The WSJ's lead editorial today criticizes proposals to mandate that derivatives trading boards and clearinghouses have boards of directors with a majority of independent members:
We're still waiting for evidence that independent directors yield better financial results. Merrill Lynch's 2006 annual report proudly noted that 11 out of the 12 members of its corporate board were independent—people who had never worked at the firm and had little connection to it. Merrill was a model of trendy corporate governance, with a board of esteemed Americans who could offer an unbiased perspective.
As it turned out, what Merrill really needed was a board that knew how to manage financial risk. And it would have helped immensely if directors had understood the mortgage-backed securities on which they had unwittingly bet the firm. The report was released in early 2007, and by that October the company was searching for a new CEO after an $8.4 billion quarterly loss.
In 2008, the firm again boasted of independent captains manning the board deck as Merrill sailed into the financial crisis. The company had 11 directors by then, and 10 of them were untainted by intimate knowledge of the business. Several months later, the securities that the board never did comprehend forced Merrill to sell itself to Bank of America.
Today the regulators are pushing aggressively for independent directors at both public and private companies, but there is even less of an argument for such changes than there was at Merrill.
I explore the evidence on the value of independent directors at some considerable length in my book The New Corporate Governance in Theory and Practice
Having said that, however, in The Rise of Independent Directors in the United States, 1950-2005: Of Shareholder Value and Stock Market Prices, 59 Stan. L. Rev. 1465 (2007), Jeffrey Gordon has put forth a provocative argument that advances a plausible explanation for the ambiguous nature of the evidence:
The strongest explanation is the diminishing marginal returns hypothesis: most of the empirical evidence assesses incremental changes in board independence in firms where there is already substantial independence and after the cultural entrenchment of norms of independent director behavior. But … the most important effects of the move to independent directors, particularly over the long term, are systematic rather than firm specific and thus are unlikely to show up in cross-sectional studies. One systematic effect, the lock-in of shareholder value as virtually the exclusive corporate objective, could have benefits for early adopters, but other effects, such as the facilitation of accurate financial disclosure and corporate law compliance, have principally external effects.
In other words, studies of director independence are inherently flawed, because—to put it colloquially—a rising tide lifts all boats. The predominance of majority and now supermajority boards has had systemic effects, improving corporate governance across the board, while making identifying firm-specific effects difficult to identify.
Gordon argues that the last 50 years have seen the rise of “a new corporate governance paradigm that looks to the stock price as the measure of most things." This paradigm emerged because stock prices have become more informative. Companies must disclose vastly increased amounts of information per evolving SEC rules. Financial disclosures have become more transparent due to improvements in accounting standards. The resulting improvements in the quantity and quality of information made available to markets that themselves have become more liquid and efficient has made market prices an increasingly accurate metric by which to measure management performance.
Gordon argues this development radically simplified the task of independent directors. Outsiders no longer needed to struggle with the information asymmetry inherent in their relationship with management, because “the increasing informativeness and value of stock market signals” allow them to rely on “stock price maximization as the measure of managerial success."
Stock market performance, however, is an exclusively output-based metric. In at least some cases, input-based metrics may be more appropriate. This is so even if we think that monitoring is the board’s sole proper function.
The board’s supervisory function can be usefully subdivided into two broad categories. First, boards assess the abilities and effort of the top management team. Although this is a constant process, it is most salient in connection with hiring, promotion, and compensation decisions. In the later contexts, the board can focus mainly on monitoring outputs. Specifically, the board will focus on corporate performance metrics. A purely output based metric, however, is both inaccurate and unfair. Corporate performance may be skewed by temporary conditions beyond the abilities of even the most competent and dedicated management team. Unfortunately, monitoring managerial abilities and efforts using inputs is notoriously difficult. Much management work entails forms of non-separable team production in which the contributions of individual team members cannot be separately metered.
Second, boards engage in oversight of management conduct. Here boards examine individual management decisions and actions for misfeasance and malfeasance. This form of monitoring inevitably focuses on inputs. If all the board knows is that the corporation is hugely profitable, without knowing whether massive law breaking is the foundation on which that profitability rests, the board is failing to be an effective monitor.
Stock price-based metrics thus may have made life easier for independent directors. It is not clear that they have made independent directors better monitors.
So I continue to share the Journal's skepticism.
