Man Without Qualities

Saturday, September 14, 2002

Welch on Independent Directors

At the margins, the Man Without Qualities has always had reservations about the cult of Jack Welch - especially when it comes to the description of his own management principles as written by Jack Welch.

But there is no denying his results at General Electric or his practical business genius. That genius shows up as he demolishes with supreme insight one of the most peculiar suggestions that the "corporate reform" crowd has been advancing: the virtue of loading the board of directors of a public company with so-called "independent directors." (He also rather successfully defends himself from recent attacks on his post retirement "perks" andf scores a good hit at the New York Fed chief's unsupported - and probably unsupportable - implication that executive compensation in this country is generally inefficiently high)

Independent directors are nominally just directors who are not part of company management. But, as the term is being used now by the "corporate reform" crowd, it often carries an implied requirement that an "independent director" be someone who is not very wealthy and is not a member of the business elite. The point of this proposed "reform" seems more political than economic. Worse, there is often an implied suggestion that "independent directors" actually represent special interest groups - such as environmental or civil rights groups. Such 'special interest" directors would breach their fiduciary duties to shareholders almost by definition.

Non wealthy independent directors are not meritless. But that merit does not lie in any supposed tendency their presence has to align the interests of company management with the interests of the shareholders. Rather, there is often a benefit of having the views of a smart, friendly person who is not part of management. Small doses of this are enough. In fact, anyone who has experience with the management of public companies should know that this kind of "independent director" is normally the most docile. Mr. Welch certainly shows that he knows when he says:

The independent director issue worries me to death, because what do you want out of a director? You want intelligence, common sense, independence, the willingness to speak out. If you get people that the compensation of the board, their compensation on the board is critical, I think they're less likely to. No offense to faculty members or foundation heads, but the income from a board is more significant to them than a wealthy person who might have a one percent conflict.

Mr. Welch addresses the problem of non-wealthy independent board members. But attempts to rely on wealthy independent board members also pose problems. The Man Without Qualities has in earlier posts pointed out that very wealthy directors whose fortunes are not derived from the company on whose board they serve have much more to lose if they neglect their fiduciary duties. In a sense, their personal fortunes constitute a kind of 'bail" or "bond" posted to guaranty their willingness to abide by their fiduciary duties. This economic effect is straightforward (indeed actual bail and bond systems are based on this observation), but political bias prevents some people from seeing what is economically obvious. (One may wonder if such people would support abolition of bail in criminal cases.)

But for this very reason, it is not often easy to find such board members. Rich, ethical people who want to "post' their personal fortunes for no other reason than the opportunity to serve unrelated public investors are just not that plentiful. However, if the director compensation is fairly high (although not what management earns) and the company is perceived to be run by the board in a transparent, ethical manner (so that the risk to the director of liability from charges of malfeasance are low), it may be possible for a public company (or at least some of them) to attract such people. But if board compensation is high enough to attract such people, the more aggressive members of the "corporate reform" crowd will argue that the board has been "bought off." For example, this argument has been made about Enron, despite the absence of substantial evidence to support such a position.

And such people often also have a personal connection to management (friend or prior business partner, for example) that can partially offset their independence. This kind of informal personal relationship is hard to track and account for. For example, what company wants to tell its CEO that he can't be friends with members of the board of directors? The CEO is supposed to try to remain on good personal terms with each board member - where's the line? And who would want to police such a line?

In sum, Mr. Welch points out the problems with non-wealthy independent board members, and reliance on wealthy independent board members is also highly problematic. The bottom line is that "independent board members" are not a likely answer to aligning the interests of management and shareholders. The corporate reform crowd should dream another dream.

So let's hear it for Jack Welch. Sometimes retirement can confer the kind of independence on a former CEO that allows him to say the politically unpopular things that he couldn't have said while he was charged with representing the interests of shareholders.

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