Seven Myths Of Boards Of Directors
Stanford University – Graduate School of Business
Stanford University – Graduate School of Business
September 30, 2015
Abstract:
Corporate governance experts pay considerable attention to issues involving the board of directors. Because of the scope of the board’s role and the vast responsibilities that come with directorship, companies are expected to adhere to common best practices in board structure, composition, and procedures. While some of these practices contribute to board effectiveness, others have been shown to have no or a negative bearing on governance quality.
We review seven commonly accepted beliefs about boards of directors:
- The chairman should be independent
- Staggered boards are bad for shareholders
- Directors that meet NYSE independence standards are independent
- Interlocked directorships reduce governance quality
- CEOs make the best directors
- Directors have significant liability risk
- The failure of a company is the board’s fault
We ask:
- Why isn’t more attention paid to board processes rather than structure?
- Why aren’t more governance practices voluntary rather than required?
- Would flexible standards lead to better solutions or more failures?
- When do directors deserve the blame for a company’s failure and when is it the fault of management, the marketplace, or luck?
- How can shareholders more effectively monitor board performance?
The Stanford Closer Look series is a collection of short case studies through which we explore topics, issues, and controversies in corporate governance and executive leadership. In each study, we take a targeted look at a specific issue that is relevant to the current debate on governance and explain why it is so important. Larcker and Tayan are co-authors of the books Corporate Governance Matters and A Real Look at Real World Corporate Governance.
Seven Myths Of Boards Of Directors
Corporate governance experts pay considerable attention to issues involving the board of directors. As the representatives of shareholders, directors monitor all aspects of the organization (its strategy, capital structure, risk, and performance), select top executives, and ensure that managerial decisions and actions are in the interest of shareholders and stakeholders. Because of the scope of their role and the vast responsibility that comes with directorships, companies are expected to adhere to common best practices in board structure, composition, and procedure. Some of these practices are mandated by regulatory standards and stock exchange listing requirements; others are advocated by experts, practitioners, and observers who may or may not have a stake in the outcome. While some common practices contribute to board effectiveness, others have been shown to have no or a negative bearing on governance quality. We review seven commonly accepted beliefs about boards of directors that are not substantiated by empirical evidence.
Myth #1: The Chairman Should Always Be Independent
One of the most widely held beliefs in corporate governance is that the CEO of a company should not serve as its chairman. Over the last 10 years, companies in the S&P 500 Index received more than 300 shareholder-sponsored proxy proposals that would require a separation of the two roles. Prominent corporations including Walt Disney, JPMorgan, and Bank of America have been targeted by shareholder groups to strip their CEOs of the chairman title. According to one investor, “No CEO, no matter how magical, should chair his own board.” Companies, in turn, have moved toward separating the roles. Only 53 percent of companies in the S&P 500 Index had a dual chairman/CEO in 2014, down from 71 percent in 2005. Similarly, the prevalence of a fully independent chair increased from 9 percent to 28 percent over this period (see Exhibit 1).
Despite the belief that an independent chair provides more vigilant oversight of the organization and management, the research evidence does not support this conclusion. Boyd (1995) finds no statistical relationship between the independence status of the chairman and operating performance. Baliga, Moyer, and Rao (1996) find no evidence that a change in independence status (separation or combination) impacts future operating performance. Dey, Engel, and Liu (2011) find 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. The evidence therefore suggests that the benefitsand costs of an independent chair likely depend on the situation. According to Sheila Bair, former head of the Federal Deposit Insurance Corporation (FDIC), “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.”
Myth #2: Staggered Boards Are Always Detrimental To Shareholders
Another widely held belief is that staggered boards harm shareholders by insulating management from market pressure. Under a staggered (or classified) board structure, directors are elected to three-year rather than one-year terms, with one-third of the board standing for election each year. Because a majority of the board cannot be replaced in a single year, staggered boards are a formidable antitakeover protection (particularly when coupled with a poison pill), and for this reason many governance experts criticize their use. Over 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 (see Exhibit 2).
While it is true that staggered boards can be detrimental to shareholders in certain settings-such as when they prevent otherwise attractive merger opportunities and entrench a poorly performing management-in other settings they have been shown to improve corporate outcomes. For example, staggered boards benefit shareholders 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. To this end, Johnson, Karpoff, and Yi (2015) find 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. They also find 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. Research evidence therefore does not support a conclusion that a staggered board structure is uniformly negative for shareholders.
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