What Makes Independent Boards So Important

The CEO may get all the attention, but a company's board of directors is equally critical to its success. Directors operate behind the scenes to make sure the management team is working in the best interests of shareholders, be it driving company strategy, delivering performance, managing relevant risks, or overseeing a major acquisition.

We talked to Britt Sahi, head of investment stewardship at Schwab Asset Management, whose team votes on behalf of fund shareholders for the securities held in certain Schwab funds. Britt and her team evaluate a fund's underlying companies based on a variety of considerations, including the quality of a board's leadership and decision-making, as well as its ability to manage risk. Britt shared what makes boards so important and how investors can factor board makeup into their investment decisions.

Britt: The board's role is to oversee the way a company is managed on behalf of its shareholders. It's there to approve business plans, provide strategic direction, and generally help make sure that everything goes as it should. In my investment stewardship role at Schwab, it's one of the first things we examine when we are assessing long-term shareholder value. If a company has the right board, everything else tends to fall into place.

Britt: The most important question is whether the board is independent, meaning does it make impartial decisions and recommendations. This includes an evaluation of whether the directors have an appropriate, arm's-length relationship with the company's management team they're in charge of overseeing.

Britt: Among other requirements, to qualify as independent, a board member and their immediate family members cannot have received more than $120,000 in compensation from the company in question for anything other than board service during any 12-month period within the past three years—which publicly traded companies must disclose in their annual proxy statements. What's more, directors and their immediate family members cannot hold management positions at the company, its parent company, or its subsidiaries. In fact, independence is of such importance that the rules of both Nasdaq and the New York Stock Exchange require the boards of listed companies to have a majority of independent directors.

Britt: Political or social relationships between board members and management are other areas to investigate. These connections aren't included in the textbook definition of independence—which means they aren't required to be disclosed—but they can have an impact. That said, it's easy enough to search online to see whether board members have business or social relationships with one another or with company executives on whose board they serve.

Britt: Look at the board's composition. Studies have shown a positive link between a company's financial performance and its board's diversity in terms of areas of expertise, skills, and personal and professional experiences. Conversely, a board whose members have similar backgrounds or skill sets can suffer from groupthink, and it could struggle to properly represent all of a company's stakeholders—to say nothing of its client base—and may not deliver on the company's full potential over time.

Britt: Tenure has the potential to affect a board's efficacy as the industry in which a company competes inevitably changes over time. At Schwab Asset Management, we like to see a healthy degree of turnover and the fresh thinking that often comes with it. There are no official term limits for board members serving in the U.S., but introducing new members every few years is generally a good place to start.

Britt: Generally, yes, but it depends on the company. For example, those with dual-class shares—in which a founder and/or a handful of executives own a majority of voting shares—diminish the influence of all other shareholders. The good news is that it's becoming more common for companies whose IPOs include a dual-class structure to have a sunset provision so that all shares eventually reach parity.

Britt: It is helpful to check whether the board discloses how and why its members are chosen. In fact, there's a growing movement toward disclosing more information when it comes to a company's board-selection process—as well as its board members' experience and skills—which you can often find in the proxy statements available online.