Well-Connected Directors Pay Off in the Long Term

Dumping directors who serve on too many corporate boards can come at a cost: sacrificing long-term investments for quarterly profits.

Based on the research of Adam Cobb

In the last century, America’s corporate boards were sometimes criticized as a fraternity of good old boys. By serving on several interlocking boards at once, directors might stretch themselves too thin to act as watchdogs, and they could get too chummy with CEOs. The results were corporate scandals like Enron and WorldCom.

Today, that’s often seen as conventional wisdom. At the demand of shareholder groups, companies have busted up networks of elite executives over the past two decades. In the name of good governance, they’ve limited the number of outside boards on which a director can serve.

But that approach might be damaging, says Adam Cobb, assistant professor in the Department of Business, Government, and Society at Texas McCombs. Analyzing over 1,800 firms over 15 years, he finds they’ve traded one set of problems for another. As boards have gotten less connected, they’ve become more vulnerable to the whims of Wall Street and more prone to sacrificing long-term investments for quarterly profits.

“Today, boards are more pressured by activist investors to focus on what’s good in the short term, rather than taking a pragmatic view of what may pay off in 10 years.” — Adam Cobb

Cobb and his coauthor, Richard Benton of the University of Illinois at Urbana-Champaign, found that as directors served on fewer boards, their companies put less money into future growth and more into immediate returns. This applied in three separate areas: research and development, pensions, and payouts to shareholders.

“Our research suggests that having a lot of unconnected directors is not optimal,” Cobb says. “Maybe the pendulum has swung too far, and it’s time to update our thinking about what makes a good board.”

Upsides of the Elite

Elite director networks aren’t all bad, Cobb argues. They can provide several underappreciated benefits, both to companies and to society at large. One is that well-connected directors tend to look beyond the interests of a single company. “There’s evidence that they protect the interests of their class, as high-ranking executives,” Cobb says. “The health of the overall economy is really important to them. There’s a sort of enlightened self-interest, an attitude that we can grow our piece of the pie and grow a bigger pie, too.”

Another role is to informally disseminate new management practices. In the 80s and 90s, Cobb says, board networks spread the word about poison pills, which blocked hostile takeovers by changing shareholder rules.

More important, these directors help insulate CEOs from short-term pressures and support their long-term gambles, he says.

Cobb points to CVS Health Corp. and its 2014 decision to stop selling tobacco products. The move cost $2 billion in revenue, but CEO Larry Merlo argued it would pay off later by positioning the firm to be a health care company. His board, which included several former CEOs, helped him sell the strategy to investors and analysts.

“You shouldn’t be bending to every whim of shareholders. You have to have freedom to make long-term bets.” — Adam Cobb

The Costs of Disconnection

To test whether less-connected boards led to more short-term thinking, Cobb and Benton examined data for all the S&P 1500 firms and their directors from 1998 to 2013.

In 1998, the researchers found, the average board was connected to 6.8 other firms. By 2013, the number was down to 4.3.

Those missing links affected three different measures of short-term thinking. On average, one less connection resulted in:

· A $2.4 million drop in R&D expenditures, meaning fewer new products for the future.

· A $21 million rise in shareholder payouts like dividends and stock buybacks. Those may divert cash away from expansion, innovation, or training.

· A 0.5 percentage point rise in projected rates of return on pension funds. By forecasting higher investment returns for the future, firms can underfund pensions today.

Though the individual numbers might seem small, they all point in the same direction, he says. “If one variable — board fracturing — explains a bunch of different indicators of time horizons, it means the effect is really powerful.”

Finding a Happy Medium

The lesson for companies is that in pushing for more independent boards, they may have gone overboard.

“In the early 80s, it was not uncommon to sit on six or seven boards,” he says. “Today, they put in contracts that a CEO can only sit on the board of one other firm. There should be a happy medium between seven and one.”

He suggests that firms look at connectedness as one more form of diversity. Just as they assess whether they have enough women or minorities, companies should look at how networked their directors are. If they come up short, firms might seek out a couple who serve on multiple boards.

“Say you have an auto company, and you bring on someone who sits on boards of a pharmaceutical, an information technology, and a retail company,” Cobb says. “They’ve been through every manner of corporate strategy change. That person is going to have keen insights you might have missed otherwise.

“I wouldn’t say that companies should have only hyper-connected directors,” he adds. “But they would likely benefit from having a few.”

“Eyes on the Horizon? Fragmented Elites and the Short-Term Focus of the American Corporation” appeared in the May 2019 issue of the American Journal of Sociology.

Story by Steve Brooks