The contemporary corporate board of directors (BoD) is a rather odd construct, although it should not be. Its dysfunction symbolizes neatly how poorly corporate governance works these days, or at least much worse than it should.

We’ve long wondered how CEOs talk about “my” BoD as if they own it; yet in some important respects they rather do. We’ve also wondered about the CEOs who retire from a company only to join the ranks of executives that embark on a second career as a “professional” director. What, exactly, does that profession entail? What do they see, do, and learn at NACD meetings?

More generally, how does a BoD take on its own, independent identity, largely separate from the shareholders that they purport to represent and defend? How does the role of a corporate director turn into a part-time job in which retired CEOs become employees of current CEOs?

And: how do we make sense of the range of proposals to improve BoDs, such as majority voting or shareholder engagement? Can we identify a consistent framework for evaluating the BoD of a portfolio company, beyond simple algorithms that merely allow investors to rank companies based on largely subjective scores on dozens of corp gov attributes?

Many Questions, One Theory

These questions have prompted us to think hard about how to understand the relationships among investors, directors, and executives. Our thinking naturally leads to Berle and Means, who first explained the separation between ownership and control of public companies. It also leads to Jensen and Meckling, who identify the real costs related to that separation, and defined the problem in terms of principals and agents.

Thus, we just drafted an essay that explores these subjects. We use agency theory to sort out the interests among the three players, in which directors have more in common with executives (job security) than with shareholders (profitable investment).

Agency theory also points to the costs that arise from that divergence, which investors know well: failed deals, senseless acquisitions, and wasteful expenses. Finally, agency theory leads us to the two principal means by which investors manage that divergence, namely monitoring and incentives. Designing and maintaining these two means also carry a cost, which together with the costs of divergence leads to what we have come to call agency costs.

Much to Criticize, One Framework

Agency theory and agency costs thus provides a useful framework for understanding the curious relationship that has emerged among investors, directors, and executives. We criticize “professional” directors, shareholder engagement, majority voting, and other current trends in BoD reform.

Agency theory also leads us to conclude that executives don’t belong on the BoD, and the BoDs shouldn’t have nominating committees. Insider trading rules do nothing but prevent the best candidate, a portfolio manager, from serving as a director.

We also urge investors to take control of BoD compensation. Earlier we concluded that we should allow investors to pay directors. Even worse, today shareholders literally have no say in how and how much companies pay directors. This glaring gap in accountability leads to some of the most insidious conflicts we see among investors, directors, and employees. It converts shareholders’ duly-elected representatives into executive loyalists.

We aspire to create a simple, logical, and consistent framework for understanding, assessing, and improving BoDs. We’ve posted The Agency Problem of the Board of Directors in draft form. Comments welcome.