"Do boardrooms dominated by independent directors improve financial performance for shareholders—or hinder it?"

Schuyler Roche's Eric Fogel asked himself this question in exploring the efficacy of the Sarbanes-Oxley Act of 2002, the federal law requiring publicly traded companies to improve accountability and internal controls. To answer this question, Eric recruited colleague Andrew Geier, and together they researched 254 public companies across 50 industries, ultimately concluding that the corporate governance paradigm guiding most boards of directors is the reverse of what it should be.

The Delaware Journal of Corporate Law, in its 2007 winter edition, will publish the results of their scholarship:  "Strangers in the House:  Rethinking Sarbanes-Oxley and the Independent Board of Directors." Eric will also address this topic at the April 4, 2007, meeting of the Corporate and Business Law Section of the Chicago Bar Association.

Rather than foist outside directors on boardrooms, argue Eric and Andrew, the SEC, the New York Stock Exchange and NASDAQ should promote a model whereby shareholders (i.e. owners) comprise the majority of public company boards, and independent directors (i.e. outsiders) comprise the minority.

"So-called independent directors," Eric says, "did not avert the staggering corporate scandals of recent memory. Consider Adelphia, Enron and Worldcom. It stands to reason that shareholder owners—not disinterested non-owners—would demonstrate greater zeal in monitoring management of the companies they own, and should therefore comprise a majority of a public company's directors. Owner-shareholders are the most efficient profit maximizers. They'll ask the tough questions and probe because it's in their interest to do so. All shareholders will benefit as a result."

The psychology of self-interest illuminates Eric's contention. What is the incentive for an outside director, paid a fixed fee despite corporate performance, to challenge a public company's finances or the company's CEO? Where is the impulse to deflate ballooning executive pay when many outside directors are closely tied to leadership? When a D&O policy frees outside directors of liability, where is the inducement to challenge existing management? These and other questions, Eric and Andrew believe, point to one conclusion:  to tip the balance of corporate governance by aligning power with owners, not outsiders.

To support their proposal to shift the corporate governance paradigm, Eric and Andrew detail their own findings and econometric research by academics and other experts. Based on return on equity, their research denotes no correlation between the best and worst performing companies and the number of outside directors. "We found no hard evidence," says Andrew, "that outside board members increased financial returns to shareholders."

Eric adds:  "Our research indicates there is no empirical data to support the notion that super majority independent boards increase financial performance for shareholders. If the real purpose of independents is to act as wise referees in the event of conflicts, then it does not take a majority of board members to sort this out—it usually takes only three."

In exploring this issue, Eric and Andrew provide in their article historical background and social context for Sarbanes-Oxley, such as the rise of the managerial class and popular wisdom, which maintains that outsiders without internal connections to management make better watchdogs. Debunking this myth is an example close to home—the recent scandal at Hollinger, Inc.

Owner of the Chicago Sun-Times, Hollinger boasted a vanity board on which sat former Secretary of State Henry Kissinger, among other luminaries. Few would dispute the fact that Hollinger's crisis went undetected by its independent directors, who comprised a majority of the board, until this crisis reached proportions fatal to management, devastating to stockholders and damaging to the corporation's existence.

Sarbanes-Oxley was a quick fix in reaction to public scandals, Eric and Andrew agree, one that is proving cost prohibitive and ineffectual for American companies eager to compete in the global marketplace. The reforms they propose are designed to pave the way for greater participation by longer-standing "oversight shareholders"—allowing owners to serve on boards of directors and enjoy safe harbors against such liabilities as ERISA, tax, insider trading and controlling party liability. No doubt these reforms and others Eric and Andrew propose will generate debate not only within the legal community but in the halls of Congress and in boardrooms across the nation.

This newest article is Eric's second venture into the pages of the Delaware Journal. In 2004, this prestigious periodical published the precursor to his current effort:  "Public Company Shareholders Acting as Owners:  Three Reforms—Introducing the 'Oversight Shareholder.'" There he and colleague David Addis argued that public shareholders should indeed serve as active owners, not passive investors, to ensure "greater accountability by the people entrusted to administer public companies." The positive feedback this article generated helped persuade Eric to continue to explore ways to improve Sarbanes-Oxley. Just recently a reader at the Chicago Kent College of Law wrote Eric to say:

In my opinion, the beauty of your argument is that your construction of the law would shift the gate-keeping function to those interested in gate-keeping....  Bravo...it's ingenious! I truly enjoyed reading this article.

Anyone wishing to discuss either Delaware Journal article is encouraged to contact Eric or Andrew:

efogel@SchuylerRoche.com
ageier@SchuylerRoche.com

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