In this article in the Harvard Business Review, a law professor from the University of Calgary makes “The Case for More Company Insiders on Boards.” From the end of World War II to the 1970s, he observes, the composition of most boards of U.S. companies was predominantly insider—75% of board directors were insiders in the decade after World War II. But, he maintains, that changed “in the wake of the rising distrust of all American institutions” after Viet Nam and Watergate in the 1970s, as new concepts of corporate governance emerged and the NYSE began to adopt listing rule changes, such as a requirement for independent audit committees. And after the Enron and WorldCom financial scandals of the 2000s, further changes in corporate governance requirements and expectations for board independence ultimately made the overwhelming prevalence of independent directors on corporate boards and committees de rigueur. By 2005, the author reports, 75% of directors of large U.S. public companies were independent and, as of 2023, that percentage had risen to 85%. But is that necessarily a good thing? Maybe not so much, the author contends. Rather, he maintains, the “empirical research on director independence suggests…that business leaders should re-consider the merits of inside directors.”
“[W] with few exceptions,” the author contends, citing numerous studies that examined decades of data, “empirical studies have found no connection between board independence and company performance outcomes.” He even cites a study of almost 300 financial firms showing that, in the 2007–2008 financial crisis, “firms with higher levels of independent directors experienced worse stock performance.”
But corporate performance was not the only measure. The author refers to a number of studies showing that “independent directors do no better than insiders at controlling executive pay or terminating underperforming CEOs.” Nor did audit and comp committees benefit from independent directors: studies showed that independent directors on comp committees had “no impact on the level of CEO compensation. Several studies find that committees comprised entirely of independent directors lead to higher executive pay.” Importantly, the author argues that “independent directors actually increase the risk of corporate misconduct.” One study cited by the author looked at 87 companies that “fraudulently manipulated their financial statements between 1982 and 2000“ (prior to the SOX requirement for completely independent audit committees), and found no difference between the percentages of independent directors on their audit committees versus the control group.
In essence, the author contends, independence is just one characteristic—it doesn’t mean that the director has “the skills, work ethic, experience, and anxious concern to be a truly valuable director.” And there are plenty of unique benefits to be gained from inside directors: “They are not entirely dependent on the CEO for their information about the company. Inside directors have a deeper understanding of the company, its strategy, R&D opportunities, and market competitors than most independent directors will be able to manage. Indeed, financial firms with more inside directors did better during the 2008 financial crisis because they had more directors familiar with the complex risks hiding in their companies’ balance sheets. They were thus able to make better decisions around the need for additional capital.”
The author also professes that, because insiders are employees with professional reputations built on the success of the company—as opposed to independent directors whose professional reputations, for example, may be validated through an institutional shareholder network—insiders may be more motivated to care about the company’s long-term success and to resist outside pressures to take actions that may not be in the company’s best interest. And, he argues, insiders “reduce the influence of short-term share price fluctuations in the boardroom” because they have access to “many sources within the organization, including information on things like morale and research progress that cannot or should not be made public.”
The author’s final point is particularly interesting. Turning conventional wisdom on its head, he contends that the “power dynamics around inside directors” has long been misunderstood:
“Inside directors indeed report to the CEO in their day-to-day work lives, but it is not true that this means inside directors automatically enhance the CEO’s authority. The reverse is often the case. In their capacity as directors, insiders become the CEO’s boss. They have unfettered and confidential access to the rest of the board. This actually makes them a rival power center inside an organization that the CEO must respect. It is a dynamic instantly recognizable to anyone who has worked in private companies with multiple insiders on the board. Those organizations are much less likely to be dominated by a powerful CEO personality, and they are much more likely to have the views of a wide range of groups in the company represented in board discussions. It should not be a surprise, therefore, that a study looking at boards with a single inside director (the CEO) finds that these boards pay the CEO ‘excessively,’ pay that CEO disproportionally relative to other managers in the company, experience increased risk of financial misconduct, and underperform companies with more than one insider on the board.”
Ultimately, the author concludes that, while there is “no one-size-fits-all set of governance arrangements” that always makes sense for every company, “[t]here has always been a place for inside directors on corporate boards, even if we have assumed for the past 40 years that this isn’t true. Now that we know the conventional wisdom is wrong, boards have a responsibility to choose the arrangements that will best advance the flourishing of the organizations they lead—and this may include adding some inside directors.”
