The Case for Professional Boards

In 2002, Congress passed the Sarbanes Oxley (SOX) to prevent a repetition of the corporate governance debacles at Enron and WorldCom. All boards of public companies as well as their important committees would be comprised mainly of independent directors. A public company’s executives would conduct a yearly assessment of internal controls, subject to a special report by its external auditors.

Six years later, many of the largest financial institutions in the US had to be rescued by massive injections of federal assistance. Yet all these institutions were SOX compliant. Most members of their boards as well as all members of their important committees were independent. They all had evaluated their internal controls and the reports of their auditors showed no material weaknesses in 2007.

So why were the SOX reforms so ineffective? This article will identify the main deficiencies of current corporate boards — too many directors and too few experts with too much emphasis on procedures. Then this article will present a new model for boards of complex global companies — a small group of professional directors with enough relevant experience and sufficient time to hold management accountable.

Smaller Size. The average board size for companies in the S&P 500 was almost 11 in 2009, typically with over 80% independents. In most groups of 10 or more, individual members engage in what psychologists call “social loafing”, instead of taking personal responsibility for the group’s actions, they rely on others to take the lead. A large group is particularly dysfunctional in the context of a board of directors since these generally operate by consensus.

Psychology research on group dynamics suggests that groups of six or seven are the most effective at decision-making. Groups of this size are small enough for all members to take personal responsibility for the group’s actions; they also usually reach a consensus quickly.

Moreover, a group of six outside directors will allow a board to achieve an appropriate composition for the main committees — audit, compensation and nominating. Three directors can be chairs of the committees, and the other three directors can each serve on two committees.

Greater expertise. The Citigroup board was filled with luminaries from many walks of life. Yet only one of the independent directors had ever worked for a financial services firm and that person was concurrently the CEO of a large entertainment firm. Of course, every board needs a generalist to provide a broad perspective on the company’s strategy, and also an accounting expert to head the audit committee. The rest, however, should be experts in the company’s main line of business.

Most directors of large companies struggle to properly understand the business of their companies. Many of these companies are engaged in complex operations that are difficult to comprehend without considerable expertise in the field – and many do business in multiple countries, each with its unique political and economic environment.

For instance, a long-time director of a technology company was asked to become the temporary CEO. After three months in that role, he told me: “I thought I knew a lot about the company, but boy was I wrong. The knowledge and information gaps are so huge between the outside directors and the senior executives.”

Increased time commitment. Most boards meet in person every other month for one day, plus conference calls in between those meetings. But that is not enough time to keep abreast of the global operations of a large company.

An effective outside director should spend at least two days per month on company business in addition to attending six full-day board meetings per year. For example, the outside director heading an audit committee at a large Canadian company started to visit its offices a few days a month. He soon knew a lot about the company’s financial issues and made sure they all came before the audit committee.

More time spent on one company will mean less time available to spend on other boards. Specifically, independent directors should be restricted, who are now allowed to serve on four or five boards, should be restricted to just two boards of public companies. They should not be prevented by this restriction from serving on nonprofit boards.

In all three respects, the proposed model would represent a significant departure from current board practice under SOX, so it is likely to be criticized on several grounds.

Professional directors are hard to find. Finding independent directors with relevant professional expertise is not easy since the people most qualified will be working for the company’s competitors. They obviously could not serve as professional directors due to conflicts of interest and potential antitrust concerns. Moreover, given a full-time job, they could not commit enough time to being a professional director.

As a result, most independent directors will have to be retired company executives (but not former executives of the company in question). Many executives retire around age 60 in good health and want to continue to work, preferably on a part-time basis. And as people live longer, more will be actively looking for second careers.

Recruiting professional directors from the ranks of retired executives should go along with an end to mandatory retirement at ages 70 or 72. Mandatory retirement is simply a device by boards to avoid the difficult process of evaluating directors on an individual basis. However, some directors do a great job at 75 and others sleep through meetings at 65.

Professional directors will be too expensive. The average compensation of directors in S&P 500 companies is currently $213,000 per year. But professional directors would be working a lot harder than the average director today – putting in roughly twice the hours. It is reasonable, therefore, to accord professional directors a total compensation of approximately $400,000 per year. Expensive as it sounds, this increase would not affect the company’s total board outlays by much, since there would be six independent directors to pay as opposed to the current average of ten or eleven.

The more challenging question is: what should be the composition of that $400,000? On average, directors of S&P companies receive 58% of their compensation in some form of stock and the remainder in cash or benefits. But I believe that professional directors should be paid more in shares than cash to better align their interests with those of long-term shareholders and would therefore increase the stock-based proportion to 75%.

To reinforce a long-term perspective, I would subject any grants of restricted shares or stock options to two conditions. First, they would vest in equal parts over four years. Second, at least half of the shares acquired by professional directors through these grants would have to be held until their retirement from the board.

Professional directors will have greater legal exposure. Since professional independent directors will be quite active in supervising the business of the company, will they become subject to increased legal liabilities? For example, if the head of the Audit Committee becomes very knowledgeable about the company’s financial issues, will he or she be personally liable under the federal securities laws if the company’s financial statements contain material misrepresentations? The answer is no, unless it can be proved that the audit head knew or these misrepresentations or recklessly disregarded them.

Professional directors will clearly be independent of company management. If directors are independent, state courts will defer heavily to their business judgment about what is best for the company.

In general, the courts will override the business judgment of the independent directors only if they did not act “in good faith”. This involves directors carefully considering all the factual and legal issues, obtaining advice from independent experts if needed, and deliberating as a board for sufficient time to make a reasoned decision. Because professional directors will spend more time on due diligence than today’s norm, they will be in a particularly strong position to show they acted “in good faith.”

The new board will get too involved in operations. Probably the most serious objection to the proposed model is that it might blur the distinction between the roles of the board and management. A board of directors has specific duties such as selecting the CEO. A board also has more general duties in areas like strategic goals, but it is not supposed to get involved in the day-to-day management of the company.

Although the new model will entail a reallocation of power and knowledge from senior executives to professional directors, it does not force the latter to cross the line into day-to-day operations. Consider the role of the compensation committee under the new model. At board meetings, the director would set the CEO’s compensation and review the compensation plans applicable to senior officers. They would also approve a report explaining the rationale of the company’s compensation plans for inclusion in the annual proxy statement.

Between board meetings professional directors would talk with managers and HR officers to get a better grasp of employee reactions to the company’s compensation policies. In these sessions, however, the professional directors would not get involved in the evaluation of the performance or pay of any individual employee or specific group of employees – these subjects would be strictly out of bounds. Instead, these sessions would be aimed at putting the professional directors in a better position to help design and assess the compensation plans of the company.

Even if these concerns are satisfied, it will take extraordinary efforts to persuade a company to adopt the new board model. First, the bank regulators could use their safety and soundness authority to force some banks to elect professional directors. In fact, the regulators have already leaned on Citigroup and other large banks to replace generalists directors with retired banking executives.

Second, activist shareholders might join together to pressure a poorly performing company into adopting the new model. They could even nominate one or directors who support this model.

Finally, a few brave and confident CEOs of sound companies might be willing to try out the new model. This has happened previously — for example, on adopting majority voting.

In short, SOX and other corporate governance statutes have been largely drafted by lawyers who tried to solve the perceived problems by creating more detailed procedures for boards to follow. Although some of these procedures may be reasonable, they do not address the key challenges in improving corporate boards —how to recruit very intelligent people with deep industry expertise, who are willing to commit a lot of time to board service. We do not need another layer of legalistic procedures. Instead, we need a different board model where directors view their role as their primary occupation and not a sideshow in their otherwise busy lives.