The Camp Fire near Paradise, California, last fall was so devastating—86 dead, 14,000 homes destroyed—it seems trivial to talk about how it affected the board of directors at Pacific Gas & Electric, but the board’s story is also telling.
The fire, the energy company has conceded, was likely sparked by a damaged electric pole and power line. Facing $30 billion in potential liabilities connected with that and other fires (it had already been convicted on six felony counts for safety violations related to a deadly 2010 pipeline explosion), but with only $2 billion of insurance, PG&E in January filed for Chapter 11 bankruptcy protection.
In the aftermath, California governor Gavin Newsom and others called for PG&E’s board to resign. Lawsuits began to fly. In short order, Geisha Williams stepped down as both CEO and board member, followed by five other directors. When reconstituted, the board will feature 11 independent directors—many with backgrounds in safety.
It’s a familiar pattern: A company experiences a crisis—say CBS botching its handling of Les Moonves’ #MeToo troubles, Facebook and Equifax’s cybersecurity breaches, or iconic GE’s struggle to regain its footing after a strategic stumble—and the company’s board is held to blame. As a 2018 UK government report on the collapse of debt-laden construction giant Carillion put it, “The board was either negligently ignorant of the rotten culture…or complicit in it.”
But is governing the modern company really a job that any board—at least as corporate boards are currently conceived—can actually do effectively?
Today’s companies need to be agile as cats to navigate a fast-moving, hyper-sensitive operating environment filled with disruptive technologies, cyber threats, and social media. Yet we still govern them with a core structure that, literally, was designed in the Middle Ages and for another purpose entirely.
We ask a group of 10-or-so part-timers—almost all independent of any other ties to the company, many with big day jobs elsewhere—to not only set and monitor something as nebulous as a corporate culture for an organization with hundreds of thousands of employees scattered around the globe, but also to set that corporation’s long-term strategy, oversee all sorts of compliance and risk-management functions, understand complex technologies and cyber threats, set CEO pay, and be ready to respond at a moment’s notice to a scandal.
Lawmakers, regulators and shareholders have spent much of the past two decades ratcheting up the board’s responsibilities, tweaking its composition, and pressing for greater access to traditional board business. But these efforts haven’t staunched the flow of problems. In some ways, they have probably made them worse.
Maybe it’s time to ask if there’s something wrong with the fundamental structure itself. Is the board broken? And can it be fixed?
The independence antidote
As recently as the 1970s, corporate boards were mostly advisory committees filled with insiders chosen by the CEO, who more often than not also was the group’s chairman. They’d have nice dinners, go on golf outings, and rubberstamp management’s decisions. Occasionally, they’d get to fly on the corporate jet. Irving Olds, US Steel’s CEO in the 1940s, once referred to directors as “parsley on fish—decorative, but useless.” In 1984, Ross Perot famously called his fellow directors at General Motors “pet rocks” for not challenging management’s plans.
That changed starting in the early 1970s, when the Penn Central railroad collapsed in what, at the time, was the largest bankruptcy in history. The failure sparked a run on commercial paper, which threatened the national economy until the Federal Reserve intervened to maintain the market’s liquidity. In a pattern that has become the default today, a corporate crisis was immediately followed by accusations of poor corporate governance. And in this case, they were undeniable: The board was filled with the railroad’s bankers, who had left shareholders holding the bag.
A powerful idea for fixing the corporate board emerged, that members should be completely independent from the company and its CEO. Filling the board with directors who had no personal, professional, or financial ties in the company, the reasoning went, would make it more willing and able to challenge the CEO and hold management accountable.
Data Point
A recent study by PwC found that 65% of companies had confronted a crisis of one sort or another in the previous three years. Another estimate says the typical company experiences one every five years or so.
The movement gained steam with an influential 1976 book by Melvin Eisenberg, a Cal Berkeley law school professor who argued that independent monitoring of management was an essential board function. And by the early 1980s, most U.S. boards had at least some independent directors. The idea spread to the UK (and beyond) with the 1992 publication of the landmark Cadbury Report, which called for a majority of non-executive directors exercising “independent judgment” on the board.
In the US, early-2000s board-level failures at Enron and WorldCom led Congress to pass the Sarbanes-Oxley Act of 2002, which empowered the stock exchanges to require that a majority of directors be independent of any other ties to the company.
Today, the notion of director independence as a sort of antidote against corporate self-dealing and wrongdoing is embraced as gospel in corporate governance circles and promoted aggressively by many shareholders and their advisors. They have expanded on the legal requirement to have a majority of independent directors, transforming it into an expectation that only one or two people connected to the company be on the board. Directors on boards that don’t fall in line could be voted out, which explains why most of them do.
Where once it wasn’t unusual to see the CEO, CFO, and one or two other ‘C’s on the board, today you’re often hard-pressed to find more than one. Instead, we often have a group of people who didn’t know much, if anything, about the company until a headhunter made contact.
“Boards constantly find themselves behind the eight ball because they’ve had all these responsibilities dumped on them, but many of don’t understand the job or the company,” says Deborah Hicks Midanek Bailey, founder and managing partner of the Solon Group, a corporate advising firm, and author of The Governance Revolution: What Every Board Member Needs to Know, NOW!“They’ve lost the native knowledge of the company and industry that they used to have.”
In the US, independent boards with independent chairs (or independent lead directors) and committees full of independent members are now par for the course, with the CEO typically the only executive in the group.
The practice has spread across the globe like a cancerous virtue. Most European Union markets, and virtually all big Asian ones, now have rules for appointing independent directors, though the purpose of independence in many of those markets—including Italy and Brazil—is more about protecting the interests of minority shareholders from being ignored by controlling shareholders. More emerging markets, in such places as Bangladesh and Nigeria, have independence rules, as well: Companies that want to attract foreign capital must embrace structures that provide accountability in a way that’s familiar to Western investors.
It’s tough to argue against independence. The word is part of the identity of most democracies, a close cousin to freedom. Being independent is what kids strive for and the elderly seek to retain. In business and politics, independence is almost always associated with integrity.
And today’s board members say having people from a variety of backgrounds can enhance strategy discussions. “You’re kind of the Knights of the Round Table to work with the CEO and maximize the company’s potential,” says Wendy Lane, a former investment banker and a director at Willis Towers Watson, a London-based risk consultant. “It’s very helpful to have a bunch of people from different industries who can look across a broad landscape and come up with ideas.”
But the independence requirements introduced in the early 2000s didn’t prevent the financial crisis later in the decade, and some argue that a lack of understanding of risk by independent directors actually contributed to its severity.
Data Point
Eighty-five percent of all directors on S&P 500 boards are technically independent, according to Institutional Shareholder Services, a proxy advisory firm, while 75% of those boards have only one employee director, typically the CEO.
The mounting responsibilities of the modern board
At the same time that boards were becoming more independent in the 70s, 80s, 90s, and early 2000s, they were also being assigned more and more responsibilities.
Beyond the things boards have always done—including helping out management with strategy, overseeing how capital is managed, and, importantly, hiring, firing, and paying the CEO—modern-day boards devote a lot of attention to keeping the company out of trouble or responding when trouble occurs.
Boards must oversee enterprise risk-management and cybersecurity efforts, (both huge, complicated tasks), help set policies on everything from hiring to social media, and go through regular drills to prepare for the next seemingly inevitable crisis.
One of their latest new tasks—an attempt to prevent the kind of bad behaviors that led to the financial crisis—is to help set the proper cultural “tone-at-the-top” of the company, while monitoring the “buzz-at-the-bottom” to ensure employees live up to high ethical standards. Ensuring incentive programs don’t encourage risky behavior is considered vital. The board either must write ethics codes or explain why it hasn’t.
Most of these demands have come from lawmakers and regulators, patchwork solutions in response to whatever caused the last economic meltdown. They’ve deputized boards to police their own companies.
The role of the board, in the words of one director, is supposed to be like that of a keen-eyed falcon soaring high above a field, scanning for prey. Boards oversee and monitor, they don’t do. “Noses in, fingers out,” is an oft-repeated mantra in boardrooms. But the list of tasks boards today are asked to perform that weren’t on the agenda 20 years ago makes living by that credo difficult. How, for example, is a board supposed to oversee the company’s culture without dirtying its fingers just a bit?
And piling more responsibilities onto the board has made the ostensible virtues of director independence just a little less virtuous, in a practical sense. Since many directors have big day jobs elsewhere, they often lack the knowledge, time, or bandwidth to adequately do all they are supposed to do, and are reliant on management—the group they’re monitoring—for information.
Studies on how board independence impacts the board’s other functions, including company performance, have had mixed results. A 2018 paper, for example, found that Indian and Chinese companies with independent boards generate higher returns on equity. This one, which delved into five Nigerian banks, also found board independence to be a plus for performance.
Conversely, a study examining a large group of Pakistani companies found a negative correlation between board independence and performance, as measured using a Tobin’s Q analysis, while another out of Spain likewise found a “negative and significant” relationship between independence and financial performance. “Fully independent boards are associated with poorer operating performance and lower firm value,” wrote Olubunmi Faleye, a finance professor at Northeastern University, in a 2014 paper on the topic. They also make management succession more difficult, Faleye concluded, because a new CEO must learn from scratch how to work with the board.
When board independence goes wrong, it can go very wrong: Take Theranos, the privately held blood-testing company that went bust amid allegations of fraud in 2018.
The Theranos board included former Secretaries of State Henry Kissinger and George Shultz, and such business luminaries as former Wells Fargo CEO Richard Kovacevich. The group’s profile gave the company credibility with Wall Street, but the board didn’t know much about the science of blood-testing, which made it difficult to police management and the strategy. When the company’s core product—a small consumer kit that supposedly could perform hundreds of tests from one drop of blood—was exposed as a fraud, so, too, was the board’s oversight. Last September Theranos ceased operations.
Julie Daum, head of the North American board practice at SpencerStuart, a recruitment and advisory firm, says that a similar problem may have contributed to the financial crisis.
“You had a lot of financial institutions during the crisis that didn’t have many financial services people on the board, which probably made things worse,” she says. “You need people in the room who understand the industry—not an entire roomful of them,” but more than we have in many cases today.
Data point
On average, board members devote 245 hours per-year to the entire job (a little less time than Atlantans sit in traffic)
Another road: Increased accountability
What do we want from the board? Many would say its primary purpose is to represent shareholder interests and increase the value of their holdings with smart strategies, good hires, and well-designed incentive plans for the top brass. Milton Friedman famously hinted to GM’s board in 1970 that the automaker continue building clunky, unsafe cars—social responsibility be damned—because it was profitable.
Others would argue that the interests of other stakeholders (employees, communities, etc.) should be given equal weight, if not more. Regulators might say that performing the abundant compliance tasks meant to keep the company on the straight-and-narrow are paramount.
What’s certain is that when a board fails at overseeing risk management or complying with various rules and regulations, the company (along with all of its stakeholders) suffers. If enough boards fail, we all suffer.
As private-sector corporations continue to grow in power and influence, the profile and importance of the boards that sit atop their organizational charts is only like to grow. Reforming boards is starting to look like it could change the world.
As Larry Fink, CEO of BlackRock, one of the largest institutional investors, wrote in his 2019 letter to CEOs, at a time of “wrenching political dysfunction,” the world is looking for corporate leaders to define a social “purpose” that goes beyond mere profitability. That includes tackling big social issues like retirement, the environment, and gender- and racial-inequality.
Both groups—those looking for profits and those looking for world-changing sustainability—have been campaigning for board reforms.
Beyond independence, shareholders are driving efforts to boost board accountability. Some of the more significant changes:
- Executive pay: As part of the 2010 Dodd-Frank Act, US boards are required to publish lengthy details of the CEO’s pay package and hold non-binding “say-on-pay” resolutions at least once every three years. The goal is to rein in executive compensation and link pay more closely to company performance. (Even when a majority of shareholders reject a CEO’s pay, as happened 93 times in 2018, the board doesn’t always respond.)
- More frequent director elections: In 2017, 87% of S&P 500 boards held annual director elections, compared to 59% in 2009—a shift from the traditional staggered, three-year cycles of years past that once dominated board elections and made it difficult to replace a poor-performing board.
- “Proxy access”: The SEC approved a rule to make it easier for large shareholders to directly nominate director candidates. The initiative was halted before it began by a lawsuit. Undaunted, shareholders took up the cause themselves, company-by-company. Today, 63% of S&P 500 boards have embraced proxy access rules.
- “Majority voting”: Ninety-two percent of S&P 500 firms have adopted rules that require sitting directors who run unopposed to capture a majority of votes cast, as opposed to a mere plurality.
The reforms, well-intentioned as they might be, have made it more difficult and time-consuming for boards to do their jobs. Shareholders’ muscle-flexing—and the threat that investors might force directors out in a vote—have created a sense of urgency for boards to engage directly with shareholders. While it might make sense that a company’s owners meet with the people hired to oversee the company, as recently as five years ago, it rarely happened.
The many meanings of “shareholders”
The problem with shareholders, of course, is that they’re not a uniform group. Retail investors account for about 30% of shares, while the rest are split among institutions with starkly different objectives.
- Activist investors: Hedge funds and other investors looking for short-term payouts target boards with regulatory filings and white papers that demand changes to strategy or leadership. In 2014, a hedge fund called Starboard Value LP ousted the entire board of Darden Restaurants by successfully arguing in a detailed, 294-slide presentation that its operations were inefficient. “The first step in Pasta 101 is to salt the water,” read one slide.
- Environmental and social investors: A growing number of specialized funds pepper boards with proposals, resolutions and annual-meeting grandstanding on topics ranging from climate change and sustainability reporting to pay equity, gun control, and political spending disclosures. The results of those resolutions are nonbinding and rarely garner majority support. But they’re having an impact, nonetheless.
- Large institutions: Pension funds, including giant CalPERS, and fund companies like BlackRock, Vanguard, and State Street, are looking to boards to ensure long-term prosperity. They are among the biggest shareholders in pretty much any company, and have become much more assertive in recent years—particularly when it comes to encouraging good-governance practices that they believe are needed to ensure returns 40 years from now.
- Proxy advisors: Investors of all stripes are backstopped by proxy advisory firms that help them decide how to vote on the tens of thousands of resolutions, pay packages, mergers, and other issues that appear on ballots each year. Even the largest investors don’t have the staff to manage the volume. A pro or con recommendation from the biggest player in the space, Institutional Shareholder Services, can swing as much as 30% of the vote. Because of its power, many boards at-once bristle at ISS’s presence and obsess over winning its support.
The differing agendas can create odd bedfellows and conflicts. Big institutions that own the most shares, for example, are increasingly resentful of smaller activist hedge funds’ influence on strategy, but also are partnering with them more frequently to boost returns. ESG investors need the bigger shareholders’ support to advance their causes, which is happening more often. But much of the do-gooder agenda comes with a bottom-line cost, which leads to opposition. Some shareholders wring their hands over the power of ISS’s scores and recommendations, but most also use them—if not outright, then at least as a guide.
Changing the board by changing who is on it
While making boards more broadly independent has been the most prominent strategy for improving board oversight, the make-up and backgrounds of individual members has been garnering more attention as of late.
Douglas Chia, executive director of the Conference Board’s governance center, says boards are best viewed as volleyball teams, not baseball teams. “In baseball, you go out and get a left-handed reliever or a [designated hitter] who can’t field. Volleyball players have certain strengths, but they can rotate everywhere.” In other words, a group of experts in narrow fields like cybersecurity or, in PG&E’s case, safety experts—increasingly an answer to boards wishing to oversee a new set of risks—might not be the best composition.
The board isn’t necessarily a spry or balanced group. The old British adage of boards being “male, pale, and stale” is falling by the wayside, but the going is slower than most would like.
In Canada, for example, 39% of companies in the TSX 400 have boards with no women members. In Australia, 90% of new board members are still white men.
According to consultant PwC, the typical S&P 500 company board member is a 63-year-old white guy who’s been in the role for eight years. Just 22% of board members are women, while 17% of those at the 200 biggest companies are minorities.
In 2018, 83% of new directors added to US company boards were older than 50, according to ISS, up from 74% a decade earlier. Women made up 32% of new directors.
Everyone seems to agree that diversity—gender, ethnicity, age—is important to get representative voices in the room. A new law in California, where just 5% of board seats are held by women, will penalize any company based in the state that doesn’t have at least one woman director by the end of 2019. Proxy advisor ISS has proposed recommending votes against board nominating committee members if the board has no women directors. In an effort to get younger, 71% of S&P 500 boards have mandatory retirement ages, though some reach as high as 80. About 5% of boards have term limits.
Progress is choppy. According to SpencerStuart, 40% of new directors at S&P 500 companies in 2018 were women, up from 24% five years earlier. “Minority” representation rose just 1% in the same time, to 19% of directors. The average age of a board member fell slightly, to 57.2 years old, while the average age of directors who stepped down was 68.4.
The diversity demands are being matched by louder calls to give employees a seat at the table. Lawmakers are supporting those efforts. In the latest twist, US senator Elizabeth Warren, a presidential candidate, has introduced a bill that, among other things, would allow employees of large US companies to elect up to 40% of directors—a practice similar to what Germany already does.
Board composition, once a mundane topic, is poised to become an election issue.
Beyond the board
The whole idea of the board being at the helm of the corporation, acting as the shareholders’ representative and corporate fiduciary, is something of an historical accident.
Some 500 years ago, big trading companies had guilds that imposed monopoly-preserving rules and resolved disputes. When companies began raising capital from larger groups of passive shareholders, the groups’ purpose morphed to providing collective governance. They became the first “boards.”
The idea spread—much like director independence more recently—across the globe. It arrived in the Americas during colonial times and displaced other forms of governance in Asia in the 1800s and early 1900s.
The thing is, says Franklin Gevurtz, a law professor at the University of Pacific and author of a 2004 paper on the history of board governance, the idea was never really vetted as a good structure for running a company.
“No one ever asked if a body that was designed to give rule-making consent among members would be a good mechanism for running a business corporation. The board just went along for the ride,” Gevurtz explains in an interview.
The widespread adoption of boards, Gevurtz adds, “may occur because they appear to work, not necessarily because they do work.”
As companies grow in size and influence, that appearance is wavering. Could it be possible that the job of the board has outgrown its structure?
How else to explain the Wells Fargo phony-account scandal, where even news reports years earlier that detailed the problem failed to capture the board’s attention. As Bainbridge notes, “it’s hard for a committee of 10 or 12 people to be well-informed about what somebody in Poughkeepsie is doing.”
Still, there aren’t many alternatives to corporate governance as we know it.
Germany is among the markets that employ two-tiered boards—one that oversees the day-to-day operations, the other to oversee management (which includes employees). China requires independence and also demands all boards to have high-level “Party organizations,” meant to ensure implementation of state and political objectives. Emerging markets from Brazil to Indonesia are embracing new governance codes that codify the role of the board and the notion of independence. But these variations at their roots still look more-or-less like the US version of the corporate board—and they still share its failings: From the emission scandal at Germany’s Volkswagen to a massive $1.78 billion in penalties paid by Brazil’s Petrobras, the board getting into trouble is a global phenomenon.
The most ambitious idea to replace the board would create a new class of companies, called “board service providers,” to perform traditional board functions, but as a consultant. The BSP would employ a group of individuals to serve as full-time directors, supported by subject-matter experts who could offer assistance on such topical areas as cybersecurity or crisis management. But that would require a change to US state corporate laws, which currently require “natural persons” to serve on boards.
Another idea is using AI to augment board processes. A venture-capital firm in Hong Kong has taken this idea a step further by including an AI algorithm, dubbed “Vital,” as one of its board members. Vital looks at a range of data and has a vote on which companies to invest in. Since the best decisions are based on good data, the reasoning goes, why not have an entity at the table capable of running the numbers dispassionately?
Patrick McGurn, special counsel for ISS, says he has heard talk of ditching the board and letting shareholders elect the CEO directly. “But if it’s a popularity contest, you could end up with Lady Gaga running the company,” he says. “Nobody wants that.”
Data Point
SpencerStuart, a big recruitment firm, pegs the average compensation for an independent director at about $295,000.
The best of bad options
In other words, for now we’re stuck with a structure that was never meant to do what we expect it to do and is being pushed and pulled on all sides. What to do?
Here are some ideas that might help make the board more effective:
- Better onboarding processes for new board members: New hires in a company get weeks, sometimes months, of training; new independent directors often get virtually nil. Small wonder that it takes 18 months for a new director to get up to speed—time to make a mistake or miss an opportunity. If we’re going to insist on everyone not knowing the company, then boards must do a better job at making the transition easier.
- Staff for the board: If time and information are key challenges, why not give it a dedicated staff to reduce both the workload and the reliance on management? Concerns that those staffers could become a sort of shadow management group inhibiting the CEO’s flexibility are outweighed by the fact that these titans of industry are often printing out materials on their home computers.
- Better evaluations: Many boards perform self-evaluations. Sometimes, it’s as simple as the chairman asking directors how they think the group is doing. Everyone nods, and it’s entered into the minutes as an evaluation. A budding best practice is to bring in an outside firm to interview directors confidentially, one-on-one, and then offer ideas for improvement.
- Continue to build younger and more diverse boards: While studies on the impact of diversity on board performance show mixed results, if we’re going to continue making board service a gig for outsiders, then they should have the energy and cultural insights to lead the company into the future.
- Less independence for the sake of independence: Boards leave a lot of company and industry knowledge on the cutting-room floor by requiring everyone but the CEO to have no ties to the organization. Having a simple majority of independent directors—what’s required by the exchanges—should provide the oversight and accountability demanded by shareholders.
Signs of a thoughtful rethink of independence have emerged. In a telling move, UK Governance Code recommendations changed following the financial crisis, from emphasizing independence to ensuring “the appropriate balance of skills, experience, independence and knowledge of the company.” Within a couple years, the percentage of independent directors on British boards fell from 90% to 61%. After a rollicking start, the movement has all but stalled out in many emerging markets.
In the end, boards might be best described by that old adage about democracy being the worst form of government except for the alternatives. They’re not perfect, and not every tweak is helpful. But they’ve also served as a backbone for the growth of corporations and the global economy.
“Everyone focuses on the big fails, but thousands of companies run well under this model,” says Lane, who has served on nine boards on three continents over the last 27 years.
Until a better way to govern the modern corporation emerges, the idea of a group of ostensibly wise people at the top of the organization asking smart questions, providing oversight, and being held accountable for the organization’s mistakes and missteps will carry the day.