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Justin Fox The Curious Capitalist
Who needs a board of directors, anyway?
While contemplating the strange mess that Hewlett-Packard's board of directors has gotten itself into, one of my FORTUNE colleagues asked last week, "Why do companies have boards of directors, anyway?"

Why indeed? I did a little checking (starting with the strenuous act of going to SSRN and searching on "corporate board history"), and discovered that legal scholars have been asking themselves the same question for a while now, and struggling to come up with a convincing answer.

The problem is that the historical purposes for which boards evolved no longer apply, and the task they are now expected to fill--that of vigilant monitors of CEO pay and performance--is one for which they are ill-suited. So why don't we abolish the institution? Perhaps because the two main alternatives just seem so weird. More on that later. But first, a little history.

In a fascinating if very long 2004 article (available as a pdf here) in the Hofstra Law Review, Franklin A. Gevurtz of the University of the Pacific's McGeorge School of Law locates modern boards' historical roots in medieval town councils and guild leaderships (whose memberships often overlapped). The guild boards were mainly occupied with resolving disputes between members--an entirely different function from that of today's boards. But as the guilds evolved into companies of independent merchants, the merchant companies into trading companies in which the merchant-investors pooled their money to outfit ships to sail to faraway ports, and the trading companies into modern corporations, the institution of the board came along for the ride.

Still, as recently as the early 1900s, the board had a pretty clear function. It was the perch from which big shareholders and creditors watched carefully over the men they had hired to manage their companies (as is true today at companies controlled by private equity firms). But the very success of some of these pioneers of industrial capitalism led to the undoing of this model. Corporations outlived their founding shareholders, outgrew the need to borrow money, and, as the stock market captured the public imagination in the 1920s, found their shares in the hands of thousands of small investors in no position to watch carefully over anything. Managers naturally took charge, and boards became appendages entirely beholden to them.

That's how things stayed through the 1960s, and on the whole you'd have to say it worked okay. CEOs decided what to do, boards rubber-stamped their decisions, and the U.S. mostly prospered. In the 1970s, though, the world changed dramatically. Corporate strategies that had worked well in a time of steady growth, low energy prices, and the absence of foreign competition began to founder. The country could probably have used a few strong boards unafraid to change course and throw out a CEO, but those didn't exist. What we got instead was the phenomenon of corporate raiders, junk-bond-funded upstarts who bought floundering companies out from under their managers. In many cases the raiders did a better job of running the companies, in others they drove them into bankruptcy. And in response, corporate executives successfully lobbied state legislatures to make hostile takeovers much harder.

In the meantime, stock ownership was becoming reconcentrated in the hands of huge pension funds and mutual funds whose managers were far less patient and far more able to make their impatience known than small individual investors were. For various reasons, though, they were not willing to sit on corporate boards. So what we got was the modern board, whose members are expected to hire and fire CEOs and monitor their performance on behalf of shareholders, but are themselves mostly part-timers with insignificant ownership stakes who remain more or less beholden to the CEO for their jobs. (The formal legal requirements of the modern board evolved a bit differently, as you can read here, but ended up in pretty much the same place.)

Under pressure from shareholders, some of these boards have thrown out CEOs, perhaps most notably at General Motors in 1993 and HP last year. But there have been far more cases of boards failing to rein in out-of-control chief executives (think Enron, Worldcom, HealthSouth), and a zillion Sarbanes-Oxley Acts won't change that. The incentives simply aren't there for board members to play the role of monitor and do it consistently well.

This is not to say there aren't lots of sage and diligent board members who add value by virtue of the advice and guidance they give. But a CEO who is willing to listen to the sage advice of a board member would presumably be just as willing to listen to the same wise person hired as a consultant. The institution of the board doesn't matter.

So what are the alternatives? Well, there's direct democracy--putting all major corporate decisions, including the choice of a new CEO, to a shareholder vote. And then there's absolute corporate monarchy--allowing management to make all the decisions without oversight. Law professor Gevurtz sees strengths in both. Shareholders "know as much as boards do," he says. On the other hand there are lots of successful investment vehicles (hedge funds, for example) that aren't governed by boards or subject to shareholder votes. Unhappy shareholders can simply vote with their feet.

However, even after observing in his article that boards have a lot in common with tonsils ("a largely useless, if mostly harmless, institution"), Gevurtz shies away from recommending their abolition. Why? Because direct shareholder democracy isn't going to happen (the nation's CEOs would be violently opposed) and corporate monarchy, while perhaps a more honest representation of the true power relationship in corporations, just wouldn't feel right. "If you had self-perpetuating management and no representation, people would question why that was," he says. "There's this feeling that managers shouldn't be in charge of these large aggregations of power, even though that's the way it is." So that's why companies have boards of directors: To make the rest of us accept their existence.

UPDATE: UCLA law professor Stephen Bainbridge has written a detailed analysis of why I'm full of baloney. I will offer up an explanation next week of why there's more to my argument than just processed meat product, but in the meantime check out Bainbridge's cool wine blog. My response is here.
Posted by Justin Fox 9:39 AM 11 Comments comment | Add a Comment

CEO's have their incomes enhanced by being on boards of other firms and having other CEO buddies on their boards. Meetings are usually expense paid boondoggles. In general boards are useless - What did the Pacific Gas & Electric Co. board do to prevent their disasterous collapse?
Posted By Glenn B Smyrna, TN : 11:56 AM  

Very interesting article about the uselessness of boards of directors. However, just ask someone who has a lymphoma that starts in the lymphoid tissues of the tonsils or even someone who just has tonsillitis how harmless tonsils are. Boards of directors are harmful in that they create the illusion of someone watching the store and give an excuse for doing nothing while they let the CEOs steal the store or lose the store through gross incompetence and greed.
Posted By William J.Nowack, Leawood, KS : 12:08 PM  

If I may suggest, google *John Carver equity corporations* and there should pop up an article related to corporate governance for equity corporations. There is also a parallel article on non-profit organizations.

New board members fail to understand immediately that their skills as chief executives must give way to a brand new way of doing things at that level... instead of acting like a council of chief executives (directing a subordinate chief executive), the new board members must become legislators (and this means a new skill set) and through policies, direct the chief executive of the corporation. In other words, the Board provides the "rules of engagement" and the Corporate Captain (CEO) operates within the ROE.

How is that so difficult?

That's my question.
Posted By Ricardo Rojo -- Glendale, AZ : 12:13 PM  

Wouldn't not paying these boards of directors make U.S. companies more efficient and more competitive? I guess executive-level pay will be the last thing to go as we try to compete more and more in the global economy.
Posted By James, San Diego CA : 12:15 PM  

Many (most? all?) boards are technically "elected" by the shareholders. Board members, however, never seem to communicate with the shareholders but simply orbit the executive corporate management (who certainly did not "elect" them).

Boards of Directors tend to be dysfunctional, then, because in most cases they effectively report not to the owners but to managers that the board hired supposedly on behalf of the owners. Truly an incestuous relationship.

There are notable exceptions where a large shareholder (i.e., Kerkorian/GM) has a tame board member for oversight, but by and large the shareholders do not have significant control except by "voting with their feet". All too often the small shareholder has to vote after the stock has tanked due to malfeasance...

With the age of computers, it is possible for board members to provide periodic reports to those shareholders that voted for them. This would at least raise the Board from a general perception of being a sinecure, although it probably would not make a noticeable difference in governance.
Posted By Mike Hocker,Rhinebeck,New York : 12:17 PM  

Imagine a world where boards would be a true gentlemen's/ladies profession by which the members (by law) would not be allowed to own any of that company's stock. Still a prestigious position--and yet better "long term" decision making since the board members be financially detached from the present stock price... One would think there would be much less "slash and burn" and the economy would better stabilize..
Posted By Stu Milford pa : 12:18 PM  

After underwriting director and officer liability insurance policies for over 18 years, I experienced many a director who was on the board as a courtesy (no one would ask him/her to step down); to make him/herself appear active in the community; or for the board fees that were paid for little work and sometimes outrageously big dollars. Those persons with management, legal, accounting, and finance backgrounds were the most valuable. Boards are selected as a representation of the community and to offer advice and make sound decisions. Unless they have a business savvy and experience in areas noted above, they do not offer a lot to the company they are paid to serve. With unlimited terms they begin to usurp their power while doing little to add value. They don't want to give up this role so they stay in good standing with the president/CEO/ Chrmn while letting him/her run the show. Why work for your money when you don't have to? Except in start-up organizations the directors are not even expected to help bring business back to their company. I think boards of directors should provide the service without getting paid for every little meeting they attend, and they should not get paid to fly to costly resorts for "board" meetings. Board fees should be eliminated or just enough to cover their expenses. They should be allowed to serve only if they are actively involved. There should be age limits. Board terms should be limited during company start-up and then be phased out. Why not try something new and different and have only rotating advisory boards filled by shareholders (who know as much if not more than many directors about the company). They should not be allowed to rubber stamp the CEO/Chrmn's wants. Board membership should not be for personal gain or to make a name for themselves. As far as legal issues, in most cases the senior executives make the decisions that result in lawsuits, and the board just agrees to the management actions. Change is good and it's time.
Posted By Kay from Cleveland, Ohio : 1:00 PM  

The failure of the Corporate Board of Directors is best exemplified by the ridiculous increase in CEO pay which over the last 30 years has gone from 43 times their average employee's salary to 500 times. It is a "good old boys" club doing more harm then good.
Posted By Mr. Brook D. Trout, Glendale, CA : 1:13 PM  

Boards would be fine if they were truly elected by shareholders. Can anyone name a board member who lost an "election"? Make the board position lucrative; good for two years max; no staggered terms; and open to anybody. Shareholders aren't stupid. Allow them to elect a slate that will exert control over the corporation, even if it means (gasp!) ditching a bad CEO. One share equals one vote. If the bylaws specify six board members and there are ten candidates, the top six vote-getters win.
Posted By Dale Lamm, Canton Ohio : 2:53 PM  

What we need are real elections for board members. Require board members to state their positions and what they plan to do as board members and let shareholders vote to elect them. Minimum requirements should be required to allow people to run for board membership.

Let's give shareholders a real choice. Current board elections are modeled after the Soviet-style of a simple Yes/No vote. Competition would be helpful and increase accountability.
Posted By Luke Chung, Vienna, VA : 3:02 PM  

Institutional shareholders MIGHT be willing to serve on boards of directors, or elect directors who understand who the owners really are IF the shareholders had access to the ballot. And why shouldn't shareholders, the owners of these companies, have this access? European companies have had significant shareholder access for years, with some major shareholders serving on boards. Has this shareholder participation collapsed the economies of European nations?
Posted By C. Lamar Hartford, CT : 5:02 PM  

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