In this paper, we show that a true measure of board independence requires a careful disentangling of both the functioning role of gray directors and the firm’s decision on whether to classify former employees as independent or gray. By reclassifying gray directors, we find that fraud is significantly more likely when former employees are serving on the board. The effects are particularly strong when they have previously served with the current CEO, or when they serve on the critical committees such as auditing and compensation committees. By contrast, we find that other “outside” gray directors are less associated with fraud. In this regard, gray directors are not a monolithic group, and there are important “shades of gray.” Given this perspective, we construct a novel measure of a board’s functioning independence. We demonstrate that while there is no significant link between the traditional measure of independence and corporate fraud, there is a strong link between our measure of functional independence and the likelihood of fraud. We also demonstrate that fraud is more likely to occur when a firm uses its discretion to classify a former employee as an independent director.
Key words: corporate fraud, board independence, gray director, and former employees
