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  • Insights about Director Independence and Industry Expertise
  • Corporate boards have more independent directors now that it is required by the Sarbanes Oxley legislation passed in response to the Enron meltdown. In theory, independent directors can more effectively monitor corporate performance than directors closely tied to management via a supplier, consulting or other professional services relationship. Yet, as pointed out in an article in the December 2010 issue of Harvard Business Review, the 2008 financial crisis still happened despite Sarbanes Oxley mandates that, at least in theory, should have improved board of directors oversight of corporate performance.

    The Harvard article's proposed solution calls for the use of professional directors--those for whom serving as a director is their primary occupation, not a part time add-on as is often the case now. The article also suggests solutions dealing with board size and director expertise. For example, pointing out that too many directors lack relevant industry expertise, the article proposes requiring most board members to have it.

    Director independence and director expertise are areas whose impact can be explained by the business success and failure patterns I have been researching for more than 20 years. My research finds that business success generally comes from building on strengths. That's why when companies started to add more independent directors in response to Sarbanes Oxley, I took the position described in a letter to the editor I wrote that Business Week published back in 2002. My position: independent directors often lacked the strength of understanding the business, while many not-so-independent directors with longer term ties to management did have this strength. Requiring that directors be independent often meant stripping the board of this valuable strength.

    And now, after several years of adding more independent directors, we are seeing the disadvantages of having so many directors without experience in or a solid understanding of the business. The emphasis on independent directors reflects a relatively common misstep: focusing too heavily upon one narrow aspect of a complex problem, rather than addressing the problem from a broader context. The narrow area that is addressed may improve, but other important aspects of the problem may worsen.

    In this case, more independent directors may help reduce biases that hinder the monitoring of management. But, more independent directors also often means more directors without industry expertise. As a result, the board may be less effective in overseeing a company's performance. Along the same lines, requiring that most directors have industry expertise, like the Harvard article proposes, can also become a solution applied too narrowly. While it can alleviate problems that come from lack of industry expertise, it can have a detrimental impact elsewhere.

    For example, too many industry insiders can lead to a board being affected by the kind of insularity that often keeps huge, primarily promote-from-within corporations from evolving successfully when conditions change. Also, inadequate outside perspective can make it more difficult to identify material issues that the board should consider, a role the Harvard article says directors should undertake. So, instead of overfocusing on industry expertise, boards also need sufficient outside perspective.

    Moreover, when an industry is changing rapidly, expertise in what the industry is becoming may be just as critical as expertise in what the industry is and was. But, a director with the new expertise cannot completely ignore what was there before. If it is too difficult to find directors with both new and old expertise, then it becomes especially important to understand how companies evolve successfully, and to apply this knowledge when combining new and old. The goal is to find a way to integrate the new with the old, not to merely superimpose the new on the old and hope it will work.

    Furthermore, boards need directors who understand the company's strategic direction. Too little industry expertise, of course, can interfere with this. But, requiring industry expertise will not necessarily improve the board's proficiency with a company's strategic direction. In some cases, it can even do the opposite because within an industry, different players can have different visions for success.

    For example, to meet industry expertise requirements, a board could add directors who worked in the industry, but are most experienced with and advocates of a strategic direction that is totally wrong for the firm. This could happen in a financial services firm, for instance, that plans to continue its successful strategy of limiting risks and discouraging excessively high leverage. Such a firm can easily falter if it adds too many directors with industry experience who thrive on extensive risk taking and high leverage, a background that is not unusual in the financial sector. Even with industry experience, these directors may be too prone to pressuring the firm into pursuing high risk, jeopardizing the very strengths that enable the firm to thrive.

    In conclusion, boards generally benefit from industry expertise, but many independent directors now serving on boards may not have it. Yet, the success of an industry expertise requirement can depend heavily upon how much flexibility companies will have to adapt it to their own particular circumstances and needs. Any industry expertise requirement for boards should not be so rigid that it blocks effective use of outside perspective or impedes board understanding of the company's strategic direction.

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