In October 1972, former Supreme Court Justice Arthur Goldberg resigned from his seat as a director of Trans World Airlines. In a New York Times article published afterward, he expressed his frustration, stating that: “[t]he outside director is simply unable to gather enough independent information to act as a watchdog or sometimes even to ask good questions. When presented with the agenda of the board meeting, the director is not basically equipped to provide any serious input into the decision. Realistically, it has already been made by management.”
The composition of U.S. boardrooms, however, has seen a dramatic shift since Justice Goldberg left the Trans World Airlines board. Over the last few decades, boardrooms that were historically controlled by company executives have been replaced with boardrooms that are dominated by independent directors which in many cases consist of the CEO as the lone executive in the room. Motivated by the belief that independent directors are better equipped to detect fraud, protect shareholders’ interests, and monitor managerial abuses of authority, shareholder pressure and regulatory reforms have forced public firms to populate their boards and committees with independent directors. But is it the case that independent directors now have the proper tools to perform their monitoring function?
While academic literature has focused on the impact director independence may have on the board’s advisory role and company performance, little attention has been given to the impact of the current independent board structure on the board’s ability to effectively carry out its monitoring role—the main goal for which director independence was sought.
We sought to address this gap in the literature by analyzing how board independence may have actually diminished the board’s ability to monitor management effectively. Specifically, independent board members suffer from what we term as “informational capture”. As part-time employees who often sit on multiple boards, independent directors lack the time, adequate resources, and the industry-specific knowledge to obtain, digest and analyze properly the extensive and complex information that modern boards are tasked with evaluating. Consequently, these directors are too dependent on that information which management chooses to provide or conceal, as well as on the manner management presents it to them.
A recent survey that covers 783 public company directors further highlights this informational capture problem, revealing that when it comes to the quality of information that directors receive from management, “[t]here is a lot of room for improvement.” The survey finds that two-thirds of the polled directors wish “their materials better highlighted risks”; more than half of directors wish “the materials were shorter and more summarized”; forty-six percent wish “they were provided with more lead time”; and nearly half of them wish “the dialogue with management was less scripted or controlled.”
These institutional constraints faced by directors have led to the following paradox: shareholders, courts, and regulators expect the board to be independent in order to ensure its ability to monitor management. But at the same time, the current composition of the boardroom, dominated by “outside” independent directors, severely limits the ability of the board to obtain independent, complete, and unfiltered information regarding the company, a prerequisite to the board’s ability to perform its monitoring role properly. Therefore, the board often oversees management’s actions while wearing “filtered glasses” that are provided by the same executives the board is tasked to monitor.
This informational capture can also explain the increasing tendency of activist shareholders to request board representation in their target companies. Activist hedge funds, we argue, identified this informational gap, and have attempted to mitigate it through what is commonly termed as “super directors”; directors who, due to the backing and resources of the activist fund that appointed them, can transcend the limitations from which “ordinary” directors have suffered due to their part-time role at their respective companies and their limited access to information. Activist super directors, who enjoy the full resources and analytical strength of the hedge funds that appointed them, have the ability to collect, process, analyze, and edit voluminous information in a timely fashion, independently of management. The activists’ working product is then provided to the entire board, through its director nominee, allowing other independent board members to base their decision-making on a more balanced and complete picture. Further, contrary to many who cast the rise of activist super directors in a negative light, we show that the presence of a director with informational advantages in the boardroom is not a new phenomenon, is not limited to activist nominees, and, most importantly, these super directors serve as a key channel for mitigating informational capture of their fellow directors.
However, while the rise of activist super directors indeed underscores the importance of addressing the informational capture of boards, we argue that the current model of activist directors provides only a partial remedy to such a fundamental, structural problem. Activist interventions are limited to a small number of companies per year, the activist-appointed directors usually serve on boards for up to three years, and the interventions do not promote the creation of institutional knowledge within the boardrooms. Therefore, as a structural matter, a board that is comprised of part-time outside directors is doomed to suffer from these information deficiencies. This acute problem, in our view, can no longer be ignored.
Addressing the issue at its core, thus, requires a rethinking of the current board structure and how this structure correlates with the board’s role as a monitor. Because the independence of directors has become a key governance feature of the U.S. boardroom, and as boards have shifted into a monitoring role, the board as an institution must provide independent directors with the tools necessary to monitor management comprehensively. To achieve this goal, we call for the creation of a new institution within the board—the “Board Suite”. Such suite is a dedicated office within the board, consisting of a full time special counsel to the board (and supporting staff) that would serve as information facilitators. The suite would request information and collect outside sources, analyzing and editing the received information, and providing it to the board in a simple, clear, and efficient with a critical eye on management’s actions. This office would become the institutional knowledge base of the board—unmoved by the personnel changes the boardroom experiences—and is likely to alleviate the informational capture from which boards currently suffer.
Finally, we address potential objections to our proposed solution and highlight its doctrinal implications on Delaware case law. First, we show that this positive informational role performed by the activist super directors carries an important doctrinal implication for the way Delaware Courts should treat information sharing between board members and the activist investors that nominated them. Second, acknowledging board informational capture could potentially lead Delaware Courts to conclude that a board, which refrains from independently gathering the needed information and blindly relies on management, may not be afforded the protections from personal monetary liability provided by Sections 141(e) and 102(b)(7) of the Delaware Code.