Courts, lawmakers and the general public all seem to agree: The modern corporation should be governed by independent directors untainted by personal or financial ties to the CEO. The principle is enshrined in Sarbanes-Oxley and the Dodd-Frank Act, which require publicly traded companies to have a majority of independent directors and independent committees to oversee matters such as audits and executive compensation.
The whole idea is to avoid scandals like Enron and Worldcom, where out-of-touch directors, some of them beholden to top management, allowed fraud to flourish under their eyes.
There’s a growing body of academic literature suggesting this conventional wisdom is wrong. Empirical studies have found little relationship between independent boards and financial performance. University of Georgia Law School Professor Usha Rodrigues, in a widely cited 2008 article, went as far as to describe it as the “fetishization of independence.” Independent directors are useful for certain things, she wrote, such as blocking self-interested transactions by the CEO. But they do not represent shareholders in other cases, such as hostile takeovers that threaten their own cushy board seats.
The debate over how to manage a business with multiple owners has deep roots. The modern corporate board can be traced back to medieval England, where guilds evolved into “chartered companies” like the Merchant Adventurers, which traded with the Netherlands and had a governor and an elected board of “assistants.” Back then, directors were owners who mostly broke up fights among themselves.
Later, joint-stock companies developed boards that watched the business on behalf of passive investors. Adam Smith bemoaned the trend in his 1776 book The Wealth of Nations, saying managers of other peoples’ money could not be expected “to watch over it with the same anxious vigilance” as private partners “watch over their own.” By the early 20th century, CEOs were recruiting celebrities and military heroes as directors to lull investors into a false sense of security.
The collapse of Penn Central in 1970 and scandals over illegal campaign contributions and bribes that emerged from the Watergate hearings propelled the move toward “independent” directors. The Securities and Exchange Commission told the New York Stock Exchange to require independent audit committees in 1977, and Delaware courts in the 1980s, began to judge transactions on whether the process was tainted by insider self-interest.
By 2000, 78 percent of directors of U.S. public companies were independent, and 23 percent of the companies had a non-executive chairman, according to Spencer Stuart. Yet the scandals kept coming, and academics persistently questioned whether supposedly independent directors were the solution.
There is an alternative as old as the Merchant Adventurers: Active boards composed of members who own significant stakes in the companies they oversee and aren’t afraid to step in and protect their investment.
A.J. Wasserstein teaches one of the most popular classes at the Yale School of Organization and Management on “search funds,” investment vehicles that buy existing businesses and install a CEO, frequently a recent graduate from business school, to grow it into something more successful. Directors of these companies are the opposite of independent: They are typically recruited for their expertise in operations or finance, own stock in the company and they are expected to weigh in with advice on executive decisions.
They also aren’t afraid to replace management if they decide, in Wasserstein’s diplomatic description, that a young CEO would be wasting irreplaceable early years in their career on the wrong project.
“That’s life,” Wasserstein says of his fellow directors having to fire their hand-picked CEO on occasion. “They represent the owners.”