Reconceptualizing corporate boards: should board members have to be "natural persons"?
Henderson, M. Todd
Corporations play a central role in our capitalist society and
therefore corporate governance is a matter of vital public debate.
Reformers argue that governance could be improved by requiring different
types of executive compensation, changing election procedures,
increasing independence requirements, or the like. Defenders of the
status quo, on the other hand, counter that these reforms are
unnecessary or even harmful and mistrust any one-size-fits-all solution.
Both sides have produced volumes of empirical and doctrinal
analysis, but little convincing has been done. It seems like only
politics matter in setting public policy. For instance, some of the
reform proposals found their way into the 2002 Sarbanes-Oxley Act and
the 2010 Dodd-Frank Act. But making broad corporate governance reforms
at the federal level and only in response to corporate catastrophe has
been labeled "quack corporate governance, in the words of Yale law
professor Roberta Romano. So is there a better way to improve corporate
governance? By putting an unstated assumption about corporate boards to
scrutiny, the answer is "yes."
The Modern American Board
The locus of modern corporate governance is the board of directors.
State corporate law, for instance, requires corporations to be
"managed under the direction of a board of directors." In
practice, however, managers--not directors--run American businesses.
Nevertheless, managers' ultimate authority comes from the board,
and boards are called on to make "fundamental" decisions. They
hire and fire the chief executive officer, set managers'
incentives, and sign off on large transactions like whether to engage in
mergers or acquisitions. Boards also provide a monitoring function
designed to limit potential divergence between the interests of managers
and shareholders or other corporate stakeholders.
This vital job (for both companies and society writ large) is
typically entrusted to a group of 10 individuals who are not experts in
governance or business, have no affiliation with the firm they serve,
work only part time, and are effectively chosen by the CEO. For
instance, the board of directors of the Walt Disney Co., which
infamously paid its former president Michael Ovitz about $150 million
for little more than one-year's work, once included several
personal friends of then-CEO Michael Eisner, including actor Sydney
Poitier, the principal of an elementary school Eisner's children
attended, and the architect who designed one of Eisner's homes.
The Disney board may be an extreme example, but the problem exists
broadly. While most boards are composed of smart and experienced
individuals with diverse experience and significant reputations, they
are simply outgunned in terms of information and incentives relative to
the managers they are supposed to control. Nothing about having a board
of powerful and talented individuals prevented the various corporate
meltdowns of the dot.com and mortgage crisis eras. The boards of Enron,
World-Com, AIG, Lehman Brothers, Fannie Mae, and so on were stacked with
industry and social luminaries, and yet they did not prevent excessive
risk taking and their firms' ultimate meltdowns.
Boards fail for a variety of reasons. These include the fact that
directors are part-time employees with weak incentives (e.g., a trivial
amount of equity ownership) and an inherent informational disadvantage
vis-a-vis management. Directors also are generalists, meaning the
average board is unlikely to have all the experts it needs at any given
time. (A risk management expert might be needed at one time while a
finance jock might be needed at another, and a board is unlikely to be
comprised of all the various experts needed over a corporation's
life.) Finally, the "market" for director talent is not
transparent and is not characterized by vigorous competition. CEOs pick
directors based on an unknown set of factors; elections for directors
are almost always irrelevant; shareholders have no information about how
decisions are made or how individual directors perform; and the costs of
the board process are completely opaque.
In short, shareholders and society rely on board members to provide
a crucial oversight role in corporate America, but the process for
choosing directors should give us little faith that board services are
provided efficiently. It strains the imagination to believe that a group
of 10 outsiders to a firm, chosen by the CEO and given only the
information the CEO chooses to give them, could possibly be an effective
check on CEO hubris, myopia, mistake, or any number of other potential
decisionmaking shortcomings.
Reforms
These potential pathologies are not news and the proposed reforms
to remedy them are legion. As noted above, legislation (from both states
and the federal government) and private rules from stock exchanges focus
on optimizing corporate governance through attempts to perfect the board
and optimally define its position in the corporate decisionmaking
hierarchy. For instance, in response to numerous corporate scandals
during the late 1990s, the Sarbanes-Oxley Act required (among other
things) that all listed companies have audit committees composed
entirely of independent directors. Similarly, the Dodd-Frank Act
implemented numerous corporate governance reforms, including new
disclosures about consultants working for boards and about compensation
of directors, as well as new independence standards for board
compensation committees.
A large industry of good-governance advocates and advisers of
various kinds exists to improve board performance as well. Proxy adviser
firms, like Institutional Shareholder Services (ISS) and Glass, Lewis,
and Company, spend considerable resources trying to improve corporate
governance by giving shareholders information about how they should vote
in director elections. For instance, ISS sells institutional
shareholders recommendations on how to vote for every director of large
publicly traded firms based on firm policies regarding areas ranging
from executive compensation to corporate strategy. While these firms
exert some influence, the fact that director elections are not
competitive and matter extremely rarely limits their power dramatically.
Academics hoping to improve corporate governance also focus on the
role and composition of the board. The typical response to board
failures is to tweak the current governance model on the edges. If CEO
domination is a problem in a particular case, reformers propose more
board independence. If information flows cause a corporate meltdown,
reformers propose empowering boards to hire their own experts. If board
members are shirking or making decisions not in shareholders'
interests, reformers suggest aligning board members' interests
through share ownership. And so on.
All of those reforms share several unattractive features. They are
reactive, meaning they try to solve the last problem instead of the next
one. They are one-size-fits-all, meaning they do not leave open the
possibility of locally optimal solutions. While say-on-pay or more
independent directors might make sense for some firms, it may actually
destroy value for others. In addition, the reforms rely on academics or
other "experts" knowing more about what is good for particular
firms than the managers and owners of those firms. They also do not take
advantage of market processes to develop and test reforms. Finally, they
are narrow in scope, meaning they leave open the possibility of
significant unintended consequences. Focusing only on fixing one problem
in a multi-facet environment risks making other problems worse.
Despite the dollars spent, books written, and articles published,
no one seriously doubts there is room for improvement in corporate
governance. For instance, a 2008 Towers Perrin survey of chief financial
officers suggests boards failed to implement effective risk management,
and this was a substantial cause of the recent financial crisis.
So is there a better way forward that recognizes the potential for
reform but rejects the idea that academics or other "experts"
can divine the optimal form of corporate governance?
"Natural-Person" Requirement
The corporate board as an institution needs to be rethought, not
reformed. If we are going to have boards play the crucial role they do
in corporate governance, actors operating in a market with robust
competition, transparency, and accountability should provide director
services. Unfortunately, this is not the state of affairs today. But,
optimistically, there is a single legal change that can move us in that
direction.
State law requires directors to be "natural
persons"--that is, individual human beings. There are similar
provisions in federal law pertaining to corporate governance and the
listing requirements of stock exchanges. This means that individuals
providing director services to firms cannot associate with other
individuals in order to provide those services.
To see the absurdity of this legal restriction on corporate
governance, imagine there is a state law requiring legal services to be
provided by individual sole proprietorships. Companies would have to
hire individual lawyers, who could then contract with others for
information, expertise, support, and so on. Such a law might be
motivated by a belief that lawyers would be more careful acting alone,
or that conflicts of interest arising from pooling legal resources
outweigh the gains, or some other reason. But whatever the reason, such
a rule would generate widespread opposition from lawyers arguing that by
pooling their resources they could offer better services to their
clients. Clients would object too. While some clients might prefer to
hire lawyers unaffiliated with a large firm, others might prefer the
costs and benefits of hiring a firm instead of a single lawyer.
The reason why individual service providers join together to
provide services through firms--be they partnerships or corporations--is
that the gains from doing so exceed the costs. The benefits of using
firms to provide goods and services are well known. Associating with
others allows individuals to share risks, obtain gains from economies of
scale and scope, optimize the deployment of various resources across
space and time, devote time and effort to innovation, and develop large
reputational assets that can constrain opportunism. Board members
currently have to get expertise from outsiders hired typically by the
CEO, which creates conflict-of-interest problems. Allowing these to be
under the same roof would reduce this problem, as well as transaction
costs.
These benefits obtain in the provision of all products and
services, and are as applicable for director services as anything else.
Just as legal, accounting, consulting, and other business services are
provided by "firms," so too should director services.
Board Service Providers
In a forthcoming law review article, University of California, Los
Angeles law professor Stephen Bainbridge and I argue for a change in
state law that would allow directors to pool together to provide
services through a firm, instead of as sole proprietors. This would
allow these firms, which we call "board service providers"
(BSPs), to offer their services directly to firms in a new market for
corporate governance. We envision a corporation, say Microsoft or
ExxonMobil, hiring another company, say Boards-R-Us, to provide it with
director services, instead of hiring 10 or so separate
"companies" to do so. Just as other service firms, like
Kirkland and Ellis, McKinsey and Company, or KPMG, are staffed by
professionals with large support networks, so too would BSPs bring the
various aspects of director services under a single roof. We expect the
gains to efficiency from such a move to be quite large.
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 judicial supervision. BSPs traded in public
markets will be disciplined to provide quality services at competitive
prices, and courts may be more willing to enforce fiduciary duties
against firms as opposed to individuals. More transparency about board
performance, including better pricing of governance by the market and
increased reputational assets at stake in board decisions, means
improved corporate governance, all else being equal.
Currently, there is no real market for corporate director talent.
Directors find their way onto boards largely through personal
connections or the opaque headhunter process, and because votes are
private and decisions are made collectively, the accountability to
shareholders is greatly attenuated. Although it is possible for any
individual to run for a board seat on any company, the publicity and
voting costs are prohibitive. The returns to winning a seat on the board
of a very large company are a few hundred thousand dollars per year,
while the costs of mounting a proxy battle run in the many millions.
Even if sensible economically, the chances of winning such a battle are
trivially small. Another alternative is for an investor, such as a
private equity firm, to take a large stake in a firm (or take over the
entire firm) and use that as leverage to win board seats and thus
influence governance. A BSP with a national reputation and the ability
to provide all director functions would be able to increase the gains
from winning board seats while reducing the per-seat cost of winning
them. This could create a market for corporate governance separate and
distinct from the market for corporate control.
Another benefit is that a BSP may be an effective means of
measuring the value of corporate governance and of those providing
director services. For instance, a publicly traded BSP providing board
services to many firms would have the quality of its services measured
in the market somewhat independently of the operational outcomes of its
clients. Partially decoupling governance and operational performance
would allow all stakeholders to more readily measure the former.
One way to think about the BSP model of governance is trying to
achieve some of the improved governance benefits of the private equity
model without the need for investors to stake an economic bet on the
entire firm. If there develops a robust market for governance, BSP firms
would be a threat to any existing board. The potential for a takeover of
the board function, separate from the takeover of the firm, would be a
real possibility, and with it the possibility that management could be
improved by the intervention of a third party offering a better
governance mousetrap. This model could, of course, be coupled with the
board taking a greater stake in the economics of the firm than it
currently has-a possibility that we discuss further below. The use of
higher-powered board incentives would thus create a sliding scale of
governance, with the full private equity model on one end and the
current approach on the other. The BSP model would fall somewhere in
between, depending on the incentives of the board in any particular
case.
Objections
To be sure, there are downsides to providing products and services
through business associations. Risk sharing creates moral hazard
problems, and therefore there may be reduced incentives for individuals
providing director services through a BSP to take care. The moral hazard
problem and the potential for risk externalization associated with
limited liability are commonly understood problems of business
associations.
But those potential problems should be balanced against the
potential benefits of BSPs, including the significant potential for the
reputation of large-scale organizations to ameliorate this risk. In
addition, there are well known ways of reducing this risk, including
using the "piercing the corporate veil" doctrine in extreme
cases. Given the broad acceptance and use of corporate forms in other
areas of providing goods and services, we think the cost-benefit
tradeoff for corporations serving as corporate boards is clearly
positive in some and perhaps many cases. But our claim is narrower: we
merely argue that firms should be permitted to experiment with having
corporate entities provide some or all of their director services.
Another objection is that nothing prevents individual directors
from buying the expertise and support they need in the market by
entering into contracts with consultants or others with the information
or experience desired. This is the practice today, more or less, and
appears to work in theory. But it is limited by the fact that directors
do not have complete freedom to spend shareholder money and are subject
to constraints imposed by the CEO in this regard. In fact, legislation
has been required to simply authorize directors to spend money on
outside advisers in a limited number of cases. Moreover, it is doubtful
that the optimal arrangement is for all director support or
specialization to be bought in the market in this way.
In his pioneering work on the theory of the firm, Ronald Coase
noted that there is also a choice between bringing expertise together in
a firm and buying it in a market, and that the size of the firm will
expand until the marginal cost of adding another element to a firm
equals the marginal cost of buying that element in the market. The
unlikely result that the optimal director services firm size is a single
person is evident by the fact that single-person firms are not the norm
in any other area of professional services.
Critics might also argue that corporations or partnerships
providing board services might serve their own interests instead of
those of shareholders or society or wherever one thinks corporate
efforts should be directed. But this objection is just as easily leveled
against individual directors as associations of directors. Directors
like Deepak Chopra (Men's Warehouse), Chelsea Clinton (IAC), or Al
Gore (Apple) may shirk, line their own pockets, or act in ways that
serve their own interests above others, just as Boards-R-Us might.
Fiduciary duty law (the twin fiduciary duties of care and loyalty) and
reputation are the constraints on this behavior by directors today, and
these would apply equally to firms as boards. In fact, reputation is
likely to be a much more powerful constraint for a firm than an
individual. When an individual director acts, the director bets only its
reputation on the outcome, whereas when individuals act together in a
firm, each act by each director affects the reputation of the entire
firm. This means that all else being equal, we should expect less
faithlessness from firms than individuals.
A final potential objection is that individuals have always
provided director services, and there may be some hidden logic to this
structure. But the history of corporate boards is not instructive on
this point. The first corporations used "boards of directors"
as a mechanism to resolve a political problem. For instance, the Dutch
East India Company (founded in 1602) was created to unite a series of
independent firms located in various Dutch cities. The six cities,
including Amsterdam, Rotterdam, and Delft, demanded political
representation on a central board of directors known as the
"Gentlemen Seventeen." Thus the first corporate boards were
more akin to the U.S. Senate than to the management of Microsoft or
ExxonMobil. Boards today are not political bodies but decisionmaking and
oversight ones, and the issues are of sufficient complexity and the
stakes sufficiently high that a new approach is warranted.
Finally, the firms-as-boards proposal is consistent with the spirit
of state corporate law as a set of default rules that merely enables
firms to create their own governance arrangements designed to generate
local maxima. Mandatory rules are the exception, not the rule, and
should be based on clear and convincing evidence that freedom of
contract would be unlikely to lead to social welfare improvements. We
believe such a case is not made and, in fact, the opposite is true. In
addition, there are a variety of contexts in which law, including state
and federal law, already tolerates corporate entities serving in a board
or board-like role. Partnerships, for instance, can have any "legal
person" serving in the board-like role of general partner.
Extending this right to corporations seems like a logical next step.
Conclusion
The reform idea that Professor Bainbridge and I have in mind is not
a requirement that firms hire professional director services firms to be
their boards, but merely that they should be permitted to do so. We are
skeptical of one-size-fits-all arguments generally, and are confident
that such a rule here would be hopelessly overbroad. Firms should merely
have a choice, subject to the constraints of the market and judicial
review for opportunism in the use of corporations, to provide these
services.
The BSP idea is one that could be used to achieve a host of
governance ends,'ranging from increased shareholder power to better
director primacy over corporations. In either case, and all those in
between, what our proposal does is increase the transparency and
competition for board services in a way that should increase confidence
that firm choices about the role of the board are ones that are in the
interests of shareholders and society in general, rather than based on a
hidden agenda.
READINGS
* "Boards-R-Us: Reconceptualizing Corporate Boards," by
Stephen M. Bainbridge and M. Todd Henderson. Social Science Research
Network paper 2291065, July 10, 2013.
* "Quack Corporate Governance," by Roberta Romano.
Regulation, Vol. 28, No. 4 (Winter 2005).
* "The Nature of the Firm," by Ronald Coase. Economica,
Vol. 4, No. 16 (1937).
M. TODD HENDERSON is professor of law and Aaron Director Teaching
Scholar at the University of Chicago Law School.