1.1 Introduction
This opening chapter consists of a quick summary of the main functions of a board of directors as well as a presentation of the types of boards of directors that exist around the world. I start by presenting some of the most common definitions of the board of directors and explaining why boards exist in Sect. 1.2. I then move on to describe the monitoring and advisory roles of the directors, the two main functions of boards (Sect. 1.3). Section 1.4 takes a closer look at some recent literature that, using proprietary data, has provided some useful insights into the day-to-day operations of the boards. After having introduced the different type of boards in Sect. 1.5, I briefly discuss director election s in Sect. 1.6. Finally, Sect. 1.7 explains how the empirical literature on boards of directors deals with the endogeneity issue.
1.2 The Board of Directors
Before discussing the board and its functions, it is both useful and necessary to provide a definition for the board of directors. Hermalin and Weisbach (2003) define the board of directors as “an economic institution that contributes to the resolution of the agency problems inherent in managing an organization”. Hermalin and Weisbach (2003, p. 9) see the board as a market solution to the contracting problems of the organization. In their own words, “boards are an endogenously determined institution that helps to ameliorate the agency problems that plague any large organization”. Jensen (1993) stresses the importance of the board of directors by including the board among the four control forces operating on the corporation to resolve the problems caused by the divergence between managers’ decisions and those that maximize firm value.1 Indeed, according to Jensen (1993), the board is the apex of the internal control system that has a vital role in making a firm function properly. While it is quite simple on paper to define what a board is expected to do, for example establishing policies for corporate management and oversight, and making decisions on major company issues, Monks and Minnow (2011, p. 252) observe that it exists a substantial discrepancy between the expected idea of corporate boards and the reality. Monks and Minnow (2011) argue that the theory sees the directors as middlemen whose role is to mediate between top managers and the shareholders. This concept of directors as middlemen is also employed by Thomsen and Conyon (2012), where the board of directors is defined as an intermediary between the company’s shareholders and top management.
As Thomsen and Conyon (2012) argue, the great majority of firms, even many for which it is not mandatory, have a board of directors, suggesting that, everything considered, boards are beneficial and necessary. This is consistent with the view of Hermalin and Weisbach (2003) that boards are not a mere product of regulation. Indeed, their existence pre-dates the regulations that mandate boards. Recent evidence also shows that firms opt to have boards of directors even when they are not legally required to have one to reduce agency problems. For example, Villalonga et al. (forthcoming) use data on privately held Colombian firms to document that the probability of having a board increases with the number of shareholders and in family firms. Burkart et al. (2017) provide some theoretical guidance to explain why boards exist. They argue that boards stem from a trade-off: on the one side a board helps to solve managerial agency problems, but on the other side it is costly because it introduces an additional agency layer to the organizational structure owing to the divergence of interest between directors and owners. For Burkart et al. (2017), these costs and benefits are firm-specific and so is the optimal role the board. However, this message is lost in many studies of boards’ actual roles because laws usually set the existence, the powers, and duties of the board. To overcome this problem, Burkart et al. (2017) look back into the past and study a sample of Norwegian publicly traded industrial firms at the turn of the twentieth century, when companies were not required by law to have a board. Since boards were not mandatory and owners had freedom in their governance choices, the assumption is that boards are optimal when they are observed in the data. They find that informed owners and boards are substitutes, and that boards exist in firms where collective action problems are most severe. Boards also arise to balance the need for small shareholder protection with the need to reduce managerial discretion.
There is not much to discover when it comes to the tasks of the board. Typically, boards have a fiduciary duty towards the firm’s shareholders and oversee the definition of broad policies and strategic objectives of the corporation. They are also tasked to select, hire, and, if necessary, fire the chief executive officer (CEO) of the firm. Boards of directors also review performance and decide the compensation of the top executives. Jensen (1993, p. 862) provides a concise and effective description of what the job of the board is: “The job of the board is to hire, fire, and compensate the CEO, and to provide high-level counsel”. The final part of Jensen’s description has been taken very seriously by directors, who often participate in strategic decisions (Demb and Neubauer 1992; Adams 2009).
From what is written above, it should already be evident that the two main roles of the board of directors are monitoring and advising the management. The monitoring role derives from the agency conflicts that arise between managers and shareholders, a conflict already well known to Smith (1776) as well as Berle and Means (1932), and between controlling shareholders and minority ones. This oversight function often pits the board, the monitoring party, against the managers, the monitored party. On the other hand, boards can provide valuable advice to managers, helping them to achieve a firm’s goals. This advisory role, which has become more and more important (Adams and Ferreira 2007; Monks and Minnow 2011), emphasizes the collaborative nature of the relationship between managers and directors. Part of the literature also stresses how these two primary roles compete for the directors’ time and task focus and differentially impact CEO incentive s to share information (for example, Armstrong et al. 2010; Faleye et al. 2011). However, other research suggests that advising and monitoring occur simultaneously and that the expertise and knowledge of the directors play a much larger role in the quality of board performance than how directors split their time and information between these two roles (Kim et al. 2014).
Nevertheless, it goes without saying that how the board interprets these two functions shapes the relationship with the CEO and the top executives of the company. I discuss in more detail these two roles in the next sections. To conclude here, Table 1.1 presents a short summary of the main papers cited in the introductory ...