INTRODUCTION I. CHANGING BOARD COMPOSITION, 1950-2005: THE RISE OF INDEPENDENT DIRECTORS AND DIRECTOR INDEPENDENCE A. Changing Board Composition, 1950-2005 B. Mechanisms of Enhanced Director Independence, 1950-2005 1. Relationship standards and rules 2. External sanctions and rewards a. Sanctions (sticks) b. Rewards (carrots) c. Reputation 3. Intra-board structures and functions a. Board committees b. The "special committee" c. Executive session; "lead director" 4. Reducing CEO influence in director selection and retention C. Summary of Part I.B II. CHANGING BOARD COMPOSITION: THE SEARCH FOR EVIDENCE THAT IT MAKES A DIFFERENCE A. Uncertain Effect on Firm Performance and Behavior 1. Firm performance tests 2. Discrete task tests a. CEO terminations b. Takeover activity as target c. Takeover activity as acquirer d. Executive compensation e. Avoidance of financial fraud 3. Understanding the evidence a. Tradeoffs b. Sorting (optimal differences) c. Diminishing marginal returns d. Firm-specific vs. systematic effects B. Summary of Parts I and II III. THE RISE OF SHAREHOLDER VALUE, 1950-2005 A. The 1950s: The Heyday of Stakeholder Capitalism and Corporate Managerialism B. The 1970s: The Rise of the Monitoring Board 1. The Penn Central collapse and the absence of performance monitoring 2. "Questionable payments" and the absence of controls monitoring 3. Corporate social responsibility 4. Reconceptualization of the board C. 1980s: The Takeover Movement, Shareholder Value, and the Rise of the Independent Director 1. The monitoring board as safe harbor in the "Deal Decade" 2. Judicial promotion of director independence 3. Summary D. The 1990s: The Triumph of Shareholder Value and the Independent Board 1. Introduction 2. Shareholder value without hostile bids 3. Resolving the paradox through the market for managerial services a. Executive compensation b. CEO termination c. Golden parachutes 4. Markets generally E. The 2000s: New Roles for Independent Directors and New Standards of Director Independence 1. Introduction 2. Contractual vulnerabilities 3. Contracting failures 4. Director independence reconsidered F. Summary III. THE INCREASING INFORMATIVENESS OF STOCK PRICES, 1950-2005 A. Introduction B. Market-Level Empirical Evidence on Stock Price Informativeness: Synchronicity and [R.sup.2] C. Firm-Level Empirical Evidence of More Disclosure by Firms D. Additional Disclosure Because of SEC Regulation 1. Disclosure forcing a. Disclosure integration b. Segment reporting c. Management's discussion and analysis 2. Disclosure permitting 3. Disclosure standardizing E. Additional Disclosure Because of Accounting Pronouncements and Changes 1. APB No. 22, Disclosure of Accounting Policies (1972) 2. SFAS No. 52, Foreign Currency Translation (1982) 3. SFAS No. 95, Statement of Cash Flows (1987) 4. SFAS No. 106, Employers' Accounting for Post-Retirement Benefits Other than Pensions (1990) F. Other Factors Enhancing the Informativeness of Stock Prices CONCLUSION: A NEW CORPORATE GOVERNANCE PARADIGM APPENDIX INTRODUCTION
"Independent directors"--that is the answer, but what is the question?
The now-conventional understanding of boards of directors in the diffusely held firm is that they reduce the agency costs associated with the separation of ownership and control. Elected by shareholders, directors are supposed to "monitor" the managers in view of shareholder interests. Who should serve on the board of a large public firm? Circa 1950, the answer was, as a normative and positive matter, that boards should consist of the firm's senior officers, some outsiders with deep connections with the firm (such as its banker or its senior outside lawyer), and a few directors who were nominally independent but handpicked by the CEO. Circa 2006, the answer is "independent directors," whose independence is buttressed by a range of rule-based and structural mechanisms. Inside directors are a dwindling fraction; the senior outside lawyer on the board is virtually an extinct species.
The move to independent directors, which began as a "good governance" exhortation, has become in some respects a mandatory element of corporate law. For controversial transactions, the Delaware courts condition their application of the lenient "business judgment rule" to board action undertaken by independent directors. (1) The New York Stock Exchange requires most listed companies to have boards with a majority of independent directors (2) and audit and compensation committees comprised solely of independent directors. (3) The NASD requires that conflict transactions be approved by committees consisting solely of independent directors. (4) Post-Enron federal legislation requires public companies to have an audit committee comprised solely of independent directors. (5) But why has the move to independent directors been so pronounced?
One of the apparent puzzles in the empirical corporate governance literature is the lack of correlation between the presence of independent directors and the firm's economic performance. Various studies have searched in vain for an economically significant effect on the overall performance of the firm. Some would deny there is a puzzle: theory would predict that firms will select the board structure that enhances the chance for survival and success; if competitive market pressure eliminates out-of-equilibrium patterns of corporate governance, the remaining diversity is functional. Others would note that corporate governance in the United States is already quite good, and thus marginal improvements in a particular corporate governance mechanism would expectedly have a small, perhaps negligible, effect.
The claim of this Article is that the rise of independent directors in the diffusely held public firm is not driven only by the need to address the managerial agency problem at any particular firm. "Independent directors" is the answer to a different question: how do we govern firms so as to increase social welfare (as proxied by maximization of shareholder value across the general market)? This maximization of shareholder value may produce institutions that are suboptimal for particular firms but optimal for an economy of such firms. Independent directors as developed in the U.S. context solve three different problems: First, they enhance the fidelity of managers to shareholder objectives, as opposed to managerial interests or stakeholder interests. Second, they enhance the reliability of the firm's public disclosure, which makes stock market prices a more reliable signal for capital allocation and for the monitoring of managers at other firms as well as their own. Third, and more controversially, they provide a mechanism that binds the responsiveness of firms to stock market signals but in a bounded way. The turn to independent directors serves a view that stock market signals are the most reliable measure of firm performance and the best guide to allocation of capital in the economy, but that a "visible hand," namely, the independent board, is needed to balance the tendency of markets to overshoot.
This Article develops this general theme through an account of the changing function of the board over the past fifty years, from the post-World War II era to the present. During this period, the board's principal role shifted from the "advising board" to the "monitoring board," and director independence became correspondingly critical. Although other factors are at work, there were two main drivers of the monitoring model and genuine director independence. First, the corporate purpose evolved from stakeholder concerns that were an important element of 1950s managerialism to unalloyed shareholder wealth maximization in the 1990s and 2000s. Inside directors or affiliated outside directors were seen as conflicted in their capacity to insist on the primacy of shareholder interests; the expectations of director independence became increasingly stringent.
Second, fundamental changes in the information environment reworked the ratio of the firm's reliance on private information to its reliance on information impounded in prevailing stock market prices. Over the period, the central planning capabilities of the large public firm became suspect. Instead, a Hayekian spirit, embodied in the efficient capital market hypothesis, became predominant. (6) The belief that markets "knew" more than the managers of any particular firm became increasingly credible as regulators and quasi-public standard setters required increasingly deep disclosure and this information was impounded in increasingly informative stock prices. The optimal boundaries of the firm changed as external capital markets advanced relative to internal capital markets in the allocation of capital. The richer public information environment changed the role of directors. Special access to private information became less important. Independent directors could use increasingly informative market prices to advise the CEO on strategy and evaluate its execution, as well as take advantage of the increasingly well-informed opinions of securities analysts. Independents had positional advantages over inside directors, who were more likely to overvalue the firm's planning and capital allocation capabilities. In the trade-off between advising and monitoring, the monitoring of managers in light of market signals became more valuable. The reliability of the firm's public disclosures became more important. Indeed, by the end of the period, boards came to have a particular role in assuring that the firm provided accurate information to the market.
Thus, fidelity to shareholder value and to the utility of stock market signals found unity in the reliance on stock price maximization as the measure of managerial success. From a social point of view, maximizing shareholder value may be desirable if fidelity to the shareholder residual (as opposed to balancing among multiple claimants) leads to...