Peteghem 2018 Faultline Theory To The Board of Directors PDF

THE ACCOUNTING REVIEW American Accounting Association
Vol. 93, No. 2 DOI: 10.2308/accr-51818

March 2018
pp. 339–367
Beyond Diversity: A Tale of Faultlines and Frictions in the

Board of Directors
Mathijs Van Peteghem
Maastricht University
Liesbeth Bruynseels
Ann Gaeremynck
KU Leuven
ABSTRACT: Various regulatory governance initiatives have strived for board diversity, as diversity stimulates
creativity, encourages discussion, and enlarges the board’s knowledge base. However, increased diversity results in
superior decision-making only when the board is free from conflicts and acts as a cohesive group. In this paper, we
extend existing corporate governance research by introducing faultline theory to the board of directors (Lau and
Murnighan 1998). The idea is to show how a board’s diversity structure can give rise to the formation of subgroups
along faultlines. The resulting subgroup formation may, in turn, reduce board effectiveness. Using a sample of U.S.-
listed firms between 2008 and 2012, results suggest that boards with strong faultlines are associated with lower firm
performance, lower CEO turnover-performance sensitivity, and higher abnormal CEO compensation. Understanding
potential unintended consequences of board diversity could be of interest to regulators and companies that plan to
appoint new directors to the board.
Keywords: group dynamics; faultlines; board of directors; corporate governance; board performance.
JEL Classifications: G30; G38; D70; M41.

Data Availability: All data are publicly available from the sources identified in the text.
I. INTRODUCTION
I
n response to the financial crisis and earlier accounting scandals, regulators worldwide have imposed stronger corporate
governance requirements that aim to expand diversity in the board of directors to improve monitoring and strategic
decision-making (NYSE Listing Requirements 2003, 2010; U.S. House of Representatives 2002, Sarbanes-Oxley Act
[SOX]; Securities and Exchange Commission [SEC] 2009, Proxy Disclosure Enhancements). However, empirical evidence
does not uniformly support the idea that greater board diversity always results in better performance (Beasley 1996; Bhagat and
Black 2001; Vafeas 2003, 2005; Ashbaugh-Skaife, Collins, and LaFond 2006; D. Ferreira, M. Ferreira, and Raposo 2011;
Bédard, R. Hoitash, and U. Hoitash 2014). Applying faultline theory from the management literature (Lau and Murnighan
1998), we argue that when multiple director diversity attributes align across board members (e.g., all financial experts are
independent and short-tenured), a hypothetical dividing line, or faultline, forms. This faultline can split the board into
subgroups, which may then negatively affect group dynamics by instigating frictions and hampering decision-making processes
(e.g., Thatcher, Jehn, and Zanutto 2003; Lau and Murnighan 2005; Barkema and Shvyrkov 2007; Bezrukova, Jehn, Zanutto,
and Thatcher 2009; Tuggle, Schnatterly, and Johnson 2010). We hypothesize strong faultlines among directors to negatively
We thank Rachel M. Hayes (editor) and two anonymous referees for helpful feedback on this paper. We also thank Ruth Aguilera, Jean Bédard, Eddy
Cardinaels, Chris Chapman, Will Ciconte, Lisa De Wachter, Anna Gold, Udi Hoitash, Robert Knechel, Ganesh Krishnamoorthy, Frank Moers, Steven
Vanhaverbeke, Sally Widener, Marleen Willekens, and Arnold Wright, as well as seminar participants at the 2014 EAA Annual Congress, Erasmus
University Rotterdam, HEC Paris, KU Leuven, The London School of Economics and Political Science, WHU–Otto Beisheim School of Management,
Tilburg University, University of Amsterdam, Université Laval, and VU University Amsterdam for helpful suggestions. Deloitte Belgium, Fonds
Wetenschappelijk Onderzoek (FWO), Hercules Grant AKUL/11/02, and KU Leuven are acknowledged for their financial support.
Editor’s note: Accepted by Rachel M. Hayes, under the Senior Editorship of Mark L. DeFond.
Submitted: June 2014
Accepted: May 2017
Published Online: June 2017
339
340 Van Peteghem, Bruynseels, and Gaeremynck
impact board performance by reducing information exchange and effective communication between directors, and by
instigating frictions and negative group dynamics (Lau and Murnighan 2005; Halevy 2008; Bezrukova et al. 2009).1
To identify faultlines, we estimate subgroup formation for each board by performing cluster analyses on nine diversity
characteristics of individual board members: qualifications as an independent, insider, or affiliated director; director financial
expertise; board tenure; share ownership; gender; years to retirement; and whether directors have a seat on multiple boards.
Based on these nine diversity characteristics, the clustering algorithm aims to classify observations (i.e., directors within the
board) into a small number of board subgroups, such that directors in the same subgroup are ‘‘similar’’ and directors in other
board subgroups are ‘‘different’’ (Zanutto, Bezrukova, and Jehn 2011). The results of the cluster analysis form the basis of our
faultlines measures (Bezrukova et al. 2009; Zanutto et al. 2011). Our algorithm identifies, on average, 3.58 board subgroups,
while the average board is comprised of nine directors. Descriptive statistics indicate that our measures capture the structure of
diversity, as diversity attributes are roughly similar across all quartiles of faultlines and no immediate trend is visible in the
underlying characteristics. Also, correlations between faultlines and the levels of board diversity are low.
To test the association between faultlines and board performance, we examine Russell 3000 index firms during the period
from 2008 to 2012. We define board performance as firm performance, CEO turnover-performance sensitivity, and abnormal
CEO compensation. Depending on the measure of board performance, the number of firm-year observations varies between
4,265 and 7,536. In line with expectations, stronger faultlines are negatively associated with board performance—i.e., lower
firm performance, lower CEO turnover-performance sensitivity, and higher abnormal CEO compensation.2 Overall, these
results suggest that the way in which diversity is structured matters in explaining board performance. Linking our results to the
findings of the management faultline literature (e.g., Barkema and Shvyrkov 2007; Martens, Totskaya, and Raveh 2007;
Hutzschenreuter and Horstkotte 2013; Tuggle et al. 2010), our results seem to imply that a more balanced distribution of
director diversity characteristics across board members may help to minimize the likelihood of subgroup formation and to
maximize the benefits of board diversity.3
Our study, which responds to calls for research on boardroom dynamics (Hambrick, Werder, and Zajac 2008; Carcello,
Hermanson, and Ye 2011), contributes to the governance literature by offering a potential explanation for the mixed evidence
on the effects of board diversity. Empirical studies differ on the merits of board diversity characteristics, such as director
independence (Bhagat and Black 2001; Cotter and Silvester 2003; Ashbaugh-Skaife et al. 2006; Cornett, McNutt, and
Tehranian 2009; Ferreira et al. 2011), financial expertise (DeFond, Hann, and Hu 2005; Krishnan and Visvanathan 2008), or
director tenure (Beasley 1996; Vafeas 2003, 2005; Castro, De La Concha, Dominguez, Gravel, and Periñan 2009). Whereas
these studies focus on various aspects of diversity in isolation, we extend the notion of board structure by considering how
different diversity characteristics jointly relate to group performance, providing a potential explanation for why a chosen board
composition does not necessarily result in higher board effectiveness.
This study also contributes to existing faultline research. To the best of our knowledge, this is one of the first studies to
perform a large-scale empirical analysis of the effects of faultlines in a real-life setting. Previous faultline studies are mainly
experimental (Thatcher et al. 2003; Lau and Murnighan 2005; Bezrukova et al. 2009) or conducted on a small empirical scale
(Barkema and Shvyrkov 2007; Tuggle et al. 2010, Kaczmarek, Kimino, and Pye 2012; Hutzschenreuter and Horstkotte 2013;
Veltrop, Hermes, Postma, and de Haan 2015). Our paper extends this research in at least three ways. First, we consider a wide
1
Eastman Kodak provides an interesting example of faultlines in a board setting. After a major refinancing in 2009, private equity firm Kohlberg Kravis
Roberts acquired the right to appoint two directors to the board of Kodak. The other sitting members of the board were long-tenured and embedded in
the ‘‘old’’ style of Kodak management. Despite initial openness to new ideas related to introducing modern technologies, the Kohlberg Kravis Roberts
representatives could not induce any real changes. They resigned from the board in 2011. In this example, the two Kohlberg Kravis Roberts
representatives formed a subgroup that was isolated from the rest of the board and, thus, hindered their ability to be heard or make progress.
Another example is Proctor & Gamble, which has a high-profile corporate board. Between 2007 and 2010, the company has experienced various
problems reflected in underperformance of the share price, unsuccessful acquisitions, and slow growth in fast-growing markets. These issues eventually
resulted in the forced retirement of the CEO. We argue that the presence of strong faultlines may partially explain why the board did not function well.
Our data show that since 2008, faultlines steadily became stronger, eventually situating Proctor & Gamble at the top quartile in our sample. Specifically,
the board of Proctor & Gamble had two strong subgroups of nearly equal size: one comprised of female and relatively low-tenured directors with low
share ownership, and the other comprised of long-tenured male directors with higher share ownership. The CEO was a single subgroup, indicating
severe CEO isolation on the board of directors. The division of the Proctor & Gamble board into three distinct subgroups might have negatively
influenced board functioning and decision-making, which ultimately led to the problems reported in the press.
2
In additional analyses, we find comparable results for investment efficiency, earnings management, and internal control deficiencies.
3
As such, our study is not a plea to restrict board diversity, as diversity can have positive effects on decision-making. However, it is important to
carefully structure board diversity to avoid subgroup formation. In other words, the focus of this study is on the alignment of diversity attributes across
directors (e.g., whether director independence overlaps with other diversity characteristics, such as tenure, number of shares, etc.), rather than the level
of board diversity per se. On the difference between faultlines and diversity, Lau and Murnighan (1998, 331) state that ‘‘at minimum and maximum
diversity, faultlines are either absent or unlikely. By their nature, faultlines become most likely in groups of moderate diversity. The presence, then, of a
limited variety of attributes creates the greatest chance of alignment and of . . . a single, strong faultline.’’ In other words, an optimal level of diversity
does not guarantee that faultlines are minimized, nor is there a linear relationship between both constructs.
The Accounting Review

Volume 93, Number 2, 2018
Beyond Diversity: A Tale of Faultlines and Frictions in the Board of Directors 341
array of director characteristics that may lead to director clustering in subgroups. Based on prior corporate governance studies,
we hypothesize that each of the considered director characteristics is likely to influence director interests, incentives, and
behaviors. These characteristics, thus, may lead to director clustering in subgroups. Second, we provide some empirical
evidence that board subgroup formation is correlated with lower firm performance, lower CEO turnover-performance
sensitivity, and higher CEO abnormal compensation. These results potentially support the assertion that subgroup formation in
the board of directors is associated with less effective board advising and monitoring. By investigating a wide array of board
responsibilities, we relate faultlines to group performance in a continuous real-life setting, which greatly enhances the external
validity of the faultline concept. Third, we econometrically optimize the leading clustering algorithm in faultline research
(Thatcher et al. 2003) by employing a two-stage clustering algorithm with standardization by range. This algorithm allows for
the formation of multiple subgroups (instead of a fixed number of two, as in previous studies), thus responding to a call for a
more refined measurement of faultlines (Thatcher and Patel 2012).4
Our findings could be important to corporations and regulators. In a speech following the enactment of the SEC (2009) rule
Proxy Disclosure Enhancements, which requires increased disclosure about board diversity, SEC Commissioner Luis Aguilar
emphasized the beneficial effects associated with director diversity and the need to better understand how diversity contributes
to board effectiveness.5 Understanding potential unintended consequences of board diversity should be of interest to regulators,
especially in light of regulation that requires a minimum set of board diversity requirements, such as a majority of independent
board members (NYSE Listing Requirements) or director financial expertise (Sarbanes-Oxley Act). Turning to companies, we
offer a framework on how to structure board diversity. The selection of new directors to join the board should consider the fit
between the new director and the rest of the board and, in particular, how the new director will influence board dynamics, as a
blind focus on enhancing diversity may leave the board worse off than before the appointment of a new board member.
The rest of the paper is structured as follows. Section II reviews related literature and develops our hypothesis. Section III
describes our variables and data. Section IV discusses our models and reports the empirical results. Additional analyses are
presented in Section V. We conclude with a summary of our main findings and suggestions for further research in Section VI.
II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT
Diversity and Board Performance

Several theories help explain how board diversity affects board performance. From an agency theory perspective, diversity
in the board (typically operationalized as the distinction between independent and non-independent directors) allows the board
to fulfill its monitoring role. For example, independent directors help ensure that management aligns with shareholders’
interests (Hermalin and Weisbach 1998). From a resource dependence perspective, diversity in board composition (e.g.,
experience, expertise, tenure) increases the board’s resource pool. In this perspective, directors are viewed as resource providers
and can provide important knowledge, assets, guidance, and connections to the firm (Salancik and Pfeffer 1978, 145–161).
Despite these proposed benefits of diversity, empirical studies on board composition find mixed evidence on the relation
between director attributes and board performance. For example, some studies on director independence find a positive relation
between independence and firm valuation or accounting quality (Ashbaugh-Skaife et al. 2006; Cornett et al. 2009), whereas
others find no such correlation (Bhagat and Black 2001; Cotter and Silvester 2003), or even a negative link (Ferreira et al.
2011). As a potential explanation, Coles, Daniel, and Naveen (2008) document that inside representation is beneficial only for
specific classes of firms (i.e., complex firms and firms with high advisory needs).6 Similarly, results from prior research on the
merits of director tenure (Beasley 1996; Castro et al. 2009; Vafeas 2003, 2005) or financial expertise (DeFond et al. 2005;
Krishnan and Visvanathan 2008) are inconclusive. The theoretical frameworks outlined above provide no answer as to why a
‘‘more desirable’’ board composition does not deliver the intended benefits.
To complement existing theoretical frameworks, we argue that the extent to which board diversity translates into board
effectiveness is largely dependent on group dynamics within the board. Organizational behavior studies show that, in addition
to its intended positive effects, group diversity may also decrease group performance through greater internal conflicts (Simons
and Peterson 2000), larger coordination and communication costs (Van den Steen 2010), and increased failure to reach an
4
Boards of directors can include up to 30 persons, so artificially imposing a two-subgroup structure is inappropriate in most cases.
5
For an example from practice, see Manzoni, Strebel, and Barsoux (2010); see, also, SEC (2009).
6
Similar to Coles et al. (2008), we investigate why a given set of board characteristics does not always result in the same level of board effectiveness.
However, the perspective of this study differs from Coles et al. (2008), as these authors focus on how certain board characteristics are optimal for
certain firms, while this study emphasizes board dynamics. Given that a firm chooses its board composition in response to its needs and environment (as
is argued in Coles et al. [2008]), we investigate whether the effectiveness of this chosen board composition depends on how the attributes of individual
directors are structured. More specifically, to maximize the benefits of an optimal board composition in terms of director characteristics, diversity must
be evenly distributed across directors to minimize the likelihood of faultlines and subgroup formation.

agreement (Wall and Nolan 1986). A key mechanism that drives these unintended and undesirable effects of group diversity is
the formation of subgroups (Lau and Murnighan 2005; Tuggle et al. 2010). Subgroup formation is explained by social identity
and categorization theories, which argue that individuals tend to select persons whom they perceive to be similar to themselves
when they interact with other group members (Byrne 1971), resulting in decreased information sharing and increased frictions
between members of different subgroups (e.g., Lau and Murnighan 2005; Halevy 2008).
Subgroup Formation and Faultlines

We argue that subgroup formation in the board may happen based on the concept of faultlines (Lau and Murnighan 1998).
Faultlines are hypothetical dividing lines that split a group into relatively homogeneous subgroups based on the simultaneous
alignment of multiple group member characteristics (adapted from Lau and Murnighan [1998]). Faultline theory focuses on the
effects of group member characteristics (i.e., diversity) in combination rather than one at a time (Lau and Murnighan 2005).
When member attributes overlap, these members may group together into a subgroup. Faultline studies identify two dimensions
of subgroup formation. First, faultline strength measures the degree to which members of a subgroup share the same
characteristics, and it represents the degree of cohesion within a subgroup (Thatcher et al. 2003). Second, faultline distance
measures how far apart subgroups are on various member characteristics (Bezrukova et al. 2009). Whereas faultline strength
measures the cohesion and self-awareness of subgroups, faultline distance focuses on the differences between subgroups that
may escalate antagonistic subgroup interactions.
Although faultline studies vary greatly in terms of both their settings and the measurement of faultline strength and
distance, results on the effects of faultlines on group performance are remarkably consistent. Specifically, strong faultlines
intensify intragroup conflict (Bezrukova et al. 2009; Li and Hambrick 2005) and negatively impact intragroup trust and respect
(e.g., Harrison and Klein 2007), as well as information sharing and knowledge exchange (Lau and Murnighan 2005). Faultlines
may also increase subgroup competitiveness (e.g., Halevy 2008) and divert the group’s attention from meeting its goals toward
bridging the schism that the faultlines created (Li and Hambrick 2005). Faultline studies have typically focused on employee
work groups (e.g., Barkema and Shvyrkov 2007; Bezrukova et al. 2009; Li and Hambrick 2005) or have been conducted in a
laboratory setting (e.g., Lau and Murnighan 2005; Thatcher et al. 2003; Zanutto et al. 2011).
Faultlines and Board Performance

In applying the faultline concept to a board setting, we acknowledge possible alignment across multiple director attributes
(e.g., director tenure, financial expertise, independence) that may lead to the formation of subgroups. Table 1 provides an
illustrative example.
In Table 1, a board consists of four directors. Panel A shows diversity attributes scattered across directors, and Panel B
shows diversity attributes clustered within directors. Attribute diversity is the same in both situations. No faultline is present in
Panel A, as the diversity attributes are mixed. However, a faultline does exist in Panel B, as the newly appointed board
members’ attributes facilitate the formation of subgroups based on the dissimilarity between their characteristics and those of
existing board members. This example shows that although director diversity can broaden a board’s expertise and perspectives,
it might also result in the formation of subgroups based on faultlines. This conjecture is corroborated by empirical research on
the politics of strategic decision-making, which shows that similarity is an important basis for coalition formation among
directors and executives (Westphal and Zajac 1995).
Because the board is fundamentally a decision-making group, we expect board performance to decrease with faultlines. As
noted by Forbes and Milliken (1999), boards are charged with complex interactive tasks (e.g., monitoring, implementing
strategy, rewarding the CEO and top management, facilitating access to capital) that require extensive communication and
deliberation. To perform these tasks effectively, it is important that board members trust and respect each other’s judgment. We
argue that the presence of faultlines, as measured by faultline strength and faultline distance, is likely to be negatively correlated
with board performance. As the board’s advisory role predominantly concerns the strategy of the firm, it necessitates
discussion, involvement, and cooperation of the full board. In this context, board faultlines can generate conflicts that hamper
communication flow and information sharing and that negatively impact the quality of decision-making processes (Lau and
Murnighan 2005; Li and Hambrick 2005; Harrison and Klein 2007; Halevy 2008; Bezrukova et al. 2009). In line with this
reasoning, prior experimental research on top management team performance has shown that strong faultlines in the team lead
to inferior executive decision-making in terms of product diversification, initial public offering (IPO) performance, and foreign
expansion (Barkema and Shvyrkov 2007; Martens et al. 2007; Hutzschenreuter and Horstkotte 2013). Furthermore, Tuggle et
al. (2010) show that strong faultlines in the board reduce the time that boards spend on meetings and on discussion of
entrepreneurial issues, such as product-market. This evidence shows that faultlines are likely to influence the focus and
effectiveness of board meetings and hence the quality of the strategic decisions, with an overall negative effect on the board
performance.

TABLE 1
Faultline Illustration
Panel A: No Faultline
Director 1 Director 2 Director 3 Director 4
Independent Independent Insider Insider
Financial expert No financial expert No financial expert Financial expert
Newly appointed Long tenure Newly appointed Long tenure
Low share ownership High share ownership High share ownership Low share ownership
Multiple appointments No other appointments No other appointments Multiple appointments
Retired Retired Not retired Not retired
Male Female Male Female
Panel B: Faultline
Subgroup 1 Subgroup 2
Director 1 Director 2 Director 3 Director 4
Independent Independent Insider Insider
Newly appointed Newly appointed Long tenure Long tenure
Financial expert Financial expert No financial expert No financial expert
Low share ownership Low share ownership High share ownership High share ownership
Multiple appointments Multiple appointments No other appointments No other appointments
Retired Retired Not retired Not retired
Female Female Male Male
Table 1 provides an illustrative example of subgroup formation based on faultlines. Consider a board that consists of four directors. Panel A displays a
situation in which diversity attributes are scattered across board members, with no faultline present. Panel B displays a situation in which diversity
attributes overlap, thus creating a faultline.
In addition to the board’s advisory function, we also expect a negative association between faultlines and the effectiveness
of management monitoring (e.g., CEO compensation and turnover). Although prior research does not directly tie faultlines to
monitoring effectiveness, initial evidence suggests that the CEO has more decision-making power when boards suffer from
communication and coordination problems and, thus, the board’s ability to control management decreases (e.g., Eisenberg,
Sundgren, and Wells 1998; Ryan and Wiggins 2004; Cheng 2008). Based on this reasoning, we formulate the following
hypothesis:
H1: Faultline strength and faultline distance are negatively related to board performance.
III. RESEARCH DESIGN

We measure the effectiveness of the board’s advisory function using proxies of firm value and performance (Bhagat and
Bolton 2008; Coles et al. 2008), and assess the quality of board monitoring by focusing on the sensitivity of CEO turnover to
firm performance (Faleye, R. Hoitash, and U. Hoitash 2011; Lee, Matsunaga, and Park 2012) and abnormal CEO compensation
(Chang, Dasgupta, and Hilary 2010; Faleye et al. 2011). The specific models used to examine the different board roles are
discussed in detail in Section IV. In this section, we describe the construction of our faultline measures, board control variables,
and sample selection.
Faultline Measurement
Diversity Characteristics Used to Construct Faultline Measures
Prior governance research and the widely cited model of board processes developed by Forbes and Milliken (1999) are
used to identify the nine director diversity attributes used for our faultline computation. Our first three attributes relate to
director independence (Beasley 1996; Chhaochharia and Grinstein 2009; Larcker, Richardson, and Tuna 2007; Bhagat and
Black 2001; Bédard et al. 2014). Independent directors are expected to exert objective control on management and safeguard
shareholder interests (Rosenstein and Wyatt 1990). The same reasoning applies to affiliated (or ‘‘gray’’) directors. These are

past employees, relatives, or directors with significant transactions, business relationships, or strong ties with the firm (Klein
2002). Therefore, we introduce in the faultline computation algorithm three mutually exclusive dummy variables that each
equal 1 if a director qualifies as independent, insider, or affiliated, and 0 otherwise.7 The fourth director attribute that we
consider is director financial expertise, as directors have different incentives in terms of firm risk-taking and monitoring
financial statement correctness (Srinivasan 2005; Krishnan and Lee 2009). We include a dummy variable that equals 1 if a
director qualifies as a financial expert according to the SOX requirements, and 0 otherwise. Multiple board membership is
added as a fifth director attribute, as it constitutes a proxy for director status, experience, and reputational capital (Ferris,
Jagannathan, and Pritchard 2003; Erkens and Bonner 2013; Field, Lowry, and Mkrtchyan 2013). Multiple board memberships
may also create frictions, as these directors may be too busy to mind the business and miss board meetings more often (Fich and
Shivdasani 2006; Jiraporn, Davidson, DaDalt, and Ning 2009). A dummy variable is constructed that equals 1 when a director
possesses outside board appointments, and 0 otherwise. A sixth director attribute captures the career horizon and incentives of
directors. As directors approach retirement and career concerns decline, their incentives change (Gibbons and Murphy 1992)
and focus shifts to the short term (Laux 2012). We construct a dummy variable that equals 1 when a director is older than 65,
and 0 otherwise. A seventh attribute is director gender. Extant behavioral research has shown that, compared to men, women
tend be less overconfident, more cautious, and less aggressive in decision-making processes (e.g., Byrnes, Miller, and Schafer
1999; Knight, Guthrie, Page, and Fabes 2002). Director gender is defined as a dummy variable that equals 1 when the director
is female, and 0 otherwise. The eighth director attribute is board tenure, representing the number of years the director serves on
the board, which may influence director behavior and monitoring, as it can render outside directors less independent and more
management-friendly (Vafeas 2003). Finally, we consider share ownership, i.e., the number of shares a board member holds, as
the ninth director attribute. The number of shares a board member holds is likely to influence director incentives by aligning
director preferences and actions with those of the shareholders (Beasley 1996; Brick, Palmon, and Wald 2006). While most of
the director characteristics used in our faultlines computation are dichotomous, board tenure, as well as director share
ownership, are continuous variables. To guarantee that these continuous variables have the same weight as the dichotomous
variables in the faultline measurement process, we rescale both variables in such a way that their values have a maximum range
of 1. Specifically, we scale the number of shares owned by a director by the range (i.e., the difference between the maximum
and the minimum number) of director share ownership in the board (Zanutto et al. 2011). Similarly, director tenure is scaled by
the range of board tenure of directors in the focal company.8
Faultline Variables
To transform the previously described diversity attributes into faultlines, we perform a cluster analysis on each board
(Bezrukova et al. 2009; Zanutto et al. 2011). The clustering algorithm classifies observations (i.e., directors) into groups, such
that observations within the same group are as similar as possible to one another and as dissimilar as possible from observations
in other groups.9 The resulting clusters are used to construct our faultline measures. This approach is in line with the leading
algorithm in the faultline literature, as developed by Thatcher et al. (2003) and Zanutto et al. (2011). Although we follow the
general setup of the Thatcher et al. (2003) procedure, we econometrically optimize the clustering process by (1) allowing for
multiple subgroups instead of two subgroups based on the pseudo F-statistic, and (2) employing a two-stage clustering
7
In our faultline computation algorithm, we use three separate dummy variables to distinguish between three levels of director independence: fully
independent directors, affiliated directors, and company insiders. We test the sensitivity of our faultline algorithm to this design choice by performing
two alternative computations: (1) we aggregate all three levels into one measure, with values of 0, 0.5, or 1, depending on the level of independence.
Insiders receive a value of 0, and fully independent directors receive the maximum value of 1. Affiliated directors receive the intermediate value of 0.5;
(2) we equate affiliated directors to company insiders. Director independence then takes the form of a single dummy variable that equals 1 when the
director is independent, and 0 otherwise. Untabulated analyses show that our conclusions do not alter when we use these alternative definitions.
8
The attributes that drive faultlines can be surface-level or deep-level. Surface-level attributes refer to readily observable attributes, such as gender, age,
and nationality. Deep-level attributes include values, experience, and knowledge (e.g., Harrison, Price, Gavin, and Florey 2002; Milliken and Martins
1996). The selected director characteristics in this study are predominantly deep-level, as previous research has shown that these characteristics have
strong and persistent effects on work group cohesiveness, whereas surface-level characteristics have shorter influence and are neutralized over time
(Harrison et al. 2002). In additional analyses, we expand our set of director characteristics with two demographic surface-level attributes (director age
and ethnicity). In line with the above reasoning, we find that adding these two demographic attributes weakens our results. Specifically, the interaction
between faultlines and stock returns in the CEO turnover model is no longer significant.
9
Note that cluster analysis focuses on similarities and differences in the chosen characteristics, rather than on the values of these characteristics. This
differs from factor analysis, which looks at communal variance and extracts a number of factors that are a weighted combination of the individual
characteristics. Cluster analysis groups observations (i.e., directors) that are as similar as possible in the underlying characteristics so as to minimize
differences in characteristics between observations in one cluster. Given that we rescale our continuous variables by range, all characteristics are of
equal weight in determining the cluster solution.

FIGURE 1
Example of Faultline Measures
Figure 1 shows a graphic representation of a board comprised of 13 directors. Each axis captures a different diversity attribute. The variance between
individual directors is represented as a small double-sided arrow. The distance between the cluster centroids is represented using a bold double-sided
arrow. Faultline strength captures within-subgroup cohesion. The shorter the small double-sided arrows are within clusters, the stronger faultline strength
will be. Faultline distance captures differences between subgroups. The larger the bold double-sided arrow, the larger faultline distance will be.
algorithm with standardization of the continuous variables by range rather than standard deviation. A detailed description of the
clustering procedure can be found in Appendix A.10
In line with previous literature, we distinguish between faultline strength and faultline distance (Bezrukova et al. 2009;
Zanutto et al. 2011). Faultline strength captures how strongly the nine director characteristics align within a board subgroup
(emphasis on within-group similarities), whereas faultline distance reflects the extent to which board subgroups diverge as a
result of differences in the nine director characteristics (emphasis on between-group differences). Following Thatcher et al.
(2003) and Bezrukova et al. (2009), faultline strength (FLSTRENGTH) is computed as the portion of the total variance in
director characteristics explained by the group split identified by our clustering algorithm (between-subgroup variance over
total group variance). Given a certain set of characteristics, a high variance between subgroups implies a low variance within
subgroups, which, in turn, reflects a homogeneous subgroup structure. To account for differences between subgroups, we
define faultline distance (FLDISTANCE) as the average Euclidean distance between subgroup centroids (i.e., the vector of
subgroup means of director characteristics). Finally, we consider the interaction between faultline distance and strength (FAU).
As each construct captures different aspects of subgroup formation, how these interact is key.11 Faultline distance exacerbates
the faultline strength effect and vice versa (Zanutto et al. 2011). The underlying idea is that the consequences of tight, strong
subgroups are likely to be more pronounced when the differences between these subgroups are larger (Harrison and Klein
2007; Zanutto et al. 2011). Indeed, the joint effect of faultline strength and distance has been extensively documented by
faultline research (Thatcher and Patel 2012; Zanutto et al. 2011). In the regression models, FAU is orthogonolized to minimize
multicollinearity (Little, Bovaird, and Widaman 2006). Essentially, this entails regressing an interaction variable on its
determinants and using the residuals, rather than the interaction, in subsequent analyses. Appendix A provides mathematical
specifications and a detailed example. Figure 1 shows a graphic example of our faultline measures.
Figure 1 depicts a board of 13 directors grouped into three clusters. For illustrative purposes, we focus on a two-
characteristic case, with each axis capturing a different diversity attribute. Clusters A and C each have four directors,
whereas cluster B has five directors. Within each subgroup, the variance between individual directors based on diversity
attributes is represented as a small double-sided arrow. Clusters A and C have the same within-group variance, whereas in
cluster B, directors are much more different from one another. Subgroup cohesion, thus, is highest in clusters A and C,
leading to a higher value of faultline strength. The distance between the cluster centroids (i.e., distance between the three sets
of averages in diversity attributes) is represented as a bold double-sided arrow. Faultline distance is largest between clusters
A and B, and smallest between clusters B and C. Clusters A and C have the same faultline strength, but their distance to
cluster B is different.
10
To validate our procedure, we tested the algorithm on several business cases and, afterward, presented the results to directors sitting on these boards.
Subsequent interviews confirmed that our clustering procedure captured potential subgroup formation on these boards.
11
If we omit FAU from the analyses, then the significance level and magnitude of the estimated coefficients for FLSTRENGTH and FLDISTANCE are
comparable to those currently reported.

Board Control Variables

In line with previous faultline research, we control for board diversity and heterogeneity (Zanutto et al. 2011). This
allows us to examine whether board faultlines add explanatory value beyond overall board diversity. Specifically, we include
the percentage of independent board members (PCTINDEPENDENCE), financial experts (PCTFINEXP), women
(PCTGENDER), directors older than 65 (PCTRETIREMENT), directors holding multiple board memberships (PCTBUSY),
the natural log of the mean value of company stock held by directors in the board (LNMEANSHAREVALUE), and the natural
log of mean director tenure (LNMEANTENURE). These are all widely used control variables in governance research (e.g.,
Gibbons and Murphy 1992; Ferris et al. 2003; Vafeas 2005; Brick et al. 2006; Bhagat and Bolton 2008; Erkens and Bonner
2013; Laux 2012; Bruynseels and Cardinaels 2014).12 We also add the natural log of board size (LNBOARDSIZE), as
faultline research suggests a need to control for overall group size (Hutzschenreuter and Horstkotte 2013). Additionally, we
include the number of subgroups scaled by board size (CLUSBS), as group dynamics may differ in the presence of more than
two subgroups (Carton and Cummings 2012; Lau and Murnighan 1998). Last, we control for CEO duality either in the
current year (CEODUALITY) or in the previous year (LAGCEODUALITY), because faultline research has emphasized the
role of strong leadership in a group, and previous governance studies have documented the importance of considering CEO
power (Kaczmarek et al. 2012). We discuss model-specific variables in the sections that describe each of the different
models.
Data
We obtain data on director characteristics from Institutional Shareholder Services (ISS) for the Russell 3000 index firms,
which represent approximately 98 percent of the investable U.S. equity market. Our sample spans from 2008 to 2012 and
contains 12,942 firm-year observations for 2,953 different firms (see Table 2, Panel A). We drop 3,255 firm-year observations
operating in financial or regulated industries, as well as all observations for which the number of directors on the board is less
than three, since subgroup formation is not possible in these boards.13 Information by industry and year is given in Panel B of
Table 2.
We then merge this dataset with Compustat to obtain a sample of 6,805 to 7,536 observations for the firm performance
analyses (Table 2, Panel A). To analyze CEO turnover, we compare CEOs across years to identify executive turnover. As
2008 is the base year, our sample for this analysis comprises 2009–2012. To retain only forced CEO turnovers, we hand-
collect data on the reason for the CEO turnover. First, we determine whether turnovers were explicitly identified in
newspaper articles or press releases as being involuntary. Second, we eliminate CEO turnovers that result from mergers,
acquisitions, joint agreements, or ‘‘personal reasons,’’ which is in line with Engel, Hayes, and Wang (2003). However, firms
are opaque in describing the circumstances and reasons for a CEO leaving the office. Hence, following previous work by
Parrino (1997) and Bushman, Dai, and Wang (2010), we identify additional turnovers when the CEO resigns because of
lawsuits, pressure by the board and shareholders, or fraud allegations (23 turnovers). Last, we classify turnovers as forced
when the CEO retires before the age of 60 and press releases or newspaper articles do not report death, health issues, or the
acceptance of another position. Of those 279 forced turnovers, 76 were dropped because of missing governance and
financial control variables. The resulting sample contains 4,383 observations, of which 203 are forced CEO turnovers.
These relative proportions are in line with previous governance research, such as Bushman et al. (2010) or Faleye et al.
(2011). To estimate the compensation models, we merge the Compustat and ISS data with Execucomp, which covers only
Standard & Poor’s (S&P) 1500 firms. We restrict our sample to all firms for which CEO tenure does not equal zero, as
previous research has found that CEO first-year pay differs considerably from ongoing pay (e.g., Rajgopal, Taylor, and
Venkatachalam 2012).14 The CEO compensation model is estimated using a sample of 4,383 firms. Table 2 summarizes the
sample selection.
12
The chosen board characteristics are the underlying variables used to compute faultline measures. The variables are included to ensure that the faultlines
are not simply picking up an underlying diversity attribute that is not controlled for (Zanutto et al. 2011). Hence, we control for the mean value of
company stock owned by the board as a proxy of how important share ownership of directors is within the board, as well as because the number of
shares is included in the faultline measures (although rescaled). Note that using the number of shares instead of the dollar value of shares does not alter
the results. The same holds for using the standard deviation of share ownership in the board.
13
Boards of directors consisting of one or two persons are outliers or do not allow for the formation of a subgroup larger than one person. Furthermore,
these boards do not comply with listing standards.
14
Rajgopal et al. (2012) find substantial differences between first-year and ongoing pay, and argue that the dynamic nature of compensation contracts
renders different compensation arrangements across time. Chhaochharia and Grinstein (2009) also acknowledge potential confounding effects from
including CEO first-year pay in the analysis. For anecdotal evidence, see Martin, Gomez-Mejia, and Wiseman (2012). Our results hold when first-year
CEOs are included.

TABLE 2
Sample Selection
Panel A: Selection Process

Firm-year observations after faultline computation process 12,942
–Observations in financial and regulated industries (3,255)
–Observations where board size is smaller than 3 (2)
9,687
Performance sample: 2008–2012 (ISS, Compustat) 6,805–7,536
CEO turnover: 2009–2012 (ISS, Compustat) 4,383
CEO compensation: 2008–2012 (ISS, Compustat, Execucomp) 4,265
Panel B: Sample Summary by Industry and Year (n ¼ 9,687)

2008 2009 2010 2011 2012 Total
Mining 200 209 232 232 229 1,102
Construction 98 104 111 115 121 549
Manufacturing 888 929 944 982 1019 4,762
Transportation and Public Utilities 103 102 107 112 114 538
Wholesale trade 65 66 66 75 70 342
Retail trade 131 134 136 144 145 690
Services 305 317 341 370 371 1,704
Total 1,790 1,861 1,937 2,030 2,069 9,687
Table 2 displays the sample selection procedure in Panel A, and the sample distribution across industries and years in Panel B. ISS contains data on
director characteristics for the Russell 3000 index. Compustat provides financial data on a wide array of U.S. firms. The data provided by Execucomp are
limited to Standard & Poor’s (S&P) 1500 firms.
IV. EMPIRICAL RESULTS
Faultline Variables and Director Characteristics

Table 3 contains summary statistics on the board characteristics using all board observations for 2008 to 2012 with non-
missing director-years available in the ISS dataset (n ¼ 12,942). The average board in our sample has nine directors, including
6.4 percent affiliated directors and 18.5 percent inside directors. The high percentage of independent board members (75
percent) and financial experts (21 percent) is arguably a direct consequence of regulatory and societal pressure. The mean
director tenure per board is about 8.4 years, and the average number of shares owned equals 1,109,181. Six percent of directors
have at least three board appointments, 36 percent are older than 65, and about 10 percent are female.
Using these director and board data for our faultline computations, the algorithm identifies, on average, 3.581 subgroups,
which, scaled to board size, equals 0.434 (Table 3, Panel A). There is a tendency toward homogeneous subgroups as the
average (median) faultline strength is quite high, 0.606 (0.611), with a subset of firms approaching the maximum value of 1.
Furthermore, the identified subgroups are quite different in terms of director attributes, as the mean (median) faultline distance
equals 1.460 (1.440), with a maximum of 1.966.15 Finally, the interaction between faultline strength and distance has a mean
(median) value of 0.875 (0.875) and a maximum of 1.497. Taken together, these results provide initial evidence of the presence
of board faultlines in our sample.
Table 3, Panel B shows descriptive statistics on the underlying diversity attributes for various levels of board faultlines, as
measured by FAU. As shown in the table, no immediate trend in diversity attributes across faultline quartiles is visible. Hence,
faultlines are not likely to capture the specific level of board diversity, but rather the structure thereof. Two boards may have
the same overall level of diversity, but they may experience different group dynamics depending on how these attributes are
clustered across board directors (Lau and Murnighan 1998, 2005). This is corroborated by an untabulated correlation matrix
that shows low correlations between faultlines and each diversity attribute.
15
The theoretical maximum faultline distance is 3 (the square root of 9, because there are nine characteristics that have a range of 1) and the theoretical
maximum faultline strength is 1.

TABLE 3
Descriptive Statistics on the Faultline Variables on the Full Sample
(n ¼ 12,942)
Panel A: Full Sample

Mean Min. Q1 Median Q3 Max. Std. Dev.
FLSTRENGTH 0.606 0.232 0.508 0.611 0.712 1.000 0.169
FLDISTANCE 1.460 1.115 1.337 1.440 1.564 1.966 0.168
FAU 0.875 0.314 0.730 0.875 1.022 1.497 0.236
PCTINDEPENDENCE 0.747 0.000 0.667 0.778 0.857 1.000 0.132
PCTAFFILIATED 0.064 0.000 0.000 0.000 0.125 0.333 0.088
PCTINSIDER 0.185 0.000 0.111 0.143 0.231 0.818 0.107
PCTFINEXP 0.207 0.000 0.111 0.167 0.286 0.571 0.123
MEANTENURE 8.414 1.100 5.500 7.889 10.721 20.750 4.007
MEANSHARES 1,109,181 9,771 108,020 267,362 805,163 18,854,554 2,638,824
PCTBUSY 0.062 0.000 0.000 0.000 0.111 0.400 0.093
PCTRETIREMENT 0.355 0.000 0.200 0.333 0.500 1.000 0.201
PCTGENDER 0.101 0.000 0.000 0.100 0.167 0.385 0.098
BOARDSIZE 8.888 5.000 7.000 9.000 10.000 18.000 2.484
CLUSBS 0.434 0.136 0.333 0.444 0.500 0.800 0.149
Panel B: Descriptive Statistics per FAU Quartile

Q1 Q2 Q3 Q4
Mean Std. Dev. Mean Std. Dev. Mean Std. Dev. Mean Std. Dev.
FLSTRENGTH 0.400 0.103 0.574 0.074 0.662 0.079 0.79 0.106
FLDISTANCE 1.464 0.181 1.426 0.157 1.448 0.157 1.503 0.166
FAU 0.575 0.122 0.807 0.041 0.946 0.042 1.174 0.125
PCTINDEPENDENCE 0.747 0.127 0.781 0.122 0.754 0.131 0.708 0.137
PCTAFFILIATED 0.077 0.086 0.055 0.081 0.058 0.088 0.067 0.096
PCTINSIDER 0.172 0.104 0.161 0.092 0.186 0.103 0.222 0.117
PCTFINEXP 0.203 0.116 0.198 0.119 0.203 0.122 0.222 0.133
MEANTENURE 8.379 3.772 8.179 3.700 8.302 3.943 8.797 4.533
MEANSHARES 1,260,882 2,833,016 944,284 2,428,874 953,831 2,366,368 1,277,726 2,869,166
PCTBUSY 0.065 0.092 0.071 0.095 0.059 0.093 0.052 0.094
PCTRETIREMENT 0.353 0.176 0.352 0.190 0.357 0.208 0.360 0.226
PCTGENDER 0.124 0.094 0.115 0.095 0.095 0.097 0.070 0.098
BOARDSIZE 9.730 2.544 9.542 2.416 8.745 2.294 7.532 2.032
CLUSBS 0.308 0.112 0.411 0.113 0.465 0.121 0.550 0.135
Panel A of Table 3 shows the descriptive statistics on the faultline variables based on the ISS dataset. Panel B shows descriptive statistics for partitions
based on FAU.
Variable Definitions:
FLSTRENGTH ¼ within-subgroup cohesion, calculated as the ratio of the between-subgroup variance over total subgroup variance;
FLDISTANCE ¼ the difference between board subgroups, defined as the Euclidean distance between subgroup centroids;
FAU ¼ an orthogonolized interaction variable of FLSTRENGTH and FLDISTANCE;
PCTINDEPENDENCE ¼ the percentage of independent board members;
PCTAFFILIATED ¼ the percentage of board members affiliated to the firm;
PCTINSIDER ¼ the percentage of inside directors on the board;
PCTFINEXP ¼ the percentage of board members who qualify as a financial expert according to SOX;
MEANTENURE ¼ the mean director tenure on the board;
MEANSHARES ¼ mean shares owned by board members;
PCTBUSY ¼ the percentage of directors on the board having at least three appointments;
PCTRETIREMENT ¼ the percentage of directors on the board who are at least 65 years of age;
PCTGENDER ¼ the percentage of female directors on the board;
BOARDSIZE ¼ the number of board members; and
CLUSBS ¼ the number of clusters in the cluster solution scaled by board size.

Model Specifications
The following models control for year and two-digit industry fixed effects. All variables are winsorized at the top and
bottom 1 percent levels and all models are estimated robust to heteroscedasticity, with standard errors clustered at the firm level
(Rogers 1993).
Model I: Firm Performance

Empirical Model. When modeling firm performance as a function of predicted FLSTRENGTH, FLDISTANCE, and FAU,
we use two measures of firm performance: return on assets (ROA) and Tobin’s Q (Cheng 2008; Kaczmarek et al. 2012).
Whereas ROA targets core operating performance, Tobin’s Q captures the market premium or market performance. Controlling
for relevant board diversity characteristics and using similar control variables as Bhagat and Bolton (2008) and Renders,
Gaeremynck, and Sercu (2010), we estimate the following model:16
PERFORMANCEit ¼ b0 þ b1 FLSTRENGTHit þ b2 FLDISTANCEit þ b3 FAUit þ b4 PCTINDEPENDENCEit
þ b5 PCTFINEXPit þ b6 LNMEANTENUREit þ b7 LNMEANSHAREVALUEit þ b8 PCTBUSYit
þ b9 PCTRETIREMENTit þ b10 PCTGENDERit þ b11 CLUSBSit þ b12 LNBOARDSIZEit
þ b13 CEODUALITYit þ b14 MTBit þ b15 LNTAit þ b16 LEVERAGEit þ b17 CAPINTit
þbX18 ALTMANZit þ b19 SALESGROWTH
X it þ b20 LAGROAit þ b21 STDROAit þ b22 RETit
þ bt Year Effectsit þ bx Industry Effectsix þ e; ð1Þ
where:
PERFORMANCE ¼ TOBINQ or ROA;
TOBINQ ¼ (total assets þ market value of equity book value of equity)/total assets;
ROA ¼ (earnings before interest and tax)/total assets;
FLSTRENGTH ¼ degree of cohesion within board subgroups;
FLDISTANCE ¼ average distance (in terms of director characteristics) between board subgroups;
FAU ¼ orthogonolized interaction between FLSTRENGTH and FLDISTANCE;
PCTINDEPENDENCE ¼ percentage of independent directors on the board;
PCTFINEXP ¼ percentage of board members who qualify as a financial expert according to SOX;
LNMEANTENURE ¼ natural logarithm of mean director tenure on the board;
LNMEANSHAREVALUE ¼ natural logarithm of 1 plus the mean value of company stock owned by board members;
PCTBUSY ¼ percentage of directors on the board having at least three appointments;
PCTRETIREMENT ¼ percentage of directors on the board who are at least 65 years old;
PCTGENDER ¼ percentage of female directors on the board;
CLUSBS ¼ number of subgroups scaled to board size;
LNBOARDSIZE ¼ natural logarithm of board size;
CEODUALITY ¼ dummy variable that equals 1 when the CEO serves as chair of the board, and 0 otherwise;
MTB ¼ market value of equity/book value of equity;
LNTA ¼ natural logarithm of total assets;
LEVERAGE ¼ long-term liabilities/total assets;
CAPINT ¼ property, plant, and equipment (PPE)/total assets;
ALTMANZ ¼ Altman Z-score indicating financial stability;
SALESGROWTH ¼ (sales in current year sales in previous year)/sales in previous year;
LAGROA ¼ ROA of the prior year;
STDROA ¼ standard deviation of ROA over the past five years; and
RET ¼ (end-of-year stock price beginning-of-year stock price)/beginning-of-year stock price.
Previous research has indicated that endogeneity problems between firm performance and corporate governance can occur
when these governance characteristics are not randomly distributed among firms, and their occurrence is indirectly related to
firm performance (Adams and Ferreira 2009; Bhagat and Bolton 2008; Renders et al. 2010; Coles et al. 2008). The potentially
endogenous relation between firm performance and board composition implies that ordinary least squares (OLS) estimates may
16
As market valuation may be driven by both core operating performance and market sentiment, we include operating and stock performance as control
variables in the Tobin’s Q model. Due to the high correlation between Tobin’s Q and MTB, the latter is included as a control variable only in the ROA
model.

be biased. To address this concern, prior research adopted a multiple equation framework using instrumental variables to
estimate the main equation of interest (Bhagat and Bolton 2008; Coles et al. 2008; Faleye 2015). Instruments should be
correlated with faultlines (instrument relevance), while being uncorrelated with board performance (instrument validity). In line
with previous research (Laeven and Levine 2007, 2009; John, Litov, and Yeung 2008; Faleye 2015), we choose the average
values of our endogenous variables for firms within the same two-digit SIC industry in the same year (i.e.,
MEANFLSTRENGTH, MEANFLDISTANCE, and MEANFAU). Our reasoning is the following. Prior research has indeed
established isomorphism in organizational structures (DiMaggio and Powell 1983), which has also been shown to hold for
governance structures (e.g., Davis and Greve 1997; Certo 2003). More precisely, board composition mimics that of peers in
order to increase legitimacy (DiMaggio and Powell 1983; Certo 2003) or as a consequence of corporate networks (Davis and
Greve 1997). Additionally, one can intuitively expect firms to be more likely to adopt a governance practice when similar firms
are engaging in the same practice (Faleye 2015), which is confirmed by Joseph, Ocasio, and McDonnell (2014). For example,
industry practice has been shown to be an important explanatory variable for age diversity and board independence (Kang,
Cheng, and Gray 2007; Coles et al. 2008). Hence, a firm’s governance and board structure are likely associated with industry
trends or practices, but governance practices of industry peers are unlikely to directly affect firm performance. We test the
relevance of these instruments using the Stock and Yogo (2005) test and the Kleibergen-Paap-LM statistic, both of which
confirm the association between firm faultlines and the average faultline values in the industry.17 Additionally, all instruments
should load strongly on the faultline variables in the first stages of the model, which is the case.18
Empirical Results. Panel A of Table 4 reports descriptive statistics on all variables included in the regression analysis.
The average Tobin’s Q equals 1.887 and the mean ROA in the sample is 6.6 percent. Descriptive statistics on faultline strength
and faultline distance align with the descriptive statistics on the full ISS dataset. As the variance inflation factors of these
variables are below 2.622, multicollinearity is not considered to be a problem.
The results of the OLS and three-stage least squares (3SLS) estimation are presented in Panels B and C of Table 4. Panel B
shows the estimation results using Tobin’s Q as the dependent variable. Model (1) focuses on board diversity attributes and firm
characteristics without considering the faultline proxies. In line with resource dependence theory, our evidence suggests a
positive association between board diversity and firm performance (Salancik and Pfeffer 1978). The coefficients on the fraction
of financial experts, busy, and female directors, as well as the mean dollar value of director share ownership, are all positive and
significant (PCTFINEXP, p ¼ 0.019; LNMEANSHAREVALUE, p , 0.001; PCTBUSY, p ¼ 0.001; PCTGENDER, p ¼ 0.004).
As expected, the variable measuring the fraction of directors older than 65 has a negative and significant coefficient
(PCTRETIREMENT, p , 0.001). Higher director tenure is associated with a lower Tobin’s Q (LNMEANTENURE, p ¼ 0.022).
In Model (2), we add the faultline variables. The coefficients on the faultline strength and distance variables are negative and
significant (FLSTRENGTH, p ¼ 0.034; FLDISTANCE, p ¼ 0.004; FAU, p ¼ 0.11). One potential interpretation of this result is
that the existence of faultlines in a board hampers firm performance. To address possible endogeneity problems, we present
results using 3SLS in Model (3). Compared with Model (2), the magnitude, as well as the significance level, of the coefficients
on all faultline variables increase (FLSTRENGTH, p , 0.001; FLDISTANCE, p , 0.001; FAU, p ¼ 0.019).19 We conclude that
boards with internally cohesive subgroups and subgroups that differ strongly from one another are negatively associated with a
firm’s Tobin’s Q. This is consistent with previous research showing that firms with strong faultlines in their top management
teams have inferior decision-making in terms of product diversification, IPO performance, and foreign expansion (Barkema and
Shvyrkov 2007; Hutzschenreuter and Horstkotte 2013; Martens et al. 2007). CEO duality is negatively associated with Tobin’s
Q, which is in line with prior research (CEODUALITY, p ¼ 0.021; Hermalin and Weisbach 1998). In all three models, the
coefficients of leverage, volatility of performance, stock returns, financial stability, and board size are all positive and
significant (LEVERAGE, p , 0.001; STDROA, p , 0.001; RET, p , 0.001; ALTMANZ, p , 0.001; LNBOARDSIZE, p ,
0.001), whereas the coefficients of capital intensity, firm size, and lagged performance are negative and significant in the
Tobin’s Q analyses (CAPINT, p , 0.001; LNTA, p , 0.001; LAGROA, p , 0.001), which is in line with previous literature
(e.g., Bhagat and Black 2001; Renders et al. 2010).
17
The Cragg-Donald F-statistic is consistently larger than the Stock-Yogo critical value of 16.38 (Stock and Yogo 2005), and the p-values of the
Kleibergen-Paap-LM statistics are consistently below 0.001.
18
For the Tobin’s Q model, the corresponding p-values in the first stages are: FLSTRENGTHIND, p , 0.001; FLDISTANCEIND, p , 0.001; FAUIND, p ,
0.001. For the ROA model, the p-values are FLSTRENGTHIND, p , 0.001; FLDISTANCEIND, p ¼ 0.001; FAUIND, p ¼ 0.001. In line with Bhagat and
Bolton (2008) and Coles et al. (2008), the endogenous variables are regressed in the first stage on their instruments, as well as on Tobin’s Q (ROA),
board diversity characteristics, and firm fundamentals.
19
As not only board faultlines, but also the other board diversity characteristics, are likely to be determined endogenously, we reestimated Model (1)
while allowing for the endogenous determination of all board diversity characteristics (i.e., PCTINDEPENDENCE, PCTFINEXP, LNMEANTENURE,
LNMEANSHAREVALUE, PCTBUSY, PCTRETIREMENT, PCTGENDER). As instruments, we use the average of the same two-digit SIC industry in
the same year, which is analogous to the faultline instruments. The results (untabulated) are similar to those currently reported in Model (3) of Table 4.

TABLE 4
Performance Model
Panel A: Descriptive Statistics

1st 3rd
n Mean Quartile Median Quartile Std. Dev.
TOBINQ 7,536 1.887 1.119 1.464 2.146 1.295
ROA 6,805 0.066 0.037 0.084 0.134 0.148
FLSTRENGTH 7,536 0.609 0.510 0.615 0.717 0.169
FLDISTANCE 7,536 1.470 1.348 1.451 1.572 0.165
FAU 7,536 0.000 0.009 0.007 0.013 0.036
PCTINDEPENDENCE 7,536 0.753 0.667 0.778 0.857 0.130
PCTFINEXP 7,536 0.215 0.125 0.167 0.286 0.123
LNMEANTENURE 7,536 2.052 1.764 2.079 2.363 0.460
LNMEANSHAREVALUE 7,536 5.374 4.719 5.510 6.128 1.019
PCTBUSY 7,536 0.069 0.000 0.000 0.125 0.096
PCTRETIREMENT 7,536 0.354 0.200 0.333 0.500 0.202
PCTGENDER 7,536 0.100 0.000 0.111 0.167 0.100
CLUSBS 7,536 0.445 0.333 0.444 0.571 0.146
LNBOARDSIZE 7,536 2.120 1.946 2.079 2.303 0.252
CEODUALITY 7,536 0.460 0.000 0.000 1.000 0.500
MTB 6,805 2.396 1.124 1.785 2.925 3.849
LNTA 7,536 6.951 5.680 6.813 8.089 1.715
LEVERAGE 7,536 0.180 0.000 0.133 0.280 0.199
CAPINT 7,536 0.238 0.078 0.164 0.332 0.216
ALTMANZ 7,536 5.024 2.228 3.708 6.247 5.854
SALESGROWTH 7,536 0.103 0.034 0.065 0.178 0.345
LAGROA 7,536 0.061 0.033 0.084 0.135 0.161
STDROA 7,536 0.064 0.019 0.035 0.068 0.092
RET 7,536 0.149 0.232 0.056 0.344 0.677
(continued on next page)
Table 4, Panel C shows the estimation results using ROA as a performance measure. Similar to the Tobin’s Q analyses,
Model (1) reports the results without the faultline variables. The coefficients of the fraction of financial experts and retired
directors, as well as mean dollar value of share ownership by directors, are positive and significant (PCTFINEXP, p ¼ 0.030;
LNMEANSHAREVALUE, p , 0.001; PCTRETIREMENT, p ¼ 0.006). This is consistent with resource dependence theory
(Salancik and Pfeffer 1978), which states that having different kinds of expertise on a board may be indicative of added
value. We further find that the coefficients on the fraction of board independence and busyness are negative and significant in
all ROA regressions (PCTINDEPENDENCE, p ¼ 0.028; PCTBUSY, p ¼ 0.005), which is different from expectations. One
potential explanation for the result for board independence is that the negative effects of intense monitoring might outweigh
its positive monitoring effects, which is consistent with Faleye et al. (2011). In Model (2), we add the three faultline
variables, and we only find a significant and negative coefficient for faultline distance (FLSTRENGTH, p ¼ 0.809;
FLDISTANCE, p ¼ 0.090; FAU, p ¼ 0.947). In Model (3), we reestimate the specification of Model (2) using 3SLS. Again,
only one faultline variable is significant (FLSTRENGTH, p ¼ 0.628; FLDISTANCE, p , 0.001; FAU, p ¼ 0.560). The
stronger evidence for the faultline variables in the Tobin’s Q than the ROA regression is in line with Bhagat and Black
(1999) and Haslam, Ryan, Kulich, Trojanowski, and Atkins (2010), indicating that board characteristics have a stronger
association with stock-based performance compared to accounting-based measures of firm performance. Turning to the firm
control variables, all three ROA model specifications show that the coefficients of board size, firm growth, and riskiness are
negative and significant (LNBOARDSIZE, p , 0.001; MTB, p , 0.001; STDROA, p , 0.001), whereas the coefficients of
leverage, firm size, and financial stability are positive and significant (LEVERAGE, p , 0.001; LNTA, p , 0.001;
ALTMANZ, p , 0.001).

TABLE 4 (continued)
Panel B: Performance Model Regression Analysis (Dependent Variable ¼ TOBINQ)
Model 1: OLS Model 2: OLS Model 3: 3SLS
Expected
Sign Coeff. t-stat. Coeff. t-stat. Coeff. t-stat.
Intercept þ/ 0.855 4.54*** 0.388 1.16 0.167 0.47
FLSTRENGTH 0.215 2.12** 0.370 3.83***
FLDISTANCE 0.242 2.85*** 0.396 4.77***
FAU 0.537 1.60 0.712 2.35**
PCTINDEPENDENCE þ 0.134 1.52 0.018 0.20 0.053 0.56
PCTFINEXP þ 0.194 2.36** 0.245 2.92*** 0.275 3.12***
LNMEANTENURE þ/ 0.060 2.29** 0.058 2.21** 0.056 2.10**
LNMEANSHAREVALUE þ 0.453 23.85*** 0.452 23.90*** 0.452 29.68***
PCTBUSY þ/ 0.371 3.25*** 0.376 3.30*** 0.379 3.34***
PCTRETIREMENT 0.266 4.30*** 0.239 3.79*** 0.226 3.80***
PCTGENDER þ 0.340 2.86*** 0.388 3.18*** 0.409 3.32***
CLUSBS þ 0.154 1.37 0.301 1.54 0.402 2.24**
LNBOARDSIZE þ/ 0.471 6.77*** 0.472 5.05*** 0.471 5.01***
CEODUALITY 0.050 2.35** 0.050 2.31** 0.049 2.30**
LNTA þ/ 0.222 18.30*** 0.221 18.24*** 0.221 21.48***
LEVERAGE þ 1.389 15.20*** 1.394 15.28*** 1.394 21.42***
CAPINT 0.620 7.34*** 0.621 7.37*** 0.620 8.17***
ALTMANZ þ 0.091 22.13*** 0.091 22.26*** 0.091 40.51***
SALESGROWTH þ 0.058 1.02 0.056 1.00 0.056 1.73*
LAGROA þ/ 1.341 8.78*** 1.344 8.81*** 1.344 15.39***
STDROA þ/ 4.018 14.72*** 4.018 14.76*** 4.011 28.12***
RET þ 0.170 6.84*** 0.169 6.85*** 0.169 9.61***
Industry controls Yes Yes Yes
Year controls Yes Yes Yes
n 7,536 7,536 7,536
Adjusted-R2 0.538 0.539 0.490
p-value model ,0.0001 ,0.0001 ,0.0001
Model II: CEO Turnover

Empirical Model. In our CEO turnover model, we estimate the effect of faultlines on the performance sensitivity of
turnover using the following logistic model based on Bushman et al. (2010), Faleye et al. (2011), Fisman, Khurana, Rhodes-
Kropf, and Yim (2014), and Goyal and Park (2002):
FORCEDit ¼ b0 þ b1 FLSTRENGTHit þ b2 FLDISTANCEit þ b3 FAUit þ b4 LAGPERFit þ b5 FLSLAGPERFit

þ b6 FLDLAGPERFit þ b7 FAU LAGPERFit þ b8 PCTINDEPENDENCEit þ b9 PCTFINEXPit
þ b10 LNMEANTENUREit þ b11 LNMEANSHAREVALUEit þ b12 PCTBUSYit þ b13 PCTRETIREMENTit
þ b14 PCTGENDERit þ b15 CLUSBSit þ b16 LNBOARDSIZEit þ b17 LAGCEODUALITYit
þbX18 LAGLNAGEit þ b19 LAGLNTENUREit þ b20 LNTAit þ b21 STDROAit þ b22 STDRETit þ b23 MTBit
X
þ bt Year Effectsit þ bx Industry Effectsix þ e;
ð2Þ
where:
FORCED ¼ dummy variable that equals 1 when there is a forced CEO change, and 0 otherwise;
LAGPERF ¼ company performance in the year preceding turnover, measured as the cumulative monthly returns in year
t1;
LAGCEODUALITY ¼ dummy variable that equals 1 when the CEO serves as chair of the board in year t1, and 0
otherwise;
LAGLNAGE ¼ natural logarithm of CEO age in year t1;

TABLE 4 (continued)
Panel C: Performance Model Regression Analysis (Dependent Variable ¼ ROA)
Model 1: OLS Model 2: OLS Model 3: 3SLS
Expected
Intercept þ/ 0.153 5.62*** 0.100 2.24** 0.042 0.86
FLSTRENGTH 0.003 0.24 0.006 0.49
FLDISTANCE 0.019 1.69* 0.038 3.38***
FAU 0.003 0.07 0.024 0.58
PCTINDEPENDENCE þ 0.027 2.20** 0.035 2.64*** 0.043 3.27***
PCTFINEXP þ 0.024 2.17** 0.028 2.47** 0.032 2.68***
LNMEANTENURE þ/ 0.001 0.29 0.001 0.26 0.001 0.27
LNMEANSHAREVALUE þ 0.045 20.13*** 0.045 20.12*** 0.045 22.86***
PCTBUSY þ/ 0.048 2.79*** 0.047 2.75*** 0.046 3.00***
PCTRETIREMENT 0.022 2.74*** 0.025 2.97*** 0.027 3.35***
PCTGENDER þ 0.011 0.69 0.017 1.01 0.025 1.53
CLUSBS þ 0.019 1.20 0.028 1.06 0.055 2.28**
LNBOARDSIZE þ/ 0.028 2.81*** 0.035 2.80*** 0.049 3.91***
CEODUALITY 0.002 0.68 0.002 0.59 0.001 0.43
MTB þ 0.002 2.47** 0.002 2.48** 0.002 4.45***
LNTA þ/ 0.008 5.58*** 0.008 5.60*** 0.008 6.18***
LEVERAGE þ 0.077 5.76*** 0.077 5.76*** 0.077 8.63***
CAPINT 0.008 0.75 0.007 0.72 0.007 0.72
ALTMANZ þ 0.008 14.88*** 0.008 14.88*** 0.008 26.67***
STDROA 0.405 8.95*** 0.405 8.94*** 0.405 20.48***
n 6,805 6,805 6,805
Adjusted-R2 0.426 0.426 0.459
p-value model ,0.001 ,0.001 ,0.001
*, **, *** Denote significance at the 10 percent, 5 percent, and 1 percent levels (two-tailed), respectively.
Panel A of Table 4 shows the descriptive statistics on the variables used in the performance model. Panel B shows the results from the model estimation
using TOBINQ as the dependent variable. Panel C shows the results from the model estimation using ROA as the dependent variable. Coefficient p-values
are based on asymptotic t-statistics robust to heteroscedasticity.
TOBINQ ¼ total assets plus the market value of equity, minus the book value of equity and scaled over total assets;
ROA ¼ earnings before interest and taxes (EBIT) over total assets;
FLDISTANCE ¼ the difference between board subgroups, defined as the Euclidean distance between subgroup centroids;
LNMEANTENURE ¼ the natural log of mean director tenure on the board;
LNMEANSHAREVALUE ¼ the natural logarithm of 1 plus the mean dollar value of share ownership by directors in the board;
PCTRETIREMENT ¼ the percentage of directors on the board who are at least 65 years old;
CLUSBS ¼ the number of clusters in the cluster solution scaled by board size;
LNBOARDSIZE ¼ the natural logarithm of the number of board members;
CEODUALITY ¼ a dummy variable equal to 1 if the CEO serves as the chairman of the board, and 0 otherwise;
MTB ¼ the market-to-book ratio, defined as the market value of equity over the book value of equity;
LNTA ¼ the natural logarithm of total assets;
LEVERAGE ¼ long-term liabilities over total assets;
CAPINT ¼ PPE over total assets;
ALTMANZ ¼ the Altman Z-score, defined by Altman (1968);
SALESGROWTH ¼ the percentage growth in sales over the previous year;
LAGROA ¼ the return on assets lagged by one year;
STDROA ¼ the standard deviation of the firm’s ROA over the past five years; and
RET ¼ the yearly stock market return.

LAGLNTENURE ¼ natural logarithm of CEO tenure in year t1; and

STDRET ¼ standard deviation of stock returns over the past five years.
All other variables are as defined in Model (1).
We use a logistic regression model for our analysis. The dependent variable of our model equals 1 for forced turnovers, and
0 for non-turnover control firms. Our variable of interest is the interaction term between firm performance in year t1
(LAGPERF) and faultlines (FLSTRENGTH, FLDISTANCE, and FAU). Whereas b4 reflects the effect of LAGPERF on CEO
turnover, b5, b6, and b7, respectively, reflect the effect of FLSTRENGTH, FLDISTANCE, and FAU on the performance
sensitivity of CEO turnover. Given that we expect higher firm performance to be associated with a lower likelihood of
subsequent CEO turnover (i.e., b4 is negative), a positive coefficient of the interaction between LAGPERF and FLSTRENGTH,
FLDISTANCE, and FAU would then suggest a moderating effect of board faultlines on the performance-turnover relationship.
As a measure of LAGPERF, we use stock returns, as prior research argues that stock return is an important factor in explaining
CEO turnover (e.g., DeFond and Hung 2004; Bushman et al. 2010; Faleye et al. 2011; Fisman et al. 2014). Specifically, we
define LAGPERF as cumulative monthly returns in the prior year (Goyal and Park 2002; Fisman et al. 2014).20 Furthermore,
based on previous literature, we include the natural logarithms of CEO age and tenure in year t1, as well as various firm
performance proxies (Bushman et al. 2010; Lee et al. 2012).
Empirical Results. Panel A of Table 5 displays descriptive statistics on our CEO turnover sample. Mean forced turnover
is 0.047, which is in line with previous research on CEO forced turnover (e.g., Bushman et al. 2010). The descriptive statistics
of the faultline variables and diversity characteristics are in line with the full sample. As the maximum variance inflation factor
equals 2.702, multicollinearity is not considered a problem.
In Panel B of Table 5, Model (1) explains CEO turnover without considering faultline effects. The coefficients of mean
tenure, the value of shares held, and the fraction of retired directors are negative and significant (LNMEANTENURE, p ,
0.001; LNMEANSHAREVALUE, p , 0.001; PCTRETIREMENT, p ¼ 0.064), whereas the coefficient of the proportion of
female directors is positive and significant in the CEO turnover regression (PCTGENDER, p ¼ 0.053). When we add the
faultline variables in Model (2), we find only a significant and negative coefficient for faultline strength (FLSTRENGTH, p ,
0.001). The coefficients of the two other faultline variables are not statistically significant (FLDISTANCE, p ¼ 0.358; FAU, p ¼
0.393). In Model (3), we introduce the interaction variables between all three faultline measures and firm performance in the
CEO turnover analysis. The coefficients for the main effects FLSTRENGTH and LAGPERF are still negative (LAGPERF, p ,
0.001; FLSTRENGTH, p , 0.001), but the coefficient on FAU LAGPERF is positive and significant (p ¼ 0.045). This result
provides some evidence that the performance sensitivity of CEO turnover is lower in the presence of faultlines. This is also
consistent with prior research in the management literature documenting that when boards suffer from communication and
coordination problems, the CEO has more power over board decision-making, and the board’s ability to control management
decreases (e.g., Eisenberg et al. 1998; Ryan and Wiggins 2004; Cheng 2008). Of the control variables, lagged CEO duality has
a negative and significant coefficient (LAGCEODUALITY, p , 0.001), which could be indicative of managerial entrenchment
(Hermalin and Weisbach 1998). The number of subgroups, board size, and CEO age, as well as CEO tenure, have significant
and positive coefficients in the CEO turnover regression (CLUSBS, p , 0.001; LNBOARDSIZE, p , 0.001; LAGLNAGE, p ,
0.001; LAGLNTENURE, p , 0.001). Larger firms are also associated with a higher incidence of turnover, while the standard
deviation of stock returns is significant with a negative sign (LNTA, p , 0.077; STDRET, p , 0.086).
Model III: CEO Abnormal Compensation

Empirical Model. We next examine whether strong board faultlines are associated with abnormal CEO compensation. We
do so by estimating the following two-stage model (Faleye et al. 2011):
LNCOMPit ¼ b0X
þ b1 LNTAit þ b2 BTMX it þ b3 RETit þ b4 ROAit þ b5 STDRETit þ b6 STDROAit
þ bt Year Effectsit þ bx Industry Effectsix þ e; ð3Þ
ABNCOMPit ¼ b0 þ b1 FLSTRENGTHit þ b2 FLDISTANCEit þ b3 FAUit þ b4 PCTINDEPENDENCEit

þ b5 PCTFINEXPit þ b6 LNMEANTENUREit þ b7 LNMEANSHAREVALUEit þ b8 PCTBUSYit
þ b9 PCTRETIREMENTit þ b10 PCTGENDERit þ X b11 CLUSBSit þ b12 LNBOARDSIZE
X it
þ b13 CEODUALITYit þ b14 LNCEOTENUREit þ bt Year Effectsit þ bx Industry Effectsix þ e; ð4Þ
20
In additional untabulated analyses, we define LAGPERF as the return on assets in the prior year, and we obtain similar results. Specifically, we find that
LAGPERF and LAGPERF FAU are significantly associated with CEO turnover (p , 0.001 and p ¼ 0.025, respectively), whereas the coefficients of
LAGPERF FLS and LAGPERF FLD are insignificant.

TABLE 5
CEO Turnover Model
Panel A: Descriptive Statistics (n ¼ 4,383)

1st 3rd
Mean Quartile Median Quartile Std. Dev.
FORCED 0.047 0.000 0.000 0.000 0.211
FLSTRENGTH 0.608 0.513 0.612 0.712 0.166
FLDISTANCE 1.468 1.347 1.447 1.570 0.163
FAU 0.000 0.008 0.007 0.013 0.035
LAGPERF 0.177 0.134 0.171 0.464 0.558
PCTINDEPENDENCE 0.765 0.700 0.778 0.875 0.124
PCTFINEXP 0.219 0.125 0.167 0.300 0.125
LNMEANTENURE 2.142 1.883 2.147 2.406 0.400
LNMEANSHAREVALUE 5.534 4.928 5.633 6.215 0.935
PCTBUSY 0.065 0.000 0.000 0.125 0.093
PCTRETIREMENT 0.375 0.222 0.375 0.500 0.200
PCTGENDER 0.104 0.000 0.111 0.167 0.101
CLUSBS 0.445 0.333 0.444 0.571 0.142
LNBOARDSIZE 2.121 1.946 2.079 2.303 0.242
LAGCEODUALITY 0.497 0.000 0.000 1.000 0.500
LNLAGAGE 4.009 3.912 4.007 4.094 0.131
LNLAGTENURE 2.002 1.386 2.079 2.708 0.937
LNTA 7.026 5.752 6.893 8.164 1.715
STDROA 0.062 0.019 0.034 0.064 0.090
STDRET 0.647 0.285 0.422 0.660 0.891
MTB 2.564 1.225 1.902 3.106 3.675
where:
LNCOMP ¼ natural logarithm of the CEO’s total compensation, defined as the sum of the CEO’s base salary, bonus, value
of restricted stock granted, the total value of stock options granted, and long-term incentive plans;
BTM ¼ book value of equity/market value of equity; and
ABNCOMP ¼ residuals from regression Model (3).
LNCEOTENURE ¼ the natural logarithm of CEO tenure.
All other variables are as defined in Models (1) and (2).
Using an OLS regression analysis, we first estimate a model of normal compensation by regressing the natural log of CEO
total compensation on observable economic determinants of CEO pay (Faleye et al. 2011). The residual of the first regression then
captures the part of CEO compensation that cannot be attributed to the underlying economic determinants included in the model.
This residual is used as a dependent variable in the second stage, in which the faultline variables are used as test variables. We call
this residual ‘‘abnormal compensation,’’ although omitted firm or CEO characteristics not taken into account in the first-stage
regression model may still influence the level of the residual.21 After controlling for board diversity and CEO characteristics, we
expect positive coefficients for the faultline variables of interest (FLSTRENGTH, FLDISTANCE, and FAU), which means that
unexplained management compensation—as a proxy for abnormal compensation—increases in board faultlines.22
21
To control for possible omitted variable problems, we ran different model specifications, which are reported in additional analyses. First, we include CEO
fixed effects in the first stage of the compensation model. These CEO fixed effects address the concern of time-invariant CEO characteristics that could
potentially drive our results, such as CEO ability, executive talent, and other personal characteristics. Furthermore, we relate abnormal CEO compensation
to future firm performance. Finally, we relate faultlines to alternative CEO compensation measures, such as the fraction of equity-based compensation and
the level of total CEO compensation. Results of those tests are robust and hint at an association between faultlines and CEO compensation. While these
tests cannot completely rule out concerns regarding omitted variable bias, they do provide some additional confirmation of our findings.
22
Next to positive abnormal compensation, negative values of the residual may be equally problematic, as they may signal ‘‘undercompensation’’ of the
CEO. Dow and Raposo (2005) model both positive and negative residual compensation analytically and show that although both situations may have
adverse consequences, those of ‘‘undercompensating’’ a CEO may be mitigated through commitment mechanisms. Furthermore, additional analyses, as
well as prior research by Core et al. (1999), show that it is positive abnormal compensation that predicts worse future firm performance, whereas
negative residual compensation is not associated with future firm performance.

TABLE 5 (continued)
Panel B: Logistic Regression Analysis (Dependent Variable ¼ FORCED)
Model 1 Model 2 Model 3
Expected
Sign Coeff. v-stat. Coeff. v-stat. Coeff. v-stat.
Intercept þ/ 26.529 50.67*** 32.050 51.84*** 32.155 50.50***
FLSTRENGTH 3.296 15.90*** 3.135 13.69***
FLDISTANCE 0.885 1.55 0.694 0.85
FAU 0.250 0.01 3.073 0.73
LAGPERF þ 0.970 21.33*** 1.011 21.74***
FLS LAGPERF þ 0.824 0.72
FLD LAGPERF þ 0.991 1.00
FAU LAGPERF þ 10.377 4.04**
PCTINDEPENDENCE þ 0.888 1.42 1.324 2.41 1.402 2.66
PCTFINEXP þ/ 0.757 1.24 0.991 1.88 1.032 2.02
LNMEANTENURE þ/ 1.650 38.33*** 1.683 38.71*** 1.701 38.95***
LNMEANSHAREVALUE þ/ 0.557 24.07*** 0.464 15.52*** 0.465 15.43***
PCTBUSY þ/ 0.676 0.61 0.831 0.89 0.732 0.69
PCTRETIREMENT 0.930 3.44* 1.272 5.78** 1.238 5.47**
PCTGENDER þ/ 1.701 3.76* 0.568 0.35 0.552 0.33
CLUSBS þ 1.104 1.33 5.770 14.11*** 5.876 14.68***
LNBOARDSIZE þ/ 1.465 5.25 3.203 14.92*** 3.211 14.93***
LAGCEODUALITY 2.248 125.09*** 2.224 118.92*** 2.235 119.71***
LAGLNAGE þ 6.191 56.00*** 6.296 56.07*** 6.329 56.35***
LAGLNTENURE þ 0.655 30.53*** 0.705 34.17*** 0.712 34.48***
LNTA þ 0.168 5.11** 0.133 3.13* 0.143 3.55*
STDROA þ/ 1.968 1.99 2.168 2.33 2.351 2.71
STDRET þ/ 0.239 3.37* 0.219 2.96* 0.225 3.08*
MTB 0.011 0.18 0.016 0.38 0.016 0.36
n 4.383 4.383 4.383
Log(Pseudolikelihood) 1,296.62 1,257.24 1,250.27
p-value model ,0.001 ,0.001 ,0.001
Panel A of Table 5 shows the descriptive statistics on the variables used in the turnover model. Panel B shows the results from the model estimation.
Coefficient p-values are based on v-statistics.
FORCED ¼ a dummy equal to 1 when there is a forced CEO change, and 0 otherwise;
FLDISTANCE ¼ the difference between subgroups, defined as the Euclidean distance between subgroup centroids;
LAGPERF ¼ the cumulative monthly stock returns in year t1;
LNMEANSHAREVALUE ¼ the natural logarithm of 1 plus the mean dollar value of share ownership by directors on the board;
PCTRETIREMENT ¼ the percentage of directors on the board aged at least 65;
LAGCEODUALITY ¼ a dummy variable equal to 1 if the CEO serves as chairman of the board in year t1.
LAGLNAGE ¼ the natural logarithm of CEO age in year t1;
LAGLNTENURE ¼ the natural logarithm of CEO tenure in year t1;
STDROA ¼ the standard deviation of the firm’s ROA over the past five years;
STDRET ¼ the standard deviation of the firm’s stock returns over the past five years; and
MTB ¼ the market-to-book ratio, defined as the market value of equity over the book value of equity.

TABLE 6
CEO Compensation Model
Panel A: Descriptive Statistics (n ¼ 4,265)

1st 3rd
Mean Quartile Median Quartile Std. Dev.
Stage 1
LNCOMP 8.165 7.528 8.195 8.814 0.928
LNTA 7.563 6.436 7.419 8.574 1.570
BTM 0.612 0.329 0.527 0.806 0.449
RET 0.112 0.207 0.059 0.310 0.532
ROA 0.100 0.057 0.096 0.145 0.089
STDRET 0.579 0.258 0.379 0.570 0.856
STDROA 0.043 0.017 0.029 0.052 0.044
Stage 2
ABNCOMP 0.431 0.15 0.326 0.599 0.392
FLSTRENGTH 0.602 0.512 0.608 0.704 0.160
FLDISTANCE 1.457 1.337 1.435 1.552 0.160
FAU 0.000 0.007 0.007 0.013 0.035
PCTINDEPENDENCE 0.782 0.714 0.800 0.875 0.113
PCTFINEXP 0.222 0.125 0.182 0.308 0.127
LNMEANTENURE 2.146 1.897 2.148 2.408 0.392
LNMEANSHAREVALUE 5.683 5.163 5.790 6.291 0.882
PCTBUSY 0.074 0.000 0.000 0.125 0.096
PCTRETIREMENT 0.371 0.222 0.364 0.500 0.197
PCTGENDER 0.113 0.000 0.111 0.182 0.100
CLUSBS 0.425 0.333 0.444 0.500 0.137
LNBOARDSIZE 2.174 1.946 2.197 2.303 0.254
CEODUALITY 0.542 0.000 1.000 1.000 0.498
LNCEOTENURE 2.115 1.609 2.079 2.708 0.788
Empirical Results. Panel A of Table 6 presents the descriptive statistics on the compensation sample. The average natural
log of CEO total compensation equals 8.165 and is strongly skewed to the right, indicating that some CEOs receive high
compensation relative to their peers. Note that descriptive statistics on faultline strength, faultline distance, and the interaction
are in line with the descriptive statistics on the full ISS dataset. The variance inflation factors for these variables remain below
2.720.
Model (1) in Table 6, Panel B presents the results from the first stage of the model, in which the natural log of total
compensation is regressed on various firm performance and risk variables. In line with previous research (Core, Holthausen,
and Larcker 1999; Faleye et al. 2011), firm size, performance, and riskiness are associated with CEO compensation in the first
stage of the model (LNTA, p , 0.001; BTM, p , 0.001; RET, p , 0.001; ROA, p , 0.001; STDROA, p , 0.001). The second
stage of our analysis is shown in Models (2) and (3). Model (2) examines the association between board diversity and CEO
abnormal compensation. Related to the diversity characteristics, the coefficients on director tenure and the fraction of female
directors are negatively correlated with abnormal compensation (PCTGENDER, p ¼ 0.008; LNMEANTENURE, p , 0.001),
whereas the coefficients of the fraction of independent and retired directors, as well as the value of director shareholdings, are
positive and significant (PCTINDEPENDENCE, p , 0.001; LNMEANSHAREVALUE, p ¼ 0.006; PCTRETIREMENT, p ,
0.001). Coles, Daniel, and Naveen (2014) and Faleye et al. (2011) suggest overburdening of independent directors, as well as
their allegiance to the CEO, as potential explanations for the positive coefficient of director independence. Adding the three
faultline variables in Model (3) shows that only the coefficient of faultline distance is positive and significant (FLSTRENGTH,
p ¼ 0.185; FLDISTANCE, p ¼ 0.010; FAU, p ¼ 0.985). Hence, our results appear to suggest that differences between board
subgroups are helpful in explaining CEO abnormal compensation (i.e., the part of compensation that is not explained by the
economic determinants of CEO pay included in the first-stage regression model). Finally, related to the other control variables,
the abnormal CEO compensation model shows positive and significant coefficients for board size, as well as CEO duality

TABLE 6 (continued)
Panel B: Compensation Model Regression Analysis (Dependent Variables ¼ LNCOMP, ABNCOMP)
Model 1: Stage 1: Model 2: Stage 2: Model 3: Stage 2:
LNCOMP ABNCOMP ABNCOMP
Expected
Intercept þ/ 4.972 54.89*** 0.453 2.27** 1.143 3.50***
FLSTRENGTH þ 0.121 1.33
FLDISTANCE þ 0.195 2.58***
FAU þ 0.005 0.02
PCTINDEPENDENCE 0.663 6.51*** 0.765 6.97***
PCTFINEXP þ/ 0.077 1.11 0.125 1.76*
LNMEANTENURE þ/ 0.161 4.96*** 0.164 5.07***
LNMEANSHAREVALUE þ/ 0.035 2.78*** 0.035 2.77***
PCTBUSY þ/ 0.127 1.28 0.120 1.21
PCTRETIREMENT þ 0.251 4.44*** 0.221 3.84***
PCTGENDER þ/ 0.274 2.65*** 0.370 3.43***
CLUSBS 0.007 0.06 0.288 1.61
LNBOARDSIZE þ/ 0.014 0.22 0.152 1.84*
CEODUALITY þ 0.032 1.58 0.036 1.78*
LNCEOTENURE þ 0.028 1.88* 0.025 1.65*
LNTA þ 0.454 61.56***
BTM þ/ 0.197 7.91***
RET þ 0.061 3.07***
ROA þ 0.397 2.94***
STDRET þ 0.012 1.06
STDROA þ 0.852 3.13***
n 4,265 4,265 4,265
Adjusted-R2 0.602 0.035 0.036
p-value model ,0.0001 ,0.0001 ,0.0001
Panel A of Table 6 shows the descriptive statistics on the variables used in the compensation model. Panel B contains the results from the model
estimations. Coefficient p-values are based on asymptotic t-statistics robust to heteroscedasticity.
LNCOMP ¼ the natural logarithm of the CEO’s total compensation;
BTM ¼ the firm’s book-to-market ratio;
RET ¼ the yearly stock market return;
ROA ¼ EBIT over total assets;
STDRET ¼ the standard deviation of the firm’s stock return over the past five years;
STDROA ¼ the standard deviation of the firm’s return on assets over the past five years;
ABNCOMP ¼ the residual obtained by regressing LNCOMP on observable economic determinants of CEO pay;
FLDISTANCE ¼ the difference between subgroups, defined as the Euclidean distance between subgroup centroids;
LNMEANSHAREVALUE ¼ the natural logarithm of 1 plus the mean dollar value of share ownership by directors on the board;
PCTRETIREMENT ¼ defined as the percentage of directors on the board aged at least 65;
CEODUALITY ¼ a dummy variable equal to 1 if the CEO serves as the chairman of the board, and 0 otherwise; and
LNCEOTENURE ¼ the natural logarithm of the CEO’s tenure.

(LNBOARDSIZE, p ¼ 0.065; CEODUALITY, p ¼ 0.075), and a negative coefficient for CEO tenure (CEOTENURE, p ¼ 0.10).
The latter findings may relate to managerial ability or entrenchment, which is explored in the additional analyses.
V. ADDITIONAL ANALYSES
To enhance the validity of our results, we perform a number of sensitivity checks and robustness tests. First, we test the
association between faultlines and additional output measures of board performance. Second, we further explore the
relationship between faultlines and abnormal CEO compensation.
Additional Measures of Board Performance

As board performance covers a wide range of responsibilities, we reestimate our main models using other output measures:
earnings management, internal control deficiencies, and investment efficiency. We expect faultlines to be associated with
higher earnings management, as boards with strong faultlines may suffer from coordination issues and disagreements, which
may ultimately negatively affect board monitoring (Thatcher et al. 2003; Li and Hambrick 2005; Harrison and Klein 2007;
Halevy 2008). First, we test the relationship between faultlines and abnormal accruals estimated using the method of Ball and
Shivakumar (2006). Untabulated results show that faultline distance is correlated with the level of positive abnormal accruals
(FLSTRENGTH, p ¼ 0.271; FLDISTANCE, p ¼ 0.047; FAU, p ¼ 0.106). Second, we use Dechow and Dichev (2002) accrual
estimation errors in the specification of Jones, Krishnan, and Melendrez (2008) as a measure of earnings management, and find
in untabulated analysis that faultline distance and the interaction are significantly associated with accrual quality
(FLSTRENGTH, p ¼ 0.900; FLDISTANCE, p ¼ 0.072; FAU, p ¼ 0.027). Using internal control deficiencies as a third
additional measure of board effectiveness, untabulated analyses show that the coefficient of faultline strength is positive and
significant (FLSTRENGTH, p ¼ 0.021; FLDISTANCE, p ¼ 0.989; FAU, p ¼ 0.630). Finally, we model under- and over-
investment using a two-stage model based on Biddle, Hilary, and Verdi (2009). We expect faultlines to be associated with
under- or over-investment as they hamper discussion of entrepreneurial issues in the board (Tuggle et al. 2010). The results
(untabulated) show that firms with high board faultline strength and distance are more likely to be subject to over- or under-
investing (FLSTRENGTH, p ¼ 0.025; FLDISTANCE, p ¼ 0.098; FAU, p ¼ 0.617). Taken together, our results provide evidence
that faultlines are associated with lower financial statement quality and investment efficiency.
Faultlines and CEO Compensation Plans

This section further investigates the association between CEO compensation and faultlines by (1) focusing on the positive
compensation residual, (2) relating abnormal CEO compensation to future firm performance, (3) including executive fixed
effects in the first stage, and (4) relating faultlines to the level of total CEO compensation, as well as the fraction of equity-
based compensation. First, based on Faleye et al. (2011), we examine the correlation between faultlines and positive abnormal
CEO compensation. To this end, we use as the dependent variable a dummy variable, DRESCOMP, which equals 1 when the
compensation residual is positive, and 0 otherwise. In line with the results of the main analysis, untabulated results show that
faultline distance is associated with a positive CEO compensation residual (FLSTRENGTH, p ¼ 0.355; FLDISTANCE, p ¼
0.034; FAU, p ¼ 0.600).
Second, we provide some evidence that the estimated residual is likely to reflect abnormal compensation rather than
unobservable determinants of CEO performance (Hayes and Schaefer 2000). Specifically, we relate abnormal CEO
compensation to subsequent-year firm ROA, as well as the average ROA over the next three years, while controlling for current
ROA, volatility in ROA, firm size, sales growth, and Altman’s Z (Core et al. 1999; Hwang and Kim 2009).23 Untabulated
results show that both abnormal compensation and the likelihood of awarding positive abnormal compensation are negatively
related to ROA in the subsequent year (ABNCOMP, p ¼ 0.003; DRESCOMP, p ¼ 0.008). Additionally, the likelihood of
awarding positive abnormal compensation is also negatively related to ROA over the next three years (ABNCOMP, p ¼ 0.128;
DRESCOMP, p ¼ 0.039). These results appear to suggest that CEO abnormal compensation likely reflects suboptimal CEO
compensation, rather than unobservable measures of CEO performance.
Third, we include executive fixed effects as a way of capturing unobservable CEO time-invariant factors, such as
managerial ability. When executive fixed effects are added in the first stage, second-stage results hold when explaining
ABNCOMP (FLDISTANCE, p ¼ 0.001), as well as the dummy variable DRESCOMP (FLDISTANCE, p ¼ 0.034) in the second
stage. This analysis alleviates some of the concerns on omitted variable bias by removing time-invariant CEO characteristics
from the compensation residual.
23
Results are analogous when we also include other control variables, such as capital intensity, leverage, market-to-book ratio, board characteristics, or
sales growth.

Fourth, we follow Adams and Ferreira (2009) in using the level of total compensation, as well as the fraction of equity-
based compensation, as dependent variables. Specifically, we adopt a one-stage approach by regressing both compensation
measures on economic determinants of CEO pay, our faultline variables, and diversity characteristics. The coefficient of
faultline distance is positive and significant (FLSTRENGTH, p ¼ 0.207; FLDISTANCE, p ¼ 0.017; FAU, p ¼ 0.950), which is in
line with the main analyses. When the fraction of equity-based pay is used as the dependent variable, results provide some weak
evidence that faultlines may influence compensation through a higher reliance on fixed pay (FLSTRENGTH, p ¼ 0.092,
FLDISTANCE, p ¼ 0.310; FAU, p ¼ 0.987).
These supplementary analyses might alleviate some of the concern that the results are being driven by omitted variables,
such as CEO power or ability, while providing some insight in how faultlines affect CEO compensation.
VI. CONCLUSION
In this paper, we examine the association between faultlines and board performance. The importance of establishing sound
corporate governance mechanisms has been widely acknowledged following the financial crisis. As a result, new legislation
and corporate guidelines aim to increase board diversity, board independence, and director qualifications, under the belief that
these attributes will positively affect board effectiveness. We challenge this assumption and explore whether, in addition to the
direct effect of diversity attributes, indirect effects through subgroup formation may help explain board effectiveness. Our
investigation of board diversity structure is based on a relatively new behavioral theory, known as faultline theory, which was
developed by Lau and Murnighan (1998). Faultline theory offers a framework for explaining how diversity attributes may
translate into subgroup formation and subsequently negatively impact group performance. Whether board diversity results in
the formation of subgroups crucially depends on how board diversity characteristics (e.g., director independence, expertise,
tenure) are distributed among directors. Faultlines are strongest when diversity attributes within a subgroup are very similar to
one another, but very different from those of other subgroups (Lau and Murnighan 2005). These faultlines then have a negative
impact on overall group performance (Bezrukova et al. 2009; Thatcher et al. 2003).
Based on this theoretical framework, we expect diversity-based faultlines among directors to be associated with lower
board performance. We test this prediction using a sample of 2,953 U.S.-listed firms between 2008 and 2012. We provide some
evidence that board faultlines are correlated with board performance, after controlling for board diversity. Specifically, our
results suggest that strong faultlines are negatively associated with firm performance and the likelihood of CEO turnover,
whereas they are positively associated with abnormal CEO compensation. One potential interpretation of this result is that that
faultlines might hamper the advisory and monitoring functions of the board of directors, which casts doubt on the suggestion
that board diversity unambiguously increases board performance.
As this paper is one of the first to test faultline theory in a large-scale empirical governance study, a number of questions
remain open to further research. One such avenue for further research may be the assessment of the long-term effects of
faultlines. For instance, do the effects of faultlines diminish over time in stable boards, or do subgroups crystallize into different
factions? Because most boards evolve over time, future research might examine how the effects of faultlines evolve and how
board replacement should optimally be structured. Another avenue for future research could be the investigation of so-called
moderators. Prior faultline studies show that factors such as shared objectives (Van Knippenberg, Dawson, West, and Homan
2011) or informational diversity (Homan, Van Knippenberg, Van Kleef, and De Dreu 2007) may mitigate or exacerbate the
effects of faultlines. Of particular importance are the moderating effects of group leadership (Kaczmarek et al. 2012), which, in
the context of a board of directors, is the chairman of the board. Insights on how CEO duality, board meeting frequency,
director attendance, and other factors affect faultline dynamics would also prove interesting.
This study is subject to some limitations. Although the notion of faultlines is intuitive and conceptually appealing, its
operationalization is not straightforward. Our algorithm is a mathematical approximation of a complex reality, so we do not
know whether subgroups actually form along the predicted faultlines. To alleviate these concerns, we pre-tested the faultline
algorithm on a set of business cases and interviewed directors to validate the computed faultlines. Despite satisfactory results
from these cases, certain issues remain. In the faultline computation algorithm that we employ, all diversity characteristics
receive equal weights. However, not all characteristics are equally relevant across all boards, and not all characteristics are
equally important for specific board performance measures. Furthermore, faultlines with equal strength and distance may have
different effects, depending on which characteristics drive the faultlines and how important the underlying characteristics are
for the specific task at hand. A final limitation relates to data restrictions. We cannot proxy for director personality, dominance,
or agreement-seeking behavior. These underlying personality traits can be measured only by using psychological tests that are
outside the scope of this research project. The same limitation applies to directors’ cultural backgrounds, for which we have no
data.
Our paper could be of interest to regulators and companies. The analyses provide some evidence that not only the level of
board diversity matters in explaining board performance, but also the structure of board diversity. In particular, board diversity

might have beneficial or detrimental effects on board performance, depending on how director diversity is structured. The
process of appointing a new director should, therefore, include consideration of the board dynamics, because such dynamics
probably influence board performance and, in turn, firm performance. As faultline theory is a general theory of group dynamics,
the results may be applicable to other work-related groups, such as specialized committees or departments. Furthermore,
regulators designing minimum board diversity requirements should be aware of the negative consequences such requirements
may have on board performance. Our results support the need, as highlighted by SEC Commissioner Luis Aguilar, to better
understand board diversity and how it affects board dynamics.
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APPENDIX A
Construction of Faultline Measures
Econometric Design
After the determination of the relevant diversity attributes, cluster analysis is applied to transform the matrix of
characteristics into a faultline variable. The clustering algorithm is based on pioneering faultline research by Thatcher et al.
(2003) and Zanutto et al. (2011). However, the leading algorithm has been econometrically optimized. First, the continuous
variables are rescaled by range rather than by standard deviation. This is in contrast to previous faultline research, but it is
grounded in econometric simulation studies (Cooper and Milligan 1988). Rescaling by standard deviation, rather than range,
leads to larger values and a higher variance of the rescaled variable. This variable, in turn, dominates the clustering solution
when other variables display less variance and, thus, have lower weight. Because the dummy variables enter our clustering
algorithm unaltered, rescaling by range is preferable. We further implement a two-step procedure to obtain the optimal cluster
solution (Ketchen and Shook 1996). In a first step, a hierarchical clustering method selects a number of initial seeds and
determines how observations are assigned into clusters. We use Ward’s (1963) error sum of squares method, which minimizes
information loss incurred by clustering observations. Second, a non-hierarchical k-means clustering model refines the cluster
solution into the best possible fit (MacQueen 1967). This approach offers important advantages in comparison with other
faultline research. First, it allows one to compare multiple cluster solutions and decide on the most appropriate number of
clusters on the basis of an objective criterion (pseudo F-statistic) that explains the significance of the group split. This allows
for more than two subgroups, which is a desirable feature (Thatcher and Patel 2012). Boards of directors can include up to 30
persons, so artificially imposing a two-subgroup structure is inappropriate in most cases. Second, solving for the optimal cluster
solution renders the clustering process less sensitive to outliers or the initial seeds on which hierarchical clustering is based.
Third, this approach accounts for within-group similarity and differences between groups. The Thatcher et al. (2003) procedure
tends to focus on the first aspect, because the clustering algorithm tries to maximize faultline strength by finding the strongest
group split. However, one cannot ignore between-group differences for finding the most appropriate subgroup composition.
Adapting the algorithm to these considerations, thus, increases the validity of the faultline measures.
The hierarchical clustering algorithm groups directors based on the Ward (1963) criterion. This entails grouping
observations so as to minimize the loss of information (or the increase in the within-sum of squares) incurred by replacing
observations by their cluster centroid. This analysis is repeated for a two-, three-, and four-cluster setup. The optimal number of
clusters is decided by the pseudo F-statistic, which explains the significance of the group split. Considering the limited group
size, the first step in the algorithm is somewhat biased toward a four-cluster solution because it minimizes information loss
incurred by the clustering procedure. Next, observations are reassigned between clusters based on the k-means clustering
method. Starting from the initial seeds provided by the Ward (1963) cluster solution, observations are replaced if the distance
between the observation and the closest seed is greater than the minimum distance between seeds. Based on the resulting cluster
solution, the algorithm provides the necessary data to calculate the faultline.
In line with previous research and Thatcher et al. (2003), we distinguish between two aspects of faultlines, namely,
faultline strength and faultline distance (Bezrukova et al. 2009; Hutzschenreuter and Horstkotte 2013). Whereas faultline
strength measures the degree of cohesion within subgroups, faultline distance captures the extent to which groups formed along
a faultline diverge. This setup has been widely used in extant research (e.g., Bezrukova et al. 2009; Hutzschenreuter and
Horstkotte 2013). Following Thatcher et al. (2003) and Bezrukova et al. (2009), we compute faultline strength as between-
subgroup variance divided by total variance:
0 X X 1
p q g 2

n ðX :jk X :j: Þ C
B j¼1 k¼1 k
FLSTRENGTHg ¼ @Xp Xq Xng Ag ¼ 1; 2; :::; S: ð5Þ
k
ðXijk X :j: Þ2
j¼1 k¼1 i¼1
:j: is the overall

In this equation, Xijk represents the value of the jth task-related characteristic of the ith member of subgroup k. X
g
group mean of characteristic j. X:jk is the mean of characteristic j in subgroup k. Finally, nk is the number of members of the kth

subgroup (k ¼ 1, 2,. . .) under split g (Kaczmarek et al. 2012). By definition, the faultline strength variable takes values between
0 and 1. The higher this value, the more homogeneous is the within-subgroup structure.
The faultline strength measure captures how neatly a group splits into subgroups. Faultline distance, on the other hand,
measures the extent of differences between two subgroups. It is computed as follows:
vffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffi
u p 2
uX
FLDISTANCEg ¼ t ðX 1j: X 2j: Þ ð6Þ
j¼1
where the faultline distance measure consists of the distance between the cluster centroids. X 1j: is the mean of the jth variable
for subgroup 1, whereas X 2j: is the mean of this characteristic for subgroup 2. The square root is taken from the aggregated
attribute differences between both subgroups. When more than two subgroups are present, multiple distance measures are
possible. These must be aggregated and averaged into one measure, capturing the average distance between subgroups.
Faultline distance can range from 0 to 3 (the square root of 9). A maximum difference of 1 on all attributes would lead to a
faultline distance equal to the square root of 9.
Application
We provide an example for illustrative purposes. Consider a board that consists of four members. In Table 7, Panel A,
diversity attributes are scattered across directors, and in Panel B, diversity attributes are strongly clustered between directors.
All diversity characteristics equal 1 when a director possesses the specific attribute, and 0 otherwise. The raw tenure for
Directors 1, 2, 3, and 4 is 16, 16, 6, and 1, respectively. We scale tenure by its range, which is 16 1 ¼ 15. All raw values of
tenure have, thus, been divided by 15. Likewise, the number of shares held equals 0, 50, or 100, or 0, 0.5, and 1 after scaling
and the variable SCALEDSHARES is, therefore, used in the cluster analysis.
Given the cluster solution depicted in Table 7, we calculate the between-group sum of squares to compute faultline
strength. In particular, we first calculate the difference in means between the subgroups and the overall group per characteristic
and per subgroup. For example, the difference in means between subgroup 1 and the overall group concerning independence
equals 0 (0.5 0.5 ¼ 0). This difference is squared, after which all differences are multiplied by the number of members in the
relevant subgroup. All numbers are aggregated and constitute the sum of squares between subgroups. In Panel A, this number
equals 0.361. Calculating the between-group sum of squares in Panel A shows that differences between the subgroup means
and the overall group mean are present only for tenure and busyness. Hence, the between-group sum of squares is very low.
Scaling this by the total sum of squares in the sample, 11.969, leads to a faultline strength of 0.030. To compute faultline
distance, we average each characteristic per subgroup and then calculate the difference between the two subgroup averages for
each characteristic. For example, the average value for independence is 0.5 in both subgroups, leading to a difference of 0.
These differences are then squared to obtain positive values for all characteristics. We next aggregate all squared differences
and take the root of the total to compute the Euclidean distance between the subgroups. This leads to a faultline distance of
0.601. Faultline strength and distance are, thus, very low, indicating low faultline strength in this hypothetical board.
Repeating the analysis for Table 7, Panel B, the between-group sum of squares is much higher, because the subgroups are
almost perfectly homogeneous. Differences manifest between subgroups, rather than within subgroups. Scaling the between-
group sum of squares (7.257) by the total sum of squares (8.685) results in a faultline strength of 0.836. Further, the distance
between groups is substantial: the differences between subgroup averages are large for each characteristic, leading to a faultline
distance of 2.694. The hypothetical board in Panel B, thus, faces a very strong faultline.

TABLE 7
Faultline Illustration
Panel A: Weak Faultline

Board Members
Faultline
Attributes 1 2 3 4 Variables
INDEPENDENCE 1 0 1 0 FLSTRENGTH
INSIDER 0 1 0 1
AFFILIATED 0 0 0 0 0.030
FINEXP 1 0 0 1
SCALEDTENURE 1.067 0.067 0.4 0.067
SCALEDSHARES 0 1 0 1
BUSY 0 0 1 0 FLDISTANCE
RETIREMENT 1 0 0 1
GENDER 0 1 0 1 0.601
Subgroup I Subgroup II
Panel B: Strong Faultline

Board Members
Faultline
Attributes 1 2 3 4 Variables
INDEPENDENCE 1 1 0 0 FLSTRENGTH
INSIDER 0 0 1 1
AFFILIATED 0 0 0 0 0.836
FINEXP 1 1 0 0
SCALEDTENURE 1.067 1.067 0.4 0.067
SCALEDSHARES 0 0 0.5 1
BUSY 0 0 1 1 FLDISTANCE
RETIREMENT 1 1 0 0
GENDER 0 0 1 1 2.694
Subgroup I Subgroup II
FLSTRENGTH ¼ within-subgroup cohesion, calculated as the ratio of the between-variance over total variance;
FLDISTANCE ¼ the difference between subgroups, defined as the Euclidean distance between cluster centroids;
INDEPENDENCE ¼ a dummy equal to 1 when the director is independent;
INSIDER ¼ a dummy equal to 1 when the director qualifies as a company insider;
AFFILIATED ¼ a dummy equal to 1 when the director is affiliated with the company;
FINEXP ¼ a dummy equal to 1 when the director qualifies as a financial expert according to SOX;
SCALEDTENURE ¼ director tenure scaled by the range of tenure in the board;
SCALEDSHARES ¼ director shares scaled by the range of shares in the board;
BUSY ¼ a dummy equal to 1 when a director has multiple appointments; and
RETIREMENT ¼ a dummy equal to 1 when the director is at least 65 years of age.

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THE ACCOUNTING REVIEW American Accounting Association

Vol. 93, No. 2 DOI: 10.2308/accr-51818

Beyond Diversity: A Tale of Faultlines and Frictions in the

JEL Classiﬁcations: G30; G38; D70; M41.

The Accounting Review

II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Diversity and Board Performance

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Subgroup Formation and Faultlines

Faultlines and Board Performance

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III. RESEARCH DESIGN

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Board Control Variables

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Panel A: Selection Process

Panel B: Sample Summary by Industry and Year (n ¼ 9,687)

IV. EMPIRICAL RESULTS

Faultline Variables and Director Characteristics

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Panel A: Full Sample

Panel B: Descriptive Statistics per FAU Quartile

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Model I: Firm Performance

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Panel A: Descriptive Statistics

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Model II: CEO Turnover

FORCEDit ¼ b0 þ b1 FLSTRENGTHit þ b2 FLDISTANCEit þ b3 FAUit þ b4 LAGPERFit þ b5 FLSLAGPERFit

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LAGLNTENURE ¼ natural logarithm of CEO tenure in year t1; and

Model III: CEO Abnormal Compensation

ABNCOMPit ¼ b0 þ b1 FLSTRENGTHit þ b2 FLDISTANCEit þ b3 FAUit þ b4 PCTINDEPENDENCEit

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Panel A: Descriptive Statistics (n ¼ 4,383)

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Panel A: Descriptive Statistics (n ¼ 4,265)

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Additional Measures of Board Performance

Faultlines and CEO Compensation Plans

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:j: is the overall

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Panel A: Weak Faultline

Panel B: Strong Faultline

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