Boards of public corporations have more independent directors than ever before. Sixty percent of boards of S&P 500 companies are not only majority independent, but have a single insider on the board: the CEO. While Jamie Dimon is still CEO as well as chair of J.P. Morgan’s board, despite attempts to unseat him, this is becoming increasingly rare. Over the last 15 years, the percentage of S&P 500 firms with separated positions has risen from 16% to 45%.
Director independence has been pushed by institutional investors, exchanges, and also government regulators. The push for independence has continued despite, at best, inconclusive evidence that independent boards improve corporate performance or reduce corporate malfeasanse.
In my forthcoming article The Political Economy of Board Independence, I argue that institutional investors value director independence because it displaces more meaningful reform. Reform is inevitable after corporate scandals and crises. But, the content of that regulation is not inevitable. Shareholders, by and large, want to prevent regulation that would reduce their returns.
Shareholders benefit when firms develop successful products. But shareholders can also benefit from wrongdoing. Price fixing and bribes, for example, boost stockholder returns at the expense of consumers and competitors. Similarly, excessively risky strategies transfer wealth to shareholders at the expense of creditors and employees; shareholders receive all of the upside if the strategy succeeds, but do not bear the full cost of the downside if it does not. Finally, even though shareholders do not benefit from fraud, they are unwilling to spend enough to prevent or discover fraud. As I showed in my previous work, The Cost of Securities Fraud, fraud harms employees, suppliers, rivals, and government. The empirical evidence is clear that the economic consequences of financial reporting fraud are largely borne by non-shareholders.
After the bribery scandals of the 1970s, the accounting scandals of 2001-02, and the 2008 financial crisis, Congress has been convinced to mandate board reforms rather than directly regulating the wrongdoing.
Requiring directors to be independent costs very little compared with alternative regulations, in particular when new laws merely codify existing practices. By 2002, when the Sarbanes-Oxley Act required fully independent audit committees, 94% of S&P 500 firms already had them. By 2010, when the Dodd-Frank Act required fully independent compensation committees, all S&P 500 firms had them.
Reforms involving independent boards have been popular with Congress and regulators for a couple reasons. Independence has connotations of objectivity, expertise, and fairness. It is also familiar, because Congress has relied on independence in a variety of institutions, from the Fed to bankruptcy trustees. Finally, Congress wants to minimize the cost of regulation and independence is inexpensive.
Independence may be inexpensive, but it is also ineffective. Managerial disloyalty is only one type of wrongdoing. Since boards put the interests of shareholders first, the board may not stop wrongdoing that siphons resources from other groups to shareholders. Some corporate wrongdoing may actually benefit shareholders. Other wrongdoing does not benefit shareholders, but shareholders are insufficiently motivated to stamp it out because the costs largely fall on others.
Director independence serves an important political goal by deflecting federal regulation; regulation that might limit rent-seeking or force firms to fully internalize the costs of wrongdoing, such as accounting fraud. Corporate governance reforms embedded in the Sarbanes-Oxley Act should be retired, not because they are too costly for shareholders, but because they are ineffective.
The full article is available here.