Clarification

The appointment of independent executive directors on the board of directors is a critical choice. Their selection is the subject of a special care. The most popular profiles are experienced entrepreneurs whose business activity is flourishing. However, they are very busy people. And it is on this specific question that the study is answering: are they able to devote themselves to their mission of Independent Executive Director at the height of what this implies?

This study is based on an analysis of the operations of more than 1000 American companies over a period of more than two decades. Due to the similarities in structure around the world, this approach is applicable to a majority of companies.

The composition of a company’s Board of Directors is generally mixed. First of all, it includes senior in-house managers, such as the CEO (Managing Director) and the CFO (Chief Financial Officer); i.e. 2 or 3 people, depending on the size of the Board. The majority of Board members are people from outside the company, called “Independent Directors”. These are shareholder representatives who will advise and monitor the organisation’s activity. They come from a wide variety of backgrounds: academic, legal, political, citizens or members of associations.
The choice of these representatives is crucial because their role is to monitor and guarantee sound strategic and financial management of the company. Special attention must therefore be given to their appointment. The most popular profile types for Independent Directors are experienced entrepreneurs with a flourishing business activity. This is because they inspire shareholder confidence. But to attract the best, the task is made all the more difficult due to the fact that they are so few and the offers numerous.

 

The concept of “distraction” to sum up the dilemma of the Independent Executive Directors


Although these Independent Executive Directors have an attractive profile and a proven track record (they hold similar positions within other companies), they are nevertheless very busy people. And this is the main focus of this study: Are they be able to invest sufficient time in their role as Independent Executive Director? Wouldn’t they prefer to be taking care of their own business?

In examining this question, the study succeeds in highlighting the concept of “distraction”, which is based on the following principle: in times of difficulty, these Independent Executive Directors will tend to prioritise and devote more time to their own companies, which is to the obvious detriment of the company they serve as a Board member.
To verify this hypothesis, the research examines a wide range of data that sheds light on the economic performance of one thousand American companies.

Evidence of distraction: members are conspicuous by their absence

The most obvious test in determining whether a Board member is distracted is the following: a correlation between the economic difficulties of the Independent Executive Director’s own company (based on stock market results) and their presence at Board meetings.
The study highlights the existence of a link between these factors: Independent Executive Directors, distracted by the poor performance of their own companies, tend to neglect the company Board meetings they should attend and are more absent.
As mentioned earlier, the role of the Board of Directors is decisive in ensuring sound company management. However, the distraction of its members has a negative impact on economic performance.

The most obvious test in determining whether an Independent executive directors is distracted is if he assists to board meetings

A series of tests carried out for the remainder of the study results in the development of a model that can predict 4 “typically” negative impacts the distraction of Independent Executive Directors can generate, depending on the Board’s various responsibilities.

1- Inappropriate remuneration

The Board maintains a “Remuneration Oversight Committee” responsible for determining the size and amount of bonuses and income allocated to the CEO. For obvious ethical reasons, this committee is only made up of members from outside the company.
The general approach is as follows: just like everybody else, the CEO wants to be paid the highest possible remuneration in the easiest possible way. If the Board of Directors is not careful when setting strategic objectives and establishing fair remuneration for the CEO, there is an significantly increased risk that the CEO will receive remuneration that is not linked to performance. In view of the amounts involved, this may represent a significant loss of income for shareholders.

2- Poor performing CEOs keep their position

Another task the Board has is replacing the CEO (in other words, firing them), if they are no longer considered to be the right person for the job. However, such procedures take a considerable amount of time and effort: identifying the factors threatening the company’s growth, conducting the dismissal procedure, finding a replacement, etc.
However, when one or more members of the Board of Directors are “distracted”, i.e. concerned about their own company, CEOs clearly tend to remain in position longer, despite the fact that the company is performing badly.

One example illustrates this point: if the company’s performance falls by 15%, the likelihood of the Board laying the blame on the CEO increases considerably. But when Board members are distracted, the chances of the CEO being removed are much lower …

3- Approximate audits of the company’s results

The Board also have an “audit committee”, which has the role of selecting which audit firm is to audit the company, but also of monitoring and assessing the selected firm’s reports and recommendations.

Audits are a key moment for the Board of Directors

This is a highly sensitive activity for the Board. Indeed, it has been well documented how CEOs are easily tempted into concealing company accounts during an audit when results are unfavourable. If the Board members do not exercise extreme vigilance when following financial and accounting reports, the company’s well-being may be severely affected.

4- Misguided mergers and acquisitions

Mergers and acquisitions represent significant investments for companies. For CEOs, external growth is a real windfall because “technically” increasing the size of the company is an easy way of generating positive results.
However, such operations are not all necessarily positive, and the health of the targeted companies need to be carefully assessed before embarking on such a project. In this case, the Board members have a crucial role to play in ensuring the quality of any acquisition or takeover and of being sure it is the best alternative, conducted at the right time and at the right price. If the Board fails with such ventures, the risks for the company are significant. For example, by monitoring the stock market reactions in the wake of a merger-acquisition announcement and the company’s estimated value on the same markets, it is possible to analyse whether the Board has made the right decision. However, the study points out that the more distracted the Board members, the more likely it is for mergers and acquisitions results to be poor or negative.

Remarks about the Board of Directors

In view of the results of the study, the smaller the Board of Directors, the greater the risk that distracted members will have a negative impact on the company’s performance. This risk is even greater when the Board is divided into specialised committees of only a few members.
> If a Board of 10 contains two distracted members, their impact will be limited. But should these two be included in a committee made up of 3 people…. then the risks increase significantly.

Conclusion and implications

A successful entrepreneur profile is certainly appealing when it comes to selecting Independent Executive Directors. However, those responsible for appointing such Board members must consider the risk that they may be distracted from their duties. This does not mean that their role as independent Executive Directors will necessarily be negative, but that extra vigilance must be exercised. This is all the more true for Boards with relatively few members or when the Independent Executive Director’s remuneration is not particularly attractive….
A further cause for concern relates to the sectors of activity the external Board members come from. Knowledge of the relevant business sector is a strength, except in the event of a market crisis. In this case, a great number of the Board’s members may encounter difficulties at the same time, thereby putting the life of the company they advise and supervise in danger.

There is certainly an art to forming the perfect Board of Directors!

29 July 2019
Zhao Hong

THE AUTHOR

Zhao Hong

Professeur NEOMA BS

Hong Zhao is an Assistant Professor of Finance at NEOMA Business School in France. Hong graduated from Arizona State University with a PhD in Finance in 2017. He has also earned a Master's Degree in Economics from Arizona State University, and a Bachelor's Degree in Economics and Mathematics from Shanghai Jiao Tong University, China. Hong’s research interests fall under the broad label of empirical corporate finance. His current papers investigate how different mechanisms affect CEO incentives and board governance.