Wanted: Owners With Oversight

The push to stack the board with independent directors was supposed to be the cure for corporate shenanigans. Here’s why it hasn’t worked.

The Sarbanes-Oxley Act of 2002 was designed to curb corporate malfeasance by holding company managers to a higher level of accountability. But we believe the act will prove ineffective, because the stiffer civil and criminal sanctions it imposes upon company managers have not altered their basic relationship to the company’s owners.

Since its passage, there has been a renewed outcry for more independent directors, with both the New York Stock Exchange and Nasdaq now requiring a majority of independents on the board. The thinking seems to be that board members without ties to the CEO will be more objective in their oversight, which in turn will lead to a better-run company and higher financial returns.

However, our analysis of 254 public companies in 50 industries finds no evidence that companies with a majority of independent directors have posted better financial returns for shareholders.
 

Given that the real purpose of independent board members is to act as wise referees in the event of conflicts, it does not take a majority of board members to sort out problems—the job can usually be done effectively with only three. Rather than require a majority of independent directors on public company boards, we believe the Securities and Exchange Commission and the major stock exchanges should promote a model in which shareholders are in the majority.

We examined the return on equity of companies in 50 industries over one year, and divided them into three categories according to their market capitalization. Of course, it’s difficult to capture all the social and personal ties that may compromise a director’s independence from management. But we carefully scrutinized the proxies of each of the 254 companies in our group to see, for example, if board members were relatives of the company’s executives or if they had any former employment or business arrangement with the company.

To our surprise, companies with a majority of independents on the board had no measurably greater returns than the rest (see chart). This was true for all industries and market caps. This conclusion may disappoint those who think independence will solve the problems that led to SOX regulation, at least when judged from a performance viewpoint.

A key problem here is that under the current system, executives are accountable to independent directors who may have vastly less information about what is occurring inside the company or the industry. As a result, the most likely outcome is that company managers will continue to exert a great influence over boards of directors on all key decision making. To get the kind of tough, objective scrutiny that proponents of independent directors are looking for, boards need greater participation by what you might call “oversight shareholders”—those with substantial, long-standing positions that give them a material stake in the company’s long-term performance. Large shareholders are also buttressed by a real understanding of the company’s business, strategy, and markets.

Encouraging board membership by oversight owners, whom we define as those holding more than 1 percent of a firm’s stock for at least six months, will require more steps than those taken by SOX. We have identified three areas in which governmental and regulatory bodies should act to make this happen:
■     Amend NYSE and Nasdaq manuals to encourage greater owner/shareholder participation on boards.
■     Enact safe harbors in SEC rules and regulations for oversight shareholders in the areas of: inter-shareholder communication; controlling party liability for tax, ERISA, and other issues; and trading liability for trading plans filed in advance.
■     Encourage public companies to utilize the latest technology to facilitate owner inquiry and communication.