TCS Daily

Directors Cut?

By Stephen Bainbridge - April 29, 2004 12:00 AM

After the Enron fiasco, reformers identified director independence as the miracle cure for everything that ails corporate governance. In Sarbanes-Oxley, Congress mandated new stock exchange listing standards requiring the corporations have a majority of independent directors and audit committees comprised solely of independent directors. The NYSE and NASDAQ have gone even further in mandating strict new director independence rules.

Shareholder activists are now taking the campaign for director independence to even greater lengths than anyone anticipated. ISS, the leading proxy voting advisory service, recently astonished observers by urging its clients to oppose reelecting Warren Buffett as a director of Coca-Cola because Buffett didn't satisfy ISS' strict definition of director independence. Then CalPers - the big California public employee pension fund -announced that it too opposed Buffett's reelection.

Not to put too fine a point on it, but this is insane. Warren Buffett is probably the most respected investor of all time. Not only is he tremendously successful as an investor, but his integrity is remarkable for a businessman of his stature. Buffett owns almost 10% of Coke's stock, moreover, which means that his personal financial interests are closely aligned with those of other shareholders (albeit not perfectly). Finally, Buffett qualifies as an independent director under the NYSE's listing standards. If Warren Buffett doesn't qualify as independent under the ISS' and CalPers' standards, the problem is with the standards not Mr. Buffett.

Yet, it just gets worse. CalPers recently announced that it will oppose the reelection of some or all of the directors at over 2,700 companies. In other words, CalPers thinks most big public corporations are being managed by the wrong people.

All of which raises a large question: Do corporations really need any independent directors, let alone a board majority of such directors? They are such an ingrained part of the corporate landscape that it seems odd even to ask the question. Yet, it is still worth asking.

In theory, independent directors oversee management and discipline managers whose performance is sub-par. If true, there should be an identifiable correlation between the presence of outsiders on the board and firm performance. In fact, however, the empirical data on this issue is decidedly mixed.

A meta-analysis of numerous studies in this area concluded that there was no convincing evidence that firms with a majority of independent directors outperform other firms. To the contrary, it found some evidence that a "moderate number" of insiders correlates with higher performance.

Interestingly, while another meta-review by Dan Dalton in the Strategic Management Journal found that, on average, increasing the number of outsiders on the board is positively associated with higher firm performance, it also found that increasing the number of insiders on the board had the same effect. In other words -- as confirmed by a second meta-analysis by John Wagner in the Journal of Management Studies - the review found that greater board homogeneity was positively associated with higher firm performance. (I reviewed the empirical studies in depth in my article A Critique of the NYSE's Director Independence Listing Standards.)

The clearest take-home lesson to be gleaned from the available evidence is that one size does not fit all. This result should not be surprising. On one side of the equation, firms do not have uniform needs for managerial accountability mechanisms. We all know managers whose preferences include a penchant for hard, faithful work. Firms where that sort of manager dominates the corporate culture have less need for outside accountability mechanisms.

On the other side of the equation, firms have a wide range of accountability mechanisms from which to choose. Independent directors are not the sole mechanism by which management's performance is monitored. Rather, a variety of forces work together to constrain management's incentive to shirk: the capital and product markets within which the firm functions; the internal and external markets for managerial services; the market for corporate control; incentive compensation systems; auditing by outside accountants; and many others. The importance of the independent directors' monitoring role in a given firm depends in large measure on the extent to which these other forces are allowed to function. For example, managers of a firm with strong takeover defenses are less subject to the constraining influence of the market for corporate control than are those of a firm with no takeover defenses. The former needs a strong independent board more than the latter does.

The critical mass of independent directors needed to provide optimal levels of accountability also will vary depending upon the types of outsiders chosen. Strong, active independent directors with little tolerance for negligence or culpable conduct do exist. A board having a few such directors is more likely to act as a faithful monitor than is a board having many nominally independent directors who shirk their monitoring obligations.

CalPers and ISS, along with Congress and the exchanges, are trying to strap all listed companies into a single model of corporate governance. By establishing a highly restrictive definition of director independence and mandating that such directors dominate both the board and its required committees, they fail to take into account the diversity and variance among firms.

Investors would be better served by an approach that allows each firm to develop the particular mix of monitoring and management that best suits its individual needs. Assuming that markets have any power to affect market actors, this approach would have resulted in optimal levels of accountability. Rational investors will not purchase, or at least not pay as much for, securities of firms lacking management accountability mechanisms. Nor will lenders lend to such firms without compensation for the risks posed by management's lack of accountability. Those firms' cost of capital will rise and their earnings will fall. Corporate managers have many strong incentives to prevent this from happening, not the least of which is that management compensation and wealth are often closely tied to firm earnings and performance.

Because monitoring by independent directors is an important source of accountability, market forces will lead management voluntarily to support the election of independent directors and to implement firm specific mechanisms designed to ensure that their directors are able to carry out their monitoring function. Nobody at CalPers or ISS has stronger incentives than that.

Stephen Bainbridge is a frequent contributor. He recently wrote for TCS about the effects of the Sarbanes-Oxley legislation.


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