by Cydney Posner

In “Seven Myths of Boards of Directors,” two academics from Stanford Business School set about debunking some of the most common and persistent expectations regard best practices in board structure, composition and procedure.  The authors contend that these seven myths “are not substantiated by empirical evidence.” 


In response to pressure from activists, there has been a growing trend toward separation of the positions of CEO and board chair, and the paper observes that “[o]nly 53 percent of companies in the S&P 500 Index had a dual chairman/CEO in 2014, down from 71 percent in 2005.”  The argument has been that an independent chair without ties to management will provide more vigilant oversight, acting as an effective counterweight to management when required.  Nevertheless, the authors contend, “the research evidence does not support this conclusion.”  The authors cite various studies finding “no statistical relationship between the independence status of the chairman and operating performance,” “no evidence that a change in independence status (separation or combination) impacts future operating performance,” and some evidence 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.” Accordingly, they argue, the costs and benefits of requiring an independent chair depend on the circumstances, and quote the former head of the FDIC, Sheila Bair: “Too much is made of separating these roles. … It’s really more about the people and whether they are competent and setting the right tone and culture.”

SoapBox: Is this “myth” even still the prevailing view? Even proxy advisor ISS has recently taken a more nuanced approach to independent board chair proposals: “Under the new approach, any single factor that may have previously resulted in a “For” or “Against” recommendation may be mitigated by other positive or negative aspects, respectively. Thus, a holistic review of all of the factors related to company’s board leadership structure, governance practices, and performance will be conducted under the new approach.”


Because staggered boards can serve to insulate management and deter unsolicited takeovers, they are often viewed by governance experts to be adverse to  shareholders’ interests. The paper reports that, “[o]ver the last 10 years, the prevalence of staggered boards has decreased, from 57 percent of companies in 2005 to 32 percent in 2014. The largest decline has occurred among large capitalization stocks….” Although the authors acknowledge that classified boards can be detrimental when they are used to entrench management and prevent deals that might be attractive to shareholders, they can be beneficial for shareholders in some circumstances, such as “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 cited in the paper found that “staggered boards are more prevalent among newly public companies if the company has one or more large customers, is dependent on one or more key suppliers, or has an important strategic alliance in place. [The study also found] that long-term operating performance is positively related to the use of staggered boards among these firms. Other studies also suggest that staggered boards can benefit companies by committing management to longer investment horizons.” 


The authors next question whether NYSE standards of independence (or presumably, Nasdaq’s for that matter) reliably measure effective independence. In support of that contention, they cite a study distinguishing NYSE “conventional” independence from “social independence,” which is based on “education, experiences, and upbringing—positing that people who share social connections feel psychological affinity that might bias them to overly trust or rely on one another without sufficient objectivity.”  In that study, which sampled directors of Fortune 100 companies between the years 1996 and 2005, the study authors founds 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 conclude that social relations compromise the ability of the board to maintain an arm’s-length negotiation with management, even if they are independent by NYSE standards.”  Other studies likewise found that directors appointed by the current CEO are more likely to be “coopted,” to be sympathetic to the CEO’s decisions.  What’s more, the larger the proportion of board members “appointed during the current CEO’s tenure, the worse the board performs its monitoring function—measured in terms of pay level, pay-for-performance sensitivity, and the sensitivity of CEO turnover to performance.” Accordingly, that study concluded that “coopted” directors do not necessarily act independently, even if they are conventionally independent.

Sidebar: Of course, the NYSE definition recognizes the limitations of its definition and advises that, in determining independence, all relevant facts and circumstances be considered.)


The authors next argue that interlocking directorships — frequently criticized for creating a kind of “psychological reciprocity that compromises independence and weakens oversight” — do not necessarily reduce governance quality.  According to the authors, the evidence on this point is mixed, with some evidence suggesting that interlocking directorships can be beneficial to shareholders by increasing information flow about best practices and providing a conduit for business relations, referrals, sourcing, capital and connections. To support that contention, the authors cite several studies that show that network connections improve performance among companies in the VC industry, lead to greater similarity in companies’ investment policies and higher profitability, and lead to higher value creation. Another study found that companies with well-connected boards “have greater future operating performance and higher future stock price returns than companies whose boards are less connected. These effects are most pronounced among companies that are newly formed, have high growth potential, or are in need of a turnaround. Shareholders should therefore evaluate the quality of director connections in the companies they are invested in to determine whether their impact is potentially positive or negative.”


According to the authors, the empirical evidence on the performance of CEOs as directors is mixed, with some studies finding “no evidence that the appointment of an outside CEO to a board positively contributes to future operating performance, decision making, or monitoring,” and that active CEO-directors are associated with higher CEO compensation levels. One survey suggested that directors who are also CEOs may be too busy to devote sufficient time to other boards, and are often unable or unwilling to serve on time-consuming committees or to participate in meetings on short notice.  There was also criticism of CEO-directors as “too bossy, poor collaborators, and not good listeners.” More recently, the level of active CEO-directors has declined, according to the authors, with companies instead recruiting to their boards retired CEOs or executives below the CEO level.


While the risk of liability remains a concern to many directors, the authors argue that, because of indemnification agreements and D&O insurance, the actual risk of out-of-pocket payment is low. Studies have shown these protections to be effective, including one study that found that, between 1980 and 2005, “outside directors made out-of-pocket payments—meaning unindemnified and uninsured—in only 12 cases.” Three of these cases were highly visible, iconic cases. In another study of the period between 2006 and 2010, no cases resulted in out-of-pocket payments by outside directors, although some cases have not yet concluded. Rather than liability, the authors appear to agree that 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.’”


To generate acceptable rates of returns, companies  must take risks, which may or may not turn out well. Boards may be at fault, the authors contend, if the cause of failure is a poorly conceived strategy, excessive risk taking, weak oversight or blatant fraud. However, the authors argue, it may be more appropriate to blame management (or bad luck) if the failure resulted from competitive pressure, unexpected shifts in the marketplace or poor results within the range of expected outcomes.  The authors also caution that it is not “realistic” to expect boards to  detect all “malfeasance” before it occurs, especially in the absence of “red flags”; the board has limited information, almost all of which is usually provided by management. Red flags, which should induce the board to make further inquiry, may involve hotline tips or other credible information of unusual activity, knowledge of problems at unrelated companies that could reasonably occur at the company (e.g., credit card breaches), or a belief by the board that management is not setting the right “tone at the top.” Nevertheless, studies cited in the paper showed that director turnover increased significantly following financial restatements and, interestingly, that “board members of firms that overstate earnings tend to lose their other directorships as well.” The authors advise that 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.” 

In conclusion, the authors question why, in light of the data, governance experts focus on structural features of the board, such as its independence and classification, instead of focusing on “the process by which the board fulfills its obligations to shareholders.” In addition, they suggest that, in light of the absence of empirical support for many of the governance practices of boards, these practices should be voluntary rather than mandated by laws and rules as is currently the case: would more flexible standards, they ask, “lead to more suitable market-based solutions, or to more failures?”  Finally, they ask, how shareholders, “as outsiders, [can] more effectively evaluate the performance of the board and its members?”

Posted by Cydney Posner