August 21, 2014
Outsourcing the Board: A Good Idea?
Posted by Sung Hui Kim

This week’s Economist has a column praising my UCLAW colleague Stephen Bainbridge’s and University of Chicago law professor Todd Henderson’s creative proposal, published in the Stanford Law Review, to replace individual directors with professional-services firms acting as Board Service Providers (BSPs).  (That article can be accessed here.)  The column nicely summarizes the possible impact of such a change:

“Messrs Bainbridge and Henderson argue that this would require only a simple legal change but could revolutionise the stick-in-the-mud world of boards. It would replace today’s nod-and-a-wink arrangements with a market in which rival BSPs compete. It would create a new category of professional director. And it would allow BSPs to exploit economies of scale to recruit the best board members, introduce more rigorous training programmes and develop the best proprietary knowledge. Now, even the most diligent board member can only draw on his or her experience. BSPs would be able to draw on the expertise of hundreds. This would increase the chances that corporate incompetence will be corrected, corporate malfeasance found out and corporate self-dealing, in the form of inflated pay, countermanded.”

The BSP idea is very creative. (Frankly, I am always puzzled by the extent to which academics have trouble appreciating creativity. Perhaps—and I’m speculating here—traits such as creativity are weakly correlated with succeeding in the academic tournament—getting high LSAT scores, writing good law school exams, getting judicial clerkships, and placing law review articles?)  I also agree that introducing market competition by enabling firms to compete on performance will likely benefit consumers and shareholders, as well as increase the leverage of the board vis-à-vis executive officers.

That said, I worry about uncontrolled expenditures as BSPs find yet another reason to bill the corporation another $250,000 for yet another “critical project.” My prior experience as general counsel of a corporation (plus my six years of practicing law in a law firm) make me skeptical of the incentives of partners within firms (“Bill, bill, bill!”). I worry about the ratio of the value of services to cost. While we may see a decrease in executive compensation as a result of increased board leverage, are we going to see an increase in the effective compensation (i.e., including billings) of the board? My guess is yes.

I also worry about the audit/gatekeeping function of the Board.  After all, we have plenty of experience with auditors being firms, rather than individuals. And the record there doesn’t look so hot. Remember Enron and Arthur Andersen? And remember Ted Eisenberg’s and Jonathan Macey’s empirical study suggesting that Andersen was not an outlier but typical?  While gatekeeping theory provides that market gatekeepers, such as investment banks and accounting firms, are incentivized to work hard to prevent malfeasance out of fear that their longstanding reputations will be damaged, the reality is that the reputational informational markets are noisy and manipulable. Moreover, the incentives of the firm’s agent – the functional gatekeeper – may diverge from the incentives of the firm.  In other words, large firms may suffer from principal-agent problems, as has often been alleged with David Duncan, the lead audit partner responsible for the Enron account at Andersen. (In prior work, I wrote about the incentives of firms vs. individuals for the audit/gatekeeping function.)

But I suppose Henderson and Bainbridge would respond that still, those reputation markets would work better with firms competing with one another than the status quo—little to no competition with respect to individual directors (for various reasons).

Perhaps there’s room for compromise. If you’ve been following the accounting profession, you know that the PCAOB (the body that regulates the accounting of public companies) in an effort to improve the transparency of audits has proposed to require the disclosure of the name of the engagement partner for the most recent period’s audit. Also, it has been suggested that the engagement partner individually sign the audit report. It should not be surprising that accounting firms uniformly dislike these suggestions. This indicates that they are probably good ideas. Perhaps, then, as a means of dealing with the principal-agent problem within BSPs themselves and to ensure that the incentives of the firm’s agents (the persons who actually sit in board meetings) are more properly aligned, similar measures should be taken.  

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