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E-MailRonald J. Gilson is Stern Professor of Law and Business at Columbia Law School and Meyers Professor of Law and Business Emeritus at Stanford Law School, and Jeffrey N. Gordon is Richard Paul Richman Professor of Law at Columbia Law School. This post is based on their recent article, forthcoming in The Business Lawyer.
In Board 3.0: An Introduction, we sketch the case for a new board structure as an option for public company boards. The current board model—Board 2.0 in our terms—had its genesis in Mel Eisenberg’s iconic 1976 book. Eisenberg framed the ideal board as one dominated by part-time independent directors charged with monitoring management’s performance. This would replace the Board 1.0 model of directors who served as management’s advisors and whose response to disagreements with management was to resign rather than act. Board 2.0, however, goes only so far. The board remains dependent on management for company-sourced information and thus is heavily reliant on stock market prices as a measure of management performance. The result has been a board model of thinly informed, under-resourced, and boundedly motivated directors, attractive to management because of the judicially provided cover that such a board can deliver in fending off the four horsemen of the corporate apocalypse: plaintiffs’ lawyers, regulators, raiders and activists.
Over time we have seen a recurrent pattern of 2.0 style monitoring boards composed of talented people that fail to effectively monitor. Nevertheless, when companies fall short in monitoring management’s business acumen or compliance obligations, we have also seen a recurrent response: place even greater demands on the very board whose structural inadequacies gave rise to the monitoring failure, for example, the Millennium accounting scandals that gave rise to Sarbanes-Oxley and the 2008 Financial Crisis that led to Dodd-Frank.
The particular business problem that urgently calls out for a new board model is created by the interaction of two developments: the dramatic shift towards majoritarian institutional ownership of most large public companies and the rise of a new form of financial intermediary, the activist hedge fund. The consequence is that, to an unprecedented extent, even the largest public companies (and their management teams) are subject to credible proxy contests by shareholder activists objecting to management’s strategic vision or operational competence. (We trace these developments in Ronald J. Gilson & Jeffrey N. Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Re-valuation of Governance Rights, 113 Colum. L. Rev. 863 (2013).) On the present Board 2.0 model, directors are poorly situated to defend management against what is at least a credible business counter-vision. The consequence is that institutional investors may themselves resolve through their votes strategic disputes between the activist and company management rather than defer to the board’s assessment of the company’s existing strategy.
Our goal is to develop a model of thickly informed, well-resourced, and highly motivated directors who could credibly monitor managerial strategy and operational skill in cases where this would be particularly valuable. Of particular current interest, Board 3.0 directors where appropriate could help credibly defend management against shareholder activist incursions when institutional investors are challenged to determine whether company underperformance results from market myopia or from management hyperopia. Similarly, such directors could find a place in extremely complex enterprise, such as finance, where the time and expertise demanded of successful directors are high and the costs of business or regulatory failure are profound.
One inspiration for Board 3.0 is found in private equity, in which the high-powered incentives of the private equity sponsor have produced a different mode of board and director engagement that seems associated with high value creation. Porting over private equity governance features to the public company board offers a fresh starting point. There is no reason to think that Board 2.0 is the “end of history” for corporate governance. The world of private markets, venture capital and private equity, have made effective use of alternative board models. We seek to bring some of that governance experimentalism to public companies. The Board 3.0 model may solve some of the serious information asymmetries posed by some public companies: Full disclosure of strategic plans may deprive companies of first mover advantages in competitive markets and, more generally, may put public companies at competitive disadvantage to private companies. Yet markets cannot give value to plans that are not yet revealed, which makes the firm vulnerable to activist shareholder pressure and may push firms to second best strategies. Board 3.0 can mediate this problem by generating credibility with the institutional investors called upon to resolve activist challenges. Seeding public company boards with the private equity characteristics of Board 3.0 also may reduce the push for corner solutions, such as dual class common structures or take-private transactions.
To be sure, Board 3.0 may not fit some companies’ businesses, and some controlling shareholders may find the more extreme versions of leveraged control more attractive whether or not they improve or reduce performance. But expanding available board models by adding one that can provide more robust monitoring and enhanced market credibility can help with the right kind of companies. The changing nature of ownership and the increasing complexity of many businesses has rendered Board 2.0 less effective than Eisenberg had hoped. The porting of elements of private equity portfolio company boards to public company boards can provide a governance structure that matches the evolution of the current business environment.
The complete article is available for download here.
