In this paper, Seven Gaping Holes in Our Knowledge of Corporate Governance, from the Rock Center for Corporate Governance at Stanford, the authors observe that it "is extremely difficult to produce high-quality, fundamental insights into corporate governance." Why is that? Well there are lots of reasons. According to the authors, instead of the theory, measurement and analysis that you might expect—given that corporate governance is a social science—the "dialogue about corporate governance is dominated by rhetoric, assertions, and opinions that—while strongly held—are not necessarily supported by either applicable theory or empirical evidence." And even empirical work from academics has serious shortcomings, often detecting a pattern that is not amenable to specific application or making findings that are too specific to generalize. Or, studies might find correlation but not permit attribution of causation; or it may be hard to suss out key variables that may not be publicly observable. As a result, there remain "central issues where insufficient or inadequate study has left us unable to answer basic questions, and where key assumptions relied upon by experts have not been verified or validated." The paper attempts to identify some of them and home in on potential further areas of study.
1. First up, what makes boards effective? Notwithstanding all the research that has been done, the authors contend that we really don't know what makes for effective boards. They identify two areas of research: board composition and board practices. There has been a lot of research on board composition—combined CEO/chair positions, classified board, director tenure, diversity, board size, director age, professional qualifications, active or retired CEOs, and what the authors refer to as "busy directors." (Overboarding? Too many jobs? Too many hobbies?) However, the authors contend, there is "little convincing evidence" that structural attributes of the board have a causal effect on board quality. On that list, only "busy directors" was found to be associated with an outcome—it was an impediment to board effectiveness—the rest were not, or were only loosely, associated with outcomes. Do effective board leaders have similar backgrounds, skills or approaches? The authors suggest that there is "little understanding of how board practices contribute to board effectiveness." These might include the types of practices that make good board leaders, such as skills in "agenda setting, inviting full participation, directing thoughtful discussion, and guiding toward a decision." In addition, the authors contend, we don't have much "insight into board practices such as information flow, performance oversight, and risk detection," an area where failure can lead to tragedy, as we know from several recent Caremark claims against directors, when directors were alleged to have failed to act on red flags or failed to establish reasonable board-level systems of monitoring and reporting. How did these breakdowns occur? According to the authors, there has been little "systematic study" of the impact on decision-making and company performance of steps taken to improve information access and delivery. The authors ask "[w]hat practices—in terms of board leadership, meeting management, and information flow—are most likely to improve board quality? How can these be measured and demonstrated in a rigorous manner? Is it possible to study the social interactions among board members to understand how they contribute to board success or failure?"
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In In re The Boeing Company Derivative Litigation, after two disastrous and tragic crashes, the question before the Delaware Chancery Court was whether the plaintiffs had adequately alleged that the board bore any responsibility. In a 103-page opinion, the Court concluded that the answer was yes—under In re Caremark International Inc. Derivative Litigation and Marchand v. Barnhill, as a result of the directors' "complete failure to establish a reporting system for airplane safety," or "their turning a blind eye to a red flag representing airplane safety problems," the board faced a "substantial likelihood of liability for Boeing's losses." (See this PubCo post.")
In Marchand v. Barnhill, Blue Bell Creameries, a large manufacturer of ice cream, experienced a listeria outbreak, which infected its products and led to the death of three people. A stockholder sued derivatively, alleging, among other things, that the directors breached their fiduciary duty of loyalty under Caremark. Then-Chief Justice Strine, writing for the Delaware Supreme Court, held that the complaint alleged "particularized facts that support a reasonable inference that the Blue Bell board failed to implement any system to monitor Blue Bell's food safety performance or compliance. Under Caremark and this Court's opinion in Stone v. Ritter, directors have a duty 'to exercise oversight' and to monitor the corporation's operational viability, legal compliance, and financial performance. A board's 'utter failure to attempt to assure a reasonable information and reporting system exists' is an act of bad faith in breach of the duty of loyalty." (See this PubCo post.)
2. What factors contribute to director independence? The authors observe that independent board oversight is "critical to the fair representation of shareholder and stakeholder interests." To that end, stock exchanges impose listing requirements for independence that include attributes related to work, comp or business relationships, and proxy advisory firms add requirements to those of the exchanges. But are those really the right indicia? Perhaps not, according to the authors. They contend that "[m]ost studies find very modest or no relation between independence and corporate outcomes, calling into question the reliability and validity of these common standards." However, research has shown that factors such as "social connections between the board and insiders can impair the 'independent' judgement of directors. Similarly, the power of the CEO relative to individual board members can also compromise independence." In addition, factors "such as the financial wealth of directors, personal qualities, and character" could have some influence over directors' "ability to maintain an independent perspective in boardroom deliberations," but these are not factors that have been measured. The authors suggest that "deeper understanding of the factors that foster true independence of thought among board members" would be instructive.
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In papers in 2019 and 2015, the same authors delved a bit deeper into this issue, contending that independent judgment—but not necessarily as defined in exchange listing standards—can improve board oversight. "The research literature," they observed, "is highly mixed on this point." Directors can be indebted to management in ways not expressed in the usual independence standards, through a kind of "social dependence" in terms of work experience, education and background. In their earlier article, the authors posited that "people who share social connections feel psychological affinity that might bias them to overly trust or rely on one another without sufficient objectivity." In that study, which sampled directors of Fortune 100 companies between the years 1996 and 2005, the study authors found that "social dependence is correlated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulates earnings to increase his or her bonus. They conclude that social relations compromise the ability of the board to maintain an arm's-length negotiation with management, even if they are independent by NYSE standards." (Of course, the NYSE definition recognizes the limitations of its definition and advises that, in determining independence, all relevant facts and circumstances be considered.) One study showed that companies with a high percentage of directors appointed during the current CEO's tenure (who tend to be less independent, or "co-opted," than those appointed previously) have "higher CEO pay levels, lower pay-for-performance, and lower sensitivity of CEO turnover to performance." And yet another study demonstrated that powerful directors (those with large professional networks and lots of opportunities) are "associated with more valuable merger-and-acquisition decisions, stricter oversight of CEO performance, and less earnings management." (See this PubCo post and this PubCo post.)
However, are too many independent directors necessarily a good thing? In a 2013 article in the NYT, "The Case Against Too Much Independence on the Board," the DealProfessor argued that board "independence, like innovation itself, can be too much of a good thing." In decades past, corporate boards were populated primarily by CEOs and their handpicked friends and colleagues. Not so much these days, when the independent director "dominates the corporate board." While the presence of independent directors has been widely viewed as favorable to shareholders, the author contends that "studies have been unable to find that their presence results in better returns for shareholders. ...[Recent studies] largely find that the good effects from majority independent boards disappear with 'super independent' boards. Such companies are less profitable. At least one study has found that the more oversight a board provides, the better monitoring that results but the worse the performance, regardless of whether it is independent or not." The author observed that those favoring a greater proportion of insiders on boards assert that "independent directors often are simply not up to the task of knowing the company as well as the executives.....[W]hen you remove insiders from the board, the outside directors lack the knowledge and experience to steer the company appropriately. According to the DealProfessor, the "quest for super independence... means that boards are losing the inside expertise they may need to properly run the company. Independent directors may be good in some measure, and no one wants to go back to the old days of crony boards. But perhaps it is time to temper the enthusiasm for all independent directors, all the time." (See this Cooley News Brief.)
3. Is the labor market for CEOs efficient? The authors define an efficient labor market as "one in which the supply and demand for talent are roughly in balance, information on the requirements of the job and the qualification of candidates is available, and, through a matching process, candidates select into a job suitable to their talents and are compensated an appropriate amount for their labor. If the match turns out not to be a good fit, either party can terminate the relation and a new matching process takes place." But that definition doesn't seem to describe the current market for CEOs: according to the authors, research shows that termination and hiring are slow and that the candidate pool is small with inadequate information on the quality and attributes of candidates. In an inefficient market, the authors say, "distortions can arise in the balance of power between the CEO and the board. Management will face less pressure to perform, with the board unwilling to terminate an underperforming CEO for fear that an adequate replacement might not be available. A tight labor market would also explain high compensation levels [and] might also explain why some companies find it difficult to compare the relative qualifications of internal talent (whose track record is well known) and external talent (whose financial performance is known but whose organization fit is more uncertain)." More insights into "how the CEO labor market actually works" would be useful. In addition, the authors ask, "[h]ow scarce is CEO talent, and how difficult is it to identify the most qualified individuals in terms of skill, experience, and fit? What steps can be taken to improve the matching process between candidates and companies?"
4. What is the value of a CEO? CEO comp is highly controversial, with criticism arising out of the CEO pay gap compared to average workers and even compared to next-level executives. Mega-grants to CEOs of stock and options also regularly come in for criticism. But, the authors observe, we "simply do not know the value of the CEO to an organization and what pay levels are appropriate for this employee." While research has focused on making various comparisons to other professions and to the growth in company size, the authors argue that these comparisons and correlations don't really tell us whether the comp is fair. How much of any increase in corporate value should be attributed to the CEO is a widely debated topic. The authors suggest there are two opposing theories of CEO pay, and research exists to support both theories: "the 'rent extraction view' of pay (in which management is seen as entrenching itself in the organization and extracting pay beyond what is economically merited)" versus "the 'pay-for-performance view' (in which the board negotiates an appropriate compensation structure through an arms-length process to encourage value creation, with monitoring mechanisms in place to prevent rent extraction)." At this point, the authors contend, "we do not know the 'correct' amount that should be offered to a CEO." The authors ask "[h]ow should we measure the level and incentive value of CEO compensation? How much impact do the efforts of an individual CEO have on the performance of an organization overall? How much value is the CEO directly responsible for creating?"
5. How should pay and performance be aligned? How should pay be tied to the achievement of outcomes, including the form of payment (cash or equity), metrics, time horizon and other restrictions? The authors maintain that the choices of cash versus equity and the form of equity "have a direct bearing on the incentives and risk premium in the compensation level of the individual." For example, cash is less risky than equity, but equity may offer more potential compensation and therefore more incentive. Other decisions relate to the time horizon (short- or long-term) and conditions, such as whether vesting should be time- or performance-based. If performance metrics are used, should they be financial (such as earnings), nonfinancial (such as ESG) or a mix, and how should the goals should be weighted, typically "based on the importance of each metric for motivating the CEO to accomplish strategic corporate objectives"? Moreover, if there are "severe economic or market disruptions" that prevent the CEO from achieving the objective of the metric, the board will face a choice about whether or not to offer a discretionary bonus as a reward for the CEO's efforts, so that the CEO "'suffers' alongside common shareholders." Other decisions identified by the authors relate to clawbacks, hedging and pledging of shares. The authors assert that there have been few attempts to "step back to ask the basic questions of whether compensation contracts need to be this complex, whether complexity increases or possibly decreases the incentive to perform, whether complex pay programs strengthen or weaken the alignment between executives and shareholders, or even how to measure compensation when its design is this complex (expected, earned, realized, etc.)" The result, the authors suggest, has been lengthy disclosure, copy-cat behavior and investor confusion, along with a call for "clearer methods for aligning pay and performance and for communicating this relation to shareholders." As the authors note, the SEC "updated disclosure requirements in 2022 to provide a clearer (although not necessarily more accurate) description of the relation between CEO pay and performance. Whether this new disclosure improves our understanding of pay and performance remains to be seen." (See this PubCo post.) In light of the controversial nature of CEO pay, "this would be a good time to uncover how pay is actually set and why it is set in this manner."
6. What is the effect of the composition of the shareholder base on corporate decisions and performance? Are some shareholders better for the company? The authors aren't talking here about politics, but rather differences in investment "time horizon, activeness, objectives, and engagement," which may "influence their preferences for use of capital (distributions versus investment), their interest in company-specific governance choices, and their willingness to engage on corporate policy." What's not known is the impact of these differences. The authors cite research showing that companies think that having a base composed of long-term shareholders would cause their stock price to trade higher. Some research shows that a high proportion of short-term investors can result in "higher stock price volatility than companies with long-term (index) investors." Other research supports the idea that companies with a "dedicated investor base are less likely to be misvalued," and that investors "with both a long-term orientation and an interest in individual company policy... exhibit superior performance and governance choices." But researchers don't know which attributes are most relevant or how to categorize investors on that basis. For example, "passive" investors may tend to be long-term investors, but are also "associated with decreased monitoring and deference to management," while "activist" shareholders may tend to challenge management but are often "accused of being short-term oriented, discouraging long-term investment, and encouraging a sale to realize short-term gains." Adding further complication, some activists are "quiet," taking a "significant minority stake in the firm, join[ing] the board, and engag[ing] with the company in a constructive, analytical, and advisory capacity." Similarly, some engaged founders can exert influence by serving on the board or "shepherd[ing] the culture and direct investment; however, we also see breakdowns of these over time, situations where they use their influence for self-interested gain. For this reason, founders who retain voting rights in excess of their ownership percentage (dual-class shares) are subject to criticism, but we know little about the circumstances under which dual-class ownership is favorable or unfavorable." The authors conclude that knowledge of the impact of the composition of the shareholder base is "highly incomplete."
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In this 2018 article in the WSJ, the authors discuss the challenges companies encounter when they try to make long-term investment decisions in the face of short-term market pressures: the debate between short-term and long-term thinking on Wall Street "is a key concern for chief executives trying to justify major capital investments that can take years to pay off. Long-range strategies can be hard to pull off in an era when Wall Street is fixated on three-month reporting periods." Should companies try to please long-term investors or investors who are "playing the quarterly game?" What about hedge-fund activists that threaten to force the company to adopt a short-term perspective? A McKinsey study cited in the WSJ article found that 75% of shareholders are considered long-term investors. However, 51% of CEOs surveyed said they feel the "most pressure to deliver strong financial performance" within a year, and 36% felt they had a window of one to two years. Only 9% thought they had three years or more to show results. In addition, when comparing actual strategic-planning horizons against their ideal horizons, 44% said that their current horizons were under two years, 41% said they were three to four years and only 11% had actual planning horizons beyond five years. Ideally, however, 37% selected a horizon that was under two years, 37% would like to plan for a three-to-four-year horizon and 23% hoped to plan for periods beyond five years. (See this PubCo post.)
7. How should companies weigh the interests of stakeholders as compared with those of shareholders? The authors make the point that while governance models in the U.S. have largely been viewed as "shareholder-oriented with a primary focus on stock-price appreciation," the rise of ESG has, in many ways, compelled companies to reconsider that model and, in some cases, to shift "at least superficially—...toward a more stakeholder-oriented approach." The authors contend that ESG is, in part, driven by an assumption that a corporate focus only on shareholder returns leads to environmental and social costs that are "ultimately borne by society, as opposed to shareholders," as well as a short-term focus, "underinvesting in operations, infrastructure, and supply chain with the result that long-term risk is heightened." However, the authors contend, whether these are accurate criticisms is not known, with research supporting and opposing these assumptions. While companies have probably always taken some ESG concerns, such as employee welfare and corporate reputation, into account, the "question is whether companies have done so to a sufficient degree and whether a higher level of investment to satisfy stakeholder objectives is required." Research on "the economic ramifications of higher stakeholder investment, including how much more should be spent, the impact this would have on productivity and value creation, and how the costs and benefits would be distributed across society," has been mixed. Some research even suggests that a "dual mandate to serve both shareholders and stakeholders allows management to sidestep accountability to either, with the potential to increase costs on shareholders and stakeholders alike—counterproductive to the very objective of advancing the broader set of interests that ESG advocates embrace." Relative to current practices, the impact of ESG on shareholders and stakeholders, the authors suggest, is unknown. The authors ask "[h]w much investment would be required to improve stakeholder outcomes? What would be the costs and benefits of this investment, and how should the costs be distributed through society? Would any of this improve outcomes for shareholders or society relative to what they currently enjoy?"
In conclusion, the authors acknowledge that, despite much research, we still have many unanswered questions about corporate governance, as discussed above. The authors ask "[w]hat new methods should researchers employ to answer these questions? How can greater collaboration between researchers and corporate practitioners free up the data and information needed for rigorous study of these topics? Do companies view the legal and compliance issues associated with this type of research too large for such research to succeed?"
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