Monday, December 13, 2010

“Professional” Independent Directors

In a recent Economic Times column, Prof. T.T. Ram Mohan discusses the concept of a professional board propagated by Lee Pozen in the Harvard Business Review (Dec. 2010, p. 50). The idea goes as follows:

The author, Robert Pozen, lists reasons why boards are ineffective. They are too large (the average size of the top 500 companies in the US was 11 in 2009). Members lack domain expertise (only one of Citigroup’s directors at the time of the subprime crisis had ever worked at a financial services firm). Members are not able to spare enough time for the boards they serve on.

The answers follow. First, have professional directors, that is, people for whom directorship is a primary, not an ancillary, vocation. Secondly, cut the size of boards to seven, the CEO plus six independent directors . Thirdly, of the six directors, make sure four are people with domain expertise. The fifth should have expertise in accounting and the sixth could be a generalist.

Professional directors would not serve on more than two boards. They should spend at least two days a month at the company, apart from board meetings. Since they would be expected to work a lot harder, they should be paid better. Most of the pay should be in the form of long-term stock options.

Since this sort of time commitment would be beyond working professionals, the choice of professional directors would be restricted to retired persons. Pozen thinks this pool is large enough to meet the requirements of companies. Regulators could make professional directors mandatory for banks. Institutional shareholders should push for professional directors in other companies.
Prof. Ram Mohan presents a critique of this idea:
But there is a more fundamental fallacy in Pozen’s formulation. The effectiveness of a director is not so much about knowledge of a company. It is more about sincerity and commitment . The questions that need to be asked are often very simple ones. Why are we losing market share? How does the company proposed to reverse the trend in declining profit margins? Which divisions have failed to meet budget targets? Are succession plans in place? Why are star performers leaving?

Asking these questions, indicating that one is not satisfied with the answers and demanding accountability for lapses, does not require great insight or ability. It requires commitment and a willingness to rock the boat. These are qualities not commonly found in boards or, for that matter, anywhere else in institutions.
This critique has been echoed in an editorial in today’s Economic Times.

To be sure, the concept of a professional independent director is not novel. It has been the subject matter of debate for over a quarter of a century. Not only has it been considered from a business perspective (Joseph W. Barr, “From the Boardroom: The Role of the Professional Director”, Harvard Business Review, May-June 1976, at 18), but it has also received attention from the legal academy (Ronald J. Gilson & Reinier Kraakman, “Reinventing the Outside Director: An Agenda for Institutional Investors”, 43 Stanford Law Review 863 (1991). More recently, I have had occasion to examine the idea specifically in a short article The Idea of a “Professional” Independent Director.

Apart from the critique mentioned earlier, there is a more fundamental practical question. If the idea of professional independent director is appealing, why have companies (whether in India or elsewhere) not embraced it and appointed such directors on boards. No compelling answer has been forthcoming yet.

However, simply because the idea is yet to take off, it need not necessarily be relegated to the bottom in the list of mechanisms to enhance corporate governance. It may still be superior to existing structure of independent directors, and to that extent it is an idea worth pursuing and sharpening.

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