The Current Board of Directors System Must Go

by Odysseas Papadimitriou on March 5, 2009

Board RoomThe original reason to put a board of directors system into place was to give representation to the stockholders. The job of the directors is to act in the best interest of the company’s investors, to hire executives so as further those interests, and to make decisions so as to keep the company healthy.  The board system has failed at these tasks because it inclines members to work towards other interests even when those interests run contrary to those of the investors.  The system, simply put, requires a complete overhaul.

Such failure at the top is a problem because it sets the tone for the rest of the company.  If the board makes bad decisions, they ripple down across the entire management chain.  An incompetent board will hire incompetent executives who will surround themselves with incompetent subordinates. The system promotes a spread of bad decisions.  Moreover, if an incompetent board of directors allows executives to keep their jobs despite poor performance, it creates a corporate environment in which there are no repercussions for bad decisions.

The system’s flaw is a natural extension of the process of representation.   As most boards are composed of big names in the industry, the inclination is to avoid slighting powerful people.  The result is a group-think mentality that maintains the status quo and keeps differences of opinion from finding their way into a healthy debate over the board’s course of action.  The standing board members’ decisions about who to bring onto the board are guided largely by this principle.  One chooses a new board member based on their position within the industry as well as their potential to agree with the positions of the other board members.

Even legendary investor Warren E. Buffett was not immune to the collegiality. In 2003 he wrote to the Shareholders of Berkshire Hathaway Inc. on the subject of Director passivity.  “Warren Buffett … confessed … after sitting on 19 boards in the past 40 years: ‘Too often I was silent when management made proposals that I judged to be counter to the interests of shareholders.’  In those cases, ‘collegiality trumped independence,’ Buffett said.  A certain social atmosphere presides in boardrooms where it becomes impolitic to challenge the chief executive, he wrote.” (CBS MarketWatch, 3/8/03, “Buffett chides corporate boards”)

Furthermore, the original function of the Board of Directors system, that it is supposed to represent the desire of the shareholders, is practically unattainable because the board simply cannot represent a group of people whose will they can not know.  It is ludicrous to assume that board members will make their decisions based on some unknown desire of the company’s investors.  For example, what if the majority of the shareholders in a particular company are interested in maximizing their investment’s return within 5 months rather than 5 years, how can they be certain that the board of directors will act on this goal?  

Lastly, the board’s representation, as it stands, isn’t proportional.  A shareholder who owns 10% of the stock isn’t guaranteed representation by 10% of the board.  In worst case scenarios, the board may find themselves beholden to a stockholder even though they do not control a majority of the stock.  Stacked terms and the election process literally create companies where a shareholder with 30% of the stock might control the entire board.

In the past, it was necessary to put up with the Board of Directors system as it now stands because we lacked the technology to actively involve the company’s investors with their investment.  While times have changed and technology has caught up with the needs of the process, the Board of Directors system has failed to change to take advantage of these new opportunities. Certain aspects of the current system made sense as recently as 10 years ago, before the internet granted the average shareholder access to immediate decisions.  It doesn’t make sense any longer. 

Communication between shareholders and the board of directors is no longer limited by its reliance on conventional mail.  A stockholder can get up-to-the-minute information about their investments and need not learn of their stock’s health solely through quarterly newsletters and reports.  Given the benefits of new communication technology, it seems only reasonable that the system be revised so that decisions concerning executive compensation, board membership, as well as mergers and acquisitions, be made immediately accessible to the company’s investors.  The change will need to be radical.  As a suggestion, it might be time to remove term limits from Board seats, to limit the Board size to 8 members, and to allow anyone (or any group) with 12.5% of the stock access to 1 Board seat in order to ensure full representation of the shareholders desires. 

The current problems stemming from the board of directors system now demand solutions similar to those offered here.  What is required is a revision that creates direct linkage between shareholder representation and board representation.  Whatever is done to revise the system, we must first acknowledge that the current system of the Board of Directors has failed and as a result, corporate incompetence and greed has been allowed to flourish.

Discussion

A. Gunther
What sort of technology to you envision can establish a direct linkage b/w shareholders and the board? And further, what will prevent a vocal minority from exerting their will disproportionately, much like the investor mentioned in your example above?
March 19 at 19:09 pm
Odysseas Papadi
Shareholders can vote thru the internet, with the same technology that is used today to vote online for proxy votes. Also on my example, the size of the board is fixed at 8 and every 12.5% of shares gets 1 board seat so you do not have the disproportionate issue any longer.
March 22 at 16:07 pm

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