In this month’s commentary, Beacon Wealth Consultants Chief Investment Officer Hillary Sunderland, CFA®, CKA® answers a question that we frequently hear from investors: Why is there an emphasis on board diversity within so many company reports?
“Diversity” is one of our culture’s current buzzwords, so it is helpful to understand if companies are merely trying to be culturally relevant or if there is something more going on.
Topics of discussion include:
- What is corporate governance and why is it important?
- Why boards need the Two A’s – Accountability and Alignment
- How a board with diversity of thought helps avoid “groupthink” and comes from a diversity of race, age, gender, culture, skillsets, professional backgrounds and experiences.
- The dangers when a board is not properly diversified and does not have accountability and alignment using the example of Theranos.
- Research reveals the advantages of having the right people in the right seats.
Please watch the video to learn more. Full transcript below.
Hi, my name is Hillary Sunderland and I’m the Chief Investment Officer at Beacon Wealth and LightPoint Portfolios, and this is your April 2022 update. One of the things I like to do every now and then is to take some time to answer some of the most commonly asked questions that we’re getting from clients and lately I’ve been getting a lot of questions on diversity.
So, a lot of clients are receiving information from companies and reports and such, and there’s been a lot of focus on board diversity within financial reports. And so, I’m getting question such as what does diversity have to do with the financial performance of a company? Are these companies just trying to be culturally relevant because diversity seems to be a buzzword of the day? Well, it’s perhaps the case, the word “diversity” was ranked as one of the most top used buzzwords of 2021.
But unfortunately, in our Twitter culture, we’ve a tendency to hear a buzzword like “diversity” and jump to conclusions about its meaning. It’s common that we take very complicated topics today and try to boil them down into hashtags and yard signs. So, I wanted to approach this topic from more of an academic perspective.
So, the question here is really when it comes to investing the focus on board diversity falls within the realm of what we call corporate governance. So corporate governance is the process and structure for overseeing the business and management of a company. And a company with strong corporate governance has an appropriate culture that will help the company deliver strong business performance without excessive risk taking. And it’s also a company that has proper business conduct. So, when we are reviewing the board of directors for a company, what we want to see is both accountability and alignment, or the two A’s.
So, within a company, people need to be given authority and responsibility for the decision making and they need to be held accountable for the consequences of their decisions and the effectiveness of the work they deliver. So senior executives need to be accountable to the non-executives on their board and the non-executive members of the board need to be accountable to the shareholders.
And in terms of the board, we also want to see alignment. Companies need to have the right people with the relevant skills and experience on the board of directors. And also, these people need to be able to contribute effectively to boardroom debate. And this is where that word diversity comes into play.
There are many types of diversity needed for a board to be successful. Though the most important is the diversity of thought. So, the aim here is really to avoid “groupthink” in the boardroom, which can lead to a lack of questioning and challenge.
So, what we like to see is diversity of gender, race, age, culture, skill sets, professional backgrounds, and experiences. These are all important considerations as each of these can help deliver that diversity of thought that we’re looking for on a board of directors.
So, one of the questions you may have, well, what can happen when the board of directors lacks such diversity? Well, you’ve likely heard of Elizabeth Holmes and her now defunct blood testing company Theranos. The company claimed many years ago that it had devised blood tests that required very small amounts of blood and could be performed rapidly thanks to the small devices the company had developed. However, these claims were later proven to be false, and the company has since went under. Now, this was not a public traded company, but it is a really good case study that illustrates what can happen when a company does not have accountability or alignment within the board of directors.
So, to take you through this case study, here’s a look at the structure in composition of the board of directors of Theranos. So, Elizabeth Holmes was the founder, CEO and chair of the board, and she held 99% of the voting rights in the company, which was a dual share class structure. So right away here, you can see a red flag. The ability of the board of directors to offer oversight was likely to be limited because of the level of authority that she had in the company. Additionally, underneath her there on this chart, you can see that the non-executive directors of the board were exclusively male, and mostly with military or foreign service backgrounds rather than medical or scientific experience. And none of them had experience in, or even basic expertise in blood testing. Not counting the executives, the average age of the board members was seventy-three and there were more Secretaries of State in their nineties on the board than people with medical training.
So combined, these are all red flags, and it’s quite easy to argue in this case that the board did not experience the proper diversity of thought to oversee an innovative blood technology company. At the very least, there should have been a better mix of skills and experience on the board of directors. And a better dynamic should have been in place for the senior executives to be held accountable by the board of directors. Elizabeth had the control and the board lacked the expertise to correct her. So, in the end, all of the $945 million invested in this private company from the likes of former Education Secretary Betsy DeVos, Rupert Murdoch, and the Walton family was lost when it was revealed that Theranos had falsified test results and misled investors about the nature and effectiveness of its technology. Elizabeth was convicted of four counts of fraud earlier this year.
And while this is a more extreme case of a lack of diversity on the board of directors, I think it serves to illustrate the point that corporate governance matters. It matters and it’s stressed in company reports because the wrong people or not enough of the right people around the boardroom table can lead the situations where the company can be financially impacted by poor decisions or lack of oversight.
So we like to say, we want to see “the right people in the right seats” when it comes to overseeing a company because when it is structured correctly, when you do have that diversity of thought that we’re looking for, diversity of experience and professional backgrounds, when the board of directors is accountable and aligned, they are more likely to make the best decisions for the company. They’re more likely to address key risks and they are less likely to have governance failings that can lead to fines, litigation, additional liabilities, or erosion of customer trust.
And this is supported by academic research. And is why there is such a push to talk about board diversity within annual reports because of the academic research that’s coming out on this over the last few years. So, here’s an example of just one of many studies: a study in 2017, concluded that:
- the diversity on the board of directors reduces stock return volatility,
- firms with diverse boards tend to adopt policies that are more stable and persistent over time,
- diverse boards tend to take less financial risk but invest more in research and development,
- and overall, the study found that greater heterogeneity among directors leads to higher profitability and firm valuations on average.
So, I hope this video on why there’s so much focus on board diversity was beneficial to you. As always, please reach out to us with any questions that you may have.
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