Taking on too many commitments, directors put corporate value at risk

The expression “distracted driver” has wormed its way into the popular lexicon as increasing numbers of drivers are hitting the roads with their smartphones and, unfortunately, are hitting other drivers as their attention wanders from the traffic around them to the text they are composing.

The term “distracted director” has not yet achieved the same level of popular acceptance, but it is an issue that has received quite a bit of attention in recent years as board members spread themselves too thin by accepting multiple outside directorships.

The number of outside board affiliations associated with a company's directors ought to be a prime concern in the due diligence process when one is contemplating an investment stake in that company. An equally important concern, but one that might sometimes get overlooked, is the nature of those outside directorships and whether they could pose a disabling conflict of interests.

Although one might reasonably question whether there can ever be a sufficiently objective measure of director “busyness,” a consensus actually has emerged that a director is considered “busy” if he or she sits on three or more boards, according to “Going overboard? On busy directors and firm value” by George D. Cashman, Stuart L. Gillan and Chulhee Jun in the June 2012 Journal of Banking & Finance. And while there have been different views expressed over the years concerning whether holding multiple outside directorships is good or bad, with some scholars arguing a “busy” director is positive evidence of that director's abilities and effectiveness, and others arguing that a “busy” director is overcommitted and thus less effective as an adviser and monitor, the authors in their article found “a consistent negative relation between busy directors and firm performance.”

Certainly, it would seem to be a matter of common sense that, at some point, a director can take on too many outside commitments to be effective in monitoring and advising senior management, which can, in turn, lead to diminished firm performance. Whether that numerical trigger is three outside directorships, it remains the case that, from a due diligence standpoint, it is important to pay heed to this issue when contemplating a sizable investment in a company. Does the board of that company have directors with an excessive number of outside commitments? Even if one is loath to automatically draw an adverse inference from the fact that some directors have two or three outside directorships, what happens if a director has twice that many? The comfort level of each institutional investor may vary, but at some point a director's overcommitment to outside interests will call into question his or her ability to effectively monitor firm performance.

A Feb. 29, 2012, Wall Street Journal article reported that in 2011 there were 118 top officers at Fortune 1,000 companies with at least three directorships and that some major institutional investors were beginning to express their displeasure by opposing board re-elections of executives with more than one outside board seat. The time commitment required to sit on a board rose to about 228 hours annually in 2011 from about 210 hours annually in 2006. Average director compensation rose to $232,000 in 2010 from about $215,000 in 2009. One of the CEOs referenced in the article served on the boards of five different companies in addition to his own, earning director compensation totaling $373,874 annually.

Related to the issue of whether a board member, either an inside or outside director, is too weighed down with directorships to be an effective monitor is the question of what those other directorships might say about that director's relative value, or even his or her professional competence. A May 26, 2012, New York Times article reported one of Facebook Inc.'s directors, James W. Breyer, who is a partner at a venture capital firm, also served on the boards of five public companies, four of which were “experiencing high-profile problems.”

Any due diligence inquiry thus should address not only the number of outside directorships, but also the performance history of the companies attached to those directorships in order to help evaluate whether the director in question has demonstrated sufficient competence in that position.

In addition to concerns over whether an “overboarded” director will have the time or focus to effectively “mind the store” or is otherwise qualified, there is also the question of whether a director with outside board commitments could have divided loyalties.

This issue might arise, for example, in the case of interlocked or connected boards of directors. An interlocked director relationship is usually described as an inside director at Company A who agrees to serve on Company B's board, on which one of Company A's outside directors also serves as an inside director. Examining the issue, Erik Devos, Andrew Prevost and John Puthenpurackal in their article “Are Interlocked Directors Effective Monitors?” in Financial Management, Winter 2009, concluded “the presence of interlocked directors is indicative of weak governance and entrenched managers.” Some negative effects associated with interlocked boards include “self-serving behavior by CEOs in the areas of accounting discretion and financial accounting fraud,” as well as lower sensitivity of firm performance to CEO job turnover and the setting of CEO compensation levels. Furthermore, announcements of director appointments that create interlocked directorships have been found to result in lower stock prices, suggesting shareholders view such directorships as indicative of “weak monitoring and entrenched management.” So from a due diligence perspective, one ought to be sensitive to whether the board of a prospective target firm includes interlocked directors because an interlocked directorship might, in certain circumstances, be unwilling to put shareholder and firm interests before those of the firm's senior management.

More generally, due diligence requires that one examine whether the outside board affiliations of the target firm's directors pose any conflicts of interest related to the business or interests of the target firm either because the other companies operate in the same industry or because they otherwise may be viewed as competitors. A related question would be whether any directors own equity interests in other companies that compete with the target firm. One would want to know the extent to which “outside” — and thus presumably independent — directors of the target firm might have had prior, overlapping connections with other board members or senior management, which might cast doubt on whether those directors can exercise independent judgment and be effective monitors.

The reasonable exercise of due diligence in connection with a proposed investment in another firm demands that careful consideration be given to that firm's board of directors, and whether the composition of that board is conducive to effective firm governance. Consideration should be given to whether any directors have an excessive number of outside directorships that would unduly distract from the monitoring function of the board, or that might shed any negative light on the professional competence of a director to properly perform that function. Moreover, attention must be paid to whether the target firm has an interlocked directorship that might create disabling conflicts of interest for certain directors, and whether any directors have conflicting business interests or have historical connections at other firms that might compromise their independence.

Geoffrey R. Kaiser is principal attorney and founder of the Kaiser Law Firm PLLC, New Hyde Park, N.Y. His practice concentrates in business intelligence, internal investigations, white-collar crime and business frauds. He is a former federal prosecutor in the U.S. attorney's offices for the Southern District and the Eastern District of New York.