A Team Production Approach to Corporate Law and Board Composition

Bernard S. Sharfman & Steven J. Toll[*]

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In today’s world of corporate governance, the board of directors of a publicly held firm[1] (public company) will almost certainly be made up of a majority of independent directors.[2]  For example, both the New York Stock Exchange and the NASDAQ require that a public company’s board have a majority of independent directors and that the major corporate board committees—audit, compensation, and nominating—be composed entirely of independent members.[3]  Moreover, both stock exchanges require that directors meet certain subjective and objective criteria before they can be considered independent.[4]  In addition, proxy advisory companies, those companies that help shareholders decide how to vote on company matters, have their own enhanced independence guidelines.[5]  This movement toward increased board independence began during the 1990s but was given a big boost by the Enron scandal.[6]  It is also a reflection of society’s evolving understanding of how a public company is to be governed.  As so well expressed by Professors Margaret Blair and Lynn Stout, “[t]he notion that responsibility for governing a publicly held corporation ultimately rests in the hands of its directors is a defining feature of American corporate law; indeed, in a sense, an independent board is what makes a public corporation a public corporation.”[7]  As discussed below, it allows the board of a public company to act as a “mediating hierarchy;” that is, as an arbiter of disputes between the various stakeholders that constitutes a public company.[8]  Moreover, many believe that independent boards can better monitor managerial opportunism and enhance firm performance relative to management dominated boards.[9]

If independence is critical, then one option to ensure board independence is to require that a board be composed solely of independent directors.  However, this is problematic because an all independent board would lack the insights, knowledge, and understanding of those who know the company best.  This would cause more harm than good in board decision-making.  Therefore, a corporate board composed of a majority but not entirely of independent directors appears preferable.

But having a majority of independent directors means nothing unless these independent directors also exercise “independence of mind.”[10]  They must be able to make independent judgments without being overly influenced by inside directors and executive management.  This, of course, is easier said than done.  Moreover, “independence does not consider how the directors will contribute to the board’s understanding of the firm’s core capabilities” and thereby help optimize firm performance.[11]  Thus, independence in itself provides little in the way of guidance on how independent board members are to be selected.

Dysfunctional Deference and Board Composition: Lessons from Enron

By Bernard S. Sharfman & Steven J. Toll[*]

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Introduction

It has been over seven years since the public was first made aware that Enron (or the “Company”) was a troubled firm,[1] ultimately doomed to bankruptcy and much litigation, both civil and criminal.  Yet, the Enron debacle continues to fascinate researchers and the general population alike.  Over the one-year period from September 3, 2007 to September 3, 2008, the Social Science Research Network has posted seventy-one papers that referenced Enron in their abstracts.[2]  What appears most baffling to many observers, especially those interested in corporate governance, is the inability of Enron’s board of directors to get a handle on the massive fraud that occurred under its watch.  For example, Charles M. Elson, director of the Center for Corporate Governance at the University of Delaware, stated in regard to the repeated warning signs that the Enron board received during this time, “[t]hey should have inquired further,” and “[t]hey were unwilling to ask and pursue tough questions.”[3]  However, for all the research done, a satisfactory explanation has yet to be provided for why the Enron board—once considered one of the best boards of a large publicly held firm[4] in the United States[5]—failed to detect the fraud that ultimately destroyed the company.

Something was obviously amiss at the top of the Enron pyramid.  We assert that it had something very much to do with the composition of the Enron board, despite the largely impressive backgrounds of its individual members.  We, of course, are not alone in this opinion, as the fall of Enron has led to enhanced independence requirements for board members.[6]

We certainly endorse the board member independence requirements of the stock exchanges and the enhanced independence guidelines as recommended by proxy advisory companies that have developed as a response to the Enron scandal.[7]  Nevertheless, it is our position that corporate boards of publicly held firms would be better off and less prone to error if other rules or guidance were in place that required or strongly encouraged corporate board nominating committees to select members who were less prone to what we refer to below as “dysfunctional deference.”  To implement this critical change, we recommend: (i) limiting the number of former or current executive officers allowed to serve as outside directors; (ii) setting term limits for outside directors; (iii) diversifying the background of outside directors; and (iv) requiring outside directors to spend a minimum amount of time on board business.