The Rise of Independent Directors

The now-conventional understanding of boards of directors is that they reduce the costs associated with the separation of ownership and control. Elected by shareholders, directors are supposed to “monitor” the managers in view of shareholder interests.

This view has had a profound impact on the answer to the question: Who should serve on the board of a large public firm? In the 1950s, the answer was that boards should consist of the firm’s senior officers, some outsiders with deep connections to the firm (such as its banker or its senior outside lawyer), and a few directors who were nominally independent but handpicked by the CEO. Today, the answer is “independent directors,” whose independence is buttressed by a range of rule-based and structural mechanisms. Inside directors are a dwindling fraction; the senior outside lawyer serving on the board is virtually an extinct species.

Independent’s Day

The composition of large public company boards has dramatically shifted from approximately 20 percent independents in 1950 to 75 percent independents today. The extent of this change is often obscured by debates about the function and value of independent directors. Much of this change occurred in the last 30 years. The standards for independence also became increasingly rigorous. As recently as 15 years ago, boards with just one or two insiders were unheard of. More recently, there has been an additional trend towards so-called “supermajority” independent boards. In a 1989 survey, 67.5 percent of large public companies reported three insiders and 32.5 percent reported four insiders on the board. But during the 1990s, insiders began disappearing from boards. By 2004, under the influence of Sarbanes-Oxley and stock exchange listing rules, the shift was virtually complete: 91 percent reported two or fewer insiders; 9 percent reported three insiders.

The move to independent directors long pre-dated the regulatory mandates that followed the failure of Enron and others. What accounts for this remarkable shift in the governance completed in a relatively short time? The answer will not be found in better economic results. Among other puzzles, evidence of the value of independent directors is quite mixed: a strong correlation between the presence of independent directors and a firm’s performance has yet to be found. Some would deny there is a puzzle: firms will likely select the board structure that enhances their chance for survival and success. Others point out that corporate governance in the United States is already quite good, and marginal improvements in a particular corporate governance mechanism would expectedly have a small, perhaps negligible, effect. But such accounts, which may explain the lack of strong effects in comparing firms of different board composition at any given moment in time, do not explain this pronounced governance shift over time for virtually all firms.

There have been two critical elements at work here: first, the shift to maximizing shareholder value as the primary corporate objective, and second, the increasing informativeness of stock market prices. Independent directors “lock in” management’s focus on shareholder value, as opposed to managerial interests or stakeholder interests. Thus, as shareholder value became the increasingly predominant corporate objective over the period, board composition shifted. More informative stock market prices and increased disclosure requirements meant that the independents had nearly the same information as insiders, or at least the difference was on the decline. Independent directors could use increasingly informative market prices to advise the CEO on strategy and evaluate its execution, as well as take advantage of the increasingly well-informed opinions of securities analysts. Independents had advantages over inside directors, who were more likely to overestimate the firm’s planning and capital allocation capabilities.

These two elements also explain why boards are focused on stock price as the measure of management success. First, stock prices directly connect to the firm’s prime objective of maximizing shareholder value. Assessing management’s performance in such terms keeps management committed to shareholder interests. Second, stock market signals are seen as generally the best guide to the efficient allocation of capital. Looking to the stock price helps the firm follow the optimal strategy.

In this environment, independent directors may have an additional social value: Given the tendency of markets to overshoot and to temporarily misprice particular strategies, the capacity of an independent board to resist the stock market’s logic, at least for a time, may prevent too quick an adjustment to conventional wisdom. Even if this is costly, on average, to the particular firm, it may reduce the risk of systemic failure in a way that has value across an economy of firms similarly organized.