Ideal composition of a board: the focus on independence overlooks the benefits of having a few insiders on the board.

• Author: Lawler, Edward E., III
• Position: COMPETITIVE EDGE

THE SEEMINGLY unending stream of corporate governance failures over the last few years has made clear the need for more powerful and effective boards. Most board reform advocates and the many new corporate governance rules that are being issued call for boards to be dominated by independent directors. A number of boards have taken this to heart and have created boards in which the CEO is the only inside director.

The reform advocates are not the only ones who think having independent boards is the answer. A recent survey we conducted with Mercer Delta of directors in Fortune 1000 companies found that board members themselves feel that of all the proposed board reforms, having boards and audit committees made up of independent directors is by far the most likely to have a positive impact on boards. But is relying on boards that are made up almost exclusively of independent directors the best way to staff boards?

Creating boards that are entirely composed of independent directors is a simple, straightforward approach, but it overlooks several decades of research that has found no consistent relationship between the percentage of outside directors and company performance. This research shows that increasing the percentage of independent directors does not enhance performance and that, if anything, companies with one or very few inside directors may actually perform more poorly than their peers.

Our research suggests that the reason cutting back on inside directors may not produce better boards is that this approach focuses on just one key element of board design--ensuring directors are sufficiently independent of management. It ignores other key dimensions of board effectiveness, such as directors' knowledge and information. The focus on director independence also emphasizes just one board role--as a monitor of company behavior and performance. It neglects other important board roles, such as shaping of long-term strategy and succession planning.

Having a few insiders on the board can add knowledge of the firm's industry and operations to the board both directly, by including individuals with in-depth industry expertise, and indirectly, by having inside directors interact with and help educate independent directors. This industry-specific knowledge is unlikely to come from independent directors who typically can't work in the sector owing to conflicts of interest.

Inside directors can provide the board with valuable information about how the...