As chairman of Aetna in 1999, William Donaldson said: “I fear there is a growing cottage industry of superficial thought about corporate governance.” This statement rings true. Recent discussions of gender imbalance on boards of directors have resulted in a spike in related training programs, consultant contracts, clichés and myths, not to mention the poor interpretation of data, which always seems to favour the sponsors of the research.
Simply put, junk science has overwhelmed the thoughtful process of clarifying the role and processes of a successful board. And if truth be told, it has spawned more than a cottage industry. Governance has become a major sector supported by investment funds, consultants, university training programs, provincial and federal governments and institutions, such as the Ontario Security Commission.
Unfortunately, this paper argues that most of this activity is driven by a fad in management theory, which will eventually fade away like yesterday’s fashion styles.
Keep in mind there are features of governance and functions of governance. Around the world, regulators have forced boards into a compliance mode that is placing high value on features of governance as opposed to the functions of governance. The penalties for non-compliance can be high. Norway, for example, threatened to delist companies from the local stock exchange if certain gender quotas were not met. And yet, the presence of features does not necessarily lead to good board functions, process, or outcomes. For example, one of the commonly accepted features of good governance is the separation of chairperson and CEO roles. The general assumption is that the simple presence of this feature will lead to a better functioning board. But this is not necessarily the case.
The focus on features has lead to a faulty evaluation metric for corporate governance. Indeed, counting features is the most common scale used when comparing boards. When The Globe and Mail, for example, publishes its rankings of Canadian boards, it scores companies by looking at the number of features of governance. If Company A can check off more boxes than Company B, then the conclusion is made that Company A has a better board than Company B. The verification of a board’s features, however, does very little when it comes to understanding and evaluating actual board behavior.
In The Value of Governance (2013), University of Toronto Professor Anita Anand, provided a Memorandum for the Canadian Coalition of Good Governance regarding firm value and good governance. She reviewed international and Canadian research literature. Her conclusion was that there is a link between corporate governance and firm value, and that exogenous (external) variables may have an impact on the value relationship. But she also noted most studies look at correlations and that the key issue of causation is very much unknown.
In Inside the Boardroom (2005), Richard Leblanc and James Gillies point out that there is actually no hard evidence to support the conclusion that boards fulfill their duties more effectively by following well-meaning rules put in place to improve governance. David Larcker and Brian Tayan reached the same conclusion in Corporate Governance Matters (2011). Indeed, they conclude most structural features of the board have little or no relationship to governance quality.
A 2004 study of 1,500 U.S. public companies by Sanjay Bhagat, Dick Wittink, and Jeffrey Sonnenfeld found no relationship between the structure of the board and company performance. According to this and other research by Sonnenfeld, no evidence supports the perceived benefit of separating the roles of chair and CEO. Furthermore, since boards of companies that failed were found to be filled with very educated and experienced members, the quality of board members can’t be said to have a clear impact on governance. Even research into the independence and size of boards does not show how these metrics make a difference.
In Corporate Governance Matters (2011), David Larker and Brian Tayan include the following quote by Myron Steel, Chief Justice of the Delaware Supreme Court:
Until I personally see empirical data that supports in a particular business sector, or for a particular corporation, that separating the chairman and CEO, majority voting, elimination of staggered boards, proxy access with limits, holding periods, and percentage of shares – until something demonstrates that one or more of those will effectively alter the quality of corporate governance in a given situation, then it’s difficult to say that all, much less each, of these proposed changes are truly reform. Reform implies to me something better than you have now. Prove it, establish it, and then it may well be accepted by all of us.
According to Larker and Tayan, governance is an organizational discipline, and therefore an analysis of governance should be based on organizational concepts and research. They suggest that the key concepts for understanding a board’s success or failure must be based on organizational theory, such as organizational design, culture, the personality and leadership of the CEO, and the quality of the board.
The key to rating boards is understanding context.Most researchers and public policies assume a similar board system across industries. This assumption allows law makers and researchers to ignore inter-company board differences. Nevertheless, board functions and effectiveness must reflect the context in which an organization finds itself. After all, board processes and functions are clearly dependent on context (growth or the lack of it, competition, strategy or the lack of it, etc.). For example, after it became very clear that the functioning of the board of directors at Canadian Pacific was no longer suitable to drive company growth, an activist shareholder pushed for new directors and a reorganized board. This led to a dramatic increase in cost ratios, profit and share price. It changed the function of the board. Other illustrations where context called for a change of the board include BlackBerry (formerly RIM) and Barrick Gold.
When it comes to an effective governance model, one size does not fit all. Context is paramount. Context is both endogenous and exogenous. Endogenous variables include complexity, asset base, competitive advantage, capital structure, quality of management, and board culture and leadership. Exogenous variables include industry structures, position in growth cycle, competitive force, macroeconomics (interest rate, commodity pricing), world supply and growth, political changes, and unforeseen events (earthquakes, tsunamis, etc.). These variables are key inputs for company performance and determine whether earnings are above or below average. Simply put, companies may need a different type of board to fit with different sets of endogenous and exogenous variables.
Boards and management typically have different mandates, not to mention a different social architecture to carry them out. It is generally agreed that the CEO and the management teams run the firm, while the board approves strategy, selects the CEO and determines the incentives, sets risk management, and approves major investments and changes to the capital structure. But as discussed in Boards that Lead (2014) by Ram Charan, Dennis Casey and Michael Useen, directors must also lead the corporation on the most crucial issues. As a result, the ideal level of board involvement remains a grey area and is rarely defined. Setting boundaries when there are overlapping responsibilities is difficult. Nevertheless, how the functional relationships between the board and management work is probably far more important than board features to the growth, and sometimes survival, of the organization.
In Back to the Drawing Board (2004), Colin Carter and Jay Lorsch suggest the reason so little has resulted from the various reforms aimed at improving governance is the focus on visible variables, or what others have labeled structural issues, instead of a focus on process or inside board behavior. In other words, features have trumped functions.
The increase in complexity may be another issue. Keep in mind that directors don’t spend a lot of time together, which is a barrier to good behavior and process and makes it difficult for boards to function as a dynamic team. According to a 2013 McKinsey survey of over 700 corporate board members, directors spend an average of 22 days per year on company issues and two thirds do not think they have a complete understanding of the firm’s strategy. Clearly, there are severe limitations on boards, which have more to do than time available, especially with their limited number of board meetings packed with presentations from management.
Boards should be viewed as an organizational system, with context part of any performance judgment. This view has more merit in distinguishing between effective and ineffective boards than the structural view. Human resource metrics may hold more promise and be more important than the structural indices currently used to distinguish between effective and ineffective boards.