Independence at a price

February 9, 2007

What does the demand to appoint independent non-executive directors mean in practice?

In public companies, non-executive directors are intended to prevent a concentration of power with the chief executive officer and/or senior executive directors of the firm. To act as an effective counterweight to the executive membership of a board, non-executive directors are presumed to be independent from the firm. But, how is this independence achieved in practice?

Following a string of financial scandals including those of Enron and WorldCom, Derek Higgs was commissioned by the UK government to review the role and effectiveness of non-executive directors. Higgs’ report, which served as the basis for the Combined Code on Corporate Governace proposed that nomination committees should ‘consider candidates from a wide range of backgrounds and look beyond the “usual suspects”’.

The implicit assumption here is that if non-execs come from outside the social networks of the existing directors, it is more likely that they would be independent. Unsurprisingly, numerous services sprung up, offering to match potential NEDs with companies looking to satisfy the regulatory demands (for example).

But, what does the demand to ‘diversify the boards’ really do to nomination practices? The Combined Code asks the firms to appoint non-executive directors from backgrounds that are different from those from which non-execs usually came. Diversity, in effect, is understood and practiced as social distance: the more remote a candidate is from the firm, the more independent she or he are deemed to be.

Of course, social distance comes at a price. The more distant one is from a social realm, the less one would know about it. This introduces an inevitable trade-off the firms. The more knowledgeable the NED they appoint would be, the more likely it is that she or he would be seen as ‘too close’ and would not be recognized by the Code as independent. Conversely, appointing a person who is remote from the firm’s realm of activity may result in the appointment of someone who is virtually clueless about the nature of the business.

The result is that the current regulatory demands turn the recruitment of non-executive directors into a utility-maximization (or damage-minimization) exercise. Firms are asked, in practice, to find the ideal candidate, one who would be stranger enough to the firm to be regarded as independent, but not too ignorant about the commercial activity to stifle the operation of the board.

4 Responses to “Independence at a price”

  1. danielbeunza Says:

    Hilarious. It is like, “let’s hope our next independent director is not too dumb!”

    More seriously, the underlying question is how social distance and expertise are related. Similar issues always came up whenever an activity gets bureaucratized: people from outside the community are deemed unknowledgeable.

    But what specific expertise is required for being a good director? Maybe not even industry knowledge is required.

    All in all, it seems to me that this makes for an excellent network/STS study of board directors.

  2. Yuval Says:

    Spot on, Daniel. Just to reiterate. There are two interesting issues underpinning this issue. First, you evoke there the relationship between expertise and social distance in relation to corporate governance. Second, there is the more general issue of expertise in this ‘negative-knowledge’ environment. That is, an environment where one is valuable not for their knowledge, but for their relative lack of knowledge (or at least for indications for relative lack of knowledge).

  3. brayden Says:

    This is actually a great argument for putting more academics on boards. Among academics you would find ideal board members who are both socially distant and somewhat knowledgable about the particular industry/organization. And besides, you probably wouldn’t have to offer as much compensation to academics to sit on boards.

    Isn’t the other problem with this scenario that boards now have more responsibilities (and therefore are required to have more knowledge) than was true in the past? It used to be that boards were much like social clubs than real jobs. But with the latest wave of corporate scandals, boards are held accountable by shareholders for the misdeeds of their employees/executives. You can’t get away with being ignorant about industry issues if shareholders expect more micro-management out of boards.

  4. yuvalmillo Says:

    Yes, this does make a case for academics to become NEDs. In fact, if you follow the link to the NED exchange, you’ll see that they target this segment of the market specifically.

    About responsibilities, expertise and other questions: I will post a more detailed answer to this later on, but here I would like to say that when we tackle this issue we have to remember that, as many other regulatory arenas, we have an inherent conflict of interests. The ideal type of the NED, according to the executives, is someone who would give them as less trouble as possible in running the corporation as they see fit. The regulator, on the other hand, would like to avoid more corporate scandals and wants to see the executive power limited. More discussion about this issue can be found here – http://www.lse.ac.uk/resources/riskAndRegulationMagazine/magazine/winter2006/treadingTheBoards.htm


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