(4) BOARD OF DIRECTORS: MONITORING SOLUTION

Core Reading
• Larcker, D. and Tayan, B. (2011). Chapters 3, 4, and 5 in Corporate Governance Matters.
• Lynell, Golden and Hillman (2003), AMR.

Executive Directors
E.g. Chief Executive Officer (CEO) & Chief Financial Officer (CFO)
• Elected to the board by shareholders
• Concerned with day-to-day operations and involved in major strategic decisions
o E.g. M&A, Divestment, Restructuring
• Provide the board with information for the NED’s role

Non-Executive Directors (NED)

They are non-contracted employees, instead are contracted to provide services
• Board is involved with finding suitable NED candidates, nominated by appointment committee,
and are approved by shareholders
• No role in day-to-day operations
• Appoint & monitor senior executives
• Advice major strategic decisions
o e.g. M&A, divestment

Role of the Board of Directors

The board is at the top of the internal control system
• Directors have a legal duty to shareholders and the firm
o To act in their interests on their behalf
• Hire & fire senior executives as part of monitoring senior executives’ performance
• Provide counsel on strategic decisions
o e.g. corporate restructuring

Agency Theory Perspective

Problem
Separation of ownership and control
• Executives employed to use skills, experience, and judgement on behalf of shareholders
• Expert decisions are non-routine
o Require good judgement when monitoring (may not understand what they are doing)
• Incomplete contracts
o Makes it difficult to hold executives accountable
• Disperse share ownership
o Shareholders do not monitor because the private costs outweigh the private benefits

Purpose of the Board

• The Board of Directors monitors executives on shareholders’ behalf to reduce the agency problem
o Promote profit-maximising behaviour by executives
 (4) BOARD OF DIRECTORS: MONITORING SOLUTION

Resource Dependence Theory

The Board of Directors provide four types of resources (Lynell, Golden & Hillman (2003):
1. Advice and counsel
a. human capital (skills, expertise, knowledge)
2. Legitimacy
a. NEDs provide the board with legitimate monitoring services of senior managers etc.
3. Channels of communication between the firm and external organisations
a. NEDs may be senior executives in other organisations
4. Assistance in obtaining resources from outside the firm
a. E.g. financial resources (senior banker on the board)

UK Corporate Governance Code

Seeks to establish a good practice to enhance the effectiveness of the board of directors as a
governance device as investors are interested in companies with good corporate governance.
• Voluntary code monitored by Financial Reporting Council
• No Chair/CEO duality (two different people as CEO and Chair of the Board)
o Otherwise, there is a legitimacy problem as less likely CEO will provide legitimacy when
judging themselves and the company
• At least half the board should be NEDs (excluding Chair)
• Board, committees, and directors are to be subject to performance review
• The board should establish committees:
o The nomination committee, audit committee, compensation committee
• NEDs remuneration should not include performance-related elements
o To make them more independent to objectively analyse strategic decisions that e.g. may
boost short-term value but destroy long-term performance

Board Characteristics
Non-Executive Directors
Appointed for their expertise to monitor executives and advise on strategy
• With no executive function, they can fulfil duties independently
• Don’t rely on the firm as their main source of income
o (in large FTSE PLCs they are paid about £70k)
• Crucial role in advising executives because we can’t rely on executives to critisise themselves
• Expect more NEDs on a Board to lead to higher performance

Board Independence
• NEDs need to be independent to fulfil their fiduciary duty to shareholders
Independence of NEDs questionable if:
o Affiliated outsiders: they are buyers/sellers which leads to a conflict of interest
o Boards are ‘interlocked’
o They are entrenched: if they’ve worked at the company too long they may become
loyal to the executive directors so ineffective monitoring of senior executives
o They rely on executives for information
• There is a labour market for NEDs which disciplines those who have operated on Boards whose
firms have underperformed as they can be replaced
 (4) BOARD OF DIRECTORS: MONITORING SOLUTION

Size
Benefits of Large Boards
• More resources available for monitoring and advice
• More diverse expertise & advice allows members to specialise in committees
• Complex firms that operate in a variety of markets benefit from larger boards containing diverse
expertise
Cons of Large Boards
• Slower decision making
• ‘Free-rider’ problem (expecting someone else to monitor)

Diversity
• Diversity means decisions are more likely to be challenged
• May make it more difficult for decisions to be made due to less cohesiveness
• Hard to determine causality in empirical analysis
o Well-run firms recognise the benefits of diversity

Female Directors
• Women under-represented on boards
• Restrict the pool of directors’ talent if we do not use women
• Quotas lead to accusations of tokenism

Impact of the Board and Committee Characteristics

The Board sets Executive Remuneration
• No relationship between CEO pay and director independence
o Insiders on compensation committee have no impact on the level of CEO pay or the
structure of equity incentives
§ (Conyon & He, 2004); (Gregory-Smith, 2012)
• Evidence is inconsistent with managerial power perspective

CEO Exit
• Outsiders to monitor better than insiders
o NEDs better at monitoring than executives
• No evidence found of insiders/outsiders having an impact on CEOs exit when firm under-performs
o (Gregory-Smith, 2009)
• CEOs with a larger proportion of the board appointed during their tenure are at a lower risk of
dismissal (Gregory-Smith, 2009)
 (4) BOARD OF DIRECTORS: MONITORING SOLUTION

Firm Performance
Size
Evidence of a positive board size–performance relationship was found in 131 studies (Dalton, 1999)
• Simple firms’ performance decreases with board size
• Complex firms’ performance increases with board size (Coles, 2008)
Outside directors
• A larger percentage of outside directors is associated with higher performance
Female directors
• Evidence from 140 studies found female board representation is positively associated with
accounting returns but has no impact on stock market performance (Post & Byron, 2015)
Ethnic diversity
• No evidence of a relationship between ethnic diversity and performance (Guest, 2019)

Mergers & Acquisitions

Outside directors
• Independent boards more likely to resist takeover bids to get a higher price for shareholders
(Cotter, 1997)
• Outside directors’ prior experience of acquisitions in the same product market has a positive
effect on post-acquisition performance (McDonald, 2008)
Female directors
• Women are less likely to be overconfident
o “Each additional female director is associated with 7.6% fewer bids, and each
additional female director on a bidder board reduces the bid premium paid by 15.4%.”
(Levi, 2014)
Ethnic diversity
• No relationship between ethnic diversity and post-acquisition performance (Guest, 2019)