Managerial Equity Ownership and the Demand for Outside Directors

This paper investigates the relationship between managerial equity ownership and the demand for outside directors in the U.K. corporate control process. In recognition of both the benefits (incentive-alignment effects) and costs (entrenchment effects) of managerial ownership, we propose and test for evidence of a convex association between the proportion of outside board members and the level of insider ownership. Two non-linear specifications (quadratic and logarithmic) are estimated and compared with the simple linear relationship assumed in prior research. Cross-sectional results provide strong evidence that the association between board composition and managerial ownership is indeed non-linear, with both the quadratic and logarithmic models outperforming the linear specification. Further analysis indicates that of the two non-linear models, the logarithmic specification dominates. These findings are also confirmed by an analysis of changes in board composition in response to the Cadbury Report's best practice recommendations on the use of outside directors. Overall, our results suggest that the role of outside directors and their association with managerial ownership is more complex than the simple substitution effect previously assumed.