State corporate law requires that “natural persons” provide director services. This Article puts this obligation to scrutiny, and concludes that there are significant gains that could be realized by permitting firms (be they partnerships, corporations, or other business entities) to provide board services. We call these firms “board service providers” (BSPs). We argue that hiring a BSP to provide board services instead of a loose group of sole proprietorships will increase board accountability, both from markets and from courts. The potential economies of scale and scope in the board services industry (including vertical integration of consultants and other board member support functions), as well as the benefits of risk pooling and talent allocation, mean that large professional director services firms may arise, and thereby create a market for corporate governance distinct from the market for corporate control. More transparency about board performance, including better pricing of governance by the market, as well as increased reputational assets at stake in board decisions, means improved corporate governance, all else being equal. But our goal in this Article is not necessarily to increase shareholder control over firms; we show how a firm providing board services could be used to increase managerial power as well. This shows the neutrality of our proposed reform, which can therefore be thought of as a reconceptualization of what a board is rather than a claim about the optimal locus of corporate power.
Maybe we should have patented this as a business process, because it looks like people are taking it seriously. There's an outfit called Integral Board Group, for example, which is now offering BSP-lioke services:
Think of a board made up only of independent directors (acting somewhat as consultants / advisors) all working under a single contract, from a single service provider (vendor) and bound to performance. Sounds like a simple concept to grasp, however, it is truly a new approach - one that should not to be confused with companies that provide executive staffing, individual board advisors, executive coaching or stand-alone independent directors. The holistic approach of a cohesive and collectively-accountable team, directly tied to a client company's performance and bottom line, is not present in these models. It is present, however, in the BSP model along with much needed transparency as well as performance-based metrics. When describing our service to clients we like to say we are an "all or nothing" model - you either get the core board team in its entirety or you get no one. This is due to the belief that it is the collective board's experience, constructive interaction and diverse industry backgrounds that elevates the mission. Additionally, a 'bench' of expert advisors supplements the board team expanding its effectiveness well beyond just the core board members in this type of outsourced model. As I discussed in a previous article, add the element of an elevated 'behavioral predisposition' to the existing 'intellectual capital' of the board team and you have an even more incredible company leadership asset. In essence, the board becomes greater than the sum of its parts.
But didn't the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010 take care of most board-related issues? Hardly. An article in The Economist summarizes"In the May edition of the Stanford Law Review Stephen Bainbridge of the University of California, Los Angeles, and Todd Henderson of the University of Chicago offer a proposal for fixing boards that goes beyond tinkering: replace individual directors with professional-services firms. Companies, they point out, would never buy legal services or management advice from people only willing to spare a few hours a month. Why do they put up with the same arrangement from board members? They argue for the creation of a new category of professional firms: BSPs or Board Service Providers. Companies would hire a company to provide it with 'board services' in the same way that it hires law firms or management consultants. The BSP would not only supply the company with a full complement of board members. It would also furnish it with its collective expertise, from the ability to process huge quantities of information to specialist advice on things such as mergers."
As I understand it, they're currently focused on privately held companies. Even so, it's an interesting development.
A revised version of my article Corporate Social Responsibility in the Night Watchman State: A Comment on Strine & Walker is now available at SSRN: http://ssrn.com/abstract=2494003
Abstract: Delaware Supreme Court Chief Justice Leo Strine and Nicholas Walter have recently published an article arguing that the U.S. Supreme Court’s decision in Citizens United v. FECundermines a school of thought they call “conservative corporate law theory.” They argue that conservative corporate law theory justifies shareholder primacy on grounds that government regulation is a superior constraint on the externalities caused by corporate conduct than social responsibility norms. Because Citizens United purportedly has unleashed a torrent of corporate political campaign contributions intended to undermine regulations, they argue that the decision undermines the viability of conservative corporate law theory. As a result, they contend, Citizens United “logically supports the proposition that a corporation’s governing board must be free to think like any other citizen and put a value on things like the quality of the environment, the elimination of poverty, the alleviation of suffering among the ill, and other values that animate actual human beings.”
This essay argues that Strine and Walker’s analysis is flawed in three major respects. First, “conservative corporate law theory” is a misnomer. They apply the term to such a wide range of thinkers as to make it virtually meaningless. More important, scholars who range across the political spectrum embrace shareholder primacy. Second, Strine and Walker likely overstate the extent to which Citizens United will result in significant erosion of the regulatory environment that constrains corporate conduct. Finally, the role of government regulation in controlling corporate conduct is just one of many arguments in favor of shareholder primacy. Many of those arguments would be valid even in a night watchman state in which corporate conduct is subject only to the constraints of property rights, contracts, and tort law. As such, even if Strine and Walker were right about the effect of Citizens Unitedon the regulatory state, conservative corporate law theory would continue to favor shareholder primacy over corporate social responsibility.
“Dual-class” structures were common in America in the 1920s but were largely stamped out in a populist campaign led by William Ripley, a Harvard professor who labelled the practice a “crowning infamy” to “disenfranchise public investors”, according to a paper by Stephen Bainbridge of the University of California Los Angeles. There were exceptions—notably the listing of Ford in 1956 on NYSE and of media firms on the American Stock Exchange, a second-tier market—but Ripley’s philosophy was largely intact until the 1980s when the rise of corporate raiders brought less democratic regimes back into fashion.
Timothy Spangler teaches the Hedge Funds and Private Equity Funds course and the Investment Companies and Investment Advisors course at the UCLA School of Law. He is the author of several books on private funds, a frequent commentator in domestic and foreign press, and the Director of Research for the Lowell Milken Institute for Business Law and Policy. In today's LA Times, he has an insightful article on the future of hedge funds in the wake of CalPERS' decision to pull its hedge fund investments:
Clearly, it is too soon to write the obituary for hedge funds. These highly entrepreneurial firms will certainly need to evolve in the coming years to ensure that they meet the expectations of their investors for high returns. And the question of fees is one that cannot be dismissed out of hand. ...
The most provactive part of the op-ed is his argument in favor of active fund management:
... the state of the hedge fund industry is better grasped by looking at the top quartile of hedge fund managers and seeing how their performance varies over time. All hedge fund managers are not created equal. Simply calling yourself a hedge fund manager is no guarantee that you will actually produce eye-wateringly high returns for your investors.
The most successful investors are backing the most successful managers. Simply put, the case for backing proven investment talent remains strong.
I'm not convinced that's right. There does seem to be some evidence that top returners do persist at least over the medium term (say three years). The trouble, of course, is identifying them ex ante and backing them before their hot streak ends.
SEC Commissioner Daniel Gallagher has given an excellent speech on the titular question. The whole thing is a must read, but this passage jumps out at me:
... sadly, we at the SEC are not doing nearly enough to ensure that small businesses have the access to capital that they need to grow. We layer on rule after rule until it becomes prohibitively expensive to access the public capital markets. Only rarely do we remove any of our rules, even after they have long since ceased to serve their purpose or have become obsolete or worse. And although we have made significant progress in expanding our economic analysis of new rules and rule amendments, we almost never consider how heavily the weight of the entire corpus of rules bears down on registrants.
Here. Just remember: The Supreme Court knows just about as much about corporate law theory as I know about string theory. So take anything it says with a grain of salt.
The California Public Employees’ Retirement System, the nation’s largest pension fund, will eliminate all of its hedge fund investments over the next year on concerns that investments are too complicated and expensive.
Granted, CalPERS itself engages in activism, but it's still an interesting point. As is this bit of news:
Through August, activist investors returned an average 5.9% for the year, according to HFR, compared with a 3.9% gain for hedge funds in general. Still, both trailed the S&P 500's 9.9% gain.
So you'd be better off stashing your money in an S&P 500 index that giving it to activist shareholders. Someone alert Lucian!
1. The Association of American Law Schools is not an accrediting agency, so nothing bad would happen to our students if we didn't belong.
2. Our students would benefit because (a) the school would save money by not having to pay the membership fee or subsidize law professor travel to whatever boondoggle places the AALS holds its various meetings and (b) faculty would not be disappearing on periodic boondoggles.
3. The AALS has zero interest in real intellectual diversity. Are you a member of the Federalist Sociery? Too bad, you can't hold a meeting at the AALS annual meeting or even use their hotel. Are you a member of the Christian Law Professor fellowship. Too bad, you can't hold a meeting at the AALS annual meeting or even use their hotel.
And so I'll repeat something I wrote back in 2012:
The best thing we could do with the AALS is to disband it:
It helps the ABA maintain the law school monopoly on legal training, which perpetuates the lawyer monopoly on provision of legal services.
It creates a monoculture in which all law schools are obliged to comply with an ever growing set of rules. Schools with particular reasons for differentiating themselves from the pack, such a religiously affiliated schools, face pressure to conform to the standard left-liberal, secular humanist model that informs AALS policies and politics. As such, the AALS lacks any real room for institutional pluralism.
Speaking of politics, it serves mainly as a talking forum for left-liberals (most of whom are so well paid that they're in the top 1 or 2 %) to whine about how they're victimized by society.
I can't think of one useful thing the AALS does except to provide a massive schmooze fest for faculty to network at taxpayer and student expense. And while that's fun, it doesn't justify the organization's existence.
While it seems unlikely that the AALS will ever do the honorable thing and fall on its sword, if I were a law school dean, I'd bail on it.
Delaware Chief Justice Leo Strine and Nicholas Walker recently posted an article (forthcoming in the Cornell Law Review) entitled Conservative Collision Course?: The Tension between Conservative Corporate Law Theory and Citizens United, which is available at SSRN: http://ssrn.com/abstract=2481061, and argues that:
One important aspect of Citizens United has been overlooked: the tension between the conservative majority’s view of for-profit corporations, and the theory of for-profit corporations embraced by conservative thinkers. This article explores the tension between these conservative schools of thought and shows that Citizens United may unwittingly strengthen the arguments of conservative corporate theory’s principal rival.
Citizens United posits that stockholders of for-profit corporations can constrain corporate political spending and that corporations can legitimately engage in political spending. Conservative corporate theory is premised on the contrary assumptions that stockholders are poorly-positioned to monitor corporate managers for even their fidelity to a profit maximization principle, and that corporate managers have no legitimate ability to reconcile stockholders’ diverse political views. Because stockholders invest in for-profit corporations for financial gain, and not to express political or moral values, conservative corporate theory argues that corporate managers should focus solely on stockholder wealth maximization and non-stockholder constituencies and society should rely upon government regulation to protect against corporate overreaching. Conservative corporate theory’s recognition that corporations lack legitimacy in this area has been strengthened by market developments that Citizens United slighted: that most humans invest in the equity markets through mutual funds under section 401(k) plans, cannot exit these investments as a practical matter, and lack any rational ability to influence how corporations spend in the political process.
Because Citizens United unleashes corporate wealth to influence who gets elected to regulate corporate conduct and because conservative corporate theory holds that such spending may only be motivated by a desire to increase corporate profits, the result is that corporations are likely to engage in political spending solely to elect or defeat candidates who favor industry-friendly regulatory policies, even though human investors have far broader concerns, including a desire to be protected from externalities generated by corporate profit-seeking. Citizens United thus undercuts conservative corporate theory’s reliance upon regulation as an answer to corporate externality risk, and strengthens the argument of its rival theory that corporate managers must consider the best interests of employees, consumers, communities, the environment, and society — and not just stockholders — when making business decisions.
As promised, I've knocked out a reply, which has just been posted to SSRN and is entitled Corporate Social Responsibility in the Night Watchman State: A Comment on Strine & Walker, and is available at SSRN: http://ssrn.com/abstract=2494003:
Delaware Supreme Court Chief Justice Leo Strine and Nicholas Walter have recently published an article arguing that the U.S. Supreme Court’s decision in Citizens United v. FEC undermines a school of thought they call “conservative corporate law theory.” They argue that conservative corporate law theory justifies shareholder primacy on grounds that government regulation is a superior constraint on the externalities caused by corporate conduct than social responsibility norms. Because Citizens United purportedly has unleashed a torrent of corporate political campaign contributions intended to undermine regulations, they argue that the decision undermines the viability of conservative corporate law theory. As a result, they contend, Citizens United “logically supports the proposition that a corporation’s governing board must be free to think like any other citizen and put a value on things like the quality of the environment, the elimination of poverty, the alleviation of suffering among the ill, and other values that animate actual human beings.”
This essay argues that Strine and Walker’s analysis is flawed in three major respects. First, “conservative corporate law theory” is a misnomer. They apply the term to such a wide range of thinkers as to make it virtually meaningless. More important, scholars who range across the political spectrum embrace shareholder primacy. Second, Strine and Walker likely overstate the extent to which Citizens United will result in significant erosion of the regulatory environment that constrains corporate conduct. Finally, the role of government regulation in controlling corporate conduct is just one of many arguments in favor of shareholder primacy. Many of those arguments would be valid even in a night watchman state in which corporate conduct is subject only to the constraints of property rights, contracts, and tort law. As such, even if Strine and Walker were right about the effect of Citizens United on the regulatory state, conservative corporate law theory would continue to favor shareholder primacy over corporate social responsibility.
The Census Bureau reports that income inequality between the richest and poorest Americans has reached historic levels. ...
CEO pay, along with that of other senior executives, is a major contributor to this inequality. We need to know more about this phenomenon: Which companies are overpaying their CEOs? How are they performing in the marketplace? How responsibly are those companies being managed?
As I explain in my book Corporate Governance after the Financial Crisis, however, complaints during times of economic distress about supposedly excessive executive compensation are hardly new. In the 1930s, during the Great Depression, for example, a lawsuit challenging executive bonuses as corporate waste gave rise to the aphorism “no man can be worth $1,000,000 per year.”[1] This complaint rested, at least in part, not on a belief that executives were being paid too much relative to their company’s performance but on the belief that the amounts they were being paid were simply too high.
Similar populist themes abound in the rhetoric surrounding the crises of the last decade. A 2008 House of Representatives committee report, for example, noted that “in 1991, the average large-company CEO received approximately 140 times the pay of an average worker; in 2003, the ratio was about 500 to 1.”[2] Delaware Vice Chancellor Leo Strine observed in a 2007 law review article that both workers and investors “feel that CEOs are selfish and taking outrageous pay at a time when other Americans are economically insecure.”[3] William McDonough, the then-Chairman of the Public Company Accounting Oversight Board (PCAOB), complained that:
We saw … an explosion in compensation that made those superstar CEOs actually believe that they were worth more than 400 times the pay of their average workers. Twenty years before, they had been paid an average of forty times the average worker, so the multiple went from forty to 400—an increase of ten times in twenty years. That was thoroughly unjustified by all economic reasoning, and in addition, in my view, it is grotesquely immoral.[4]
The rhetoric of class warfare makes a poor foundation for economic policy. As a justification for regulating executive compensation, however, it is particularly inapt. First, why single out public corporation executives? Many occupations today carry even larger rewards. The highest paid investment banker on Wall Street in 2006 was Lloyd Blankfein of Goldman Sachs, for example, who “earned $54.3 million in salary, cash, restricted stock and stock options,”[5] or about 4 times the median CEO salary from the year before. The pay of some private hedge fund managers dwarfed even that sum. Hedge fund manager James Simons earned $1.7 billion in 2006, for example, and two other hedge fund managers also cracked the billion-dollar level that year.[6] Not to mention, of course, the considerable sums earned by top athletes and entertainers.
Second, regulating executive compensation may scratch the public’s populist itch, but it does little to address inequalities of income and wealth. To be sure, as Brett McDonnell observes, fat cat “CEOs have become poster boys for” the dramatic increase in “inequality in income and wealth in this country.”[7] Even if one assumes that redressing such inequalities is appropriate social policy, however, capping or cutting CEO pay is not an effective means of doing so.
Steven Kaplan and Joshua Rauh determined that executives of nonfinancial corporations comprise just over 5 percent of the individuals in the top 0.01 percent of adjust gross income. Hedge fund managers, investment bankers, lawyers, executives of privately-held companies, highly paid doctors, independently wealthy individuals, and celebrities make up the bulk of the income bracket. They further found that the representation of corporate executives in the top bracket has remained constant over time and that realized CEO pay is highly correlated to stock performance. Accordingly, they conclude that “poor corporate governance or managerial power over shareholders cannot be more than a small part of the picture of increasing income inequality, even at the very upper end of the distribution.”[8]
[1] Harwell Wells, “No Man Can Be Worth $1,000,000 a Year”: The Fight Over Executive Compensation in 1930s America, 44 U. Rich. L. Rev. 689, 726 (2010).
[3] Leo E. Strine, Jr., Toward Common Sense and Common Ground? Reflections on the Shared Interests of Managers and Labor in a More Rational System of Corporate Governance, 33 J. Corp. L. 1, 10-11 (2007).
[4] William J. McDonough, The Fourth Annual A.A. Sommer, Jr. Lecture on Corporate, Securities & Financial Law, 9 Fordham J. Corp. & Fin. L. 583, 590 (2004).
[5] Jenny Anderson & Julie Creswell, Top Hedge Fund Managers Earn Over $240 Million, N.Y. Times, Apr. 24, 2007.
[7] Brett H. McDonnell, Two Goals for Executive Compensation Reform, 52 N.Y.L. Sch. L. Rev. 586, 587 (2008).
[8] Steven N. Kaplan & Joshua Rauh, Wall Street and Main Street: What Contributes to the Rise in Highest Incomes, NBER Working Paper No. 13,270 (July 2007).
Back to Eskow:
... there has been a trend in recent decades toward compensating senior executives with stock gifts, stock options, and other "performance-based bonuses." This has become attractive because it allows companies to take tax breaks for the wildly generous sums they give to their chief executives.
This practice has the unfortunate side effect of encouraging CEOs to emphasize short-term stock performance over the long-term financial security and well-being of the company and its stakeholders -- a group which includes customers and employees, as well as shareholders.
What greed-driven CEO in his or her right mind would invest in a corporation's long-term growth if it minimized next quarter's stock performance, and that meant a few million dollars taken off an end-of-the-year bonus?
CEOs have increasingly behaved like stock manipulators, rather than executives of working companies. If they can pump up a stock's short-term performance by buying and selling smaller companies, flipping real estate properties, and engaging in other highly-leveraged transactions, most executives these days are only too eager to do so.
There's some validity to that point, but he's mostly wrong and his prescription is entirely wrong. Back to my book my book Corporate Governance after the Financial Crisis, in which I explain that scholars are divided as to whether this incentive structure causally contributed to either the housing or credit crunch. Grant Kirkpatrick contends that incentive pay encouraged high levels of risk taking.[1] Richard Posner argues that the structure of executive compensation practices encouraged management to cling to the housing bubble and “hope for the best.”[2] In contrast, Peter Mulbert contends that the empirical evidence does not support treating compensation as a major causal factor.[3] What seems clear, however, is that the problem was localized to the financial sector. Whether or not financial institution executive compensation practices contributed to the crisis, there is no evidence that executive compensation at Main Street corporations did so.
[1] Grant Kirkpatrick, The Corporate Governance Lessons from the Financial Crisis, 2009 Fin. Mkt. Trends 1, 2.
[3] Peter O. Mulbert, Corporate Governance of Banks After the Financial Crisis: Theory, Evidence, Reforms (ECGI Law Working Paper No. 130/2009, Apr. 2010).
Let's turn to Eskow's prescription for this supposed problem: "Shareholders should have more responsibility for executive pay decisions."
Piffle. Back to my book my book Corporate Governance after the Financial Crisis, in which I explain that shareholders and society do not have the same goals when it comes to executive pay. Society wants managers to be more risk averse. Shareholders want them to be less risk averse. If say on pay and other shareholder empowerment provisions of Dodd-Frank succeed, manager and shareholder interests will be further aligned, which will encourage the former to undertake higher risks in the search for higher returns to shareholders.[1] Accordingly, as Christopher Bruner aptly observed, “the shareholder-empowerment position appears self-contradictory, essentially amounting to the claim that we must give shareholders more power because managers left to the themselves have excessively focused on the shareholders’ interests.”[2]
[1] See Carl R. Chen et al., Does Stock Option- Based Executive Compensation Induce Risk-Taking? An Analysis of the Banking Industry, 30 J. Banking & Fin. 915, 943 (2006) (arguing that the structure of executive compensation in the banking industry pre-crisis induced risk taking by managers); Kose John & Yiming Qian, Incentive Features in CEO Compensation in the Banking Industry, FRBNY Econ. Pol’y Rev., Apr., 2003, at 109 (arguing that if executive compensation induces the interests of managers to “closely aligned with equity interests in banks, which are highly leveraged institutions, management will have strong incentives to undertake high-risk investments”).
[2] Christopher M. Bruner, Corporate Governance in a Time of Crisis 13 (2010), http://ssrn.com/abstract=1617890.
Back to Eskow:
Some Democrats in Congress are now proposing to disallow tax deductions of more than $1 million for senior executive pay -- unless the corporation pays its lowest-paid employees $10.10 per hour or more, in which case that ceiling is lifted.
<SARCASM>Now there's a good idea.</SARCASM> In 1994, President Bill Clinton and the Democrats in Congress passed a budget that changed the tax laws to cap at $1 million the deduction corporations may take for executive compensation. Clinton and the Democrats, however, ensured that performance or incentive-based forms of compensation, most notably stock options were exempt from this cap (as they still are). So if you don't like current executive compensation practices, the blame lies at the Democrats' door. (Of course, the 1994 budget was a major factor in the GOP takeover of the House, which gives folks on my side of the aisle special reason to feel kindly towards it.)
For all that Section 162(m) is intended to limit excessive executive compensation, it is the shareholders and the U.S. Treasury who have suffered financial losses.
The code does not prohibit firms from paying any type of compensation; instead, they are prohibited from deducting that amount on their tax return. The result is decreased company profits and diminished returns to the shareholders.
Assuming a 25 percent marginal tax rate on corporate profits (a conservative estimate), revenue lost to the federal government in 2010 from deductible executive compensation was $7 billion, and the foregone federal revenue over the 2007–2010 period was $30.4 billion. More than half the foregone federal revenue is due to taxpayer subsidies for executive “performance pay.”
In short, the one thing you can count on is that the Congressional Democrat caucus when it comes to CEO pay is that they'll screw it up. After all, all the Dodd-Frank provisions on CEO pay are nothing more than quaxk corporate governance (see my book Corporate Governance after the Financial Crisis).
An article at Chief Executive on How to “Rightsize” Your Board has attracted some attention on several of the Linkedin corporate governance groups I follow. Curiously, while the article opines that "boards must be the right size for their charge," it fails to propose an optimal number. Instead, it ticks of a checklist of 7 considerations to be taken into account in determining whether a specific board is the right size. It's all pretty vague IMHO.
In fairness, however, getting a handle on the optimal size for a board of directors is very hard. In my article Why a Board? Group Decision Making in Corporate Governance, I review the relevant legal, psychological, economic, and sociological literature to conclude that:
Corporate statutes historically required that boards consist of at least three members who had to be shareholders of the corporation and, under some statutes, residents of the state of incorporation.[1] Today these requirements have largely disappeared. DGCL Section 141(b) authorizes boards to have one or more members and mandates no qualifications for board membership. MBCA Sections 8.02 and 8.03 are comparable. As a default rule, allowing single member boards probably makes some sense. It gives promoters maximum flexibility, while allowing the creation of multi-member boards at low cost. In light of the apparent advantages of group decision making, however, it is hardly surprising that multi-member boards are the norm for corporations of any significant size. To be sure, board sizes vary widely. A 1999 survey found that slightly less than half had 7 to 9 members, with the remaining boards scattered evenly on either side of that range.[2]
Is there an optimal board size? It is mildly puzzling that the literature on group decision making has not paid more attention to questions of group size. Studies in which group size is an experimental variable are rare; worse yet, many studies of other variables fail even to hold group size constant.[3] The principal exceptions are studies of optimal jury size. Unfortunately, those studies are inconclusive at best.[4]
As for studies of board size in particular, one meta-analysis found a statistically significant correlation between increased board size and improved financial performance.[5] Given the potential influence of moderating variables, however, it does not seem safe to draw firm conclusions from that survey. Other studies, moreover, are to the contrary.[6]
Here then is an opportunity for further research. In theory, a number of factors favor large boards. Larger boards may facilitate the board’s resource-gathering function. More directors will usually translate into more interlocking relationships with other organizations that may be useful in providing resources, such as customers, clients, credit, and supplies. Board interlocks may be especially helpful with respect to formation of strategic alliances. Firms considering a joint venture need access to credible information about the competencies and reliability of prospective partners. Almost by definition, however, this information is asymmetrically held and subject to strategic behavior. Interlocks between prospective partners provide both access to such information and, by analogy to hostage taking, a credible bond of the information’s accuracy.[7]
Larger boards with diverse interlocks are also likely to include a greater number of specialists—such as investment bankers or attorneys. This is relevant not only to the board’s resource gathering function, but also to its monitoring and service functions. Complex business decisions require knowledge in such areas as accounting, finance, management, and law. Providing access to such knowledge can be seen as part of the board’s resource gathering function. Board members may either possess such knowledge themselves or have access to credible external sources who do. This hypothesis is consistent with the new institutional economics view of specialists. In that model, specialization is a rational response to bounded rationality. The expert in a field makes the most of his or her limited capacity to absorb and master information by limiting the amount of information that must be processed through limiting the breadth of the field in which the expert specializes. As applied to the corporate context, larger, more diverse boards likely contain more specialists, and therefore should get the benefit of specialization. In addition, with reference to the debate over the best member hypothesis, specialization is a way for the group to identify the superior decision maker with respect to specific issues.[8]
On the other hand, a number of considerations suggest that small boards may be preferable. Large boards will be contentious and fragmented, which reduces their ability to collectively monitor and discipline senior management. In such cases, the senior managers can affirmatively take advantage of the board through “coalition building, selective channeling of information, and dividing and conquering.”[9]
The social loafing phenomena also suggests an upper limit on efficient group size. As group size grows, for example, the number of non-participants (loafers) likely increases. Conversely, larger boards may inhibit the formation of the sorts of close-knit relationships by which groups constrain agency costs.
[5] Dan R. Dalton, Number of Directors and Financial Performance: A Meta-Analysis, 42 Acad. Mgmt. J. 674, 676 (1999).
[6] See, e.g., Theodore Eisenberg et al., Larger Board Size and Decreasing Firm Value in Small Firms, 48 J. Fin. Econ. 35 (1998) (finding a significant negative correlation between board size and firm profitability in small and medium Finnish firms); see generally Sanjai Bhagat and Bernard Black, The Uncertain Relationship Between Board Composition and Firm Performance, 54 Bus. Law. 921, 941-42 (1999) (summarizing studies).
[7] See Ranjay Gulati and James D. Westphal, Cooperative or Controlling? The Effects of CEO-board Relations and the Content of Interlocks on the Formation of Joint Ventures, 44 Admin. Sci. Q. 473 (1999).
[8] Note that, because their decisions are publicly observable, board members have a strong incentive to defer to expert opinion. Because even a good decision maker is subject to the proverbial “act of God,” the market for reputation evaluates decision makers by looking at both the outcome and the action before forming a judgment. If a bad outcome occurs, but the action was consistent with approved expert opinion, the hit to the decision maker’s reputation is reduced. In effect, by deferring to specialists, a decision maker operating under conditions of bounded rationality is buying insurance against a bad outcome.
In a collegial, multi-actor setting, the potential for log-rolling further encourages deference. A specialist in a given field is far more likely to have strong feelings about the outcome of a particular case than a non-expert. By deferring to the specialist, the non-expert may win the specialist’s vote in other cases as to which the non-expert has a stronger stake. Such log-rolling need not be explicit, although it doubtless is at least sometimes, but rather can be a form of the tit-for-tat cooperative game. In board decision making, deference thus invokes a norm of reciprocation that allows the non-expert to count on the specialist’s vote on other matters. This prediction is supported by findings with respect to group polarization, in which the majority coalition makes small concessions so as to trigger the norm of reciprocity. See Kerr, supra note 140, at 92 (noting the use of such norms).
The normative payoff of this insight is at least two-fold. First, insofar as board decision making itself is concerned, directors should consciously ask whether deference to specialists is appropriate in a particular instance. Second, it validates state statutes relating to board reliance on expert opinion. Under Delaware code § 141(e) directors are “fully protected in relying in good faith” on reports or opinions of external experts. The statute requires that the director reasonably believe the matters in question are within the expert’s professional competence and that the expert have been chosen with reasonable care. Case law suggests that this standard requires at least some inquiry into the basis of the expert’s opinion. See, e.g., Smith v. Van Gorkom, 488 A.2d 858, 874-75 (Del. 1985) (interpreting DGCL § 141(e)).
[9] Jeffrey A. Alexander et al., Leadership Instability in Hospitals: The Influence of Board-CEO Relations and Organizational Growth and Decline, 38 Admin. Sci. Q. 74, 79 (1993). On the other hand, some commentators contend that large boards provide more opportunities to create insurgent coalitions that constrain agency costs with respect to senior management. William Ocasio, Political Dynamics and the Circulation of Power: CEO Succession in U.S. Industrial Corporations, 1960-1990, 39 Admin. Sci. Q. 257, 291 (1994).
, however, complaints during times of economic distress about supposedly excessive executive compensation are hardly new. In the 1930s, during the Great Depression, for example, a lawsuit challenging executive bonuses as corporate waste gave rise to the aphorism “no man can be worth $1,000,000 per year.”
