How Effective are Boards of Directors?

Directors are supposed to represent shareholder interest. Isn’t it ironic then that new directors are usually a) handpicked by the CEO and b) not shareholders? How can a director represent shareholder interest when they haven’t been a shareholder? The situation is even worse when a hired CEO who has little share ownership himself is picking directors.

I recently read Dear Chairman, which is a great book about corporate governance (or lack thereof) on public company boards. One of the examples from the book was Steve Jobs inviting someone to join Apple’s board. But after that person mentioned some of his ideas to improve corporate governance, Jobs rescinded the offer. He wanted directors who were yes-men, not ones who wanted to change things. This happens all the time and it shouldn’t be a surprise. Humans are selfish and we look out for ourselves first (and that’s how it should be, our self-preservation instinct is a good thing). A CEO wants to keep his cushy position making way too much money every year—why would he want to shake up the group of people that “oversee” him? It makes perfect sense when you think about it from a psychology standpoint.

Discussed in Robert Cialdini’s Influence, one of the best ways to get someone to do something for you is to first do something for them (known as the law of reciprocity). If a CEO asked me to serve on his board, I’d be grateful for the opportunity and would subconsciously (or even consciously) feel a debt to that CEO. An easy way to repay that CEO’s generous offer is to support his corporate strategy. And when a director supports a CEO’s strategy, that director is no longer objective in measuring the success of that strategy. Think about it: a board that supports a strategy (could be an investment, acquisition, major hire, etc) and then later admits that decision was wrong is essentially reprimanding themselves by telling shareholders they made a bad decision. It’s much easier to kick the can down the road and delay the day of reckoning as long as possible. This is also why bringing in new people (managers or directors) is important in companies that are having issues. New people don’t have a psychological commitment to those previous decisions so they’re able to be more objective (this is related to the loss aversion principle). One of the SEC’s ways to thwart some of these issues is requiring independent directors.

The logic goes that an independent director will be more willing to question and stand up to management as opposed to a director who has family or business relationships with the company. This of course makes sense and is probably true, but Dear Chairman makes a convincing argument on why it’s a fool’s errand to determine true independence. This is because directors and managers can be independent from a business standpoint, but still be very connected from a social standpoint. If the CEO chooses personal friends for directors, it doesn’t matter whether they have business dealings or not, those directors are not independent. Even a truly independent board will probably not stay that way for long because humans are social creatures. Directors that get together a few times a year will inevitably become friends. It won’t take long for them to fly in for meetings a day or two early and go golfing and grab dinner with each other and the CEO. Carl Icahn said it succinctly: “Too many board members think of the board as a fraternity or club where you must not ruffle feathers.” Makes sense. No one wants to ruffle feathers among their friends.

What’s the solution?

Boards are supposed to represent shareholders, so it logically makes sense that shareholders choose their representatives. While this is technically the case now, in reality shareholders generally vote in any new director recommended by management. Unfortunately, I’m not sure there’s a better way. Should there be a board of outside shareholders to decide who to put up for the corporate board elections? Too complicated and it’ll be the same problem we have now. New director elections have to come from somewhere and the easiest source is a) the CEO b) the current board c) large shareholders.

It’d also make sense if a new director is required to have a certain threshold of stock ownership that was purchased in the open market prior to being elected. Some companies have stock ownership requirements for executives and directors, which is nice on the surface, but almost all of these companies give their insiders options every year to meet the ownership target. And being gifted options is not the same as spending your own hard earned money to purchase shares. One person will have an owner’s mentality and the other can easily have a “this is house money” mentality.

As a passive investor, what are you to do? Without some serious due diligence, it’s impossible for most of us to determine how independent a board truly is (where does each director live, have they ever lived near each other in the past, what college did they go to, what clubs do they belong to, what clubs do their wives belong to, do their kids go to the same school, etc). I think the #1 thing to look for on board effectiveness is share ownership among directors. I’d prefer it was purchased on the open market, but gifted shares are better than nothing. Next, look at how the board is structured by asking the following questions:

  1. Is the board staggered or do directors serve one-year terms?
  2. Is there a poison pill?
  3. Is the CEO also the Chairman or are the two positions separated?
  4. Are directors paid a small amount to cover their time and travel expenses or are they each paid six figures?
  5. Are there hedge funds or private equity firms on the board? Generally, they care about share appreciation and they aren’t afraid to ask difficult questions and shake things up if necessary.
  6. Is it a stale board where every director has been there for 15 years or is there a steady stream of one or two new directors every few years?
  7. Is the company controlled (>50% ownership) by insiders or is there at least a chance of activists getting involved if the team doesn’t perform?

None of these are deal breakers by themselves, but answering these questions will give you some major clues into how the CEO and the directors view outside shareholders. Do they view outside shareholders as enemies they need to insulate themselves against or do they view everyone as being on the same team trying to maximize the value of the company? When you see a company with a staggered, entrenched board with a poison pill and high pay, think about why that is and how friendly they are being to shareholders. Are the type of people who implements those things the type of people you want running your company?