NASHVILLE, Tenn. – Both the Sarbanes-Oxley Act of 2002 and recently revised New York Stock Exchange and NASDAQ listing standards prescribe a high percentage of outside directors on the corporate boards of public companies. This could spell disaster for certain types of companies, cautions Charu Raheja, assistant professor of finance at the Owen Graduate School of Management at Vanderbilt University.
In her paper “Determinants of Board Size and Composition: A Theory of Corporate Boards” in the current issue of the Journal of Financial and Quantitative Analysis, Raheja points to “evidence that board size and composition should depend on the type of firm.”
Raheja understands the government‘s willingness to take action in 2002, but says her study demonstrates that the rules it passed are too broad and restrictive to apply across the board. “Reacting to several very public corporate scandals, Congress acted three years ago to address the crisis of confidence in the U.S. capital markets. Sarbanes-Oxley tried to some extent to standardize corporate boards and to increase board independence, reducing the proportion of directors drawn from senior management and resulting in fewer inside directors on corporate boards. But optimal corporate governance doesn‘t result from a ‘one size fits all‘ prescription,” she explains.
The issue of who serves on corporate boards is an important one. Legislation and increasingly restrictive listing standards have placed more responsibility than ever on boards of directors. And boards whose effectiveness is compromised due to an imbalance in their makeup will see the toll exacted on their two most important functions, planning for management succession and monitoring the management of the company‘s projects and strategies.
In her paper, Raheja examined the interaction of inside and outside board members and the way in which combinations of insiders and outsiders affect the monitoring effectiveness of corporate boards. She asked what factors should determine board size and composition and looked at how the optimal board structure varies with the type of firm.
Raheja modeled boards of directors comprising a CEO and varying numbers of inside directors (senior managers of the firm) and independent, or outside, directors. She devised a situation in which the CEO proposes a project and it‘s left to the board to accept or reject it. “The optimal board design maximizes the probability that the majority of the board will vote against inferior projects,” she explains in the paper.
From her theoretical study comes an appreciation of the balancing act that comes into play when a board of directors is named. Assuming a limited number of seats at the table—the average company has about a dozen directors—a company should assess its board membership taking into account what the inside and outside directors bring to the equation.
“Outsiders are independent of the CEO but are less informed about firm projects. Inside managers are an important source of firm-specific information, and their inclusion on the board can lead to more effective decision making. However, insiders may require motivation to reveal their better information,” she writes.
“Since an important role of the board is to make promotion decisions, outside directors can use promotion and CEO succession to motivate insiders to reveal their superior information and help the board in implementing higher value projects,” Raheja says.
“The optimal board structure is determined by the tradeoff between maximizing the incentive for insiders to reveal their private information, minimizing coordination costs among outsiders and maximizing outsiders‘ ability to reject inferior projects,” she writes.
The type of company and the willingness of inside directors to be forthcoming and outside directors to dissect a proposed project should have tremendous bearing on the ratio of inside to outside directors. “Overall, the most effective optimal boards are the boards of firms with low verification costs to outside board members and low private benefits to inside board members,” she writes.
The harder it is to understand a company‘s business or to have access to firm-specific information, the less effective outside directors will be. Firm-specific information includes not only the company‘s conditions, its competition and its products, but also the subtle or soft information about the business and the workings of management.
As such, fast-paced, high-tech companies with considerable proprietary information should favor more members of senior management for the board. On the other hand, if the company is in a mature industry, where the assets are more tangible, the competition is well-known and there isn‘t a great deal of change or takeover risk, a higher percentage of outside directors can work well.
Raheja advises, however, against the lack of balance if the percentage of outsiders should get too high. In the extreme case of a company with only the CEO representing senior management on the board, Raheja says, “It‘s better if other managers are there to check each other, and it‘s important that the board gets to know the managers as possible successors to the CEO.”
Why not just name a very large board, with a lot of insiders and outsiders? It‘s very costly to have a large board, it‘s much harder to coordinate activities and, the more people there are in a meeting, the more intimidating it is to participants, making it less likely anyone will speak up if he sees something irregular, she says.
Founded in 1969, the Owen Graduate School of Management at Vanderbilt University is ranked as a top institution by Business Week, The Wall Street Journal, U.S. News & World Report, Financial Times and Forbes. For more news about Owen, visit www.owen.vanderbilt.edu.
Media contact: Susanne Hicks, (615) 322-NEWS
Susanne.hicks@vanderbilt.edu