L. A. A. Van den Berghe** and Abigail Levrau
This paper is an attempt to identify what constitutes a good board of directors, and this is based on a comparison between academic literature, corporate governance rating systems and our field research into board practices. We observed that “traditional” academic research focused on a limited number of quantifiable board characteristics, while practitioners attach greater importance to “soft” elements, which are nearly absent in the literature and in the gov-ernance ratings. These findings highlight the need for a better understanding of all elements that determine board effectiveness. Furthermore, our results identify three areas of improve-ment for boards of directors.
Keywords: Corporate governance, board of directors, board evaluation, board effectiveness, corporate governance rating
*This paper was presented at the 6th International Confer-ence on Corporate Governance and Board Leadership, 6–8 October 2003 at the Centre for Board Effectiveness, Henley
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of the running the company. Besides, boards are responsible for the standing of their company in the community.
Observable, most of the recommendations usually put great emphasis on formal board structures and board characteristics such as board size, number of independent directors, number of board meetings, board committees etc. The disclosure of these structural ele-ments enables market participants to evaluate if boards of directors are complying with the corporate governance recommendations.
However, as recent corporate failures have shown, living up to the “formal” standards is not enough. More attention should be paid to correct governance attitude and behaviour of directors and management. In fact, corporate governance is about “doing the right things”
and “doing the things right”: a twofold condi-tion, often neglected.
The main purpose of this paper is to iden-tify the key criteria of board effectiveness and to examine how they apply in practice. The paper is structured as follows. The next section provides key attributes for good boards of directors from three perspectives: an in-depth review of the academic literature, a com-parison of the corporate governance rating systems and an analysis of directors’ views.
After this section, we use a sample of Belgian listed companies to examine and evaluate board practices. The final section discusses the overall findings and includes concluding remarks.
Identifying criteria for good boards of directors
Evidence from the literature
One of the widely discussed issues in aca-demic literature concerns how to appropriately structure the board of directors and to what extent the make up of the board of directors influences board actions or corporate perfor-mance. In this respect, board size, board com-position and board leadership structure are three main characteristics frequently used in academic research.
Board size
Board size is one of the well-studied board characteristics from two different perspec-tives. First, the number of directors may influence the board functioning and hence corporate performance. Yermack (1996) found a negative relationship between board size and firm market value, using a sample of large US public companies. Similar results were
reported using European data. Eisenberg et al.
(1998) studied small non-listed Finnish firms and found a negative correlation between firm’s profitability and the size of the board.
The study by Conyon and Peck (1998) showed an inverse relationship between return on shareholders’ equity and board size for five European countries.
Second, researchers have started to study boards of directors as decision-making groups by integrating literature on group dynamics and workgroup effectiveness. Hence, board size can have both positive and negative effects on board performance. Expanding the number of directors provides an increased pool of expertise because larger boards are likely to have more knowledge and skills at their disposal. Besides, large boards may be able to draw on a variety of perspectives on corporate strategy and may reduce domina-tion by the CEO (Forbes and Milliken, 1999;
Goodstein et al., 1994). However, increasing board size might significantly inhibit board processes due to the potential group dyna-mics problems associated with large groups.
Larger boards are more difficult to coordinate and may experience problems with com-munication and organisation. Furthermore, large boards may face decreased levels of motivation and participation and are prone to develop factions and coalitions. Finally, boards may have difficulties to further co-hesiveness and may suffer from a diffusion of responsibility or “social loafing” often found in large groups. Consequently, these group dynamic problems may hinder boards of directors in reaching a consensus on important decisions and may put a barrier on the ability of the board to control management (Judge and Zeithaml, 1992; Goodstein et al., 1994;
Eisenberg et al., 1998; Forbes and Milliken, 1999; Golden and Zajac, 2001).
In sum, academic evidence demonstrates that larger boards are less efficient and hence negatively influence corporate performance.
Notwithstanding these observations, we may not ignore the fact that a minimum number of directors is needed to guarantee the required countervailing power and diversity. The latter can express itself in different ways such as the need for a balanced representation of multiple stakeholder groups, the need for non-domestic directors in multinational com-panies, the need for sufficient expertise in diversified groups etc. (Van den Berghe and De Ridder, 2002).
Board composition
Much of the academic research on boards of directors focuses on the role and the
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tion of inside, outside and independent direc-tors. In general, two theories form the basis for the reliance on insider or outsider-dominated boards. Agency theory focuses on the conflicts of interest that occur among the shareholders (principals) and the managers (agents), stem-ming from the separation of ownership and control. Managers who gain control may have the potential to pursue actions that maximise their self-interest at the expense of the share-holders. The board of directors is one of the mechanisms designed to monitor these con-flicts of interest (Jensen and Meckling, 1976;
Fama and Jensen 1983). Thus, from an agency perspective, boards should be able to act inde-pendent of management and therefore must include a preponderance of outside directors.
The opposite perspective is grounded in stewardship theory. According to stewardship theory, managers are good stewards of the company assets. Managers do not misappro-priate corporate resources at any price because they have a range of non-financial motives, such as the intrinsic satisfaction of successful performance, the need for achievement and recognition etc. Reallocation of control from shareholders to management leads to maximi-sation of corporate profits and hence share-holder returns (Muth and Donaldson, 1998).
Following this reasoning, boards of directors dominated by insiders are preferable.
Academic research provides evidence that support both perspectives. The effect of out-sider-dominated board on performance is indeed contradictory. Greater representation of outside directors on the board has a nega-tive impact on firm performance, as measured by Tobin’s Q (Agrawal and Knoeber, 1996) and on Market Value Added (Coles et al., 2001). In contrast, Rosenstein and Wyatt (1990) found that a clearly identifiable announcement of the appointment of an outside director leads to an increase in shareholder wealth. Also Baysinger and Butler (1985) reported that firms with higher proportions of independent directors ended up with superior performance records.
Wagner et al.(1998) conclude that both greater insider and outsider representation can have a positive impact on performance, while others conclude that there is virtually no relationship between board composition and firm perfor-mance (Dalton et al., 1998; Hermalin and Weisbach, 2000).
Evidence suggests that board composition is also related to strategic decisions taken by the board and to the monitoring of manage-ment. Outsider-dominated boards are more involved in restructuring decisions (Johnson et al., 1993) and positively influence diversifica-tion strategies (Baysinger and Hoskisson, 1990). Similarly, higher insider representation
has a negative effect on overall board involve-ment in the strategic decision-making process (Judge and Zeithaml, 1992). The presence of outside directors has a negative implication for the intensity of R&D (Baysinger and Hoskisson, 1990) and other entrepreneurial activities of the company (Short et al., 1999).
The inclusion of insiders in the board may be useful because they have access to information relevant to outside directors in assessing both strategic initiatives and managerial perfor-mance (Fama and Jensen, 1983; Baysinger and Butler, 1985).
Board leadership structure
Agency theory, as well as stewardship theory, is also applicable to board leadership struc-ture. Advocates of agency theory favour the separation of the roles of CEO and chairman of the board. Splitting these roles dilutes the power of the CEO and reduces the potential for management to dominate the board. Con-versely, stewardship theory suggests that if the CEO also serves as the chairman, this duality provides unified firm leadership, builds trust and stimulates the motivation to perform (Muth and Donaldson, 1998).
The results of academic research are incon-clusive on the effects of leadership structure on performance. Coles et al.(2001) reported a positive relationship between a joint struc-ture and Economic Value Added, while the results for the meta-analyses by Dalton et al.
(1998) show no relationship between board leadership structure and firm performance.
However, a robust interaction effect is sug-gested between firm bankruptcy and board structures. Firms that combine the CEO and chairman roles and that have lower represen-tation of independent directors are associated with bankruptcy (Daily and Dalton, 1994a, 1994b).
Corporate governance rating systems
For several years now, different parties assess and score the quality of corporate governance, both of countries and companies. The devel-opment of these rating systems is stimulated by the need to compare corporate governance structures and practices between countries and companies. Indeed, there is a rising demand from investors for tools helping them to judge the level of corporate governance as part of their investment strategy. Remarkably, the available rating systems use different methodologies and weighting in measuring the level of corporate governance and they
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take varying approaches to reach their final conclusions. However, a company’s board structure and processes is one of the three minimum categories found in all corporate governance rating systems (for a comparison, see Van den Berghe and Levrau, 2003). Appen-dix 1 provides a detailed overview of the cri-teria used in assessing boards of directors as part of the overall corporate governance rating systems. Besides these overall rating systems, specific board ratings have also emerged.
Since 1996, Business Week magazine publishes its ranking of the best and worst boards in Corporate America (Bryne and Melcher, 1996).
Recently, a specific “board effectiveness”
rating tool was launched by The Corporate Library (see Appendix 2).
The comparison of the rating systems reveals a large variety of the detailed set of cri-teria used to assess boards of directors. This variety concerns both the number and the content of the indicators. The differences in focus can, to a large extent, be explained by the underlying principles. Most of the rating systems rely on the internationally recognised corporate governance principles and codes (e.g. OECD, ICGN, World Bank), completed with national recommendations (Van den Berghe and Levrau, 2003). In particular, the latter may differ from one country to another.
This is also reflected in the rating systems con-cerned. For example, the corporate gover-nance scorecard developed by DVFA includes specific criteria relating to the two-tier board structure and the co-determination found in Germany. Furthermore, the differences in focus can also be explained by the varying quality of the legal environment. In some emerging countries, corporate governance rating systems intercept the weak legal en-vironment by including criteria not fully covered by law. For example, the CLSA’s cor-porate governance scoring system includes a whole set of indicators a company must take to prevent and punish mismanagement.
A more in-depth examination of the rating systems entails a division of the main criteria in three categories: (I) criteria used by (almost)
all rating systems, (II) criteria found in some of the rating systems and (II) criteria excep-tionally included. The classification is pre-sented in Table 1.
Almost all rating systems pay attention – explicitly or implicitly – to board independence.
This is not a surprise given the fact that the independent board is the cornerstone of the actual corporate governance debate. It is widely recognised that independent directors have an important role to play, especially in those areas where there is a potential for conflicts of interest, such as financial control, nomination and remuneration. Consequently, criteria concerning the selection and election of those directors are also included. One theme that is consistent in all rating systems is board committees. Many arguments can be put forward to demonstrate that the installation of board committees leads to a more effective operation of the board. The audit committee receives particularly high priority. Emphasis is also placed on director and executive compensa-tion, including stock option plans and stock ownership. The extent to which the remuner-ation of directors is linked to financial or other performance measures is, however, fairly controversial.
Moderate priority is given to board sizeand board leadership structure.A limitation of the maximum number of board members is advo-cated. The board of directors should be small enough to be effective, more cohesive and to enable more participation and discussion. Fur-thermore, there is an outspoken preference for a separation of the positions of chairman and CEO. Some rating systems also include speci-fic criteria for CEO succession. The role of the board and more specifically the division of tasks between management and the board of directors also receives less attention. While the distribution of responsibilities in a two-tier board structure is perhaps straightforward, it is more vague in a unitary board model. In general, boards of directors are supposed to direct the company and not to manage it.
Some rating systems include the frequency of board meetingsas a criterion. After all, an active
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Table 1: Classification of the criteria used by corporate governance and board rating systems
Category 1 Category 2 Category 3
Independence of outside directors Board size Access to information Board committees Board leadership structure Age limitation Director and executive compensation Role of the board Board review
Frequency of board meetings Education/training
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board implies a minimum number of board meetings. Moreover, the agenda of the board meetings or the opportunity to meet without the presence of inside directors is also taken into account.
Minimal emphasis is placed on access to information, including both the availability of information from management and the possi-bility to consult outside advisers. The same counts for age limits regarding the directors’
terms of office. Finally, board reviewand direc-tors’ education receive the least attention. A formal evaluation of the board of directors, at least annually, is seen as a means to improve its working. Training of directors is high-lighted because of the growing demand of professionalism and the increasing complexity of tasks.
Directors’ perspectives
Beyond the criteria used in academic research and corporate governance rating systems, directors themselves have own views on what constitutes a good board of directors. On the basis of in-depth interviews with 60 board members of Belgian listed companies, the directors were asked to sum up what they believe are elements of a good board of direc-tors. A detailed overview is given in Appen-dix 3. Table 2 provides a summary of the results, grouped and sorted by frequency in descending order.
The interview results presented in Table 2 show that the quality of the board meetings is the most frequently reported element, fol-lowed by a balanced composition of the board and the board of directors as a decision-making group. The latter expresses more qualitative and human elements of the board.
Less frequently mentioned elements are the role the board of directors is supposed to play and the relationship of the board with management and shareholders.
Board meetings1
In order to have an effective and constructive board meeting, several conditions need to be fulfilled. The first issue concerns information.
Information refers to the documents the direc-tors receive in advance. Moreover, direcdirec-tors must take the time to prepare themselves. A well-prepared director is viewed as crucial.
Information also includes data and the format in which these data are presented during the board meetings. For instance, information about the functional domains of the company and about the activities of competitors, presented in an analytic and comprehensive way, furthers efficient decision-making. Final-ly, information also refers to the willing-ness of directors to learn about the company’s busi-nesses outside the board meetings. Directors must show interest in what the company and its business units are doing. The second issue, reported nearly as often as the previous one, isthe quality of the discussions or debates.Real, open, in-depth debates are essential for an effective board meeting. Moreover, discus-sions must take place inside the board room and not “behind the scenes”. Each director should have the opportunity to speak up freely and to contribute, but the deliberations should be characterised by neutrality and objectivity. Or, as one director stated, “one should play the ball, not the man”.Finally, the board of directors must be critical, but at the same time preserve a comfortable and con-structive climate. The third issue relates to the role of the chairman. According to the directors interviewed, the chairman needs to be a strong leader who keeps control, but without being dominant. He should be impartial and he is the driving force of the board. Finally, he must monitor the presence and preparation of the other directors. The fourth issue concerns the way the decisions are taken by the board of directors. The board of directors in making decisions may not be dominated by manage-ment or shareholders. Furthermore, important
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Table 2: Elements of a good board of directors: directors’ perspectives
Elements of a good board of directors Frequency this element is reported
Group 1: Quality of the board meetings N =71 40.6%
Group 2: Composition of the board of directors N =48 27.4%
Group 3: Board of directors as a decision-making group N =33 18.9%
Group 4: Role of the board of directors N =16 9.1%
Group 5: Board–management–shareholder relationship N =7 4%
Total N =175 100%
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items should be well thought out and there-fore might appear on the board agenda more than once. Finally, the resolutions taken by the board must be respected and be reproduced in the board minutes in a correct way. The last issue is the engagement or involvement of the directors. Directors must be “mentally” pre-sent and actively involved in the decision-making process.
Composition of the board2
The board of directors needs to have the appropriate structure. This involves several related dimensions. The two most frequently reported dimensions are diversity and
The board of directors needs to have the appropriate structure. This involves several related dimensions. The two most frequently reported dimensions are diversity and