FREE online courses on Introduction to Strategic Management - Corporate Governance and Stakeholders - Board of Directors

 

The board of directors is a group of elected individuals whose primary responsibility is to act in the owners' interests by formally monitoring and controlling the corporation's top-level executives. Legally, the board of directors has broad powers, which include directing the affairs of the company, punishing (disciplining) and rewarding (compensating) managers and protecting the rights and interests of shareholders (owners). As a result, if the board of directors is appropriately structured and operates in an effective manner, it can protect owners from managerial opportunism.

 

There are several types of people on the board of directors. The company's CEO and other top-level managers represent insiders. Related outsiders are individuals who are not involved in the company's day-to-day operations, but may have a relationship with the company. Examples might include the company's legal counsel, a large customer or supplier, or a close relative of one of the company's top-level managers. Outsiders are individuals who are independent of the company.  They are neither involved in the company's day-to-day operations, nor do they have other relationships with the company. An example of an outsider might be the ‘professional director' (normally a retired senior manager) or a representative of the institutional investors.

 

Because the primary role of the board of directors is to monitor and ratify major managerial actions to protect the interests of owners, there is a call by advocates of board reform that outsiders should represent a significant majority of a board's membership. Although outside directors have become more common in major companies, many critics of board effectiveness complain that boards are shirking their primary fiduciary responsibility to protect shareholders, compromising the board's objectivity, expertise, and motivation.

 

Outside directors (and boards) are perceived as ineffective because insiders continue to dominate boards (by controlling the flow of information to outside directors) and outside directors are nominated for board membership by insiders (primarily by the CEO) and thus are indebted to insiders.

 

The board of directors represents an important internal governance mechanism. Because of the board's importance, the performance of individual board members as well as that of entire boards is being evaluated more formally and intensely. As a result, many boards have voluntarily initiated changes, which include, increasing the diversity of board members' backgrounds, strengthening internal management and accounting control systems and establishing and consistently using formal processes to evaluate the board's performance.

 

The findings from research regarding the effectiveness of board involvement in the strategic decision-making process are mixed, indicating the following:

 

• Board involvement in the strategic decision-making process may improve company performance because it provides the company's mangers with access to outside opinions, and outside directors should be more objective and more interested in protecting shareholders' interests.
• Boards are more likely to be involved in strategic decisions when the company is smaller and less diversified, since information regarding strategic actions is more readily available and both the scope and size of the company are manageable.
• Boards are less active in large, diversified companies.
• The board's access to sufficiently rich information on appropriateness of strategic actions in large diversified companies is limited.
• Board assessments may be limited to evaluating financial outcomes (rather than appropriateness of action).

 

McKinsey & Co. research found that institutional shareholders were willing to pay an 11 percent premium for the shares of companies when outsiders constitute a majority of the board, owned significant amounts of stock, were not personally tied to top management, and when management was subjected to formal evaluation.

 

A research shows that boards working collaboratively with management make higher quality strategic decisions and makes them faster. Recent research suggests that inside director performance increase if they hold an equity position.  The announcement of a new inside director with less than 5 percent ownership decreases shareholder wealth, but an insider with ownership between 5 percent and 25 percent increases shareholder wealth.  Thus, an inside director's knowledge of the company can be used appropriately.  Also, an inside director's connection to the CEO may not protect the CEO if the inside director has a strong ownership position.