Imagine there were a state law requiring legal services to be provided by individual sole proprietorships. Companies would have to hire individual lawyers, who could then contract with others for information, expertise, support, and so on. Such a law might be motivated by a belief that lawyers would be more careful acting alone or that conflicts of interest arising from pooling legal resources outweigh the gains or some other reason. But whatever the reason, such a rule would generate widespread opposition from lawyers arguing that by pooling their resources they could offer better services to their clients. Clients would object too. While some clients might prefer to hire lawyers unaffiliated with a large firm, others might prefer the costs and benefits of hiring a firm instead of a single lawyer. Business associations allow individuals to pool their resources to share risks, obtain gains from economies of scale and scope, optimize the deployment of various resources across space and time, devote time and effort to innovation, and develop large reputational assets that can constrain opportunism. In Coase’s framework, ringing the boundary of the law firm around multiple lawyers would bring efficiencies in the provision of legal services.
These benefits seem as applicable or even more so in the context of corporate director services. But state corporate law requires director services be provided by “natural persons.” Therefore, corporate boards are currently composed of ten or so part time sole proprietorships, who are forced to contract with others, be they inside or outside of the company, for information, expertise, support, and risk pooling (that is, insurance). This state of affairs is the source of many of the most severe problems of corporate governance identified by scholars and governance experts. Managerial domination of boards, such as it is, is founded primarily on the weakness of individual board members and the information asymmetries between managers and board members. And yet, governance experts take the sole proprietor board model for granted, and offer reforms, such as greater independence or destaggered boards, that merely tinker at the edges of this system.
Our article, “Boards-R-Us: Reconceptualizing Corporate Boards,” puts the natural-person obligation to scrutiny, and concludes that there are significant gains that could be realized by permitting firms (be they partnerships, corporations, or other business entities) to provide board services. We call these firms “board service providers” (BSPs). We argue that hiring a BSP to provide board services instead of a loose group of sole proprietorships will increase board accountability, both from markets and judicial supervision. BSPs traded in public markets will be disciplined to provide quality services at competitive prices, and courts may be more willing to enforce fiduciary duties against firms as opposed to individuals. More transparency about board performance, including better pricing of governance by the market, as well as increased reputational assets at stake in board decisions, means improved corporate governance, all else being equal.
Currently, there is no real market for corporate director talent. Directors find their way onto boards largely through personal connections or the opaque headhunter process, and because votes are private and decisions are made collectively, the accountability to shareholders is greatly attenuated. Although it is possible for any individual to run for a board seat on any company, the publicity and voting costs are prohibitive. The returns to winning a seat on the board of a very large company are a few hundred thousand dollars per year, while the costs of mounting a proxy battle run in the many millions. Even if sensible economically, the chances of winning are trivially small. Another alternative is for an investor, such as a private equity firm, to take a large stake in a firm (or takeover the entire firm), and use this as leverage to win board seats and thus influence governance. A BSP with a national reputation and the ability to provide all director functions would be able to increase the gains from winning board seats, while reducing the per seat cost of winning them. This could create a market for corporate governance separate and distinct from market for corporate control.
Another benefit is that a BSP may be an effective means of measuring the value of corporate governance and of those providing director services. For instance, a publicly traded BSP providing board services to many firms would have the quality of its services measured in the market somewhat independently of the operational outcomes of its clients. Partially decoupling governance and operational performance would allow all stakeholders to more readily measure the former.
Our proposal is consistent with the spirit of state corporate law as a set of default rules that merely enable firms to create their own governance arrangements designed to generate local maxima. Mandatory rules are the exception, not the rule, and should be based on clear and convincing evidence that freedom of contract would be unlikely to lead to social welfare improvements. We believe such a case is not made, and, in fact, the opposite is true. In addition, there are a variety of contexts in which law, including state and federal law, already tolerates corporate entities serving in a board or board-like role. Partnerships, for instance, can have any legal person serving in the board-like role of general partner. Extending this right to corporations seems like a logical next step.
This is not to argue that all firms should hire other firms to provide their board services. We doubt one-size-fits-all arguments generally, and are confident that such a rule here would be hopelessly overbroad. Firms should merely have a choice, subject to the constraints of the market and judicial review for opportunism in the use of corporations to provide these services. As we show, the Boards-R-Us idea is one that could be used to achieve a host of governance ends, ranging from increased shareholder power to better director primacy over corporations. In either case, and all those in between, what our proposal does is increase the transparency and competition for board services in a way that should increase confidence that firm choices about the role of the board are ones that are in the interests of shareholders and society in general, rather than based on a hidden agenda.
The full article is available for download here.