Do board committees hinder decision-making?
Committees of the corporate board could be hindering firms from making optimal strategic decisions, says UNSW Business School's Robert Tumarkin
In Australia and the US, the board is responsible for the overall governance, management and strategic direction of the organisation. It is also responsible for delivering accountable corporate performance in accordance with the organisation's goals and objectives.
Committees, on the other hand, make recommendations for action to the full board, which retains collective responsibility for decision making. Directors' involvement in committees is often seen as allowing them to deepen their knowledge of the organisation, become more actively engaged and fully utilise their experience.
However, a recent analysis of several US companies from 1996 through 2010 has shown that when committees are composed entirely of outside directors, this actually hurts the firm's performance in the long run. The findings showed that concentration of formal decision-making authority in committees, controlled by people from the outside with different vested interests, essentially hinder the decision-making capabilities of the board and led to low performance.
The findings are discussed in the paper, Death by Committee? An Analysis of Corporate Board (Sub-) Committees, co-authored by Robert Tumarkin, Senior Lecturer in the School of Banking and Finance at UNSW Business School.
In their study, Dr Tumarkin and others closely examined an interesting period for corporate governance in the US – a period when the Sarbanes-Oxley Act of 2002 (SOX) required companies to conform to structural and operation norms that continue to be considered best practice. The Act's influence was echoed around the world, with many countries including Australia implementing similar governance reforms.
While it's natural for governments to respond to corporate scandals through increased regulation (SOX was a reaction to accounting scandals in the early 2000s) it couldn't prevent the Financial crisis of 2007–2008.
"It’s probably impossible to regulate away corporate malfeasance altogether. Our results suggest that corporate regulations may have costs as well as benefits. At some point, one may expect that regulations have costs that exceed their benefits," explained Dr Tumarkin.
But the research is not itself a study of SOX. “We make a break from most of the existing research in finance, which tends to isolate a limited number of structural characteristics such as board size or the presence of outside directors (i.e., directors that do not work for the firm). Instead, we employ a broader approach that includes operational characteristics,” said Dr Tumarkin.
A closer looks at board decision-making
There has been little research to date surrounding the comprehensive role of committees as sub-groups within boards. This is surprising given the prevalence of committees in corporate and academic decision-making, according to the authors.
Corporations provide a lot of qualitative information to investors, they also have a lot of freedom in how they disclose the information, making it very hard for researchers to collect a large enough amount of this data to permit rigorous studies, explained Dr Tumarkin.
In his study, the researchers analysed the meeting frequency and stated responsibilities relating to gathering and decision-making of the board, and utilised a grammar-based algorithm to dissect the meaning of words (how words are used and how they were interrelated) to find the impact of committees (comprised of independent directors) on board decision making as a whole.
"A lot of existing research looks at word patterns to identify information, but this is inaccurate. Fortunately, there is a long history of research in the grammatical parsing of sentences, which identifies parts of speech and interrelationships. We use a tool provided by Stanford and then create a specialised domain-specific language to help us turn sentence meaning into data," explained Dr Tumarkin.
Economic research into decision-making has often shown that directors may selectively disclose information depending on their formal decision-making authority. Essentially, this means that if an inside director is in charge of making decisions, then there is no harm in disclosing negative information to outside directors. On the other hand, if outside directors formally make decisions, insiders may withhold information about the inner workings of the firm so as to influence the outside directors.
Why committees are important
In the study, the researchers created a proxy for the split of decision-making across the board and its committees, emphasising situations in which outside directors maintain full formal authority, using key grammatical relations among words in proxy statements to extract information on the number of board and committee meetings each fiscal year.
“We began by extending the structural data used in research to include all the committees of the board and their members. This allowed us to understand the composition of all the groups within the board.
"Then, we used a variety of natural language processing techniques to pull out the distribution of described responsibilities and the number of meetings from proxy statements.”
The results also confirmed that the market views outsiders as less informed, which is consistent with insiders strategically withholding information. “This ties nicely with our analysis of acquisition decisions and firm value, with those results reinforcing the idea that information sharing affects decision-making quality,” said Dr Tumarkin.
What makes this study unique is that the data revealed the importance of committees to boards. For every board meeting, there were approximately 2.3 committee meetings, on average. Similarly, for every stated board responsibility, there were approximately 3.8 stated committee responsibilities.
“Our results suggest that firm value decreases and that acquisitions are more poorly received by the market as outside director committees are more active. Both results are consistent with poorer decision-making quality and inside directors selectively disclosing information about the firm,” reiterated Dr Tumarkin.
Previous research had not really looked at committees very much, despite the fact that much of what the board does is through committees.
But it's important to note that board governance is very multi-dimensional, and so a ‘one size fits all’ approach will not work. Instead, Dr Tumarkin suggests:
- Outside directors will continue to be an important part of boards going forward with many key responsibilities assigned to them through regulations.
- But it’s important that shareholders pick these directors carefully to ensure the board has the right mix of experience.
- And, it’s important that the directors themselves recognise that there is an interplay between how decision-making authority is assigned and how information is revealed. That’s not to say that anything nefarious is going on with directors. It’s just human nature; people seek to influence the decisions of others.
It is also important to note that today, nearly all committees these days are composed entirely of outside directors.
“There is some reason to think that this can contribute to groupthink due to a shared perspective. But, we don’t really have too much data on mixed committees because regulations do not allow them in most cases,” added Dr Tumarkin.
Robert Tumarkin is a Senior Lecturer in the School of Banking and Finance at UNSW Business School. His research interests include corporate finance, executive compensation and incentives, behavioural finance, portfolio choice and derivatives.