing. As a result, we estimate our full sample regressions
using Tobit models because zero R&D in the sample mostly reflect unobserved R&D
spending, that is, the dependent variable is left-censored at zero.
In column (1) of Table 4, the proportion of industry expert directors is positive and
significant at the 1% level. Its coefficient implies that an increase of one standard deviation
in the proportion of industry expert directors is associated with an increase of 64 basis
points in the ratio of R&D to sales, evaluating other variables at their sample means.
Relative to the sample average R&D spending of 5.0%, this is an economically significant
increase in R&D investment.
This result suggests that board industry expertise facilitates greater investments in R&D,
which is consistent with the hypothesis that industry experts are better able to monitor and
advise executives with a view to attenuating the latter’s myopia in R&D investment. Yet
we recognize that several potentially confounding issues must be addressed before
establishing this conclusion. First, the regression pools firms with R&D investments along
with those that do not invest in R&D. Since industry expert directors are more prevalent at
firms that invest in R&D, this potentially biases the results toward finding a positive
relation between board industry expertise and R&D. We address this by estimating a
regression restricted to firm-years with positive R&D, results of which we present in
column (2). As the table shows, board industry expertise remains positive and significant at
the 1% level. Thus, conditional on a firm investing in R&D, its R&D investments increase
with board industry expertise. This suggests that our baseline results are not attributable to
the pooling of R&D firms with those that do not invest in R&D.7
The above notwithstanding, it is possible that industry expert directors are attracted to
firms that invest more in R&D even within the sample of R&D firms. It could also be the
case that some unobservable factors drive both R&D spending and board industry expertise
so that a regression of the former on the latter produces a spurious relation. In cases like
this, the literature often relies on instrumental variable (IV) two-stage regressions as a
solution because it allows consistent estimation in the presence of reverse causality, cor-
related omitted variables, and other sources of unobservable heterogeneity. The major
challenge lies in finding relevant and valid instruments, that is, variables that are strongly
correlated with the suspected endogenous variable but uncorrelated with the error term in
the structural model.
We rely on prior studies of board composition in an attempt to overcome this challenge.
In particular, Knyazeva et al. (2013) theorize and show that firms mostly recruit
7
Nevertheless, we perform the additional tests described in this sub-section using the sample of firms with
non-zero R&D spending to sidestep the potential pooling problem.
123
Table 4 Board industry expertise and the level of R&D investments

Dependent (1) R&D/ (2) R&D/ (3) %Board (4) R&D/ (5) R&D/ (6) R&D/
variable sales sales experts sales sales sales
Sample Full sample R&D R&D R&D R&D R&D
sample sample sample sample sample
%Board 0.130*** 0.109*** – 0.278*** 0.084*** 0.075***

industry (6.84) (5.64) (4.72) (4.06) (3.69)
experts
Firm size 0.009*** 0.007*** -0.039*** 0.000 (0.06) -0.021** -0.014*
(3.81) (2.91) (-2.85) (-2.20) (-1.90)
Leverage -0.038 -0.006 0.009* 0.006** 0.010*** 0.010***
(-1.13) (-0.16) (1.67) (2.21) (2.60) (3.65)
Sales growth -0.025* -0.024* 0.033 (1.43) -0.023 -0.067 0.001 (0.05)
(-1.92) (-1.67) (-1.45) (-1.13)
Firm age -0.001*** -0.001*** -0.003*** -0.001** -0.001*** -0.001***
(-3.98) (-4.72) (-5.60) (-2.18) (-3.74) (-2.92)
Asset -0.240*** -0.210*** -0.213*** -0.137*** -0.034 -0.104***
tangibility (-7.00) (-6.30) (-3.89) (-4.83) (-0.76) (-2.99)
Board size -0.040** -0.041** -0.099*** -0.026 -0.008 -0.039*
(-2.40) (-2.30) (-2.63) (-1.22) (-0.32) (-1.78)
Board 0.016 (0.59) -0.037 0.048 (0.82) -0.047 0.039 (0.67) -0.002
independence (-1.29) (-1.49) (-0.08)
Board age -0.001 -0.000 -0.002 0.001 (0.57) 0.001 (0.42) -0.001
(-1.09) (-0.15) (-1.10) (-0.95)
Board tenure 0.001 (0.80) 0.002 (1.49) -0.005*** 0.002** -0.000 -0.001
(-2.72) (2.29) (-0.03) (-0.79)
CEO duality -0.007 -0.007 -0.026 0.008 (0.19) -0.057 -0.045*
(-1.14) (-1.07) (-0.63) (-1.59) (-1.75)
CEO ownership -0.064 -0.003 -0.293*** 0.034 (0.59) 0.157 (1.47) 0.098 (1.33)
(-1.15) (-0.05) (-2.95)
CEO equity- 0.003*** 0.003*** 0.007*** 0.002* 0.002 (0.82) 0.001 (0.59)
based pay (3.01) (3.17) (3.37) (1.89)
Active CEO -0.002 -0.002 0.010 (1.37) -0.005* -0.006 -0.007*
directors (-0.73) (-0.92) (-1.70) (-1.26) (-1.89)
Retired CEO -0.000 -0.003 0.009 (1.20) -0.006* 0.001 (0.30) -0.008**
directors (-0.06) (-1.14) (-1.91) (-2.26)
Proximal – – 0.005*** – – –
industry firms (5.13)
Industry – – 0.405** – – –
information (2.34)
cost
Observations 8440 4525 4525 4525 245 1190
123
O. Faleye et al.
Table 4 continued
Dependent (1) R&D/ (2) R&D/ (3) %Board (4) R&D/ (5) R&D/ (6) R&D/
variable sales sales experts sales sales sales
Sample Full sample R&D R&D R&D R&D R&D
sample sample sample sample sample
Adjusted/ n.a. 0.303 0.241 0.200 0.359 0.379

Pseudo R2
The dependent variable in all columns except (3) is the ratio of R&D expenditures to sales. Column (3) is the
first stage of a two-stage IV model; its dependent variable is %Board industry experts, that is, the ratio of
industry experts to independent directors. Column (4) contains results of the second stage model. The
regression in column (1) is a Tobit model estimated over the full sample. The other columns are estimated
for firms with positive R&D. Column (2) is an OLS model for the full sample of such firms. Column (5) is a
regression of R&D in 2009 on %Board industry expert in 2000. Column (6) is estimated over firms that have
at least one industry expert who is not an industry expert at another firm and firms that do not have any
industry experts but whose boards have at least one member who is an industry expert at a different firm.
Firm size is the natural log of market capitalization. Leverage is the ratio of long-term debt to total assets.
Sales growth is the 1-year percentage change in sales. Firm age is the natural log of the number of years
since incorporation. Asset tangibility is the ratio of fixed assets to total assets. Board size is the natural log of
the number of directors. Board independence is the percentage of directors who are unaffiliated with the firm
beyond being directors. Board age and board tenure are the average age and average tenure of independent
directors. CEO duality equals 1 if the CEO serves as board chair, 0 otherwise. CEO ownership is the
proportion of outstanding shares owned by the CEO. CEO equity-based pay is the ratio of the value of stock
options and restricted stock awarded the CEO to the CEO’s total pay. Active CEO directors is the number of
directors who are current CEOs of other firms. Retired CEO directors is the number of directors who are
retired CEOs of other firms. Proximal industry firms is the number of firms in the same two-digit SIC code
as the focal firm whose head offices share the same three-digit ZIP code with the firm. Industry information
cost is the two-digit SIC code industry average of an index based on percentile rankings (reversed) of the
number of analysts, dispersion of analyst forecasts, and analyst forecast error. Each regression includes year
and two-digit SIC code fixed effects with the exception of the 2SLS model which includes year fixed effects
only (because one instrument is constructed at the two-digit industry level). Numbers in parentheses are test
statistics based on robust standard errors clustered at the firm level. Levels of significance are indicated by
***, **, and * for 1, 5, and 10%, respectively
independent directors from areas near their head offices. Thus, our primary instrument for
board industry expertise is the number of same-industry firms that share the same three-
digit postal ZIP code with each firm’s headquarters. Prior studies that invoke similar
arguments to identify location-based instruments for endogenous board variables include
Dass et al. (2014), Wang et al. (2014), and Knyazeva et al. (2013). As reported earlier, this
variable is highly correlated with board industry expertise. We expect it to satisfy the
exclusion restriction because our sample covers larger firms with operations in multiple
locations. Thus, their R&D investment profiles are less likely to depend on local industry
structure in the specific geographical location of their head offices.8
8
As an example, consider Intel Corp. and Texas Instruments (TI), two same-industry firms in our sample
(SIC code 36xx). Intel’s head office is located in Santa Clara, California (ZIP code 95054), while TI’s head
office is located in Dallas, Texas (ZIP code 75243). During our sample period, 29 other firms with SIC code
36xx share the same 3-digit ZIP code with Intel (i.e., ZIP code 950xx) while only 4 such firms are located in
the same 3-digit ZIP code as TI. Consistent with the argument that our instrument is relevant, 23.3% of
Intel’s independent directors are industry experts while TI has no industry experts on its board. Nevertheless,
it is less likely that Intel’s location in ZIP code 950xx in and of itself confers any significant advantage in
R&D relative to TI because TI has 6 wholly owned subsidiaries in California, including 2 that are located
within 5 miles of Intel’s headquarters.
123
Our second instrument is the industry-level information acquisition cost variable of

Duchin et al. (2010). First, we construct an index based on percentile ranking (reversed) of
the number of analysts, dispersion of analyst forecasts, and analyst forecast error. Next, we
average this index for each two-digit SIC industry and use the industry average as our
instrument. We expect this variable to be positively correlated with board industry
expertise because prior studies such as Raheja (2005) suggest that high information
acquisition costs increase the need for expert directors. We expect it to satisfy the
exclusion restriction because it is less likely that industry-level analyst activity has a direct
effect on firm-level R&D spending.
Columns (3) and (4) of Table 4 show results of our IV analysis. Column (3) presents
results of the first-stage model predicting board industry expertise. It shows that both
instruments are positive and highly significant. The Kleibergen-Paap test rejects the null of
underidentification while the Cragg-Donald Wald F-statistic for weak instruments is larger
than all Stock-Yogo critical values for weak identification (Stock and Yogo 2005). Thus,
the instruments are statistically strong. They also statistically satisfy the exclusion
restriction. Hansen’s J test of over-identification does not reject the null hypothesis that
they are exogenous in the second stage, with a p value of 0.55. Column (4) presents results
of the second-stage regression. As the table shows, we find a positive relation between
R&D and instrumented board industry expertise.
In a further attempt to establish the substantiveness of our results, we follow the
approach of Cheng (2008) who regresses the dependent variable on lagged values of the
endogenous explanatory variable based on the argument that such historical values are
predetermined. In our case, we encounter the difficulty that our measures of industry
expertise are sticky over time. For example, the correlation between contemporaneous
values and the first three lags of the proportion of board industry experts are 0.95, 0.90, and
0.85, respectively. Consequently, we use the longest possible lag in our data (i.e., the ninth
lag) and regress 2009 R&D investments on board industry expertise in 2000 so as to allow
sufficient time to lessen the time series dependence in board industry expertise.9 Column
(5) of Table 4 presents results of this regression. Similar to the full sample results, it shows
that industry expertise is positive and statistically significant.
Another potential concern is the possibility that industry expert directors are better-
qualified directors in general, for example, because of their professional achievements or
other characteristics. Thus, our tests would simply capture the effects of general director
quality rather than the impact of industry expertise. We believe that this is less likely to be
the case because, as shown in Sect. 3, industry expert directors are similar to other outside
directors in terms of age and education. And while industry experts are more likely to be
retired CEOs, our regressions already control for the fraction of retired CEO directors.
Nevertheless, we perform an additional test to address this issue. We identify directors
who serve on the boards of at least two firms and who qualify as industry experts on one
board but not on the other. We then create a subsample that includes both sets of firms
provided that the latter firm has no other industry expert director. In effect, this sample
consists of two types of firms: (1) those without industry expert directors that have at least
one director who is an industry expert at a different firm (653 observations), and (2) those
with at least one industry expert director who serves on another board where he does not
have relevant industry experience (537 observations). Since both sets of firms share the
same industry expert directors, we should find no effect for industry expertise in a
regression estimated over this sample if our tests merely capture general director quality.
9
The correlation between 2009 and 2000 values of the proportion of board industry experts is 0.63.
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O. Faleye et al.
Conversely, our board industry expertise variables should be positive and significant if
industry experience matters. As column (6) of Table 4 shows, this is the case. Thus, our
results are more likely attributable to industry expertise rather than general director quality.
Overall, the various tests discussed in this section suggest that our basic findings are less
likely to be mere artifacts of some confounding endogeneity problems. Rather, they
indicate that board industry expertise significantly enhances corporate investments in
R&D.
4.3 Board industry expertise and the quality of R&D investments
The preceding section suggests that industry expert directors are associated with a sig-
nificant increase in R&D investment. Yet it is not obvious that such an increase is nec-
essarily desirable. Jensen (1993) argues that higher R&D spending can simply reflect
wasteful investments in pet projects that increase the riskiness of corporate cash flows
rather than significant corporate innovation that enhances firm value. In this section, we
evaluate the quality of R&D investments by firms with industry expert directors.
4.3.1 Volatility of future earnings
The U.S. accounting treatment of immediately expensing R&D spending is based in part
on the argument that the future economic benefits associated with R&D investments are
uncertain. Consistent with this argument, Kothari et al. (2002) show that R&D expendi-
tures increase the volatility of future earnings more than other types of investments,
suggesting a diminished relevance of accounting disclosures about R&D expenditures.
Thus, our result that industry expert directors curtail R&D-based real earnings manage-
ment and encourage investments in R&D may imply excessive risk taking that creates
greater uncertainty in future earnings. If this is so, we should observe a more positive
relation between R&D spending and future earnings volatility among firms with industry
expert directors. On the other hand, board industry expertise should reduce the uncertainty
of future benefits of R&D if industry expert directors assist managers to identify and
nurture higher quality R&D projects.
We evaluate these arguments using the framework of Kothari et al. (2002), that is, we
estimate regressions of the standard deviation of earnings before extraordinary items and
discontinued operations per share over years t ? 1 through t ? 5 on year t R&D spending
per share. Each regression includes the control variables in Kothari et al. (2002) and is
estimated over firms with positive R&D. Consistent with Kothari et al. (2002), column (1)
of Table 5 shows that R&D is associated with an increase in the volatility of future
earnings. In columns (2) and (3), we estimate this model for firms with and without
industry expert directors, respectively. R&D remains positive and significant in both
columns. However, its coefficient in the model for firms with industry expert directors is
only half its size in the one for firms with no industry experts. The difference in coefficients
is significant at the 1% level and is also economically meaningful. An increase of one
standard deviation in R&D spending increases the volatility of future earnings by 5.7%
points among firms with no industry expert directors, compared with an increase of only
3.2 points among those whose boards include at least one industry expert.
This suggests that industry expert directors provide strategic advice and board oversight
that encourage higher quality R&D projects and enhance the relevance of accounting
disclosures about such expenditures. An alternative interpretation is that industry expert
directors encourage routine R&D investments whose payoffs are more certain. In the next
123
Table 5 Board industry expertise and the quality of R&D investments: Earnings volatility
Dependent variable (1) EPS volatility (2) EPS volatility (3) EPS volatility
Sample R&D firms R&D firms with industry R&D firms w/o industry
experts experts
R&D per share 0.368*** (5.45) 0.296*** (3.91) 0.601*** (4.77)

Firm size -0.014*** -0.013*** (-3.40) -0.016** (-2.53)
(-4.16)
Leverage 0.156*** (4.21) 0.139*** (3.52) 0.149** (2.06)
Negative income 0.091*** (7.82) 0.098*** (6.86) 0.072*** (3.58)
Board size 0.007 (0.34) 0.002 (0.10) 0.016 (0.40)
Board independence 0.025 (0.61) 0.028 (0.61) 0.020 (0.27)
Board age 0.000 (0.03) 0.000 (0.10) 0.000 (0.16)
Board tenure -0.001 (-1.00) -0.002 (-0.98) -0.002 (-0.94)
CEO duality -0.012 (-1.24) -0.020* (-1.79) 0.005 (0.25)
CEO ownership -0.109 (-1.53) -0.196** (-2.43) -0.012 (-0.10)
CEO equity-based -0.002 (-1.27) -0.001 (-0.78) -0.003 (-1.18)
pay
Active CEO -0.001 (-0.25) -0.003 (-0.56) 0.006 (0.75)
directors
Retired CEO 0.009 (1.47) 0.009 (1.31) 0.009 (0.98)
directors
Observations 3624 2512 1112
Adjusted R2 0.197 0.191 0.239
Chow test (p value) 8.240*** (0.004)
The dependent variable is the standard deviation of earnings before extraordinary items and discontinued
operations per share over years t ? 1 through t ? 5. Column (1) is estimated over the full sample of firms
with positive R&D while columns (2) and (3) are estimated over such firms with and without board industry
experts, respectively. R&D per share is R&D expenses divided by shares outstanding. Firm size is the
natural log of market capitalization. Leverage is the ratio of long-term debt to total assets. Negative income
equals 1 if net income for the year is less than zero, 0 otherwise. Board size is the natural log of the number
of directors. Board independence is the percentage of directors who are unaffiliated with the firm beyond
being directors. Board age and board tenure are the average age and average tenure of independent directors.
CEO duality equals 1 if the CEO serves as board chair, 0 otherwise. CEO ownership is the proportion of
outstanding shares owned by the CEO. CEO equity-based pay is the ratio of the value of stock options and
restricted stock awarded the CEO to the CEO’s total pay. Active CEO directors is the number of directors
who are current CEOs of other firms. Retired CEO directors is the number of directors who are retired CEOs
of other firms. Each regression includes year and two-digit SIC code fixed effects. Numbers in parentheses
are test statistics based on robust standard errors clustered at the firm level. Statistical significance is
indicated by ***, **, and * for 1, 5, and 10% levels, respectively. The Chow test is for the null hypothesis
that the coefficients of R&D per share in (2) and (3) are equal
section, we examine patenting activities to evaluate this interpretation since patents capture
the quality of R&D projects because they reflect the conversion of such projects into
valuable intellectual property.
4.3.2 Patents and patent citations
We obtain patent data from the National Bureau of Economic Research (NBER) patent
database described in Hall et al. (2001) and updated on Bronwyn Hall’s web site. We
123
O. Faleye et al.
assign each patent to the year of application (rather than the grant year) because the timing
of innovation is closer to the year the company filed the patent application. On average,
patents are granted 2.1 years after an application is filed. Since our patent data end in 2006
and patents are not reported until granted, we restrict our patent regressions to 2004 and
earlier years to account for this truncation. We also adjust patent citations for the truncation
bias stemming from the fact that older patents can garner more citations simply because of
their longer lives.
We estimate several regressions of our patent variables on board industry expertise and
control variables suggested by prior work, including firm size, firm age, leverage, growth
opportunities, fixed asset intensity, board size, board independence, CEO duality, CEO
equity ownership, and CEO compensation incentives (Baysinger and Hoskisson 1990; Hall
and Ziedonis 2001; Xue 2007) as well as our other board structure control variables. We
also control for R&D expenditures, which allows us to evaluate the quality of R&D
investments when the board has industry expert directors by estimating the effect of board
industry experts on the extent and quality of corporate patenting activity conditional on the
level of R&D spending. We employ the natural log of (one plus) our patenting activity
variables and estimate each regression as a Tobit model because true innovation activity is
unobserved for firm-years with zero scores on our measures, that is, our dependent vari-
ables are left-censored at zero. Each regression includes year and industry fixed effects,
with standard errors double-clustered at the firm and year levels.
The first column of Table 6 presents full-sample results for the (natural log of one plus
the) number of patents. It shows that board industry expertise is positive and significant at
the 1% level. The coefficients imply that an increase of one standard deviation in the
proportion of board industry experts is associated with an increase of 3.61% in patents
given the same level of R&D spending. Next, we split the sample into firms that invest in
R&D and those that do not and estimate a separate regression for each subsample. As
columns (2) and (3) of Table 6 show, board industry expertise is significant only in the
regression for R&D firms. Thus, board industry expertise enhances corporate patenting
only at firms that invest in R&D, which is consistent with our arguments and prior results
on the important roles of these directors in R&D investment.
Columns (4)–(6) of Table 6 show analogous results for patent citations. The dependent
variable is the natural log of (one plus) truncation-adjusted citations per patent. The full
sample regression in column (4) shows that board industry expertise is significantly pos-
itively related with the quality of corporate patents as measured by citations in other
patents, even after controlling for R&D spending. Coefficients in the regression implies
that an increase of one standard deviation in the proportion of industry experts on the board
of directors is associated with an increase of 1.54% in citations per patent. Similar to our
result for the number of patents, columns (5) and (6) show that this effect is present only
among firms that invest in R&D.10 Overall, our analysis of patents and patent citations
suggests that board industry expertise enhances the ability of firms to engage in higher
quality R&D projects that generate valuable intellectual property.
10
In untabulated tests, we also examine the effect of board industry expertise on innovation efficiency.
Following prior studies (e.g., Hirshleifer, et al. 2013; Chan et al. 2001) we define innovation efficiency as
the ratio of patents granted or citations per patent (natural log) to R&D capital, where R&D capital for year
t = R&Dt-1 ? 0.8*R&Dt-2 ? 0.6*R&Dt-3 ? 0.4*R&Dt-4 ? 0.2*R&Dt-5. This measure captures the
number of patents granted or their importance as a function of R&D capital invested. We find that industry
expert directors are associated with greater innovation efficiency.
123
Table 6 Board industry expertise and corporate innovation

Sample (1) Patents (2) Patents (3) Patents (4) Cites (5) Cites (6) Cites
Full sample No R&D R&D Full sample No R&D R&D
sample sample sample sample
%Board 0.508*** 0.251 0.209** 0.816*** -1.156 0.333**

industry (5.82) (0.32) (2.35) (5.02) (-0.60) (2.12)
experts
Firm size 0.707*** 0.519*** 0.709*** 1.206*** 1.267*** 1.113***
(110.79) (5.30) (101.73) (102.01) (5.28) (93.02)
Sales growth -0.609*** -1.132** -0.422*** -0.952*** -2.172** -0.625***
(-11.25) (-2.45) (-7.55) (-9.86) (-2.22) (-6.66)
Board size 0.732*** 1.312*** 0.562*** 0.711*** 2.713** 0.350***
(31.41) (2.76) (21.79) (16.35) (2.20) (7.87)
Board 1.173*** 1.090 0.866*** 1.619*** 2.968 0.807***
independence (16.69) (1.29) (11.47) (12.19) (1.51) (6.07)
CEO duality 0.008 (0.18) 0.216 -0.117** 0.075 (0.92) -0.037 -0.057
(1.03) (-2.45) (-0.07) (-0.69)
R&D/Sales 2.976*** 2.127*** 4.278*** 2.871***
(25.81) (17.88) (20.55) (13.88)
Firm age 0.022*** 0.026*** 0.018*** 0.037*** 0.056** 0.031***
(17.30) (2.76) (13.31) (16.30) (2.43) (13.10)
Leverage -0.065 0.145 0.014 (0.11) -0.306 0.695 -0.435*
(-0.53) (0.24) (-1.34) (0.45) (-1.87)
Asset tangibility 0.295** 0.669 1.458*** 0.016 (0.07) 0.279 2.126***
(2.47) (0.94) (8.95) (0.14) (7.69)
CEO ownership -1.111*** -0.452 -1.279*** -2.594*** -1.090 -2.921***
(-5.79) (-0.29) (-5.57) (-7.29) (-0.30) (-7.25)
CEO equity 0.010* (1.65) 0.004 0.018*** 0.015 (1.32) -0.015 0.029**
(0.13) (2.82) (-0.18) (2.55)
Board age 0.008*** 0.018 0.025*** 0.004*** 0.022 0.033***
(10.21) (0.58) (30.22) (2.66) (0.30) (22.66)
Board tenure -0.018*** -0.031 -0.016*** -0.040*** -0.175** -0.027***
(-3.94) (-1.02) (-3.18) (-4.57) (-2.23) (-3.01)
CEO directors 0.084*** 0.192 0.063*** 0.132*** 0.660 0.103***
(4.00) (0.99) (2.74) (3.41) (1.56) (2.62)
Retired CEO -0.045* -0.042 -0.097*** -0.036 0.373 -0.172***
directors (-1.80) (-0.042) (-3.64) (-0.77) (0.82) (-3.79)
Observations 3956 1816 2140 3956 1816 2140
123
O. Faleye et al.
Table 6 continued
Sample (1) Patents (2) Patents (3) Patents (4) Cites (5) Cites (6) Cites
Full sample No R&D R&D Full sample No R&D R&D
sample sample sample sample
Pseudo R2 0.265 0.250 0.173 0.239 0.270 0.165

The dependent variables are patents granted by the USPTO (Columns 1–3), and average cites per patent
(Columns 4–6). The regression is estimated over 2000–2004 to reduce potential truncation bias. %Board
industry experts is the ratio of independent directors with prior or current experience in a firm that operates
in the same two-digit primary SIC code as the focal firm to all independent directors. Firm size is the natural
log of market capitalization. Sales growth is the 1-year percentage change in sales. Board size is the natural
log of the number of directors. Board independence is the percentage of directors who are unaffiliated with
the firm beyond being directors. CEO duality equals 1 if the CEO also serves as board chair, 0 otherwise.
R&D/Sales is the ratio of R&D expenditures to sales. Firm age is the natural log of the number of years
since incorporation. Leverage is the ratio of long-term debt to total assets. Growth opportunities is the
percentage change in sales. Asset tangibility is the ratio of fixed assets to total assets. CEO ownership is the
proportion of outstanding shares owned by the CEO. CEO equity-based pay is the ratio of the value of stock
options and restricted stock awarded the CEO to the CEO’s total pay. Board age and board tenure are the
average age and average tenure of independent directors. CEO directors is the number of directors who are
active CEOs of other firms. Retired CEO directors is the number of directors who are retired CEOs of other
firms. Each column is based on a Tobit regression and includes year and two-digit SIC code fixed effects.
Numbers in parentheses are test statistics based on robust standard errors clustered at both the firm and year
levels. Levels of significance are indicated by ***, **, and * for 1, 5, and 10%, respectively
5 Board industry expertise and firm value
Our results thus far suggest that industry expert directors curtail R&D-based real earnings
management and generally encourage R&D investments. In this section, we evaluate
whether their presence on the board ultimately leads to higher firm value, where our proxy
for firm value is Tobin’s q, that is, the book value of assets minus the book value of equity
plus the market value of equity, divided by the book value of assets.
Table 7 presents results of regressions of Tobin’s q on the proportion of board industry
experts, controlling for the variables discussed in Sect. 2.2 earlier. Column (1) is estimated
over the full sample. It shows that the proportion of industry expert directors is positive and
significant at the 1% level. Its coefficient of 0.494 implies that an increase of one standard
deviation in the proportion of industry expert directors is associated with an increase of
11.2% points in Tobin’s q. Since the sample mean of Tobin’s q is 2.0, this amounts to an
economically significant increase of 5.6% in firm value for the average firm.
Results from the previous section provide strong evidence that industry expert directors
encourage more and higher quality R&D investments. Thus, an interesting question is
whether the effect of these directors on firm value differs based on whether a firm invests in
R&D. We examine this by estimating separate regressions for firms that invest in R&D and
those that do not. As columns (2) and (3) of Table 7 show, board industry expertise is
positive and significant at the 1% level in the regression for R&D firms. In contrast, it is not
significant in the regression for firms that do not invest in R&D and the two coefficients are
statistically different from each other. Thus, board industry expertise enhances value only
at firms that invest in R&D, which is consistent with our prior results on the important roles
of these directors in R&D investment.
123
Table 7 Board industry expertise and firm value
Dependent variable: (1) Tobin’s q (2) Tobin’s q (3) Tobin’s q (4) %Board ind. (5) Tobin’s q (6) Tobin’s q (7) Tobin’s q (8) DTobin’s q
experts
Sample Full sample No R&D R&D sample R&D sample R&D sample R&D sample R&D sample Quasi natural
sample experiment
%Board industry 0.494*** (4.89) 0.159 (1.27) 0.491*** – 1.094** (2.00) 0.357** (2.39) 0.532*** 2.151** (2.50)
experts (3.69) (2.65)
Firm size 0.330*** 0.242*** 0.375*** 0.018*** (3.13) 0.362*** 0.118*** 0.258*** 0.709*** (4.93)
(17.01) (11.08) (13.62) (11.78) (3.95) (6.46)
ROA 3.059*** (9.48) 4.084*** 2.727*** -0.474*** 2.938*** 1.195 (1.32) 2.960*** 2.934* (1.94)
(11.92) (5.40) (-5.93) (4.77) (3.33)
ROAt-1 1.357*** (4.82) 0.806*** 1.732*** 0.107 (1.54) 1.541*** 1.589 (1.53) 3.206*** –
(2.72) (3.80) (3.33) (4.00)
ROAt-2 0.874*** (2.84) 1.831*** 0.390 (0.90) -0.185*** 0.554 (1.22) 3.045*** 0.102 (0.12) –
(5.30) (-2.92) (3.85)
Sales growth 0.691*** (6.59) 0.270*** 0.892*** 0.103*** (4.06) 0.895*** 0.864** (2.56) 1.121*** 0.246 (0.60)
(2.88) (5.84) (5.33) (3.68)
Corporate -0.027*** -0.010 -0.044*** -0.003 (-1.30) -0.044*** -0.018** -0.022** -0.014 (-0.40)
diversification (-4.58) (-1.46) (-5.54) (-5.20) (-2.26) (-2.51)
Board size -1.092*** -0.613*** -1.367*** -0.188*** -1.370*** -0.976*** -1.120*** -0.582 (-1.41)
(-11.74) (-6.19) (-9.38) (-5.47) (-7.15) (-5.30) (-5.14)
Board 0.077 (0.51) -0.078 0.107 (0.45) 0.033 (0.57) 0.067 (0.27) 0.232 (0.56) 0.522 (1.34) 0.384 (0.59)
independence (-0.49)
CEO duality -0.144*** -0.071** -0.177*** -0.054*** -0.175*** -0.017 -0.163** -0.018 (-0.10)
(-4.25) (-2.10) (-3.38) (-4.07) (-2.90) (-0.26) (-2.43)
Board ownership 0.388*** (2.68) 0.259* (1.95) 0.756** (2.55) -0.131** (-2.06) 1.007*** 1.159*** 0.924* (1.86) 0.056 (0.10)
(3.27) (3.02)
Busy board -0.119*** -0.051 -0.186*** 0.051*** (3.41) -0.228*** -0.143** -0.129** 0.279 (1.06)
(-3.23) (-1.15) (-3.56) (-3.73) (-2.03) (-2.04)
Board age -0.010* -0.013** -0.003 -0.005*** -0.004 0.011 (1.11) -0.020* -0.008 (-0.40)
(-1.84) (-2.23) (-0.32) (-2.82) (-0.38) (-1.76)
123
Table 7 continued
experts
123
sample experiment
Board tenure 0.014** (2.54) 0.019*** 0.008 (0.94) -0.007*** 0.013 (1.42) 0.017 (1.61) 0.015 (1.56) 0.001 (0.03)
(2.71) (-3.33)
Active CEO -0.061*** -0.060*** -0.066** -0.005 (-0.67) -0.062** -0.012 -0.082** -0.040 (-0.33)
directors (-2.96) (-2.80) (-2.19) (-2.03) (-0.34) (-2.15)
Retired CEO -0.046** -0.057** -0.026 0.007 (0.86) -0.035 0.042 (1.39) -0.006 -0.127 (-1.05)
directors (-2.40) (-2.38) (-1.04) (-1.30) (-0.18)
Proximal industry – – – 0.005*** (5.40) – – – –
firms
Industry – – – 0.442** (2.52) – – – –
information cost
Observations 9078 4248 4830 4830 4830 251 1238 117
O. Faleye et al.
Table 7 continued
experts
sample experiment
Adjusted R2 0.461 0.570 0.448 0.230 0.409 0.619 0.456 0.299
The dependent variable in columns (1)–(3) and (5)–(8) is Tobin’s q, defined as the book value of assets minus the book value of equity plus the market value of equity, divided
by the book value of assets. Column (4) is the first stage of a two-stage IV model; its dependent variable is %Board industry experts, that is, the ratio of industry experts to
independent directors. Column (5) contains results of the second stage model. The dependent variable in column (9) is the change in Tobin’s q from 2000 to 2005. Columns
(1), (2), and (3) are estimated over the entire sample, firms with no R&D, and firms with R&D, respectively. Column (6) is a regression of Tobin’s q in 2009 on %Board
industry expert in 2000. Column (7) is estimated over firms that have at least one industry expert who is not an industry expert at another firm and firms that do not have any
industry experts but whose boards have at least one member who is an industry expert at a different firm. Column (8) is estimated over firms whose boards were not majority-
independent in 2000 and had no industry expert directors at that time. The dependent variable as well as all continuous explanatory variables in this model are changes from
2000 to 2005. Firm size is the natural log of the market value of equity. ROA is operating income before depreciation divided by total assets. ROAt-1 and ROAt-2 are the 1-
and 2-year lagged values of ROA. Sales growth is the 1-year percentage change in sales. Corporate diversification is the sum of geographical and business segments. Board
size is the natural log of the number of directors. Board independence is the percentage of directors who are unaffiliated with the firm beyond being directors. CEO duality
equals 1 if the CEO serves as board chair. Board ownership is the proportion of outstanding shares owned by all directors. Busy board equals 1 when a majority of independent
directors serve on three or more boards, 0 otherwise. Board age is the average age of independent directors. Board tenure is the average tenure of independent directors. Active
CEO directors is the number of directors who are current CEOs of other firms. Retired CEO directors is the number of directors who are retired CEOs of other firms. Proximal
industry firms is the number of firms in the same two-digit SIC code as the focal firm whose head offices share the same three-digit ZIP code with the firm. Industry
information cost is the two-digit SIC code industry average of an index based on reversed percentile rankings of the number of analysts, dispersion of analyst forecasts, and
analyst forecast error. Each regression includes year and two-digit SIC code fixed effects with the exception of the 2SLS model which includes year fixed effects only (because
one instrument is constructed at the two-digit industry level). Test statistics based on robust standard errors clustered at the firm level are in parentheses. Statistical significance
is indicated by ***, **, and * for 1, 5, and 10%, respectively
123
O. Faleye et al.
These results are important for at least two reasons. First, while surveys indicate that
most firms desire directors with prior experience in their industries, our results provide
practical guidance by showing that these directors are mostly valuable at firms that invest
in R&D. Second, these contrasting findings provide initial evidence that our firm value
results are not due to some spurious underlying factors, for if that were the case, we should
observe no differences in the effect of board industry expertise based on firm character-
istics. In the next section, we perform several robustness tests, focusing on the sample of
R&D firms to maintain consistency with our previous tests and because our basic result
holds only in this sample. These tests are analogous to those for R&D investments as
detailed in Sect. 4.2.
5.1 Firm value robustness tests
We begin with an IV analysis using the same instruments as in the R&D regressions in
Table 4.11 Columns (4) and (5) of Table 7 show results of the first and second stage
regressions, respectively. As the second stage model shows, instrumented board industry
expertise is positive and significant at the 5% level. In column (6), we regress Tobin’s q in
2009 on board industry expertise in 2000, while column (7) is estimated over the sample of
firms that share directors who are industry experts at one firm but are not industry experts
at the other. As results of these tests show, we continue to find a positive relation between
board industry expertise and firm value.
In a further attempt to address endogeneity concerns, we rely on regulatory mandates
that took effect over 2002–2005.12 During this period, the major stock exchanges approved
governance rules that require boards of listed firms to be majority-independent and their
compensation, nominating, and audit committees to be fully independent.13 In a similar
approach to Duchin et al. (2010), we identify firms that were forced by these requirements
to appoint new independent directors, that is, those whose boards were not majority
independent prior to the new regulatory regime. We recognize that the mandates do not
force the appointment of industry expert directors. Therefore we require that firms have no
industry expert directors prior to the new standards before admitting them to the sample.
This makes it more likely that any appointment of industry expert directors by these firms
in the period immediately around the new mandates is a plausibly exogenous event since
they should have had at least one such director prior to the requirements if board industry
expertise is endogenous to their value or other characteristics.
The above yields a sample of 117 firms. By 2005 when the new listing standards
became mandatory, each firm had restructured its board to meet the new requirements. In
doing so, 39 appointed industry expert directors (51 experts in total) while 78 did not.
Column (8) of Table 7 presents results of a regression estimated over this sample. The
dependent variable is the change in Tobin’s q from 2000 to 2005 while the explanatory
variable of interest is the difference in the percentage of board industry experts from 2000
11
Diagnostic tests confirm the validity of these instruments in the Tobin’s q model. The Kleibergen–Paap
test rejects the null of under identification while the Cragg–Donald Wald F-statistic for weak instruments is
larger than all Stock–Yogo critical values for weak identification (Stock and Yogo 2005). Finally, Hansen’s
J test of over-identification does not reject the null hypothesis that the instruments are exogenous in the
second stage.
12
We are unable to conduct a similar analysis for R&D investments and patents due to sample size issues.
For these variables, only 41 observations satisfy the sampling requirements.
13
NYSE and Nasdaq submitted their governance reform proposals to the SEC in August 2002 and October
2002, respectively. The proposals were approved in November 2003 and became fully mandatory in 2005.
123
to 2005. We measure all continuous control variables also as the change from 2000 to
2005. As the table shows, the difference in firm value increases with the difference in board
industry expertise. Overall, these tests suggest that the positive effect of board industry
expertise on firm value is substantive rather than spurious.
6 Motivating R&D: Industry expertise and board monitoring
Prior studies (Xue 2007; Manso 2011) show that different board monitoring decisions are
required to incentivize executives to invest in non-routine R&D projects because such
projects are more likely to fail. In this section, we evaluate whether boards with industry
experts design compensation contracts to emphasize long-term performance and/or provide
the CEO with job security after relatively poor short-term performance as one would
expect given that these boards are associated with increased and higher quality R&D.
6.1 CEO compensation incentives
We evaluate the effect of board industry expertise on executive compensation incentives in

two complementary tests. First, we analyze its impact on the sensitivity of CEO com-
pensation to firm performance. Second, we examine its effect on the composition of CEO
pay. We measure board industry expertise at the compensation committee level in these
tests because the compensation committee is primarily responsible for designing CEO pay.
Not surprisingly, results are not significant when we use board-level industry expertise
variables.
Our pay sensitivity tests use the procedure pioneered by Jensen and Murphy (1990) to
estimate the responsiveness of CEO pay to changes in shareholder wealth by regressing the
first difference of total CEO compensation on the 1-year lagged dollar change in share-
holder wealth. We estimate separate regressions for firms with at least one industry expert
on their compensation committees and those without, and then compare the coefficients of
the change in shareholder wealth in the two regressions.
The first column of Table 8 presents results for firms with at least one industry expert on
their compensation committees while the second presents results for those without. The
change in shareholder wealth is positive and significant in both columns. Thus, the CEO
earns more (less) when the firm performs better (worse) regardless of the presence of an
industry expert on the compensation committee. However, pay–performance sensitivity is
higher at firms with industry experts. For these firms, CEO pay changes by 19.5 cents for
each $1000 change in shareholder wealth. In contrast, the corresponding change in CEO
pay for firms with no industry experts is only 10.1 cents. The Chow test indicates that the
difference is statistically significant. Thus, the presence of an industry expert on the
compensation committee is associated with an economically meaningful increase in the
sensitivity of CEO pay to firm performance. This, as Manso (2011) shows, is necessary to
motivate higher investments in non-routine R&D projects.
Our previous findings all suggest that industry expert directors are most valuable at
firms that invest in R&D. Thus, we repeat the pay sensitivity analysis for R&D firms and
firms with no R&D spending. We find that industry expert directors are associated with
higher pay–performance sensitivity only at R&D firms. Columns (3) and (4) of Table 8
show that CEO pay is more sensitive to shareholder wealth among R&D firms with
industry experts than among R&D firms with no industry experts. In contrast, industry
123
Table 8 Board industry expertise and CEO compensation incentives
Dependent (1) DCEO Pay (2) DCEO Pay (3) DCEO Pay (4) DCEO Pay (5) DCEO Pay (6) DCEO Pay
variable
123
Sample Full sample, industry Full sample, no industry R&D [ 0, industry R&D [ 0, No industry R&D = 0, industry R&D = 0, No industry
experts experts experts experts experts experts
DShareholder 0.195*** (4.56) 0.101*** (2.66) 0.201*** (4.42) 0.087* (1.83) 0.153 (1.12) 0.105* (1.67)
wealth
Firm size 41.946 (0.59) 106.871* (1.68) 46.088 (0.50) -26.095 (-0.24) -48.660 (-0.39) 214.738*** (2.67)
ROA 136.101 (0.17) -1855.255** (-2.41) -280.291 (-0.29) -184.174 (-0.15) 2078.251 (1.24) -3512.980*** (-3.50)
Operating risk -274.568 (-0.62) -432.758 (-1.01) -275.095 (-0.42) -318.521 (-0.43) -306.677 (-0.52) -386.921 (-0.69)
Stock market risk -601.176** (-2.54) 171.974 (1.25) -642.701** (-2.37) 181.495 (0.98) -846.405** (-2.54) 285.711 (1.16)
Leverage -472.519 (-1.15) 287.357 (0.80) 123.285 (0.25) 15.140 (0.02) -2032.314*** 623.013 (1.36)
(-2.76)
CEO age 1112.778* (1.84) 17.533 (0.04) 836.455 (1.13) -566.614 (-0.82) 1789.046* (1.76) 351.950 (0.60)
CEO ownership 3093.437 (1.12) 720.906 (0.58) 6224.277 (1.23) 78.018 (0.04) -369.136 (-0.17) 1351.977 (0.81)
Board size -15.187 (-0.04) -790.998** (-2.41) -214.905 (-0.39) -117.065 (-0.20) 435.360 (0.66) -1277.762*** (-3.01)
CEO duality 25.393 (0.13) 129.552 (0.86) -141.397 (-0.57) 346.222 (1.40) 468.094* (1.76) -10.650 (-0.05)
Board ownership -743.509 (-0.64) -120.420 (-0.13) -2052.194 (-0.91) 206.093 (0.12) 809.083 (0.87) -634.199 (-0.57)
Busy board -15.486 (-0.07) -406.269** (-2.00) -192.353 (-0.72) -28.882 (-0.10) 555.289 (1.30) -647.076** (-2.20)
Board age -0.535 (-0.03) 12.070 (0.86) 1.562 (0.06) 41.722 (1.54) -29.436 (-1.04) -4.798 (-0.28)
Board tenure -11.243 (-0.59) -17.330 (-1.07) -10.913 (-0.48) -35.531 (-1.26) -12.524 (-0.35) -13.984 (-0.65)
Active CEO 78.684 (0.83) 114.300 (1.17) 137.532 (1.28) 194.637 (1.18) -66.606 (-0.29) 50.869 (0.40)
directors
Retired CEO -62.925 (-0.74) -3.011 (-0.04) -80.274 (-0.75) -49.383 (-0.43) -26.485 (-0.20) -96.248 (-0.84)
directors
Observations 3229 3862 2222 1598 1007 2264
Adjusted R2 0.030 0.004 0.040 0.014 0.002 -0.004
O. Faleye et al.
Table 8 continued
Dependent (1) DCEO Pay (2) DCEO Pay (3) DCEO Pay (4) DCEO Pay (5) DCEO Pay (6) DCEO Pay
variable
Sample Full sample, industry Full sample, no industry R&D [ 0, industry R&D [ 0, No industry R&D = 0, industry R&D = 0, No industry
Chow test 2.820* (0.093) 3.290* (0.070) 0.110 (0.744)

(p - value)
The dependent variable is the inflation-adjusted change in total CEO pay, in thousands of dollars. DShareholder wealth is the product of the percentage return to shareholders
during year t - 1 and the firm’s inflation-adjusted market value at the end of year t - 2, in millions of dollars. Models are estimated separately for firms with or without at
least one industry expert director on the compensation committee over the entire sample (columns (1) and (2)), among R&D firms (columns (3) and (4)), and among firms with
no R&D investments (columns (5) and (6)). Industry expert directors are independent directors with prior or current experience in a firm that operates in the same two-digit
primary SIC code as the focal firm. Firm size is the natural log of market capitalization. ROA is operating income before depreciation divided by total assets. Operating risk is
the standard deviation of ROA over the preceding 5 years. Market risk is the standard deviation of percentage stock return over the preceding 5 years. Leverage is the ratio of
long-term debt to total assets. CEO age is the natural log of CEO age in years. CEO ownership is the proportion of outstanding shares owned by the CEO. Board size is the
natural log of the number of directors. CEO duality equals 1 if the CEO serves as board chair, 0 otherwise. Board ownership is the proportion of outstanding shares owned by
all directors. Busy board equals 1 if a majority of independent directors serve on three or more boards, 0 otherwise. Board age is the average age of independent directors.
Board tenure is the average tenure of independent directors. Active CEO directors is the number of directors who are current CEOs of other firms. Retired CEO directors is the
number of directors who are retired CEOs of other firms. Each regression includes year and two-digit SIC code fixed effects with standard errors clustered at the firm level.
Levels of significance are indicated by ***, **, and * for 1, 5, and 10%, respectively. Each Chow test is for the null hypothesis that the coefficient of DShareholder wealth in
the regression for firms with at least one industry expert director on their compensation committees equals its coefficient in the corresponding regression for firms with no
industry expert director on their compensation committees
123
O. Faleye et al.
expertise makes no difference in pay–performance sensitivity among firms with no R&D

investments, as shown in columns (5) and (6).
Xue (2007) finds that compensation contracts with greater equity-based pay encourage
executives to invest more in R&D. Similarly, Manso (2011) shows that the optimal
compensation scheme that motivates innovation involves substantial stock option awards
rather than fixed salary or stock awards. Thus, our second set of compensation tests focus
on the composition of CEO pay. First, we calculate the ratios of salaries, stock options, and
restricted stocks to total CEO pay for each year. We then regress each ratio on compen-
sation committee industry expertise using fractional logit models. We present results in
Table 9.
Columns (1)–(3) contain results for the full sample. The ratio of salary to total CEO pay
decreases with the proportion of board industry experts on the compensation committee
while the ratio of stock options increases with it. The coefficients imply that an increase of
one standard deviation in the proportion of industry experts is associated with a reduction
of 7.0% points in the ratio of salary to total CEO pay and an increase of 13.0 points in the
ratio of stock options. Based on Xue (2007) and Manso (2011), this is consistent with our
earlier results that industry expert directors encourage R&D investments.14 We also
evaluate whether these results differ for R&D firms relative to non-R&D firms by esti-
mating separate regressions for the two classes of firms. As columns (4)–(6) show, results
for the R&D sample are similar to those for the full sample. In contrast, columns (7)–(9)
show that industry expert directors have no effect on the composition of CEO pay in the
sample of firms that do not invest in R&D.
6.2 Board industry expertise and CEO turnover decisions
We obtain CEO dismissal data from Ertugrul and Krishnan (2011) and Faleye et al. (2011).
The data include 242 CEO dismissals over 2000–2008. We merge these data into the full
sample, coding firm-years with forced turnover as 1 and other years as 0 but excluding
years with routine CEO changes. We are interested in the impact of board industry
expertise on the performance–sensitivity of CEO dismissal. Hence, we estimate separate
regressions for firms with no board industry experts and those with at least one industry
expert and compare the coefficients of firm performance in the two regressions. We
measure firm performance using market-adjusted stock return over the preceding year,
where the market is defined as the CRSP equal-weighted portfolio of NYSE/Nasdaq/
AMEX stocks.
Market-adjusted return is negative and significant in the regressions in columns (1) and
(2) of Table 10. Thus, CEOs are fired for poor performance in both samples. Yet turnover
performance-sensitivity is weaker among firms with industry expert directors. The average
marginal effect of a decline of one standard deviation in adjusted stock returns is an
increase of only 1.3% points in the probability of forced CEO turnover among firms with at
least one industry expert director compared with an increase of 2.4% points among firms
with no industry experts. We obtain similar results in untabulated regressions where we
adjust stock returns using the value-weighted market portfolio. Results are also similar
when we measure performance using ROA rather than excess stock market returns.
14
We also perform a 2SLS analysis for our compensation variables using the instruments in our R&D tests.
Instrumented industry expertise is positive and significant in the regression for stock option ratio and
negative but insignificant in the regression for salary ratio. We do not tabulate these results due to space
considerations.
123
Table 9 Board industry expertise and CEO compensation components
Dependent (1) Salary ratio (2) Options (3) Stock ratio (4) Salary (5) Options (6) Stock ratio (7) Salary (8) Options (9) Stock
variable ratio ratio ratio ratio ratio ratio
Sample Full sample Full sample Full sample R&D sample R&D sample R&D sample No R&D No R&D No R&D
sample sample sample
%Comp industry -0.237** 0.509*** 0.004 (0.03) -0.273* 0.573*** -0.047 -0.123 0.253 (1.54) 0.151 (0.81)
experts (-2.02) (5.65) (-1.89) (5.30) (-0.31) (-0.55)
Firm size -0.298*** 0.221*** 0.013 (0.53) -0.282*** 0.220*** -0.004 -0.325*** 0.200*** 0.080* (1.92)
(-12.18) (10.49) (-8.71) (8.24) (-0.12) (-7.91) (6.34)
ROA -0.502 -0.509** -0.729** -0.555 -0.546 -1.377*** -0.404 -0.187 -0.667
(-1.48) (-2.01) (-2.31) (-1.13) (-1.55) (-2.76) (-0.80) (-0.49) (-1.51)
Operating risk -0.425 1.111*** -0.894* -0.427 1.289*** -1.687** -0.863 0.575 (0.84) 0.773 (1.02)
(-0.82) (2.89) (-1.79) (-0.65) (2.70) (-2.42) (-0.93)
Stock market risk -0.171 0.413*** -0.336** -0.012 0.405*** -0.523*** -0.319 0.409** -0.137
(-1.26) (4.11) (-2.32) (-0.07) (3.20) (-2.71) (-1.47) (2.47) (-0.62)
Leverage -0.302* -0.335** 0.878*** -0.160 -0.416** 1.075*** -0.506* -0.194 0.719***
(-1.76) (-2.52) (5.22) (-0.67) (-2.37) (4.16) (-1.96) (-0.98) (3.07)
Board size -0.122 -0.296** 0.514*** -0.144 -0.305** 0.499** -0.066 -0.269 0.386* (1.79)
(-0.93) (-2.55) (3.32) (-0.76) (-1.98) (2.41) (-0.34) (-1.58)
Busy board -0.086 -0.037 0.129** -0.134 -0.073 0.237*** -0.016 -0.001 0.002 (0.03)
(-1.18) (-0.80) (2.31) (-1.38) (-1.20) (3.31) (-0.14) (-0.02)
CEO duality -0.071 -0.051 0.084 (1.49) -0.025 -0.032 0.039 (0.51) -0.125 -0.100 0.120 (1.50)
(-1.25) (-1.15) (-0.31) (-0.53) (-1.48) (-1.52)
CEO age 0.003 (0.76) -0.007** -0.011*** 0.004 (0.69) -0.004 -0.010* 0.004 (0.75) -0.011** -0.012**
(-2.15) (-2.82) (-1.09) (-1.79) (-2.29) (-2.19)
CEO ownership 2.050*** -1.666*** -3.302*** 1.630* (1.86) -0.978 -4.063*** 2.234*** -1.851*** -3.029**
(3.83) (-2.87) (-3.48) (-1.01) (-2.84) (3.22) (-2.71) (-2.50)
Board ownership 0.633** (2.20) -0.921*** -0.493 1.048** -0.844** -0.517 0.342 (0.92) -0.875*** -0.442
(-3.76) (-1.39) (2.23) (-2.01) (-1.03) (-2.86) (-0.95)
Board age 0.005 (0.72) -0.025*** -0.001 0.007 (0.69) -0.030*** -0.006 -0.001 -0.018** 0.001 (0.12)
(-4.11) (-0.18) (-3.49) (-0.49) (-0.09) (-2.03)
123
Table 9 continued
Dependent (1) Salary ratio (2) Options (3) Stock ratio (4) Salary (5) Options (6) Stock ratio (7) Salary (8) Options (9) Stock
variable ratio ratio ratio ratio ratio ratio
123
Sample Full sample Full sample Full sample R&D sample R&D sample R&D sample No R&D No R&D No R&D
sample sample sample
Board tenure 0.013* (1.68) 0.007 (0.94) -0.011 0.006 (0.58) 0.018* (1.89) -0.007 0.018* (1.66) -0.008 -0.017
(-1.18) (-0.56) (-0.88) (-1.28)
Active CEO -0.019 -0.020 0.032 (1.02) 0.000 (0.01) -0.040 0.042 (0.99) -0.037 0.014 (0.37) 0.029 (0.66)
directors (-0.49) (-0.82) (-1.27) (-0.60)
Retired CEO -0.046 0.044* (1.82) 0.013 (0.45) -0.006 0.041 (1.33) -0.029 -0.104* 0.041 (1.03) 0.064 (1.28)
directors (-1.21) (-0.13) (-0.75) (-1.69)
Observations 8342 8341 8255 4482 4482 4442 3860 3859 3813
The dependent variables are the ratios of the inflation-adjusted CEO salary, stock option awards (Black–Scholes value), and restricted stock awards to total CEO com-
pensation. Models (fractional logits) are estimated separately for the entire sample, for R&D firms, and for no R&D firms. %Comp industry experts is the fraction of
compensation committee members with prior or current work experience in a firm that operates in the same two-digit primary SIC code as the focal firm. Firm size is the
natural log of market capitalization. ROA is operating income before depreciation divided by total assets. Operating risk is the standard deviation of ROA over the preceding
5 years. Market risk is the standard deviation of percentage stock return over the preceding 5 years. Leverage is the ratio of long-term debt to total assets. Board size is the
natural log of the total number of directors. Busy board equals one when a majority of independent directors serve on three or more corporate boards, zero otherwise. CEO
duality equals one when the CEO also serves as board chairman, zero otherwise. CEO age is the natural log of CEO age in years. CEO ownership is the proportion of
outstanding shares owned by the CEO. Board ownership is the proportion of outstanding shares owned collectively by all directors. Board age is the average age of
independent directors. Board tenure is the average tenure of independent directors. Active CEO directors is the number of directors who are current CEOs of other firms.
Retired CEO directors is the number of directors who are retired CEOs of other firms. Each regression includes year and two-digit SIC code fixed effects. Test statistics based
on robust standard errors clustered at the firm level are in parentheses. Levels of significance are indicated by ***, **, and * for 1, 5, and 10%, respectively
O. Faleye et al.
These results suggest that industry expertise attenuates the propensity of boards to
dismiss the CEO following poor firm performance and are consistent with optimal mon-
itoring by boards seeking to maximize value via increased investments in non-routine
R&D.15 Manso (2011) argues that the threat of termination following poor performance
encourages CEOs to pursue routine rather than innovative ideas. He also shows that the
optimal incentive scheme that motivates non-routine innovation exhibits a considerable
tolerance for failure. Thus, in order to encourage investment in innovative ideas, the board
may need to commit to not firing the CEO even if it is ex-post efficient to do so. In line
with these arguments, Acharya et al. (2012) find that labor laws with stringent employment
protection are associated with increased corporate innovation. Similarly, Tian and Wang
(2014) show that firms backed by failure-tolerant venture capitalists are more innovative
while Faleye et al. (2014) show that CEOs with higher ex ante post-dismissal re-em-
ployment probabilities engage in more and higher quality corporate innovation.
We also evaluate whether our turnover sensitivity results differ for R&D firms and firms
with no R&D investments. Columns (3) and (4) of Table 10 show results of regressions for
R&D firms that have industry expert directors and those that do not, respectively. In both
columns, excess stock return is negative and significant at the 1% level. The coefficients
suggest that CEO turnover is less sensitive to firm performance among R&D firms with
industry expert directors. For these firms, a decline of one standard deviation in adjusted
returns increases the likelihood of CEO dismissal by 3.8% points compared with an
increase of 2.1 points at R&D firms with no industry expert directors. However, the
coefficients are not statistically different from each other. We observe similar results for
firms with no R&D as reported in columns (5) and (6).
7 Summary and conclusion
A number of recent surveys identified industry expertise as the most-desired director

qualification. Likewise, several major firms recently supported board nominations with
references to the nominee’s industry experience. Ultimately, these claims force a discus-
sion of the role of industry-experienced directors in board effectiveness. This paper extends
the literature by evaluating the role of board industry expertise in corporate R&D
expenditures and value creation.
Our results suggest that industry experienced directors attenuate managerial myopia in
R&D spending, both in cases where managers could reverse a short-term earnings shortfall
by cutting R&D expenditures and in the general population of firms. Our results further
suggest that this increase in R&D spending is value-enhancing. Firms with industry expert
directors receive more patents for the same level of R&D expenditures, their R&D
spending is associated with lower volatility of future earnings, and their value is higher.
15
An alternative interpretation is that industry expertise diminishes board effectiveness in CEO termination
decisions. This could be because industry expert directors are more beholden to the CEO although it is not
clear why that would be the case. It is also possible that industry expert directors identify with the CEO
based on similar professional backgrounds. As shown by Tajfel and Turner (1979), individuals evaluate
others more favorably when they regard those others as belonging to the same group(s) as themselves.
However, similar industry experience is not likely to generate strong in-group identity because the group of
individuals with similar industry backgrounds is potentially large and loosely defined. Furthermore, our
pay–performance sensitivity result is inconsistent with an in-group bias explanation since such bias would
predict the decoupling of CEO compensation and firm performance.
123
O. Faleye et al.
Table 10 Board industry expertise and forced CEO turnover

Sample (1) (2) Turnover (3) (4) Turnover (5) (6) Turnover
Turnover Turnover Turnover
Full sample, Full sample, R&D [ 0, R&D [ 0, R&D = 0, R&D = 0,
industry no industry industry no industry industry no industry
Excess return -0.448*** -0.818*** -0.466*** -0.752*** -0.495** -1.032***

(-3.61) (-5.43) (-3.15) (-3.87) (-2.31) (-3.77)
Firm size -0.001 -0.086* 0.029 -0.134** -0.153* -0.113
(-0.02) (-1.89) (0.63) (-2.10) (-1.93) (-1.57)
CEO duality -0.368*** -0.339*** -0.402*** -0.480** -0.320** -0.200
(-4.21) (-2.70) (-3.74) (-2.51) (-2.06) (-1.12)
CEO -1.656 -8.064* -3.504 -4.610 -0.724 -15.167***
ownership (-1.37) (-1.88) (-1.44) (-1.37) (-0.59) (-2.85)
Board size 0.032 (0.15) 0.321 (1.21) 0.113 0.170 (0.43) -0.023 0.497 (1.14)
(0.41) (-0.06)
Board 0.520 (1.53) 0.658* (1.85) 0.388 0.889 (1.63) 0.771 0.068 (0.14)
independence (0.90) (1.38)
CEO age 0.013* 0.019** 0.016* 0.014 (1.22) 0.013 0.036***
(1.79) (2.32) (1.67) (1.07) (2.63)
Board age 0.005 (0.40) -0.039*** -0.004 -0.048** 0.023 -0.059**
(-2.78) (-0.26) (-2.46) (1.17) (-2.50)
Board tenure -0.040*** 0.009 (0.63) -0.041** 0.032 (1.57) -0.049* -0.003
(-2.99) (-2.50) (-1.91) (-0.13)
Active CEO -0.070 -0.010 -0.084 -0.002 -0.050 -0.005
directors (-1.20) (-0.12) (-1.21) (-0.01) (-0.41) (-0.04)
Retired CEO -0.043 -0.106 -0.051 -0.364** -0.022 0.000 (0.00)
directors (-0.77) (-1.22) (-0.78) (-2.01) (-0.19)
Observations 3693 2311 2503 879 1062 971
Pseudo R2 0.069 0.160 0.083 0.161 0.126 0.216
Chow test 3.660* 1.41 2.40
(p - value) (0.056) (0.235) (0.122)
The dependent variable equals 1 for firm years with forced CEO turnovers and zero for firm-years with no
turnovers. Models are estimated separately for firms with or without at least one industry expert director
over the entire sample (columns (1) and (2)), among R&D firms (columns (3) and (4)), and among firms with
no R&D investments (columns (5) and (6)). Industry expert directors are independent directors with prior or
current experience in a firm that operates in the same two-digit primary SIC code as the focal firm. Excess
return is prior year annual stock return less same-period return on the CRSP equal-weighted portfolio of
NYSE/Amex/Nasdaq stocks. Firm size is the natural log of market capitalization. CEO duality equals 1 if
the CEO also serves as board chair. CEO ownership is the proportion of outstanding shares owned by the
CEO. CEO age is the natural log of CEO age in years. Board size is the natural log of the number of
directors. Board independence is the percentage of directors who are unaffiliated with the firm beyond their
directorship. Board age is the average age of independent directors. Board tenure is the average tenure of
independent directors. Active CEO directors is the number of directors who are current CEOs of other firms.
Retired CEO directors is the number of directors who are retired CEOs of other firms. Each regression
includes year and two-digit SIC code fixed effects. Numbers in parentheses are test statistics based on robust
standard errors clustered at the firm level. Levels of significance are indicated by ***, **, and * for 1, 5, and
10%, respectively. Each Chow test is for the null hypothesis that the coefficient of excess return in the
regression for firms with at least one industry expert director equals its coefficient in the corresponding
regression for firms with no industry expert directors
123
Our results have practical implications for board appointments. They highlight the role
that industry expertise can play in enhancing board effectiveness but also show that the
value of industry experts is mostly limited to R&D firms. Thus, our results do not support a
one-size-fits-all approach. Rather, they suggest that some classes of firms do not benefit
from industry experienced directors. For such firms, other types of expertise may be more
appropriate.
Acknowledgements We thank Divya Anantharaman, Niki Boyson, Ebru Reis, Atul Gupta, Kartik Raman,
Jin-Mo Kim, Alexander Kogan, Karthik Krishnan, Lakshmana Krishna Moorthy, Kristina Minnick, Anya
Mkrtchyan, Donald Monk, Ari Yezegel, and seminar participants at Bentley, Northeastern, and Rutgers for
helpful comments.
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Rev Quant Finan Acc

Industry expertise on corporate boards

Olubunmi Faleye1 • Rani Hoitash2 • Udi Hoitash1

Ó Springer Science+Business Media New York 2017

Keywords Director qualifications Industry expertise Real earnings

JEL Classification G34

& Rani Hoitash

aversion in R&D investments by diminishing the ex ante riskiness of such projects. In

2 Sample and data

2.1 Sample construction

2.2 Main variables

Table 1 Summary statistics for main variables

Board size 9.237 9.000 8.000 11.000 2.278

3 The appointment of industry expert directors

of intangible assets. We expect the likelihood of appointing an industry expert director to

Table 2 Industry experts on boards

Director age 0.010 (1.06) 0.011 (1.12) – – –

Pseudo R2 0.109 0.161 0.151 0.042 n.a.

4 Board industry expertise and R&D myopia

4.1 R&D-based real earnings management

reducing or eliminating R&D spending. Following Cheng (2004), we classify firm-years

Pre-tax incomei;t þ R&D expendituresi;t [ Pre-tax incomei;t1 ð2Þ

These conditions define firms as susceptible to R&D-based earnings management when

Table 3 Board industry experts and R&D-based real earnings management

%Board -0.984*** – – -0.027*** – –

Pseudo/ 0.149 0.147 0.147 0.105 0.105 0.095

4.2 Board industry expertise and broad-based R&D investments

Table 4 Board industry expertise and the level of R&D investments

%Board 0.130*** 0.109*** – 0.278*** 0.084*** 0.075***

Adjusted/ n.a. 0.303 0.241 0.200 0.359 0.379

Our second instrument is the industry-level information acquisition cost variable of

4.3 Board industry expertise and the quality of R&D investments

4.3.1 Volatility of future earnings

R&D per share 0.368*** (5.45) 0.296*** (3.91) 0.601*** (4.77)

4.3.2 Patents and patent citations

Table 6 Board industry expertise and corporate innovation

%Board 0.508*** 0.251 0.209** 0.816*** -1.156 0.333**

Pseudo R2 0.265 0.250 0.173 0.239 0.270 0.165

5 Board industry expertise and firm value

Adjusted R2 0.461 0.570 0.448 0.230 0.409 0.619 0.456 0.299

5.1 Firm value robustness tests

6 Motivating R&D: Industry expertise and board monitoring

6.1 CEO compensation incentives

We evaluate the effect of board industry expertise on executive compensation incentives in

Chow test 2.820* (0.093) 3.290* (0.070) 0.110 (0.744)

expertise makes no difference in pay–performance sensitivity among firms with no R&D

6.2 Board industry expertise and CEO turnover decisions

7 Summary and conclusion

A number of recent surveys identified industry expertise as the most-desired director

Table 10 Board industry expertise and forced CEO turnover

Excess return -0.448*** -0.818*** -0.466*** -0.752*** -0.495** -1.032***

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%Board -0.984* – – -0.027* – –

%Board 0.130* 0.109* – 0.278* 0.084* 0.075***

R&D per share 0.368* (5.45) 0.296* (3.91) 0.601*** (4.77)

%Board 0.508* 0.251 0.209 0.816* -1.156 0.333

Excess return -0.448* -0.818* -0.466* -0.752* -0.495 -1.032*