The endangered director

Citation

Daily, C.M. and Dalton, D.R. (2004), "The endangered director", Journal of Business Strategy, Vol. 25 No. 3. https://doi.org/10.1108/jbs.2004.28825caf.002

The endangered director

Catherine M. Dailyis the David H. Jacobs Chair of Strategic Management, Kelley School of Business, Indiana University, Bloomington, IN (cdaily@indiana.edu).

Dan R. Daltonis Dean and Harold A. Poling Chair of Strategic Management, Kelley School of Business, Indiana University, Bloomington, IN (dalton@indiana.edu).

Affiliated directors – outside board members with professional or personal relationships with the firms or executives on whose boards they serve – now have much in common with the blue whale, tiger, thick-shell pond snail, and panda. As a result of recent legislative and guidelines oversight (e.g. Securities and Exchange Commission, New York Stock Exchange, NASDAQ), affiliated directors are being systematically banned from corporate boardrooms. These directors, therefore, reside squarely beside their brethren on the endangered species list. In the wake of too many corporate disasters (the "Enron" effect), corporate governance reformists have renewed efforts to purge boardrooms of any semblance of a relationship between directors and officers. In fact, the hunt for interdependencies has been extended to ties between board colleagues (i.e. board interlocks). Directors serving on common boards are now subject to extinction as well.

At issue is the extent to which relationships of these types compromise directors' ability to effectively oversee firms' officers. This increased stringency in what constitutes an "acceptable" director is not altogether misplaced. There is, for example, a delicate balance to be achieved between effectively serving the company and its shareholders and maintaining a relationship with firms' officers that positions directors to serve as a source of advice and counsel for officers. Directors must walk that fine line between maintaining enough distance to exercise oversight; yet they must remain close enough to the firm and its officers to be informed board members.

We question, however, whether there are potential pitfalls in extinguishing an entire "species" of directors. Would the rather notable series of corporate scandals in recent years have been prevented if director independence had been greater? If so – and we question whether that would have been the case – it nonetheless seems rather restrictive to view corporate board memberships, positions that carry significant responsibility, as fulfilling exclusively a monitoring function. Effective directors' roles presumably extend far beyond serving as the "hall monitors" of the corporate world.

What proponents of this more stringent approach to board independence have apparently failed to consider is the strategic value of linkages between directors and firms' stakeholders. Boards structured exclusively for independence, for example, will not include representatives of major suppliers or customers to the firm. Nor will such boards include representatives of professional organizations that might do business with the firm, such as investment banking firms or other financial institutions, law firms or advertising agencies. Directors with these relationships, however, could provide access to sources of expertise and resources that might not otherwise be available to the firm, or that might be retained at a significantly higher cost.

Directors with these resource connections can also facilitate "introductions" to individuals in the respective areas of expertise that greatly assist firm executives in specialized areas. Directors who interact through service on common boards not only expand their network of contacts, but also develop a measure of trust and respect that enhance their comfort in making introductions for their board colleagues. A related benefit of interconnected directors is the diffusion of innovations across boards and firms. Innovative approaches for engaging in strategic acquisitions or for evaluating corporate board members, for example, are more easily spread from one corporation to the next when board members share common directorships.

There is another important element to consider. Absent a significant reversal in the current corporate governance environment, a relatively large segment of experienced, capable corporate board members will no longer be welcome on corporate boards. This is rather like having an octopus with no tentacles. Each director becomes a lost opportunity for creating linkages between the firm and its environment. While we certainly do not advocate a board comprised predominately of affiliated directors, we are hesitant to endorse the wholesale exclusion of such directors.

As importantly, there is the issue of director recruitment. One of the greatest challenges boards and their nominating committees face today is successfully recruiting new board members. We would submit that this task will be exponentially more difficult in an environment where an entire segment of the director pool is disqualified from consideration.

We also recognize, however, that there are certain types of directors that fall within the overall affiliated director category for which it is difficult to sustain an argument in favor of their inclusion of corporate boards. Family members of firms' officers are one such example. Any benefits that might arise as a function of their connections are not likely to be offset by the clear lack of independence. Moreover, we would suggest that these connections can effectively be leveraged whether the family member is, or is not, a board member.

We are also sensitive to board interlocks that potentially compromise director independence. Imagine, for example, two corporations – Daily Enterprises and Dalton Corporation. The CEO of Daily Enterprises serves as the Chair of the Compensation Committee for Dalton Corporation and the CEO of Dalton Corporation serves as the Chair of the Compensation Committee for Daily Enterprises. Clearly, this creates an untenable situation. Whether or not these Compensation Committee chairpersons would overtly collude, there is the likely perception of "quid pro quo".

An effectively comprised board should be structured to capture the multiplicity of directors' roles. Boards are rather like a kaleidoscope. The kaleidoscope relying on the three primary colors configures these elements in different combinations in order to create an array of beautiful images. Similarly, boards of directors are comprised of three types of directors – inside, outside, and affiliated. By drawing on the variety of director types, boards create a combination of directors that best suits the corporation's needs. To remove one of these "primary colors" (i.e. affiliated directors), substantially diminishes the power of the kaleidoscope.