Boards Aren’t the Right Way to Monitor Companies, less control, more advice

Boards Aren’t the Right Way to Monitor Companies, less control, more advice

One of the key functions of a board of directors is to oversee the CEO to ensure that shareholders are getting the most out of their investment. This idea has led to regulation such as the Sarbanes-Oxley Act (2002), as well as requirements by the NYSE and NASDAQ that boards have a majority of independent directors and that members on the audit committee have financial expertise. Such rules rest on the premise that if we can just structure the board properly, management misconduct can largely be prevented. But is this a realistic expectation for directors? Maybe not.

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Over the past few years there has been a growing gap between what shareholders and regulators expect of boards and what academic research shows they are capable of. For instance, consider what it means to be a director of a company like General Electric. GE states, “The primary role of GE’s Board of Directors is to oversee how management serves the interests of shareowners and other stakeholders.” However, GE’s annual revenues last year were $117 billion, and it had over 300,000 employees. The company provides services in a myriad of industries, such as health care, water treatment, aviation, and financing.

While we are not aware of any instances that demonstrate particularly poor monitoring by GE’s board members, this example does illustrate the complexity and sheer amount of information that directors of large firms have to deal with. Do we really expect that part-time directors who attend approximately 13 meetings a year are going to be able to understand GE’s businesses in such depth that they can vigilantly evaluate potential actions and determine which ones are good for shareholders?

This question prompted us to conduct a study, which we recently published with our coauthor Ruth Aguilera in the Academy of Management Annals. Analyzing nearly 300 research articles that examined the effectiveness of board monitoring, we came to the conclusion that it is unreasonable to expect boards to be able to do an effective job at ongoing monitoring. We show that for most boards there are significant barriers at the director, board, and firm level that prevent them from being effective monitors.

One of the barriers that we identify and discuss at the director level is outside job demands. Consider that many directors who sit on boards hold senior management positions at other firms, and some sit on the boards of multiple companies. For example, Marijn Dekkers, who served as the CEO of Bayer, is also the chair of Unilever, an independent director on GE’s board, president of the German Chemical Industry Association, and vice president of the Federation of German Industry. Many directors have similarly demanding positions at firms other than the one they serve as a director. Given the large demands placed on these individuals, how do they have enough time to vigilantly protect shareholder interests?

A potential barrier at the board level is that it is often considered improper for directors to become too involved in checking the day-to-day operations of a firm, even if they have the time and will to do so. Most boards have strong cultures that promote deference to the CEO. Consequently, this makes directors feel that their job is not to directly challenge the CEO, but instead to ensure that the CEO is performing adequately, and if not, to find someone who can. In addition, there is evidence that boards suffer from many of the same group decision-making biases as other work groups, and the infrequency with which boards meet can make these dysfunctional group dynamics an even bigger issue.

Firm size and complexity create barriers at the firm level. Is it realistic for a limited number of mostly part-time directors to understand the inner workings of today’s enormous firms? Especially when the firms themselves employ hundreds, if not thousands, of accountants and also hire outside companies to double check their employees? While each firm’s board has an audit committee that a few directors sit on, it is unreasonable to expect that in general they can spot a mistake that has not already been found by an outside auditing firm.

Taken together, much of the research we reviewed shows that these barriers are so prevalent and significant that consistent monitoring just isn’t very likely. Even when boards are filled with capable, motivated directors, we believe that there are simply too many barriers that prevent them from effectively protecting shareholders. In order to gain the full value from a board, we believe that shareholders and regulators need to focus on what boards can do, and then recalibrate their expectations.

First, we need to stop blaming boards for every failure. Too often the press, shareholders, and legislators blame corporate governance failures on directors, suggesting are unmotivated or unwilling to do their job properly. This was illustrated in 2012 when Groupon’s board came under fire for the company revising its earnings. JPMorgan Chase directors were similarly criticized for not preventing a $6 billion trading loss in the company’s investment office back in 2013.

Boards can do a better job in some cases, but these types of criticisms are often misguided. We have found that most directors are hardworking and capable — they’re just placed in a context that makes it virtually impossible for them to do what is expected of them.

Second, we need to focus more on boards’ ability to provide expert advice to CEOs based on their significant knowledge and experience. Board members often are able to provide insights that top executives may not have considered. Going back to GE’s board, most of the directors have expertise in a specific industry and can therefore draw on that experience to connect managers to external resources and knowledge that can benefit the firm. In addition to providing expert advice, boards can take a much more active role in guiding firms during times of crisis, such as when a CEO is being replaced, when the company is in financial distress, or when there is a significant merger or acquisition under consideration.

Third, if shareholders and regulators insist that boards must monitor, then we need to do a better job of removing the barriers in their way. For instance, if external job demands make it impossible for a director to devote enough time and mental energy to their duty as a director, perhaps we need to change our perception that the best directors are active CEOs of other firms. Maybe we also need to work to promote cultural change within boards through increased sharing of information and by using technology to allow them to meet more frequently.

Boards can and do play an important role in the success of companies. Instead of criticizing them for not meeting impractical expectations, we should value them sharing knowledge, providing advice, and lending legitimacy to firms by virtue of their reputations in the industry.

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