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The Role of Boards of Directors in Corporate Governance: A Conceptual Framework and Survey Author(s): Rene B. Adams, Benjamin E. Hermalin and Michael S. Weisbach Source: Journal of Economic Literature, Vol. 48, No. 1 (MARCH 2010), pp. 58-107 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/40651578 . Accessed: 29/10/2013 04:14
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2010, 48:1,58-107 ofEconomicLiterature Journal http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.1.58

in The RoleofBoardsofDirectors A Conceptual Governance: Corporate Framework and Survey


Rene . Adams, BenjaminE. Hermalin,and Michael S. Weisbach*
Thispaperis a survey on boardsofdirectors, with an emphasis on oftheliterature E. Hermalin research donesubsequent to theBenjamin and MichaelS. Weisbach The two questions mostasked about boardsare whatdetermines (2003) survey. their andwhatdetermines their actions? These arefundamentally makeup questions which thestudy and actions are intertwined, ofboardsbecausemakeup complicates Afocusofthis is howtheliterature, theoretical as wellas jointly endogenous. survey - or on occasions deals thiscomplication. Wesuggest failsto deal- with empirical, that studies canbestbe interpreted asjointstatements aboutboth the ofboards many directorselection and theeffect on boardactions and ofboardcomposition process ( JEL G34,L25) firm performance. 1. Introduction often whether question corporate People boardsmatter because theirday-to-day isdifficult toobserve. Butwhen impact things can become the center ofattengowrong, they tion.Certainly thiswas trueof the Enron, and Parmalat scandals. ThedirecWorldcom, torsof Enronand Worldcom, in particular, wereheldliablefor thefraud thatoccurred: Enrondirectors had to pay $168 million to
*Adams: Universityof Queensland and ECGI. Hermalin:University of California, Weisbach: Berkeley. Ohio StateUniversity. The authors wishtothank Ji-Woong Eliezer Fich,JohnMcConFahlenbach, Chung,Rdiger nell, La Stern,Ren Stulz, and Shan Zhao forhelpful commentson earlierdrafts. The authorsare especially ofthecomments receivedfrom threeanonyappreciative mousreferees and theeditor, RogerGordon.

investor ofwhich$13 million was plaintiffs, outofpocket and covered (not byinsurance); Worldcom directors had to pay$36 million, ofwhich$18 million As was outofpocket.1 a consequence ofthesescandals andongoing concerns about boards corporate governance, havebeen at thecenter ofthepolicy debate reform and the focus concerning governance of considerable Because academic research. ofthisrenewed in boards, a review interest ofwhatwe haveand havenotlearned from research on corporate boards is timely. Much of the researchon boards ultitouches on thequestion "what is the mately roleof the board?"Possibleanswers range from boards'beingsimply legalnecessities,
1 Michael Klausner,Bernard S. Black, and Brian R. Cheffins (2005).

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akin to the wearing of wigs in and Weisbach 1988, 1998,and 2003). This something if to their an active creates estimation courts, problems playing endogeneity English in made on the basis of the overall and control choices are management part governance with theerror term ofthe corporation. No doubtthe truth lies unobservables correlated estimated. somewhere between theseextremes; indeed, in theregression equations being inthis is areprobably truths whenthis In fact, oneofourmain there survey multiple points in of differthe of Governance is asked different firms, importance endogeneity. question structures ariseendogenously because ecoorindifferent entcountries, periods. in response actors choosethem tothe Giventhatall corporations have boards, nomic face.2 ofwhether boardsplaya role governance issuesthey the question theimplications holds be answered as there cannot econometrically Beyond endogeneity in the explanatory it also has variable. for econometric is no variation analysis, implicaacross tions for howtoviewactualgovernance Instead,studieslook at differences pracwhenwe observewhat these differences tice. In particular, boardsand ask whether in the wayfirms func- appearsto be a poorgovernance structure, explaindifferences waschosen. The board dif- weneedtoaskwhy that structure and how tion they perform. it is possible thatthe governance onewouldmost liketocapture Although ferences that one needs in behavior. was chosen are differences Unfortunately,structure bymistake, itis difficult to to giveat leastsomeweight to thepossibility ofdetailed outside fieldwork, in behavior itrepresents theright, albeit soluand harder that differences observe poor, in a wayuseful for sta- tion totheconstrained them still to quantify optimization problem work theorganization faces. After tistical all,competition empirical study. Consequently, should dif- infactor, andproduct markets in thisarea has focused on structural capital, to the survival to lead, in Darwinian across boardsthatare presumed ferences fashion, in behavior. Whileadmittedly "fittest" does For ofthefittest. withdifferences correlate was subnot mean that is that outa common instance, "optimal," anything presumption willbehave optimal forknownreasonswouldbe unfit directors side(nonmanagement) toaddress would be pressure direc- insofar as there thaninside(management) differently In other of these reasonsfor suboptimality. tors.One can thenlook at the conduct is to boards(e.g.,decisionto dismissthe CEO words, suboptimality unlikely existing or obvious fixes. with lend itself to is when financial quick performance poor) Thisinsight about ratiosof outsideto insidedirecdifferent is,however, endogeneity in the faceof data. Figure1 conduct variesin a sta- easyto forget torsto see whether On the acrossdifferent showsa plot of two data points.3 manner tistically significant is notdirectly observratios. Whenconduct advice totheCEO aboutstrategy), 2 Harold Demsetz and Kenneth Lehn (1985) were able(e.g., financial onecanlookata firm's to makethegeneral performance amongthefirst pointthatgovernance structures are endogenous.Others who have raised it matters to see whether boardstructure (e.g., R. Glenn Hubbard,and CharlesP. Himmelberg, with theratio include theway vary accounting profits L. Coles, Darius Palia (1999), Palia (2001), and Jeffrey toinside ofoutside Michael L. Lemmon,and J. Felix Meschke (2007). The directors). suchan empiri- pointhas also been discussed in varioussurveysof the One problem confronting consider, e.g., Sanjai Bhagat and Richard H. is thatthereis no reasonto literature; cal approach and Ailsa Bolton, (2002) and Marco Becht,Patrick Jefferis (2003), amongothers. suppose board structureis exogenous; Rell 3 Figure 1 is presentedforillustrative purposes and areboth theoretical there indeed, arguments should research. notbe read as a critiqueof anyexisting evidenceto suggestboard In and empirical none of the studiesdiscussedbelow are as particular, is endogenous structure 1. (see,e.g.,Hermalin naiveas figure

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal


Financial performance

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'
'Firm ' ' '

'

'

'

'

'

'

'

^ Firm2 ' '

Governance attribute betweena Specific FirmAttribute and FirmFinancialPerformance Figure1. Relation

horizontal axisis an attribute ofgovernance axis is a (e.g.,board size). On the vertical measure offinancial One firm performance. has more oftheattribute butweaker perforfirm whiletheother has less ofthe mance, attribute A regresbutbetter performance. sionlinethrough thepoints the underscores relation between attribute apparent negative and performance. Without further analysis, onemight be tempted toconclude that a firm if it shrank woulddo better the size of its board.The problem withsucha conclusion is thatit fails to consider whya largeboard havebeenchosen inthefirst might place. 1, but it also Figure2 replicates figure showsthe optimization facedby problems inquestion. thetwofirms Observe a that,/or there is a nonmonotonic relation firm, given between the attribute and financial performance.In particular, therelation is concave and admits an interior maximum. Moreover, each of the two firms is at its maximum.

Firm2 wouldprefer whereas Consequently, ceteris tobe onFirml's curve, itisn't paribus woulddo worse if thanitis doing and,thus, it wereto shrink itsboardin linewiththe naiveconclusion drawn from theregression in figure 1. issue another Figures1 and 2 illustrate thestudy ofgovernance, confronting namely inthesolutions firms choose for heterogeneity theirgovernance As illustrated, problems.4
4 To be sure, a real empiricalstudywould attempt, in part,to controlforsuch heterogeneity in by putting othercontrols, ifthe data permitted, firm fixed including, effects. It shouldbe noted,however, that(i) therecan still be a problem withthe specification ifthe attribute enters intothe specification (as opposed to nonlinonlylinearly 2); and (ii) earlyas suggested by the parabolasin figure if different firms face differently shaped trade-offs (e.g., ifthe parabolasaren'tthe same shape forall firms), then the coefficients on the attribute, itssquare,etc.,willvary acrossfirms, a random-coefficients is suggesting approach warranted. See Hermalinand Nancy E. Wallace (2001) and Bhagatand Jefferis a discussion ofsomeof (2002) for thesemethodological issues.

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin,

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Figure2. The Real DecisionsFaced bythe Firms

Firms 1 and 2 face different governance are driven and, not surprisingly, problems modelof Almost solutions. to different every the outshows that equilibrium governance toitsexogenous comeissensitive parameters; in thoseparamheterogeneity consequently, in solutions. willlead to heterogeneity eters varitakes into account once one Moreover, such as those ous sourcesof nonconvexity, in optimalincentive one schemes, arising lead considerations find that strategic may firms to adoptdifferent identical otherwise solutions (see, e.g., Hermalin governance 1994). issue Some help withthe heterogeneity moretheoretifrom could be forthcoming - and not a common cal analyses. Although of the inaccurate perception necessarily on corporate literature governance, particuis thatit to boardsofdirectors, related larly a sucha viewoverlooks is largely empirical,

thatis readily theory largebodyofgeneral of to the specific topic boards.For applied instance, monitoring by the board would on seem to fitinto the generalliterature Oliver E. hierarchies and supervision (e.g., A. Calvo and Williamson 1975; Guillermo and Stanislaw Wellisz1979; Fred Kofman Tirole Lawarre 1986; 1993, Jean Jacques issuesof Tirole1992).As a secondexample, board collaboration wouldseem to fitinto and the on free-riding thegeneral literature teamsproblem (see, e.g.,BengtHolmstrom 1982). The teams-problem example serves to thatcan arisein applyillustrate a problem Itis well toboards. theory ing"off-the-shelf" shareofa team's known as a member's that, lesseffort. For he orshesupplies falls, output is nota single thequestion boards, however, butwhathappensto total director's effort, effort are largerboards less capable (e.g.,

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal ina certain ofboard, fashion, type operating a incentive havingimplemented particular in certain and responding package, waysto feedback from therelevant and product capital markets. in To include all thosefeatures a modelis infeasible, butcan we expect the ofceteris with to assumption paribus respect thenonmodeled of the situation to be aspects reasonable? The constrained answer arrived at byholding all else constant need notrepresent theunconstrained answer accurately. Yet anotherpoint,relatedboth to the previouspoint and to our emphasison issuesof endogeneity, is that,motivated by botha desireto simplify and to conform to institutional the modeler is often details, to takecertain tempted aspectsof thegovernancestructure as given.The problem withthisis thatthe governance structure is largely in it its endogenous; is, entirety, the solution reachedby economic actors to their Of course, cergovernance problems. tainfeatures, suchas thenecessity ofhaving a boardofdirectors, can largely be seen as it shouldbe rememexogenous (although beredthatthe decision to makea company a corporation rather a partnership than, say, is itself thetimFurthermore, endogenous). in the short run, ingof events, particularly can makeitreasonable totreat someaspects ofthegovernance structure as exogenous for the purposesof investigating certain questions theoretically. In thissurvey, we focus onwork primarily thatillustrates the sortsof challenges discussed above,papersthathelp clarify the nature ofboardbehavior, or thatuse novel We also attempt toputthework approaches. under the same conceptualmicroscope, howshould theresults be interpreted namely in light of governance structures beingthe second-best solution tothegovernance problemsfacedbythefirm. Our focus is also on morerecent evenifthey are notyet papers, because priorsurveys published, by Kose Johnand Lemma W. Senbet (1998) and

monitors because of the teams problem)? cannot a definitive Yet,here, theory provide - whether answer total equilibrium effort increases or not withboard size depends on assumptions about functional critically forms.5 While "anything goes" conclusions can be acceptable in an abstract theoretical in are often less than model, they satisfactory The lack of clear definitive applied modeling. in muchof the related predictions general a hindrance to modelis, therefore, theory if a speissues.Conversely, inggovernance cificmodel makesa definitive prediction, thenone can often ifitis be left wondering an artifact ofparticular rather assumptions thana reflection ofa robust economic truth. A second,related in is a simpoint that, and thus can tractable, model, ple, theory be too strong; thatis, byapplication ofsophisticatedcontracts or mechanisms, the parties(e.g.,directors and CEO) can achievea more outcome thanreality indicates optimal is possible. To an extent, that can be problem if for attenfinessed; instance, one restricts tionto incomplete contracts. But as others have noted,the assumption of incomplete contracts can fail to be robustto minor of the information structure perturbations and Michael L. Katz 1991)orthe (Hermalin introduction of a broaderclass of mechanisms andTirole1999). (EricMaskin A further issue is thatcorporations are a model complex, yet,to haveanytraction, mustabstract of awayfrom manyfeatures real-life Thismakes itdifficult corporations. to understand thecomplex and multifaceted solutions firms use to solvetheir governance For instance, the optimalgovproblems. ernancestructure involve a certain might
5 For instance,if a team's total benefitis ^=1 en, where en is the effort of agent n, each agent gets 1/N ofthe benefit, and each agentn's utility is (^=1 em)/N then total effort is + 1), N{l/N)l/' (e,T+I)/(7 equilibrium which is increasing in if 7 > 1, decreasingin if if7 = 1. 7 (0, 1),and constant

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, Hermalin and Weisbach (2003) covermany in established this field. we papers Although aimtobe comprehensive, itwould be impossibleto discussevery of the paperin light in recent the literature on boards.6 explosion Of necessity, we omit many interesting in this area andwe apologize totheir papers in advance. For a more detailed authors discussion of the event-study evidencesurboard we refer the rounding appointments, M. reader to DavidYermack Andrew (2006). Fieldsand Phyllis Y. Keys(2003) review the role of the as well as the board, monitoring on literature board (see emerging diversity also David A. Carter, and Betty J.Simkins, W. GarySimpson Kathleen A. Farrell 2003; and PhilipL. Hersch2005; and Rene B. Adamsand Daniel Ferreira 2009 on board We do notdirectly discuss direcdiversity). tor Hermalin andWeisbach turnover; (2003) reviewsome of the relevant literature on this Forthesakeofbrevity, we do not topic.7 theliterature on boardsoffinancial discuss Becausethisis a survey ofcorinstitutions. porateboards,we also do not discussthe oforganizations suchas literature on boards central banks. because s and Partly nonprofit in obtaining of the difficulty data,thislitis lessdeveloped thantheliterature erature on corporate boards (WilliamG. Bowen 1994 discusses someofthe similarities and differences between corporateand nonSimilar data limitations boards).8 corporate ofboardsofpubrestrict us to a discussion we do not traded licly corporations. Finally,
6After the literature, we estimate thatmore searching in the than 200 working papers on boards were written five first yearssince Hermalinand Weisbach(2003) pubboardsurvey lishedtheir (no causal linkis implied). 7 See also Eliezer M. Fich and AnilShivdasani (2007), and Shivdasani Tod Perry (2005), and Yermack (2004), for in thisarea. somerecent work 8Also see Hermalin (2004) fora discussionof how the studyof researchon corporateboards may inform O. Freedman(2004) and collegeboards.James university and colleges' discussesthe relation betweenuniversities boardsand their presidents.

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consider studiesthatcomparegovernance internationally. this surveyprimarily considAlthough ers the economics and finance literatures, in many boards are a subjectof interest other law, disciplines, including accounting, and management, psychology, sociology.9 inthese Whilethere is an overlap literatures, there are also differences. Forinstance, the economics and finance literature's focus has been on the agency traditionally problems boardssolve In create. or,in someinstances, the and contrast, sociological management literatures also emphasize thatboardscan and (ii)pro(i) playa rolein strategy setting vide critical resources to the firm, suchas networks and connections (see,e.g., building and Albert Finkelstein, Hambrick, Sydney A. Cannella2009). Someofthetopics previin thedomain ofother are ously disciplines in the economto be of interest beginning ics and finance literature. Forexample, this literature has begunto incorporate issuesof trust, expertise, diversity, power,and networks intotheir analyses.10 The nextsectionconsiders the question ofwhatdirectors do. The section following, section issuesrelated to board 3, considers structure. Section4 discusseshow boards fulfill theirroles.Section5 examines the
9 Some include examples of this broader literature Lucian A. Bebchukand JesseM. Fried (2004), Ada Demb and F. Friedrich Neubauer(1992),AnnaGrandori (2004), Donald C. Hambrick, Theresa Seung Cho, and MingJerChen (1996), JayW. Lorsch (1989), Myles L. Mace Pfeffer (1971),Jeffrey (1972), MarkJ. Roe (1994), James D. Westphal and EdwardJ.Zajac (1995),Westphal (1999), and Zajac and Westphal(1996). 10porresearch from an economic on direcperspective tor diversity, see Carter,Simkins,and Simpson(2003), Farrell and Hersch (2005), and Adams and Ferreira in section2.3. is discussedinfra (2009). Director expertise Some aspectsofpowerrelatedto boardsare capturedin Hermalinand Weisbach(1998); see Raghuram G. Rajan and Luigi Zingales (1998) fora more generaleconomic ofpowerin organizations. See AsimIjaz Khwaja, analysis Atif Mian and AbidQamar (2008) for work on thevalueto a firm createdbyitsdirectors' social networks.

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Vol.XLVIII (March Literature, 2010) ofEconomie Journal in setting "involved forthe comstrategy ofrespon43). pany" (p. Seventy-five percent dentsto another of Demb and Neubauers that "setstrategy, questionnaires report they overall direction, mission, corporate policies, vision" (p. 44). Indeedfarmorerespondents with that oftheir agreed description job than with the statements that their agreed job entailed "oversee[ing], monitor[ing] topmanCEO" (45 percent); "succession, agement, CEO and top management" hiring/firing or serving as a "watchdog for (26 percent); dividends" shareholders, (23 percent). The disciplinary role of boards is also unclearfromdescriptive studies.Perhaps theperiodhe studied, Mace sugreflecting stems from the geststhatdiscipline largely CEO and othertop management knowing "that must a periodically they appearbefore board madeuplargely oftheir peers" (p. 180). Lorsch takesan evendimmer view, suggestboardsare so passive that offer ingthat they little (see,especially, bywayofdiscipline p. seem 96). Demb and Neubauersstatistics consistent with this as lessthan view, broadly half of theirrespondents agree thattheir is to monitor "oversee, job topmanagement, CEO" and less than a quarteragree that their as a "watchdog for sharejob is toserve dividends" holders, 44). (p. On theother hand,ithas been suggested thattheboardpassivity described by Mace and Lorschis a phenomenon of the past. For instance, Paul W. MacAvoy and Ira M. Millstein thatboards have (1999) suggest become less passive;thatis, they recently haveevolved from rubberbeing "managerial to active and monitors." stamps independent and Millstein MacAvoy providestatistical evidence in support ofthat findconclusion, that CalPERS' of a firm's board ing grading correlatedwith proceduresis positively measures ofperformance. accounting-based Another of evidence consistent with piece the viewthatboardshavebecometougher is that CEO dismissalprobabilities have

literature on whatmotivates directors. We endwith someconcluding remarks. 2. WhatDo Directors Do? To understand corporateboards, one shouldbeginwiththe question ofwhatdo directors do?11 2.1 Descriptive Studies One wayto determine whatdirectors do is to observe that do field work. directors; is, There is a large descriptive literature on boards(e.g., Mace 1971;ThomasL. Whisler 1984; Lorsch 1989; Demb and Neubauer 1992,andBowen1994). The principal conclusions of Mace were that"directors serveas a sourceof advice andcounsel, serve as somesort ofdiscipline, and act in crisissituations" if a changein CEO becomes The nature necessary (p. 178). of their"advice and counsel"is unclear. Mace suggests thata board serveslargely as a sounding boardforthe CEO and top management, occasionally providing expertisewhena firm facesan issueaboutwhich one or more boardmembers are expert. Yet Demb and Neubauerssurvey results find thatapproximately two-thirds of directors that the direction of agreed "setting strategic the company" was one ofthejobs they did added).12 (p. 43, emphasis Eighty percent of the directors also agreedthatthey were
11This from the questionof what questionis distinct should directors do? This second questionis answered, in part,bythelegalobligations law imposedbycorporate and precedent), (bothstatute havingto do withfiduciary (see, e.g., Robert C. Clark 1986, especially obligations 3 and 4). chapters 12It is to notethatthe Demb and Neubauer important surveysand questionnaires sample very few American directors The topfour nationalities (4.2 percent). surveyed German(11.3percent), (29.6 percent), bythemare British French(11.3percent), and Canadian (9.9 percent). Overall 43.7 percent oftheir come from common-law respondents countries.

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, been trending (see MarkR. Huson, upward 2001for Robert andLauraT. Starks Parrino, overtheperiod1971to 1994 and evidence see StevenN. Kaplan and Bernadette A. 2006 for more recent Minton evidence).

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toboards. Within have career concerns, agents on how authors havefocused thatapproach, ofability relates to thepower theassessment of the CEO (e.g.,Hermalin and Weisbach totheselection ofprojects andstrategy 1998); Otto H. Silvia (e.g., Dominguez-Martinez, andAssessment 2.2 TheHiring, of Firing, andBauke Visser Swank, 2008);totheprocess Management theCEO (e.g.,Hermalin ofselecting 2005); other issues. ascribedto among One role that is typically directorsis controlof the process by and 2.2.1 Assessment, Power, Bargaining are hired,promoted, whichtop executives CEO Control dismissed (see, assessed,and, if necessary, The firstarticleto apply Holmstrom's for F. Vancil 1987 a descriptive Richard e.g., framework to boards was Hermalinand Naveen 2006 for statisand Lalitha analysis Weisbach(1998). In theirmodel,thereis ticalevidence). under can be seen as havingtwo an initial Assessment periodoffirm performance incumbent CEO. Based on this is of what an one perfortop monitoring components, about isdetermin- mance,the boardupdatesits beliefs doesandtheother management In the CEO's of these of intrinsic updated ability. light ability topmanagement. ingthe the theboardmay chooseto dismiss actionscan, beliefs, of managerial The monitoring and hire a from the in part,be seen as partofa board'sobliga- CEO replacement pool with mal- ofreplacement CEOs oritmay tionto be vigilant bargain against managerial to changes CEO withregard it is difficult theincumbent feasance. Yet,beingrealistic, and his future to see a boardactually salary. beingin a position in boardcomposition chooses whether to obtain malfeasance to detectmanagerial then, directly; The board, aboutCEO abilon an additional, at best,a boardwouldseem dependent costly signal if incumbent thatof the original the actionsof outsideauditors, regulators, ity(either ifhired).14 Based orthereplacement the news media. retained and, in some instances, if obtained, the boardagain a board mightguard against on thissignal, Indirectly, about or replacing its choice makes a decision malfeasance keeping through managerial CEO is a (another) over reporting the CEO. If replaced, of auditor,its oversight CEOs. from the of over accountdrawn and its control pool replacement requirements, are second(and final-) period profits Finally, ingpractices. with theexpected valueoftheprofon realized, focusof the literature The principal function of the then-inhas itsbeinga positive at leastat a theoretical level, assessment, CEO's ability. ofhowtheboarddeter- charge beenonthequestion to obtain an addiThe board's inclination andwhat itdoeswith mines ability managerial is a function of its One strategy for tional information.13 that independence signal studying assessment has been of ability the question ofHolmstrom's theadaptation (1999)model, and when which analyzes agency monitoring 14 modelbut An alternative,
13 the CEO is a memberof the board. In Typically, the CEO is at odds with"theboard,"we are, like stating forthe board theliterature, usingtheboardas shorthand minustheCEO. equivalent, essentially forthisstagewould be to assume the board ing strategy alwaysreceivesthe additionalsignal,but the board has of the signal,with over the informativeness discretion to the boardthan moreinformative signalsbeingcostlier less informative signals.See the discussionin Hermalin (2005) on thismatter.

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal

from theCEO.15 Theboard's at ingto budgeon the issueof independence independence at least will of the to monitor) thansalary, that on the outcome (willingness stage depend indethere is movement on between the board and the hence, initially; bargaining game wellends Because pendence. So a CEO whoperforms incumbent CEO ifhe is retained.16 of the additional a lessindependent board.The flip the acquisition signalcan up facing of dismissed and side is that a CEO who is increase the risk being performs poorly only to replacement. the CEO enjoysa noncontractible control vulnerable theCEO prefers a lessindependent Malcolm Baker and Paul A. Gompers benefit, less to that a board board; is, likely acquire (2003),AudraL. Boone et al. (2007), and E. Ryanand RoyA. Wiggins thisadditional The board,however, Harley (2004) signal. its When each find evidence consistent withthe idea to maintain independence. prefers - specifi- that successful CEOs are ableto bargain for the CEO has bargaining power he's a boards. Boone et al. find when he has demonstrated that less independent cally - the that well variables thatare reasonably associated "rarecommodity" by performing either for the board boards independence declines.Intuitively, withbargaining power to be above or the CEO are significant and have the a CEO whohas shown himself he measures of CEO right sign.In particular, averagebargainson two dimensions: and the CEO's can bargainfor more compensation and, bargaining power,tenure, to remainCEO rather shareholdings, arenegatively correlated with because he prefers in The tenure than be fired, thedegree oftheboards inde- boardindependence. findings, in time, its particular, are precisely whatthe Hermalin Atanymoment given pendence. betweenfirm and Weisbachmodel predicts.Measures rateof substitution marginal a that indicate that theCEO hasrelatively less and disutility of monitoring, performance outside director boardviewsitself as optimally independent bargaining power, including viewanychangein their ownership and the reputation of the firm's (i.e.,the directors ofitsIPO, are that leadtomore orlessdil- investment banker atthetime composition may in monitoring as moving itaway from all positively correlated with boardindepenigence find board'soptimum).17 Bakerand Gompers the incumbent Hence, dence. Similarly, that measures that reflect the CEO's bara local changein independence represents an estimate ofthe a second-order loss forthe board (thetop gaining power, including ofthe ofthe hillis essentially whereas as an CEO's Shapley valueandthereputation flat), venture the in the CEO's salary is a first-order firm's have increase capitalists, predicted for theformer andpositive for loss (themarginal costof a dollaris always signs (negative will- thelatter) of is more withrespect to thepercentage a dollar). The board, therefore,
15 is a complex Withrespect Independence concept. who tomonitoring theCEO, oneimagines that directors haveclosetiesto theCEO (e.g., professionally, socially, wouldfind or becausetheCEO has power overthem) him with fewer ties more than directors monitoring costly see Westphal 1999for an opposing We view). (although discuss atlength independence infra. 16 there is sufficient Hermalin andWeisbach assume CEOs for competition amongpotential replacement theposition that a replacement CEO has no bargaining a replaceTheir model would be robust togiving power. ment CEO somebargaining as longas itwasless power than that CEO whois retained. enjoyed byanincumbent 17For instance, if the board'sactionsare determinedby a median-voter model,then the incumbent median director(voter) knows that moniif toringwill be optimal from her perspective thereis no changein board composition. If, howthe so thatshe is no longer ever, composition changes willno median thenthe levelof monitoring director, Provided, longerbe optimalfromher perspective. thatthe tastesof the new mediandirector though, median from the incumbent rangeon a continuum thenhavinga new mediandirector with director's, different tastes than the incumbent only slightly a second-order loss for the incumbent. represents

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, non-inside directors on the board.At odds with theHermalin andWeisbach modeland unlike Booneet al.,Baker andGompers find - albeit a positive statistically insignificant between CEO tenure and relationship perofnon-inside directors. centage Finally, Ryan find that a CEO's paybecomes andWiggins as hisconlesslinked toequity performance trol overtheboardincreases (proxied byhis andtheproportion ofinsiders). These tenure authors thesefindings as consistent interpret andWeisbach with theHermalin bargaining becauseitsuggests that as CEOs framework, use this becomemore powerful, they power to improve theirwell-being (e.g.,as here, where thispower allowsthem to reducethe oftheir volatility compensation). Bakerand Gompers, Boone et al., and andWiggins areallsensitive totheissue Ryan are endogenous. thatgovernance structures in particular, a Baker and Gompers, provide solution to theproblem convincing byideninstruments for theendogetifying plausible in their venture neousvariable specification, these instruments being capitalfinancing, ofoperation anda time that thestate dummy inflows to vencaptures exogenous capital turecapital funds. Yetnoneofthesepapers shedslight on whether successful CEOs are for a lessindependent board able to bargain becausethey all rely within the same firm, of on analysesof repeatedcross-sections datarather thanpaneldatawithfirm fixedeffects. more direct Shedding empirical light natureof the CEO -board on the dynamic within firms remains an interrelationship for future research. esting topic 2.2.2 Assessment and Project Selection

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and Visser's modelis thatthereare Swank, twopossibletypesof CEO, good and bad. In each of twoproductive a CEO periods, drawsa project at random from a distribution of different on projects(conditional CEO ability, each period's drawis an indeThink ofeachproject event). pendent being summarized its net value(NPV). by present The difference betweenthe two typesof CEOs is thatthe distribution of projects of NPVs to be is better (distribution precise) forthe good typethanthe bad type(e.g., the good type's distribution dominates the inthesenseoffirst-order bad type's stochasticdominance). The CEO sees the"stamped" NPV on the he draws, whereasthe board does project not.In thesecond(final) theCEO's period, incentives are suchthathe implements the ifandonly ifithasa positive he draws project NPV.In thefirst theCEO's however, period, incentives are possibly withthat misaligned oftheshareholders: theCEO valueskeeping hisjob. If his first-period actions or perforto infer he is the mancelead the directors bad typeand theboardis notcommitted to retain then he willbe dismissed as itis him, better to drawagainfrom thepool ofCEOs thanto continue to the secondperiodwith a CEO whois known to be bad. The CEO's concernabout retaining his job makesit him for to avoidrisk to therefore, tempting, his reputation not even by pursuing positive NPVprojects inthefirst period. One potential solution wouldbe forthe board to commit to retainthe first-period CEO for thesecondperiod. Withthat comCEOs wouldchooseonlypositive mitment, in thefirst NPV projects This,howperiod. and Visser the is not because Swank, ever, Dominguez-Martinez, necessarily optimal to Hermalin and directors are throwing the (2008) is a modelsimilar away optionto Weisbach between replacetheCEO ifthey infer he is likely to (1998).A keydifference in Hermalin the two is that,in Dominguez-Martinez, be bad. Thatis,as is also noted andVisser, itis theCEO whodeter- and Weisbach, theability to replacea CEO Swank, mineswhatinformation the board learns. a boardinfers a valuis probably bad creates An interpretation of Dominguez-Martinez, ablerealoption for thefirm.

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal

ofthe Dominguez-Martinez, and Visser(2008) Model Swank, Figure3. Illustration Notes:The probability functions overNPV are shownfor thetwotypes.Froman informational density pertheCEO shouldbe retained ifand onlyifthe realizedvalueofa project is above1.If,however, v spective, denotes theproject with an NPV = 0, thentheboard,tolimit wishtocommit toretain losses,may first-period theCEO ifand onlyiftherealizedvalue is above somecutoff betweenvl and u. strictly

Given that good-type CEOs are more tohavepositive NPVprojects thanbad likely an alternative forthe board types, strategy would be to commit to dismissthe CEO ifhe doesn't undertake a project. This, only is notwithout costbecausenowa however, CEO couldbe willing to undertake a negativeNPV project ifit is notso bad thatthe from theproject disutility resulting pursuing hisutility from hisjob.18 outweighs retaining Under this somenumber of rule, governance NPVprojects willbe pursued. negative A thirdstrategy be forthe board might to commit to keep the CEO only if he
18 Swank,and Visserassume a Dominguez-Martinez, CEO's first-period function is + ,where is utility the returns from thefirst-period > 0 is hisbenproject, efit ofkeeping hisjob, and {0,1) indicates whether he loses or keepshisjob, respectively.

undertakes a positiveNPV project.This seemoptimal, insofar as itavoids might negativeNPV projects and allowssomelearnbe suboptimal: ing,but could nevertheless howmuchis learnedabouttheCEO's abilon therelative likelihood ofthe itydepends twotypeshaving witha particular projects NPV.It is possible, thatifa given therefore, NPV is morelikely from a good typethan a bad type,thenit could be worth having thatproject undertaken evenifthe NPV is becauseseeing theproject negative provides valuableinformation aboutthe CEO's abilifa given NPV is more ity. Conversely, likely from a bad typethana good type,thenit could be worthwhile the CEO dismissing therealization oftheproject even following if its NPV is positive. Figure3 illustrates. from theperspective ofoptimal inferPurely a CEO if he ence,the boardshouldretain

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin,

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unknownCEO than that of a with an NPV abovevl and dis- relatively hasa project is that The reason established veteran. himotherwise. v1< 0 = , more miss If,however the to dismiss a costs. thenthis cutoff performing option poorly impliesfirst-period costsagainst CEO andhirea newoneis likean exchange offthesefirst-period Trading its value is greater, the board may option.Consequently, the value of information, is the amount the greater 1and ; ceterisparibus, wishto set a cutoff, vc,between ifhe of uncertainty. Hermalinbuilds on this that is,a CEO keepshisjob ifandonly between therelationship to examine and thatproject a project undertakes pays insight tohire anditspropensity a board's structure at leastvc. off external from the outside a new CEO and Visser (an Swank, Dominguez-Martinez, a possible hire) versusfromthe inside (an internal observethattheirmodeloffers hireis a betan internal of for evidence "poordeci- hire).Presumably explanation why external than an ter-known lead to CEO does notalways sionmaking" hire, commodity hireoffers that an external it is optimal to let a dismissal. Sometimes greater meaning ratherthan uncertainty CEO pursue a bad strategy and, thus, a greateroption more hireis, therefore, to pur- value.An external to the statusquo (i.e.,better stick How much more valuable ceteris NPV than do rather sue a negative paribus. project to on the revealed information because the however, valuable, degree depends nothing) will monitor the CEO the board the board which allows from thatcourseofaction (its and LiketheHermalin abouttheCEO's ability. degreeofdiligence). toupdatepositively theboardmakesa as formulated (1998) model, here,the same Weisbach Admittedly, itwillmonitor of decision as tohowintensively modelwouldalso explainthe dismissal intheprobabilis reflected successif moderate theCEO, which moderate a CEO after correlated itwillgetan additional withlow ability ity successis moreassociated signal is there Without thesignal, hisability.20 than high ability.19 Dominguez-Martinez, with thevalueof no option value.Consequently, an modelalso suggests and Visser's Swank, the abouta newCEO is greater seem uncertainty newCEOs rarely for why explanation the more the board wheels when more to be ridingwith training (i.e., likely diligent a it comes to managingtheir companies. it is to acquirethe signal)and,therefore, to trade more board is while more of CEO's a action, willing perdiligent range Limiting forgreater also lim- offotherattributes mistakes, uncertainty hapsa wayto avoidrisky theboardcan learnabouthis than is a less diligentboard. Hermalin itshowmuch offers an explanawhen arguesthatthisinsight in his career, early ability. Especially trend has been a tion for there value the little is known, growing why expected relatively hires andshorter bothmore external the expected toward can outweigh of information CEO tenures:Due to increasedpressure costofmistakes. moregovfrom institutional shareholders, and CEO Selection 2.2.3 Assessment of threats ernmentregulations, greater and newexchange withthe litigation, Hermalin(2005) is concerned requirements, and when boardshavebecomemore is more valuable information fact that independent of a the ability to infer a boardis seeking
19 Swank, and Visser do not Dominguez-Martinez, This is one ofthewaysourinterpretation makethispoint. fromtheiractual of theirmodel could be said to differ model. 20 the signal and essentially equivalently, Alternatively, funcis an increasing is alwaysobserved, butitsprecision See section6 of at monitoring. tionof the board'sefforts Hermalin.

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal

More CEO

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ofthe Hermalin(2005) Model Figure4. A Graphical Summary

Hence,boardsare morewilling diligent.21 to monitor, which raisesthe likelihood they hireexternally for theCEO position.22 More raisesthe likelihood of monitoring directly CEO dismissal and indirectly raisesit if it leadsfirms to hireCEOs about whom lessis known. One response ofCEOs tothis mongreater is for them towork "harder" itoring pressure could be interpreted as taking less (which Both because theyare led to perquisites). work harder and their jobs are less secure,
21See Huson,Parrino and Starks (2001) and StuartL. Gillan and Starks(2000) forevidenceon trendstoward boards with a greaterboard independence(technically, of outsidedirectors) and the rise of greaterproportion institutional investors. 22See KennethA. Borokhovich, Parrino,and Teresa Trapani (1996), Huson, Parrino,and Starks(2001), and JayDahya, John J. McConnell,and NickolaosG. Travlos evidencethattheproportion ofnewCEO hires (2002) for that are externalhas been increasing; the last provides evidencefor thistrend outsidethe UnitedStates.

CEOs willdemand greater payin compensation. ofmore indeHence,a consequence boardsovertimecouldbe upward pendent on CEO compensation.23 pressure Figure4 summarizes Hermalin's model.24
23As Hermalinnotes, thepositive correlation between board independenceand CEO pay in time series need notimply a positive correlation in the crosssectionat any sketches an extension ofhismodel pointintime.Hermalin thatwouldpredict a negative in crosssection, correlation correlation overtime.See his section5. despitea positive 24It is worth thatHermalin is nottheonlytheonoting reticalexplanation forthe trendtowardmore external hires and greaterCEO compensation. Kevin J. Murphy and Jn Zbojnk (2006); Murphyand Zbojnk (2004) offer a non-boards-based model that takes as its main premisethat there has been a decline in the value of relative to thevalue of managers' firm-specific knowledge theirgeneralknowledge. As theyshow,thiswill increase the willingness of firms to hire CEOs externally. Given and Zbojnk 's modeling of the CEO labormarMurphy to go outsidetranslates intoa ket,thisgreater willingness rise in CEO compensation. Hermalindiscusseshow his model can be extendedto incorporate the Murphy and Zbojnkmodel,see his section6.

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TheRoleofBoardsofDirectors and Weisbach: Hermalin, Adams, Models Assessment 2.2.4 Other of otherpapersexaminethe A number associatedwith the board's mechanisms of the CEO. Clara Graziano assessment and AnnalisaLuporini(2005) also has a CEO ability. boardthatseeksto determine is the ofa to their Critical analysis presence who is the one on shareholder board, large but cost of bear the to monitoring, willing if the combenefits who also gainsprivate certain strategies (projects). pany pursues will Because only the large shareholder can be find there monitor, advantages they to a dual-board (e.g.,as in muchof system continental Europe) because it may be role themonitoring to divorce advantageous comthepowerto havea sayoverthe from andAnjan David Hirshleifer strategy. pany's boardsalways V. Thakor (1994)assumethat theCEO's useful to assessing receive signals insofar as someare butboardsdiffer ability, boards lax and some are vigilant. Vigilant of on the basis fire the CEO to choose may and in Hirshleifer The situation a bad signal. ofa Thakor is complicated bythepossibility with indebid byan outside takeover party conabout the firm; information pendent board a behoove it vigilant sequently, may butwait notto act on itsown information, can be learnedby to see whatinformation bid and thepresence (ornot)of a takeover the alsoexemplifies bid.Thisarticle theprice onesource is only that boardgovernance fact of managerial and, morespecifidiscipline and that internal notion the it cally, captures as substitutes can serve external monitoring A. Warther Vincent or complements. (1998) in the board which model another presents abilabout information managerial acquires we've dismodels other unlike the Here, ity. a cussed,each director signal gets private insois costly ofinformation andaggregation a he received whoindicates faras a director his board of is at risk losing signal negative tobe intheminority. seatifhe proves

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has A recent strandof the literature of that the board's monitoring recognized a danger the CEO can create,in effect, or holdupby the board.25 of opportunism he has theCEO after to dismiss The ability meansthe investments made firm-specific some of the CEO's board can appropriate his original returns, diminishing thereby Two papersin this incentives. investment strand are Andres Almazan and Javier Laux (2008). In Suarez (2003) and Volker are (i) initial two critical both, assumptions betweenboardand CEO can be contracts and (ii) at least some kinds renegotiated in Almazanand Suarez, of boards (strong to not commit in independent Laux) cannot or behaving opportunistically aggressively in renegotiation. after and Suarez, In Almazan hired, being a CEO can,at personal cost,takea discrete the thatraises, action amount, bya discrete or project thata givenstrategy probability is observable Thisaction willsucceed. bythe whichcreatesan board,but notverifiable, theCEO After for later holdup. opportunity a profitable his action, takes(sinks) oppora for thefirm mayarisethatrequires tunity If the boardis strong new CEO to exploit. CEO in favor to fire theincumbent enough ofa newCEO, thentheboardcan use that from concessions to obtainsalary possibility hisjob means becauselosing theincumbent The threat ofbeing benefit. he losesa private can underforced to makesuchconcessions to takethe incentive minetheCEO's initial action. costly a variation consider To be more concrete, on Almazanand Suarez'sidea:26Suppose has the same that the new opportunity
25 Opportunism and holdup problems have been studied in a large numberof areas of economicssince Williamson (1975, 1976). 26The actual Almazan and Suarez (2003) model is more complexthan what we presenthere. While those and morenuancedanalysis, lead to a richer complications to getthebasic idea across. are notnecessary they

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Vol. XLVIII (March 2010) JournalofEconomic Literature, independence. This variationin degree of independence acts, however, like a shift in bargaining power. Consequently, for reasons similar to those in Almazan and Suarez, a firmcan be betteroffwith a less independent board than a more independent board. 2.2.5 AdditionalEmpiricalAnalysesof Assessment There is both anecdotal and statistical evidence that boards dismiss poorly perCEOs. Based on interviews, Mace forming and Vancil conclude that (1971) (1987) boards fire,albeit often reluctantly, poorly performingCEOs. There are numerous statisticalanalyses that show poor performance, measured either as stock returns or accounting profits, positively predicts a in the CEO.27 a change Simply documenting between poor performance and relationship an increasedprobability of a CEO turnover, is althoughsuggestiveof board monitoring, nonethelessfarfromconclusive.Afterall, a sense of failureor pressurefromshareholders could explain this relationship. To better identify the role played by the board, Weisbach (1988) interactsboard composition and firm in a CEO turnperformance over equation. His results indicate that when boards are dominated by outside directors,CEO turnoveris more sensitive to firm than it is in firms with performance

as keeping the incumbent expected payoff CEO if he took the action and, thus, a than keepinghim if higherexpected payoff he didn't take the action. Suppose a weak board will never fire the CEO when the expected value of keeping him equals that of the new opportunity, but can fire him when the latteris greater.A strong board is of the CEO. Assume always capable firing it is possible,when the threatto dismissthe CEO is credible,forthe board to capture, in renegotiation, the CEO's privatebenefit of controland push the CEO to some reservationutility (call it 0). Hence, a CEO with a strongboard has no incentiveto take the action:If the new opportunity doesn'tarise, he retains his job no matterwhat he did, there is no renegotiation of his compensaand he the control benefit.But tion, enjoys if the new opportunity does arise he gets 0 regardlessof his action; either he is fired, thus denied both pay and private benefit, or throughrenegotiation is forceddown to a 0 reservation Because his utility (payoff). ultimatepayoff is independentof his action, he has no incentiveto incurthe cost of takfora ing it. The storyis, however,different CEO who faces a weak board. Now, he is betteroffif he has taken the action strictly and the new opportunity arises: the board cannot threatento firehim, so he continues to capture rents(wage plus privatebenefit).If he didn't take the action and the new opportunity arose, then he would lose both wage and privatebenefit.If the new arises withlow frequency, so it opportunity is efficient forthe incumbentCEO to take the action,thenhavinga weak board will be betterthan havinga strong board. In Almazan and Suarez, the distinction between strongand weak boards is a distinctionabout their bargaining power. In Laux (2008), the board always has all the bargainingpower at the renegotiation stage offerto the (can make a take-it-or-leave-it in their degree of CEO), but boards differ

27A workis thatfirms often problemfacing empirical offer a face-saving rationale fora changein CEO (e.g.,he wishesto spend moretimewithhis family) rather than admitthe CEO was forcedout fordoinga bad job. See JeroldB. Warner,Ross L. Watts,and Karen H. Wruck (1988),Weisbach(1988), Parrino(1997), and Dirk Jenter and Fadi Kanaan (2008) forfurther discussionsof this issue and strategies for dealing with it. To the extent CEO turnoveris random, it non-performance-based adds noise to turnover thusreducing simply regressions, the power of such tests,but leaves them unbiased and consistent.

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin,

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s results insider-dominated boards.28 This resultis howto reconcile Yermack withthe models discussed consistent withthepredictions ofHermalin renegotiation-based previtoovigilant Thesemodels that andWeisbach (1998)and Laux(2008) under ously: suggest to a firm thepresumption that outsider domination is (here, small)a boardis detrimental theCEO from takfor boardindependence. insofar as it discourages a goodproxy valuable or it means such actions Yermack also seeks to relate board actions (1996) ing cost. Insteadof an can be implemented structure to CEO turnover. onlyat greater and Yermack 's findings couldalsobe atoddswith interaction between boardcomposition 's (1998)bargainingandWeisbach Yermack interacts the log of Hermalin performance, If are less vigibased model: boards and boardsize withfinancial larger performance - effectively - then lessindependent the coefficient on lant finds a positive and significant and Weisbach model thisinteraction term.29 That the coefficient logicofthe Hermalin to a successful CEO will bargain thatfirms withsmaller suggests is positive indicates of his board. This would between increase the size boardshavea stronger relationship 's consistent withYermack than do yielda prediction andCEO turnover poor performance will be less effect: boards This is coninteraction firms with boards. larger finding larger to a signalof poorperformance viewthat smaller responsive sistent with theoften-heard than smallerboards. However, because it overseers oftheCEO boards aremore vigilant in response is the moresuccessful In particular, CEOs whohavethe thanlarger boards. and Weisbach to poorperformance, boards,the Hermalin they maynotbe para- larger or otherwise plagued model would seem to predictthat firms lyzedby free-riding those boardswouldoutperform intheway that boards are. withlarger inertia with larger to s findings Another ofYermack boards,whichis contrary (supported withsmaller Stefan Yermack s work Theodore later Eisenberg, findings. by by Yermack 's It maybe possible to reconcile and MartinT. Wells 1998) is Sundgren, Hermalin and Weisbach the with the thatboardsize and firm finding performance, CEO is a CEO that lattermeasured by averageTobin's), are modelif(i) a successful ofvaluable It is not obvious took successful correlated.30 growth advantage negatively firm his and (ii) thetime had; opportunities it takesto recognize the CEO was success28 hisfirm wouldbe ful is Travlos and and McConnell, (2002); sufficiently longthat Dahya Dahya, McConnell (2007) finda similar resultin the United mature at thetimeit is recognized, leading of Kingdom:firmsthat adopted the recommendations to a lower Q.3] of the Cadbury Commissionshow a greatersensitivity Suchissuesled Coles,NaveenD. Daniel, firms. than nonadopting CEO turnover to performance Related,VidhanK. Goyal and Chul W. Park (2002) find and Naveen(2008) to reestimate Yermack, is of CEO turnover to performance that the sensitivity to but with attention heterogeneity greater less when the CEO also serves as board chair. Adams 2 withthe spirit offigure issues.Consistent ofwomenon and Ferreira thattheproportion (2009) find sensiboards increasesthe CEO performance-turnover set forth and the conceptualframework forthe proportion of outside even after controlling tivity there,Coles, Daniel, and Naveenseek to of female whichsuggeststhat the proportion directors, - directors forthe possibility thatboardshave control outsideof the "old-boy netoutsidedirectors - is proxying for work" boardindependence. firms sizes because facedifferent different 29See Olubunmi a similar study. Faleye(2003) for In s findings, contrast to Yermack 30Average problems. Tobin's is the ratioofthe market value of in theliterature bookvalue.A presumption assetsto their Coles, Daniel, and Naveen findthatfirm
ofthe goodjob manis thatQ > lis partially a reflection is doing.As longas one controls for bookvalueof agement are similarto market-value assets,Tobin'sQ regressions regressions. 31The authors thisinsight. thankRen Stulzfor

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Vol. XLVIII (March 2010) JournalofEconomic Literature, assumed to have an intrinsic for preference the incumbent versus a strategy replacement (the incumbent strategy provides,e.g., more to consume perquisites).In an opportunity of Laux (2008), similar results adaptation would followif one assumed the financial returns to the replacement are indestrategy of the CEO's initial actions. pendent An alternativemodeling approach is to the choice of strategy as a game investigate of information transmission: the CEO (or managementmore generally)has different than the board concerning preferences projects (strategies). A numberof observersare transcoming to the view that information mission between the board and the CEO is important forgood governance(see, e.g., Holmstrom2005). This is particularly true when the CEO has payoff-relevant private insofaras an agency problem information, arises because the CEO can influencethe board'sdecisionthrough the strategic release ofinformation. Adams and Ferreira (2007) build a model based on four broad assumptions: (i) the CEO dislikes limits on his actions (loss of control);(ii) advice fromthe board raises firmvalue withoutlimitinga CEO's of the board's actions; (iii) the effectiveness controland the value of its advice are better the more informed the board is; and (iv) the board depends cruciallyon the CEO forfirm-specific In the Adams information. and Ferreiramodel,the board can learn the a G [0,1],bywhicha projectshould amount, be optimally adjusted (e.g.,what the approin it should be). priate level of investment The board can do this,however, onlyif the CEO has informed themabouttheproject.It is assumedthe CEO can withhold thatinformation,but if he chooses to share it, then he mustdo so honestly (i.e., using the standard terminology of the contracts literature, the information is "hard"). The CEO has a bias, b > 0, such that he likes to increase the size of projects(e.g.,investmorethan is

performance (averageTobin's Q) is increasin board size forcertaintypes of firms, ing those that are highlydiversified or namely thatare high-debt firms. Perry (1999) breaks down the cross-sectional relationship between CEO turnover and firmperformance by whetherthe outside directors are paid using incentives.He finds that the relationshipbetween CEO turnoverand firmperformance is stronger when boards have incentives.This finding suggests that providingexplicit incentives to directorsleads them to be more vigilant (act more independently). Beyond incentive another is the reasons, potentialexplanation in firms that make use of incenfollowing: tive pay for directors, the directorshave a rather than a personal relationprofessional with the CEO and, thus,are relatively ship of him. independent To conclude this section,it is worthnotconing thatfewanalysesof CEO turnover trol for firm-specific heterogeneityusing firm effects. As increasingly long panel-data sets become available, futureresearchwill be able to shed more lighton within-firm changesin CEO turnover. 2.3 Setting of Strategy In additionto makingdecisions concernof CEOs, boards ing the hiringand firing may also be involvedin the settingof stratthe selection egy or,somewhatequivalently, of projects.Certainlysurveysof directors see the discussionof Demb and Neubauer believe (1992) above- indicatethatdirectors themselves to be involved in setting strategy. 2.3.1 Theory To an extent, ofthemodelsdiscussed many above could be modified to make them about boards' oversight of strategy. Instead of replacingthe CEO, the board compels him to change strategy. In an adaptationof Almazan and Suarez (2003) or Hermalin and Weisbach (1998), the CEO could be

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, fixed terms andaddiappropriate).32 Ignoring of their tively aspects respective separable theutility oftheboardandCEO as utilities, a function ofthesizeoftheproject, s,andthe a arequadratic true losses,

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between the To generate further tension board and the CEO, Adamsand Ferreira a personalloss, assume the CEO suffers I > 0, ifcontrol is taken from him.Further, is assume the board not necessarily they assured ofbeing abletoseizecontrol. Rather, = = a the board chooses the and -(s a)2 , -(s b)2, Uc UB probability, thatit willseizecontrol. Theboard incurs a costthat in . The cost The board s of a is is increasing marginal of is, respectively. knowledge in The boardcan,how- however, the board's levelofindeitsprivate information. falling The for this lastassumpm as to what its rationale send a G ever, [0,1] pendence. message it the tionis thatmoreindependent boardsfind valueis. Unlike theCEO's information, in thata false easierto confront the CEO thanless indes information is "soft," board boards. Under Adams andFerreiras the pendent (m^ a) can be sent.Provided message is never it CEO has the powerto choose s and the maintained assumptions, optimal the theboardtochoose = 1. Critically, boardhas learned a, the message-transmis-for the CEO has or has not is a cheap -talk board chooses sionsubgame after game(Vincent because and JoelSobel 1982).Thissub- revealed hisinformation. P. Crawford Moreover, when control is greater butoneis max- thevalueof seizing equilibria, gamehasmultiple = = of the the board can sets a rather than not just , imally although fully revealing the boardwill choosea greater value of information. board's s a (atleastalmost ithasbeeninformed Observe that bytheCEO than surely) when theCEO now becauseoftheCEO's biasandtheimperfec- whenit hasn't. Consequently, in equilib- has incentive towithhold hisinformation: transmission tionofinformation by he a motive withholding rium. Thisprovides theboardwith it,he raisesthe probability retains control that to assert ). is,takethechoiceofs (avoids control; losing in indeIftheboardis sufficiently outoftheCEO's hands.Supposetheboard lacking thentheprobability ofitsseizing Observe itwould, pendence, couldalways takecontrol. tohavealways control, even if the CEO revealshis inforbe intheCEO's interest then, it can be so lowthat Absent that mation, is low.In fact, informed it aboutthe project. risk to runtheincreased the board would sets = a, theCEO is willing information, thatfollows his revealing would of losingcontrol where= {).The CEO's payoff in order to gaintheboard's of the random vari- his information be a concavefunction able - a -b, which has an expected advice (i.e., the informative messagem), value of- b. Withthe CEO's information, becausetheadvicewillhelphimreducehis and Ferreira loss.Adams theboardwouldsets - a. The CEO's pay- expected quadratic that there can exist an interior function ofthecon- show off wouldbe a concave equilibriumin which, the board'sinde-b. Since the former scenariois a stant, provided theCEO indeed is belowa cutoff, spread of the second,it pendence mean-preserving Conditional on the thesecond; reveals his information. that theCEO willprefer follows at or below the hisinformation. board'sindependence that is,revealing being are the firm's cutoff, expected profits greatest if the board'sindependence equals the the At this level of cutoff. independence, 32 one could assume he likes to econoAlternatively, the able to utilize from being expected gain so prefers smallerprojects;in this case, mize on effort, the board's information is that b 0. b < 0. The critical outweighs expected assumption

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to the outsidthe size oftheproject sometimes sufficiently valuablerelative loss from > in when ers' distorted those states > 1, a con(i.e., (i.e., Var(7)/Var(o) being and The Adamsand stant that on the CEO retains values) control). depends parameter totheagency modelalso implies thatit maybe information is valuable relative Ferreira > > 1, to separate the advisory and moni- problem Var(#7)/fo2 (specifically, optimal on valroles of the that to have a a constant that is, board; toring depends parameter in ues),theninsider control is superior to outdual boardsystem as in many countries If thoseconditions aren't sidercontrol. met, Europe. is superior. MiltonHarris and ArturRaviv (2008) then outsider control in spirit is similar to Adamsand Ferreira. Like Adamsand Ferreira and Harrisand Harris and Raviv assumethattheCEO and Raviv,Charu G. Raheja (2005) wishesto inthelight ofthe theinsider liketheoutside direc- understand boardstructure directors, inAdams information about the tors andFerreira, haveinformation board's needtoobtain Unlike Adams relevant to the quadratic loss. The payoffs, firm's or projects strategies. net of fixed terms and additively whereall boardmembers are separable and Ferreira, or Harris and where of their are utilities, Raviv, equally ignorant, aspects respective both inside andoutside directors respectively have privateinformation, Uo - -(s - ao - 7)2 and Raheja assumes that theinside directors private only possess = information. In tomost oftheliteracontrast -(s Ui ao- aI- b)2, from theidea thatthe ture, Rahejadeparts where thesubscripts O and I denote outsid- non-CEOinside directors andtheCEO have Insiderscontrol the ers and insiders, and at is the coincident incentives. respectively, him the t of of information that thethreat "ratting" out group directors CEO through whowillthen the haveaboutthe optimal size of the project. to theoutsiders, joinwith in firing theCEO that theoptimal size from the insiders theCEO, should Observe, now, shareholders' iss = ao + a7.The misbehave. perspective valueofat is theprivate information ofthe a clevermodel,it is difficult Although t groupof directors. Unlikein Adamsand to reconcileRaheja'smodelwiththe evinowit couldbe suboptimal, from dence in Mace (1971) or Vancil (1987). Ferreira, theshareholders' togivecontrol Insubordination by a CEO's management perspective, rare. Moreover, over s to theoutsiders: theinsiders team seems exceedingly although will almost whatevidence thereis aboutwhistle-blownotchoosethe optimal s surely forRaheja's is hardly givencontrol, theymight getcloseriftheir ers (rats) encouraging is particularly valuable Anecdotal atleast, information evidence, (i.e.,the model. suggests tend to suffer, more variance of al is relatively big). Harrisand that whistle-blowers actions Raviv consider twoboardstructures: outsider thanbe rewarded, for their (see,e.g., control and insider control. When groupt Joann S. Lublin, ofwhistle2002).Evidence has control, it has the choiceof choosing s blowers to outside directors is rare going or delegating thechoiceto theother recent whistle-blower, group. the mostprominent Whengroupt makesthe choiceit receives Enron's instance went Sherron for Watkins, a message from herconcerns. the other groupaboutthat totheCEO (KenLay)with other s information. As in Adamsand group FenghuaSong and Thakor(2006) also information transmission relevant the equilibria of thesecheap-talk consider Ferreira, work in fullinformation rev- toproject selection. Likesomeother gamesdo notpermit buildon thecareer-concerns elation.When the insiders' information is thisarea,they

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notions of Holmstrom the project butbefore (1999).Unlike arises, previ- realizedafter ous work, assume that both the board the board must commit to the they project. s ~ (a, 1/q), and theCEO havecareerconcerns. Unlike Assume where q is a measure who assumes all actors are of the board'squality. Note the uncondiHolmstrom, about theirs and others' tional distribution of s is N(0, l/H),where equally ignorant = and Thakor assume that both l/H 1/r Normalize the firm's rev+ abilities, l/q. Song the the CEO and boardeach knowtheirown enuesiftheboarddecidesnottopursue In the Song and Thakormodel, project to be 0. Usingthe standard formula abilities. meanshow likely the CEO is forforming from normaldistriCEO ability posteriors a project to undertake; whereas butions Morris H. DeGroot to identify 1970, (see,e.g., meanshowaccurate theboard p. 167), the expectedvalue of the project boardability onthesignal is the value of anyproject is at assessing put conditional of his the CEO. forth ability, by Independent a signalofa project's theCEO also obtains q+ r whichhe can pass alongtruthfully quality, ifthat with theproject is show Theboard or notto theboard.Songand Thakor proceeds if of that when the that probability good projects positive; is, is low, thentheboardwillbe biasedtoward If theprobability ofgood underinvestment. will is high, then theboard however, projects NPV theoption ofblocking a negative be biased towardoverinvesting. Song and Given value tothe ofgood project, thefirm's Thakor thattheprobability expected prior suggest willbe lowduring economic down- reception ofthesignal is projects turnsand high duringeconomicbooms, an explanameanstheir modeloffers which in governance overthebusi- (1) V= tionofchanges Lmax^r+^j theboardwill nesscycle: downturns, during the board be tougher and,during upturns, willbe more lenient. is rather commodel The SongandThakor To with manymoving parts. provide plex, = SfLtisVH) forits results, consider an some intuition of Weisbach Hermalin and (2009) adaptation motivated by Song and Thakor.Assume averse CEO with career concerns a risk+ (1 - <(Sy/H))r-w, la Holmstrom (1999). Assumehis abilw is the CEO's compensation, ex ante to all,is a <~N(0,1/r), where unknown () is ity, of a standard normal distribu- the density function whereN(/i, 2) denotesa normal 2.33 A proj- random variable(i.e.,withmean zero and tionwithmean andvariance r + a -f, where variance willpayoff ect arisesthat one),and () is thecorresponding r is a known the current distribution function. constant reflecting V withrespect to q, it is environment and ~ (0,). A economic Differentiating shown the firm's the CEO's is that about value, s, readily expected ability publicsignal, in the quality ofthe board, V,is increasing theability 33Whilethe realization q, all else heldequal. Intuitively, of is unknown all byanyone, An bad creates an to block a are common distributions project option. knowledge.

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal the measure of the current economic envihasthesamesign as ronment,

thatis neverexercised is worthless; option ifthesignal werecomplete hence, noise,as wouldbe the case if boardhad zero qualvariance is 1/q), there ity(recallthesignal's would be effectively nooption. Asthequality oftheboard information and,thus, improves, the more valuable this option becomes the morevaluablethe firm and, therefore, becomes. It is not, however, costlessto increase boardquality without bound.First, itseems reasonable that directors comhigher quality manda premium or thatproviding a board with sufficient incentives todo a high-quality is the So cost ofboardqualjob expensive. is in Under suitable ity increasing quality. about this cost function assumptions (e.g., thatmarginal costbe rising in q), there will be an optimal In finite valuefor q. addition, iftheCEO labormarket reacts to thesignal so that theCEO's future is salary an increasfunction of the thenthe CEO is ing signal, to more future risk themore exposed salary informative the signalis (i.e., the greater is q). Intuitively, theposterior estimate ofthe CEO's ability is a weighted of the average whichis fixed, and the signal, which prior, is noisy. The moreinformative the signalis known tobe,themore is assigned the weight the CEO's riskmore signal.This increases thanthe lower variance of the signalitself reduces it(see Hermalin andWeisbach 2009 fordetails). A CEO will require compensationfor thisgreater so hisinitial risk, salary (w in expression (1)) willhaveto be greater. In light of thiscost,undersuitable condiitwillagainbe thecase thata finite tions, q is optimal. From expression (1), the marginalnet return toq is
1

drY'y/Hj

=' < 0

where the inequality followsbecause an in r is a movefurther increase intotheleft tail of the density. the marginal Therefore, netreturn in r,whichmeans to q is falling that theoptimal of quality theboardis lower wheneconomic conditions aregood(i.e.,r is than when are bad (i.e.,r is low). high) they when times are Intuitively, good,theboard will wish to let mediocre CEOs go ahead with butthey won't whentimes are projects, bad. Consequently, the value of improving the monitoring of projects is greater when times arebad than when are they good. Nina Baranchuk and Philip H. Dybvig in thisarea article (2009) is an interesting becauseit is notworried aboutinformation transmission between CEO and board,but themamongthe variousboard members selves(which, in practice, include theCEO). Each director i has a belief, as to at G W1, whatthe firm shoulddo. Similar to Adams and Ferreira (2007) and Harrisand Raviv a qua(2008), a director expectsto suffer dratic lossinthedistance between hisbeliefs as to whatthefirm should do and whatthe firm's actualcourseofaction, , is; that is,a director's is utility - || a, - || . The directors arrive at according to a solutionconcept that theauthors callconsensus. This solution concepthas manydesirable existence forall such properties, including Aweakness oftheconcept, is however, games. that there is no explicit extensive-form game towhich itis a solution is a coop(consensus erative game-theoretic concept).Another issue is thereis no scope fordirectors to

2rq20'^J

( -rr'

TT3/2 _ dw

~dq

The change in the (noteS'/H = -rr/y/H). net return to q withrespect to r, marginal

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In the beliefs basedonwhat learn another, their offsetting problem.35 partially they update theoffsetting biasesonthepart of literature onboards, ofothers' beliefs. Absent "problem" a less diligent/less itis notclearwhy thedirectors is having thedirectors, controlling/less a "lax"boardis a board.Having share their information and independent wouldnotfreely to howinformain which turn of arrive at a consensus belief committing way partially inpart, willbe used,thereby choiceas towhat tion would leadto a unanimous mimicking, thata contractual thecommitment do. thefirm should solution, wouldprovide. the informa- wereone feasible, principle, By the revelation models discussed here tion-transmission and Experimental 2.3.2 Empirical could all be solvedby a direct-revelation Evidence if completecontracting were mechanism Thomas H. Noe, and Ann B. Gillette, if the could That parties fully possible.34 is, Noe and Rebello transfers ofanylevel Michael and monetary commit (2003);Gillette, J. interesta series of Rebello then the them were (2008) perform feasible, parties among to at the issue constrained ingexperiments an informationally couldachieve designed get within the boardinformation transmission There of via would, contracting. optimum aboutboard room.In Gillette, be no need to worry Noe, and Rebello(2003), therefore, in which consider a is comas or control. Hence, laboratory setting they composition with unininsiders are the informed to models monofmany grouped seeking explain in a simulated boardroom at formed outsiders there is a we institutions observe, reliance, ofoutsidfind that theinclusion that contract- setting. on theassumption somelevel, They welfare undesirable In particu- ers improves by making incomplete. ing is necessarily lesslikely. as to equilibria commit boardscannot Gillette, Noe,andRebello lar,either fully in setrevealed (2008) compare, willuse the information howthey again a laboratory two-tiered for ting, to themor it is infeasible boards, boards, single-tiered contractually in a man- insider-controlled to paytheCEO (orothers) them boards, and outsiderthattwo-tiered boards. revelation. controlled to induceefficient nersufficient Theyfind intheir tend tobe overly conservative in Harrisand Raviv(2008),a boards For instance, boards mechanism woulddo bet- choicesand thatoutsider-controlled direct-revelation toleadtothemost efficient outcomes consid- tend terthanthe equilibrium payoffs. The class of modelsbased on strategic couldcontract that theparties eredprovided relies on a funcinformation transfer of the as on the size implicitly project directly are thatoutsider directors could the assumption and they announcements tionoftheir than are inside direcless well informed this literature make transfers. Although Ravinaand Paola Sapienza contracts are tors.Enrichetta tendsnotto explore fully why would casual adopt a cleverapproachto sug- (forthcoming) empiricism incomplete, this limits to both there that indeed, are, testing assumption.These authors gest of trades and transfers. commitments So, realistically, examinethe relative profitability in in their stocks made a secondare byoutsiders companies' organizations necessarily the situation. or third-best Consequently, - to "law of the secondbest"often applies 35An example of the law of the second best is, for in part,the second-or third-best instance, remedy, some degree of cartelization of a encouraging can gainbyintroducing pollutingindustry: theparties price will by reducingcompetition, problem,
34Note Song and Thakor is not an informationmodel. transmission be driven above privatemarginalcost; hence, society cost (i.e., mayhope to get price closerto social marginal caused by the cost inclusiveof the negativeexternality pollution).

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal How are on real-world boardsof directors. in practice?Does this boards structured structure coincide with theearlier-discussed theories? Howhasitchanged over both time, in response in the economy to changes and environments? regulatory 3.1 SomeFacts

Observers dividedirectors into typically two groups:inside directors and outside directors. a director who is a Generally, firm in full-time of the employee question is deemedto be an insidedirector, whilea director whoseprimary is not employment withthe firm is deemedto be an outside director. Outside directors areoften taken to be independent the directors, indepenyet denceofsomedirectors whomeet thedefinitionofan outsider is questionable. Examples ofsuchdirectors arelawyers orbankers who do business withthecompany. of Outsiders dubious are independence sometimes putin a third in work (see,e.g., category empirical Hermalin andWeisbach or 1988):"affiliated" In recent directors. "gray" years, public pressure and regulatory have led requirements firms tohavemajority-outsider boards. The characteristics ofboardsoflargeU.S. ina number have beendescribed corporations ofstudies. Forexample, Fichand Shivdasani a sample of508 ofthelargest (2006)consider 3. Howare BoardsofDirectors U.S. corporations between1989 and 1995. Structured? find onaverage, outsiders make that, They up We havediscussed someexplanations for 55 percent ofdirectors, 30 percent, insiders 15 directors the remaining whythereare boards,and whyone might and affiliated boardsto pro- percent. The average boardcontains twelve expectendogenously-chosen videmonitoring ofmanagement, the directors,each receiving approximately despite factthat management has some $36,000in fees(plusstock and has typically options), A number But the 7.5meetings a year. ofthedirectors say overthe board'scomposition. theories a stylized on multiple theoutside direcboards; simply provide descrip- served in theroleof tors inthesefirms over tionoftheunderlying tensions three direcaveraged the boardin corporate Actual torships. While these dataarefor governance. large public is muchricher thanthesebare- firms, S. Linck, M. Netter, and governance James Jeffry bonescharacterizations. TinaYang(2008)consider a larger of sample There are a numberof questionsthat 8,000(necessarily) smaller with similar firms, can onlybe answered inthedata. by lookingat data patterns

and insiders and findthat both typesof directors earn abnormal but that profits, insiders earnbetter returns thando outsidthat bothtypes of ers.Theseresults suggest directors haveaccess to insideinformation is strictly but that outsiders' information worsethaninsiders'. Thus the finding supof the ports the underlying assumption information-based models ofboards. Breno Schmidt considers a situ(2008) ation in which advice could be particuand valuable, larly namely during mergers On the basis of the social ties acquisitions. betweenthe CEO and otherdirectors, he classifies boardsas "friendly" and (tiesexist) measureis also (a continuous "unfriendly" Whenit is likely thatdirectors employed). valuable information about an acquipossess ofthe sition index the returns (an measure), on announcement ofthe are acquirer higher for bidders with more acquisition friendly boards.Conversely, whentheneed to disciis a greater social concern, plinethemanager tiesprove tobe a negative. is a growing litthere Although empirical toestimate theroleofdirecerature seeking torsin strategy it is safeto saythat setting, thisis an area in which much work remains tobe done.

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While the existence and basic structure shareholders' the net effect of perspective, ofboardshaveremained constant this is not future research clear; relatively regulation thewayin whichtheyare com- willneedto address overtime, theextent to which the Sukesh has and additional offsets the incremenLehn, Patro, posed changed. monitoring a sample of81 talcostsimposed Zhao(2009)consider Mengxin bySarbanes-Oxley. as public firms that havesurvived companies 3.2 Factors in BoardComposition that 1935until 2000.Survivorship biascomfrom a Board'sActions Affect Potentially the interpretation of their findings, plicates reflect some basic trends We have alreadydiscussedmuchof the nevertheless they boards.First, boardsize literature thathaveaffected (in relatingboard composition a over it terms of the to have insider-to-outsider ratio)and hump pattern time; appears 11in 1935, overpeaksat 15 in 1960,and boardsize to boardactions regarding averages firm declines to 11 in 2000. However, boardsize sight ofthe CEO, as wellas to overall overtimeas the performance section Yet has becomemoreuniform (see 2.2). beyond ratioand boardsize, standard deviation ofboardsize dropsfrom theinsider-to-outsider boardattributes no doubtplaya role. 5.5 in 1935to2.7 in2000.Thesecompanies' other is likely to haveits boards have become more outsider-domi- Each boardofdirectors own a function of natedas well; insider representation drops dynamics, manyfactors in 1935 to 13 the and from 43 percent just percent including personalities relationships in 2000. Partofthisdropcan be explained among thedirectors, their and backgrounds lifecycleof firms. As found- skills, and their incentives and connections. bythetypical exit and firms become more Some ofthesefactors are readily measured ing families are not.Therehas been conmanaged,agencyproblems whileothers professionally as thosein control are no siderable research thatseeksto estimate the can becomeworse In response, on owners. firms impactof variousboard characteristics longer significant willwishtoadd outside directors tocounter- boardconduct andfirm performance. acttheincreased agency problems. 3.2.1 CEO-ChairmanDuality Since 2000, therehave been significant contained a numCEOs alsohold thetitle ofChairman Sarbanes-Oxley Many changes. holdsin almost that increased thework- of the Board; this duality berofrequirements for outside directors 80 percent of large U.S. firms loadofandthedemand (see Paula L. Rechner and Dan R. Dalton1991).This and Yang 2009 fora (see Linck,Netter, In addi- structure oftheserequirements). is viewed as giving CEOs bymany description control at the expenseofother tion,the scandalsat Enronand Worldcom greater parTo mitigate have ledtosubstantially increased scru- ties,including outside directors. public of observers ofcorporate many governance. Consequently, theconsequent problems, tiny moreindepen- corporate have called for a boardshavebecomelarger, prohigovernance meet more bition on theCEO serving as chairman (see, dent,have more committees, havemoreresponsibil- e.g.,Michael C. Jensen and generally 1993). often, and A number ofrecent haveexamined papers ityand risk(againsee Linck,Netter, in increased the These both use of dual titles 2009). changes corporate governance Yang for directors and decreased the empirically. thedemand James A. Brickley,Coles, the ofdirectors to servefora given and GreggA. Jarrell (1997) estimates willingness titles. These It is not that effects of combined therefore, price. surprising, performance insurance find little evidencethatcombining director premi- authors pay and liability affects corporate umshaveincreased From the or titles substantially. separating

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal theconstrained that is optimization program Hence, imposcorporate -governance design. titles wouldeither ing separate yielda less solution or lead to a, possibly ineffioptimal that work-around maintained theopticient, mal amount of CEO power.36 as Moreover, notedearlier, the CEO's worse making job in payas meansan offsetting increase likely with most as compensation. Consequently, in the area of policyprescriptions govermakers should be wary ofcalls nance, policy for theCEO serving as chairman. prohibiting 3.2.2 Staggered Boards A common, yetcontroversial, governance is known as "staggered boards." arrangement Whena firm has a staggered instead board, of holding annualelections foreach direcdirectors are electedformultiple tor, years at a time(usually and only a fraction three), a third) ofthedirectors are elected (usually in a givenyear.This practiceis typically a firm from adoptedas a wayof shielding takeover because a potential canacquirer notquickly takecontrol ofthe firm's board even it controls 100 percent of the votes. Thisarrangement is more common thanone - in the Faleye(2007) sammight imagine halfofthefirms haveclassified ple,roughly boards. (staggered) While the consequenceof the separation of the CEO and chairman positions on firmperformance is ambiguous, less exists with to ambiguity respect staggered boards; the empiricalevidence indicates this arrangement is not in the shareholders'interests as withmuch ofthe (although, caution is warranted due work, empirical to joint-endogeneity issues). Both Jarrell and Annette B. Poulsen(1987) and James M. Mahoney and Joseph T. Mahoney (1993)
36Recall that, in a number ofmodelsofboards,ceding somecontrol to management is optimal(see e.g., Almazan and Suarez 2003; Laux 2008; Adamsand Ferreira 2007; and Harrisand Raviv2008).

thatthe sepaperformance. Theyconclude ration and combination of titlesis part of thenatural succession described by process Vancil(1987). In contrast, Goyaland Park that thesensitivity ofCEO turn(2002) find overtoperformance is lower whentitles are consistent withthe notionthat combined, the combination of titles is associated with increased over the board. power Similarly, Heitor andFerreira Adams, Almeida, (2005) find withtheviewthat evidence consistent title CEOs alsoholding thechairman appear tohold influence over decigreater corporate sionmaking. with thesestudies are consistent Overall, theviewthatcombined titles are associated withCEOs havingmoreinfluence in the firm. this relation is not necesHowever, causal. Influence inside an sarily organizationarisesendogenously, andwith influence come fancier titles. The generally Goyaland Park and Adams,Almeida,and Ferreira reflect CEO powerthat findings potentially cameaboutendogenously a manner through intheHermalin similar tothat and described Weisbach a (1998) model.In otherwords, wellwouldbe rewarded CEO whoperforms thechairman title as well. byhisbeing given iftheincrease in Sucha process, especially arises because of a demonstrated power high wouldnotnecessarily ability, imply perforintitles, mance shifts conchanges following sistent withthe Brickley, Coles,and Jarrell findings. Evenifitistrue that thetitles of combining CEO andchairman means that an individual more influence over hisfirm, has,on average it does notfollow thatmandating separate titles would improve corporate performance. In fact,Adams,Almeida,and Ferreira to Brickley, similar Coles,and Jarrell find that measures ofCEO power arenotsystemrelated to firm Thisis atically performance. consistent withour overarching argument that actual corporate-governance practice needs to be seen as partof the solution to

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whenfirms announce service(and thosewho failto provethemreturns find negative to destaggering their boards are classifying (although selves become vulnerable they In not and this Poulsen's is statistiand takeover). finding light,stock-market Jarrell aboutwhether C. reaction to announcements Bebchuk, Coates, John callysignificant). or notcouldbe and Guhan Subramanian (2002) findthat theboardwillbe staggered a classified boardalmostdoublesthe odds duetothenewssuchannouncements convey and indewhenfaced vis--vis thebargaining remains that a firm toughness independent thanto simply would- pendence oftheboardrather takeover. Becausesome with a hostile is or isn't the whether the board be acquirers are no doubtscaredoff staggered. by Coates,and 3.3 TheRole Particular board,the Bebchuk, staggered of ofOutside Types underestimate Subramanian likely findings Directors takeboardtoresist theability ofa classified s an outsider, a director To be considered andAlmaCohen(2005) find Bebchuk overs. with a difmust be have lower with boards firms that employment primary staggered on whose ferent thanthe firm Tobin's valuethanother firms, Q as a organization using directors finds board he serves. Outside measure ofvalue.Finally, (2007) typically Faleye thatwill enablethemto thesensitivity havebackgrounds boardlowers thata staggered an be valuableto a board,or to represent tofirm ofCEO turnover performance. A literature small An implication oftheviewthatstaggered important constituency. and boards entrench particular typesof directors managersand decrease considers incorporate roles return their whenfirms valueis that governance. specific "destagger," value forall directors, to annualelections 3.3.1 Bankers A. shouldincrease.Re-Jin Guo, Timothy on their boards. havebankers a Kruse,and Tom Nohel (2008) consider Manyfirms both added to boards Bankers be and find that firms that of may destagger sample the firm forthe increase. because theycan monitor firms thevalueofthese does,infact, is nottypi- lenderforwhomtheyworkand because thatdestaggering Theyalso find Both but initiated expertise. by managers, by activist theycan providefinancial cally N. Deli and Daniel the R. Booth to shareholders. (1996) destagger- James Subsequent indicates that these and Daniel T. Byrdand MarkS. Mizruchi reaction ing, investor towhich bankers theextent to be takeover firms are morelikely targets. (2005) consider find role.These authors reinforce theviewthat playa monitoring All ofthesefindings affiliated with a bank when a director is that serves is a mechanism boards that, staggering overall debt the firm's takeovers lending to the firm, toprotect bymaking management is consistent with Thisfinding ratio is lower. difficult. director can withstag- a viewthatsuch an affiliated All in all, it appearsthatfirms interest firms with the bank's worse than boards do by discouraging protect gered other from out loans from annual board elections.Of course,some the firm taking couldbe due to endogeneity; banksthatcould increasethe riskto the of thiseffect are director's bank.While monitoring entrenched with firms through managers already benefit a bank,RandallS. shareholdto convince more to be able directorships may likely E. Strahan Kroszner andPhilip boards.Or,to takea ersto adoptstaggered (2001)argue also involves costs.In whoprove thatsuchmonitoring thosemanagers lesssinister view, liable for particular, bankers can be heldlegally to bargain themselves are in a position of firms that enter if are on the boards of an as they optimal job security part greater the idea with distress. Consistent their continued financial for (second-best) bargain

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal firms presencecan affect long afterthey have leftthe board. Baker and Gompers findthatthe initialpresenceof a venture onewith a strong investor, capital especially is to decrease the CEO's reputation, likely relative the to board. power bargaining a high-reputation venture Empirically, capitalist leads to a morepowerful board,even after the venture exitshis investcapitalist ment.The interpretation of this resultis that sucha venture subcapitalist negotiates more control than is stantially rights typical foroutside in other investors firms. private When these firms this balance go public, of powerawayfrom tendsto management in CEOs persist, leading venture-capitalist-backed firms to have less control over theirboards than CEOs in non-venturefirms. capitalist-backed 3.3.3 Politically Connected Directors

Firms that deal regularly with governsuch as oroneswith ment, utilities, regulated contracts, significant government place a value on abletoinfluence high being governmental decisions. thesefirms Consequently, shouldhave a demandfordirectors with politicalconnections. Anup Agrawaland Charles R. Knoeber (2001)testthishypothesisand,notsurprisingly, find that firms that are morereliant on governmental decisions are more likelyto appointdirectors with in law and politics. backgrounds Extending 3.3.2 Venture Capitalists thisidea,EitanGoldman, and Rocholl, Jrg are foundedwith funding Jongil So (2009)consider ofthese thenature Many firms from in greater venture As a condition of connections detail.Theseauthors capitalists. new enterprises must classify directors to which receiving funding, bytheparty they to theventure belong. Around the timeof the 2000 elecyieldsomedegreeofcontrol Venture have a fidu- tion, which was a very closewinfor capitalists. capitalists George totheir owninvestors to W.BushandtheRepublican firms with ciary responsibility party, exittheseenterprises and Republican-connected in boardsincreased relatively quickly, leave these enterprises' boards value while Democratic-connected firms generally when theysell theirownership in value.Thisfinding stake in decreased emphasizes them. ofventure connected directors can Despitetheshortness capi- thevaluepolitically talists tenures as directors, a study the importance and, consequently, byBaker provide and Gompers(2003) suggeststhat their oftheseconnections tofirms.

is that monitoring through directorships find that bankers are more costly, they likely to be on the boardsof large,stablefirms. Theyalso arguethatliability explains why fewer bankers are on boardsofnonfinancial U.S. firms thanin other suchas countries, A. Ulrike and Burak Gner, Germany Japan. and Geoffrey Tte (2008) find Malmendier, evidence that commercial suggesting adding to boardsincreases a firm's bankers ability but thatthe firms to access debt markets, flexibilthatutilizethisincreased financial the most are those firms with ity goodcredit but poor investment Gner, opportunities. Malmendier, and Tte argue that having bankers on boardscan be a double-edged in can improve a sword, thatthe bankers firm's access to capitalmarkets, but sometimesthis improved access worksto the benefit of the bank rather than the firm the Because doing borrowing. theyhave and Tte panel data, Gner,Malmendier, intwoways, areabletoaddress, theproblem thatfinancing needsmaydrive theappointment ofbankdirectors instead ofviceversa. fixed to control effects First, theyuse firm for firms. Second, heterogeneity among they associated withfailing argue thatbankers banksare less attractive as directors. Thus for an instrument thenumber ofcommercial bankers ontheboardis thenumber ofdirectors hired financial crises. during

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, 3.3.4 CEOs as Directors an outsidedirector of one Sometimes firm is theCEO ofanother. CEOs ofother firms havemanagement skills and an clearly of the issues understanding facing topmanFahlenbrach, Rdiger AngieLow, agement. theeffect andRenM. Stulz(2008)consider of having on boards.These CEO directors that authorsfind no evidence,however, CEOs on boardsadd value,at leastrelative is to other outside directors. Thisconclusion Fich(2005), somewhat atoddswith discussed indetail theannouncement which finds later, firms willbe thatCEOs ofwell-performing abnoraddedtotheboardgenerates positive malreturns. Fellow CEOs on the board may,howvalue in at leastone cirever,reducefirm whena CEO is added cumstance, namely thatis, to a boardas a partofan interlock; is added to the whenthe CEO ofone firm s CEO boardof a secondwhilethe second on board of the serves the simultaneously When directors are added as interfirst. that Fahlenbrach, Low,and Stulzfind locks, firm declines. This decline is performance to mutual the attributed "back-scratching": threat ofwhatthefirst CEO can do implicit for oragainst thesecondin thefirst's roleas causesthesecond toactmore favordirector in first the second s role as toward the ably director. Consistent withthisidea,KevinF. thatinterlocked direcHallock(1997) finds tors receiveabnormally Similar high pay. results are foundin FrancisKramarzand DavidThesmar (2006)andDavidF. Larcker et al. (2005), who use moresophisticated between CEOs measuresof connections ofworsefirm andboards, and find evidence in CEO and payat firms performance higher totheboard. which theCEO hasconnections Fichand Lawrence J.White(2005) explore, moregenerally, the reasonswhyCEOs sit on each others boards. thatmeaTheyfind - tenure, sures of CEO bargaining power

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evidenceof ability (Tobin's Q), and sitting - are posion the nominating committee correlated with whileCEO interlocks, tively is correlated. These ownership negatively are consistent with a of interview findings locksas a meansofproviding the CEO job and Lemmon, security. Finally, John Bizjak, find that board RyanWhitby (forthcoming) thelikelihood of"option interlocks increase a controversial backdating," practicethat serves to increase top management's payby ex postadjusting the date on which options are dated. This finding the view supports in thatboardsplaya role setting corporate further evidence that policiesand provides interlocked boards benefit management, posat theexpense ofshareholders. sibly Overall,thereappearsto be substantial evidencethatinterlocks and otheroutside theCEO and between personal relationships hisdirectors canbe associated with poorperAs before, formance. however, interpreting theseresults is tricky due to theunderlying It is difficult to know endogeneity problem. iftheboardstructure thefirm's determines is merely ortheboardstructure performance a manifestation ofthepower a CEO hasover his firm and the problems thatstemfrom to that.In addition, CEOs maybe invited the boards of firms that are join performing of These distinctions are notmerely poorly. academic to board interest; policies regulate and someare often composition proposed timesenacted.The extent to whichthese to be effective policiesare likely depends on the extent to whichthe board crucially firm structure causally changes performance a symptom ofunderlying and is notmerely inside thefirm. issues is Another issuewithCEOs as directors firm should the the CEO manages perwhy mithimto devotetimeand effort to other firms? MartinJ. Conyon and Laura E. a theoretical Read (2006) offer explanation. of otherfirms on the boards helps Serving tobuildtheCEO's human Moreover, capital.

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Vol XLVIII (March Literature, 2010) ofEconomic Journal firm whenlaborcan affect either policies, board or ownthrough representationequity it is able to influence firm to ership, policies benefit workers at theexpense ofshareholders.However, Fauver and MichaelE. Larry Fuerst thatlaborrepresentation (2006) find on the boardsof Germanfirms is associated withbetter performance, particularly in firms which havea greater needfor coordination. Thissuggests thatlaborcan bring valuable first-hand totheboard. knowledge 4. How Does theBoardWork? The discussion of boardsso farhas left the working of the board as a blackbox. Whattheydo has been discussed, but not how theydo it. How do boardsfunction? Whatare the mechanics bywhichtheydo their towhich we jobs?Theseare questions nowturn. An obviousproblem in addressing these questionsis that what happens inside a boardroom isnecessarily While some private. academic research hastried touncover these of the board through interviews workings andcase studies 2.1supra), most (see section research has reliedon publicly observable data thatarguably shed light on the inner of the board. workings 4.1 TheWorking ofTeams A boardof directors is a team.Thereis a lengthy in economtheoretical literature ics on the workings of teams (see Bolton and Mathias an 2005,8.1 for Dewatripont, wasnoted introduction). As,however, earlier, ofthistheory to boardsdoes not application lead to clear Forinstance, always predictions. totalboardeffort can increase or decrease with thesizeoftheboard. One might suchambiguhope to resolve ous theoretical to predictions by turning the data. If,forexample, totalboardeffort is positively correlatedwith outcomes, thena potential testof size on totaleffort

thefirm can subtract theopportunity costof histimeand effort from the firm from away thecompensation itpays him. The interest of theCEO andhisfirm's arenot, owners howinsoever, perfectly alignedon thismatter faras theCEO also gainsa personal benefit from service on theboardsofother companies (e.g.,additional incomeand prestige). thatdid notlimit thenumber Hence,a firm ofdirectorships itsCEO couldacceptwould findthatthe CEO acceptsmoredirectorthan would be optimal from theshareships holders' and Urs perspective. Perry Peyer (2005) providesome evidence consistent withthisargument. thatacceptTheyfind additional benefits the ing directorships firm" the when "sending primarily sending firm to be well-governed. Butwhen appears the sending firm exhibits potential agency additional problems, directorships appear value-decreasing. 3.3.5 Stakeholder on Representatives Boards Often, especially outside the United a variety ofconstituencies States, (stakeholdan interest ina firm arerepresented ers)with on thefirm's A particularly board. important setofsuchstakeholders is labor. Presumably the reasonwhylaboris eagerto gain such is to influence representation management to takeactions favorable to workers. Faleye, VikasMehrotra, and RandallMorck (2006) find evidence that supportsthis notion: labor-controlled tradedfirms tend publicly to invest lessin long-term takefewer assets, and exhibit lowerlaborand totalfacrisks, torproductivity. and Similarly, GaryGorton Frank A. Schmid (2004) consider employee on supervisory boards in representation Theseauthors find that when labor Germany. has equal representation, firms tradeat a 31 discount to firms with1/3 percent employee and have representation, higherpayrolls. Boththe Faleye,Mehrotra, and Morck and Gortonand Schmidarticlessuggestthat,

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Adams, Hermalin,and Weisbach:The Role of Boards ofDirectors would be to examine the relationbetween outcomesand board size. Although, as discussed in section 2.2, such tests have been is complicatedby run, their interpretation issues. The workthatbest joint-endogeneity controlsforthose issues,Coles, Daniel, and Naveen (2008), findsambiguousresults:for Tobin'sQ decreases in board "simple"firms, it increases size; while, for"complex"firms, in board size.37 of Coles, Daniel, and One interpretation DirectorsproNaveen'sresultsis as follows. vide the CEO with advice, as suggestedby fieldwork(see section 2.1). Advice is more This valuable the more complexthe firm.38 is a factorin favorof increasingboard size is "complex." whenthe firm Withoutmeaningto suggestthis isn'tthe it does raise quescorrect interpretation, with fieldwork, tions. Althoughconsistent one might speculate as to why the CEO relies on the board ratherthan, say, manforadvice. And whyis agementconsultants it thatthe total qualityor amountof advice increaseswithboard size (i.e., whyis it that the free-riding problemisn'tso severe as to make thesevalues decrease withsize)? Alternatively, complex firms could be which could, in to monitor, more difficult
firm is one thatscoresabove the median 3"A complex is one thatscores a simplefirm on an indexofcomplexity, relatedto the numberof below. The indexis positively a firm businesssegments has,itssize,and itsleverage. 38For instance,suppose the qualityof advice from i is qh whereqt~ F. The CEO adopts the best director has a monetary which, assume, advice, payoff proportional The benofthe firm. to maxq^s, wheres is the simplicity directors is efit from r fJ() qnFn-'q)f(q) dq = |E{max q'n}. of that expression with derivative The cross-partial tos and is respect 1 v dE{maxq'n] ein s where the sign followsbecause the expectationof the extremevalue is increasingin the number of draws. is declinbenefit ofaddingdirectors Hence,the marginal ofthe firm. ingin thesimplicity

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theory,warrant more monitors (a larger let C(n) be the cost of board). Specifically, directors (e.g.,the amountof their having compensationplus other associated expenditures). Suppose that, if a problem exists, the independent probabilitythat a given director detectsit is sp, wheres is a measure of the simplicity of the firmand is a connormalize stant.Withoutloss of generality, the probability of a problemexistingtimes the benefitof correctingit to one. Then a firmchooses its number of directors, n, to maximize (2) (l-(l-spT)-C(n).

The cross-partial derivative of (2) with respectto s and is (1 - sp)n~lp + n(l - sp)n-lhg(l - sp)p, whichhas the same signas (3) 1 + log(l - sp) .

If sp > 0.632 or for large enough, (3) is negative the marginal return to adding in the simplicity is decreasing ofthe directors firm. firms to Hence, itis optimalforsimpler than should morecomhave fewerdirectors plex firms. 4.2 Busy Directors wantto haveoutsidedirecFirmsgenerally individualswho tors who are distinguished to add value as directors. also have an ability Many of these individualshave demanding or full-time jobs, such as CEOs, attorneys, bankers.Even if directorsdo not have fulltime jobs, some of them are in sufficient demand that they serve on many boards, sometimes as many as ten simultaneously. A concern oftenvoiced about this arrangementis thatsuch "extremely busy"directors to will not be able to devote sufficient effort

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Vol. XLVIII (March 2010) JournalofEconomic Literature, (board seat), her assigned one more activity on anygivenactivity falls.39 effort A problemwith this simple model is that the numberofboard seats held by a director is notan exogenous variable(i.e.,our director is notcompelledto accept M seats).Rathera director has choices.This makesM an endogenous variable,implying thatwe need to ask some directors to be busierthan choose why in others. can alter our conclusion This, turn, that busier directorsdevote less effort on a board than their given less-busycolleagues. To see this,assume thereare typesof direcof type derivesbentors,where a director efit0b(am)fromeffort expended on her rath A director's as a funcactivity. type-0 utility, tionofM, is (6) *()) - c(Ma*(M)) .

any one board. The alternative argumentis thatthe directors who are considered"busy" are in factchosen to be on so manyboards which because of theirhighability, precisely serves to offsetthe effectof their lack of time. Not surprisingly, the effectherefore, tiveness ofsuch "busy"directors has become an activearea ofinterest. 4.2.1 Theory The simpletheorybehind the problemof busy directorsis that,the busier a director he or she devotes to each is, the less effort ofhis or herduties.This idea is readilymodeled: Suppose, forsimplicity, thatthe benefit a director derivesfrom effort is expenditure the same for all her activities.Hence, her totalbenefit is = b(am), whereamis effort on the rath b : M+ - R+ is expended activity, the common benefitfunction, and M is the totalnumberof activities. assume Critically, on activity ra increases spendingmoreeffort her marginalcost of effort on activity j for ra andj. This would, for anypair ofactivities funcinstance,be true if her cost of effort tion were c(^m=' flm)> where c() is increasing and convex (i.e., her utilityfor leisure exhibits If &() diminishing marginalutility). is concave,thenthe directoroptimally allocates her efforts across her activiequally ra satisfies effort on activity ties; specifically, condition the first-order

(4)

b'(am)-c'(jta})=0.
= 0,

Utilizingthe envelope theorem,the crosspartial derivativeof (6) with respect to M and is readilyshown to be b(a*(M)) > 0; thatis, higher-type directors enjoya greater marginal benefit from adding an activity than do lower-type directors. Consequently, directorswill optimallychoose higher-type to do more activities directhan lower-type tors.Moreover, because a highertype directorenjoysa highermarginalreturnto effort than does a lower-type director,a higherdirector more effort than a type expends director the constant lower-type holding In otherwords,busier numberof activities. directors are highertypeswho would, thus, more effort were they expend per activity
39Proof: Suppose not; that is, suppose *(M + 1) > in totaleffort, Because hermarginal costsare rising fl*(M). itfollows that c'(Ma*(M)) < c'((M + l)a*(M + 1)). (5) thenentails Expression b'(a*(M)) < b'(a*(M + 1)), but, because she has diminishing marginal benefits, this last expression implies the contradiction a*(M) > a*(M + 1).

We can rewrite (4) as (5) b'(a*(M))-c'(Ma'(M))

wherea*(M) is the optimalamountof effort she expends on any one activity given that she is undertaking M activities.Using (5), it followsthata*(M + 1) < fl*(M ); that is, if

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, table l

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Utility for Different Director Types According to Number of Directorships Taken fortype Utility Directorships 3 4 5 6 7 (9= 9 13.33 13.47 12.33 10.20 7.27 (9-15 33.71 37.78 39.70 39.98 38.94

Note: Numbersare calculated accordingto the example connected to expression(7) in the text.

to the same numberof activities restricted This is a directors. as less-busy(lower-type) vis--vis the less-efforteffect countervailing effectidentifiedin the the-more-activities ofthetwoeffects Which paragraph. previous indeterminate. dominates is,a priori, Theory, a definitive does not offer therefore, predicof busy directorsonce tion about the effort one recognizes that the number of board seats held is endogenous. To illustratewhy this is an important factto recognize,suppose thatb(a) = log(a) and c(x) = x2/2. Straightforwardcalculations reveal that a* - / . Expression (6) is readilyshownto equal (7)

it followsthat the Because ^15/6 > /9/4, who are busierin equilibrium(the directors on each oftheir 15-type)expend moreeffort than do the less-busy directors directorships In other words, (the9-type)on each oftheirs. in this busier does not equate to less effort example. 4.2.2 Empirical Workon Busy Directors is ambiguousin itspreGiven thattheory of busydirectors dictionof the overalleffect on firms, have attemptedto discern people of the two effectsdomiwhich empirically nates. In otherwords,is the factthat busy directors are likely to be relativelyhigh than the quality directorsmore important on their lack of time of their potential impact effectiveness?Consistent with the quality arguments,Kaplan and David Reishus (1990), Booth and Deli (1996), and Stephen and Adam C. P. Ferris,Murali Jagannathan, Pritchard (2003) findthatthereis a positive between a firmsperformance relationship and the additional directorshipsacquired by its board members:when the firmcuts

^log(^)-^,

ofM for concave function whichis a globally 9 and are two . there just types, any Suppose that the optimal 15. Table 1 demonstrates is 4 for numberof activities(directorships) the 9 -type and 6 forthe 15-type director.

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For lose directorships some underlying its directors its dividend, problem. governance and Yermack firm Shivdasani when a and (1999) Reishus); performs example, (Kaplan that directors aremore to land document are morelikely well, its directors likely busy when theCEO to the board to be seatson other boards(Ferris, appointed Jagannathan, overthe director-nomiand has moreinfluence and Pritchard). Ferris,Jagannathan, ofmany thepresence Pritchard also findthat "busy"directors nating Thus, process. in could indicate a situation to serveon committees busydirectors are equallylikely In this to which theCEO has toomuch as other directors and are no morelikely power. affect thatbusydirectors whichthese case, the finding be sued thanotherdirectors, not about view need as the authors say anything performance interpret supporting exert. thatbusydirectors do not shirkon their theeffort thatbusydirectors Perhaps effort meaofmoredirect thedevelopment responsibilities. in of sures can aid the sued and not However, understanding busy agreebeing Adamsand Ferreira seem like rela- directors. (2008) show ingto serveon committees are that that directors with more indirect tests of the directorships tively hypothesis at more to have attendance Fich and hurts likely problems performance. being busy that tests board which Shivdasani more direct (2006) provide busy meetings, suggests Fichand Shivdasani find directors ofthishypothesis. Busy spendlesstimeat each firm. who directors stillbe of a higher witha majority of directors thatfirms could,though, as we describe serveon threeor moreboardshave lower type, above,thustotaleffort to In exerted directors couldbe similar ratios than other firms. market-to-book bybusy to that exerted less directors. is less sensitive CEO turnover addition, busy by in suchfirms to othcompared performance 4.3 BoardCommittees whenbusydirecers.Stock pricesincrease Boards usuallydo most of theirwork the stock torsdeparta board.Conversely, and data on the commiton whose boards they in committees, price of the firms is generally available. publicly alreadysit declineswhen busy directors tee structure haveused thesedatato study boardseat.Overall, these Someauthors add an additional oftheboard. on a thefunctioning busydirectors findings suggest having and Yermack interests.40 Shivdasani tobe inthefirms boardcan fail (1999)use inforto aboutthe nominating committee The above contributions notwithstand- mation on CEO's influence draw inferences over the still to more research is necessary fully ing, when the Theseauthors find understand the impactof busy directors. theboard. that, committee directors CEO serveson the nominating Mostempirical work relates "busy" fewer firm Whileitis pos- or whenthereis no suchcommittee, to aggregate outcomes. areappointed andthe of independent directors siblethatseveral additional directorships director firm itoften stock to independent canhurt directors pricereaction performance, is a is lower thanwhenthere should appointments seems implausible that "busyness" include that does not effect. committee have an economically nominating meaningful could be causal, in be a proxy for the CEO. This effect Instead, busyness maysimply committee that being on the nominating over CEOs to exercise control could allow 40 from Although, drawing Khwaja,Mian, and Qamar or it could simply reflect board selection, who sitson manyotherboards (2008), havinga director can improve a firm's network and, hence,add value. It is thatmorepowerful CEOs are bothable to is greater in a of thiseffect possiblethatthe importance to committees and appointed nominating get (such as the one studiedby Khwaja, developing country In either also to influence director selection. Mian,and Qamar) thanin a developedcountry.

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and Yermack towardprofessional case, the Shivdasani findings management manageare consistent withthe viewthatpowerful ment, theboardplays a larger rolein corpoCEOs are able to influence thestructure of rategovernance. their board. a number of papers have used Finally, Klein considers the relation data on audit committee to (1998) April membership firm between and board comdraw inferences about the performance accounting prostructures. She finds mittee offirms.41 Thisliterature looksat that,although cess inside thereis no relation betweenoverall board the quality of accounting, suchas whether firm and the firms accruals performance, composition manipulate earnings through onthefinance andinvest- andwhether number ofinsiders a firm's coefearnings response ment committees is positively associated ficient meansthatearnings are informative The same causal- aboutvalue. In general, withbetter thesepapersfind performance. as discussed above is relevant that the of the audit committee is ityquestion makeup her findings: Do insiders correlated forinterpreting with these variables ofaccounting on the finance and investment committees quality. Onceagain, itis difficult toinfer cauis cause good performance or thiscommit- sality from thesestudies. Whileitis possible a consequence teestructure somehow ofbet- thatauditcommittees playa rolein improvIn particular, iffirms terperformance? can ingaccounting itisalsopossible that practice, to improve their determined accountsubstantially simply by firms improve performance their committee structure, why ing changeboththeiraccounting practices rearranging their andtheir haven't all firms audit committee rearranged membership. "optimally" are definitely an area where committees? On the otherhand,it is posCommittees tostaff more work can be done.We still lacka good sible that firms faceexternal pressure in with which leadsthem understanding of the causes ofvariation committees outsiders, nor do we understand too few insiders on committee tosuboptimize structure; byhaving committees. therelation between committees andthefull key in Adams(2003) and Rachel board.One reasonfora lackofprogress Morerecently, committees is that there M. Hayes, Hamid Mehran, and Scott understanding is,as boardcom- yet,no readily available data set Schaefer ("canned") (2004)haveconsidered in more structure detail. Adams uses containing all committees. mittee ofboardsas a way thecommittee structure to infer the natureof the tasksto which 5. WhatMotivates Directors? boards spend theirtime. She findsthat to protect ofdiversified firms devote more time Directors havea fiduciary boards duty whileboards ofgrowing firms shareholders' interests. to monitoring Yet, theirinterests with the moretimeto strategic issues.Hayes, are unlikely to be perfectly devote aligned Their incentives, finda numberof shareholders'. therefore, Mehran,and Schaefer which ofwhich reflect thenumber of havebeena natural for most research, results, topic disandtheir tasks. The committees we survey here. Given that thepreceding committees onthese issues here andthere oflarger firms and ones thatpaydividends cussion touches to them, tendto have moretasksassigned infirms ownerthose with CEO while higher 41A These have fewer tasks. includesKirstenL. findings suggest ship partial list of this literature Deli, and Gillan (2003), Ronald C. Anderson, that theboardis partoftheprofessionaliza- Anderson, SattarA. Mansi, and David M. Reeb (2004), Deli and As thefirm becomes tionofthefirm. larger, Gillan (2000), Klein (2002), and Biao Xie, Wallace N. founder Davidson,and PeterJ.DaDalt (2003). and transitions from moremature,

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and manageandwe seekto avoid unnecessary repetition, collusionbetweendirectors willprove tobe relatively short. this section ment,but manyof these have also been in thebroader addressed literature (see,e.g., 5.1 DirectCompensation Tirole1986,1992). An interestingboard-specifictheoLike all economic directors actors, may wealth less retical be presumed to prefer to is PraveenKumarand K. greater analysis should be to Sivaramakrishnan wealth; hence, (2008). First, unlike they responsive almost all on financial incentives. the theoretical literature Indeed,firms routinely use a variety of such incentives Kumar Sivaramakrishnan and examboards, including additional feesfor stock inetheroleoftheboardinsetting theCEO's attending meetings, andoption and bonuses. incentive the Second, authors grants, performance compensation. of1,198 in2002,Stephen explicitly Fora sample firms the of incentive role study payfor H. Bryan and Klein (2004) report thatthe directors with to the of respect performance in director received total their duties. their are that $102,976 average Among findings annualcompensation; of this,$71,839was board independence and board incentive incentive boards pay and $31,137was cash. The paycouldbe substitutes; independent latter also contains an incentive comcould be less monitors than lessfigure diligent insofar as are as a $8,129 boards; and, ponent approximately independent consequence, attendance fees. Roughly 73 having a maximally boardneed -contingent independent of firms in the made not be best for the shareholders ceteris percent sample option pariand37 percent stock Yermack bus.The basicintuition A lessis as follows. grants grants.42 evidencethatwhenall incen- independent itwillnotbe as (2004) finds board, knowing tivesare accounted for(including a negotiator the CEO when keeping strong against current boardseatsand gaining new ones), itcomestimeto sethiscompensation, has a theaverage outside director ofa Fortune 500 incentive than doesa more-indepenstronger firm each $1,000increase dentboardto learnpayoff-relevant informagains11 centsfor in firm value.He finds thata one standard tionprior to thosenegotiations. The reason deviation changein the market capitaliza- beingthatsuchinformation helpsto offset firm tion ofthemedian weaker In essence, (a $2.6billion their sample bargaining position. in a $285,000changein an a less-independent results boardis playing a "lash change) outside director's wealth. itself to themast" because it knows strategy itwon't be ableto resist theCEO's demands 5.1.1 Theory as wellas itwouldotherwise like.Becausea Froma theoretical the basic less-independent boardhasa stronger incenperspective, ideas of incentive and tiveto gather the strength of information, pay are well known have been analyzed at depth (see, e.g., the compensation incentives it requiresis Holmstrom inde1979,StevenShavell1979,and lessthanwouldbe required bya more Sanford Grossman andOliver D. Hart1983; pendent board.Hence,it is cheaper for the J. Bolton and Dewatripont 2005 offers a text- shareholders to employa less dependent booktreatment). Thethree-level of boardinterms ofinducing theboardtolearn hierarchy information. Of course,the shareholders-directors-management gener- payoff-relevant atessomeadditional suchas possible fact that itis a more boardmeans issues, dependent the shareholders bear othercosts; but as Kumar andSivaramakrishnan itis posshow, 42See KatherineM. Brown (2007) for a surveyof sible for the former effect to be great enough some of the, largelylegal, issues connectedto director tooutweigh theseother costs. compensation.

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ofoption significant predictor compensation. In relating boardindependence tothestrucTherehas been someempirical workon ture ofdirector it is important compensation, the determinants of director to in mind that inside directors are not compensation. keep NikosVafeas(1999) conducts a matched- paid fortheir boardservice. Hence,it may with a of 122 firms be too to introduce sampleanalysis sample simply costly sophistithat a director scheme cated compensation contracts when there adopted compensation forthe grant of stockor are fewoutside directors. As thenumber of (a plan providing 1989 1995 122 between and and that outsiders it be more reasonable to options) grow, may didnot(andhadnot). He finds that a strongly ask shareholders to approvedirector stock of is the and share significant predictor adoption propor- option plans. tionof outside which is positively LikeBryan andKlein, FichandShivdasani directors, to adoption. related and find that firms with (2005) Comparing adopters highmarket-totheir matched three after book ratios are more to nonadopters years likely utilizeoption Vafeas finds continue for their directors thanfirms planadoption, adopters compensation to havea higher of outside direcwith low marketto-book ratios. further proportion They of differences between findthat,consistent tors.A comparison with an attenuationand nonadopters, the stockmarket adopters alongwithsug- of-agency-problems story, butnotalways to theadoption ofa director gestive, statistically significant, reacts favorably indicate that firms that stock-option led tosignificant coefficients, regression plan.Adoption tend tobe larger abnormal returns (as measured (0.31 percent adopt bysales), cumulative are less likely to havean unaffiliated block- for all adopters, 0.18percent for a subsample directors. andhavebusier Vafeas also holder, events). puts of "uncontaminated" Adoption thatadopting firms led to an improvement in the earnings-perforth the interpretation reliant ontheboardas a monitoring share aremore forecast. is deviceand,thus, On the otherhand, it is possiblethat, contingent compensation of this instead of being a solution to an agency governance part strategy. withVafeas and problem, Consistent director (1999),Bryan compensation plans are Klein (2004) find evidence thatfirms with evidence of an unresolved agencyprobmakegreater use of lem.IvanE. Brick, Oded Palmon, and John greater agency problems for outside K. directors.43 Wald find a correla(2006) option compensation strong positive In contrast to Vafeas, find no evidence tion between excess CEO and they compensation thatthepercentage ofoutside directors is a excessdirector where excess compensation, is definedas the residual compensation froma pay-for-performance If regression. 43The authors use measuresofinvestment opportunithe were residuals random regression truly ties (either R&D expensesor market-to-book ratio)as an then theyshouldbe uncorrelated. errors, agencyvariable;the idea being thathavingmorepotenmeans the Correlationindicates systematicfactors tiallysquanderableinvestment opportunities is worse.Otheragency variables are leveragency problem within each firm. Palmonand Wald Brick, thedisciplining ofdebtor nature age and beingregulated; that one such factor could outside reduces More controsuggest systematic regulation agency problems. versialis a measureof closenessto financial the distress; be "cronyism" between thedirectors andthe leads to greater creditor authors conargue thatdistress andCEO collude CEO; that is,thedirectors whichreducestheagency the trol, problem. Alternatively, shareholders toimpropthe will likelihood that the stock be worthless reduces together against higher the value of stockoptions, increase their makingthema less-powerful erly compensation. the incentivefor directors.Or, as anotheralternative, Other authors(Perry1999 and Adams worriedabout the asset-substitution creditors, problem, andFerreira todetermine directors incentives to gamble. wantto avoidgiving 2008) havesought

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omithas an as we haveemphasized, whether incentive Nevertheless, pay fordirectors are alwaysa worrisome effect on their actions. Adamsand Ferreira ted variables poswheninterpreting these(and other) theeffect ofmeeting-atten- sibility (2008) estimate dance feeson directors' decisions to attend findings. someboardmeetings. These authors find, 5.2 Reputational Concerns what the surprisingly given high opportunity besides direct cost of mostdirectors' What other motivations, time,thatreceiving could director as little as $1,000per meeting affect behavsignificantly compensation, with the ior?A possiblemotive increasesattendance. Consistent thathas been heavview that incentive is theconcern thatdirectors pay improves perfor- ilyinvestigated finds that incentive makes have for seen as able business mance, pay Perry being people. outsider-dominated boards even more An idea, dating back at leastto EugeneF. theCEO for to dismiss forhis repupoorfinancial Fama (1980),is thatconcern likely will tation cause an to performance. agent act morein An important consideration whenevalu- his principal's intereststhan standard is approaches to agency On the atingstudiesof director compensation might suggest. thatbothdirectors' and their other as Holmstrom hand, (1999) observes, compensation actionscould be a function of some third reputational concerns are not sufficient to factor. For example,one possible source eliminate and can,in agency problems they in governance of variation is between create additional ones. With to pro- fact, respect and firms. It is the latter, concerns can genfessionally managed family reputational thatprofessionally are erateagency firms withrespect to the likely managed problems more tohirecompensation consultants agent's choice ofrisky likely projects.44 whendesigning director Directors'reputations are likelyto be compensation sysin the market are morelikely to important fordirectorships. tems,and consequently include incentive-based aids in getplans,and are also A strong reputation presumably to havehigher levelsofcompensation tingmoreboardseatsor retaining theones likely mustbe hiredvia arms- already the oppoheld,a weak reputation (givendirectors Suchan explanation is site. StuartC. Gilson (1990) and Kaplan transactions). length - although often difficult to ruleout Adams and Reishus thispossibility (1990) examine and Ferreira able to do These articles find thatpoorly (2008) are largely empirically.45 so by usingbothdirector fixed effects and performing CEOs arelesslikely togainboard effects forfam- seatson other control than (which directorship companies well-performversus and instrumental CEOs firms) (with ily non-family ing poor performance being variables to addressendogeneity problems. It is also likelythat these professionally 44In Holmstrom concernscause (1999), reputational firms havehigher market-to-bookthe agentto shyaway fromriskyprojects.As, however, managed attendance at boardmeetings, othershave noted,thatconclusiondepends on whether ratios, higher knowthe riskof the projecttaken.If observers and moreperformance-based evaluation of outside be overly risklovtheydo, thenan agentcould rationally the CEO. The professionalism of the man- ing whenchoosingprojects.The reasonis thatobservers not update theirbeliefsabout the agent'sabilities teamis onlyone of many agement possible will much in responseto a risky project'soutcome,because omitted variables. On theother hand,there it is a noisysignal;consequently, the riskto the agent's is no "smoking thatone or reputation is lowerthanifhe undertook a less risky and, gun"to indicate more omitted factors are theexplanation for hence,moreinformative project.See, e.g.,Hermalinand (2009) fora morecompletediscussionof this the results of thesestudies(and,as noted, Weisbach issuein a governance context. 45Another Adamsand Ferreira 2008 is verycareful). articlein thisarea is Yermack (2004).

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is hurt as a poormonitor distress ora reduction publicreputation indicated byfinancial seats he to number of board with the in the two studin dividends, respect respectively, a thestock-price reac- or she holds.At the same time,however, ies).Fich(2005)studies as who a director directors ofdifferent toadding tion reputation develops private qualities. - that that thecumulative a poormonitor he finds Mostnoticeably, is,as someone unlikely - might be favored theboat in response to theaddition torock return abnormal byCEOs to acquire powerat the firm is who are looking whois CEO ofanother ofa director a number of board. of the the the Certainly, greater higher industry- expense significantly on in section 2.2 discussed the models firm new direchis is. The ROA of rely adjusted an MBA also has a positive there tor'sholding (totheCEO at least) beingobservable in the intensity acrossdirectors abnormal on the cumulative return, differences impact out their A withwhich levelof significance. albeitat a marginal monitoring carry they aboutourown reputations roles. finding sobering dualtenatthis A model that to a boardis assoacademics is thatadding gets partially In there his is Warther the sion with a ciated model, (1998). return, although negative of board is a is notstatistically effect consisting two three-person significant. The outside the CEO. and outside directors the Fich and Shivdasani (2007) examine their care about if sit directors on directors' effect publicreputation, reputations they CEO. a poorly thatare the subject so wishtoremove on the boardsof firms performing his for own never votes lawsuits class-action of shareholder alleging The CEO, ofcourse, so anyremoval direc- removal, outside that fraud. financial unanimity requires Theyfind in A problem directors. theoutside to leavetheboardof between are no more tors likely is thatthetwooutside wouldbe otherwise. achieving thanthey thesuedfirm unanimity oftheCEO's receive see a significant directors Thesedirectors do,however, signals private his abilon conditional that The size of held. seats in board other are, ability drop The outside distributed. fraud severe the the more is this independently ity, drop greater ina but share directors can formal an associated is information, (there only allegations indiwho director an outside manner: and when the action SEC) they arguably costly by oftheCEO's for monitoring catesshehas a negative bear greater signal responsibility to for her will be audit on the serve fraud committee). disloyalty punished ability (they if fails seat she her board more the CEO are directors these "tainted" bylosing Finally, both directors with atfirms tolosedirectorships argu- to oust him. Consequently, likely the bad about receive meacan (as moderately signals governance corporate ablystronger to oust would be that it such Andrew and the sured CEO, Ishii, optimal Joy by Gompers, oflosing fear butneither is him, 2003 index)and their Metrick speaksup for departure is bad a director's abnor- herseat.If,however, cumulative withpositive associated signal her for her concern then for thesefirms. malreturns (i) public enough, will be moresevereand (ii) the such studiesare valuable,it reputation Although director it is thatherco-outside thattheytouchonlyon morelikely is worth observing in this a bad signal; visible to theecono- has also received ofreputation measures hence, The CEO. the out on she don't case, metrician; against speaks necessarily pickup they awful CEOs result is thatonlytruly In particu- overall of reputation. "soft" dimensions ofweak a proportion with toohigh or getfired, who wishesto maintain lar, a director tokeeptheir boardseatscould,at leastin theory, CEOs' getting obtain jobs. thereare two pointsof As formulated, As the studies trade-off. facea reputational model. with theWarther concern who developsa a director above indicate, First, why

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal Because of corporaAdam Smith1776).46 tions'enormous share of economicactivthe cost of their economies, ityin modern is important. agencyproblems extremely and Consequently, corporategovernance the role of boards of directors are issues in economics. of fundamental importance the role of boards isvital both Understanding for ofcorporate behavior ourunderstanding to setting to regulate andwith respect policy activities. corporate Given thefundamental ofthe importance in the issueand itsprominent public place thatthere has been eye,it is notsurprising a surgeof research on boardsof directors; it the fact is that indeed, perhaps surprising has taken so longfor boardsto becomesuch an active this litofresearch. We survey topic to that erature attention here, paying special done by the economics and finance profesand also to that research donesubsesions, andWeisbach (2003) quentto theHermalin there is muchwork we survey. Unavoidably haveneglected; one of the difficult aspects ofwriting thissurvey is thatthereare new papersappearing nearly every day, outstriptowrite aboutthem!47 pingourcapacity Boards of directors are difficult institutions to study. The twoquestions most asked aboutboards concern what determines their
46With Smithwrote"The direcrespectto directors, tors of such companies,however,being the managers ofother thanoftheir rather own,itcannot people'smoney well be expectedthattheyshouldwatchoverit with. . . anxious and profusion, therefore, vigilance. . . Negligence of mustalwaysprevail,moreor less, in the management the affairs ofsuchcompanies]"(Book V, PartIII, Article whichare necI, "Of the PublickWorksand Institutions BranchesofCommerce," essaryforfacilitating particular 18). paragraph 47A possible reason forthe growthin the literature A numberof new databases is betterdata availability. on boards have become availableand have been used in a numberof studies.A database providedby Compact Disclosurehas a longtimeseries,running from1988 to the present, while an alternative database providedby IRRC has detailed information structure on committee and the professional of directors. Both databackground bases are used and describedin Fahlenbrach (2009).

the powerto has the CEO been granted ontheboard?Ifthe determine whoremains CEO can't retaliate againsta boat-rocker, theproblem Second,whydon't disappears. sharetheirevidence the outsidedirectors fromthe CEO and coordinate privately actions?In the Warther theirsubsequent model,the directors, havingsharedinforwill agree as to the CEO's abilmation, he ityand will,thus,agree aboutwhether shouldgo or stay; hence,the CEO's power of a trouble-making director to ridhimself As notedpreviously, is no longer relevant. to influence the CEO an ability granting is consistent withfield board membership studies(e.g.,Mace 1971),but this doesn't explainwhyhe has thatpower.It is posWarther's modelinto siblethatintegrating modelofboarddetermia bargaining-type and Weisbach1998) nation (e.g.,Hermalin to retalicouldrationalize theCEO's ability The second ate against directors. dissenting issue might also be finessed a suitable by changein the model. Suppose the direcfor somereason, do notagreewhatthe tors, for dismissal should be. The more standard to hard-nosed director could be reluctant for fear the morelenient director approach conclusions (i) theywould reachdifferent rat and (ii) themorelenient director might favor heroutto theCEO (perhaps to curry withthe CEO, to avoid future problems witha dissident or to promote a director, CEOs as a direcprivate reputation among torwhodoesn't rock theboat). 6. Conclusions and in particuCorporategovernance, lartheroleofboardsofdirectors, has been thetopicofmuchattention lately. Although thisattention is particularly topicaldue to well-publicized governancefailures and subsequentregulatory changes,corporate is an area oflongstanding intergovernance est in economics(datingback to at least

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, and whatdetermines their actions. makeup, fundamenThese questions are, however, - the makeup ofboardsis intertwined tally it affects what theboard because interesting their does; and, consequently, makeupis a desire to affect what do. influenced they by ofjointendogeneity is vexing Thisproblem and empirical research forboththeoretical that focuses on one side on boards; research whileignoring the other is of the equation and the results misincomplete necessarily has been progress leading.Nevertheless, in five or sixyears. of it the last much made, is for a of boards difficult study Empirical with one must deal number ofreasons. First, ofdirectors. idealclassifications broader than An outside for instance, director, getscoded or she is truly as suchwhether independent friend.48 she's theCEO's oldest Second, nearly of interest all variables are, as discussed, in Unlikethe situation endogenous. jointly there are no areasofeconomics, someother instruments that onecan use todeal cure-all muchof withthisendogeneity. Ultimately, aboutboardsis aboutequiwhatone learns in the usual librium associations. Causality, to determine. For sense,is often impossible Weisbach s consider (1988) findings example, directors thatoutside appearmoreresponin the CEO retensive to performance Because thaninsidedirectors. tiondecision in question were determined the directors some equilibrium (albeit, possibly, through one does not selection second-best) process, in which different havea classicexperiment are tocondirector types randomly assigned Whether random troland treatment pools. wouldyieldsimilar allocations of directors onecannot is unknowable and, thus, findings bothsenthefindings, be surethat although are notdriven sibleand suggestive, bysome
48 Hwang and SeoyoungKim (2009) Byoung-Hyoun and Lauren Cohen, Andrea Frazzini, and Christopher which to estimate Malloy(2008) are two recentattempts outsidedirectors are truly independent.

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unseenthird force thatdetermines theproof outsiders on the the board, portion performance oftheCEO, andproclivities ofthe former to fire thelatter. ofthe strongest Ultimately, many empirithat havebeenfound canbest cal regularities be interpreted as statements aboutboththe director-selection and theirdirect process on boardactions. For example, effect staggeredboardstend to base CEO -retention less on theirCEO's performance decisions boards. Why? than do non-staggered as the Perhapsbecause, consequenceof the past good performance, CEO gains which he uses to protect bargaining power, he arranges for himself. for Thus, instance, but increashisboardtobecomestaggered; inghispowerin thiswaycomesat thecost him in to discipline of a reducedability shouldcircumstances warrant. the future withstagHence, in the longer run,firms gered boards will have lower valuations A boards. thando firms withnon-staggered similar can be toldfor anydecreasein story ofinterboardpower, suchas the creation locked boards. results can be interpreted Other empirical the selection both sensibly by considering there are ofboards. Forexample, andactions lookattheactions of a number ofstudies that tofind that boards outside directors that tend dominated tend to be more by outsiders than shareholder-friendlyboardsdominated studies that haveexamined Yet, byinsiders.49 firms with differtheoverall of performance ofboards haveall found little orno entkinds in overallperformance.50 These difference resultsmake sense ostensibly conflicting whenboth the selection and actionissues are probare considered. Outsidedirectors better from a shareholder perspective, ably
49See, for example, Weisbach (1988), Shivdasani Coles, and RoryL. Terry (1994). (1993),and Brickley, 50See, for et al. (1983), Hermalin example,MacAvoy and Weisbach(1991),or Bhagatand Black(1999).

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal on the empirical side. hope to see progress Even understanding whethergovernance mechanisms arecomplements orsubstitutes, oneis left toponder thesources ofheterogein that we howis observe; neity governance suchheterogeneity bestexplained? Although there has been some workin this area (consider, e.g., Hermalin1994 as an early there are still manyopen quesattempt), tions. Otherpromising areas fortheory are howtheboardfits intotheCEO succession theroleofthecomplexity ofa firm's process; and environment on the choice of operations directors andtheir actions sketched (we possiblepathsto explore above);moredynamic models ofboardevolution andthelong-term of boardinteracpath governance; modeling tions 1998 onelineof (Warther representing and what other thanprobenefit, approach); the insiders on a board tecting CEO, might play. work will need to continue to Empirical devise ofdealing with thejoint-endogeways issue.A possible in thisregard neity strategy is to lookfor "natural One set experiments." of suchexperiments are changes in regulation.In particular, ifa newregulation is put in place,it is possiblethatsome firms are in compliance withit,whileothers already are not.If bargaining models ofgovernance Hermalin and Weisbach 1998)are cor(e.g., then we should see little in tonochange rect, CEO compensation for those firms that were while CEO comalreadyin compliance, in the longterm, risefor should, pensation thosefirms that must comeintocompliance. If firms settheir structure governance optitheir thenthelongconstraints, mally given run performance of thosefirms forwhich the new regulations bind shouldbe worse thanthatofthosealready in compliance. In theshort theresults couldbe run,however, more totheextent that theregulaconfused, tionholdsup theCEO for theshareholders' thatis, to the extent thatthe CEO benefit; for that him benefitted bargained something

but because theytendto be added follow(see, e.g., Hermalin ing poor performance and Weisbach1988) or mostdemonstrate their value in crisissituations, the relation between outsider directors and firm valueis obscured. Boardsare too,facesitshurdles. Theory, of the only part corporate governance equabutan all-inclusive model is impractical tion, ofgovernance. Even giventhe complexities attention to it is hard to boards, limiting decidewhich institutions should be treated as exogenousand which as endogenous. too muchbe endogenous and the Letting modelsbecomeunwieldy and often failto definitive results. too much as yield Treating and critical of exogenous points joint endogeconclusions neity get overlooked, rendering that aresuspect. Despite these issues, valuable insights have been gleaned. Models linkingthe determinants of the board and its monitoringfunctionhave proved reasonably robust and broadly consistent withsubsequent empirical analyses.There has also been progress on modelsthatexamine the board's role in setting strategy, although their conclusions aredifficult totestempirically and these models have not always been as sensitive tojoint-endogeneity issues as wouldbe ideal. Where do we see researchon boards headed?The open questions are many and oftenfundamental. For instance, are the variousmeans of governing a corporation orsubstitutes? Thatis,do firms complements tendto be strong-governance firms across all thevarious dimensions ofincentive comto takeovers, and board pensation, openness in one Or does strength independence?51 area correspond in another? to weakness At a theoretical level,this questionis almost to answer, but one can surely impossible
51Hirshleifer and Thakor (1994) can be seen as an to thisquestion. earlycontribution

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, at shareholder buthad that expense, bargain undone there bytheregulation, subsequently shareholders would be short-term (this by gain to consider is whyit maybe morerelevant thanfirm CEO compensation value).Vidhi andYaniv Grinstein Chhaochharia (2009)folin to with lowthisapproach respect changes the NYSE and Nasdaq boardrequirements oftheEnron andWorldcom madeinthewake with find evidence consistent scandals. They effects: those for theshort-run thepredictions withthe firms thatwereout of compliance time of the saw at the regulations regulations Thereis also a fallin CEO compensation. in favor of the some,albeitweak,evidence can that constraints view binding long-term the immeAfter push up CEO compensation: torise CEO compensation diate shock, began Table andGrinstein, over time (Chhaochharia to know I, PanelC). It wouldbe interesting if whena longer whether, panelis examined, atthe firms that were outofcompliance those were theregulations time putinplacehadthe in after the CEO faster compensation growth those that hadbeenin shock than immediate compliance. us as profitAdditional topicsthatstrike research are: ableareasoffuture 1. How are potentialoutside directors Whatis the roleofsearch identified?52 in thisprocess? Whatis the role firms in this process?53 of social networks as noted above, thereare Moreover, kindsof outsidedirectors different former acabusiness people, politicians, demics,and otherprominent people. in search first Do firms ofnewdirectors then the the kind seek, they identify
52This questionhas receivedattention outsideof economics; see, e.g.,Westphaland Zajac (1995). The relation and theirperforof directors betweenthe identification mance or how the mechanicsof directoridentification not our modelsof board behaviorhave, however, affect to thebestofourknowledge. attention received 53 a partialanswer. and Zajac (1995) provide Westphal

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a range individual or do theycompare of different kindsof individuals simulDo shareholders exercise taneously? any control oftheprocess?54 A related is howare inside question chosen. Arethey, as sometimes directors selected claimed Vancil 1987), (see,e.g., because theyare potential successors to thecurrent CEO and service on the board allows the outsidedirectors to An alternative, assess theirabilities?55 but not mutually exclusive, hypothesis is that moremanagement on the having boardfacilitates better information flow, either totheCEO orfrom management totherest oftheboard. 2. As theprevious alludes and as has topic here and thereprevibeen mentioned how do social networks among ously, Ifa corpofit into theequation? directors whositson many ration addsa director from the addiboards,does it benefit To what tional connections thisbrings? extent could such a benefit outweigh Are thecostofhaving a busydirector? in some suchsocialnetworks beneficial economies economies, (e.g.,developing societies thatstress ties,etc.) personal inothers? Economists andlessbeneficial to have begun to pay more attention socialnetworks (see,e.g.,SanjeevGoyal 2007andMatthew O. Jackson 2008)and to boards theapplication ofthisanalysis seems a logical extension.56
54 Cai, Jacqueline L. Garner, and RalphA. Walkling Jie theresponsiveness ofshareholders examine (forthcoming) reelection. to director whenitcomesto their performance to some meaare responsive Theyfindthatshareholders suresofperformance. 55Statistical findingsin Hermalin and Weisbach withthisview,but cannotbe seen (1988) are consistent as definitive. 56As discussed supra, Khwaja, Mian, and Qamar data,they (2008) is one suchexploration. UsingPakistani findevidence that the social network among directors the firms on whichtheysit. benefits

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Vol.XLVIII (March Literature, 2010) ofEconomic Journal box.Givensurvey evidence (Demb and Neubauer 1992,p. 142) thatAmerican boards can be characterized as star social networks, ("hub-and-spoke") withthe CEO at the hub,it is a nontrivial to understand howthe question directors coordinate for disto, example, misstheCEO.58Lorsch (1989)provides evidence thatit is "taboo"fordirectors to consult eachother behind theCEO's back(p. 93); yet, at thesametime, they resultsthat indicatein reportsurvey a crisisthe averagescoreon a threescale (1 = always, 2 = sometimes, point = 3 never) for thequestion ofcontacting other directors aboutfinancial privately data is 1.6 (p. 100),sugperformance thistaboo can be broken. On gesting theother onthesamethree-point hand, scale, the mean scoreon "confronting CEO at boardmeeting aboutdepressed market valueof shares" is 1.98 and on other directors privately contacting about thesamematter themeanis 2.21. The 1.98 measureis also consistent with evidence that 51 percent of survey directors feelinhibited aboutspeaking outin boardmeetings (p. 83). A robust of the of directors role understanding a better ofjust requires understanding in what on the boardroom. goes

3. If, as some evidencereviewed above directors are a source of suggests, then how and does this expertise, why matter?57 After can all, firms expertise and do hire management consultants. Such consultants devote presumably more hours tothefirm than doesan outsidedirector and they havean impressive amountof experience, research, and analytic to capabilities uponwhich draw.Is the benefit of director expertise perhaps, thatthe CEO canthen, not ignorethem,unlikeconsultants? one couldhavetheconsul(Ofcourse, tants totheboard,making them report harderto ignore.)Alternatively, perwe areconsidering is hapstheexpertise the expertise to be effective monitors; that todetect thewarning is,theability signsthatthe CEO and othermanagersare notup to snuff orthat have they notthought a proposed course through of actionwithsufficient Yet diligence. a further alternative is thatthe CEO is especially careful whenit comesto those dimensions on which a director's couldcause herto block expertise what the CEO wishesto do. In this comesintoplayoff case,expertise only the equilibrium path; in equilibrium, the CEO never"triggers" a director's expertise. 4. There has been some work on the dynamicswithin boards. Typically, the boardis modeledas a singledecisionmaker. suchan approach Although couldbe justified byappealtoa medianvoter model orcertain other preferenceit stillleavesthe methods, aggregation actual workings of the board a black
57There are, in fact,a numberof issues concerning information flow in addition to expertise; thereis therisk, for ofherding orinformational cascades. See, for instance, SteveL. Slezakand NaveenKhanna(2000). instance,

58Westphal(1999) considerssome issues related to thishub-and-spoke In particular, he studieshow system. board-CEO interactions affect firm performance, finding thatfirms thatscore betteron measuresof "advice and counsel interactions" and "board monitoring" have staon equitythan those tistically significant greaterreturn firms thatscoreworse.Westphalarguesthathis findings thatstronger socialtiesin theCEO-directorrelasuggest enhancesboardinvolvement, to thebenefit ofthe tionship firm. Schmidt further (2008) provides evidence;an interof his analysisis thatsocial ties are beneficial pretation whenmonitoring is less important and detrimental when is important. Adamsand Ferreira(2009) can monitoring be seen as further evidencethatloosersocial tiesare beneficial whenmonitoring is important (e.g.,whena decision must be made to retain or fire theCEO).

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and Weisbach: TheRoleofBoardsofDirectors Adams, Hermalin, lit5. Although there has been a growing at the role of board comerature looking mittees (see discussion supra),the role relaofcommittees and their generally tiontotheoverall boardspecifically are The samedynamnotfully understood. ics questions askedaboutthe boardas a whole applyequallyto committees. how do the committees Furthermore, For relateto overallboard behavior. reforms have dictated recent instance, firms that havesomecommittees (audit, of comprisedentirely compensation) Does providing some outside directors. to talk directors an opportunity outside s affect ofmanagement outside hearing when it the overallboard's behavior comesto issuessuchas approving large or deciding whether to capitalprojects theCEO? Do thesecommittees dismiss being a hubchangethe board from to being an social network and-spoke Does interlinked-star social network? increase outside on committees serving andknowledge directors' understanding monithem better ofthe firm, making There more meddlesome? tors orsimply for intelmay also be opportunities lectualarbitrage here,as the relation committees and the between legislative is an issue thathas overalllegislature inpolitical science.59 beenstudied oftheliterature focuses 6. Thevast majority on Anglo-American firms. Studiesof innon-Anglo-American firms and boards of boards across countries comparisons an understudied area. It is,in contrast, - space an empty area is not, tobe sure, this led us notto survey considerations - butis, arguably, underexplored. area
59 Examples of this literatureinclude Kenneth A. and KeithKrehbiel Shepsle(1979)andThomasW. Gilligan (1989); Gilliganand Krehbiel(1990). The authorsthank ErnestoDal Bo for guidanceon thisliterature.

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Numerousquestionsexist: does, for board independence matter instance, with weak sharemore in countries holder thanincountries with protection How shareholder strong protection? do different boardarrangements dual (e.g., the boardsas in much ofEuropeversus corboards of the United States) unitary relate with other aspectsofgovernance executive turnover, (e.g.,compensation, or firm behavior with takeovers, etc.) relations merger activity, (profitability, In one withsuppliers, etc.)? particular, in the laws govcould use differences boardsas "natural experiments" erning For to help test varioushypotheses. if more of facindicates instance, theory ofy,do we see tor should leadtomore in nations firms thatrequiregreater more y ornot? having A relatedissue,whichalso harkens back to how are directors chosen,is firms benefit from forwhether having on theirboards,pareign directors in situations in which are they ticularly of a firm, foreign considering acquisition in foreign or toexpand markets, seeking overseas. haveimportant suppliers linksbetween 7. There are undoubtedly ofbehavfield boardsand thegrowing ioral corporate finance (see, e.g., and Tte 2005). Directors Malmendier the wellcould, for instance,suffer too bias of putting knowncognitive on much their initial impression weight of the CEO and not updating quickly on thebasisofnewinformation. enough tothe couldbe subject Conversely, they bias and, for fundamental attribution too much example, assign responsibility totheCEO andnot for outcomes enough these onthecircumstances that affected are favorably outcomes. Indeed,ifthey to theCEO, research suggests disposed would then attribute that directors good

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Vol XLVIII (March Literature, 2010) ofEconomic Journal outcomes totheCEO andbadoutcomes to circumstances (see,e.g., ScottPious 1993,especially 16);ifunfavorchapter then the ably disposed, oppositebias In this would exist. it light, is interesting to which to speculate aboutthe extent the"cult oftheCEO" that has emerged inthelasttwenty the years helps explain risein CEO turnovers Parrino, (Huson, andStarks 2001andKaplanandMinton As 2006): people become more convinced aboutthecentrality oftheCEO toa firm's success orfailure, do directors to cometo overattribute bad outcomes the CEO and underattribute themto circumstances?
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