Examining Classified Boards

With promises of higher shareholder returns, greater stability, better focus on long-term strategies and decreased complexity, classified boards have been offered as a solution to the U.S. corporate governance crisis. However, these promises aren’t being realized, argues Olubunmi Faleye, Lloyd Mullin Research Fellow and an assistant professor of finance and insurance at Northeastern University. In fact, in 2005, 63% of all votes to declassify boards were approved, and through August 2006, 67% were approved. Despite advocates, growing evidence indicates that classified boards merely obfuscate the process while providing no discernible benefits.

While previous studies have shown that higher shareholder returns are rare, the other claims by proponents of classified boards have been previously left unchallenged. However, in the 2006 working paper, “Do Classified Boards Facilitate Institutional Stability and Effective Strategic Thinking?” Faleye analyzes data from 1995 to 2002 from over 2,000 companies with both classified and traditional boards. He examined these companies from the point of view of stability, capital investment generally associated with long-term strategic growth, and complexity and uncertainty. The study showed that there was no statistically significant difference between the two types of companies in most cases, and in some cases companies with nonclassified boards saw better performance.

One of the areas in which traditional boards outperformed classified boards was long-term strategic investments. Classified boards are promoted as being beneficial to long-term strategy focus because members do not have to be constantly focused on reelection. A major measurement of investment in long-term success is research and development expenditure. Surprisingly, Faleye found that as a ratio of other expenditures, classified boards spent only 2.1% on R&D investments, compared to 4.3% spent by nonclassified boards. Additionally, companies with classified boards invested 19.8% in long-lived physical assets, compared to 20.6% by companies with nonclassified boards. While the difference is not statistically significant in this case, it does show that classified boards do not have an advantage in another common measure of long-term strategy focus.

Related to the question of long-term strategy is the question of stability. Proponents of classified boards suggest that the longer terms of service that accompany classified boards would create more stability, which would lead to more effective boards. However, Faleye shows this is not the case. Of the directors with the studied companies in 1995, 58.9% remained with the classified boards and 60.5% remained with the traditional boards as of 2002.