The Downside to Full Board Independence

High-profile accounting and corporate governance scandals have resulted in significant changes in the structure of corporate boards of directors, especially the move to (nearly) fully independent boards — that is, boards on which the CEO is the only employee director. According to data from the proxy advisory firm Institutional Shareholder Services, 36% of S&P 500 companies had no other employee director besides their CEOs in 1999. The percentage of such companies has increased steadily since then, reaching an astonishing 75% in 2015. This dramatic trend raises the important question of whether board effectiveness improves or suffers with fully independent boards.

The Benefits of Full Independence

The potential benefits of an independent board are well known. Independent directors are usually leaders with few reasons to be beholden to the CEO. Boards dominated by independent directors are better able to oversee the CEO and protect the interests of shareholders and other stakeholders. Increasing their number can foster better board performance by enhancing a company’s access to external resources and connections. A larger number of independent directors also allows a board to ensure that its members are not overburdened with oversight responsibilities to the detriment of strategic counseling. A fully independent board enables a company to reap these benefits without enlarging its board, thereby avoiding the potential disadvantages of a large board.

The Disadvantages of Full Independence

However, full board independence is not without its costs. First, research has shown that the quality of managerial oversight and strategic advising by independent directors depends significantly on the quality and completeness of information they receive. Senior executives other than the CEO often have unique insights into different aspects of the company’s operations. While such insights can be transmitted to the board via the CEO, this can introduce systematic noise (or deliberate bias on the part of the CEO) that reduces the value of such information. Further, inviting non-director executives to board meetings on an ad hoc basis does not facilitate the ongoing information exchange between independent directors and executives that comes naturally with board membership. A fully independent board may thus become less effective because it works with relatively poorer information.

Second, a major responsibility of corporate boards is to replace the CEO when needed. Because no senior executives other than the current CEO are members of a fully independent board, independent directors on such boards do not regularly interact with, observe, and evaluate them as they contribute to important strategy development and execution decisions. A fully independent board thus may evaluate internal candidates for the CEO position less accurately due to less familiarity with them. The board may appoint an external candidate when an internal candidate would be the better choice. Even if it does choose an internal successor, a fully independent board’s reduced firsthand information on senior executives may mean that the candidate is not the best fit.

Finally, senior executives traditionally perfect their company-specific strategy development skills by serving on their companies’ boards. Fully independent boards deny them this significant opportunity. While the board can invite non-member executives to participate in its deliberations as needed, this is an inadequate substitute for the spontaneous exposure to board discussions that comes with regular membership. Regardless of whether they are the best fit for the position, internally promoted CEOs appointed by fully independent boards are likely to face a steeper learning curve that can result in costly mistakes, especially during the initial years of their tenures.

Do the Benefits Outweigh the Costs?

The ultimate goal of corporate boards is to create long-term value. Therefore, to evaluate whether the benefits of full board independence outweigh its disadvantages, I examined the effect of fully independent boards on operating profits and corporate value in a study published in the Journal of Empirical Finance. My sample consisted of over 20,000 annual observations for 2,900 S&P 1500 companies from 1998 through 2011. Of these observations, about 54% belonged to years when a company’s board was fully independent, while the rest occurred when the company had more than one employee director. I then compared the two groups on operating profits and market valuation. My tests controlled for factors such as company size, use of debt, growth opportunities, managerial equity ownership, and other board attributes.

I found that companies with fully independent boards earned significantly lower operating profits than other companies — up to 8.2% lower. Similarly, these companies deviated more from value maximization and attracted lower market values. These performance differentials were more pronounced during the initial two years following the promotion to CEO of a senior executive without prior service on the company’s board. This suggests that the lack of regular exposure to the board presented a particularly difficult learning curve for internally promoted CEOs and hurt their early performance.

Does One Size Fit All?

A common theme in recent corporate governance research is that one size does not fit all when it comes to structuring a board of directors. Some companies have relatively straightforward operations that are easy for outside directors to understand and oversee. A fully independent board may be beneficial (or at least not harmful) to such companies. Other companies invest heavily in R&D and have significant amounts of intellectual property. Such companies are more difficult for outsiders to understand, so overseeing them requires continuous access to the high-quality information provided by employee directors at regular board meetings. I evaluated whether fully independent boards had a worse effect on the latter type of companies. Results indicated that this was the case — companies with more complex operations showed an 8.2% decrease in operating profit on average, while ones with more straightforward operations averaged a 4.8% decrease.

Although the value of independent directors is well established, my findings suggest that setting up a fully independent board is counterproductive. Boards that did away with senior executives’ knowledge, skills, and company-specific information diminished their own effectiveness.

So what’s a company to do? The demand of regulatory agencies for greater involvement of independent directors in board oversight means that companies need more independent directors to spread out oversight responsibilities. Yet adding independent directors without reducing the number of employee directors means enlarging the board, which may create other problems. However, boards can balance the need for independent and employee directors without altering their current size.

The median S&P 500 board has 11 directors. I propose allocating three positions to employee directors and the rest to independents. With eight independent directors, a company can staff its audit, compensation, and nominating/governance committees so that only a handful of directors serve on more than one committee, optimizing their contribution to board oversight and strategic advising. At the same time, two additional senior executives on the board will allow independent directors regular access to their expertise and knowledge. This will eliminate the need to filter internal information to the board through the CEO and improve the CEO succession process.