Governance reforms: Boon ... or bafflegab?

• Author: CUNNINGHAM, LAWRENCE A.

Worthy of credit -- and adoption -- are only those governance proposals that have some inherently defensible logic, which many do not.

MOST CORPORATE governance reforms fail to solve governance problems, and some exacerbate them. Nevertheless, institutional investors and other shareholder advocates have promulgated a variety of policies about corporate governance, most of which are designed to promote an owner orientation. But just as fads infect finance, they gum up governance too.

Perhaps the most popular governance idea in the past couple of decades has been the call for independent boards of directors. The National Association of Corporate Directors (NACD) and many institutional investors, including CalPERS and TIAA-CREF, urged that corporate boards be composed of at least a majority of outside directors, those without employment or other affiliation with the corporation. The idea was that this would strengthen directorial spines to keep management in check. Nearly all major companies fell into line, with 90% of Fortune 1000 companies having a majority of independent directors.

These arguments were made on the basis of intuition, however, rather than analysis. It was as if there were little or no doubt that managers needed to be kept in line and that director watchdogs could do the trick. This premise has been exploded by several studies showing that far from independent boards enhancing economic performance, there is actually a negative correlation between the degree of independence and financial results. ("The Uncertain Relationship between Board Composition and Firm Performance," by Sanjai Bhagat and Bernard Black, published in Business Lawyer [vol. 54, 1999], is one such study.)

This is not to say that having some or many independent directors is never desirable (Warren Buffett, for example, believes that most directors should be outsiders), but there is no reason to give credit ipso facto to a company just because it does this. The unanswered commonsense questions are: (1) Who are these independent directors? and (2) What value do they add to the boardroom? Independent directors famous for international diplomacy or senatorial jobbery may be far worse to have at the table than a chief financial officer with extensive industry and managerial experience.

A template that calls for independence is not a virtue but a mirage. The key is to choose directors for their business savvy, interest in the job, and owner orientation. To be avoided are celebrity directors and others who are chosen for nonfundamental reasons, such as adding diversity or prominence to a board.

A questionable formula

Another popular move some companies fell for was the push to split the functions of the company's CEO from those of its board chairman. This manifested the same rationale of independence prescriptions, a need to check the boardroom power of the CEO. Only about 5% of Fortune 1000 companies succumbed to this formula, probably with good reason.

As an empirical matter, as with board independence, most evidence shows that companies that split these functions do not perform better than those which do not. (See "Leadership Structure: Separating the CEO and Chairman of the Board," by James A. Brickley, Jeffrey L. Coles, and Gregg Jarrell, Journal of Corporate Finance [vol. 3, 1997].) As an abstract matter, it is hard to justify giving a company governance credit for this separation of function -- for putting a watchdog on the CEO suggests as many reasons to be...