This is “Recent Board Trends”, section 3.5 from the book Governing Corporations (v. 1.0).
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The optimal size of a board has been the subject of much debate in recent years. As a general proposition, smaller boards have a number of advantages over larger ones: They are easier to convene, require less effort to lead, and often have a more relaxed, informal culture. Research on group decision making supports the contention that smaller groups typically are more effective.The statistics in this chapter are taken from the Spencer Stuart Board Index 2007.
As a practical matter, however, board size should be governed by the skills needed to do the job. Larger corporations with more complex structures, substantial global interests, or multibusiness operations will require larger boards than smaller, mainly domestic, single-business firms. Today, the average Standard & Poor’s 500 board has 11 directors, compared to 18 directors about 25 years ago. It is unlikely boards will shrink further, however, as a result of new rules and proposals requiring that the audit, nominating or governance, and compensation committees of boards in publicly held companies be composed of independent directors only, in some cases, with specialized expertise (audit committee).
Fewer CEOs are accepting directorships, for two reasons. First, many boards—in the wake of the recent scandals and the Sarbanes-Oxley legislation—now insist that the chief executive concentrate fully on his or her job and restrict the number of outside boards the CEO can serve or, in some cases, prohibit it altogether. Second, as boards expand their role to areas, such as company strategy, they look for directors who have risen through specific functional areas in which the company must excel in order to compete effectively—sales and marketing, global operations, manufacturing, and others. And, in the aftermath of Sarbanes-Oxley, directors with a background in finance, especially chief financial officers (CFOs), are in strong demand.Heidrick and Struggles (2006).
For a while, it looked as though the reduced availability of CEOs and the growing demand for specialized directors would significantly reduce the talent pool of qualified directors and make it even more difficult for companies to attract new board members. Fortunately, this has not proven to be the case. If anything, the talent pool has become larger as boards are changing the definition of what constitutes a qualified candidate and widening their search. Instead of focusing almost exclusively on CEOs as candidates for the board, companies are increasingly tapping division presidents and other executives who have experience running large operations or bring specialist expertise. The redefinition of director qualifications has also expanded the talent pool of diversity candidates who may not have risen to chief executive but excel in a critical, functional area.
These changes do not mean that attracting qualified directors has become easier. Although the pool of qualified candidates is larger, many candidates are far more reluctant to serve. More than ever, candidates perform extensive due diligenceReasonable care exercised by an individual or a corporation to prevent harm or as preparation for a business action. about the companies recruiting them and look for ways to mitigate as much as possible the risk of associating themselves with a disaster or incurring personal liability. They are also far more critical and objective about their ability to add value, particularly in complex organizations, such as conglomerates, or industries like financial services and insurance. The overwhelming reason why candidates decline to serve, however, remains a lack of time. Given their already enormous responsibilities, many qualified and desirable director candidates feel that they will be unable to devote adequate attention to the job.
The proposition that boards should “act independently of management, through a thoughtful and diligent decision-making process,” has been a major focus of corporate governance reform in recent years.Macavoy and Milstein (2003), pp. 22–23. In the United States, the Sarbanes-Oxley Act of 2002, as well as the revised NYSE and NASDAQ listing rules, as affirmed by the SEC, are premised on a belief that director independence is essential to effective corporate governance. In the United Kingdom, the Cadbury Commission’s report of 1990—The Code of Best Practice—included a recommendation for having at least three nonexecutive directors on the board. Currently, reflecting this broad consensus, about 10 out of the average 12 directors of a major U.S. public company board are nonexecutives; in the United Kingdom, the corresponding number is a little less than half.
The idea of an independent board is intuitively appealing. Director independenceThe absence of any conflicts of interest through personal or professional ties with a corporation or its management., defined as the absence of any conflicts of interest through personal or professional ties with the corporation or its management, suggests objectivity and a capacity to be impartial and decisive and therefore a stronger fiduciary. At times a board needs to discuss issues that involve some or all of the company’s senior executives; this is difficult to do with senior executives on the board. The independence requirement also stops destructive practices, such as “rewarding” former CEOs for their accomplishments by giving them a role on the board. Having the former CEO on the board almost always limits the ability of the new CEO to develop his or her own relationship with the board and put his or her imprint on the organization. There is also limited evidence that outsider-dominated boards are more proactive in firing underperforming CEOs and less willing to go along with outsized compensation proposals or vote for poison pills.
Director independence should not be viewed as a proxy for good governance, however. At times, not having more insiders on the board actually can reduce a board’s effectiveness as an oversight body or as counsel to the CEO. Independent, nonexecutive directors can never be as knowledgeable about a company’s business as executive directors or senior managers. CEOs say that some of their most valuable directors are those with experience in the same industry, counter to current independence tests. The higher the proportion of outside directors, therefore, the more difficult it is to foster high-quality, deep board deliberations. Moreover, it is less likely that a CEO can mislead a board, intentionally or otherwise, when some of the directors are insiders who also have intimate knowledge of the company.Carter and Lorsch (2004), p. 93. Boards mostly comprised of independent directors must, at a minimum, therefore, create regular opportunities to interact with senior executives other than the CEO. The more complex a company’s business is, the more important such communications are.
The bottom line is that effective corporate governance does not depend on the independence of some particular subset of directors but on the independent behavior of the board as a whole. The focus should be on fostering board independence as a behavioral norm, a psychological quality, rather than on quasi-legal definitions of director independence. Director independence can contribute to but is no guarantee for better governance.