Friday, August 22, 2014

A Radical Idea for Restructuring Corporate Boards

Last week’s Schumpeter column in the Economist carries a provocative idea that involves a complete relook at the way boards of companies are structured and operated. It borrows a proposal from an article titled “Boards-R-Us: Reconceptualizing Corporate Boards” authored by two leading US corporate law academics. The column summarizes the proposal as follows:

In the May edition of the Stanford Law Review Stephen Bainbridge of the University of California, Los Angeles, and Todd Henderson of the University of Chicago offer a proposal for fixing boards that goes beyond tinkering: replace individual directors with professional-services firms. Companies, they point out, would never buy legal services or management advice from people only willing to spare a few hours a month. Why do they put up with the same arrangement from board members? They argue for the creation of a new category of professional firms: BSPs or Board Service Providers. Companies would hire a company to provide it with “board services” in the same way that it hires law firms or management consultants. The BSP would not only supply the company with a full complement of board members. It would also furnish it with its collective expertise, from the ability to process huge quantities of information to specialist advice on things such as mergers.

Messrs Bainbridge and Henderson argue that this would require only a simple legal change but could revolutionise the stick-in-the-mud world of boards. It would replace today’s nod-and-a-wink arrangements with a market in which rival BSPs compete. It would create a new category of professional director. And it would allow BSPs to exploit economies of scale to recruit the best board members, introduce more rigorous training programmes and develop the best proprietary knowledge. Now, even the most diligent board member can only draw on his or her experience. BSPs would be able to draw on the expertise of hundreds. This would increase the chances that corporate incompetence will be corrected, corporate malfeasance found out and corporate self-dealing, in the form of inflated pay, countermanded.

While this proposal is an interesting one and merits further consideration, it also evokes a great deal of skepticism. A few concerns are discussed here. First, merely because there are problems with current board structures that place an overemphasis on board independence, it may not necessarily justify a complete overhaul. Perhaps it may be preferable to address the problems with the current structure through refinements that may involve less cost and may be more efficient. For example, the focus may be on revamping institution of independent directors and the support systems available to independent directors to carry on their role more effectively.

Second, the BSP concept would encounter the same agency problems as other third party intermediaries that operate as “gatekeepers”. In that sense, the incentives of BSPs are likely to operate in a manner that is similar to those of auditors, credit rating agencies and the like. If instances of corporate governance failures have provided the impetus for a total overhaul of board structures, history is replete with instances where such intermediaries, despite their strong reputation incentives, have themselves partaken in responsibility for such failures. Corporate governance scandals involving board failures are usually also accompanied by deficient conduct on the part of the auditors. Hence, by creating an institution such as the BSPs, it is likely that the problem with individual directors may be relocated to corporate intermediaries who may suffer from distorted incentives that may cause a different set of governance problems.

Third, the concept of having corporate directors is not novel. For instance, in some jurisdictions, it has been possible for one company to be a director of another company. Closer home, historically the concept of “managing agency” was prevalent in India for nearly 150 years even before every company was required under law to have a board of directors. Managing agents were appointed by companies under a contract to manage and control companies. Each managing agent could undertake such a function across a portfolio of companies. However, the concept of managing agency ran into significant governance issues and problems, and was ultimately abolished in India as long ago as 1970. Readers interested in the historical role of managing agencies in Indian corporate governance may refer to (i) “Chapter 2: Evolution of Corporate Governance in India” in Subhash Chandra Das, Corporate Governance in India: An Evaluation, and (ii) Kamal Ghosh Ray, “The forgotten managing agency system: a nineteenth century model of Indian corporate governance”, Social Responsibility Journal, Vol. 5 Iss 1 pp. 112 – 122 (subscription required) (where the author is somewhat sanguine about the ability of the managing agency concept to address modern-day corporate governance problems).

Finally, the answer to the shortcomings of corporate boards may lie somewhere in-between. While professionalization of corporate boards is desirable, a total outsourcing to an outsider service provider may not be. One option, which has been considered before would be the appointment of professional independent directors (as I have argued elsewhere).

Despite the doubts raised regarding the viability of the BSP model, the discourse and scholarship towards a total overhaul of the current board governance mechanisms cannot be ignored. A deliberation of such ideas, as radical as they are, could help shape the direction in which board and governance structures are likely to shift.

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