The Twenty-First Century Boardroom: Who Will Be in Charge?

We are witnessing an organic change in American corporate governance. The balance of power among owner, manager, and director is in the process of transformation. The once archetypal model of the CEO’s unchallengeable control of the board of directors and shareholders is fading. The future will definitely see a new paradigm of governance. What is uncertain, as we enter a new century, is exactly how the power to control corporate behavior will be configured among shareholders, directors, and managers.

A series of factors is triggering a modification of the current structure of corporate governance. Financial institutions, which have pressed openly for changes in corporate directors’ roles, now own a growing proportion of shares. The hostility to, and the lessened availability of financing for, hostile corporate takeovers has diminished takeovers as catalysts for corporate change, at least for a time. The Securities and Exchange Commission has modified its rules to facilitate communication among shareholders and has pressed corporations to reveal more information concerning senior management compensation. At the same time, the business press and academic journals, in their increasing attention to governance issues, have suggested an urgent need for governance reform.

In this article, our focus is on the role of the board of directors in corporate governance and the range of potential changes in the rules and norms governing board behavior. We believe that an independent board of directors is best suited to perform the essential functions of corporate governance. The flaws in the present governance system lie in the self-imposed rules and cultural norms under which most boards operate. To enhance the board’s ability to govern, the “culture” of the board and the balance of power between independent directors and the chief executive officer need to be changed to make the board function as a cohesive unit.

We present here eleven options for reform, weighing the pros and cons of each. We believe that these options, if adopted, would lead to a visible change in the board’s character and significantly strengthen its monitoring function. However, we need to be careful not to overstate their potential. The success or failure of a business enterprise still rests overwhelmingly with the quality of its management, and by that we mean the management team and not just the CEO. This argues for a certain degree of modesty in advancing claims for reform. Strategic misjudgments and operating mistakes will still occur, even if the board discharges its responsibilities with maximum effectiveness. Nevertheless, we believe that a strengthened board can — without indecision or procrastination — realistically evaluate a company’s performance, assess the quality of its management, and act decisively to change the course of the corporation as necessary.

The Costs of Separating Ownership and Control

More than sixty years ago, Berle and Means articulated the classic view of the public corporation as one in which ownership of the firm’s equity was separated from control of the firm’s assets by management.1 Jensen and Meckling, who revisited this view, emphasized that the managers of public corporations, although agents of the shareholders, will, in maximizing their own interests as managers, “not always act in the best interests of the principal.”2 They pointed out that shareholders can limit divergence from their interests by establishing appropriate incentives for the agent-managers and by incurring “monitoring costs,” which they defined as budget restrictions, compensation policies, and operating policies designed not merely to observe or measure the behavior of the agent but to control it.

In Jensen and Meckling’s view, the conflict between principal and agent in the corporate system is broader than the manager’s tendency to “appropriate perquisites out of the firm’s resources for his own consumption.” More recently, Jensen has argued that many managements may gain prestige from maximizing the size of the firm, as opposed to its profitability, and will squander the firm’s “free cash flow” on negative net present value investments as a result.3 In Jensen’s view, management will often continue to invest in money-losing ventures rather than accept the reality that the company can no longer compete effectively in a particular market. When it comes to potential sources of external discipline, Jensen maintains that there are only four “control forces” that could serve to constrain managers’ decisions:

• Capital markets.
• The legal/political/regulatory system.
• Product and factor markets.
• The internal control system headed by the board of directors.

Jensen argues that hostile takeovers were once a powerful, healthy source of discipline, a point we suspect is true but a bit overstated, because some managers and their advisers were probably more motivated by pure ego and a hunger for fees. In any event, this market has now become less active (but not altogether dormant). He dismisses the legal/political/regulatory system as “far too blunt an instrument to handle the problems of wasteful managerial behavior effectively” and asserts that the product and factor markets, while slow to act as a source of discipline, are often fatal once they do act, making it impossible to save much of the enterprise.4

The primary burden to ensure that companies are managed efficiently and effectively is thus left on the internal control system. While Jensen agrees that we must improve the system, he also argues that “substantial data support the proposition that the internal control systems of publicly held corporations have generally failed to cause managers to maximize efficiency and value.”5 As we indicate later, we are more sanguine that the board of directors can be sufficiently strengthened to act as an effective monitoring agent, but we cannot help but agree with Jensen that there are many examples of boards failing to take timely and appropriate action.

In the late 1980s, Lorsch and MacIver systematically examined the roles of contemporary corporate directors. Their research found the following board weaknesses:

• Most directors acknowledge that the CEO has greater power under normal conditions. The CEO’s major power source, relative to directors’, is rooted in a comprehensive knowledge of company affairs.
• Outside directors are seldom cohesive. They meet infrequently at brief, structured meetings as a loosely defined group without an alternative leader (where the CEO also serves as board chairman). Contacting fellow directors outside of meetings is typically not acceptable.
• Power emanates from the CEO’s control of the board meeting. The CEO creates the agenda, determines what information directors receive in advance, and leads discussions at board meetings.
• Directors are expected, above all, to treat the CEO with respect, which means not embarrassing him or her in a board meeting. Since directors should not openly criticize the CEO, or the CEO’s positions, the accepted way of objecting is to ask penetrating questions. If other directors join in and the tone of the discussion becomes increasingly critical, they convey a message of disapproval. Under normal circumstances, such disapproval is rarely made explicit in a board meeting.6

We add another source of board weakness — and perhaps the most serious one — the failure to define for itself what its precise responsibilities are and how it should act to discharge these obligations.

The challenge, then, is to enhance the internal corporate governance system so that managers are induced to maximize corporate efficiency before the corporation must take radical measures to stave off impending financial collapse. The broader issue is, in a highly competitive global business environment in which rapid change is the only constant, how to organize and manage corporations to adapt to inevitable change in an evolutionary, continuous manner.

The Potential Power Shift

Some commentators, such as Brancott and Gaughan, see hope for more effective monitoring of management in the increased activism of institutional shareholders.7 Institutional investors now own roughly half of U.S. corporate shares and account for a much larger fraction of trading. Moreover, economic power is concentrated among a relatively small, stable universe of institutions. The largest twenty pension funds own roughly one-third of the assets of the 1,000 largest corporations, according to Brancott and Gaughan. The growing share of U.S. corporations “owned” by institutions, particularly the concentration of shareholdings among a relatively few such investors, has led a number of commentators to conclude that the largest institutions should be able to organize themselves to minimize agency costs and exert substantial influence not only on the companies in which they have invested, but also on the very form of corporate governance.8

Clearly, more and more chief executives are becoming sensitive to the agendas of institutional shareholders. In a recent poll of CEOs by the executive search firm Korn/Ferry, 82 percent of those questioned believe that “pressure from institutional investors will cause corporate boards to become increasingly critical of management performance.”9

However, whatever the perceived shortcomings in the roles of a good many corporate boards to date, we do not think it is practical to rely on institutional shareholders as the primary source of corporate monitoring. It takes a special set of talents, experience, and personality to monitor the management of a corporate enterprise without micromanaging it and intruding into professional management’s legitimate domain. Managers of pension funds, mutual funds, and other types of institutional investors rarely, if ever, have expertise and experience in directing a company. Gathering the knowledge and experience required to run a corporation is time consuming and costly, especially in today’s globally competitive environment in which new technologies have vastly accelerated the velocity of change.

These realities make it unlikely that institutional investors, especially public pension funds with their own often-cumbersome decision-making processes, will make timely, informed governance decisions regarding the companies in which they invest. Moreover, most institutional investors employ money management firms to invest their funds. Money managers are unlikely to profit from close monitoring of managerial behavior because a change that benefits their clients will also benefit other clients and their managers. In addition, many money managers seek corporate clients, especially private pension fund money, and are concerned that disciplining the management of a corporation will cost them business.

Most institutional investors would therefore have to recruit individuals with the talent to supervise the operations of their portfolio companies. In the case of private company pension funds, corporate executives might have to be diverted from their ordinary responsibilities to act as monitors of the companies in which pension investments have been made. In either case, the investor would incur additional expense. Finally, we should note that “active” portfolio managers cannot really act as long-term owners. Their fiduciary responsibility, reinforced by interpretation of the Employee Retirement Income Security Act (ERISA), is to sell the shares of companies in need of radical surgery, whose results are expected to be relatively poor over the foreseeable future.

At the same time, the voice of the shareholders should not be ignored; it is, after all, in their interests that the directors are intended to serve. As we discuss later, the board should take steps to expand communication between directors and shareholders and be more aware of what the shareholders consider to be in their best interests.

How to Make Independent Directors More Effective

Boards have a natural inclination to support management; management has a live persona that the directors interact with and form relationships with, in contrast to an amorphous body of shareholders. The board’s shared experience with management in working through problems further builds an innate loyalty. Still, we believe that it is possible for the board to achieve more independent decision making without building an antagonistic and confrontational atmosphere between itself and management.

A starting point in strengthening the board’s role is to define expectations of what is reasonable for directors to accomplish. It is wishful thinking to expect that directors be more clairvoyant than operating management in seeing the right strategy for the company. For instance, the directors of companies that failed to foresee their primary business’s decline cannot be faulted for lack of sufficient foresight. The issue rather is the quality of their hindsight; did they take appropriate and timely action once they knew that the company’s profit slide was not a short-run aberration? Did a persistently deteriorating bottom line or substantial erosion in share price provide warning that management did not have the business under control and warrant the board’s thorough inquiry into the company’s business?

Board members should be able to:

• Discern inconsistencies between management’s outlook and objective evidence of the realities of the business’s condition.
• Understand the risks and potential rewards of a business strategy, and recognize when management has not formulated one.
• Evaluate the quality of operating management and spot flaws in either individual senior executives or major managerial systems.
• Test, with the aid of outside auditors, the adequacy of financial controls and reporting systems.
• Design and supervise compensation systems that align management and shareholder interests to the maximum feasible extent.
• Have the confidence to take unpleasant actions that their business judgment indicates is necessary.

While the fate of a business will always turn primarily on the quality of its management, independent directors who are willing to take an active role in the governance of a corporation can make a difference.

The heart of any reform lies in creating a board that acts cohesively, independent of and not subordinate to the CEO. The board must be capable of holding management accountable rather than simply acquiescing in exculpatory accounts of management’s stewardship. And the board must trust its informed instincts and not, out of ingrained reflex, simply defer to management’s wishes in all cases. Such a board will also transform its meetings into an even-handed forum in which both management and directors can freely put issues on the table.

Accordingly, to change the character of corporate governance, the culture that prevails in many board-rooms must be altered. But changes must be crafted to meet each company’s particular needs and situation. Imposing uniform rules and practices would not make sense, given the widely varying nature of public companies. For instance, the norms that apply to the nation’s 100 largest corporations would not apply to, say, a small, newly formed company. Even companies of the same size, but in different industries, may warrant different forms of governance.

We offer here a menu of steps that companies, especially the larger U.S. corporations, can take to strengthen independent directors, who can adapt them to their own particular needs and circumstances. We try to illuminate these suggestions by pointing out their pros and cons.

Compose a Board of Outside Directors

A board should be composed entirely of nonemployee directors, with the exception of the CEO. In addition, a majority of the directors should have no business or familial affiliation with management. This means barring any board member from receiving, directly or indirectly, any form of compensation from the company, other than his or her director’s fees. The possibility for abuse, or perception of abuse, in allowing directors to receive additional compensation from management warrants great care in awarding any such payments and requires review by the compensation committee.

In our view, creating a board entirely of independent directors is essential to building board cohesiveness. An argument is often made that certain executives — other than the CEO — are so important to the company that they should have seats on the board where they can be evaluated as potential CEOs. For example, Bowen argues that inside directors can provide useful insights and information and can strengthen the allegiance of certain key employees.10 But inside directors cannot be truly independent of the CEO. As Smale has bluntly put it, “Inside directors, for governance purposes, are essentially useless.”11 We believe that adding employees to a board can contribute to a lack of cohesiveness as an independent entity. Other ways to reward senior executives and expose them to the board are by inviting them to board meetings, requiring them to make presentations, and allowing them to join in various discussions.

Establish the Position of Lead Director

Many proponents of board reform advocate separating the position of chairman from that of chief executive officer.12 They argue that having an independent director serve as chairman of the board will enhance the board’s effectiveness as an overseer and monitor of management. Moreover, the board would be strengthened by having its own leadership, would be better organized, and would be put on a stronger footing in dealing with management. Proponents of separating the positions point to the apparently successful use of this structure in a variety of nonprofit institutions and in corporations in Europe and the United Kingdom, though there is often strong criticism in these countries of the board’s role.

We are persuaded, however, that there are practical arguments against separating the positions. Such a change could lead to confusion over the locus of decision-making authority and to friction with the CEO. The Korn/Ferry study cited earlier notes that 24 percent of the companies surveyed separate the chairman and CEO functions, and an additional 35 percent of the CEOs would consider separating these functions in the future. However, some 63 percent of the CEOs believe that such separation would diminish their authority.

Elevating one independent director to chair the board could also lead to an unhealthy distinction between the chair and the board, undermining the board’s ability to act collectively. Moreover, a separate CEO would also create a new layer of management requiring additional reporting burdens. Finally, defining a meaningful role for the independent chair without overlapping the CEO’s role would be extraordinarily difficult.

We believe that the advantages of an independent chair of the board can be accomplished in a less contentious and divisive way. Several models could restore the full potential of the independent directors as more effective monitors of management, such as a chair of the independent directors (CID), chair of a board governance (and nominating) committee (CGC), or, as recently adopted by a major financial institution, chair of a committee on committees (CCC), in which the committee is made up of the chairpersons of the various board committees. Such models could create the position of a lead director, while preserving the collective character of board governance. This chair (designated or lead director, or ombudsman) could perform a number of special functions:

• The CEO would chair the board but would work with the CID (or CGC or CCC) in setting the board’s agenda. The committee chair would canvass other directors and, from time to time, informally survey major shareholders on the issues they would like to see addressed. In this way, the board’s independent directors could ensure that the board discusses important matters and that board time is not devoted to “show and tell” slide-show presentations or decisions on specific transactions that could just as well be delegated to management.
• The CID would organize periodic board sessions at which management is not present. The independent directors should meet separately at least once a year to permit completely open and candid discussion of management’s effectiveness and the company’s performance. Moreover, other subjects — such as impending merger prospects or executive compensation — are not likely to be discussed openly with management present. While frequent closed meetings of the independent directors could create a potential devisiveness and undermine the confidence of even an effective management, some regularly scheduled, periodic meetings could enhance the board’s effectiveness as a monitor.
• The CID could also be an intermediary between the independent directors and the CEO, permitting directors to ask the CEO sensitive questions that might prove embarrassing in public. As Bowen has suggested, “There is much to be said for having an authorized place within the organizational structure to which directors can go to register concerns and check impressions, especially when an organization seems to be in trouble or to be missing opportunities.”13
• The CID could meet occasionally with various large shareholders to understand their concerns and to reinforce the concept that the directors are acting in their best interests. These small, informal meetings, without management present unless requested, would permit a more candid exchange than the public annual meeting of shareholders.
• The chair could also conduct exit interviews if top officers of the organization resign.

Require the CEO to Retire from the Board

Except in unusual circumstances, the CEO should not continue to serve as a board member after retirement. Any CEO has difficulty being entirely objective about policies and strategies undertaken during his or her tenure. And it is enormously difficult for a new CEO to change direction and, in effect, repudiate his or her predecessor and for directors to be completely frank about the need for organizational change when the former CEO is sitting in the boardroom.

Establish an Outside Nominating Committee

A committee of outside (nonaffiliated) directors should nominate new board members. Choosing new members by conscientiously exercising due diligence can have the greatest impact on the balance between the board and the CEO in governing a corporation. A CEO who has the effective power to name his or her board and even force the removal of members he or she objects to controls the board rather than accounts to it. Establishing accountability — and defining the areas in which it operates — should be the primary thrust of governance reform. For this reason, the proposal governing the election of board members is potentially one of the most potent yet controversial reforms. As a practical matter, it would be a major step in creating independent boards, provided that the nominating committee in fact exercises its own judgment and does not just serve as a rubber stamp for the CEO’s choices.

At the same time, the process has a number of associated risks. Letting a committee of directors control the nominating process could lead to a handful of board members who dominate the board makeup, injecting their own biases into corporate governance. Board “cronyism” is by no means preferable to CEO dominance. The risk can be mitigated, however, by limiting the terms of directors who serve on the nominating committee and rotating all members.

The nominating committee — prior to any search — should establish criteria for the vacancies. In some cases, experience in a particular field might be required. Some committees might bar from board membership any officer of a company on whose board their CEO sits. These criteria should then be submitted for full board approval. The process should lead to the selection of persons with the right professional and temperamental qualifications — and the available time to contribute — rather than simply a “prestigious” name. The CEO would be closely consulted during this process, and nominations would first be submitted to the full board before being voted on by shareholders.

Another risk is that a board that elects its own members will become too independent of management, resulting in conflicts on important policy matters. However, an intelligent board should be wise enough to know how much latitude and support to give management without abandoning its primary responsibilities to the shareholders.

The selection process could also incorporate some input from shareholders. The current system typically confronts shareholders with the choice of either accepting a fait accompli in voting for management’s slate of directors or mounting a proxy challenge with very limited chance of success.

Set Term Limits with the Possibility of Later Renomination

Setting term limits with the possibility of renomination after one year may, in some circumstances, provide a way for the board to monitor its members’ effectiveness and weed out directors who do not perform satisfactorily. For this reason, some observers have suggested that board membership should be limited to a maximum fixed term of, say, twelve years.14 However, rigid rules on tenure could deprive a board of some of its most useful members, and continuity and past board experience can play a useful role in improving the board’s effectiveness.

We believe, therefore, that a reasonable compromise would be to rotate every director off the board after a certain number of years, subject to later reelection after a year off the board. This provides a graceful way to handle the awkwardness of removing a board member. As Bowen points out, the board can renominate “a particularly valuable member without grossly offending that individual’s ‘classmates.’ ” Such a system, he adds, “would also make it easier to select relatively young members, since there is no risk that someone will serve uninterruptedly for as long as three decades or more.”15

Align Management Compensation with Shareholders’ Interests

The board should devise and oversee the administration of a compensation system that provides incentives to management to maximize the long-term profitability of the corporation. As we indicated earlier, management and shareholder interests can often diverge. Thus it is important for directors to limit the degree of divergence not just by monitoring management’s behavior but by providing incentives to management to act in the shareholder’s best interests. Such a compensation system should include payments based on certain long-term corporate objectives, and some part of the compensation should be tied to the performance of the company’s common stock through stock ownership.

Directors should not invariably limit their role to just commenting on the compensation plan that management proposes but, where useful, initiate a plan in consultation with management. In addition, without management present, the board should privately undertake a review of management performance and the compensation to be awarded, after hearing the CEO’s recommendations.

Disclosure of the system adopted is essential for public confidence and is, in fact, required by the SEC. Under current SEC regulations, the company must report the pay of the CEO and the four other most highly compensated employees as well as the factors and criteria on which compensation was based. We would add the requirement that the report concretely disclose how the board’s compensation system gives management the incentive to maximize the corporation’s long-term profitability, and how the proposed compensation for senior management is consistent with the plan. The report should also reveal how the board reviewed proposed awards, including any outside expertise used during the review.

Align Directors’ Compensation

Directors’ compensation should also be aligned with the shareholders’ stake. Just as management’s financial interests should be aligned, to the extent feasible, with the shareholders’, the directors should be paid in a similar manner. Directors’ fees can be made up primarily of shares in the corporation, which they might be required to hold for a period of years in the same way management is. We favor giving outright shares, rather than options, to expose directors to both the risk of loss and the opportunity for gain.

We do not agree that directors should necessarily make significant investments of their own funds in the company’s shares (Jensen suggests at least $100,000 in cash16). Directors should be chosen for their ability to contribute to the board’s work, not for their capacity to make significant financial investments. It would be a mistake to exclude a person who lacked the personal financial resources to purchase a certain amount of shares, such as a research scientist with special knowledge of the company’s business.

We also caution that directors should not be given incentive to favor actions that may increase share price so that they are inclined to approve high-risk strategies. In the effort to align directors’ financial interests with shareholders’, one should not forget that directors are fiduciaries legally obliged to act in the shareholders’ best interests, without consideration of their personal financial gain.

Establish Ground Rules for Merger Discussions

The governance committee (or other designated committee of independent directors) should set the ground rules for merger discussions — and actively monitor them — before management enters into detailed negotiations. The state of Delaware law governing mergers can be described only as uncertain; at issue is when and under what circumstances a board of directors is obligated to consider competing bids or whether it may ignore unsolicited bids and pursue a merger with another company because it reflects implementation of long-term strategy rather than a decision to sell the company. But the one clear implication of the law is that directors need to establish, independent of management, ground rules and policies that will govern a prospective merger and to maintain ultimate control of the merger negotiations when it seems that management will benefit financially or is acting for personal motives. In the future, it would be prudent for a board to have the governance committee or other committee of independent directors closely oversee merger activities.

Employ Independent Advisers

In some circumstances, a board may need to hire its own independent advisers. For example, in an attempted hostile takeover or merger discussions, an independent outside counsel would be especially useful. The board would not have to rely on company counsel who, even if a member of an outside firm, may feel a divided loyalty between management and the directors and the shareholders for whom management serves as agent.

Compensation committees may also find their own advisers important. As Bowen points out, “In complex situations, where much is at stake for all parties, standards of professionalism cannot be counted on to guarantee that experts hired by management will provide truly objective advice to boards, which must evaluate proposals in which management may have a vested interest (and which the same advisers may have helped to formulate).”17

Strengthen the Audit Committee

Many companies now have an audit committee made up of independent directors. (The New York Stock Exchange imposes this requirement on member firms.) The traditional role of such a committee is to meet with the company’s outside auditor to hear its report on the company’s financial position as well as management’s response to the auditor’s concerns. At some point, the committee also meets with the auditor without management present. An audit committee is an essential element in a governance structure, yet the number of well-publicized breakdowns in company control systems suggests that not all audit committees or outside auditing firms are as aggressive as they need to be in scrutinizing management.

One flaw in the audit process is that management chooses outside auditors and sets their fees, even though the board and the shareholders ratify their selection. Audit committees could take a more active role in the selection and fee-setting process, signaling clearly that the board will ultimately evaluate an outside auditor’s performance and value.

To be more effective, the audit committee should also direct both the outside and inside auditors’ review of company affairs. For example, each year, the committee could routinely designate, on a random rotating basis, one or more specific areas of the company’s control system that the inside and outside auditors should investigate in depth, even though the areas may seem to be fine. Their objective is to investigate an area as if a major abuse had been uncovered, but to do so before and not after the fact. Similarly, the committee could ask the auditors to annually scrutinize particular financial reporting practices, even though they may appear sound.

As a minimum, the audit committee should discuss with the outside auditors the areas of financial controls to examine and test during the coming year, not leaving the choice to the auditors, as is typical. The “bottom line” for the audit committee is to shed its reactive mode and become a catalyst in probing for weak spots in the company’s internal controls and financial reporting practices.

Establish a Board of Appropriate Size

Many observers have suggested that the size of a board be strictly limited to no more than eight directors, because a small board engenders greater focus, participation, and genuine interaction and debate. For example, Jensen has argued, “When boards get beyond seven or eight people, they are less likely to function effectively and are easier for the CEO to control.”18 Johnson has suggested, “Wonderful things might happen to the group dynamic if boards were limited to seven members. . . . An issue-oriented agenda and true deliberation might be hard to avoid.”19

We are not persuaded that the advantages of a small board outweigh those of a somewhat larger one of perhaps twelve or even eighteen members, at least for a large, publicly traded corporation. A very small board can defeat the objective of encouraging a wide range of views. Moreover, a size constraint can limit the board members’ varied experiences and potential diversity of race, gender, and geographical distribution.

Conclusion

Separation of ownership and control and the potential for divergent interests are an inherent part of the corporate structure, but there is substantial scope for the initiative of a dedicated and able group of independent directors, supported by informed shareholders. While there is no uniform prescription, or inherent right and wrong way to run a board, the appropriate form of governance should be a subject of ongoing, regular concern for the board.

An effective board, with its own sense of cohesiveness and determination to be informed about its company’s business (if necessary, through access to information not provided by management) can: (1) take meaningful action to minimize management’s opportunities to benefit when shareholders do not and, in particular, to curb excessive perquisites and compensation; and (2) determine when the company is in severe difficulty, especially when its own culture paralyzes it from adapting to a changing environment.

However, the discharge of these critical functions will not guarantee that corporations will not fail. Expert management is still the foundation of a successful enterprise. Put simply, reform of the board can benefit shareholders even if it cannot spare them from making unsatisfactory investments. We predict growing recognition of an effective board’s value and venture that, in the future, the investor community will aggressively challenge any ineffective board.