A New Idea For Getting Directors To Think Like Owners

A New Idea For Getting Directors To Think Like Owners

UNIVERSITY PARK, PA-Numerous critics have raised serious concerns recently about outside directors who do not have much riding on the financial performance of their firms. One method for improving corporate governance is to make outside directors owners, but not necessarily by just giving them shares, suggests a Penn State management professor.

"Companies should adopt programs to increase the levels of ownership of their outside directors. The directors need not own large percentages of their companies; they must have holdings that are financially meaningful to them - often about three to five percent of their personal net worth, or around $500,000. Such amounts are enough to capture the attention, time, and energy of busy people whom otherwise might approach their board tasks as honorific rituals," says Donald Hambrick, Smeal Chair of Management in the Penn State Smeal College of Business.

Hambrick co-authored a study on the topic, "Outside Directors With a Stake: The Linchpin in Improving Governance," that appeared in California Management Review (Summer 2000).

"The majority of outside directors of major American companies are modest shareholders in the companies they govern. This reflects an implicit long-held belief that directors are fully motivated to act conscientiously and vigorously by forces other than a financial stake in the firm-their sense of professionalism, concern for their reputations and stature, and the threat of lawsuits," says Hambrick.

Recent scandals, however, have led many observers to conclude that these are not, in reality, sufficient motivators, and have led to proposals intended to strengthen the vigilance of outside directors in advising and monitoring management. There are a variety of ways to get equity into directors' hands, and Hambrick believes companies should remember four main points when designing company policy.

It is important that directors hold meaningful amounts of equity. "Although directors vary widely in their financial wherewithal, past research suggests a target of $500,000 is reasonable for the vast majority of directors," says Hambrick

It is important that directors think and behave like owners at the onset of their time on the board, and not only gradually after several years of service. "The problem with annual stock grants or paying annual retainers in company stock is that it takes several years for the holdings to become substantial. Directors should hold meaningful stakes throughout their whole tenures," says Hambrick

Giving directors an equity stake is not nearly as effective as if the directors have to reach in their own pockets and place some of their own cash on the line. "Common sense and research by psychologists tell us that people tend to be more cavalier with 'found money' than with money they have worked hard to obtain," says Hambrick.

Any mechanism for achieving director equity stakes must not preclude service from highly qualified individuals who do not have a great deal of financial wherewithal. "There is a valuable role for academics, foundation directors and former government officials on some boards, and it would be a mistake to establish stock purchase requirements that prevent the service of such individuals," says Hambrick.

He concludes that companies should make outside directors owners through stock purchase-matching programs. Under this approach, a company would establish a fund, perhaps about $200,000, for each director, which would be used to match the director's own purchases of the company's stock. Only stock purchased after being elected a director would be eligible for matching. Matching purchases could be made upon being elected or on anniversaries after elections, until the $200,000 fund is depleted. Directors would be required to hold any of their purchases until they leave the board. In addition to this matching program, directors' annual retainers would be paid one-half in cash and one-half in stock.

"Stock ownership can tip the balance of incentives, motivating outside directors to be more generous with their counsel, and more vigilant in their monitoring. Because directors will have an incentive to receive their matching shares as early as possible, they will attain a significant ownership position as quickly as their personal financial capacity allows," says Hambrick.

He is author of several books, Navigating Change: How CEOs, Top Teams, and Boards Steer Transformation , presents leading edge thinking for executives who are embarking on corporate change initiatives. Another recent book, Strategic Leadership: Top Executives and Their Effects on Organizations , is extensively used by scholars of executive leadership.

Editors: For more information, contact Donald Hambrick via e-mail at dch14@psu.edu or by 814-865-1789.