Are Independent Directors the Answer? An Opinion Editorial by Edward E. Lawler III and David A. Finegold.

Editorial Editors

--(BUSINESS WIRE)

The following is an opinion editorial provided by Edward E. Lawler III, director of the Center for Effective Organizations at the Marshall School of Business, University of Southern California, and David A. Finegold, an associate professor at the Keck Graduate Institute. Along with Jay A. Conger, they are the authors of Corporate Boards.

The NYSE Board fiasco is only the latest in a series of corporate governance failures that make clear the need for more powerful and effective boards. Most board reform advocates and the many new corporate governance guidelines that are being issued, call for boards to be dominated by independent directors. A number of boards have taken this to heart, and have created boards where the CEO is the only inside director.

The reform advocates are not the only ones who think having independent boards is the answer. A recent survey we did of large company directors found that board members themselves feel that of all the proposed board reforms, having boards and audit committees made up of independent directors are by far the most likely to have a positive impact on boards. But, is relying on boards that are made up of independent directors the best solution?

It is a simple, straightforward approach, but it overlooks several decades of research on corporate boards which shows that increasing the percentage of outside directors beyond a majority does not improve company or board performance. It also ignores some important points about what makes for a powerful and effective board. In order to be effective, our research suggests that boards need the ability to make tough decisions, and they need to base them on valid information.

Having boards that are made up almost entirely of independent directors can certainly contribute to the power of boards, but it may not be as effective a way to build an independent board as having someone in a board leadership position who is independent of management. To be specific, having either a Lead Director or a board Chair who is not a current or former employee of the firm, as is common in many other countries and venture capital backed start ups in the US, is a very effective way to create a board that acts independently of management. Only with leadership that is independent can the board assure full and frank discussion of the issues that need to be considered and effectively counter balance the inherent power advantages of the CEO.

A further advantage of having independent board leadership is that it makes it reasonable to have a small number of members of management, say two or three, on the board. This can be a very important design feature for boards because it brings insider information and additional channels of communication within the company to the board, thereby potentially allowing a more fruitful and informed discussion of issues. It also gives outside board members a chance to assess internal candidates to succeed the CEO, while serving as a training ground for future CEOs on how boards operate.

Let's probe more deeply into who the independent directors on a board should be. There are a number of ways to measure independence. Most reform efforts argue that board members should be financially independent of the company whose board they sit on and lacking any family or personal ties to the CEO of the company. These clearly are important tests of independence, but simply having a board of individuals who pass this test of independence does not necessarily assure that the board will be independent enough of management to raise the right issues. If all the members of the board come from the same social and employment background, and particularly if they are nominated by the current CEO, there is a real risk that the board will be homogenous and of the same mindset as the CEO, even though it has "independent" directors on it.

In the case of CEO pay, for example, executives from other companies may gain as much as the CEO does from generous compensation packages. Higher pay for one CEO almost always leads to higher pay for other CEOs as firms benchmark each other to determine a "fair" market value for top talent.

In order to have an effective board, it is important that some members of the board be leaders who are not corporate executives. Individuals who bring information and expertise concerning the business environment, suppliers, customers, employees, etc. to the board and are independent in their way of thinking about issues and problems are needed.

What should the composition of a board look like, then? Our belief is that it should contain two or three senior executives from the company, an independent board Chair or Lead Director, a few independent directors who are senior executives in other firms, and a group of independent directors who are knowledgeable about key business issues. A board with this composition is much more likely to act independently and be informed about the internal operations of the organization, as well as the external environment than is a board of all independent directors which is headed by the CEO.

Dr. Lawler may be reached at [e-mail].

About the USC Marshall School of Business

Both U.S. News & World Report and Business Week rank Marshall's programs among the top 20. Marshall with its many research centers and Leventhal School of Accounting focuses on a core set of skills and on strengthening its position as a global center of business education and research at the graduate, undergraduate and executive levels.