The Demythification of the Board of Directors
71 Pages Posted: 1 Aug 2014 Last revised: 16 Jan 2015
Date Written: July 30, 2014
In the debate over corporate governance, the relationship between shareholders and the directors rests at the epicenter. Management has a legal obligation to act in the best interests of shareholders but sometimes does not. Shareholders have an interest in overseeing the actions of management but often cannot.
Reforms designed to address these issues frequently take the form of structural changes to the board. These reforms have not always generated the anticipated results. This may occur in part because of an emphasis on structural reform unaccompanied by necessary changes in process. It may also occur, however, because of misconceptions about board behavior.
Two prevailing myths are commonly used to explain board behavior at large public companies. One is the myth that directors at these companies are chosen primarily on the basis of their substantive qualifications. They are not. Directors are foremost selected because of their predisposition towards the policies of management. Boards have the inherent authority to intervene in corporate affairs, including the right to dismiss top officers. Moreover, in an era of independent directors and heightened shareholder organization, the potential for intervention has grown. Management, therefore, has a rational incentive to reduce this risk. The goal can be advanced by ensuring that the board consists of directors who favor the positions taken by the CEO. This does not render substantive qualifications irrelevant but does reduce them to a matter of secondary importance. The other is the myth that boards at large public companies perform a meaningful advisory function. Boards are commonly said to both monitor and advise management. Advising, however, increases the risk of intervention. As a result, while the role may have existed at one time, it is no longer a significant and systematic part of the board's responsibilities. Without an advisory role, the relationship between directors and management loses much of its cooperative appearance and is mostly reduced to oversight and monitoring, activities that can be more accurately characterized as adversarial. Dispelling these myths explains certain board practices. First is the lack of diversity. The absence of women and minorities is usually attributed to an insufficient pool of qualified candidates. Yet when considering the universe of substantively skilled individuals, this explanation has a hollow ring. By focusing on the need for reliability rather than substantive qualifications, however, the lack of diversity is more readily explained. Directors are mostly selected from a pool of candidates notable for their willingness to support management. These categories consist of top executive officers and persons with personal and business connections to management. Both lack meaningful diversity.
Demythification also explains the current shift taking place in board structure. Increasingly, the largest public companies have opted for boards that consist entirely of independent directors, with the CEO the only exception. The CEO also typically serves as the chair of the board. Although beneficial in appearance to shareholders, the structure actually promotes the interests of the CEO by enhancing control over the information flow to independent directors and reducing the risk of board intervention. Some have recognized these dynamics and proposed a variety of reforms. They include an increase in the number of insiders on the board and a reduction of the CEO's influence through the elimination of his or her voting rights. When examined in the context of a demythicized board, however, these proposals are not likely to yield the anticipated results.
Reliability as a primary criterion for board membership can be reduced. The board has the authority to determine the relevant qualifications for directors and can at any time demote its importance in selecting nominees. Such a shift, however, is unlikely to occur absent some sort of catalyst.
Two possible catalysts exist. Pressure for reform can come from shareholders. Shareholders have a variety of mechanisms that can be used to pressure boards into reducing the number of reliable members. These efforts, however, are hampered by inadequate disclosure of personal and business relationships between management and directors. State courts and the Securities and Exchange Commission represent a second catalyst. Both have enhanced the obligation on the part of companies to reveal personal and business relationships. Increased disclosure and the resulting consequences provide an incentive to reduce the number of directors with excessively close ties to management.
This article will do several things. As an initial matter, it will examine the prevailing myths applicable to board behavior. The article will then discuss the impact of these myths on diversity and board structure. The next section will consider other reform proposals and assess them in the context of a demythicized board. The piece will finish by examining the role of shareholders and regulators in reducing the prevalence of reliable directors on the boards of public companies.
The appendices for this paper are available at the following URL: http://ssrn.com/abstract=2505109
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