The Activist Investor Blog
The Activist Investor Blog
Do BSPs Solve the AP of the BoD?
If corporations are people, and have defensible political and religious views, can they take the place of humans on a BoD?
It seems farfetched. Two law professors (Bainbridge and Henderson) propose investors hire a “board service provider” (BSP) instead of electing individuals. Companies would retain firms like accountants or management consultants to provide the same services that individual directors now provide.
Normally, we automatically suspect a scheme like this. One of the authors is noted corporate stooge Stephen Bainbridge. Both authors have worked for the accounting firms that could become BSPs. Instead, we’ll analyze the idea with some care.
We think individual directors represent investors better, and at a lower cost to investors, than a BSP would. We apply agency theory to BoDs to conclude that agency costs will likely increase with a BSP. This follows from the reasoning in our recent essay on the agency problem (AP, so we’ll stop here) at the intersection of investors, directors, and executives. We mention BSPs briefly in the essay, and expand on that discussion here.
BSPs
The authors suggests a deceptively simple and straightforward idea: allow firms to serve on a BoD. A firm could occupy all director positions, only one, or a subset. They reason that a firm would deliver “board services” more efficiently than individuals, since a firm could pool knowledge and effort. Firms would compete for engagements, and lower the cost a BoD.
They are somewhat vague about how companies would select and manage a BSP. They admit “[m]ost of [the] process could stay the same.”
BSPs and the AP of the BoD
As our essay explains, investors confront a tough agency problem. Instead of aligning with investors, BoDs have taken on a separate identity in which they have more in common with executives. We can use agency theory to assess the BSP concept, and how well it lowers agency costs.
The agency problem manifests itself as a divergence of interests. Today, individual directors have interests closer to executives (job security) than shareholders (profits). Agency theory identifies the two methods to align interests: monitoring and incentives. Does a BSP align interests better, and reduce investor cost in monitoring and incenting the BoD and executives?
As agency theory and our essay explain, agency cost has three components:
❖cost of monitoring of BoDs and executives
❖cost of incenting (designing incentives, really) for BoDs and executives
❖residual cost of BoDs and executives pursuing selfish interests.
In the case of a BoD, investors incur these costs in two ways: between investors and the BoD, and between the BoD and executives. We can compare these three costs with individuals as directors and with a BSP.
Interests
As with individual directors, a BSP would likely start with different interests than investors, and similar ones to executives. Individual directors want to keep their job. A BSP will likely want to promote its firm identity, preserve its contract with the company, and earn profits for the BSP. Neither set of interests align well with increasing company value.
Relative to individual directors, a firm would likely have an even stronger motive to create a separate identity. Firms now create and promote brands, unlike individuals. A BSP would reinforce the separate identity of the BoD, rather than merge it with shareholders.
Preserving the contract between a BSP and the company can also cause interests to diverge. Today, individual directors get close to executives to protect their jobs. BSP firms will do the same. Much like CFOs manage an external auditor, the CEO or another corp gov executive will manage a BSP.
Finally, a BSP will have a much stronger profit motive than individual directors. Incentives to hit profit goals will lead them minimize the number and qualifications of staff. The quality of BoD oversight over executives will suffer accordingly.
Because of these divergent interests, investors will need to incur costs to monitor and incent the BSP, as the BSP in turn monitors and incents the BoD.
Monitoring and Incentives
Correct monitoring and incentives align BoD interests with investors’. How well could investors monitor and incent a BSP, relative to monitoring and incenting individuals? A BSP would clearly increase investor costs to oversee the BoD, but would not necessarily reduce BoD costs (and thus investor costs) to oversee executives by a greater extent.
Monitoring does not work as well, and would cost more, for a BSP as it does individuals. A company would need more extensive controls over a BSP than it would an individual. It requires detailed contracting and contract enforcement, extensive planning and reporting of BSP activity, and review and scheduling of rotating BSP personnel.
Incentives also do not work as well for a BSP as they do for individuals. Companies can structure the form of incentive compensation, including equity, easily for BSPs and individuals alike. But, a material amount of compensation for an individual, one which commands their time and attention, becomes immaterial for a larger firm. The company becomes just another BSP client.
A BSP thus increases agency costs between investors and the BoD. Does it in turn lower agency costs between the BoD and executives more? We doubt it.
Investors already incur cost to manage executives, through what they pay to maintain a BoD. It’s not clear that a BSP would cost less than what investors now spend on the individuals on a BoD. Bainbridge and Henderson assert a BSP would “potentially” cost less, “driving down board costs, while holding constant or improving corporate governance.” Still, a BSP needs to cover the cost of partners and overhead, likely similar to the cost of individual directors. A BSP adds its firm profit, thus increasing the cost to investors to manage executives.
Residual Costs
Agency theory presents investors with an interesting trade-off: spend more on monitoring and incentives, and incur less in residual costs of private benefits. For example, if investors spend more to monitor the CEO (say, on internal auditors), then the CEO spends less on fancy offices and private aircraft.
BSPs present the same problem of private benefits as individual directors do. Individuals seek prestige and expense accounts. BSPs also seek prestige, and profit instead of expense accounts. It costs more to monitor and incent a BSP, with comparably little gain in lower residual costs.
We go through this exercise only because we investors need to manage executives well. It’s hard enough for us to monitor and incent CEOs. A BoD should make it easier, and less costly, for investors to do that. Instead, BSPs add to our burden, as we then need to monitor and incent the BSP in addition to the CEO. We’d prefer to improve the structure and function of BoDs comprised of individuals, rather than complicate it with an expensive outside firm.
Accounting firms and management consultants have caused many other problems for portfolio companies. We should now hire them instead of individual directors?
Tuesday, September 9, 2014