How exactly did the corporate board come to be? This is an important question to consider when thinking about how important board director positions are today. The concept of corporate governance in practice dates back as far as the 12th-16th centuries. Although many of the fundamental principles of corporate governance have endured the test of time, the dynamics of how they operate, including the responsibilities of individual roles and the distribution of power and decision-making, have continued to evolve.
The earliest roots of the corporate board can be found in Medieval Europe, where merchants and traders formed partnerships, sharing risks and profits. During this period, guilds, associations of craftsmen and merchants who practiced trade, played a significant role in the economic and social structure of the medieval village. Guilds had a sort of board that oversaw their activities and made decisions regarding things like trade regulations and apprenticeships. The individuals on this board were typically elected by guild members. This is the first concept of an early corporate board, meaning there was a group of individuals responsible for making decisions collectively and overseeing an organization’s affairs.
More notably, the Dutch East India Company (the VOC), established in 1602, is highly regarded as one of the first multinational corporations. This company introduced a more formalized corporate governance structure. It had a board of directors and shareholders, serving as the template for modern corporate governance. More specifically, the VOC was made up of multiple private trading companies where individuals and directors acted as shareholders. Their liabilities were limited to their paid-in capital, meaning the company was essentially what is today known as a limited liability corporation. Critical elements of success for this board included the carefully balanced representation of shareholder interests and the director positions being filled by existing merchants who had authority over the investors. With these successes, we see the importance of separation of ownership and control and how a board should focus on policies that benefit the whole company.
In the 17th century, the formalization of stock exchanges was significant for defining corporate governance. Particularly, the establishment of the London Stock Exchange in 1698 greatly contributed to the development of joint-stock companies. Exchanges served as platforms to buy and sell shares of publicly traded companies, further reinforcing the need for corporate governance. This was more organized and transparent for companies who were aiming to raise capital by issuing shares to the public. Shareholders were able to vote on company affairs during general meetings, giving them a way to influence the board’s decision-making. The London Stock Exchange had requirements and regulations regarding financial disclosures and transparency of operations, which established levels of accountability in terms of corporate governance.
During the 19th century, the United States experienced a railroad boom, alongside the rapid expansion of modern corporations. The expansion of the railroad industry, during this period, led to the formation of many railroad companies and a surge in corporate activity. Therefore, corporate boards became more common, as growing companies needed increasingly complex management. The complexity and scale of railroad operations meant companies needed to improve their regulations and such. Many of these companies fell victim to financial speculation and fraud.
The Industrial Revolution marked a significant shift in business practices. This was a period that shifted manual labor-based economies to industrial and machine-driven ones. As industries expanded, the need for capital and management also increased. Capital accumulation led to the further emergence of joint-stock companies. The concept of limited liability became even more crucial to protect the financial responsibilities of investors, leading to newly developing legal structures and other management. The formation of corporations continued to expand.
Finally, in the 20th century, we witnessed the formalization of corporate governance. The term, “corporate governance,” wasn’t actually used until the 1970s and largely stayed within the United States. During this time, the role of the board became more defined, as corporations grew in influence, with an emphasis on representing shareholder interest, strategic planning, and management oversight.
Today, corporate boards are a necessary part of corporations, playing a crucial role in decision-making and oversight. The many historical pioneers, of simpler corporate governance systems and the framework of principles they began with, are still relevant to this day. Modern responsibilities of today’s board directors have changed greatly and their complexities will continue to evolve.
Developing a strong organizational framework for the board of directors is critical to ensuring that company matters are addressed by the correct committees and receive the attention necessary for solving these matters. Issues of importance should be prioritized appropriately and given ample time for review.
Corporate Culture and Board Organization
There are many mechanisms for organizing the board, all of which lead back to the topic of corporate culture. Corporate culture begins with the board; if the board is unable to establish an understanding grasp of what motivates corporate behavior, the rest of the company will follow suit. Failing to give thoughtful attention to employee and executive interactions, behaviors, and language will undoubtedly result in a disorganized board and a company that lacks a clear focus of what defines its team members. Thus, it is important for boards to maintain an environment that fosters engagement and meaningful conversation as a backdrop against accomplishing agenda tasks. This is the first step to spreading a culture of candor and trust within the company and cannot be accomplished through one 40-minute team bonding meeting. It must be consistently worked upon and established over time through healthy discussions of sensitive topics, transparency about company goals, and acknowledgment of personal weaknesses to make room for learning growth.
Corporate culture should also be included in a company’s formal risk assessments as it can very easily influence workforce productivity, company reputation, and law breaches. According to the 2017 Board Leadership of Corporate Culture in Europe Report, approximately 85% of the value of leading businesses come from intangible assets, such as a company’s brand, reputation, and internal relations. These intangibles are all inextricably linked to the board’s ability to set the right organizational culture and are important factors to business success. Thus, investing more time and resources into mindful culture development will bring a company greater returns.
Tailoring the Board to Meet Company Needs
When talking about board organization, it is important to keep in mind that not every board is the same. Board work should be tailored to the specific needs and culture of the company. What makes sense in the context of one board may not work for another. While looking at best practices and board trend reports may be helpful in establishing a general framework for your own practices, it should not be viewed as the golden rulebook of board organization. Such trends come and go; a company should only adopt a policy after considering the specific benefits it will bring in their unique corporate circumstances.
One example of the significance of examining company specifics is the debate over combining or separating the chairman and CEO roles. One generally accepted argument is that the role of the CEO/management is to run the business operations while the role of the board is to oversee this management, thus the leadership of the two roles must be separated to keep each other in check. Conversely, others argue that the role of the CEO and Chairman go hand in hand and can be combined to one position of oversight. This age old debate has no one-size-fits-all answer because it depends on the circumstances of the company. In the U.K., the CEO does not serve the dual role of the chairman, whereas in the U.S., over 50% of CEO’s surveyed also serve as chairman.
A simple yet helpful device for setting the distinction between management and board decision-making is to set up periodical reviews of the specific responsibilities reserved for the board. While this is just one example of how different systems can adopt differing policies, in general, all major questions regarding board and leadership structure require careful consideration of the unique set of company needs and corporate culture that influence these decisions.
To understand the important job that board directors uphold, we must first take a look into the complex origins of how governance boards came to be. While the foundational pillars of governance have remained constant, the dynamics of how they operate have since evolved to encompass broader roles. We will examine the historical emergence of boards to gain an understanding of the framework of modern governance, providing a necessary foundation for directors today.
The role of boards of directors is and always has been to protect and enhance the well-being of its corporation. The overarching definition of governance can be stated as a system to control the decision making processes surrounding resource allocation and risk tolerance. Different governance structures have emerged and evolved to perform this definition, but ubiquitous commonalities between these structures remains — the presence of intermediaries operating control between multiple owners, periodic reports of fiscal status to owners and an elected authority to appoint the leader.
The first demands for such a structure can be dated back to the early 17th century, when the Dutch battled for control of trade in the East Indies. With the launch of the Dutch East India Company (Verinidge Oostindige Compagne or VOC for short) in 1602, the Dutch were the first to introduce a stock market to Amsterdam, transforming its regional market towns into a dominant financial center. The VOC was an aggregation of private trading companies into a single entity, where the economic participants and managing directors acted as shareholders whose liabilities were limited to the paid-in capital, or what is today known as a limited liability corporation (LLC).
The Dutch Become the Predecessors of Corporate Governance
Alongside being the world’s first LLC, the VOC set the precedent for many other business practices such as establishing the world’s first stock exchange (the Amsterdam Stock Exchange) and releasing the first initial public offering (IPO). These progressive changes to corporate trade and allocated wealth created demands for new management strategies, leading to the early semblances of a governance board.
Governance of the VOC was organized into six chambers based on various ports. Seventeen delegates were selected from the managing shareholders to represent each chamber, with the last seat in rotation. They convened to administer executive decisions such as defining general policy, delegating operations, etc.
The key feature of success in this early board was the carefully balanced representation of shareholder interests — an effective assurance that policies benefit the overall company. Another important feature of this board was that its directors did not originate from its passive shareholders, rather it was managed by the preexisting individual merchants that collectively held legislative and adjudicative power above the investors. This separation of ownership and control is a fundamental property that must be held in order to advance a company’s well-being, and we will see this as a common source of pitfall in boards moving forward.
Early Corporate United States
Shifting our focus to colonial America, as it strived towards an independent nation, they needed to learn how to operate as a confederation of states and redefine the roles of government. Examining the first 150 years of American history in the context of socioeconomic organization reveals the early origins of corporate America and how modern board practices came to be.
At the time the Declaration of Independence was written, large corporations were frowned upon for their unpredictable influences on the economy; hence only special corporations were allowed rights to formation under government authorization or a royal charter. However, the shifting power structures in post-revolutionary America incited national debate over private vs. federal control of corporations. In 1811, New York laid the groundwork for an incorporation law that established a simple procedure to register a corporation sans legislative permission and allowed investors limited liability. The incorporation law created a set of legal guidelines for corporations, including provisioning control to a board of directors and maintaining maximum capital under $100k. These policies reflect the formation of the modern board, as well as the ongoing dichotomy between corporate and political power.
The fundamental pillars of corporate governance revolve around independent, non-biased decision making that serve the best interest of the company, though early boards lacked the legal and structural framework to uphold these principles. As numerous scandals led to rising public scrutiny, the role of the the board evolved to encompass a separation of director interests from those of upper management to prevent the reoccurrence of corporate collapses at firms such as Enron Corp., WorldCom Inc., and Global Crossing Ltd.
Post WWII Developments
The economic boom following World War II allowed corporate power to flourish, making the role of governance boards increasingly important. During this period of market growth, corporate managers were leading the reigns while board directors and investors were expected to follow. With corporate powers mushrooming out of proportion, the board of directors served more of a symbolic role than actual oversight which led to an era of scandals and financial fraud, one of the most notable being the wreck of Penn Central.
Penn Central’s collapse in the 1960s was caused by its board’s misinformation, poor monitoring of capital and its further debt propagation of $100 million in dividend approvals. The story caused a widespread backlash against inside directors and fueled the shift in board structure from the advisory to oversight model. As more firms such as LTV, Ampex and Memorex came under fire for fraud and mismanagement, recognition grew for the significance of independent directors. Reform was on the horizon.
Things began to change in the 1970s when the Securities and Exchange Commission (SEC) introduced new regulations that cracked down on the structure of boards. In 1976, the SEC pushed the New York Stock Exchange (NYSE) to require audit committees be composed of independent directors with access to accurate accounting information and outside auditors should they see fit. Other legislative reform proposals placed emphasis on shareholder representation and the distinction between management and oversight members. This era of corporate governance reforms had the collective effect of reconceptualizing the board’s purpose and composition in favor of actively informed, nonpartisan decision-making.
The Rise of Institutional Shareholders
Moving into the 80s, corporate governance focus shifts back to shareholder’s rights and deregulation that corresponded with a political rightward shift. Lawmakers and corporate advocates let corporate governance reside to align itself with the market mechanisms. During this decade, “The Deal Decade,” institutional investors bought more shares and held more than 40% of the U.S. equity markets, giving them more control to exercise hostile takeovers. The cycle of mergers and acquisitions that ensued were mainly motivated by quick returns.
Fearing takeovers, executives and legal courts turned to the idea of independent directors to decide on hostile bids and compare them against the value of the company. In a series of cases, the Delaware Supreme Court gave boards permission to adopt a “poison pill,” a corporate finance technique designed to drive away hostile bidders by imposing them with high costs. Placing the responsibility on independent directors re-enforced the oversight and judgement role of directory boards.
The value of independence continued to grow at the turn of the century, as reflected by continued tightening of standards for disqualifying relationships of directors, reinforced legal frameworks for fiduciary duty violations and equity linked compensation rewardingvigilance. Beyond this, internal structure developments led to the formation of nominating committees to shift the power of director selection away from CEOs. In 1996, the federal government further established the board independence standard through Section 162(m) of the Internal Revenue Code which appended a set of eligibility criteria that prohibited former officers of a corporation or anyone who has received compensation, either directly or indirectly, from said corporation to act as directors. These IRS regulations divorced economic interest from corporate governance and became important guiding points for future evaluations of board independence.
Post 2000 Board Refocus
As the economy continued to grow in the early 2000s, the lack of robust legal standards, and growing market conditions ripened the scene for numerous cases of fraud, such as systematic financial mis-reportings and deceitful accounting practices. One of the most severe and prevalent forms of profiteering was stock option backdating. Following a 1972 revision (APB 25) to accounting standards, companies were able to report executive incomes in the form of “at-the-money” stock options as business expenses for the purpose of increasing executive compensation while misinforming shareholders. Many companies then discovered that by backdating stock option grants, they were able to generate additional income that was both tax-deductible and held an underlying lower stock price. This resulted in widespread earning overstatements and record falsifications.
Enron Scandal Leads to Sarbanes Oxley
Enron Corporation, a major energy, utilities and natural gas company, was exposed in major case of institutionalized accounting fraud that generated a vicious cycle of insider trading and money laundering among its executives. In 2001, Enron filed for bankruptcy and emerged from it in November of 2004, reorganizing under the name Enron Creditors Recovery Corp. and continuing its streak of fiduciary failure, high risk accounting and “off-the-books” activities — all of which was facilitated by their lack of independent auditors and board members. Enron’s board was comprised of members who held financial ties with the company and inappropriate conflicts of interest that fueled the wildfire of diverting funds, overstating profits, and growing debts.
In the wake of major scandals from Enron to Worldcom, the federal government cracked down on lax corporate laws which led to Congressional hearings that focused on the responsibility of board directors in such matters. Following the hearings, the Sarbanes-Oxley (SOX) Act of 2002 was quickly developed and passed which mandated, among other things, independent board audit committees, the creation of the Public Company Accounting Oversight Board (PCAOB) to regulate auditing processes, internal control tests, and required that CEOs and CFOs to attest to their financial statements. The principal goal of SOX was upholding financial integrity, though it accomplished sweeping accounting reforms beyond this by reestablishing the expected roles of corporate boards.
SOX continues to have a profound impact on capital markets and boardrooms today. By enforcing independent audit committees, it strengthens the board’s role in overseeing management’s accounting practices to separate conflicting interests and ensure that no misreportings slip through to the public. In addition, SOX imposes harsher punishments for securities fraud by sentencing up to 25 years in prisonif top management knowingly signs off on falsified reports. The company also loses credibility and investor confidence when they publish the required accounting restatement stating management’s misconduct. Finally, SOX strengthens disclosure between companies and the public by closing the loopholes for off-the-books activities.
In simple terms, boards are the governing bodies of corporations elected to make major decisions concerning financing, mergers and acquisitions, selling the company, nominating the CEO, and when or if they should release an IPO to take the company public.
The board serves the corporation as its agent and makes decisions in an unbiased service of the company and its shareholders’ best interests. An important distinction to note between board members and management teams is that it is not the board’s responsibility to run the company. Their responsibility falls more under oversight and ensuring that the right people are running the company. Boards that get too involved risk undermining the management team and fail adherence to the crucial board principle of acting with independence.
The sum of these responsibilities is a board’s fiduciary duty, meaning they must place the company’s best interest before their own. This sounds simple in theory, but in practice, many boards run into trouble when faced with difficult decisions that go against their personal interests. Therefore, it is poor practice for board members to have strong financial ties with the company that will inhibit them from acting ethically.
High performing boards will maintain an active spirit of debate. Because every matter of strategic importance needs the board’s approval, good directors must always be on their toes and highly involved in deliberating the best course of action. Additionally, good board members must listen carefully to and respect opposing opinions. Only then can a consensus be reached efficiently and smoothly.
The leader of the board, the chairman, must ensure that everyone remains in check and leads the decision-making process. The chairman should not be affiliated with the CEO and should weigh the CEO’s opinion of no greater importance than the board directors. A strong chairman will drive its board to ask the necessary hard questions, challenge the status quo, and continuously evolve to develop highly informed, up-to-date perspectives.
The trending evolution as of late has been a sweeping move to incorporate more diversity members and women on boards. A more diverse board reflects an independent board selection process and predicts a greater ability of the board to make unbiased decisions that have been considered from all angles.
Diversity standards typically mean having at least one person of color, one woman, and one independent director on the board, though recent growing pressures to increase diversity have caused some companies to raise the standard to at least two people of color and women. The current top-three public companies ranked by board diversity are leading this movement with numbers as high as 60% female directors in Stitch Fix, 50% ethnic-minority directors in Hewlett-Packard, and 92% independent directors in Verizon. Further proof of the diversity movement is seen through Goldman Sachs CEO David Solomon’s statement that the bank will no longer take companies with all-male, all-white boards public.
It will be interesting to see how these shifting board dynamics play out, but in the meantime, we can rest assured that the overarching roles of boards are not changing anytime soon.