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Powerful Independent Directors

The European Corporate Governance Institute published in January 2014 a working paper written by Fogel, Kathy and Ma, Liping and Morck, Randall, in which they advocated for “Powerfull independent directors” (PID) to be present in boards. (1)

PIDs are defined as individuals placed in the top quartiles in distributions for at least three out of the following factors:

  • Degree centrality, or number of people with whom the person is connected;
  • Closeness centrality: mean degrees of separation with others in the network;
  • Betweeness centrality: number of pairs of people he serves as connector;
  • Eigenvector centrality: weighted average of his/her connections`s social power.

 

These four factors provide a measure for an individual`s power, that is his/her capacity to receive information and make it circulate strategically. Connections mean available resources, friends to gather help from, etc., all of which reduces the downside stemming from challenging the CEO and the rest of management.

The authors use data available in the US to get information about connections: graduate or professional education that overlaps, common work experience and shared non-profit board memberships. They use only professional and not personal connections, which gives comparability and objectivity to their research, although it also fails to cover the full picture.

A powerful board is one made of a majority of legally independent and powerful directors.

The authors argue that Powerful Boards have economically and statistically significantly higher firm valuations: they have higher valuations, they take their companies to fewer value-destroying acquisitions, they increase the Ceo turnover-poor performance and the pay for performance relationships, and they reduce earnings manipulations.

These results can help understand why tests for the Independence-Firm Performance relationship have been so elusive, as not all independent directors are PIDs. Voiced dissent interrupts “unthinking obedience to the CEO –authority-”, (2) conformity to group behavior (3) or other groupthink forms, (4), so that rational decision-making prevails. PIDs can also help avoid the “Rule of Thumb” in decision-making, where thorough analysis only emerges when the rule does not provide “convergence”, (see (5)). This also “underscores calls for behavioral models of director decision-making (6) on the grounds that “various social and psychological factors – collegiality, team spirit, a natural desire to avoid conflict within the board team, and sometimes friendship and loyalty” can render independent directors impotent”.

  1. Fogel, Kathy and Ma, Liping and Morck, Randall, Powerful Independent Directors (January 9, 2014). European Corporate Governance Institute (ECGI) – Finance Working Paper No. 404/2014. Available at SSRN: http://ssrn.com/abstract=2377106 or http://dx.doi.org/10.2139/ssrn.2377106
  2. http://www.jstor.org/discover/10.2307/2786545?uid=2&uid=4&sid=21106415266191, by Prof. S. Milgram.
  3. Asch, S. 1951. Effects of Group Pressure upon the Modification and Distortion of Judgment. In H. Guetzkow (ed.) Groups, Leadership, and Men. Pittsburgh: Carnegie Press.
  4. Janis, I. 1971. “Groupthink”. Psychology Today 5(6):43–46, 74–76.
  5. Kahneman, D. 2011. Thinking, Fast and Slow. Farrar, Straus and Giroux: New York
  6. Bebchuk, Lucian A. and Fried, Jesse M., Pay Without Performance: The Unfulfilled Promise of Executive Compensation. Harvard University Press, 2004; UC Berkeley Public Law Research Paper No. 537783. Available at SSRN: http://ssrn.com/abstract=537783
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