Corporate Governance: how to build a high-impact Board

Directing the organization towards better Corporate Governance practices requires profound changes in the way decisions are made. It implies moving from individual to collective responsibility, from clear business objectives to multiple and conflicting objectives, and from stagnant operation by areas, functions and business units to the integration of these parts.

The Board is the group that regulates the relationships between shareholders and Management, and also with other stakeholders (government, regulatory bodies, the community, banks, etc.). Therefore, the decisions about its composition and mode of operation strongly affect performance.

The optimal composition of the Board will depend on the characteristics of the organization and the circumstances it is going through. While there is no ideal configuration, based on our experience we see that it is important to consider the following aspects.

The proportion of executive and non-executive directors

This aspect determines the degree of “independence” of the Board.

Depending on the objective sought, in some cases a higher proportion of non-executive directors is preferable to maintain the independence of the Board from Management. In other cases, however, the ideal is the opposite.

The conventional wisdom that advocates for a Board dominated by non-executive directors is based on Agency Theory. This warns that the separation between ownership (shareholders) and control (managers) allows the latter to make decisions for their own benefit and to the detriment of the owners. A Board composed of independent directors acts as a monitoring tool to protect the interests of shareholders.

The opposing position argues that a higher proportion of executive directors allows the Board to make better decisions, since they have higher quality information about the company’s operations and clarity about the roles that each one plays. This position is based on the Stewardship Theory, which assumes that managers are inherently trustworthy and that they will not necessarily seek to benefit themselves at the expense of shareholders.

The two positions are based on the notion of trust, a critical element when thinking about the effectiveness of decision-making. In general terms, the proportion of external and internal members should be defined based on the most relevant concerns of the shareholders. If they are focused on reliability when allocating large resources, a larger number of external members will allow them a higher level of security. On the other hand, if the main intention is the efficiency (agility) of strategic decisions and accountability for them, having a larger number of internal members will be the most convenient.

Degree of separation between the chairman of the Board and the CEO

There are different positions on the independence in the appointment of the chairman of the Board and the CEO.

Agency Theory proposes that the CEO and the chairman should be different people. And if both positions are concentrated in the same person, the Board will lack monitoring capacity. Its leader will be the same person it must control.

In practice, however, we see that many companies decide that it should be the same person. They argue that this unifies leadership and removes any internal or external ambiguity about who is responsible for processes and results.

Frequently, the separation between CEO and chairman is the response to major crises in companies. In any case, in order to achieve quality corporate decisions, it will be required that a clear assignment of roles and responsibilities in decision-making and critical processes be carried out between these two functions.

The degree of diversity in its composition

A group of people can make better decisions than an individual, as long as its composition is correct. And here the key disjunction is between homogeneity versus heterogeneity.

Ilan Yaniv, from the Hebrew University of Jerusalem, found in research that heterogeneous groups attenuate the impact of the Framing Effect1 improving the quality of the decision, while homogeneous groups amplified it worsening it.

Diversity, on the other hand, enriches the decisions of groups, even though members tend to feel better and more confident when they participate in homogeneous groups.

In concrete terms, in general we prefer to spend more time with people who think like us than with people we don’t agree with. In the latter case, conversations are a potential source of conflict. However, in heterogeneous groups, information is shared more effectively and extensively, and information processing is deeper, which leads to a better quality when making decisions.

If diversity improves the quality of decisions in simple contexts, let’s imagine the impact of the improvement in the decisions of a Board. How relevant can this factor be in a group that must withstand multiple pressures, think about the interests of different stakeholders, in different businesses and serve different communities? The more complex the decision-making context a group faces, the greater the impact of diversity in its composition on the quality of its decisions.

In summary, the configuration of the Board is a complex decision in itself. As such, we cannot provide simple recipes, but we can offer clear guidelines that allow for its optimization. To define the proportion of executives and non-executives, it is first important to clarify the tension between reliability and efficiency in strategic decision-making, weighing what we consider most relevant. Regarding the positions of CEO and Chairman, rather than focusing on whether they should be occupied by the same or different people, it is advisable to better define the necessary roles in strategic decision-making and then see if it is convenient to unify or divide them. And beyond the comfort of being among like-minded people, investing in diverse profiles among Board members will surely yield better results.

Federico Esseiva
Partner at Tandem.
fe@tandemsd.com

  1. Framing Effect: cognitive bias that affects our choices in an irrational way. For more information, see “Group diversity and decision quality: Amplification and attenuation of the framing effect”, 2011, Ilan Yaniv, Department of Psychology & Center for the Study of Rationality, Hebrew University of Jerusalem. ↩︎
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