In recent years, there’s been a marked trend toward corporate boards on which the only insider is the CEO. But there’s a problem with that kind of board independence: New research finds it’s associated with poorer financial performance.
High-profile accounting and corporate governance scandals have resulted in significant changes in the structure of corporate boards of directors, especially the move to (nearly) fully independent boards — that is, boards on which the CEO is the only employee director. According to data from the proxy advisory firm Institutional Shareholder Services, 36% of S&P 500 companies had no other employee director besides their CEOs in 1999. The percentage of such companies has increased steadily since then, reaching an astonishing 75% in 2015. This dramatic trend raises the important question of whether board effectiveness improves or suffers with fully independent boards.
The Benefits of Full Independence
The potential benefits of an independent board are well known. Independent directors are usually leaders with few reasons to be beholden to the CEO. Boards dominated by independent directors are better able to oversee the CEO and protect the interests of shareholders and other stakeholders. Increasing their number can foster better board performance by enhancing a company’s access to external resources and connections. A larger number of independent directors also allows a board to ensure that its members are not overburdened with oversight responsibilities to the detriment of strategic counseling. A fully independent board enables a company to reap these benefits without enlarging its board, thereby avoiding the potential disadvantages of a large board.
The Disadvantages of Full Independence
However, full board independence is not without its costs. First, research has shown that the quality of managerial oversight and strategic advising by independent directors depends significantly on the quality and completeness of information they receive. Senior executives other than the CEO often have unique insights into different aspects of the company’s operations. While such insights can be transmitted to the board via the CEO, this can introduce systematic noise (or deliberate bias on the part of the CEO) that reduces the value of such information. Further, inviting non-director executives to board meetings on an ad hoc basis does not facilitate the ongoing information exchange between independent directors and executives that comes naturally with board membership. A fully independent board may thus become less effective because it works with relatively poorer information.
Second, a major responsibility of corporate boards is to replace the CEO when needed.