The board of directors exists to ensure that potentially self-interested managers do not take actions that benefit themselves (personally or professionally) at the expense of shareholders. The board serves this very crucial role on behalf of shareholders because the public ownership of shares makes it impractical that shareholders directly oversee management on their own.
Stock exchanges and governmental regulations require that companies have a board of directors. They also dictate minimum requirements for how the board should be structured. For example, in most countries, boards are required to have a majority of non-executive directors and restrictions are placed to ensure their independence from management influence. Boards must also maintain special committees to oversee the publication of financial statements and interface with auditors, to set executive compensation, and to nominate directors to the board.
The question of how effective is the board of directors and its various committees really has two parts. First, how effective is the board in carrying out its oversight function? Second, do these formal structural requirements contribute to board effectiveness?
Following the accounting scandals involving Enron, Parmalat, and other major corporations, added emphasis has been placed on improving internal controls and the quality of financial reporting. The main tool for achieving this has been a push toward more rigorous standards for audit committee independence and the inclusion of financial experts on the committee. But has this had a positive effect? While there is some academic evidence that companies with entirely independent audit committees with financial experts have higher quality earnings than companies with executives on the audit committee, the evidence is quite weak.
This suggests that current standards for independence are not as effective as many would believe. Independent directors may not consistently improve board oversight, largely because regulatory requirements fail to accurately measure independence. They assume that if no material business relationship exists between the director and the company, then the board member will act independently. This is a questionable assumption. A director is independent only if he or she maintains independent judgment.
The highly touted audit committee of Satyam Computer Services was independent on paper, but appears to not have sufficient independence of judgment to challenge a CEO who was clearly misleading them.
Rather than increase the regulatory burden for how a board and its committees should be structured, more attention should be paid to the harder to measure factors that really improve board effectiveness. For example, research shows that “busy” boards (i.e., boards whose directors serve on many other boards) provide worse oversight than boards whose directors have fewer outside obligations. This makes sense, because in order to provide effective oversight, directors need to have the time to carefully review, consider, and act on the information they are provided as board members. Busy directors simply do not have this time.
Research also shows that board members who have social ties to the CEO (e.g., they attended the same university or were born in the same region) also provide worse oversight than board members who have no social connections. Board members with social ties to the CEO are more likely to award large compensation packages, are less likely to fire an underperforming CEO, and are less likely to detect that management is manipulating earnings. These board members are legally independent, but it is not clear they execute independent judgment.
One final question to consider on board effectiveness is whether it is better to have specialised committees to consider such topics as risk, strategy, technology and social responsibility or whether it is better to have the board as a whole consider these. Evidence shows that these committees can be highly effective when executives and directors with expert knowledge serve on them. These committees may also benefit from the fact that they are small in size, and it is therefore easier for a group of, say, three directors to discuss critical issues than a monolithic board of 10 to 20 directors.
If shareholders really want to improve governance at their companies, they should pay more attention to the factors that matter and less to the ones that are popular, purely legal, or seem superficially important. First, they should scrutinize whether board members have a history of strong independent judgment. Second, they should object to board members who have too many outside obligations or social ties to the CEO.
Third, they should carefully consider the expertise directors bring to bear and demand specialized committees if they feel that the board is too big or too slow to intelligently handle complex issues that are important for corporate success. If shareholders are able to win these changes, they are much more likely to realize increased stock returns.