Chapter 6 Boards.pdf

# Challenges and doubts concerning board effectiveness This section explores the fundamental challenges and doubts surrounding the effectiveness of corporate boards in their oversight and advisory roles. ### 1.1 The theoretical and practical roles of boards Corporate boards are legally vested with ultimate managerial authority, though they typically delegate day-to-day management to executives due to their periodic meeting schedules. Their primary potential roles are monitoring potentially wayward executives and providing advice and counsel on corporate policy and strategy. The corporate governance perspective primarily focuses on the monitoring function, acknowledging that boards are not ideally suited for this task and that much effort is directed towards identifying and assessing potential "fixes". A key assumption is that boards are "unitary," acting collectively as a single body [1](#page=1). ### 1.2 The legal landscape and director categorization In unitary corporate board jurisdictions, corporate law statutes typically allocate managerial authority to the board, with the U.K. being an exception where this is defined in the articles of association. Boards operate as collective bodies through meetings and voting, led by a chair. Individual directors owe duties of care (attentiveness and skill) and loyalty (eschewing self-interest) to the company [2](#page=2). Directors can be broadly categorized into: * **Senior full-time executives** who also sit on the board. * **Outside/Non-executive directors (NEDs)** who are not involved in day-to-day company affairs [2](#page=2). * **Independent directors**, a universally referenced concept in corporate governance codes [2](#page=2). While not being a full-time employee suggests objectivity, it is insufficient to guarantee it. Independence is often defined by the absence of relationships that could create a conflict of interest and impair judgment [3](#page=3). ### 1.3 Roles directors can potentially play NEDs contribute to public companies solely through the board, primarily by advising and monitoring the management team. Shareholders can expect input from NEDs on strategy and its implementation. However, academic research and boardroom reform agendas predominantly focus on the monitoring role. It is understood that boards spend most of their time on monitoring and accountability issues, aligning with survey evidence where directors believe they focus on strategy but actually spend more time on oversight [3](#page=3) [4](#page=4). The rationale for emphasizing monitoring stems from a managerial agency cost logic, where executives might act in self-serving ways at the expense of shareholders. Boards are expected to reduce these agency costs by conscientiously and objectively monitoring management. Outside directors are deemed suitable for this scrutiny due to their potential for impartiality and detachment, as they do not have day-to-day managerial responsibilities [4](#page=4). In companies with dominant shareholders, outside directors may not face the same onus to bolster managerial accountability as their counterparts in widely held firms. However, they can serve as a check on the dominant faction to prevent the extraction of private benefits of control [4](#page=4). ### 1.4 Doubts concerning board effectiveness Despite the theoretical roles, significant doubts exist regarding the effectiveness of boards, particularly concerning objectivity in their monitoring function [4](#page=4). Key concerns include: * **Personal, financial, or professional ties** of NEDs to the company or its controllers, which can bias them against vigilance [4](#page=4). * **The manner in which directors are chosen**, especially in companies with dominant shareholders. Directors require the backing of a dominant shareholder for election or re-election, creating an incentive not to antagonize that shareholder, thereby compromising the monitoring function [5](#page=5). * **Shareholder voting patterns**: Shareholders typically vote in favor of nominated directors, often by large majorities, as voting against directors is seen as a last resort. Incumbent directors often nominate candidates, providing independent directors with an incentive to avoid antagonizing their colleagues [5](#page=5). * **Board composition and balance**: The ratio of executives to independent board members is a concern. Directors prefer unanimous voting, and if independent directors are in the minority, they may only formally exercise a veto if a rift develops among executive directors and those linked to management [5](#page=5). ### 1.5 The board reform agenda In response to potential failures in board effectiveness, a substantial reform agenda has emerged, with board composition, particularly independence, being a central focus [5](#page=5). Reforms include: * **Increased independent director representation**: Between 1990 and 2013, emphasis on director independence increased significantly across 30 countries, though a majority of jurisdictions did not mandate boards with a majority of independent directors by 2013 [6](#page=6). * **Board diversity**: This includes legally mandated gender quotas in nearly 25 countries or states, with the European Union requiring listed companies to have at least 40 percent female non-executive directors or one-third female representation on the board as a whole by 2026 [6](#page=6). * **Separation of CEO and Chair roles**: This is seen as a logical step towards an independent board, as CEOs who also chair are strategically positioned to entrench control by appointing sympathetic members and controlling the agenda [6](#page=6). * **Nomination committees**: To address concerns about self-nomination, the task of selecting candidates can be delegated to committees primarily comprised of independent directors [6](#page=6). * **Specialized board committees**: Nomination, remuneration, and audit committees are considered pivotal for fostering accountability. Audit committees, overseeing financial statements and internal controls, are particularly crucial and often mandated to be comprised exclusively of independent directors (e.g., by U.S. federal securities law and the U.K. Corporate Governance Code) [6](#page=6) [7](#page=7). ### 1.6 The uncertain benefits of board reform While reforms aim to improve board behavior and corporate performance, the tangible benefits are not always clear-cut [7](#page=7). **Empirical evidence on the impact of reforms is mixed**: * **Board diversity**: While a case can be made for improved economic outcomes with more women on boards, empirical evidence remains inconclusive [7](#page=7). * **Monitoring capabilities**: Reforms designed to enhance monitoring may have similar uncertain outcomes [7](#page=7). * **Independent director representation**: A 2017 study found independent directors were in the minority on average in publicly traded firms across most jurisdictions [7](#page=7). * **Board committees**: Audit committees are prevalent, but nomination committees are not universal [7](#page=7). > **Tip:** The effectiveness of reforms often depends on their implementation and the specific context of a company's ownership structure and internal dynamics. Relying solely on formal criteria for independence does not guarantee objective oversight. --- This section delves into the challenges and doubts surrounding board effectiveness, particularly concerning director independence and the structure of board models. ### 1.1 Inconclusive empirical evidence on board independence Despite theoretical benefits, empirical evidence for the positive impact of independent directors on corporate performance or reduction of wrongdoing is surprisingly scarce. Studies suggesting that "better" board governance arrangements lead to superior performance are problematic, as strong performance might influence board structure rather than the reverse [8](#page=8). #### 1.1.1 Reasons for inconclusive evidence * **Difficulty in empirical detection:** Subtle ways in which ostensibly independent directors might be beholden to insiders could escape researchers' detection, thus obscuring the true benefits of independence [8](#page=8). * **Lack of director motivation:** Even genuinely independent directors may lack sufficient motivation if their remuneration is modest and not tied to corporate performance. Outside directors traditionally have had a limited direct economic interest in the company's success, leading to a colloquial view that they have "little reason to break a sweat" [8](#page=8). ### 1.2 Incentive-oriented director pay: pros and cons To address the lack of motivation, increased use of incentive-oriented director pay, such as stock awards, has been recommended and adopted in some jurisdictions like the U.S., where stock awards now constitute over half of director compensation in large public firms. However, there is skepticism regarding this approach [8](#page=8). #### 1.2.1 Doubts regarding incentive-oriented pay * **Insubstantial financial incentives:** For many wealthy outside directors, the amounts involved in performance-related pay may not be substantial enough to significantly alter their motivation, especially compared to their earnings from full-time employment [9](#page=9). * **Counterproductive motivational effects:** Linking director pay closely to shareholder returns could create concerns about retaining positions to cash in, potentially making directors reluctant to speak out freely on crucial issues. This close involvement with financial performance may also lead to a loss of the detached, objective viewpoint that non-executive directors are meant to provide [9](#page=9). ### 1.3 Tension between advisory and monitoring roles A key challenge explaining why theoretically desirable board structures might not deliver beneficial outcomes is the inherent tension between the advisory and monitoring roles of independent directors [9](#page=9). * **Advisory role influencing monitoring:** Directors participating in corporate policymaking may identify too closely with management, making it difficult to act as vigilant, unbiased monitors [9](#page=9). * **Monitoring role hindering advice:** Conversely, directors perceived as tenacious watchdogs by insiders might struggle to operate effectively as advisors. Executives may be reluctant to share information fully if it increases the risk of unwelcome board meddling [9](#page=9). * **Emphasis on control over innovation:** A strong commitment to supervision can lead to a detrimental shift away from executive innovation towards a counterproductive emphasis on control, with the management team facing skepticism rather than receiving support and encouragement [9](#page=9). ### 1.4 The two-tier board model The two-tier board model is presented as a potential solution to the difficulties non-executives face in balancing advisory and monitoring roles on a unitary board [9](#page=9). #### 1.4.1 Basic configuration In a two-tier system, a management board composed of executives is accountable to a supervisory board composed of outside directors. Individuals generally cannot serve on both boards simultaneously. The supervisory board formally approves key corporate policy decisions proposed by the management board. However, the supervisory board is primarily reactive rather than proactive, with the management board proposing and the supervisory board disposing. Germany is a prominent example of a jurisdiction with a statutory two-tier board system under its Stock Corporation Act. The supervisory board (Aufsichtsrat) oversees the management board (Vorstand), with core responsibilities including setting executive pay, approving dividend policy, and exercising veto rights over specified transactions [10](#page=10). #### 1.4.2 Pros and cons of two-tier boards * **Advantages:** * **Clarity for directors:** Non-executive directors' involvement is primarily limited to signing off on the company's basic direction, with the purpose being to prevent mismanagement. This offers substantial clarity compared to unitary boards where advisory roles can be difficult to reconcile with monitoring expectations [10](#page=10). * **Clarity for executives:** Executives can have clearer guidelines on what information to share with the supervisory board, focusing solely on what is needed for effective monitoring [10](#page=10). * **Disadvantages:** * **Loss of advisory input:** The advisory input that non-executive directors can provide on unitary boards, which can improve corporate policymaking, is lost in a two-tier system, potentially to the detriment of the firm [11](#page=11). * **Information deficit for monitoring:** Outside directors on unitary boards may have a better understanding of their companies due to direct involvement in deliberations, which could lead to more effective monitoring than that of German supervisory boards, as exemplified by the Wirecard scandal [11](#page=11). #### 1.4.3 Empirical evidence and convergence Definitive data substantiating the superiority of two-tier boards is lacking. Comparisons between one-tier and two-tier jurisdictions are complicated by numerous other variables affecting corporate performance. France, offering a choice between models, has not shown a clear correlation between board structure and financial results [11](#page=11). However, there are signs of convergence: * **Unitary boards becoming more like supervisory boards:** As independent directors gain importance and numerical dominance on unitary boards, they begin to resemble supervisory boards in two-tier systems, with monitoring management often dominating the agenda [11](#page=11). * **Two-tier boards adopting unitary best practices:** German two-tier boards have increasingly incorporated features common in unitary jurisdictions, such as audit and nomination committees and a majority of independent supervisory board members [11](#page=11). #### 1.4.4 Convergence and choice Many jurisdictions now offer companies a choice between one-tier and two-tier board models. While the one-tier model appears more popular where both options are available, the absence of a clearly superior model makes offering a choice a defensible policy decision [11](#page=11) [12](#page=12). --- # Board reform agenda and its impact The board reform agenda has primarily focused on enhancing board composition and independence to strengthen corporate governance, though the tangible benefits of these reforms are not always conclusive [5](#page=5) [6](#page=6) [7](#page=7). ### 2.1 Rationale for board reform Boards of public companies are intended to act as a check on management and dominant shareholders, but their potential as corporate governance mainstays may be unfulfilled due to inherent limitations. These limitations include potential conflicts of interest among directors, the nomination process that can incentivize directors not to antagonize dominant shareholders or colleagues, and the tendency for shareholders to overwhelmingly approve director slates presented to them. Furthermore, the ratio of officers to independent board members can influence board composition and decision-making, with independent directors in the minority potentially lacking effective veto power [5](#page=5). ### 2.2 Key areas of board reform The primary focus of board reform has been on increasing director independence, which has been described as a "megatrend". Empirical research indicates a significant increase in the emphasis placed on director independence across various countries between 1990 and 2013. However, as of 2013, a majority of surveyed jurisdictions did not require companies to have a board where a majority of directors were independent [5](#page=5) [6](#page=6). #### 2.2.1 Independence While independence is a key reform area, it is not always sufficient to guarantee objectivity. Even with formal independence criteria, directors may lack a sufficiently detached viewpoint if nominated by a management-friendly board. A situation where a board might be considered management-friendly, even with a majority of independent directors, is when the chief executive also chairs the board. CEOs who also chair boards are strategically positioned to entrench their control by appointing sympathetic members and controlling the agenda [6](#page=6). Splitting the CEO and chair roles is seen as a logical step towards developing an independent board. To address concerns about the nomination process, the task of selecting board candidates can be delegated to a nomination committee composed primarily or entirely of independent directors [6](#page=6). #### 2.2.2 Diversity Diversity, particularly gender diversity, has also been a significant aspect of board reform. As of 2023, nearly 25 countries or states had legally mandated gender quotas for corporate board membership, with a dozen more requiring explanations for non-compliance. The European Union is set to require member states to implement laws by 2026 mandating listed companies to have at least 40 percent female non-executive directors or one-third female representation on the board as a whole [6](#page=6). #### 2.2.3 Board committees Three board committees are typically identified as pivotal for fostering accountability: nomination, remuneration, and audit committees [6](#page=6). * **Nomination committees:** These committees can help address concerns about the board's self-nomination process. Most jurisdictions instruct public company boards to establish nomination committees with independent directors predominating. However, nomination committees are not universally present [6](#page=6) [7](#page=7). * **Remuneration committees:** These committees will be considered elsewhere [6](#page=6). * **Audit committees:** These committees oversee the preparation and auditing of financial statements and review internal control and risk management systems. They are described as the most important of the three key committees and an "indispensable" feature of sound corporate governance. U.S. federal securities law requires publicly traded companies to have an audit committee comprised exclusively of independent directors. The U.K. Corporate Governance Code also mandates this, with a comply-or-explain approach. More than three-quarters of jurisdictions surveyed in a 2017 study directed publicly quoted companies to establish an audit committee [6](#page=6) [7](#page=7). ### 2.3 Impact and outcomes of board reform The reform agenda has led to an increase in the number of women on boards, with them now holding more than a quarter of all board seats in larger public companies. Anecdotal evidence suggests that the emphasis on independence has also resulted in a cross-regional increase in the percentage of directors labeled independent. A 2020 study indicated that nearly two-thirds of directors qualified as independent and that the chair/CEO roles were split in a substantial majority of cases [7](#page=7). However, the evidence for substantial change is not entirely clear-cut. A 2017 study found that independent directors were in the minority on average in publicly traded firms in most of the 22 jurisdictions examined. Cross-country empirical evidence for board committees is less available, but audit committees are now prevalent and considered a mainstay in publicly traded firms [7](#page=7). #### 2.3.1 Uncertain benefits While a plausible case can be made that increased boardroom diversity, particularly the inclusion of more women, could improve economic outcomes, the empirical evidence remains inconclusive. Similarly, the tangible beneficial outcomes of reforms aimed at enhancing the board's monitoring capabilities are not always clear. Corporate governance logic regarding improved monitoring and reduced agency costs does not always translate into demonstrable benefits [7](#page=7). --- # Comparison of one-tier and two-tier board structures The comparison of one-tier and two-tier board structures addresses how different organizational frameworks for company oversight can impact corporate governance and performance. ### 3.1 One-tier board structures One-tier board structures, also referred to as unitary boards, are characterized by a single board of directors responsible for both management oversight and strategic decision-making [9](#page=9). #### 3.1.1 Challenges in one-tier boards A key challenge in one-tier boards is the potential tension between the advisory and monitoring roles of non-executive directors (NEDs). When NEDs participate in corporate policymaking, they may identify too closely with management, hindering their ability to act as objective monitors. Conversely, if NEDs are perceived as overly critical "watchdogs," their effectiveness as advisors can be diminished. This duality can lead to situations where the focus shifts from beneficial innovation to counterproductive control [9](#page=9). #### 3.1.2 Director remuneration in one-tier boards The link between director pay and company performance in one-tier boards can be problematic. The financial incentives may not be substantial enough for outside directors, who often have significant wealth from their primary careers. Furthermore, strong performance-related remuneration could make NEDs reluctant to raise controversial issues, fearing jeopardization of their lucrative positions and thus compromising their independent oversight. This can lead to a loss of the detached, objective viewpoint that NEDs are intended to provide [9](#page=9). ### 3.2 Two-tier board structures The two-tier board structure separates the functions of management and oversight into two distinct boards: a management board and a supervisory board [10](#page=10). #### 3.2.1 Basic configuration In a two-tier system, the management board (Vorstand in Germany) is composed of company executives and is accountable to the supervisory board (Aufsichtsrat in Germany). The supervisory board consists of outside directors and is responsible for selecting the members of the management board. Crucially, an individual cannot serve on both boards simultaneously. The supervisory board's role is to formally approve key corporate policy decisions proposed by the management board. This structure is often described as the management board proposing and the supervisory board disposing [10](#page=10). #### 3.2.2 Germany as a prominent example Germany is a jurisdiction most associated with the two-tier board model, having adopted it in the late 19th century. The German Stock Corporation Act mandates this structure for publicly traded companies. Under this act, the management board must report specified items, such as intended business policy and annual financial statements, to the supervisory board. The supervisory board's core responsibilities include setting executive pay, approving dividend policy, and exercising veto rights over certain transactions [10](#page=10). #### 3.2.3 Advantages of two-tier boards A significant advantage of the two-tier model is the clear separation of roles, resolving the tension faced by NEDs in one-tier systems. Outside directors on the supervisory board focus on approving the company's basic direction and acting as watchdogs to prevent mismanagement, thereby largely eliminating the advisory role that can conflict with monitoring duties. This clarity extends to senior executives, who have a clearer understanding of what information is needed by the supervisory board for effective monitoring [10](#page=10). #### 3.2.4 Disadvantages of two-tier boards The theoretical disadvantages of two-tier boards are the inverse of their advantages. The loss of direct advisory input from outside directors can detract from corporate policymaking, potentially to the detriment of the firm. Furthermore, supervisory boards may have less detailed knowledge of company operations compared to directors on a one-tier board, as they are not directly involved in all deliberations. Evidence from high-profile failures, such as the Wirecard accounting scandal, has highlighted that monitoring by German supervisory boards has not been flawless [11](#page=11). #### 3.2.5 Empirical evidence and convergence There is a lack of definitive data to prove the superiority of either one-tier or two-tier board structures. Empirical comparisons are difficult due to numerous confounding variables. While France offers companies a choice between both models, studies have not found a clear correlation between board structure and financial results [11](#page=11). There is evidence of convergence between the two models. Unitary boards, with a growing numerical dominance of independent directors, increasingly resemble supervisory boards. Conversely, German two-tier boards have adopted practices common in unitary jurisdictions, such as establishing audit and nomination committees and emphasizing director independence, in line with the German Corporate Governance Code. This convergence suggests that the distinctions between the two models may be blurring [11](#page=11). ### 3.3 Choice and popularity Many jurisdictions now offer companies a choice between one-tier and two-tier board models. While both options are available, the one-tier model appears to be more popular in practice. However, given that neither structure is definitively superior, offering a choice is considered a defensible policy decision [11](#page=11) [12](#page=12). --- ## Common mistakes to avoid - Review all topics thoroughly before exams - Pay attention to formulas and key definitions - Practice with examples provided in each section - Don't memorize without understanding the underlying concepts

| Term | Definition | |------|------------| | Unitary Board | A board structure where all directors are members of a single body, acting collectively. This is contrasted with a two-tier board system. | | Two-Tier Board | A corporate governance structure comprising two distinct boards: a management board (Vorstand) responsible for day-to-day operations and a supervisory board (Aufsichtsrat) tasked with monitoring the management board. | | Managerial Authority | The power and right vested in a board of directors to manage a company's affairs. Corporate laws in many jurisdictions specifically allocate this authority to the board. | | Monitoring Function | A primary role of corporate boards, particularly non-executive directors, focused on overseeing and scrutinizing the actions of company executives to ensure they act in the best interests of the company and shareholders. | | Advisory Function | A role of corporate boards where directors provide guidance, counsel, and strategic input to the management team on matters of corporate policy and strategy. | | Non-Executive Director (NED) | A director who is not involved in the day-to-day management of the company. NEDs are expected to provide independent oversight and advice. | | Independent Director | A non-executive director who is free from any business, family, or other relationship with the company, its controlling shareholder, or management that could impair their judgment. This is a key concept in corporate governance codes. | | Agency Costs | Costs incurred by a company due to conflicts of interest between management (agents) and shareholders (principals). Boards are expected to reduce these costs through monitoring. | | Shareholder Protection Index | A metric used to analyze trends in how well shareholders are protected across different countries. It often includes variables related to board composition and director independence. | | Board Composition | The makeup of a corporate board, including the proportion of independent directors, executive directors, and considerations of diversity such as gender. | | Gender Quotas | Legal mandates or requirements for a minimum percentage of women to serve on corporate boards, aimed at increasing gender diversity. | | Nomination Committee | A board committee, often comprised primarily of independent directors, responsible for selecting and recommending candidates for board membership. | | Dominant Shareholder | An individual or entity that holds a significant enough portion of a company's shares to exert considerable influence or control over its decisions and the election of directors. | | Independent Directors | Directors who are free from any business or other relationship with the company or its management that could, or could reasonably be perceived to, interfere with the exercise of their independent judgment. | | Board Reform Agenda | A set of proposed or implemented changes aimed at improving the structure, composition, and functioning of corporate boards to enhance corporate governance and performance. | | Remuneration Committee | A committee of the board of directors responsible for determining the compensation of executive directors and senior management, often comprised of independent directors. | | Audit Committee | A committee of the board of directors responsible for overseeing the financial reporting process, internal controls, and the audit of the company's financial statements, usually composed exclusively of independent directors. | | Monitoring Model | A perspective on corporate boards that emphasizes their primary role in overseeing management and ensuring accountability, often through the appointment and active participation of independent directors. | | One-tier board | A corporate governance structure where all directors, both executive and non-executive, sit on a single, unitary board responsible for both management oversight and strategic decision-making. | | Management board | In a two-tier system, this board is comprised of company executives who are responsible for the day-to-day management and operations of the company. | | Supervisory board | In a two-tier system, this board consists of outside directors who are responsible for overseeing the management board, approving key corporate policy decisions, and setting executive remuneration. | | Executive directors | Directors who are also employees of the company, typically holding senior management positions, and are involved in the day-to-day running of the business. | | Corporate governance | The system of rules, practices, and processes by which a company is directed and controlled, involving the balancing of the interests of a company's many stakeholders. | | Shareholder returns | The profit or loss an investor realizes on an investment, typically expressed as a percentage of the initial investment. | | Agency cost theory | A theory that explains the relationship between principals (e.g., shareholders) and agents (e.g., management) and the costs that arise from conflicts of interest between them. | | Stakeholder-oriented assessments | An approach to corporate governance that considers the interests of all parties who have a stake in the company, including shareholders, employees, customers, suppliers, and the community. | | Convergence | In the context of board structures, this refers to the tendency for different models (e.g., one-tier and two-tier) to adopt similar features and practices over time. |