Better Boards: The Equity Answer

America‘s corporate boards are generally working better than ever, but they’re still far from uniformly effective. Witness the recent business messes that have been aggravated by inattentive or inert boards: Conseco, Mattel, AT&T, Rite-Aid, Toys ‘R’ Us. And for every one of them, there are a dozen smaller public firms with shareholders reeling because of boards that were asleep at the switch.

The crux of the problem is that outside directors have a plethora of reasons to not exert themselves. Because they are selected for their accomplishments and stature, outside directors are often exceedingly busy and face their own pressures elsewhere. For instance, those who are top executives of other companies typically work 5o to 7o hours per week, travel extensively, and incur a lot of stress in their jobs. How much time and attention can they spare? Not much.

And since these directors are outsiders, they’re at a serious informational disadvantage; they must largely rely on the CEO’s portrayal of the firm’s condition and prospects. To ask for an in-depth inquiry is to ask for big headaches: a lot of work for themselves, lots of work and stress for fellow directors, and possibly resentment and even retaliation from the CEO.

It comes as little surprise that researchers have found no correlation between the proportion of outsiders on boards and corporate performance. This is not to say that we should return to the days when boards were numerically dominated by insiders. But having a preponderance of outsiders on the board doesn’t accomplish much by itself.

Other seemingly sensible initiatives for adding heft to boards also have substantial drawbacks. For instance, appointing a “lead director”-an outsider who can marshal the other outsiders and  pose a counterweight to the CEO-can lead to a caste system and often has the unintended effect of causing some directors to take a secondary, passive role in board affairs. Nor does instituting formal evaluations of directors work wonders, because they often become perfunctory feel-good rituals.

Show Me the Money

There are no silver bullets for improving corporate governance, but evidence is mounting that one factor matters a great deal: the equity holdings of outside directors. Proponents of significant director holdings have long argued that the most effective way to get outside directors to vigorously represent the firm’s owners is to make them owners themselves. These observations have been borne

out by several systematic studies. Research has found that outside directors’holdings are related to a) company resistance to paying greenmail; b) speed of restructuring among troubled firms; c) prompt dismissal of CEOs who are performing poorly; and d) avoidance of excessive CEO compensation. Namely, when outside directors have significant holdings, they appear to behave vigorously in support of stockholders.

Logically, such behaviors should show up in improved corporate performance. Several studies have found that that is precisely what happens. The most recent, a study I conducted with Eric M. Jackson, yields a striking pattern. We examined a sample of firms that significantly outperformed their business sectors in shareholder returns over a 10-year period (dubbed “Stars”) and a matched sample of companies that underperformed their sectors during the same period (“Laggards”). We found that at the outset of the 10-year period-before their directors of the Star firms held substantially more equity than those of the laggard firms. For example, at the start of the 10-year period, the median value of stock held by each outside director of Star companies was $470,000, compared to only $80,000 for the outside directors of Laggard firms. As the Stars outpaced the Laggards in performance, this disparity grew even wider.

Could the outside directors of the Star companies have acquired their large stakes because of inside information about their firms’ superior prospects? While such a possibility cannot be ruled out, and may have occurred to some degree, it’s not a plausible primary explanation for our findings. Trading on inside information occurs when the information is about a relatively specific, usually near-term event. It seems unlikely that directors could have knowledge that other investors would not have about fundamentally advantageous prospects for long-term superior returns. We are much more persuaded by the interpretation that directors who hold significant stakes help to bring about superior performance.

Implications for Company Policy

In the last several years, companies have responded to activists’ calls to get equity into outside directors’ hands. They’ve gone about this in two primary ways: paying all or part of directors’ annual retainers in company stock and making one-time or annual stock or option grants to directors. These initiatives are directionally sensible, but often miss the mark. We believe that in designing a company policy to make outside directors owners, four main considerations should come to mind.

First, while it’s important that directors hold meaningful amounts of equity, what constitutes “meaningful”? Although directors’ financial wherewithal varies widely, our research and interviews suggest a target of $500,000 is reasonable for the vast majority of directors of major firms. One director I interviewed-a retired CEO with a net worth of $10 million-plus-confirmed that a $500,000 stake is an attention-getter: “I’m in for about half a million dollars, and I can tell you I’m a heck of a lot more attentive to this company than I have been to the others. If this company faces a challenge, I lose sleep at night-which is what you want from your directors.”

Second, it’s important that directors think and behave like owners when first appointed rather than gradually after years of service. The problem with annual grants or paying annual retainers in stock is that it takes several years for the holdings to become substantial.

Third, giving directors an equity stake is not nearly as effective as when the directors have to reach in their pockets and put their own cash on the line. In our study, the bigger stakes of the Star company directors were evident prior to any grant programs. These directors had voluntarily committed themselves to a position stake. A director ownership program should entail a commitment from the individual, not only grants from the company.

Fourth, any mechanism for achieving director equity stakes must not preclude service from qualified individuals who don’t have a great deal of financial wherewithal. There’s a valuable role for foundation directors, academics, and former government officials on some boards, and it would be a mistake to establish purchase require ments that prevent their service. A New Approach

Taken as a whole, these considerations lead us to propose a new approach: Companies should establish a fund, perhaps about $200,000, for each director, which would be used to match the director’s own voluntary purchases of company stock. Matching purchases could be made upon election or on election anniversaries, until the $200,000 fund is depleted. Directors would be required to hold their matched purchases until they leave the board. In addition, annual retainers would be paid half in cash and half in stock.

Because directors will have an incentive to receive their matching shares as early as possible, we would expect the vast majority of directors to purchase their full allotment upon election, immediately holding $400,000 worth of the firm’s stock ($200,000 from their own money and $200,000 from the company). The $400,000 stake, along with stock grants for one-half of their annual retainers will get most directors close to the ideal $500,000 level fairly quickly. Directors who have less financial capacity will get there more gradually, but will have the incentive to buy as much, and as early, as their personal circumstances allow.

Of course, an equity stake is no substitute for superior qualifications. Boards need to be as selective as ever in replenishing themselves. They must search for and attract individuals who have sophisticated and diverse insights, the expertise to provide astute advice, and responsible monitoring.


Donald C. Hambrick is Samuel Bronfman Professor of Democratic Business Enterprise at Columbia University Graduate School of Business.

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