Professor Cole's Finance Blog

As pointed out in today's NY Times column by Gretchen Morgenson, the recent financial crisis has refocused attention on the failure of the board of directors at publicly traded U.S. corporations, especially at financial institutions such as Countrywide, Fannie Mae/Freddie Mac, Lehman Brothers, and Washington Mutual.

In our system of corporate governance, the board of directors is supposed to represent the interests of shareholders, hiring, firing, monitoring and setting compensation for the top management team of its corporation. The recent crisis has demonstrated the abject failure of boards to fulfill their responsibilities to shareholders.

Why has this happened? There are a number of reasons, which together have wrested control of the board of directors from shareholders and handed it to CEOs.

Dispersed ownership: in contrast to corporations elsewhere in the world, ownership of U.S. corporations is dispersed. This means there are few large block holders to ensure that the board of directors represents shareholder interests.

Dominance of inside directors: at most corporations, inside directors (meaning members of the management team or their flunkies) hold a majority of the positions so that they can vote the interests of management over the interests of shareholders.

Multiple roles for the CEO: The CEO is often also the Chairman of the Board of Directors. As such, he controls the agenda for the annual shareholders' meeting and chairs that meeting. He also chairs all meetings of the board. Few outside directors want to challenge a CEO who also holds the Chairman's seat. In yet another role, the CEO also often is head of the board's nominating committee, which nominates new directors. As such, he is in position to select "compliant" directors, even when they are allegedly "independent."

Voting of "unvoted shares" by brokers: Existing rules allow for your stock broker to vote your shares in the event you choose not to vote them (or forget to vote them). On average, about 20 percent of all shares are voted in this manner, and surveys indicate that brokers overwhelmingly vote for the existing management team. This means that management starts with two-fifths of the 51 percent share it needs to retain control of the board. Alternatively, it means that someone challenging management has to win five-eights (more than 60 percent) of the remaining 80 percent of the shares in order to defeat incumbent management. Fortunately, this outrageous practice will end next year.

Anti-takeover provisions: Such provisions are too numerous to enumerate here, but, in sum, they make it all but impossible for dissident shareholders to throw out an incumbent management team by replacing its lapdog board of directors.

In the absence of an effective board, what are shareholders to do? Well, they can vote with their feet and sell their shares. Unfortunately, in an age of index mutual funds and EFTs, we all end up owning shares in these companies run by bad managers. In such an environment, it may fall to government regulators the role of disciplining management. When viewed through these glasses, the Fed's recently announced plan to oversee compensation policies for bankers looks less like over-reach and more like much-needed oversight. Proposals to provide shareholders with a "say on pay" also deserve our attention and support.