Seven Myths of Boards of Directors
Should the chairman always be independent? Do CEOs actually make good directors?
Corporate governance experts pay considerable attention to issues involving boards of directors, and with good reason. Boards are responsible for monitoring all aspects of a business (its strategy, capital structure, risk, and performance), hiring and firing the CEO, and answering to shareholders when something goes awry.
Because of the importance of these roles, companies are expected to adhere to best practices, some mandated by regulatory standards and stock exchange requirements and some advocated by experts.
But these “best practices” don’t always create better board effectiveness or quality. Here we debunk seven of these practices.
Myth 1: The chairman should always be independent.
One of the most widely held beliefs in corporate governance is that the CEO of a company should not serve as its chairman. In fact, over the last decade, companies in the S&P 500 Index received more than 300 shareholder-sponsored proxy proposals that would require a separation of the two roles. Shareholder groups have targeted prominent corporations including Walt Disney, JP Morgan, and Bank of America to strip their CEOs of the chairman title.
Companies, in turn, have moved toward separating the roles. Only 53% of companies in the S&P 500 Index had a dual chairman/CEO in 2014, down from 71% in 2005. Similarly, the prevalence of a fully independent chair increased from 9% to 28% over this period.
Despite the belief that an independent chair provides more vigilant oversight of the organization and management, the research evidence does not support this conclusion. One study found no statistical relationship between the independence status of the chairman and operating performance, while another found no evidence that a change in independence status (separation or combination) impacts future operating performance. Additional research actually found that forced separation is detrimental to firm outcomes: Companies that separate the roles due to investor pressure exhibit negative returns around the announcement date and lower subsequent operating performance.
Myth 2: Staggered boards are always detrimental to shareholders.
Many believe that staggered boards harm shareholders by insulating management from market pressure. Under a staggered board structure, directors are elected to three-year rather than one-year terms, with one-third of the board standing for election each year. Because a majority of the board cannot be replaced in a single year, staggered boards are a formidable antitakeover protection, and for this reason many governance experts criticize their use. Over the last 10 years, the prevalence of staggered boards has decreased, from 57% of companies in 2005 to 32% in 2014. The largest decline has occurred among large capitalization stocks. While it is true that staggered boards can be detrimental to shareholders in certain settings — such as when they prevent otherwise attractive merger opportunities and entrench a poorly performing management — in other settings they have been shown to improve corporate outcomes. For example, they benefit shareholders when they protect long-term business commitments that would be disrupted by a hostile takeover or when they insulate management from short-term pressure, thereby allowing a company to innovate, take risk, and develop proprietary technology that is not fully understood by the market. One study found staggered boards improve long-term operating performance among newly public companies. Other studies also suggest that staggered boards can benefit companies by committing management to longer investment horizons.
Myth 3: Directors who meet NYSE independence standards are independent.
Just because a director satisfies the independence standards of the New York Stock Exchange does not mean he or she behaves independently when it comes to advising and monitoring management. For example, a 2009 study examined directors who are independent according to NYSE standards (“conventionally independent”) and those who are independent in their social relation to the CEO based on education, experiences, and upbringing (“socially independent”). The researchers discovered that board members who share social connections can be biased to overly trust or rely on CEOs, regardless of whether they’re considered independent by NYSE standards. Those board members were more likely to pay CEOs more and less likely to fire a CEO following poor operating performance.
Other studies reach similar conclusions. One study found that directors appointed by a CEO are more likely to be sympathetic to his or her decisions and therefore less independent. The greater the percentage of the board appointed during the current CEO’s tenure, the worse the board performs its monitoring function. While independence is an important quality for an outside director to have, NYSE standards do not necessarily measure its presence (or absence).
Myth 4: Interlocked directorships reduce governance quality.
Interlocked directorships occur when an executive of Firm A sits on the board of Firm B while an executive of Firm B sits on the board of Firm A. Corporate governance experts criticize board interlocks as creating psychological reciprocity that compromises independence and weakens oversight. While some evidence suggests that interlocking can create this effect, research also suggests that interlocking can be beneficial to shareholders. Interlocking creates a network among directors that can lead to increased information flow, whereby best practices in strategy, operations, and oversight are transferred across companies. Network effects created by interlocked directorships can also serve as an important conduit for business relations, client and supplier referrals, talent sourcing, capital, and political connections. For example, one study found that network connections improved performance among companies in the venture capital industry, while another found that companies that share network connections at the senior executive and the director level have greater similarity in their investment policies and higher profitability. These effects disappear when network connections are terminated. Other studies have found board connections lead to more successful mergers and acquisitions, and greater future operating performance and higher future stock price returns.
Myth 5: CEOs make the best directors.
Many experts believe that CEOs are the best directors because their managerial knowledge allows them to contribute broadly to firm oversight, including strategy, risk management, succession planning, performance measurement, and shareholder and stakeholder relations. Shareholders, too, often have this belief, reacting favorably to the appointment of CEOs to the board. But empirical evidence is less positive. Studies have found no evidence that a CEO board member positively contributes to future operating performance or decision-making and finds CEO directors are associated with higher CEO pay. Additionally, a survey by Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University finds that most corporate directors believe that active CEOs are too busy with their own companies to be effective board members. Over the last 15 years, the percentage of newly recruited independent directors with active CEO experience has declined. Companies instead are recruiting new directors who are executives below the CEO level or who are retired CEOs.
Myth 6: Directors face significant liability risk.
Two-thirds of directors believe that the liability risk of serving on boards has increased in recent years, and 15 percent of directors have thought seriously about resigning due to concerns about personal liability. However, the actual risk of out-of-pocket payment is low. Directors are afforded considerable protection through indemnification agreements and director and officer liability insurance. Indemnification agreements stipulate that the company will pay for costs associated with securities class actions and fiduciary duty cases, provided the director acted in good faith. Insurance provides an additional layer of protection, covering litigation expenses, settlement payments, and, in some cases, amounts paid in damages up to a specified limit. These protections have been shown to be effective in protecting directors from personal liability. One study found that in the 25 years between 1980 and 2005, outside directors made out-of-pocket payments — meaning unindemnified and uninsured — in only 12 cases. A follow-up study of lawsuits filed between 2006 and 2010 finds no cases resulting in out-of-pocket payments by outside directors (although some of these cases are still ongoing). The authors conclude that “directors with state-of-the art insurance policies face little out-of-pocket liability risk. … The principal threats to outside directors who perform poorly are the time, aggravation, and potential harm to reputation that a lawsuit can entail, not direct financial loss.”
Myth 7: The failure of a company is always the board’s fault.
In order for a company to generate acceptable rates of returns, it must takes risks, and risks periodically lead to failure. If the failure was the result of a poorly conceived strategy, excessive risk taking, weak oversight, or blatant fraud, the board can and should be blamed. But if failure resulted from competitive pressure, unexpected shifts in the marketplace, or even poor results that fall within the range of expected outcomes, then blame lies with management or poor luck.
Even within the scope of its monitoring obligations, a board won’t necessarily detect all instances of malfeasance before they occur. The board has limited access to information about the operations of a company. In the absence of “red flags,” it relies on the information provided by management to inform its decisions. A board usually doesn’t seek information beyond this except in a few cases (if it receives whistleblower information, for example, or believes management isn’t setting the right tone through words or behavior).
Still, evidence shows boards are punished for losses. A 2005 study showed that director turnover increases significantly following financial restatements and that board members of firms that overstate earnings tend to lose their other directorships as well. Similarly, directors who served on the boards of large financial institutions during the financial crisis (such as Bank of America, Merrill Lynch, Morgan Stanley, Wachovia, and Washington Mutual) became targets of “vote no” campaigns to remove them from other corporate boards where they served.
The degree to which a director should be held accountable depends on a fair-minded assessment of whether and how the director might have contributed to the failure and whether it is reasonable to believe that he or she could have prevented it.
This is an excerpt from “Seven Myths of Boards of Directors” from the Stanford Closer Look Series, published by the Corporate Governance Research Initiative at Stanford Graduate School of Business and the Rock Center for Corporate Governance at Stanford University. David F. Larcker is the James Irvin Miller Professor of Accounting and Brian Tayan is a researcher at Stanford GSB.
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