master thesis younes

Faculty of Finance and Business Administration Department of FinanceVrije Universiteit AmsterdamSupervisor: Dr. R. Calcagno

Younes El Gartit 1394169

Master Thesis

The performance impact of interlocking directorates:The case of The Netherlands

Abstract

In this research we explore the effect of interlocking directorates on firm performance for80 publicly listed Dutch firms. An interlock between two firms occurs if the firms share one ore more directors in their boards of directors. In The Netherlands firms operating under the structural regime have a two-tier board structure which consists of a management board and a supervisory board. We therefore examine the effect of two types of interlocks: (1) management board interlocks and (2) supervisory board interlocks. The literature points towards five reasons for interlocks to exist: (1) collusion, (2) cooptation and monitoring, (3) legitimacy, (4) career advancement, (5) social cohesion. The first three reasons predict a positive influence of interlocks on firm performance where the last two have no a priori predictive value. The cooptation and monitoring perspective which stems form resource dependence theory has received the most support. In the context of interlocking directorates, this theory views boards of directors as important boundary spanners that link with the environment and extract resources (capital, information and markets) for successful operations. According to this view interlocking directorates are thus expected to reduce the interdependence on resources and improve firm performance.We use four different performance measures for the years 2005 and 2006, and we allow the number of interlocks to be either with or without lags.Based on our results we conclude that supervisory board interlocks can have a positive effect on current and future firm performance. We also find management board interlocks to have a positive effect on current and future firm performance.

Keywords: interlocks, firm performance, The Netherlands.

Younes El Gartit Master Thesis Business Administration 2

Acknowledgements

My special thanks go to Dr. Calcagno for sharing his knowledge and experience, offering

supervision, and giving helpful comments and suggestions.

I am also thankful to my parents who have always supported me during my time at the

university.

Younes El Gartit

October 2007


Table of contents

1. Introduction................................................................................................................... 4

2. Theoretical framework ................................................................................................. 7

2.1 Agency Theory ........................................................................................................ 72.1.1 Corporate governance systems ........................................................................... 9

2.2 Corporate governance in The Netherlands. ....................................................... 112.2.1 Functions of supervisory boards....................................................................... 13

2.3 Board Interlocking.................................................................................................... 162.3.1 Reasons for interlocking.................................................................................... 16

2.4 Number of board interlocks and firm performance (Literature review) ............ 222.4.1 Advantages Associated with more interlocks .................................................. 222.4.2 Disadvantages associated with more interlocks .............................................. 27

3. Interlock effects on firm performance; an empirical study .................................... 30

3.1 Data ........................................................................................................................ 313.2 Hypotheses ............................................................................................................. 343.3 Methodology .......................................................................................................... 35

4. The main empirical results......................................................................................... 39

4.1 Relationship between supervisory board’s interlocks and firm performance 404.2 Relationship between management board interlocks and firm performance 43

5. Discussion and conclusion .......................................................................................... 45

References ........................................................................................................................ 51


1. Introduction

Corporate governance has been forefront in public and government debate over the past

several years. This debate has largely been triggered by failures at Enron, WorldCom,

Tyco, and other prominent companies. Those failures, in turn, have served as catalysts for

legislative change in the U.S., of which the Sarbanes-Oxley Act of 2002 is one of the

main results (Holmstrom and Kaplan, 2003). Closer to home the accounting scandal

surrounding Royal Ahold (Koninklijke Ahold NV) triggered a somewhat similar reaction

as the failure of U.S. companies. Royal Ahold shattered the illusion that corporate

governance and accounting were U.S. problems (DeJong et al., 2005). It caused Dutch

and European policymakers to rethink their approach to corporate governance.

In the Netherlands a committee (Commissie Tabaksblatt) on corporate governance was

installed to restore confidence in public companies. On December 9, 2003 the committee

presented the Dutch Corporate Governance Code. The corporate governance code came

into force with effect on January 1sth of 2004. Publicly traded companies with a statutory

seat in the Netherlands are obliged to comply with the code. The code subscribes

principles of good corporate governance and best practice provisions. These best practice

provisions are not mandatory but are part of what is known as the ‘comply or explain’

principle. This ensures that companies that decide to deviate from the best practice

provision have to explain why they did so.

Among the best practice provisions are for example those that relate to the number of

seats a director can have at supervisory boards of other publicly traded corporations.

According to the code a member of the management board is allowed only to be a

director of the supervisory board at two other publicly traded corporations. In addition the

code commands that an individual can be a member of the supervisory board at

maximum five publicly listed companies. The reason for the committee to set a maximum

number of directorships is to ensure the proper performance of his duties (Commissie

Tabaksblatt, 2003). This provision is line with the busyness hypothesis which suggests

that directors with many directorships get short of time and cause the performance of

their firms to detoriate (Non and Franses, 2007).


At the other end of the spectrum is the idea that individuals with multiple directorships

can actually enhance firm performance. The main force behind this idea is resource

dependence theory. According to resource dependence theory the linking of organizations

through individuals with multiple directorships (interlocking directorates) is important in

the inter-organizational exchange of resources (capital, information, and markets) (Phan

et al., 2003). These interlocking directorates will thus reduce the interdependence on

resources and improve firm performance.

The focus of this thesis will lie on board interlocks and firm performance. The aim of this

thesis is to research if the number of board interlocks influences firm performance. The

research that has been conducted on board interlocks so far is very extensive. The

research in this area has focused on how interlocks come into existence as well as the

consequences of board interlocks. The research linking board interlocks and firm

performance is far less extensive and the results of the research conducted are mixed. The

results range from studies that have found a positive effect of interlocks on firm

performance (Pennings, 1980; Burt, 1983; Phan et al., 2003), to studies that have found a

negative effect (Fligstein and Brantley, 1992; Van Ees et al., 2003), and yet others that

have found no effect (Richardson, 1987). Most of these studies however are based on

U.S. data. We are only aware of three studies which concern The Netherlands. These are

Meeusen and Cuyvers (1985), Van Ees et al. (2003), and Non and Franses (2007). Again,

the findings of these studies are mixed. The first study documents a positive relation

between interlocks within financial firms and their performance. The second and third

study document a negative effect of interlocks on firm performance. In this study we

again take up the issue of interlocks and firm performance. In contrast to previous studies

our sample will constitute non-financial publicly listed companies in The Netherlands. In

addition, in contrast to previous studies we will also study the effect of management

board interlocks on firm performance, where most studies traditionally have focused on

supervisory board interlocks. The main research question that accompanies this research

is the following:


What effect has the number of board interlocks (management or supervisory) on

firm performance for a sample of Dutch firms?

In reaching an answer to the research question the following hypothesis will be tested

Hypothesis 1

H0 The number of supervisory board interlocks does not influence firm performance. H1 The number of supervisory board interlocks positively influences firm performance.

Hypothesis 2

H0 The number of management board interlocks does not influence firm performance. H1 The number of management board interlocks positively influences firm performance

The remainder of the thesis is set up as follows. Chapter 2 will provide the theoretical

grounding for the research and a literature review. This chapter will deal with the

following questions:

1. What is Corporate Governance and which systems exist? 2. How does the corporate governance system in the Netherlands look like?

3. What are potential reasons for interlocks? 4. What are the effects of interlocks on firm performance? 5. What effects have there been found empirically between interlocks and firm performance?

This chapter will be followed by the analysis section. This includes chapter 3: Data,

hypotheses and methodology, and chapter 4: Empirical results. Finally in chapter 5 we

discuss the results and conclude.


2. Theoretical framework

In this chapter we will first explain the agency theory of the firm and corporate

governance, followed by a section about corporate governance in The Netherlands and

functions of the supervisory board. Then we will discuss one particular function in more

detail.

2.1 Agency Theory

Agency theory in its simplest form discusses the relationship between two people: a

principal and an agent who makes decisions on behalf of the principal. Examples of

principal-agent relationships are (Douma and schreuder, 2002, P. 79):

The owner of a firm (principal) and the manager of a firm (agent), who makes

decisions affecting the owner’s wealth;

A manager (principal) and his subordinate (agent), who makes decisions affecting

the manager’s reputation;

A patient (principal) and his physician (agent), who makes decisions affecting the

patient’s health;

An insurance company (principal) and a person holding an insurance policy

(agent), who makes decisions affecting the insurance company’s cash flows.

In all these cases the principal “enjoys” the outcome of the activity of the agent. The

agent’s effort together with a random element determines the outcome (Shavell, 1979).

The principal then pays the agent a fee in return. In the first example an entrepreneur, or a

manager, raises funds from investors either to put them to productive use or to cash out

his holdings in the firm. The investors need the manager’s specialized skills to generate

returns on their investments. The manager on his turn needs the investors’ funds, since he

does not have enough capital of his own to invest or else he wants to cash out his

holdings (Shleifer and Vishny, 1997).


According to Eisenhardt (1989, P. 58) agency theory is concerned with resolving two

problems that can occur in agency relationships: “The first is the agency problem that

arises when (a) the desires or goals of the principal and agent conflict and (b) it is

difficult or expensive for the principal to verify what the agent is actually doing”. The

problem here is that the principal cannot monitor if the agent has behaved appropriately,

in the sense that he took a decision that serves the principal’s best interest. In the context

of the investor acting as principal and the manager as agent, the agency problem arises

when managerial actions lead to non-value maximizing investments being undertaken (or

value-enhancing investments foregone) despite their negative consequences for firm

value (Rediker and Seth, 1995). The second problem is risk sharing which arises when

the principal and agent have differing attitudes towards risk. The problem with risk

sharing is that different attitudes towards risk can result in different courses of actions

being preferred (Eisenhardt, 1998).

Given that there is no perfect congruence between managerial interests and those of

shareholders, Shleifer and Vishny (1997, P. 748) bring up the following question: “Why

do investors part with their money and give it to managers when both theory and

evidence suggests that managers have an enormous discretion about what is done with

that money, often to the point of being able to expropriate much of it?”

The answer to this question would be that shareholders must have some assurance that

managers will invest their money in a way that maximizes firm value. Corporate

governance is the terminology used to describe the defense of shareholders’ interests

(Tirole, 2001). More specific, Shleifer and Vishny (1997, P.737) write: “corporate

governance deals with the ways in which suppliers of finance to corporations assure

themselves of getting a return on their investment.” There are several mechanisms both

internal and external which offer this assurance and thus reduce the agency problem.

These include:

1. the threat of takeover (Grossman and Hart, 1980; Douma and Schreuder, 2002),

competition in product markets (Shleifer and Vishny, 1997), and the managerial

labor markets (Fama, 1980);


2. monitoring by large outside shareholders (concentrated ownership) (Shleifer and

Vishny, 1997; Demsetz and Lehn, 1985), monitoring by boards of directors and

monitoring of managers by managers themselves (Fama, 1980); and

3. incentive effects of management share ownership (Jensen and Meckling, 1976)

and other elements of compensation packages such as options (Murphy 1985;

Shleifer and Vishny, 1997)

2.1.1 Corporate governance systems

In the previous section we came across several corporate governance mechanisms, in this

section we will relate the use of these mechanisms to the context of two corporate

governance systems: the Anglo Saxon model of corporate governance and the German

bank based model.

In Anglo Saxon countries (the USA, the UK, Canada, Australia, New Zealand) a market

oriented system of corporate governance is present (Douma and Schreuder, 2002).

Market-oriented systems are characterized by well-developed financial markets, large

scale presence of open corporations with widely dispersed share-ownership, and active

markets for corporate control (Moerland, 1995). Network-oriented systems which prevail

in the countries of continental Europe and Japan are characterized by closely held

corporations, group membership of corporations, and large involvement of banks in

financing and controlling corporations (Moerland, 1995). Table 1 summarizes these and

other characteristics of the two governance systems.

Among the most notable differences is the difference in board systems between the

governance systems. Under the Anglo-Saxon system companies operate under a one-tier

board system. Under the one-tier board system companies are controlled by a board of

directors that consists of inside directors and outside directors (Douma and Schreuder,

2002). Inside directors (executive officers) are the full-time managers of the firm in

charge of day-to-day operations. Outside directors (non-executive officers) are experts

who are frequently also executive board members of other firms. Outside directors have

the task of protecting the shareholders’ interests and their primary accountability is to


shareholders. In practice their main duty is to advice inside directors on major policy

decisions (Weimer and Pape, 1999). Under the two-tier board system a company is

controlled by two boards. There is a management board that consist of inside directors

and a supervisory board that consists of outside directors. Under a two-tier board system

decision management and control are separated and respectively the responsibility of the

management board and supervisory board.

Table 1: Anglo-Saxon vs. Continental corporate governance: capital- and labour-related aspects

Source: Adapted from Cernat (2004. P.150); Weimer and Pape (1999, P.154)

Aspects Anglo-Saxon Continental

Capital-relatedRole of stock market Strong role in corporate finance Reduced

Role of banks Banks play a minimal role Important both in in corporate ownership corporate finance and control

Active external market Yes, hostile takeovers No, hostile takeovers for corporate control are common are rare

Board system One-tier board Two-tier boards; executive and supervisory board

Labour-relatedCo-operation between Conflictual or minimal contact Extensive at nationalsocial partner level

Labour organizations Fragmented and weak Strong, centralized unions


2.2 Corporate governance in The Netherlands.

The Netherlands has a rather unique governance system since it combines aspects of the

market-oriented system (having a well-developed equity market) and elements of the

more network-oriented control mechanisms (Postma et al., 2001). The focal point of this

system is a two-tier board structure consisting of a management board in charge of the

day-to day operations (Raad van Bestuur) and a supervisory board (Raad van

Commisarissen) (Postma et al., 2001; Maassen and Bosch, 1999). Shareholders rights

consist of electing members of the supervisory board and management board as well as

approving the annual accounts and dividend policy. Shareholders are furthermore

allowed to vote on important issues like mergers and acquisitions (de Jong et al., 2007).

The influence the supervisory board exerts varies widely depending on which legal

regime the firm adopts. There are basically three possibilities: the structural regime, the

mitigated structural regime, and the common regime (Postma and Ees, 2000).

1. The structural regime (structuurregeling) is legally required for corporations that meet

each of the following three criteria: (1) the corporation employs 100 or more employees

in The Netherlands, (2) it has an established works council, and (3) the corporation has a

subscribed capital plus reserves of at least 11.4 million euros (De Jong et al., 2000). The

only exemption to this rule is made for subsidiaries of a structural holding company. The

structural regime requires a supervisory board that is set up to take over several powers

from shareholders. The supervisory board has three primary functions: appoint, monitor

and dismiss members of the management board; establish and approve the annual

financial statements for presentation at the annual shareholders meeting; and approve

major decisions proposed by the management board (Chirinko et al., 2004; De Jong et al,

2000). As is to be expected the structural regime (structuurregeling) applies to the

majority of public limited liability companies (Naamloze Vennootschappen, NV’s)

(Chirinko et al., 2004).

2. The Mitigated Structure Regime (gewijzigde structuurregeling) applies to corporations

that meet the criteria of the structural regime but for which a foreign company holds more


than 50% of a Dutch subsidiary’s shares. This variation of the Structured Regime also

requires a supervisory board. The supervisory board in the Mitigated Structure Regime

however has less power than the supervisory board in the Full Structure Regime. This

regime for example prohibits the supervisory board from hiring and firing of members of

the management board (Postma and Ees, 2000; de Jong et al., 2000).

3. The common regime is applicable to public limited liability companies that do not

meet the above criteria. For these companies a supervisory board is optional. If a

supervisory board is in place, its main responsibility is restricted to ratify major business

decisions. All other decisions, such as the hiring and firing of members of the

management board are made at the annual shareholders meeting (Postma and Ees, 2000;

De Jong et al., 2000).

It has become apparent from this discussion that the legal regime a firm adopts largely

determines the board structure and the responsibilities of the supervisory board. In the

next section we will explore the functions of the supervisory board more thoroughly.


2.2.1 Functions of supervisory boards

In general there are three views relating the functional duties or roles of the (supervisory)

board, these are (Goodstein et al., 1994; Postma and Ees, 2000):

1. Interlocking function

2. Monitoring function

3. Strategic function

Resource dependence theorists have emphasized the interlocking function of boards.

They argue that boards perform an important function in linking organizations to their

environment. According to resource dependence theorist increasing the size and diversity

of a board helps to link the organization to its environment and secure critical resources,

including prestige and legitimacy (Goodstein et al., 1994). According to Pfeffer and

Salancik, “The greater the need for effective external linkage, the larger the board should

be” (1978, P.172). There are various ways through which an organization can link to the

environment and its critical resources. Linking an organization to its environment through

the board is one way; another might be through establishment of personal relations with

board members of firms on which yours depend. One way of doing so is through

interlocking directorates (Postma and Ees, 2000). Later on we will explain in detail how

interlocking directorates are created, for now it is sufficient to know that interlocking

directorships can be created by members of the management board and supervisory board

(Mizruchi, 1996). The network perspective of this interlocking function is based on the

idea that members of the supervisory board undertake the interlocking activity on behalf

of the firm in order to develop and maintain long-term relationships (Postma and Ees,

2000). These relationships should in turn reduce the organizations interdependence and

uncertainty.

Another function of the (supervisory) board is the monitoring and governing of

management on behalf of the shareholders. Remember from our discussion earlier that

public corporations are confronted with the possibility of the ‘agency problem’, the

situation in which the managers of the firm pursue their personal goals. Remember also

that we mentioned monitoring of managers by the board of directors as a mechanism to


reduce the ‘agency problem’. The same is true for monitoring of members of the

management board by members of the supervisory board. Members of the supervisory

board have been found especially well suited for this task because they are more likely to

be objective and independent, and more capable of resisting self-interested efforts by

inside managers to influence board decisions (Goodstein et al., 1994). Some of the tasks

the supervisory board performs in this context are approving decisions, appointing and or

removing ineffective managers.

The third view relating the functional duties or roles of the supervisory board is that of

strategic decision making and ratification. According to this view the board performs

besides the acquiring of resources and representing shareholders interest another

important function. This is the strategic function, which involves taking important

decisions on strategic change that help the organization adapt to important environmental

changes (Goodstein et al., 1994). This strategic function, besides the formation of new

strategies also entails the evaluation of former strategic decisions. Finally the board’s

strategic involvement has been found to be positively related to the financial performance

of an organization (Postma and Ees, 2000).

To conclude we will summarize the discussion of this section into a set of theories and

relevant aspects and indicators (see table 2). In the remainder of this thesis we will focus

on the interlocking function of boards.


Table 2: Board functions. Source: Postma and Ees (2000).

Board functions:Theoretical perspective

Relevant aspects Indicators

Interlocking function:- Resource dependency

- Social networking

Interlocking

Trust

Board sizeInsiders-outsidersBackground directorsReputation

Monitoring function:- Agency theory Monitoring Board compensation

Board committeesInsiders-outsidersCEO-duality

Strategic Function:-Strategic choice Strategic discretion Initiation of strategic decision

Evaluation/ratification


2.3 Board Interlocking

The interlocking between boards of directors is a heavily researched subject. “An

interlocking directorate occurs when a person affiliated with one organization sits on the

board of directors of another organization” (Mizruchi, 1996, P. 271). Interlocks can take

on several forms. There is an interlock when a director of a focal organization sits on the

board of another firm or when an individual from another organizations sits on the board

of the focal organization. There is also an interlock when two individuals A and B of two

different firms sit on the board of a third firm, X. The firms of A and B have an indirect

interlock with each other, while firm X is interlocked with the firms of A and B (Phan et

al., 2003). The research in this area has focused on how interlocks come to existence as

well as the consequences or effects of these interlocks. Especially the latter is a well-

researched topic in which several theories on the effects of interlocks have been

proposed. Previous research in this area has pointed out five potential reasons for

interlocks to exist.

2.3.1 Reasons for interlocking

Collusion

The collusion perspective tells us that interlocks facilitate inter-firm collusion. Firms that

are horizontally (within-industry) interlocked are said to gain advantages through

communication regarding pricing, advertising, and research and development, especially

in highly concentrated industries (Schoorman et al., 1981). The difficulty to identify

evidence on this issue, since there are almost no systematic data on firms’ motives for

interlocking, has led researchers to examine the consequences of horizontal (within-

industry) interlocks (Mizruchi, 1996). The results of the research in this area are at best

very mixed. For example, Pennings (1980) found in a study of US firms a positive

association between industry concentration and horizontal ties, while Burt (1983) in a

similar study of US firms found an inverted U-shaped relation, in which horizontal

interlocks where highest in industries with intermediate levels of concentration. Although

there are differences between the two studies, both indicate that up to some point a higher

level of interlocks is associated with higher levels of concentration. According to


Mizruchi (1996) this finding is consistent with the idea that up to some point

concentration facilitates horizontal interlocks, but that the industries that experience the

highest concentration, because of their small number of members have little need for

interlocking in order to collude.

Cooptation and Monitoring

Cooptation and Monitoring is a much more popular perspective with scholars and has its

roots in resource-dependence theory. Phan et al. (2003, P. 339) describe this perspective

as follows: “Resource-dependence theory holds that interlocks exist to coordinate the

inter-organizational exchange of resources (capital, information, and markets)”. The

implication of resource dependence theory would be that composition of the board should

be affected by environmental circumstances (Boyd, 1990). Several studies have indeed

reported relationships between a firm’s environment and the degree of interlocking.

Pfeffer (1972) studied board size and composition in relation to specific environmental

characteristics. He found that the percentage of board members representing financial

institutions is significantly related to the need for access to external capital as measured

by the debt-equity ratio. In addition, he found that the appearance of attorneys on the

board is positively related to the level of regulation.

In a more recent study by Lang & Lockhart (1990) the effect of increased industry

uncertainty on interlocking relationships among competitors in the airline industry was

researched. They observed board interlocks and the posited related variables in 1970,

which preceded deregulation, and in 1982, which followed it. The results of this study

indicated that firms would focus their interlocking on direct competitors, especially when

competitive uncertainty is high. In another study of 22 major industrial organizations

between 1955 and 1983, Mizruchi and Stearns found that those faced with declining

solvency during economic downturns were more likely to interlock with financial

institutions to increase their access to financial capital (Phan et al., 2003). Other studies

focusing on whether inter-firm dependence contributes to the existence of interlocks are:

Dooley (1969), Allen (1972), Bunting (1976), Pennings (1980), Burt (1983), Palmer et al

(1986) and Sheard (1993). The findings of these studies have been mixed, but on balance


they support the view that interlocks are associated with inter-firm resource dependence

(Mizruchi, 1996).

So far the studies we discussed almost exclusively focused on managing dependence

through cooptation. This is for example the case when a firm forms an interlock with a

bank to secure the flow of capital into the firm. Interlocks however can also have a non-

control oriented information effect. This means that interlocks can have another effect

then the control of critical resources. Useem (1984) was the first to discuss these non-

control oriented information effects of interlocks. His idea is that interlocks enable

managers to achieve an optimal ‘business scan’ of the latest business practices and

overall business environment. One consequence would be that we should see firms adopt

the practices and structures previously adopted by their interlock partners. Thus, if a focal

firm’s interlock partners do “X,” then the focal firm should be more likely to do “X”

subsequently (Haunschild and Beckman, 1998). Davis (1991) has shown this relationship

to occur in the case of adoption of poison pills. He explored the question of what factors

influenced the poison pill’s rapid spread among large corporations and found that a firm’s

interlock network centrality increases a firm’s rate of poison pill adoption. This

relationship has also been shown to occur for mergers and acquisitions (Haunschild,

1994), adoption of the multidivisional form (Palmer et al., 1993), and paying acquisition

premiums (Haunschild, 1994).

Legitimacy

The third perspective frequently mentioned in the literature as a significant motive for

organizations to interlock is ‘Legitimacy’.

The concept of legitimacy comes from institutional theory that suggests that institutional

environments put pressure on organizations to justify their activities (Oliver, 1990;

Barringer and Harrison, 2000). These pressures are a driving force for organizations to

increase their legitimacy in order to appear in agreement with the prevailing norms,

beliefs and expectations of the external environment (Oliver, 1990; Barringer and

Harrison, 2000). One way for an organization to increase its legitimacy is through its

board of directors. An organization can achieve this by hiring prestigious people to its


board of directors or to have its own directors sit on prestigious boards (Galaskiewicz,

1985). Mizruchi (1996, P. 276) demonstrates the relevance of legitimacy to organizations

with the following example: “When investors decide whether to invest in a company, they

consider the firms strength and the quality of its management. By appointing individuals

with ties to other important organizations, the firm signals to potential investors that it is

a legitimate enterprise worth of support. The quest for legitimacy is thus a further source

of interlocking.” Other targets of these legitimacy efforts may include resource-granting

agencies, the general public or external shareholders (Oliver, 1990). Legitimacy may thus

also play an important role in securing resources. It may be easier for a firm to borrow

money from a bank if the bank believes the firm is directed by reputable individuals

(Dimaggio and Powell, 1983). The bank may thus be more likely to lend the firm money

if the firm already has bankers its board.

Empirical studies that relate legitimacy to board interlocking are however scarce, because

the legitimacy model is difficult to test and its predictions are closely related to the

cooptation model (Oliver, 1990; Mizruchi, 1996).

Career advancement

Career advancement approaches interlocks from the perspective of individuals.

Interlocks occur between organizations, but are created by individuals. This perspective

suggests that from the point of view of a director, interlocks are a way to advance one’s

career (Mizruchi, 1996). There are several studies that have proposed theories of

interlock formation that treat interlocks in terms of the individuals who create them.

These studies view interlocks not primarily as an inter-organizational phenomenon

facilitating a firm’s external links. Rather this perspective views interlocks as facilitating

an individual’s career, not ignoring that there may be positive consequences for the

director’s firm as well. According to Zajac (1988) economic incentives, a desire for

prestige and career objectives are the motivators of individual board members to hold

multiple board memberships. In this view interlocks have little to do with the desire to

link organizations. Stokman et al. (1988) found in a study of large Dutch firms over a 20-

year period (1960-1980) that the majority of director appointments were drawn from a

small group of persons with a broad view on the industrial scene on the basis of


experience in executive positions in large companies. It is illustrative in this regard that

only 405 persons were responsible for all interlocks in 20 years. The authors suggest, in

line with Zajac’s argument, that these directors were chosen for their individual

characteristics rather than for the organizations they represent (Mizruchi, 1996). Directors

who are more heavily interlocked are thus more likely to be chosen for new board

positions (Davis, 1993). These findings suggest that interlocks provide benefits for the

individual director as well as the inviting firm, but that they are independent of any

specific relations between the connected firms (Mizruchi, 1996).

Social Cohesion

The Social Cohesion perspective suggests that board interlocks exist for class integration,

defined as the mutual protection of interests of a social class by its members (Phan et al.,

2003). This process is driven by the identification and appointment of director candidates

with same aspirations, class backgrounds and lifestyles (Koenig and Gogel, 1981; Phan et

al., 2003).

At the other end of the spectrum is the view that interlocks serve individual corporations.

These two views of interlocks are distinct, but not contradictory functions of board

interlocking (Ornstein, 1984). Several empirical studies have focused on establishing

Social Cohesion as a reason for interlocks to exist. The difficulty however is to

empirically distinguish between inter-organizational coordination and control and class

integration as reasons for interlocks. This limitation has been overcome by modeling the

frequency with which accidentally broken interlocks were reconstituted (Ornstein, 1984;

Palmer et al., 1986). For Koenig et al (1979), Ornstein (1980), and Palmer (1983) the

frequency with which accidentally broken interlocks were reconstituted was an indicator

of the degree to which such interlocks represented important inter-organizational

linkages. These authors figured that because most of the accidentally broken interlocks

were not reconstituted, this phenomenon is not primarily an organizational phenomenon.

They inferred from this that the majority of accidentally broken interlocks reflected intra-

class social ties, rather than inter-organizational resource dependence or control ties

(Mizruchi, 1996). Stearns and Mizruchi (1986) argued that even interlocks that

represented resource-dependence ties will not necessarily be reconstituted with the same


firm. Instead they looked at what they called functional ties, which means these ties can

be reconstituted by interlocking with a different firm in the same industry as the previous

tie. Even when taking account of these functional ties, they still found that more than half

of the broken ties were not reconstituted. This research contributed to the understanding

that interlocks reflect both inter-organizational and intra-class ties (Mizruchi, 1996).

Table 3 summarizes the discussion of the potential reasons for interlocks and provides

their research-based evaluations.

Table 3: Potential reasons for interlocks and research-based evaluations.

Potential reasons for interlocks Research-based evaluations

Collusion: interlocks represent intentional attempts Plausible but unlikely: No systematic by organizations to engage in practices that restrict evidence that collusion is a motivation for competition. interlocks or that interlocks would be effective in this regard.

Cooptation and monitoring : interlocks are used On balance, the evidence supports the view by firms to co-opt sources of environmental that a minority of interlocks are associated uncertainty as well as for the purpose of exerting with interfirm resource dependence.inter-organizational control.

Legitimacy: interlocks are used to increase a firm’s Conceptually expected, but little empirical environmental legitimacy through prestigious research by has been conducted. Thisconnections. model is difficult to test and closely related to the cooptation model.

Career advancement: From the perspective of Supported empirically. This view is the individual director, interlocks are ways to complementary rather than opposing toto advance one’s career. alternative views

Social cohesion: interlocks are in effect Evidence suggests that interlocks can social ties among members of the upper capitalist partly represent intra-class ties in additionclass. to inter-organizational ties.

Source: Adapted from Heracleous and Murray (2001, P. 150).


2.4 Number of board interlocks and firm performance (Literature review)

2.4.1 Advantages Associated with more interlocks

In the previous section we discussed five potential reasons for interlocks to exist. The

question that remains unanswered however is: Why is so much research directed at

studying potential motives of interlocks, when at the same time it is difficult to

distinguish between these motives? The answer has probably everything to do with the

differing consequences that different motives for interlocking predict. Empirical research

on interlocks has focused on interlocks as a predictor of firm performance (Pennings

1980; Burt, 1983) mergers and acquisitions (Haunschild, 1993; Palmer et al., 1995), and

corporate behavior (Koenig, 1979; Ratcliff, 1980)

Relating interlocks to firm performance, resource dependence theory has been the

primary foundation for the perspective that more highly interlocked boards will be

associated with higher levels of firm performance (Boyd, 1990; Mizruchi, 1996). Besides

the cooptation and monitoring perspective which stems from resource-dependence

theory, collusion, and legitimacy also associate board interlocks with higher levels of firm

performance (Schoorman et al., 1981; Mizruchi, 1996). The collusion perspective

suggests that interlocks enhance inter-firm collusion. According to this view firms

manage competitive uncertainty through use of interlocks (Zajac, 1988). Central to this

viewpoint is the emphasis on cooperation, coordination and collaboration among firms,

rather than domination, power, and control (Oliver, 1990). The advantages of these

interlocks would include communication regarding pricing, advertising and research and

development (Schoorman et al., 1981). The result should be visible in higher levels of

firm performance; otherwise it would not be rational for firms to collude. Research has

shown that the market contact between competitors generates weaker competition

between firms, higher prices and higher survival rates (Brass et al., 2004). Moving along

the lines of the cooptation and monitoring perspective, interlocks would lead to improved

firm performance because they allow the firm access to critical resources, legitimacy and

information (Phan et al., 2003). According to Galaskiewicz (1985, P.282.): “The direct

procurement of facilities, materials, products, or revenues to ensure organizational

survival has been an overriding reason for establishing interorganizational relations.” In


contrast to the collusion perspective, the cooptation and monitoring perspective suggests

that resource scarcity motivates organizations to attempt to exert power, influence, or

control over organizations that possess the required scarce resources (Oliver, 1990). For

example, a corporation may be motivated to form an interlock with a financial institution

in order to gain influence and control over capital and to increase its power relative to

other firms competing for financial resources in the same industry (Oliver, 1990). As we

pointed out earlier, interlocks can also have a non-control oriented information effect. In

this respect interlocks enable directors to achieve an optimal ‘business scan’ of the latest

business practices and the overall business environment (Useem, 1984). This should

allow the board of directors to make better (informed) decisions resulting in a higher

level of firm performance. The logic underlying this argument also suggests that the

advantages of interlocks will increase as the number of ties increases (Keister, 1998). The

legitimacy perspective suggest that interlocks can lead to higher levels of firm

performance because of easier access to resources, but also the procurement of favorable

treatment such as a better price (Schoorman et al., 1981). This benefit can be explained

for as a means of uncertainty reduction. The recruitment of well-placed and prominent

directors enhances the social standing of the organization in the corporate world and so

serves a useful public relations function (Scott, 1985). The “favorable” image that a

highly legitimate board of directors will communicate to suppliers, customers, and

stockholders is one of an organization with reliable and predictable operations. This will

make that for example suppliers will be more prone to transact with the organization, and

in turn this will enable the firm to negotiate more favorable terms (Schoorman, 1981).

Table 4 summarizes the discussion of the potential reasons and their predicted effects on

firm performance.


Table 4: Potential reasons for interlocks and predicted effects on firm performance

Potential reasons for interlocks Predicted effects

Collusion: Interlocks enhance inter-firm collusion.

Advantages regarding communication about,

prices, advertising and research and development

will be obtained. This will result in higher levels

of firm performance, higher prices, weaker

competition, and higher survival rates.

Cooptation and monitoring: Interlocks allow firms better access to critical

resources, legitimacy and information. This will

lead to higher levels of firm performance,

because firms will have lower costs of acquiring

critical resources, and will be able to make better

(informed) decisions.

Legitimacy: Interlocks will increase a firm’s legitimacy.

This will lead to higher levels of firm

performance because the firm will have easier

access to critical resources and will be able to

negotiate more favorable terms.

Source: My own elaboration of: Schoorman et al., 1981; Brass et al., 2004; Phan et al.,

2003; Keister, 1998; Galaskiewicz, 1985; Oliver, 1990; Useem, 1984; Scott, 1985; Zajac,

1988.


A considerable amount of empirical research has been conducted in an attempt to

establish a positive relation between interlocks and firm performance. Only a few studies

have managed to do so: Phan et al (2003) found in a study of Singaporean companies

that the number of inter-industry interlocks was positively and significantly related to the

Return on Equity. In another study, Boyd (1990) tested several hypotheses that relate

measures of environmental uncertainty to board size and number of interlocks. He found

that high-performing firms across all industries are more responsive to environmental

uncertainty. He found that firms respond to the same source of uncertainty by increasing

their number of interlocks and that high-performing firms would be more inclined to do

so. This research obviously does not provide much information on the causal order of this

relationship. In a study of Australian firms Kiel and Nicholson (2003) found a positive

relationship between interlocks and a market based measure of performance. The authors

however believe that this relation could exist due to the relationship of board size with

performance. Keister (1998) found in her study of Chinese business groups strong

evidence that interlocking directorates have a positive effect on firm performance.

In another study of interlocks, Meeusen and Cuyvers (1985) compared the situation in

three countries (The Netherlands, Belgium, and the USA). One of their main findings is

the existence of a positive relation between financial interlocks and performance for

Belgium and the Netherlands. The study however could not confirm other existing

relationships in the literature, such as the alleged positive relation between profitability

and interlocking directorships with banks in the USA. Besides these studies there are only

a few others which have found a positive effect of interlocks on firm performance.

Bunting (1976) found an inverted U-shaped curve, which suggests that performance

increases in relation to interlocks until a certain point at which there is a negative

relationship between performance and the number of interlocks.

The following table gives a summary of these studies.


Source: Author

Table 5: Overview of Empirical Research on interlocks and firm performanceSample Number of

interlocksPerformance Measure

Findings

Phan et al (2003).

191 companies listed at the Singaporean stock exchange(1990)

Mean interlocks: 6.62

SD: 5.39

Return on Equity (ROE)

Inter-industry interlocks are positively and significantly related to ROE.

Boyd (1990) 147 U.S. publicly held companies (1980)

Mean: 22*total per board

Sales growth and ROE

High performing firms are more responsive to uncertainty and respond by increasing interlocks.

Kiel and Nicholson (2003)

348 companies trading on the Australian Stock Exchange Limited (ASX)(1996)

Mean: 6.38SD: 6.08

Tobin’s Q and ROA

Weak simple positive relationship between interlocks and Tobin’s Q

Keister(1998)

535 Chinese firms organized in 40 business groups (1988-90)

Mean: 0.40SD: 0.496

Profit Presence of interlocks in a business group has a positive effect on the profits

Meeusen and Cuyvers(1985)

200 production and commercial companies

N/A Net profit before taxes divided by sales

Positive relation between financial interlocks and performance for The Netherlands and Belgium.


2.4.2 Disadvantages associated with more interlocks

Researchers have not reached consensus on the idea that interlocks will be associated

with better firm performance. Non and Franses (2007), for example, suggested that

directors with many directorships get short of time and cause the performance of their

firms to detoriate. This is the so-called busyness hypothesis. In their research they

defined a busy director as one with more than four directorships. They found that the

ratio of non-busy directors in a board has a positive influence on performance when

measured by the price-earnings and price-to-book ratios. Another much cited

disadvantage of interlocks has everything to do with the Social Cohesion perspective of

interlocks we discussed earlier. This view treats interlocks as a mechanism to protect the

mutual interest of a social class. This process is driven by the identification and

appointment of director candidates with same aspirations, class backgrounds and

lifestyles (Koenig and Gogel, 1981; Phan et al., 2003). Interlocks designed to protect a

managerial class have no a priori implication for firm performance (Phan et al., 2003).

Thus from this view the effect of interlocks on firm performance can be negative, neutral

or positive. Board diversity has been shown to result in higher creativity, innovation and

quality decision-making which increase firm performance (Erhardt et al., 2003). From

this point of view interlocks can have a negative effect on firm performance because of

the absence of diversity in the board and a homogenous upper class of directors (Non and

Franses, 2007).


Table 6: Potential reasons for interlocking and predicted effects on firm performance

Source: My own elaboration of: Koenig and Gogel, 1981; Phan et al., 2003; Erhardt et al,

2003; Non and Franses, 2007.

Potential reasons for interlocking Predicted effect

Career advancement: No a priori effect of interlocking. The

effect can be either positive, negative

or neutral. An explanation for a

negative effect would be the busyness

hypothesis. Career advancement

suggests that directors are chosen

from a small group of people, so that

an individual has multiple

directorships and can become too

busy.

A positive effect can be the result of

the directors experience.

Social cohesion: No a priori effect of interlocking. The

effect can be either positive, negative

or neutral. An explanation for a

negative effect would be that social

cohesion causes board of directors to

be a too homogenous group.


Several studies have found in support of this view of interlocks a negative relationship

between board interlocks and firm performance. Okazaki and Yokoyama (2002) found in

a study of interlocking relationships between banks and non-banks that interlocks have a

negative effect on the liquidity performance and profitability of banks. In addition,

interlocks increased the probability of bank closure in 1927, the year of the Showa

financial crisis. In a similar study, Fligstein and Brantley (1992) tested the hypothesis that

bank interlocks enhance firm performance because of their ability to reduce resource

dependence. They could not establish such a relation empirically; instead they found that

firms that had lots of interlocks with banks were less profitable. A plausible explanation

for this could be that firms that are in troublesome environments, firms with a low

profitability reduce their dependence by interlocking (Burt, 1983).

In a study of corporations in The Netherlands, Van Ees et al (2003) found that the

percentage of outsiders in the supervisory board has a negative effect on firm

performance. In their research they define outsiders as supervisory board members that

hold board positions at other firms. As a possible explanation for this result the authors

hypothesize that members of the management board under the structural regime indeed

influence the appointment of members of the supervisory board. The authors go a step

further by saying that under the system of co-optation it may even be so that friendly

persons are given jobs for not monitoring activities.

In another study of corporations in the Netherlands Non and Franses (2007) found the

same negative relation between interlocking directorates and firm performance. This

effect appeared with a one year lag.

The following table gives a summary of these studies.


Source: Author

Table 7: Overview of Empirical Research on interlocks and firm performance

Sample Number of interlocks

Performance Measure

Findings

Okazaki and Yokoyama(2002)

1182 Japanese banks.

Mean number of interlocks: 7.85

Return on Equity (ROE)

Interlocking is negatively related to bank liquidity and profitability.

Fligstein and Brantley (1992)

100 largest industrial corporations in the United Sates.

Mean: 2.71SD: 2.81

Return on assets, sales and equity

Highly (Bank) interlocked firms are less profitable in terms of these performance measures.

Postma, van Ees and Sterken (2003)

94 Dutch listed non-financial companies(1996)

N/A, Measures the percentage of outsiders

Market-to-book ratio, arithmetic average ROA, ROE and ROS

Percentage of outsiders negatively affects firm performance

Non and Franses(2007)

101 Dutch listed firms(1994-2004)

Mean:0.65SD:0.55*interlocks per director

Price-to-book ratio and Return on equity

A small Negative effect of interlocks on firm performance that occurs with a lag.


3. Interlock effects on firm performance; an empirical study

This part elaborates on the research conducted in order to establish a relation between

board interlocks and firm performance. This chapter will outline the data, hypotheses,

and research methodology used in the study.

3.1 Data

We gathered data on supervisory and management boards of 80 Dutch firms, listed at

Euronext in Amsterdam. We started out with a sample of 119 firms. We then excluded all

companies with a one-tier board structure. We then excluded all banks, insurance

companies, and other financial services companies from our sample which is standard in

the empirical corporate finance literature due to problems in computing appropriate

valuation measures (Kiel and Nicholson, 2003; Beiner et al., 2004). However considering

that access to capital has been seen as a key benefit to a company, it is necessary to

consider interlocks with these excluded firms (Kiel and Nicholson, 2003). This leaves us

with a final sample of 80 publicly listed firms. These firms can be classified into eight

industries according to the Dow Jones industry classifications (ICB): technology, basic

materials, healthcare, oil & gas, consumer goods, consumer services, and

telecommunications. These industry classifications correspond with the Dow Jones

Industrial indexes which follow the performance of industries.

In the Netherlands the focal point of the Dutch regime of corporate governance is the

two-tier board structure consisting of a management board (Raad van Bestuur) in charge

of day-to-day operations and a supervisory board (Raad van Commissarissen) (Van Ees

et al, 2003). In this research two types of interlocks will be considered. Most of the

interlocks are formed by supervisory board members that hold board positions at other

organizations (Van Ees et al, 2003). Most empirical research uses this definition of

interlocks. This research will use this definition of interlocks as well as a definition of

interlocks where members of the management board of the focal firm, who also sit on the

supervisory board of another firm, form interlocks. The choice to use these two different


definitions is driven by the fact that in the Netherlands the management board and the

supervisory board have clear distinct responsibilities and so differ in the way they

influence firm performance.

Data on supervisory board and management board interlocks were collected from annual

reports and the REACH database for the years 2004 and 2005.

Supervisory and management board interlocks will be treated as follows. For example,

when A and B, both members of the management board of company X also both sit on

the supervisory board of company Y, then this will be counted for as one interlock for

company X. When for example directors D and E of the supervisory board of company Z,

simultaneously sit on the management board of respectively company G and H, then this

is counted for as two interlocks for company Z. Finally the number of interlocks is

divided by the board sizes, to reflect the differences in board sizes between firms. The

resulting average of interlocks will be the number of interlocks that will be used in the

estimation of the regression models.

Besides these data on interlocks, also data on the financial performance of the firms for

the years 2005 and 2006 has been gathered from the REACH database. There are various

performance measures, which mainly fall in two categories. First there are the accounting

measures, like return on equity, return on assets and sales. Second, performance can be

measured with the use of market data; in this category we have measures as Tobin’s Q

and market-to-book ratio (Van Ees et al., 2003). There is no consensus in the literature on

which of these measures to use. In this research we try to establish a relation between

interlocks, a measure related to a director’s activities, and a firm’s financial performance.

We will therefore emphasize the use of accounting based measures, as these are more

subject to a manager’s influence than market-based measures of financial performance

(Dalton et al., 1998). Accounting based measures of financial performance are in this

regard better able to reflect the effect of management’s prior decisions. Accounting

measures however also display some disadvantages. They are for example subject to

manipulation and they lack standardization in the handling of international accounting

conventions (Dalton et al., 1998). For this reason we will also include a market-based

indicator of performance.


The performance of the firms in this research will be measured by the Return on Equity

(ROE), Return on Assets (ROA), a standardized arithmetic average of ROE and ROA,

and the stock return.

Lastly, we gathered data on several control variables. We use these variables to condition

for ‘normal’ corporate performance as an independent variable. The conditioning

variables proxy for three classes of corporate performance (Van Ees et al., 2003). The

first is product-market performance (size and diversification). Second is financial market

performance (financial structure). Third is product market uncertainty (liquidity ratio).

Finally we use industry dummies to take account of the industry specific characteristics

of the performance model.

The conditioning variables are the following:

Size of the firm: proxied by the log of total assets and log of total sales

Financial structure: proxied by debt ratio

Diversification of the firm (denoted by a BIK-code): proxied by the number of

non-core activities.

Uncertainty faced by the firm: proxied by the liquidity ratio. We include liquidity

ratio to control for financial resources of the firm, which may operate as

organizational slack and affect the organizational reaction to the performance gap.

Organizational slack operates as a buffer to protect an organization from

turbulence in its environment. (Chang, 1996).

Degree to which a firm is established: proxied by the log of the age (older firms

are more established, and are more likely to have interlocked boards).

Industry dummies: in total 8 industries are included.

We came across these control variables frequently in the literature. We do however not

include several other variables found frequently to condition for corporate performance.

We do not include growth in sales & assets because this variable has been found most

important in conditioning performance at the industry level analysis of performance

(Capon et al., 1990). At the firm level of analysis the importance of this variable is much


smaller. In addition we do not include market share because of a complete lack of data,

and also research & development because many data were missing.

3.2 Hypotheses

Hypothesis 1

H0 The number of supervisory board interlocks does not influence firm performance. H1 The number of supervisory board interlocks positively influences firm performance.

Hypothesis one will consider the effect of supervisory board interlocks on the firm’s

financial performance. The question that accompanies this hypothesis is: Do firms with a

higher number of supervisory board interlocks show better financial performance than

firms with lower number of supervisory board interlocks.

Hypothesis 2

H0 The number of management board interlocks does not influence firm performance. H1 The number of management board interlocks positively influences firm performance

Hypothesis two will consider the effect of management board interlocks on the firm’s

financial performance. The question that accompanies this hypothesis is: Do firms with a

higher number of management board interlocks show better financial performance than

firms with lower number of management board interlocks.


3.3 Methodology

The method used to see which of the proposed predicting variables has a significant

influence is the ordinary least squares (OLS) regression. Some descriptive statistics on

the performance indicators are provided in table 8. Table 9 does the same for the

independent variables MGB and SVB, which respectively represent the average number

of interlocks per member of the management board and the average number of interlocks

per member of the supervisory board. Table 10 provides definitions and descriptive

statistics on the control variables. These control variables are the same for each model we

estimate.

Table 8: Definitions and descriptive statistics for the performance indicators

ROE = Return On Equity (Net Income as a percentage of equity capital).

ROA = Return On Assets (Net Income as a percentage of total assets).

AVERAGE = Standardized arithmetic average of ROE and ROA.

STOCK = The percentage growth of the stock price (stock return).

Performance indicator 2005 2006

ROE Mean 7,09 13,12

S.D. 50,31 27,42

Median 16,49 17,25

ROA Mean 8,35 7,43

S.D. 27,88 9,65

Median 6,68 7,04

AVERAGEMean 2,01228E-17 -2,01228E-17

S.D. 0,38 0,95

Median 0,09 0,08

STOCKMean 31,40 25,49

S.D. 35,71 29,60

Median 25,06 27,24


Table 9: Definitions and descriptive statistics for the independent variables.

Table 10: Definitions and descriptive statistics for the control variables

MGB = Average number of interlocks per member of the management board.

SVB = Average number of interlocks per member of the supervisory board.

2004 2005

MGB Mean 0,56 0,51S.D. 0,79 0,78Median 0,25 0

SVBMean 1,95 1,93S.D. 1,04 1,10Median 1,82 1,78

TS = Total sales, measured by the log of total sales

TA = Total assets, measured by the log of total assets

AGE = Age of the firm, measured by the log of numbers of years since establishment

LIQ = Liquidity ratio

DEBT = Debt to total assets ratio

DIV = Indicator of diversification ( the number of non-core activities are counted for each firm)

INDUSTRY = Industry to which the firm belongs (8 industries). The average industry returns of the 8 the Dow Jones industries for the years 2005 and 2006 are used.

Control variable 2005 2006

TS(LOG)

Mean 8,62 8,68S.D. 1,08 1,01Median 8,78 8,83

TA(LOG) Mean 8,62 8,68

S.D. 1,08 1,01Median 8,78 8,83

DEBT Mean 0,52 0,54

S.D. 0,17 0,17Median 0,52 0,56

LIQ Mean 1,38 1,17

S.D. 2,23 0,93Median 0,91 0,97


Models

We will test our hypotheses by using different regression models. We basically have four

models for each of the two hypotheses. The four models represent the four performance

measures.

ROA i = 0 + 1 MGB i + 2 LOG (TS i ) + 3 LOG (AGE i ) + 4 LOG

(TA i ) + 5 LIQ i + 6 IND i + 7 DIV i + 8 DEBT i + i

(Model 1)

In model 1, ROA is the dependent variable. ROA represents the Return on Assets of a

firm. The subscript ‘i’ depicts the fact that the variable concerns one firm. As there are 80

firms in the sample, i= 1,…..80. With model 1 we test the hypothesis that the number of

management board interlocks does not influence firm performance against the alternative

hypothesis that management board interlocks positively influence firm performance. As

independent variables in this model we have MGB, the number of management board

interlocks as well as the control variables described earlier. Model 1 is a general model;

the actual models we test are more specific. There are 8 variations to this model which

we test (see table 11). We get the tested variations to the general model by replacing

ROA with ROA 2005 and ROA 2006, and MGB by MGB 2004, MGB 2005, SVB 2004,

and SVB 2005. We define SVB as the number of supervisory board interlocks. Table 9

provides the formal definitions of SVB and MGB. We include all these variations to

allow for a lagged effect of MGB and SVB on ROA. So we test for a non-lagged effect,

an effect with a one-year lag, and an effect with a two-year lag. This lagged effect makes

Table 10 continued 2005/2006

DIV Mean 4,55S.D. 3,42Median 4

AGE(LOG) Mean 1,72

S.D. 0,44Median 1,81

NDUSTRY Mean 15.31

S.D. 6,28Median 13,55


it possible for us to see if the effect of interlocks is immediately quantifiable or whether it

takes some time before the effect can be noticed. Another advantage of using lagged

interlocks is that it improves the robustness of the estimates. Indeed, there are researchers

that have pointed to a possible reverse causality that may exist between the number of

interlocks and firm performance. The number of interlocks improves firm performance,

but good performing firms could attract more interlocking directors (Non and Franses,

2007). By including lagged interlocks we eliminate any reverse causality problem.

Table 11: Tested variations to the general model 1

Independent variable /Dependent variable

MGB 2004 MGB 2005 SVB 2004 SVB2005

ROA 2005 X X X X

ROA 2006 X X X X

The general models 2, 3, and 4 are as follows:

ROE i = 0 + 1 MGB i + 2 LOG (TS i ) + 3 LOG (AGE i ) + 4 LOG


(Model 2)

AVERAGE i = 0 + 1 MGB i + 2 LOG (TS i ) + 3 LOG (AGE i ) + 4 LOG (TA i ) + 5 LIQ i + 6 IND i + 7 DIV i + 8 DEBT i + i

(Model 3)

STOCK i = 0 + 1 MGB i + 2 LOG (TS i ) + 3 LOG (AGE i ) + 4 LOG


(Model 4)


Again, as for model 1, models 2, 3, and 4 have 8 variations which test for a non-lagged

effect of board interlocks, an effect with a one-year lag and an effect with a two-year lag.

Model 2 has the return on equity as the dependent variable, model 3 the standardized

arithmetic average of the return on equity and return on assets and model 4 the stock

return. Table 8 provides the formal definitions for the dependent variables.

4. The main empirical results

In this chapter we will present the main empirical results of our regression analysis.

Section 4.1 will deal with hypothesis one with which we test the effect of supervisory

board interlocks on firm performance. Section 4.2 will discuss the results of the

regression models which test the effect of management board interlocks on firm

performance. But before we continue with these empirical results, we will have a look at

the descriptive statistics of table 9.

From the table we observe that the mean number of supervisory board interlocks is larger

than the number of management board interlocks. This is consistent with the idea that

most interlocks are formed by supervisory board members who hold board positions at

other firms. The mean number of interlocks per supervisory board member is 1, 95 and 1,

93 in respectively 2004 and 2005. These numbers show a considerable difference with

the mean number of interlocks found by Non and Franses (2007). They found a mean

number of interlocks per director of 0, 65. This is not surprising however when we

carefully examine the differences in samples. Meeusen and Cuyvers (1985) suggest

differences in countries and sectors examined, sample size, sample period, and sampling

method to be one of four major factors that explain the contradicting results produced in

interlock research. We find that Non and Franses include financial institutions in their

sample while this study does not. Moreover the samples have only 64 organizations in

common. This equals 63% of Non and Franses’ total sample size and 80% of our total

sample. Unfortunately we can not determine the average number of interlocks per

director for these 64 organizations in the sample of Non and Franses, making comparison


of these organizations impossible. Comparing the same organizations is very important

however because we measure the average number of interlocks per director, causing not

just the number of interlocks but also the board size to be important. We observe that the

average board size of the sample in Non and Franses’ study is 5, 36 where this study

reports an average board size of 4, 96. The consequence of this would be that with the

same number of interlocks, Non and Franses would have a lower number of average

interlocks per director. Lastly the way in which interlocks are treated may explain for the

difference in the average number of interlocks. Although the treatment of multiple

interlocks is the same for both studies there still may exist differences in the actual

counting of interlocks which we can not observe.

4.1 Relationship between supervisory board’s interlocks and firm performance

In this section we will test the null hypothesis that supervisory board interlocks do not

influence a firm’s performance against the alternative hypothesis that supervisory board

interlocks have a positive influence on firm performance. We will only report the result

of the models in which supervisory board interlocks (SVB) is a significant variable.

Table 12 reports the results of the regression analysis for the models with the number of

supervisory board interlocks in 2005 as the predictor variable. From the table we can

observe that supervisory board interlocks (SVB 2005) have a significant positive

influence on various performance measures.

We have a non-lagged effect for the models with the dependent variables ROE 2005 and

STOCK 2005. For the ROE 2005 dependent variable, SVB 2005 and DEBT are

significant at the 10% level. LIQ is significant at the 1% level For the STOCK 2005

dependent variable; SVB 2005 and DIV are significant at the 10% level. The positive

sign for SVB 2005 underwrites that the number of interlocks positively influences firm

performance. This result is in line with the findings of Phan et al. (2003) who found that

inter-industry interlocks are significantly and positively related to ROE.


Drawing on Capon and colleagues’ (1990) findings for the control variables we find only

the debt ratio to have the expected (negative) sign with respect to firm performance. We

expected a negative sign for diversification, which turned out to be positive, and a

positive sign for liquidity ratio which turned out to be a negative sign. For the variables

total assets and total sales that control for firm size Capon et al. did not find a consistent

effect. We repeatedly found a positive sign for total sales and a negative sign for total

assets.

Table 12 also reports an effect that occurs with a one-year lag. These are the models with

ROE 2006, ROA 2006, and AVERAGE 2006 as dependent variables. In all these models

the logarithm of total sales, Debt ratio and supervisory board interlocks (2005) are

significant. In addition, the logarithm of total assets is significant in the ROA 2006 and

AVERAGE 2006 models. As with the direct effect of supervisory board interlocks on

ROE 2005 and STOCK 2005, supervisory board interlocks also have a positive influence

on the above performance measures with a one-year lag.

None of the models show significant results for SVB (2004). This means that if we

replace the supervisory board interlocks (2005) with supervisory board interlocks (2004)

we do not observe SVB (2004) to be significant in any of the models. From this we can

conclude that supervisory board interlocks do not significantly influence performance

with a two-year lag. For the effect with a one-year lag we found SVB (2005) to be

significant and SVB (2004) not.

From the preceding discussion we can conclude that there is evidence in support of our

hypothesis that supervisory board interlocks positively influence firm performance. The

evidence is however very slim because its significance is only identifiable at the 10%

level. In addition, the fact that the test offers mixed results in the form of a significant

influence of SVB 2005 with a one-year lag and non-significant effect of SVB 2004 with a

one-year lag, does not contribute to the credibility of the statement either.


Table 12: Results of regression with supervisory board interlocks as predicting variable

Dependent variable

Board variable:

SVB (2005)

ROE 2005

6,302(3,237)

STOCK 2005

7,380(4,361)

ROE 2006

5,608(2,971)

ROA 2006

1,769(0,994)

AVERAGE2006

0,194(0,099)

Control variables

TS(LOG) 4,248(5,054)

3,786(6,809)

18,815 (7,409)

11,638 (2,478)

0,946 (0,247)

TA(LOG) 1,590(4,783)

-1,899(6,445)

-9,075(7,844)

-9,971 (2,624

-0,682 (0,262)

DEBT -37,995(22,538)

-30,267(30,365)

-76,287 (19,969)

-27,902 (6,680)

-2,673 (0,666)

LIQ -19,542 (1,527)

-0,925(2,058)

1,855(3,916)

1,430(1,310)

0,108(0,131)

DIV -0,849(0,933)

2,143(1,257)

O,684(0,837)

-0,112(0,280)

0,007(0,028)

AGE(LOG) -4,347(7,071)

-2,827(9,527)

-1,080(6,469)

-0,530(2,164)

-0,047(0,216)

INDUSTRY 0,037(0,484)

0,154(0,653)

0,076(0,441)

0,041(0,148)

0,004(0,015)

Statistics

Observations

R 2

800,757

800,125

800,326

800,390

800,370

Note to the table: This table displays the results of the regression analysis related to null hypothesis that supervisory board interlocks do not influence firm performance. Therefore in the first column are given the independent variable SVB 2005 along with the control variables. At the top of columns 2-6 are the dependent variables of the particular model. The control variables are all non-lagged, which means that the control variables are given for the same year as the dependent variable. The numbers between brackets represent the standard errors. Above the numbers between brackets are the coefficients. The symbols ***, **, * denote statistical significance at the 1%, 5%, and 10%, respectively.


4.2 Relationship between management board interlocks and firm performance

In this section we will test the null hypothesis that management board interlocks do not

influence a firm’s performance against the alternative hypothesis that management board

interlocks have a positive influence on firm performance. We will only report the result

of the models in which management board interlocks (MGB) is a significant variable.

Table 13 reports the results of the regression analysis for the models with the number of

management board interlocks in 2004 and 2005 as the predictor variable. From the table

we can observe that management board interlocks in 2005 (MGB 2005) has a significant

positive influence on the stock return in 2005 (STOCK 2005). The same effect appears to

happen with a one-year lag.

For the STOCK 2005 model, MGB 2005 is significant at the 1% level and diversification

(DIV) is significant at the 10% level. MGB 2004 is significant at the 5% level and DIV at

the 10% level.

These results provide enough evidence to reject the null hypothesis that management

board interlocks do not influence a firm’s performance and to accept the alternative

hypothesis that management board interlocks positively influence firm performance. The

fact that the coefficients of SVB 2004 and SVB 2005 are also positive for the

performance measures for which these variables are not significant gives us extra

confidence in the direction of this effect.


Table 13: Results of regression with management board interlocks as predicting variable

Dependent variable

Board variable: MGB (2004)

MGB(2005)

STOCK 2005

15,133 (5,122)

STOCK 2005

12,883 (5,280)

Control variables

TS(LOG) 3,290(6,478)

4,369(6,560)

TA(LOG) -1,408(6,180)

-2,497(6,321)

DEBT -24,186(29,338)

-19,988(30,220)

LIQ -1,062(1,997)

-0,828(2,016)

DIV 2,136(1,204)

2,178(1,226)

AGE(LOG) -1,432(9,079)

-0,150(9,237)

INDUSTRY 0,338(0,615)

0,177(0,632)

Statistics

Observations

R 2

800,189

800,160

Note to the table: This table displays the results of the regression analysis related to null hypothesis that management board interlocks do not influence firm performance. Therefore in the first column are given the independent variable MGB 2004 and MGB 2005 along with the control variables. At the top of columns 2 and 3 are the dependent variables of the particular model. The control variables are all non-lagged, which means that the control variables are given for the same year as the dependent variable. The numbers between brackets represent the standard errors. Above the numbers between brackets are the coefficients. The symbols ***, **, * denote statistical significance at the 1%, 5%, and 10%, respectively.


5. Discussion and conclusion

Boards of directors have been receiving increasing attention from the media and

legislators in recent years. Corporate scandals, excessive pay of CEO’s, and increasing

shareholder power are just three topics concerning boards of directors that receive much

attention. This attention is not just apparent through the prime media coverage of these

topics, but also through legislative changes. In The Netherlands the main result is the

adoption of a corporate governance code. The code subscribes principles of good

corporate governance and best practice provisions. Among the best practice provisions

are for example those that relate to the number of seats a director can have at supervisory

boards of other publicly related corporations. The reason for the committee to set a

maximum number of directorships is to ensure the proper performance of his duties

(Commissie Tabaksblatt, 2003).

From a theoretical perspective Cooptation and monitoring, Collusion, and Legitimacy all

predict a positive effect of interlocks on firm performance. The career advancement and

social cohesion perspectives do not predict a particular effect of interlocks on firm

performance. So the effect of these last two perspectives can be positive, neutral or

negative. If we would find a negative effect of interlocks on firm performance we could

relate this to the career advancement and social cohesion perspective. In practice, the

evidence is mixed. There are studies that find a positive effect of interlocks on firm

performance, those that find a negative effect, and yet others that find no effect.

This study has evaluated the interlock-performance relationships for a sample of publicly

listed firms in The Netherlands.

The main research question is the following:

What effect has the number of board interlocks (management or supervisory) on

firm performance for a sample of Dutch firms?

For this research we collected data on 80 publicly listed organizations in The

Netherlands. The data consisted of interlock data for the supervisory board and


management board for the years 2004 and 2005. The performance indicators were

collected for the years 2005 and 2006. The performance indicators used are ROE, ROA,

the standardized arithmetic average of ROE and ROA, and the stock return.

We find a weak positive effect of supervisory board interlocks on firm performance. This

in line with previous research conducted by Pennings (1980), Carrington (1981), and

Burt (1983) who found generally positive but slight associations between interlocking

and firm profitability.

This result is not surprising and there are several possible explanations for our findings.

We find that supervisory board interlocks influence several accounting measures of firm

performance. This result is line with the studies of Phan et al. (2004) and Keister (1998)

who found a positive influence of interlocks on an accounting measure of performance.

We can explain this result by referring to resource dependence theory (Cooptation and

monitoring). Of the theories underlining interlocks research, resource dependence theory

has received the strongest support (Zahra and Pearce, 1989). Resource dependence

theory’s main proposition is that organizations attempt to control the flow of resources in

the uncertainty of the environment. In the context of interlocking directorates, this theory

views boards of directors as important boundary spanners that link with the environment

and extract resources (capital, information and markets) for successful operations ( Burt,

1983). These interlocking directorates thus reduce the interdependence on resources and

improve performance. In this regard we expected interlocks to have the most notable

influence on accounting measures of performance, because these are more subject to

management’s control.

We observe a direct effect of interlocks on firm performance as well as an effect with

interlocks one-year lagged. An explanation for both effects can be offered in terms of

improved decision making. The effect of improved decision making is immediately

observable in the form of improved performance because of better short-term decisions.

The supervisory board’s duties however also concerns long term decision making, of

which the effects are not directly observable in improved firm performance but take time


to become visible. This causes interlocks one-year lagged to also have an effect on firm

performance. Drawing from resource dependence theory we can also provide an

alternative explanation. The legitimacy perspective predicts that interlocks make it easier

for firms to secure resources, but also the procurement of favorable treatment such as a

better price (Schoorman et al., 1981). This alternative perspective explains both the

lagged as the non-lagged effect of interlocks on the accounting measures of firm

performance.

We do not observe a significant influence of supervisory board interlocks on firm

performance when we use supervisory board interlocks with a two-year lag. Neither do

we find a significant effect when we use the number of supervisory board interlocks in

2004 as a predictor variable. We would expect interlocks to have a positive effect on firm

performance even after two years, especially if we think of the effect of interlocks in

terms of improved decision making by directors. A very plausible explanation is that the

number of interlocks shows a lot of variation from year to year. Supervisory board

interlocks which exist in 2004 may not exist anymore in the year 2005 and it may be

therefore that an effect on firm performance in the year 2006 is not found. The effect of

the interlocks in the year 2004, without having the same interlocks in 2005, may not be

strong enough to have a significant influence on firm performance in 2006.

We do not observe an effect of supervisory board interlocks in 2004 on firm performance

in 2005 either. The installment of the corporate governance code on January 1sth of 2004

may play a role in explaining this. The code subscribes best practice provisions that relate

to the number of seats an individual may have at supervisory boards of publicly listed

companies. This may have caused a lot of changes in directorship positions held by

individuals, with as a consequence a lot of changes in interlocks. All these changes in

interlocks may have distorted the normal relationship between interlocks and firm

performance.

We also found evidence for a significantly positive effect of interlocks on a market-

based measure of performance. The numbers of supervisory board interlocks in 2005

positively influence the stock return in 2005. This result is comparable to that of Kiel and


Nicholson (2003) who found a positive effect of interlocks on another market-based

measure of performance, Tobin’s Q. We can offer the same explanation for this result as

that for the accounting-based measures of performance. Especially the legitimacy

perspective would offer a reasonable explanation for this result. From the legitimacy

perspective it can be argued that director interlocks have a positive effect on stock return.

Mizruchi (1996, P. 276) demonstrates the relevance of legitimacy to organizations with

the following example: “When investors decide whether to invest in a company, they

consider the firms strength and the quality of its management. By appointing individuals

with ties to other important organizations, the firm signals to potential investors that it is

a legitimate enterprise worth of support. The quest for legitimacy is thus a further source

of interlocking.” This statement explains exactly the influence of supervisory board

interlocks on the stock return. The number of interlocks signals to potential shareholders

that the firm is managed by credible individuals, which makes it more likely for investors

to invest in the firm. This demand for the shares of the company causes the stock price to

rise and results in a higher stock return. This idea has also received empirical support.

Lin et al. (2003) for example found in a study of 714 appointment announcements of

directors by UK firms, that the announcement of the appointment of outside directors

had a positive influence on the abnormal stock returns. Perry and Peyer (2005) found a

similar result as they found that the market reaction on the appointment of an additional

director depends on the perceived level of agency problems. Thus additional directorships

of managers coming from firms with lower perceived agency problems lead to

significantly higher announcement returns of the sender firm and vice versa (Periz, 2006).

We also tested for the influence of management board interlocks on firm performance.

The results of this analysis indicated that management board interlocks have a positive

influence on firm performance, as measured by the stock return. This result is surprising,

especially because most studies have focused on supervisory board interlocks, as the

interlocking function is normally considered a function of the supervisory board. More

strongly, we are even unaware of any study in The Netherlands concerning executive

(management board) interlocks and firm performance, which makes it difficult to explain

for this result.


When we examine management board interlocks closely we find that the large majority

of management board interlocks are formed by members of the management board who

simultaneously have a seat in the supervisory board of another company. This is not

surprising when you consider the different duties of the management and supervisory

boards. The management board is in charge of day-to-day operations which makes its less

likely for a member of the management board to hold multiple other management board

positions. In this regard we can argue that members of the management board perform

the same interlocking function as members of the supervisory board and offer the same

explanation as we did for the effect of supervisory board interlocks on firm performance.

It is however interesting to see that we found a stronger result for the effect of

management board interlocks on firm performance than we did for supervisory board

interlocks. A possible explanation for this could be found in the different duties of the

management and supervisory board. This can make that management board interlocks are

more beneficial, in the sense of having a stronger positive influence on firm performance,

to the focal firm than supervisory board interlock. However, we can not draw this

conclusion from our results. Further research would be needed tot test this hypothesis.

There are also studies which have specifically focused on linking executive directors

interlock and firm performance. Drawing from these studies we can offer an alternative

explanation. Loderer and Peyer (2002) find a positive relationship between the number of

directorships hold by the chairman of the board (executive committee) in listed firms and

firm value as measured by Tobin’s Q. An explanation for this result could be that, seat

accumulation is simply the evidence of superior talents. Directors with a larger number of

board seats could be better advisors or monitors, or they could have a wider network of

business contacts (Mace, 1986). This would mean that better directors hold more board

seats. And assuming that directors are unable to charge the full price for their services,

seat accumulation by the average director could mean higher firm value (Loderer and

Peyer, 2002).


We can conclude this research by stating that the evidence suggests that there is a weak

positive relation between supervisory board interlocks and firm performance. More

surprising is the positive relation between management board interlocks and firm

performance. The evidence is however not strong which makes it difficult to generalize

these results. In the case of the supervisory board interlocks the evidence is weak because

the results are only significant at the 10% level. For the management board interlocks,

significance exists at the 1% and 5 % level; much of the variance in the models however

remains unexplained.

Recognized is that these outcomes could be resulting from not using the right variables.

There are numerous other performance indicators which we can use. Also the chosen

sample period can have a distorting effect on the results. Although the sample is believed

to be large enough to draw valid but cautious conclusion, we still had to eliminate almost

40% of the initial sample of publicly listed companies. More research is advisable for a

better understanding of the effect of interlocks on firm performance in The Netherlands.

Future research should focus on the characteristics of interlocks and directors in order to

explain for the mixed results that have been produced. Interlocks as a measure of network

ties could for example focus on the ties between individuals (counting the number of

director-director ties), instead of the ties between an individual and an organization.

Another interesting subject of research are the interlocking directorates of members of the

management board. Previous studies have almost exclusively focused on interlocks

formed by members of the supervisory boards or chief executive officers (CEO’s).


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