The latest issue of the UCLA Lawyer magazine has a series of Q&As with yours truly about my book Corporate Governance after the Financial Crisis. I'm reprinting the Q&As in this series of blog posts. As the article intro explains, the book argues "that federalizing corporate governance impinges on state sovereignty, hobbles corporate efficiency and shortchanges both investors and the American taxpayer .... Professor Bainbridge offers an incisive analysis of the landscape-altering Sarbanes-Oxley and Dodd-Frank acts, responses to the near-cataclysmic economic downturns of the last decade," which "advances a critical dialogue about the limits of crisis-driven public policy."
Q: The past decade has witnessed a gradual narrowing of the scope of boards of directors and an increasing reliance on director independence. Why is this not a panacea for the ills of corporate governance?
A: This is such an important question that I devoted an entire chapter to the ever-increasing reliance on independent directors. In it, I argue that director independence rules not only failed to prevent the financial crises of the last decade, but may well have contributed to them. I admit that’s a provocative claim, but I’m confident it’s correct.
The strict conflict of interest rules embedded in the new definitions of independence made it difficult for financial institutions to find independent directors with expertise in their industry. A survey of eight U.S. major financial institutions, for example, found that two thirds of directors had no banking experience. Given the inherent information asymmetries between insiders and outsiders, the lack of board expertise significantly compounded the inability of financial institution boards to effectively monitor their firms during the pre-crisis period. More expert boards could have done more with the information made available to them and, moreover, would have been better equipped to identify gaps therein that needed filling.
In addition, the need to find independent directors put an emphasis on avoiding conflicted interests at the expense of competence. In other words, the problem was not just that the new definition of independence excluded many candidates with industry expertise. It was also that the emphasis on objective indicia of conflicts dominated the selection process to the exclusion of indicia of basic competence and good judgment. The financial crisis thus appears, in part, to have been an unintended consequence of the Sarbanes-Oxley Act.