We're still waiting for evidence that independent directors yield better financial results. Merrill Lynch's 2006 annual report proudly noted that 11 out of the 12 members of its corporate board were independent—people who had never worked at the firm and had little connection to it. Merrill was a model of trendy corporate governance, with a board of esteemed Americans who could offer an unbiased perspective.
As it turned out, what Merrill really needed was a board that knew how to manage financial risk. And it would have helped immensely if directors had understood the mortgage-backed securities on which they had unwittingly bet the firm. The report was released in early 2007, and by that October the company was searching for a new CEO after an $8.4 billion quarterly loss.
In 2008, the firm again boasted of independent captains manning the board deck as Merrill sailed into the financial crisis. The company had 11 directors by then, and 10 of them were untainted by intimate knowledge of the business. Several months later, the securities that the board never did comprehend forced Merrill to sell itself to Bank of America.
Today the regulators are pushing aggressively for independent directors at both public and private companies, but there is even less of an argument for such changes than there was at Merrill.This raises a good point that applies to all companies and not just financial services. It is important that non-executive directors understand the business they are in if they are to contribute anything. However, it may push the balance too far. Having an outsider who can ask apparently simple questions and challenge the company orthodoxy is probably helpful but you don't need everyone to be like that. It also points to a weakness of the American model where most boards predominantly comprise non-executive directors. That leads to power residing elsewhere and protects the real decision makers from scrutiny.
Bainbridge questions whether the evidence from financial returns supports the effectiveness of a majority of non-executives on a board. He suggests the benefit may arise from having any such independent element, though highlighting a study that argues that the reason for the weak evidence by company is that the whole market has improved governance and performance as a result of this independent scrutiny.