A few months ago, the director and a researcher at Stanford University’s Corporate Governance Research Initiative issued a paper with the above title, confronting some of the more common “myths” surrounding corporate governance. Last month, we looked at several of these “myths,” and here we examine a few more—along with what’s really behind them.
Myth: Directors face significant liability risk
Researchers: A 2009 survey found two-thirds of directors believe their board-related liability risk has increased in recent years, with 15 percent having thought seriously about resigning due to concerns about personal liability. The actual risk of out-of-pocket payment, however, is low. Directors are afforded considerable protection through indemnification agreements and purchase of D&O insurance. Another study found that between 1980 and 2005, outside directors made out-of-pocket payments in only 12 cases (including Enron, WorldCom, and Tyco); and between 2006 and 2010, no directors made such payments (although some cases are still ongoing). The conclusion: “directors with state-of-the art insurance policies face little out-of-pocket liability risk ... The principal threats to outside directors who perform poorly are the time, aggravation, and potential harm to reputation that a lawsuit can entail, not direct financial loss.”
Analysis: It’s fair to say the vast majority of directors will not have to open their wallets to pay awards or settlements for their board performance. That being said, directors indeed are very much concerned about the potential of personal liability. The reality is that some board members have had to pay up, and the possibility of having to do so and spend inordinate amounts of time and suffer reputational damage are on directors’ minds. There’s not one board I’ve dealt with over the years, including recently, where directors are not concerned about the potentiality of lawsuits and related personal impact.
Yes, capable individuals continue to serve major company boards and bring the necessary loyalty and care and skills and attributes to add value to the companies they serve. But they do this in spite of serious concerns about liability—financial and otherwise.
We can argue about the word “significant” and what is entailed in “liability,” as well as the likelihood of finding oneself being cross-examined on a witness stand. But all told, it’s clear directors do indeed care deeply about potential personal liability.
Myth: Staggered boards are always detrimental to shareholders
Researchers: Staggered boards provide formidable antitakeover protection, particularly when coupled with a poison pill, causing many governance experts to criticize their use. Over the last 10 years, the prevalence of staggered boards decreased from 57 percent of companies in 2005 to 32 percent in 2014, with the largest decline among large-capitalization stocks. While staggered boards sometimes can be detrimental to shareholders—when they prevent otherwise attractive merger opportunities and entrench a poorly performing management—otherwise they’ve been shown to improve corporate outcomes. For example, staggered boards benefit shareholders when they protect long-term business commitments that would be disrupted by a hostile takeover or when they insulate management from short-term pressure, thereby allowing a company to innovate, take risk, and develop proprietary technology that is not fully understood by the market. Studies suggest staggered boards can benefit companies by committing management to longer investment horizons, and research evidence does not support a conclusion that a staggered board structure is uniformly negative for shareholders.
At the end of the day, where directors serve with loyalty and care, act in good faith, and use good business judgment, blame should be placed not with a board but with the vagaries of the business world.
Analysis: This is a case of one-size-does-not-fit-all. Certainly governance activists despise staggered boards, as they make takeovers much more difficult. But whether shareholders win or lose depends on the individual facts and circumstances.
Myth: A company failure is always the board’s fault
Researchers: In order for a company to generate acceptable rates of returns, it must take risks, which may lead to failure. Before attributing blame to a board, it’s important to identify the root cause of failure. To the extent it resulted from a poorly conceived strategy, excessive risk taking, weak oversight, or blatant fraud, the board can and should rightly be blamed for failing in its monitoring function. However, to the extent that failure resulted from competitive pressure, unexpected marketplace shifts, or poor results falling within the range of expected outcomes, then blame lies with management, or poor luck. The board might still rightly be said to have fulfilled its duties.
Furthermore, even within the scope of its monitoring obligations, it’s not realistic a board will detect all instances of malfeasance before they occur. The board has limited access to information about company operations. In the absence of “red flags,” it is allowed to rely solely on information provided by management to inform its decisions. The board generally does not seek information beyond this, with some exceptions: If a board receives credible information of unusual activity (e.g., through a whistleblower hotline or internal audit report), it is expected to follow up. If an unrelated company gets in trouble over a unique issue (e.g., the 2013 Target credit card breach), the board might bring in a consultant to present on the issue and ask management to report on procedures and systems in place to prevent a similar problem from occurring. And if a board believes management is not setting the right tone at the top, it is expected to communicate its concerns to management and increase monitoring. Absent such “red flags” to trigger deeper scrutiny, it is unlikely that the board will detect all occurrences of malfeasance within a company.
The degree to which a director should be held accountable depends on a fair-minded assessment of whether and how the director might have contributed to the failure and whether it is reasonable to believe he or she could have prevented it.
Analysis: That a board always is at fault for corporate failure indeed is a myth. Of course, too often investors don’t see it this way, and attempt to put the blame at the directors’ door.
I disagree, however, with elements of the researchers’ statements. A blanket statement that directors can and should rightly be blamed to the extent failure is due to such factors as a poorly conceived strategy just doesn’t make sense. Usually one doesn’t know whether or not a strategy is a winning one until after the company has travelled well down the road. And subsequent marketplace and other events can turn on a company, causing a strategic plan to have less-than-desired results. The researchers rightly backtrack a bit on the first statement, providing a more balanced position.
Saying that a board generally does not seek information beyond what’s provided by management, with three identified exceptions, also is not correct. Boards generally do seek information from a variety of sources, including industry research and financial analyst reports, news services, rating agencies, proxy advisers, their own on-sight visits, and a variety of other sources. Although directors certainly don’t need to audit information provided by management, they do need to keep an open mind, and use knowledge of the industry and business to consider management’s input in that context.
And yes, at the end of the day, where directors serve with loyalty and care, act in good faith, and use good business judgment, blame should be placed not with a board but with the vagaries of the business world.
What’s behind these myths?
The noise around corporate governance has increased tremendously in recent years, with institutional investors, including pension funds and shareholder activists, along with proxy advisors, lawyers, and others, calling for changes in rules and protocols. Some of the changes have benefited or would benefit a wide shareholder group, but others, based on myths, would not. I’ve been speaking out on this for years, and believe that many of the proposals surrounding corporate governance are indeed self serving.
In a recent New York Times’ article, law Professor Steven Davidoff Solomon supports the view that we have a governance industry in which proposals are brought by each with their own interests. He poses such pointed questions as, is a city or state comptroller bringing a proposal because he or she thinks it benefits the public pension fund, or rather a political career? Noting that proxy advisory services profit from their services, he says the “divisions in the corporate governance wars may make for a robust cottage industry, but they don’t necessarily help shareholders.”
There’s certainly a good deal of pent-up animosity among these parties, who have been long ignored, and now enjoy newfound influence. As Solomon puts it, some investors appear simply to be caught up in the rush of exercising power, with shareholders gleefully telling companies that ignored them for decades they’re now in charge.
Well, while some are spreading “myths,” there’s no doubt their influence is part of the new reality in the world of corporate governance.