Seven Myths of Boards of Directors

Corporate governance experts pay considerable attention to issues involving the board of directors. Because of the scope of the board’s role and the vast responsibilities that come with directorship, companies are expected to adhere to common best practices in board structure, composition, and procedures. Our paper, Seven Myths of Boards of Directors, which was recently made publicly available on SSRN, reviews seven commonly accepted beliefs about boards of directors that are not substantiated by empirical evidence.

Myth #1: The Chairman Should Always Be Independent

One of the most widely held beliefs in corporate governance is that the CEO of a company should not serve as its chairman. Over the last ten years, companies in the S&P 500 Index received more than 300 shareholder-sponsored proxy proposals that would require a separation of the two roles. Companies, in turn, have moved toward separating the roles. Only 53 percent of companies in the S&P 500 Index had a dual chairman/CEO in 2014, down from 71 percent in 2005. Despite the belief that an independent chair provides more vigilant oversight of the organization and management, the research evidence does not support this conclusion. Boyd (1995) finds no statistical relationship between the independence status of the chairman and operating performance. Baliga, Moyer, and Rao (1996) find no evidence that a change in independence status (separation or combination) impacts future operating performance. Dey, Engel, and Liu (2011) find that forced separation is actually detrimental to firm outcomes: Companies that separate the roles due to investor pressure exhibit negative returns around the announcement date and lower subsequent operating performance.

Myth #2: Staggered Boards Are Always Detrimental to Shareholders

Many believe that staggered boards harm shareholders by insulating management from market pressure. While it is true that staggered boards can be detrimental to shareholders in certain settings—such as when they prevent otherwise attractive merger opportunities and entrench a poorly performing management—in other settings they have been shown to improve corporate outcomes. For example, staggered boards benefit shareholders when they protect long-term business commitments that would be disrupted by a hostile takeover or when they insulate management from short-term pressure thereby allowing a company to innovate, take risk, and develop proprietary technology that is not fully understood by the market. Johnson, Karpoff, and Yi (2015) finds that staggered boards are more prevalent among newly public companies if the company has one or more large customer, is dependent on one or more key suppliers, or has an important strategic alliance in place. They also find that long-term operating performance is positively related to the use of staggered boards among these firms. Other studies suggest that staggered boards can benefit companies by committing management to longer investment horizons.

Myth #3: Directors that Meet NYSE Independence Standards are Independent

A third misconception is that directors who satisfy the independence standards of the New York Stock Exchange (NYSE) behave independently when it comes to advising and monitoring management. For example, Hwang and Kim (2009) find that independent directors that have social relationships to the CEO are associated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulates earnings to increase his or her bonus. Similarly, Coles, Daniel, and Naveen (2014) find that directors appointed by the current CEO are more likely to be sympathetic to his or her decisions and therefore less independent. The greater the percentage of the board appointed during the current CEO’s tenure, the worse the board performs its monitoring function. While independence is an important quality for an outsider to have, NYSE standards do not necessarily measure its presence (or absence).

Myth #4: Interlocked Directorships Reduce Governance Quality

Interlocked directorships occur when an executive of Firm A sits on the board of Firm B while an executive of Firm B sits on the board of Firm A. Corporate governance experts criticize board interlocks as creating psychological reciprocity that compromises independence and weakens oversight. While some evidence suggests that interlocking can create this effect, research also suggests that interlocking can be beneficial to shareholders. Interlocking creates a network among directors that can lead to increased information flow, whereby best practices in strategy, operations, and oversight are more efficiently transferred across companies. Networks effects created by interlocked directorships can also serve as an important conduit for business relations, client and supplier referrals, talent sourcing, capital, and political connections. For example, Hochberg, Ljungqvist, and Lu (2007) find that network connections improve performance among companies in the venture capital industry. Fracassi and Tate (2012) find that companies that share network connections at the senior executive and the director level have greater similarity in their investment policies and higher profitability. These effects disappear when network connections are terminated. Other studies find board connections lead to more successful mergers and acquisitions, greater future operating performance, and higher future stock price returns.

Myth #5: CEOs Make the Best Directors

Many experts believe that CEOs are the best directors because of their managerial knowledge allows them to contribute broadly to firm oversight, including strategy, risk management, succession planning, performance measurement, and shareholder and stakeholder relations. Shareholders, too, often share this belief, reacting favorably to the appointment of current CEOs to the board. However, the empirical evidence is less positive. Fahlenbrach, Low, and Stulz (2010) find no evidence that the appointment of an outside CEO to a board positively contributes to future operating performance, decision making, or monitoring. Faleye (2011) finds that active CEO-directors are associated with higher CEO compensation levels. A survey by Heidrick & Struggles and the Rock Center for Corporate Governance at Stanford University finds that most corporate directors believe that active CEOs are too busy with their own companies to be effective board members. Over the last 15 years, the percentage of newly recruited independent directors with active CEO experience has declined. Companies instead are recruiting new directors who are executives below the CEO level or who are retired CEOs.

Myth #6: Directors Face Significant Liability Risk

Two-thirds of directors believe that the liability risk of serving on boards has increased in recent years, and 15 percent have thought seriously about resigning due to concerns about personal liability. However, the actual risk of out-of-pocket payment is low. Directors are afforded considerable protection through indemnification agreements and director and officer liability insurance. These protections have been shown to be effective. Black, Cheffens, and Klauner (2006) find that between 1980 and 2005 outside directors made out-of-pocket payments in only 12 cases. A follow-up study of lawsuits filed between 2006 and 2010 finds no cases resulting in out-of-pocket payments by outside directors (although some are still ongoing). The authors conclude that “directors with state-of-the art insurance policies face little out-of-pocket liability risk…. The principal threats to outside directors who perform poorly are the time, aggravation, and potential harm to reputation that a lawsuit can entail, not direct financial loss.”

Myth #7: The Failure of a Company is the Board’s Fault

In order for a company to generate acceptable rates of returns, it must takes risks, and risks periodically lead to failure. If the failure was the result of a poorly conceived strategy, excessive risk taking, weak oversight, or blatant fraud, the board can and should rightly be blamed for failing in its monitoring function. But if the failure resulted from competitive pressure, unexpected shifts in the marketplace, or even poor results that fall within the range of expected outcomes then blame lies with management or poor luck. Even within the scope of its monitoring obligations, it is not realistic that the board will detect all instances of malfeasance before they occur. The board has limited access to information about the operations of a company. In the absence of “red flags,” it is allowed to rely solely on the information provided by management to inform its decisions. The board generally does not seek information beyond this except in a few cases (if it receives whistleblower information, for example, or believes management isn’t setting the right tone through words or behavior).

Still, evidence shows boards are punished for losses. Srinivasan (2005) finds that director turnover increases significantly following both minor and major financial restatement and that board members of firms that overstate earnings tend to lose their other directorships as well. Similarly, directors who served on the boards of large financial institutions during the financial crisis (such as Bank of America, Merrill Lynch, Morgan Stanley, Wachovia, and Washington Mutual) became the target of a “vote no” campaign to remove them from other corporate boards where they served.

The degree to which a director should be held accountable depends on a fair-minded assessment of whether and how the director might have contributed to the failure and whether it is reasonable to believe that he or she could have prevented it.

The full paper is available for download here.