When lawyer and corporate governance icon Ira Millstein was once asked a quarter century ago why institutional investors submit shareholder resolutions on issues such as requiring a majority of independent board members, he responded, “Because they can't submit the one resolution they really would like.” When asked what that would be, he said simply: “They would like to ask the board to do better.”

Faced with the legal and practical impossibility of asking the board to do better, early advocates of improved corporate governance focused instead on the structural reasons why boards “did worse.” They quickly coalesced around the need for non-executive, independent board members. Given the situation then, that made sense. Overly cozy relationships between directors and management were blamed for quiescent boards that failed to govern. But that was 25 years ago.

Independence is still important, of course, but more recently investors have focused on deep industry expertise as another vital attribute for the board. For several years, there has been an undercurrent in the shareowner community calling for more than well-intentioned, smart, independent directors. But now the call for directors who are industry experts has suddenly become a tsunami.

Speaking at an activist conference in New York, Chris Cernich, director of merger & acquisition and proxy contest research at proxy advisor ISS, said that the firm looks favorably on director candidates with domain expertise. “What we look for is a good match between the problem that's been identified and the solution being proposed. To the extent the problem requires specific industry knowledge, we would look for that in the director nominees,” he said. The hedge funds, lawyers, and others in the audience took notice.

Barely a few weeks later, an academic paper started making even bigger waves. Four academics from universities on four different continents looked at the effect of independent directors on performance at S&P 1500 companies. The paper, titled “Do Independent Expert Directors Matter?” for the first time divided independent directors into those who had previous work experience in the industry, and those who did not.

For several years, there has been an undercurrent in the shareowner community calling for more than well-intentioned, smart, independent directors. But now the call for directors who are industry experts has suddenly become a tsunami.

What the authors found was intuitive, but also fascinating: expertise matters. The proportion of independent expert directors correlates to positive firm performance. Firms with a higher percentage of independent expert directors boast higher book-value multiples and fewer earnings restatement. A high proportion of independent expert directors also correlate to better CEO pay-for-performance sensitivity and, perhaps most importantly in today's world, a higher level of innovation as evidenced by patents and citations of those patents.

Moreover, a company's announcement of the appointment of an independent director with industry expertise is greeted by the market with an abnormal positive price move. The findings are particularly strong for companies with stated research and development expenditures. By contrast, independent directors who have not worked in the industry have no such positive correlations to firm performance. And the market does not reward their appointment.

That paper was presented at a symposium at the University of Delaware's Weinberg Center for Corporate Governance. Earlier that day, an investor panel said nearly the same thing—Independence just isn't enough anymore. With the advent of disclosure regulations mandating that a company state what a director candidate brings to the board, rather than just an antiseptic bio, investors are increasingly seeking to understand the skills and experiences on the board, and cross-referencing those characteristics to their understanding of what is required for the company to thrive. And it wasn't just the usual suspects making these arguments.  Along with a representative of a public pension plan and two activist hedge funds, were representatives of Vanguard, Fidelity, and State Street; firms clearly in the mainstream of mutual fund investors.

Now this might seem basic. But corporate governance as it's practiced today sometimes drifts into a check-the-box compliance mode, rather than a value-added discipline. Board independence was moving in that direction. So refocusing on how expertise adds value should be welcome by both corporations and investors. What are the implications of that new-found focus for your company?

Understand that the chair of the nominating and corporate governance committee (NCGC) is becoming the newest “hot seat” on the board. Indeed, in many boards with unified CEOs and Chairmen, the NCGC chair doubles as the “lead director.” True, the heat isn't quite as extreme as it is for audit and compensation committee chairs, but it's going up by a few degrees each year. Particularly if your company could be in a merger or activist battle, the NCGC chair may need communication skills to explain decisions to investors and proxy advisors. Choose your chair appropriately.

 

Make sure your nominations process is up to evolving best practices. That means a structure that includes an evaluation of the skills and experiences resident on the board, cross-referenced with the skills and experiences needed to execute the corporate strategic plan. Let that evaluation guide your director search.

 

Take advantage of the proxy disclosure requirement to explain why each director adds value to the board. The investors at the Weinberg conference condemned generic disclosure. They wanted to see the applicability of the director's skill set to his or her specific company. We urge readers to learn from the recent “say-on-pay” experiences, where companies first viewed compensation committee reports as compliance exercises and then had to file supplemental documents to get their points across. Consider the proxy disclosures as valuable communication paths; your investors certainly do.

Clearly, independence is no longer enough, if it ever was. It's no accident that the paper on independent expert directors begins with a quote from Warren Buffet: “Over a span of 40 years, I have been on 19 public company boards and have interacted with perhaps 250 directors. Most of them were ‘independent' as defined by today's rules. But their contribution to shareholder well-being was minimal at best. These people simply did not know enough about the business.”

Independence was the watchword 25 years ago. Domain expertise is the mantra of today.

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