Giving Toothless Boards Some Bite

MAJORITY SHARE BENEFITS. Over time, abuses have crept into the system, leading to "agency costs," such as $15,000 umbrella stands, $4.7 million Renoirs, or $2 million Sardinian birthday celebrations. The directors' job is to minimize these costs. In theory, directors are there to ensure that a company's managers increase the value of the business -- or, at the very least, protect its value from being reduced.

In practice, directors fall into two broad categories: Majority Share, who generally walk the talk, and Minority Share, who usually don't.

Majority Share directors control a majority of the equity of the outfits on whose boards they serve. Usually, directors who are general partners in private-equity firms are Majority Share directors. Such firms have done a better job of aligning the incentives of owners and managers to minimize agency costs. According to the National Venture Capital Assn., buyout firms generated annual average returns of 12.3% from 1982 to 2002 -- outpacing the 9.6% returns of the benchmark Standard & Poor's 500-stock index.

LIMITED CONTROL. The general partners of such firms are paid to find private companies whose cash flows can be increased through attentive management. These directors choose and pay the CEO with a mix of stock and cash, and monitor the efforts to increase the company's value. When it comes time to sell, these directors -- and their fellow shareholders -- usually profit because the price is keyed to the business' increased cash-generating potential.

Unfortunately, most boards are filled with Minority Share directors, who hold very small stakes in the companies on whose boards they serve. The CEO invites most Minority Share directors to the board -- providing them with an incentive to preserve that CEO's position. More importantly, most Minority Share directors with valuable business experience are too busy with their main jobs to contribute meaningfully to key business decisions. As a result, boards often fail to evaluate rigorously resource-allocation decisions.

Minority Share directors are caught in a system that makes it difficult for many of them to protect shareholder interests. Such directors generally owe the bulk of their net worth to sources other than their positions on corporate boards. They join boards for the prestige, the perks, and to a lesser extent, the pay. With insurance covering less of their potential costs, directors bear a larger personal responsibility for a company's failure to act in the shareholders' best interests, while exercising limited control over the outfit's conduct.