Corporate governance experts and investors are often quick to blame the board of directors for bad decisions by a company's management team. Research suggests, however, that shareholders and regulators may expect more than current corporate boards can deliver.
We examined almost 300 research articles that explored the effectiveness of monitoring by boards from different disciplines such as finance, industrial organisation, psychology, sociology, and management, and across different types of organisations. Our findings, which were initially published in 2016 in the Academy of Management Annals ("Are Boards Designed to Fail? The Implausibility of Effective Board Monitoring"), identify ten barriers preventing boards from being effective.
One of the key functions of a board of directors is to monitor management. This view of boards has led to regulation such as the Sarbanes-Oxley Act of 2002 in the US, as well as New York Stock Exchange and Nasdaq Stock Market requirements that boards have a majority of independent directors and that members on the audit committee have financial expertise. In the UK, the Corporate Governance Code has rules about board structure, and companies listed on the London Stock Exchange must report on how they are complying with aspects of the code. In Canada, the Toronto Stock Exchange has adopted rules about director voting, the number of board seats directors can hold, director tenure, and more. In a comparable fashion, China recently adopted changes to its corporate governance policies that reflect similar norms and trends.
Such regulatory actions and normative assumptions rest on the premise that if an organisation can just structure the board properly, it will govern the company effectively and monitor its top managers. But is this a realistic expectation for directors? The example of General Electric (GE) raises some doubts.
To be a director of GE means serving the interests of shareholders of a company with $117 billion in annual revenues in 2015 and more than 300,000 employees. GE provides services in many different industries. Among them are health care, water treatment, aviation, and financing. In 2015, GE's part-time directors attended 13 board meetings. Considering the complexity of the company, how likely is it that GE's board would understand the company's businesses in such depth that board members could vigilantly evaluate potential company actions and determine which ones are best for shareholders?
Ten barriers prevent directors from being effective monitors. These barriers occur at the director, board, and organisation level.
Barriers on the director level
These factors arise from the individual challenges that outside directors face as working individuals and as a result of their cognitive and time constraints.
- Outside job demands. Directors tend to be busy individuals. The greater the outside demands a director faces, the harder it is for him or her to effectively oversee the organisation's managers. Active CEOs are often coveted board members because of their experience. When you consider what a CEO has to do at his or her own company, is he or she really going to be able to spend the time and effort necessary to be an effective monitor of management?
- Similarity of outside job demands. The more dissimilar the company is from the director's prior work experience, the longer it will take for the director to truly develop the expertise necessary to understand success factors in the given industry.
- Complexity of outside job demands. Organisational behaviour research has shown that directors' ability to effectively process large amounts of complex information is limited. The number of board appointments directors have can weaken the performance at the focal company.
These barriers arise from individuals' inherent cognitive limitations. Consequently, it seems important to choose directors who not only have the time but also have the attention to devote to the board.
One possibility would be to have boards composed of fewer active executives and more retired executives. Companies could encourage executives to retire earlier and then use those retired executives to create a pool of professional directors. Or perhaps bring back company insiders to the board. Most boards now only have the CEO as an insider director. However, insider directors other than the CEO could help ensure that the board has enough relevant knowledge of the company to drive decision-making.
Barriers on the board level
These barriers come out of the natural dynamics that exist within groups and teams. Working on a board requires information-sharing skills, communication skills, and learning capabilities.
- Board size. As the board gets bigger, potential difficulties are caused by increasing coordination costs amongst the larger group. And the bigger the board, the more likely it is that most directors do not know each other well, which makes communication more difficult. Also, there is a greater risk of what is called "social loafing" because individuals feel less accountable for the work that needs to be done. Research on groups generally, and on boards in particular, tends to support the idea that larger boards are associated with negative outcomes for organisations.
- Meeting frequency. Boards typically don't meet very often, and their meetings are quite task-oriented, following a fairly rigid agenda set by the board chair. This makes it harder for a board to develop into a cohesive decision-making body and to provide extensive ongoing monitoring for the company.
- Diversity of directors. Research on board diversity shows that having a more diverse board can provide certain benefits while also increasing some barriers. Boards that are more diverse are often better equipped to consider a variety of alternatives and secure access to a greater range of valuable information. Yet, increased diversity in groups can raise biases that can make it more difficult for boards to communicate effectively and develop the necessary trust. There is even evidence that certain types of diversity on boards can facilitate group decision biases where directors are more hesitant to discover and raise shared concerns about the company.
- Norms of deference. Many directors see their job as being primarily to support and advise the CEO and other C-suite executives. This can cause directors to become hesitant to voice concerns, favour social ties and ingratiation, and defer to the CEO's judgement. Directors inherently have to rely on top management for much of their information, and this information disparity can also increase the board's deference to the CEO.
- CEO power. CEOs differ substantially in their degree of formal and informal power. Powerful CEOs are often able to influence board meeting agendas and the hiring of directors, and to persuade individual board members to support strategic initiatives. This is particularly the recent trend on boards on which the only insider is the CEO. It is a tough task for directors to effectively monitor a CEO with substantial formal and informal power when the CEO is their conduit to access company information.
Many barriers that arise from group interaction have some obvious fixes. For instance, board size is easy to regulate. Similarly, organisations could increase meeting frequency. However, the problem with more meetings is that most outside directors are working executives who have difficulty meeting often enough to create a cohesive and trusting group.
Boards need to invest in training on group processes and dynamics. Most group problems occur because the group lacks training. Boards need to make sure they have training to help them communicate effectively, they need to review their unspoken norms, and they need to make sure they have regulations and processes that can help rein in powerful CEOs. (See the article, "12 Emotional Habits of Effective Board Members.")
Barriers on the organisation level
These barriers arise from the fact that directors serve in many types of organisations. The nature and complexity of these organisations influence the degree to which they can accomplish their oversight role.
- Organisation size. The bigger the organisation, the more difficult it is for a group of part-time directors to effectively monitor. Larger organisations simply have more things going on, and thus there are more ways in which things can go wrong. They also tend to be quite inertial and difficult to change, and so the board's potential influence is likely to be diminished.
- Organisational complexity. When the focal organisation is highly diversified, both in product and geography, the scope of information that needs to be understood tends to create higher cognitive demands. These increased cognitive demands on directors with finite information-processing capabilities are likely to provide another barrier to effective monitoring.
Organisations are not going to get smaller or less complex, and any part-time director is eventually going to find it quite difficult to fully understand a company that's massive. Perhaps boards need to go back to a model that includes a few more insiders. Having multiple directors who are full-time employees of the company may help with this problem.
The fact that these barriers to monitoring exist does not mean directors are automatically to blame for problems. The research shows these problems tend to be structural in nature.
Despite the structural problems, boards can act effectively. The first way that a board can be effective is in its role as a group that provides advice and suggestions to management. The second way is as an oversight body in times of crisis or in short, punctuated events such as replacing the CEO or overseeing an acquisition.
Directors can be effective when serving as advisers and counsellors for the management team. One of the most recent ways academics have been studying boards is by considering the value directors provide as sources of valuable knowledge and information. Directors often have decades of experience in varied industries. This knowledge can be an incredible resource for executives when used properly.
There is a growing pool of evidence that knowledgeable directors can help the organisation, especially when their knowledge matches what the company is going through. In a similar way, if a CEO knows and trusts the directors, he or she will be more willing to seek out their advice outside of board meetings. Directors can also ask important questions and work to make strategic actions better and more relevant. Diversity can be valuable — if the board works to develop trust and communication amongst directors.
The second way directors can be effective is by banding together and overcoming the barriers discussed above in short-term bursts. For instance, when a company is considering an acquisition, it is possible for the directors to devote considerable time and attention to that one particular decision.
We can't expect this to occur in an ongoing fashion, but many important business outcomes occur in this kind of punctuated situation. We expect similar types of focused attention when the board needs to replace the CEO. If the board realises that a major part of its job is to provide focused attention in short bursts such as these, then directors may see this as a much more realistic way to view how they allocate their time and attention to their duties as directors.
Joel Andrus, a doctoral student at Texas A&M University, contributed to research for this article and was a co-author on the research paper.
Steven Boivie (email@example.com) is an associate professor at Texas A&M University's Mays Business School in College Station, Texas. Michael K. Bednar (firstname.lastname@example.org) is an associate professor of business administration at the College of Business at Illinois in Champaign, Illinois. Ruth V. Aguilera (email@example.com) is professor for international business and strategy at Northeastern University in Boston.