At more than half of the companies in the S&P 1500, the CEO is the lone board insider, according to this study and the related article in the WSJ. Isn’t that a good thing? Maybe not, say the authors, whose study showed that lone-insider boards can lead to lower profits, excessive CEO pay and more financial fraud.

The authors looked at data for companies in the S&P 1500 from 2003 to 2014 to examine the consequences of lone-insider boards. They found that lone-insider CEOs received on average “excess CEO pay,” that is, “pay above what objective factors, such as firm size and performance, would predict.” More specifically, they concluded that, “[o]n average, lone-insider CEOs received roughly 81% more pay a year than their peers. That’s an additional $4.6 million a year, which is money that could have been retained to fund growth strategies or returned to shareholders as dividends.” They also found that CEO pay at companies with lone-insider boards was disproportionately higher than the pay of other key executives. CEOs who were lone insiders on their boards earned an average $7.39 million more than the average of the next four highest-paid executives, while CEOs who were not lone insiders made only $4.4 million a year more on average than the other executives. And here’s the stunner: according to the authors, “companies with lone-insider boards were 27% more likely to commit financial misconduct and…their profits were roughly 10% lower on average.” So much for good corporate governance?

Before the scandals of the 2000s, there were lots of insiders on boards. But the result was another type of corporate governance failure: “a rigged system that gave CEOs excessive influence and undermined boards’ ability to monitor executives’ behavior.” These scandals led the NYSE and Nasdaq to adopt rules for listed companies requiring that a majority of the board be independent as defined by the applicable exchange. While the goal was to strengthen corporate governance — and it clearly did have that effect — none of the rules require that the entire board, other than the CEO, consist of outside directors. The authors contend that companies have taken the concept too far: “This is where too much of a good thing comes in. While the drive toward greater independence was an important improvement, removing all insiders except the CEO takes independence to an extreme that wasn’t dictated by exchange rules — or by good corporate governance.”

Why is that? The authors contend that having additional inside executives on the board provides advantages from a governance perspective. First, they argue that they “reduce the information asymmetries” that can plague independent directors, who generally do not have daily interactions with the company. That is,

“insiders provide critical information. A CEO’s job is complex and largely hidden from outside directors’ view. Inside directors are immersed in day-to-day operations and directly observe the CEO’s actions, so they can provide outside directors with detail and context they wouldn’t otherwise possess. In the absence of other board insiders, CEOs have an easier time shifting blame when performance slides or taking more credit than deserved when performance excels. In contrast, the presence of insiders who know the behind-the-scenes story can help outside board members better assess CEO performance and set appropriate CEO pay.”

While members of management are frequently invited to attend and to make presentations at board meetings, “they are unlikely to present information that challenges the CEO given that it is relatively easy for a CEO to fire” a non-director executive. In addition, other research has established that the CEO-other executive “pay gap” increases when board members have less access to inside information. The authors also suggest that large “[p]ay gaps indicate weak internal monitoring by boards and reflect ‘the relative importance of the CEO.’” The authors contend that, when other executives serve on the board, “these inside directors should logically join the CEO in working to achieve equitable, if not greater, pay for all top managers. Thus, with multiple insiders on the board, compensation committees are likely to consider executive pay more holistically and distribute compensation relative to managers’ individual contributions.”

With regard to misconduct and financial performance, the authors contend that “without the information and potential for contestation that insiders bring, CEOs have greater discretion to pursue self-interested, risky, and potentially even illegal actions.” As a result, the authors hypothesize, “[i]f lone-insider boards confront greater information asymmetries and lack viable successors who might monitor and contest CEO actions as we theorize, it follows that lone-insider boards are, on average, less effective and thus more susceptible to the misbehavior and fraud that previous research associates with ineffective boards.” In addition, they suggest, as a consequence of limited information, the independent directors “will be less equipped to advise and oversee strategic decision-making and implementation, which potentially harms firm performance.”

Second, the authors suggest that having other inside executives on the board can help mitigate the risks associated with CEO succession when the time comes: “outside board members get to know [the other executives on the board] and are able to assess their leadership skills. Knowing that competent internal candidates are available makes it easier to challenge the current CEO. When a need for change becomes apparent, the board might still look externally for a new CEO, but at least the bench strength of the current executive team will be well understood.”

The study did find, however, that “external governance forces,” such as analyst coverage and institutional ownership, mitigated, in some cases, “the negative effects of lone-insider boards by pressuring independent directors to remain alert to CEO self-serving outcomes.” However, mitigation was evident only with respect to “excess CEO pay and the negative impact of lone-insider boards on firm performance,” but not the pay gap or financial misconduct (measured as instances of non-reliance restatements that were considered material). Interestingly, however, for boards that did have non-CEO insiders, “analyst coverage and institutional ownership appear to make things worse.”

The authors conclude that, while every company is unique, their data shows that companies with “two or three insiders on the board don’t suffer any of the executive-compensation and performance problems endured by firms with lone insiders.” Companies looking to add insiders, as the authors recommend, “should focus on personal characteristics rather than titles. An executive who asks hard questions, values candor and has strong potential as a future CEO would be a wise choice—whatever his or her title.”

SideBar: Some academics have speculated that the absence of “real” inside directors has just led boards to find a substitute. According to this article in the WSJ, long board tenure, together with the rise in the appointment to boards of retired CEOs or other C-suite executives from other firms, is giving rise to a new class of director: the “new insider.” One academic cited in the article speculates that the “increasing use of board members who serve for longer periods and come with a predisposed background as corporate insiders elsewhere is not accidental, but is in fact an effort on the part of companies to import the benefits that an ‘insider’ board would have produced.” According to the article, he ventured that this corporate reaction could be “a sign that regulation stressing the need for independent directors ‘may have gone too far,’ and could be inducing public companies to seek proxies for their ‘missing’ insiders in the board room” — a contention that seems consistent with the authors’ basic recommendation above. (See this PubCo post.)

These new insiders, who may well be “independent directors” under NYSE and Nasdaq definitions, lack a different kind of independence: “social independence.” One concept of “social independence” was described in the academic paper “Seven Myths of Boards of Directors,” as based on “education, experiences, and upbringing—positing that people who share social connections feel psychological affinity that might bias them to overly trust or rely on one another without sufficient objectivity.” In the paper, the authors discuss a study of directors of Fortune 100 companies between the years 1996 and 2005, which showed that the absence of “social independence” is “correlated with higher executive compensation, lower probability of CEO turnover following poor operating performance, and higher likelihood that the CEO manipulates earnings to increase his or her bonus. They conclude that social relations compromise the ability of the board to maintain an arm’s-length negotiation with management, even if they are independent by NYSE standards.” (See this PubCo post.)