Rob Swystun, Pristine Advisers
Like most things in life, boards of directors have had their fair share of myths and untruths pop up around them like mushrooms on a tree stump.
David Larcker, professor of accounting at Stanford University, and Brian Tayan, researcher with the Corporate Governance Research Initiative at Stanford University, set out to test some of these myths and found that many of them were not held up by empirical evidence. Larcker published some of their findings in the Harvard Law School Forum on Corporate Governance and Financial Regulation.
Myth No. 1: The Board Chair Should Always be Independent
A commonly held belief is that a chairperson who is separate from the CEO position will automatically provide more vigilant oversight of the business and its management. However, research evidence does not support this belief and, in fact, some of that research actually negates it.
Larcker and Tayan cite two different studies that find no statistical relationship between changing the status of the chairperson’s independence and operating performance or future operating performance. One study they cite actually found that companies that separate the chairperson and CEO roles due to investor pressure actually have negative returns around the announcement date and have lower operating performance afterward.
Myth No. 2: Staggered Boards are Always Detrimental to Shareholders
This belief holds that staggered boards harm shareholders by insulating management from market pressure. Larcker and Tayan contend that staggered boards can be harmful to shareholders when they prevent attractive merger opportunities and keep poorly performing management entrenched, but they can be beneficial in certain situations.
Those situations include protecting long-term business commitments that could be disrupted due to a hostile takeover and insulating management from short-term pressure, which allows the management team to innovate, take risks and develop technology that will take time for the market to adopt.
Certain studies have suggested that staggered boards also benefit companies by committing management to longer investment horizons.
Myth No. 3: Directors that Meet NYSE Independence Standards are Independent
Even if a director satisfies the standard for independence of the New York Stock Exchange (NYSE), that doesn’t necessarily make them independent as they advise management, as at least one study found that independent directors who have social relationships with the CEO are associated with higher executive compensation, lower CEO turnover rates due to poor operating performance and a higher likelihood that the CEO will manipulate earnings to increase their bonus.
Also, the researchers found that directors appointed by the current CEO are more likely to be sympathetic to that CEO’s decisions, rendering them less independent.
The more board members appointed during the current CEO’s tenure, the worse the board performs its monitoring function, rendering the NYSE’s independence standards basically moot.
Myth No. 4: Interlocked Directorships Reduce Governance Quality
Corporate governance experts are fond of saying that interlocked directorships — where an executive of Firm A sits on the board of Firm B while an executive of Firm B sits on the board of Firm A — compromises independence and weakens oversight.
Some evidence exists that suggests this can occur, but even more evidence suggests that interlocking boards can be beneficial to shareholders because it creates networks among directors so they can share information more easily, including best practices in strategy, operations and oversight. These networks can also serve as an important channel for business relations, client referrals, supplier referrals, talent sourcing, capital connections and political connections.
A couple of different studies have found that network connections improve performance among companies in the venture capital industry and that companies that share these connections have similar investment policies and greater profitability. Other studies find board interconnectedness leads to more successful mergers and acquisitions, greater future operating performance and higher future stock price returns.
Myth No. 5: CEOs Make the Best Directors
With their managerial knowledge, it is easy to see why many experts and shareholders alike believe CEOs make the best board directors. However, the empirical evidence says otherwise. One study found zero evidence that the appointment of an outside CEO to a board positively contributes to future operating performance, decision making, or monitoring.
Another study found active CEO-directors are associated with higher CEO compensation levels while a survey by Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University found most corporate directors believe active CEOs are too busy with their own companies to be effective board members. Also, the number of active CEOs being recruited to sit on boards has been steadily declining over the last 15 years.
Myth No. 6: Directors Face Significant Liability Risk
Larcker and Tayan say two-thirds of directors believe the liability risk of serving on boards has increased within the past several years, and 15% have considered resigning due to concerns about personal liability. But, it turns out the actual risk of out-of-pocket payment is low because directors are afforded considerable protection through indemnification agreements and director and officer liability insurance, which have shown to be quite effective. In fact, between 1980 and 2010 outside directors made out-of-pocket payments in only 12 cases. The harm to reputation is much more of a threat than personal financial losses.
Myth No. 7: The Failure of a Company is the Board’s Fault
Sometimes, a company’s failure is the board’s fault, like when that failure is the result of poorly conceived strategy, excessive risk taking, weak oversight, or blatant fraud.
On the other hand, if the failure resulted from competitive pressure, unexpected shifts in the marketplace, or poor results that fall within the range of expected outcomes, Larcker and Tayan say, blame lies with management or even just bad luck.
It is not realistic to expect a board — even within the scope of its monitoring obligations — will detect all instances of malfeasance before they occur, as it has limited access to information about the operations of a company. Without obvious red flags, the board must rely solely on the information provided by management to inform its decisions.
Despite this, evidence shows that boards get punished when companies perform poorly through no fault of the board.
“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,” the researchers say.
These myths are deep-rooted and are not easily busted, but Larcker and Tayan hope to shed the light of truth on them through actual evidence. Read their full paper here.