Why Directors Don’t Direct
Over four score years ago, William O. Douglas told us that directors don’t direct. Since then, there have been multiple attempts to enable directors to direct the corporations they nominally manage, often by proposing or mandating changes in the composition of the board. Directors’ backgrounds, biases, opportunism and group behaviors have been diagnosed as both the cause and cure to the problem of director inaction.
Rather than examining directors, Adam Badawi shifts attention to those outside the board to explain why it is in the interest of the business that directors don’t direct. His focus is not on coalitions within the board, but on lobbying of the board by others in the corporation. So that these other interests don’t spend their time attempting to influence the board (and instead concentrate on activities more profitable to the business), it is essential that boards exercise little of the authority they possess. By delegating authority to management, boards constrain the investment management makes in lobbying the board.
As Badawi makes clear, restricting board activity may restrict the board’s abilities to reduce the agency costs occasioned by the separation of ownership and control. His focus is on the trade-offs. He considers, for example, the displacement of inside directors by outside ones. The gains in better monitoring of agency costs, Badawi argues, come with increases in lobbying costs, especially those imposed on the firm by the former directors. (P. 678.) As employees have non-diversifiable firm-specific capital investments, they will actively lobby the board. This lobbying may take various forms from massaging the information that the board receives to overt politicking. Because they have strong interests in the outcome, employees will impose influence costs on the firm when the board seeks to exercise its authority, “[t]o put it another way, the drag that lobbying can exert on a firm increases with every additional decision the board makes.” (P. 687.)
The trade-offs between influence costs and agency costs will be business and issue specific. Hence, Badawi argues, the deference of the business judgment rule to director exercise of their authority reflects fear of imposing influence costs on the firm. (P. 679.) As board oversight increases, agency costs might decrease, but the organizational drag of influence costs might increase. The appropriate trade-off, how board decision-making is structured, is contextual and difficult to make, perhaps especially by the board. Hence, the judicial hands-off policy is the proper default option. In an M.I.T. dissertation, Michael Powell has found a convex shape to the costs of lobbying. (P. 684.) Hence, a rule of law that required more board governance – such as a weakening of the business judgment rule – would “escalate very quickly” influence costs “in a way that is quite difficult for a court to observe.” (P. 708.)
Badawi’s account also explains why firms sometimes use outside law firms and independent consultants. Information that the board gets internally should be presumed to be influenced by the strong interests of firm employees. They may be knowledgeable, but they are interested. So, in an acquisition, a firm is likely to seek the independent but less knowledgeable opinion about whether the target is or is not a good fit for the firm. (P. 690) (even without Van Gorkom).
Badawi doesn’t claim that influence costs are the only reason why directors don’t direct (P. 692). But it is a breath of fresh air to find an article that neatly illuminates that question and that doesn’t impugn directors. One mark of a very good article article is the reaction, “of course.” And, that was my initial reaction to this article. I then thought that it is shocking that it hadn’t already been written. Badawi has his finger on something, and analyzes it beautifully. It should be much cited.
I hope this article also stimulates empirical work. If the CEO is Chairperson of the Board, what lobbying takes place? Does that influence the range of activities that the board undertakes? Do boards with CEO’s as Chairperson direct more than those without? When the General Counsel (as Board Secretary) sets the agenda, how is the legal department lobbied? There are, I believe, many more studies of intra-board politics than of firm-board politics. Badawi challenges us to undertake such research, and we should be grateful for that stimulus.
