C&B Notes

Too Much of a Good Thing

 

Good and effective governance is not primarily a result of an exhaustive set of rules and regulations, but rather a product of a strong and clear culture of accountability and of doing the right thing on behalf of all stakeholders.  For some companies, good board-governance practices have swung way too far towards independence, which is far from a cure-all.

The conventional wisdom couldn’t be clearer: The more independent a company’s board is, the better.  The presence of any company employees, other than perhaps the company’s CEO, can only bring trouble.  The conventional wisdom couldn’t be more wrong: Boards that are too independent invite trouble.  According to our research, it can lead to lower profits, excessive CEO pay and more financial fraud.  In other words, when it comes to the independence of corporate boards, there can be too much of a good thing.  This will no doubt surprise a lot of people.  Boards where the CEO is the lone insider — what we call “lone-insider boards” — have been growing in popularity. Today, in fact, the CEO is the lone board insider at more than half of S&P 1500 firms…

While the drive toward greater independence was an important improvement, removing all insiders except the CEO takes independence to an extreme that wasn’t dictated by exchange rules — or by good corporate governance.  That’s because having one or more additional inside executives on the board provides two important benefits.  First, other insiders provide critical information.  A CEO’s job is complex and largely hidden from outside directors’ view.  Inside directors are immersed in day-to-day operations and directly observe the CEO’s actions, so they can provide outside directors with detail and context they wouldn’t otherwise possess.  In the absence of other board insiders, CEOs have an easier time shifting blame when performance slides or taking more credit than deserved when performance excels.  In contrast, the presence of insiders who know the behind-the-scenes story can help outside board members better assess CEO performance and set appropriate CEO pay.

The second benefit of placing other key executives on the board is that it reduces the risks associated with CEO turnover.  When non-CEO executives serve on the board, outside board members get to know them and are able to assess their leadership skills.  Knowing that competent internal candidates are available makes it easier to challenge the current CEO.  When a need for change becomes apparent, the board might still look externally for a new CEO, but at least the bench strength of the current executive team will be well understood.

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The obvious antidote to the negative consequences of lone-insider boards is to invite one or two key executives to join the board.  Every company has unique governance needs, of course, but our data show that firms with two or three insiders on the board don’t suffer any of the executive-compensation and performance problems endured by firms with lone insiders.  As to whom to tap, we find that boards often default to putting the chief financial officer on the board if they want a second insider.  But that may not be the preferred route every time.  Instead, boards should focus on personal characteristics rather than titles.  An executive who asks hard questions, values candor and has strong potential as a future CEO would be a wise choice — whatever his or her title.

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