Opinion

Alison Frankel

Board independence is just cheap way to appease Congress: new paper

By Alison Frankel
December 5, 2013

If there’s one assumption that underlies the shareholder litigation I’ve covered over the years, it’s that truly independent boards serve shareholder interests. Plaintiffs lawyers often don’t agree with defendants about whether particular directors are actually independent, but the corporate governance ideal of a disinterested board is rarely questioned by either side. Changes in the composition of corporate boards seem to reflect that assumption. In 1998, according to a forthcoming article by Emory University School of Law professor Urska Velikonja for the North Carolina Law Review, S&P 500 companies reported that 78 percent of their board members were independent. By 2012 the number was up to 84 percent. Even more dramatic, according to Velikonja, has been the rise of boards with only one insider – the CEO – on the board. As recently as 2000, Velikonja found, these so-called supermajority independent boards represented only 20 percent of public companies. In 2012, by contrast, 59 percent of public company boards had only one non-independent director.

But are supermajority independent boards actually good for shareholders? That turns out to be a complicated question, teased out in Velikonja’s paper. She concludes, as a threshold matter, that it is shareholders who have driven the trend toward increasingly independent boards. “That is what investors want, encouraged by proxy advisors and unopposed by managers resigned to more vigilant shareholders,” the professor writes. Yet her survey of the literature on board independence and shareholder value showed “substantial academic backlash against increasingly independent boards.” As Velikonja explains, once the majority of directors on a board is independent, shareholders experience diminishing marginal returns from replacing insiders with outsiders, and increasing marginal costs because the board receives less inside information about the company. “Empirical studies seem to support the theoretical intuition that majority independent boards are a good development, but supermajority independent ones are not,” Velikonja writes.

So why, she asks, do shareholders – largely through institutional investors – continue to press for increasingly independent boards? As she notes, two theories for the phenomenon have previously been suggested. Sanjai Bhagat of the University of Colorado and Bernard Black of Northwestern hypothesized back in 1999 that unfounded conventional wisdom about a correlation between board independence and corporate performance was driving the move against inside directors. Several years later, Jeffrey Gordon of Columbia argued that board independence is (in Velikonja’s description) “a positive development made possible by better securities disclosure and the rise of shareholder primacy as the goal of corporate governance.”

Velikonja’s paper proposes a third explanation that, in some regards, bridges the gap between the two previous theories: Shareholders (and corporate officials) actually do benefit from increasingly independent boards because appointing outside directors is a cheap and easy way to get Congress and the public off the backs of corporations. Or, in her more scholarly phrasing, “It is a rational political strategy for managers and institutional investors to trade marginal decreases in corporate performance for the reduced risk of costly federal regulation of corporate behavior.”

After financial scandals, like the accounting frauds of the Enron era and the securitization failings that led to the 2008 crash, Velikonja writes, it’s inevitable that regulators will act to curb perceived corporate abuses, as we saw with the passage of the Sarbanes-Oxley and Dodd-Frank financial reform laws. So the question is what form that beefed-up regulation will take. According to the professor, increasing board independence is a way to appease Congress and the public without actually subjecting corporations to regulation that could endanger corporate returns. “‘Good’ corporate governance,” she writes, “can satisfy the public demand for regulation while otherwise maintaining the pre-crisis status quo. Independence mandates have been a particularly useful tool for deflecting regulation that would be more costly for investors.” Especially because board members have a duty to shareholders, Velikonja argues, “independent boards can be coopted for investor purposes more easily than an independent agency implementing new legislation.”

Velikonja believes her theory solves the mystery of why shareholders have pushed for supermajority independent boards, arguably costing themselves the marginal benefit of better-informed directors. But she doesn’t think the motive she has discerned is a benefit to social welfare. Sure, shareholders want to maximize their returns, and if they have to support an outside director to avoid more onerous regulation, they’ll do it. Velikonja argues, however, that corporate governance is a poor stand-in for substantive prohibitions on business shenanigans.

“Independent boards can be sold to regulators and the public as cheap and effective watchdogs to curb corporate excesses, but (directors) are accountable only to shareholders,” she writes. “While the costs of independent boards are considerably lower than the cost of regulation, their benefits (to non-shareholders) appear to be even smaller. For investors, however, the cost-benefit of independent boards compared with alternatives that they displaced is decidedly positive.”

Velikonja’s reasoning leads her to a provocative and counterintuitive stance: Corporate governance mandates, which proliferated in the Sarbanes-Oxley era, when the Securities and Exchange Commission and the New York Stock Exchange codified board independence requirements, should be retired – not because they’re bad for shareholders but because they’re bad for everyone else.

(Reporting by Alison Frankel)

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