Trustees and staff of the California Public Employees’ Retirement System are developing guidelines to grade companies in Calpers’ portfolio according to the independence of their boards. Calpers cannot be ignored: its $80 billion in equities makes it one of the nation’s largest shareholders and a force to be reckoned with in the governance arena. A study conducted with Diane Del Guercio at the University of Oregon shows that Calpers has the power to provoke significant changes, such as takeover attempts, shifts in turnover, restructurings, and asset sales.

CEOs would be wise to embrace the idea of strongly independent boards. For if investors can’t get boards to work well, they may resort to other measures: sitting on boards themselves, lobbying for direct government regulation, or supporting a return of corporate raiders.

The battle for governance

The growing power and independence of boards in the United States represents a reversal of a trend that dates back to the early years of this century. A seminal event occurred in 1914, when representatives of J. P. Morgan resigned from 30 company boards in a single day. They and other institutional investors had held sway in boardrooms for more than two decades, leaving CEOs with little real decision-making power. But as they came under critical public and political scrutiny, these investors beat a hasty retreat. Meanwhile, family owners were also losing influence as company founders aged and ownership tilted toward outsiders. So a new group of professional CEOs, bred in new management schools, took the reins of corporate America.

Their grip loosened in the 1950s, when an economic boom drove a wave of investors into stocks. Increased individual ownership raised expectations and fed a belief in shareholder democracy. New regulations requiring the disclosure of senior management pay, along with the rise of the corporate raider, spurred a growing number of contested elections for boards, known as proxy contests. Following a concerted lobbying and publicity effort on governance issues by the Business Roundtable, new regulations introduced in 1956 clamped down on proxy battles, and CEOs prevailed at the end of the decade.

Many large private money managers are willing to pay a higher stock price for companies with good, independentboard governance

Today, institutional investment is booming again. After falling as low as 15 percent in the 1940s, institutional ownership returned to turn-of-the-century levels of 50 percent and higher in the mid-1980s. Takeovers flourished in the 1980s environment of few regulatory restrictions and easy financing via junk bonds. Then public opinion turned against raiders, state regulations and court decisions made takeovers more difficult, junk bonds dried up, and management created innovative defences against takeovers. Many CEOs believed they had won the governance battle.

However, institutional investors sought other ways to prod CEOs. In 1992, the Securities and Exchange Commission (SEC) made it easier for investors to coordinate on governance issues. Shareholders issued "hit lists" of underperforming companies, announced their own proposals, and communicated directly with management. But it didn’t make sense for Calpers and other institutions to intervene in each of the thousands of companies whose stock they held. They turned instead to boards—shareholders’ elected representatives—as management watchdogs.

Stocks at a premium

What do these investors want? The bottom line is long-term returns. The most active investors are pension funds with mind-boggling obligations. Calpers will need to be able to pay out $30 billion each year to its beneficiaries by 2020. Institutional investors rely on strong, independent boards to create shareholder value. They believe strong boards will help companies correct mistakes, recover from crises, and find, support, and reward outstanding CEOs.

Numerous recent examples, along with academic research, support the notion that boards can have a significant impact on stock prices. Recent research conducted by McKinsey in conjunction with Institutional Investor found that many large private money managers—especially those looking for long-term value—are willing to pay a higher stock price for companies with good, independent board governance. We surveyed 50 money managers representing about $850 billion in assets and found they were willing to pay a premium of 11 percent on average for good governance.

Building the best board

How should CEOs respond to the demand for strong, independent boards? Companies that are performing well have the option of doing nothing for now—but only until there is a period of poor results, a complex acquisition, or a crisis. CEOs could search for ways to thwart investors, as they did in the 1980s. But underlying forces make this strategy unpromising.

Institutional ownership will probably continue to increase. Public opinion is suspicious of CEOs, whose pay has soared even while companies downsized. The most prominent investors, meanwhile, are more sympathetic: not the "greedy raiders" of the 1980s, but institutions like Calpers, which pays the pensions of fire fighters, police officers, and school librarians. Politicians aren’t likely to attack investors like these on behalf of CEOs. Finally, the SEC has been embracing a pro-shareholder stance that seems unlikely to change.

CEOs can benefit personally from strong, independent boards. As major stockholders themselves, they should pursue strategies that increase the stock price. Harmonious relations with investors free CEOs to focus their time and energy on substantive business issues. CEOs will find, too, that investors are much more patient and understanding in bad times if they trust the board. And while a weak board may rubber-stamp the CEO’s decisions when times are good, often its first response to a crisis is to fire the CEO—whereas a strong board with substantive knowledge of strategy and company performance will tend to support management.

CEOs who resist pressure for strong governance risk having Calpers or regulatory bureaucrats tell them what kind of board they should have—an outcome that serves no one’s interests. After all, the best boards aren’t built by outsiders. Only the CEO has the knowledge and the position to build the optimal board for his or her company. Rather than fight the tides, CEOs should take the lead by tailoring strong boards for their companies, thereby shaping the next era of corporate governance to their—and their shareholders’—benefit.