To assess the benefits of corporate governance— and, for that matter, to define what actually constitutes the much-used term—it is necessary to analyze the functions of the board of directors and determine what practices contribute to board effectiveness. In a new book, Stanford Professors David Larcker and Brian Tayan examine structural and organization elements of corporate governance and present an analysis of the real “value” of governance. What follows is an excerpt from Corporate Governance Matters: A Closer Look at Organizational Choices and Their Consequences (FT Press, April 2011) that deals specifically with issues of board structure and process.
The position of lead independent director has emerged as somewhat of a compromise between allowing companies to maintain dual chairman/CEO positions and forcing companies to separate these roles and appoint an independent chairman. The position evolved from the role served by the director who presides over executive sessions of the board. The New York Stock Exchange (NYSE) requires that nonexecutive directors meet outside the presence of management in regularly scheduled executive sessions and that an independent director preside over these meetings. In recent years, this director has assumed a more prominent role with expanded powers and has come to be known as the lead independent (presiding) director.
Many corporate governance experts recommend that companies formally appoint a lead independent director, particularly those in which the CEO also serves as chairman of the board. The expectation is that the lead independent director can serve as an important counterbalance to the chairman/CEO. However, beyond presiding over executive sessions, the responsibilities of this role are still being defined and vary widely across companies.
According to Spencer Stuart, the lead director at most companies serves as liaison between the chairman/CEO and independent directors. This person also plays a prominent role in the evaluation of corporate performance, CEO succession planning, director recruitment, and board and director evaluations. Sometimes the lead director serves as the main contact to receive and address shareholder communications. He or she can particularly be important during times of crisis, including periods of increased government or regulatory scrutiny, hostile takeover attempts, and contentious proxy battles. In these situations, the lead director brings clarity of communication and clear leadership to internal and external stakeholders.
David Larcker (l) and Brian Tayan
To be effective, the lead director needs many of the same attributes required of the chairman, including communication and listening skills, diplomacy, and an ability to gain confidence. The lead director must also be willing to take stands that are counter to those of management and, in doing so, compel change. According to one director, “The person has to care for the spirit of the board. He or she needs to be committed to integrity, loyalty and equanimity. You need someone in this role who calls for candor and makes people feel safe about asking the tough and proverbial ‘dumb’ questions.” However, the lead director should not become too involved in management issues, particularly during a crisis.
Experts believe that lead directors can contribute to improved corporate performance in these ways:
- Taking responsibility for improving board performance
- Building a productive relationship with the CEO
- Supporting effective communications with shareholders
- Providing leadership in crisis situations or in turbulent times
- Ensuring that the board is engaged effectively in developing corporate strategy
- Leading the board in succession planning for the CEO and senior management and for the board and its leaders
Although the board should already be discussing these items, appointing a lead director might accelerate the process. Anecdotal evidence suggests that this can be accomplished by concentrating responsibility for selected matters in the hands of one capable director and granting him or her authority to act. Several examples of successful lead directors can provide a model for other companies to emulate. However, as these examples indicate, the lead director is likely to succeed only if given sufficient autonomy and if the chairman or other board members don’t undermine his or her authority.
The research literature on lead independent directors is modest because it is difficult to distinguish between companies that have a truly empowered lead director and those that grant that title to the director who presides over executive sessions. Still, some evidence suggests that lead independent directors improve governance outcomes. Larcker, Richardson, and Tuna (2007) found that appointing a lead independent director, in combination with other factors, is associated with improved future operating performance and stock price returns.
The benefit of a lead director likely will depend on the governance situation of the firm and the personal qualities of the director selected, instead of the simple fact that the role was created.
Outside Directors
Securities regulations in most developed countries require that companies have a majority of outside (nonexecutive) directors. Outside directors are expected to execute their duties without undue influence from management because they have no reporting lines to the CEO and do not rely on the company for their livelihood. They are also expected to draw on their professional backgrounds and lend functional expertise to advise on the company strategy and business model. Therefore, they are expected to be better suited to fulfill the advisory and monitoring functions of the board than inside directors.
However, outside directors are likely to be less informed about the company than inside directors. We refer to this as the “information gap” and have noted that such a gap is more likely to occur when specialized knowledge is required to run the company. When an information gap occurs, decision- making can suffer. Decision-making can also suffer through lack of independence. Although companies are required to meet the independence standards of listing exchanges, it doesn’t guarantee that outside directors who meet these standards in a technical sense are truly independent. Some governance experts point out that insiders can co-opt the board by nominating outside directors who appear to be independent but are not. Alternatively, outside directors might be independent but not adequately engaged or qualified. When this occurs, numerical targets for outside representation become ineffective.
Research indicates that investors generally look favorably upon companies that add outside directors to the board. Rosenstein and Wyatt (1990) found that adding an outside director to the board leads to a statistically significant increase in stock price around the announcement date. Interestingly, the addition of an insider to the board is greeted with a negative reaction by shareholders if the insider owns only a small amount of company stock, but is greeted with a positive reaction if the insider owns a large amount of stock. Apparently, investors understand the potential trade-off between the information advantage of insiders and their potential for self-dealing, and they expect high stock ownership to help mitigate this risk.
The impact of outside directors on the long-term operating performance of the company is less clear. Bhagat and Black (2002) found almost no relationship between the percentage of outsiders on a board and the long-term performance of the company’s stock. In contrast, Duchin, Matsusaka, and Ozbas (2010) found that the effectiveness of outside directors depends on the cost of acquiring information about the firm. When it is easy for outsiders to gain expertise on the firm (because the firm is in a straightforward industry), company performance increases following the appointment of outsiders to the board. When it is difficult for outsiders to gain expertise, company performance decreases following their appointment. These findings tend to support the idea that outside directors are more effective when it is easy to close the information gap between insider and outsider knowledge.
Boards with a higher percentage of outside directors might also make better decisions regarding mergers and acquisitions. Cotter, Shivdasani, and Zenner (1997) found that when a company announces an acquisition, the stock price change of the acquiring firm is more negative if its board consists largely of executive directors than if the board consists mostly of nonexecutive directors. The expectation is that an acquisition is more likely to destroy value through empire building if executive directors have negotiated the purchase price. Similarly, companies receive a higher takeover premium if the board of the target company is independent. Byrd and Hickman (1992) found similar results. The results suggest that a board comprised of outsiders is more likely to negotiate arm’s-length transactions, thereby ensuring that the targets and takeover prices are rational.
Finally, it is not clear whether boards with a higher percentage of outsiders negotiate more rational compensation packages with CEOs. Boyd (1994) found an unexpected positive relationship between the level of CEO compensation and the percentage of outside directors. However, Finkelstein and Hambrick (1989) found no relationship between these variables.
Clearly, outside directorships have both positive and negative aspects. Outsiders have the potential to bring expertise and independence to the board, which can reduce agency costs and improve firm performance. However, outsiders operate at an information disadvantage that can decrease their effectiveness. The research results on this point are mixed, but the potential information disadvantage of outside directors should be a critical concern for shareholders.
Board Independence
The NYSE requires that listed companies have a majority of independent directors. Independence is defined as having “no material relationship with the listed company (either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company).” A director is not considered independent if the director or a family member:
- has been employed as an executive officer at the company within the last three years.
- has earned direct compensation in excess of $120,000 from the company in the last three years.
- has been employed as an internal or external auditor of the company in the last three years.
- is an executive officer at another company where the listed company’s present executives have served on the compensation committee in the last three years.
- is an executive officer at a company whose business with the listed company has been the greater of 2 percent of gross revenues or $1 million within the last three years.
These standards are intended to ensure that directors execute their duties with independent judgment. Independence is important for both the advisory and monitoring functions of the board. It enables a director to objectively evaluate the top executives, strategy, business model, and risk-management policies proposed by senior management. It also enables them to be objective when measuring operating and financial results against predetermined targets. Independence means that compensation arrangements are established through arm’s-length negotiation and that acquisitions are determined in the best interest of shareholders. Directors who maintain material relations with the company or otherwise rely on the company for their livelihood are less likely to be independent in these areas.
The risk for investors is that the independence standards of the NYSE (or other listing exchanges) do not reliably produce directors with truly independent judgment. The NYSE acknowledges this risk: “It is not possible to anticipate, or explicitly to provide for, all circumstances that might signal potential conflicts of interest, or that might bear on the materiality of a director’s relationship to a listed company.…Accordingly, it is best that boards making ‘independence’ determinations broadly consider all relevant facts and circumstances.”
Effectively, NYSE guidelines draw a line in the sand. For investors, this means that some directors will meet independence standards and not be independent in their perspectives, while others will not meet these standards yet be perfectly capable of maintaining independence. Stated differently, there is a risk that the structural characteristics used in the NYSE test for independence are a misleading measure of the independence of an individual director.
Most studies fail to find a significant relationship between formal board independence and improved corporate outcomes. We cited some of these studies in the previous section on outside directors. In aggregate, they tend to demonstrate either a modest relationship or no relationship between independence and market returns or long-term performance. Some evidence suggests that independence leads to more rational merger-and-acquisition activity. The relationship between independence and CEO compensation is not clear. We suspect that the structural shortcomings of the NYSE standards of independence confound the data used in most studies and at least partially explain the weak results.
Hwang and Kim (2009) recognized this shortcoming and attempted to correct it by designing a study that takes into account situational or psychological factors beyond NYSE guidelines that risk compromising a director’s judgment. The authors made a distinction between directors who are independent according to NYSE standards (conventionally independent) and those who are independent in their social relation to the CEO (socially independent). They used the board of Cardinal Health to illustrate this distinction: “In the year 2000, this board had 13 directors, 10 of whom were conventionally independent of the CEO. However, one conventionally independent director was not only from the same hometown, but also graduated from the same university as the CEO (incidentally, this director provided a job, at his own firm, for the CEO’s son). Another conventionally independent director graduated from the same university and specialized in the same academic discipline as the CEO. Similarly, 3 others shared informal ties with the CEO and, ultimately, only 5 of the 13 directors were conventionally and socially independent of the CEO.”
[Hwang and Kim] identified six areas where the independence standards of the NYSE might fail to take into account social relationships that could compromise independence if the director and the CEO have the following in common:
- Served in the military
- Graduated from the same university (and were born no more than three years apart)
- Were born in the same U.S. region or the same non-U.S. country
- Have the same academic discipline
- Have the same industry of primary employment
- Share a third-party connection through another director to whom each is directly independent
People who share these social connections feel a psychological affinity that might bias them to overly trust or rely on one another without maintaining sufficient objectivity. Among a sample of directors of Fortune 100 companies between the years 1996 and 2005, the authors found that 87 percent are conventionally independent, but only 62 percent are both conventionally and socially independent. Hwang and Kim found that social dependence is correlated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulates earnings to increase his or her bonus. They concluded that social dependence compromises the ability of the board to maintain arm’s-length negotiations with management.
Although this type of analysis is certainly not easy, it demonstrates a level of critical thinking that is sometimes absent in the debate on corporate governance. Their findings suggest that an expanded and more sophisticated assessment of independence is likely to lead to better understanding of governance quality than simply checking for adherence with regulatory guidelines.