adams hermalin and weisbach (2010) jel

7/27/2019 Adams Hermalin and Weisbach (2010) JEL

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Journal of Economic Literature 2010, 48:1, 58107http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.1.58

58

1. Introduction

People oten question whether corporateboards matter because their day-to-dayimpact is difcult to observe. But when thingsgo wrong, they can become the center o atten-tion. Certainly this was true o the Enron,

Worldcom, and Parmalat scandals. The direc-tors o Enron and Worldcom, in particular,

were held liable or the raud that occurred:Enron directors had to pay $168 million to

investor plaintis, o which $13 million wasout o pocket (not covered by insurance); and

Worldcom directors had to pay $36 million,o which $18 million was out o pocket.1 Asa consequence o these scandals and ongoingconcerns about corporate governance, boardshave been at the center o the policy debateconcerning governance reorm and the ocuso considerable academic research. Because

o this renewed interest in boards, a reviewo what we have and have not learned romresearch on corporate boards is timely.

Much o the research on boards ulti-mately touches on the question what is therole o the board? Possible answers rangerom boards being simply legal necessities,

1 Michael Klausner, Bernard S. Black, and Brian R.Chefns (2005).

The Role o Boards o Directors inCorporate Governance: A ConceptualFramework and Survey

R B. A, Bj E. H, M S. W*

This paper is a survey of the literature on boards of directors, with an emphasis onresearch done subsequent to the Benjamin E. Hermalin and Michael S. Weisbach(2003) survey. The two questions most asked about boards are what determines

their makeup and what determines their actions? These questions are fundamentallyintertwined, which complicates the study of boards because makeup and actions arejointly endogenous. A focus of this survey is how the literature, theoretical as well asempirical, dealsor on occasions fails to dealwith this complication. We suggest

that many studies of boards can best be interpreted as joint statements about both thedirector-selection process and the effect of board composition on board actions and

rm performance. (JEL G34, L25)

*Adams: University o Queensland and ECGI.Hermalin: University o Caliornia, Berkeley. Weisbach:Ohio State University. The authors wish to thank Ji-WoongChung, Rdiger Fahlenbach, Eliezer Fich, John McCon-nell, La Stern, Ren Stulz, and Shan Zhao or helpulcomments on earlier drats. The authors are especiallyappreciative o the comments received rom three anony-mous reerees and the editor, Roger Gordon.


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59Adams, Hermalin, and Weisbach: The Role of Boards of Directors

something akin to the wearing o wigs inEnglish courts, to their playing an activepart in the overall management and controlo the corporation. No doubt the truth liessomewhere between these extremes; indeed,there are probably multiple truths when thisquestion is asked o dierent frms, in dier-ent countries, or in dierent periods.

Given that all corporations have boards,the question o whether boards play a rolecannot be answered econometrically as thereis no variation in the explanatory variable.Instead, studies look at dierences acrossboards and ask whether these dierencesexplain dierences in the way frms unc-

tion and how they perorm. The board di-erences that one would most like to captureare dierences in behavior. Unortunately,outside o detailed feldwork, it is difcult toobserve dierences in behavior and harderstill to quantiy them in a way useul or sta-tistical study. Consequently, empirical workin this area has ocused on structural di-erences across boards that are presumed tocorrelate with dierences in behavior. Forinstance, a common presumption is that out-side (nonmanagement) directors will behavedierently than inside (management) direc-tors. One can then look at the conduct oboards (e.g., decision to dismiss the CEO

when fnancial perormance is poor) withdierent ratios o outside to inside direc-tors to see whether conduct varies in a sta-tistically signifcant manner across dierentratios. When conduct is not directly observ-able (e.g., advice to the CEO about strategy),

one can look at a frms fnancial perormanceto see whether board structure matters (e.g.,the way accounting profts vary with the ratioo outside to inside directors).

One problem conronting such an empiri-cal approach is that there is no reason tosuppose board structure is exogenous;indeed, there are both theoretical argumentsand empirical evidence to suggest boardstructure is endogenous (see, e.g., Hermalin

and Weisbach 1988, 1998, and 2003). Thisendogeneity creates estimation problems igovernance choices are made on the basis ounobservables correlated with the error termin the regression equations being estimated.In act, one o our main points in this survey isthe importance o endogeneity. Governancestructures arise endogenously because eco-nomic actors choose them in response to thegovernance issues they ace.2

Beyond the implications endogeneity holdsor econometric analysis, it also has implica-tions or how to view actual governance prac-tice. In particular, when we observe whatappears to be a poor governance structure,

we need to askwhy that structure was chosen.Although it is possible that the governancestructure was chosen by mistake, one needsto give at least some weight to the possibilitythat it represents the right, albeit poor, solu-tion to the constrained optimization problemthe organization aces. Ater all, competitionin actor, capital, and product markets shouldlead, in Darwinian ashion, to the survivalo the fttest. While admittedly fttest doesnot mean optimal, anything that was sub-optimal or known reasons would be unftinsoar as there would be pressure to addressthese reasons or suboptimality. In other

words, existing suboptimality is unlikely tolend itsel to quick or obvious fxes.

This insight about endogeneity is, however,easy to orget in the ace o data. Figure 1shows a plot o two data points.3 On the

2 Harold Demsetz and Kenneth Lehn (1985) were

among the frst to make the general point that governancestructures are endogenous. Others who have raised itinclude Charles P. Himmelberg, R. Glenn Hubbard, andDarius Palia (1999), Palia (2001), and Jerey L. Coles,Michael L. Lemmon, and J. Felix Meschke (2007). Thepoint has also been discussed in various surveys o theliterature; consider, e.g., Sanai Bhagat and Richard H.Jeeris (2002) and Marco Becht, Patrick Bolton, and AilsaRell (2003), among others.

3 Figure 1 is presented or illustrative purposes andshould not be read as a critique o any existing research.In particular, none o the studies discussed below are asnaive as fgure 1.


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Journal of Economic Literature, Vol. XLVIII (March 2010)60

horizontal axis is an attribute o governance(e.g., board size). On the vertical axis is ameasure o fnancial perormance. One frmhas more o the attribute but weaker peror-mance, while the other frm has less o theattribute but better perormance. A regres-sion line through the points underscores theapparent negative relation between attributeand perormance. Without urther analysis,one might be tempted to conclude that a frm

would do better i it shrank the size o itsboard. The problem with such a conclusion

is that it ails to considerwhy a large boardmight have been chosen in the frst place.

Figure 2 replicates fgure 1, but it alsoshows the optimization problems aced bythe two frms in question. Observe that,for a

given rm, there is a nonmonotonic relationbetween the attribute and fnancial peror-mance. In particular, the relation is concaveand admits an interior maximum. Moreover,each o the two frms is at its maximum.

Consequently, whereas Firm 2 would preerceteris paribus to be on Firm 1s curve, it isntand, thus, would do worse than it is doing iit were to shrink its board in line with thenaive conclusion drawn rom the regressionin fgure 1.

Figures 1 and 2 illustrate another issueconronting the study o governance, namelyheterogeneity in the solutions frms choose ortheir governance problems.4 As illustrated,

4 To be sure, a real empirical study would attempt,

in part, to control or such heterogeneity by putting inother controls, including, i the data permitted, frm fxedeects. It should be noted, however, that (i) there can stillbe a problem with the specifcation i the attribute entersinto the specifcation only linearly (as opposed to nonlin-early as suggested by the parabolas in fgure 2); and (ii)i dierent frms ace dierently shaped trade-os (e.g.,i the parabolas arent the same shape or all frms), thenthe coefcients on the attribute, its square, etc., will varyacross frms, suggesting a random-coefcients approach iswarranted. See Hermalin and Nancy E. Wallace (2001)and Bhagat and Jeeris (2002) or a discussion o some othese methodological issues.

Figure 1. Relation between a Specifc Firm Attribute and Firm Financial Perormance

Financial

performance

Governance

attribute

Firm 1

Firm 2


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Firms 1 and 2 ace dierent governanceproblems and, not surprisingly, are drivento dierent solutions. Almost every model ogovernance shows that the equilibrium out-come is sensitive to its exogenous parameters;consequently, heterogeneity in those param-eters will lead to heterogeneity in solutions.Moreover, once one takes into account vari-ous sources o nonconvexity, such as thosearising in optimal incentive schemes, onemay fnd that strategic considerations lead

otherwise identical frms to adopt dierentgovernance solutions (see, e.g., Hermalin1994).

Some help with the heterogeneity issuecould be orthcoming rom more theoreti-cal analyses. Although a commonand notnecessarily inaccurateperception o theliterature on corporate governance, particu-larly related to boards o directors, is that itis largely empirical, such a view overlooks a

large body ogeneral theory that is readilyapplied to the specifc topic o boards. Forinstance, monitoring by the board wouldseem to ft into the general literature onhierarchies and supervision (e.g., Oliver E.

Williamson 1975; Guillermo A. Calvo andStanislaw Wellisz 1979; Fred Koman andJacques Lawarre 1993, Jean Tirole 1986;Tirole 1992). As a second example, issues oboard collaboration would seem to ft intothe general literature on ree-riding and the

teams problem (see, e.g., Bengt Holmstrom1982).

The teams-problem example serves toillustrate a problem that can arise in apply-ing o-the-shel theory to boards. It is wellknown that, as a members share o a teamsoutput alls, he or she supplies less eort. Forboards, however, the question is not a singledirectors eort, but what happens to totaleort (e.g., are larger boards less capable

Figure 2. The Real Decisions Faced by the Firms

Financial

performance

Attribute

Firm 1s optimization problem

Firm 2s optimization problem


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monitors because o the teams problem)?Yet, here, theory cannot provide a defnitiveanswerwhether total equilibrium eortincreases or not with board size dependscritically on assumptions about unctionalorms.5 While anything goes conclusionscan be acceptable in an abstract theoreticalmodel, they are oten less than satisactory inapplied modeling. The lack o clear defnitivepredictions in much o the related generaltheory is, thereore, a hindrance to model-ing governance issues. Conversely, i a spe-cifc model makes a defnitive prediction,then one can oten be let wondering i it isan artiact o particular assumptions rather

than a reection o a robust economic truth.A second, related point is that, in a sim-

ple, and thus tractable, model, theory can betoo strong; that is, by application o sophis-ticated contracts or mechanisms, the par-ties (e.g., directors and CEO) can achieve amore optimal outcome than reality indicatesis possible. To an extent, that problem can befnessed; or instance, i one restricts atten-tion to incomplete contracts. But as othershave noted, the assumption o incompletecontracts can ail to be robust to minorperturbations o the inormation structure(Hermalin and Michael L. Katz 1991) or theintroduction o a broader class o mecha-nisms (Eric Maskin and Tirole 1999).

A urther issue is that corporations arecomplex, yet, to have any traction, a modelmust abstract away rom many eatures oreal-lie corporations. This makes it difcultto understand the complex and multiaceted

solutions frms use to solve their governanceproblems. For instance, the optimal gov-ernance structure might involve a certain

5 For instance, i a teams total beneft is n=1N en,

where en is the eort o agent n, each agent gets 1/No the beneft, and each agentns utility is (m=1

N em)/N(en

+1)/( + 1), then total equilibrium eort is N(1/N)1/,which is increasing in N i > 1, decreasing in N i (0, 1), and constant i = 1.

type o board, operating in a certain ashion,having implemented a particular incentivepackage, and responding in certain ways toeedback rom the relevant product and capi-tal markets. To include all those eatures ina model is ineasible, but can we expect theassumption o ceteris paribus with respect tothe nonmodeled aspects o the situation to bereasonable? The constrained answer arrivedat by holding all else constant need not rep-resent the unconstrained answer accurately.

Yet another point, related both to theprevious point and to our emphasis onissues o endogeneity, is that, motivated byboth a desire to simpliy and to conorm to

institutional details, the modeler is otentempted to take certain aspects o the gov-ernance structure as given. The problem

with this is that the governance structureis largely endogenous; it is, in its entirety,the solution reached by economic actors totheir governance problems. O course, cer-tain eatures, such as the necessity o havinga board o directors, can largely be seen asexogenous (although it should be remem-bered that the decision to make a companya corporation rather than, say, a partnershipis itsel endogenous). Furthermore, the tim-ing o events, particularly in the short run,can make it reasonable to treat some aspectso the governance structure as exogenous orthe purposes o investigating certain ques-tions theoretically.

In this survey, we ocus primarily on workthat illustrates the sorts o challenges dis-cussed above, papers that help clariy the

nature o board behavior, or that use novelapproaches. We also attempt to put the workunder the same conceptual microscope,namely how should the results be interpretedin light o governance structures being thesecond-best solution to the governance prob-lems aced by the frm. Our ocus is also onmore recent papers, even i they are not yetpublished, because prior surveys by KoseJohn and Lemma W. Senbet (1998) and


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Hermalin and Weisbach (2003) cover manyestablished papers in this feld. Although weaim to be comprehensive, it would be impos-sible to discuss every paper in light o therecent explosion in the literature on boards.6O necessity, we omit many interestingpapers in this area and we apologize to theirauthors in advance. For a more detaileddiscussion o the event-study evidence sur-rounding board appointments, we reer thereader to David Yermack (2006). M. AndrewFields and Phyllis Y. Keys (2003) review themonitoring role o the board, as well as theemerging literature on board diversity (seealso David A. Carter, Betty J. Simkins, and

W. Gary Simpson 2003; Kathleen A. Farrelland Philip L. Hersch 2005; and Rene B.Adams and Daniel Ferreira 2009 on boarddiversity). We do not directly discuss direc-tor turnover; Hermalin and Weisbach (2003)review some o the relevant literature onthis topic.7 For the sake o brevity, we do notdiscuss the literature on boards o fnancialinstitutions. Because this is a survey o cor-

porate boards, we also do not discuss theliterature on boards o organizations such asnonprofts and central banks. Partly becauseo the difculty in obtaining data, this lit-erature is less developed than the literatureon corporate boards (William G. Bowen1994 discusses some o the similarities anddierences between corporate and non-corporate boards).8 Similar data limitationsrestrict us to a discussion o boards o pub-licly traded corporations. Finally, we do not

6 Ater searching the literature, we estimate that morethan 200 working papers on boards were written in thefrst fve years since Hermalin and Weisbach (2003) pub-lished their board survey (no causal link is implied).

7 See also Eliezer M. Fich and Anil Shivdasani (2007),Tod Perry and Shivdasani (2005), and Yermack (2004), orsome recent work in this area.

8 Also see Hermalin (2004) or a discussion o howresearch on corporate boards may inorm the study ouniversity and college boards. James O. Freedman (2004)discusses the relation between universities and collegesboards and their presidents.

consider studies that compare governanceinternationally.

Although this survey primarily consid-ers the economics and fnance literatures,boards are a subect o interest in manyother disciplines, including accounting, law,management, psychology, and sociology.9

While there is an overlap in these literatures,there are also dierences. For instance, theeconomics and fnance literatures ocus hastraditionally been on the agency problemsboards solve or, in some instances, create. Incontrast, the sociological and managementliteratures also emphasize that boards can(i) play a role in strategy setting and (ii) pro-

vide critical resources to the frm, such asbuilding networks and connections (see, e.g.,Sydney Finkelstein, Hambrick, and AlbertA. Cannella 2009). Some o the topics previ-ously in the domain o other disciplines arebeginning to be o interest in the econom-ics and fnance literature. For example, thisliterature has begun to incorporate issues oexpertise, trust, diversity, power, and net-

works into their analyses.10

The next section considers the questiono what directors do. The section ollowing,section 3, considers issues related to boardstructure. Section 4 discusses how boardsulfll their roles. Section 5 examines the

9 Some examples o this broader literature includeLucian A. Bebchuk and Jesse M. Fried (2004), Ada Demband F. Friedrich Neubauer (1992), Anna Grandori (2004),Donald C. Hambrick, Theresa Seung Cho, and Ming-Jer Chen (1996), Jay W. Lorsch (1989), Myles L. Mace

(1971), Jerey Peer (1972), Mark J. Roe (1994), JamesD. Westphal and Edward J. Zaac (1995), Westphal (1999),and Zaac and Westphal (1996).

10 For research rom an economic perspective on direc-tor diversity, see Carter, Simkins, and Simpson (2003),Farrell and Hersch (2005), and Adams and Ferreira(2009). Director expertise is discussedinfra in section 2.3.Some aspects o power related to boards are captured inHermalin and Weisbach (1998); see Raghuram G. Raanand Luigi Zingales (1998) or a more general economicanalysis o power in organizations. See Asim Iaz Khwaa,Ati Mian and Abid Qamar (2008) or work on the value toa frm created by its directors social networks.


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been trending upward (see Mark R. Huson,Robert Parrino, and Laura T. Starks 2001 orevidence over the period 1971 to 1994 andsee Steven N. Kaplan and Bernadette A.Minton 2006 or more recent evidence).

2.2 The Hiring, Firing, and Assessment ofManagement

One role that is typically ascribed todirectors is control o the process by

which top executives are hired, promoted,assessed, and, i necessary, dismissed (see,e.g., Richard F. Vancil 1987 or a descriptiveanalysis and Lalitha Naveen 2006 or statis-tical evidence).

Assessment can be seen as having twocomponents, one is monitoring o what topmanagement does and the other is determin-ing the intrinsic ability o top management.The monitoring o managerial actions can,in part, be seen as part o a boards obliga-tion to be vigilant against managerial mal-easance. Yet, being realistic, it is difcultto see a board actually being in a positionto detect managerial maleasance directly;at best, a board would seem dependent onthe actions o outside auditors, regulators,and, in some instances, the news media.Indirectly, a board might guard againstmanagerial maleasance through its choiceo auditor, its oversight over reportingrequirements, and its control over account-ing practices.

The principal ocus o the literature onassessment, at least at a theoretical level, hasbeen on the question o how the board deter-

mines managerial ability and what it does withthat inormation.13 One strategy or studyingthe question o ability assessment has beenthe adaptation o Holmstroms (1999) model,

which analyzes agency and monitoring when

13 Typically, the CEO is a member o the board. Instating the CEO is at odds with the board, we are, likethe literature, using the board as shorthand or the boardminus the CEO.

agents have career concerns, to boards. Withinthat approach, authors have ocused on howthe assessment o ability relates to the powero the CEO (e.g., Hermalin and Weisbach1998); to the selection o proects and strategy(e.g., Silvia Dominguez-Martinez, Otto H.Swank, and Bauke Visser 2008); to the processo selecting the CEO (e.g., Hermalin 2005);among other issues.

2.2.1 Assessment, Bargaining Power, andCEO Control

The frst article to apply Holmstromsramework to boards was Hermalin and

Weisbach (1998). In their model, there is

an initial period o frm perormance underan incumbent CEO. Based on this peror-mance, the board updates its belies aboutthe CEOs ability. In light o these updatedbelies, the board may choose to dismiss theCEO and hire a replacement rom the poolo replacement CEOs or it may bargain withthe incumbent CEO with regard to changesin board composition and his uture salary.The board, then, chooses whether to obtainan additional, costly signal about CEO abil-ity (either that o the original incumbent iretained or the replacement i hired).14 Basedon this signal, i obtained, the board againmakes a decision about keeping or replacingthe CEO. I replaced, a (another) CEO isdrawn rom the pool o replacement CEOs.Finally, second- (and fnal-) period profts arerealized, with the expected value o the pro-its being a positive unction o the then-in-charge CEOs ability.

The boards inclination to obtain an addi-tional signal is a unction o its independence

14 An alternative, but essentially equivalent, model-ing strategy or this stage would be to assume the boardalways receives the additional signal, but the board hasdiscretion over the inormativeness o the signal, withmore inormative signals being costlier to the board thanless inormative signals. See the discussion in Hermalin(2005) on this matter.


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rom the CEO.15 The boards independence atthat stage will depend on the outcome o thebargaining game between the board and theincumbent CEO i he is retained.16 Becausethe acquisition o the additional signal canonly increase the risk o being dismissed andthe CEO enoys a noncontractible controlbeneft, the CEO preers a less independentboard; that is, a board less likely to acquirethis additional signal. The board, however,preers to maintain its independence. Whenthe CEO has bargaining powerspecif-cally when he has demonstrated that hes arare commodity by perorming welltheboards independence declines. Intuitively,

a CEO who has shown himsel to be aboveaverage bargains on two dimensions: hecan bargain or more compensation and,because he preers to remain CEO ratherthan be fred, the degree o the boards inde-pendence. At any moment in time, given itsmarginal rate o substitution between frmperormance and disutility o monitoring, aboard views itsel as optimally independent(i.e., the directors view any change in theircomposition that may lead to more or less dil-igence in monitoring as moving it away romthe incumbent boards optimum).17 Hence,a local change in independence representsa second-order loss or the board (the topo the hill is essentially at), whereas as anincrease in the CEOs salary is a frst-orderloss (the marginal cost o a dollar is alwaysa dollar). The board, thereore, is more will-

15 Independence is a complex concept. With respectto monitoring the CEO, one imagines that directors whohave close ties to the CEO (e.g., proessionally, socially,or because the CEO has power over them) would fndmonitoring him more costly than directors with ewer ties(although see Westphal 1999 or an opposing view). Wediscuss independence at lengthinfra.

16 Hermalin and Weisbach assume there is sufcientcompetition among potential replacement CEOs orthe position that a replacement CEO has no bargainingpower. Their model would be robust to giving a replace-ment CEO some bargaining power as long as it was lessthan that enoyed by an incumbent CEO who is retained.

ing to budge on the issue o independence(willingness to monitor) than salary, at leastinitially; hence, there is movement on inde-pendence. So a CEO who perorms well endsup acing a less independent board. The ipside is that a CEO who perorms poorly is

vulnerable to replacement.Malcolm Baker and Paul A. Gompers

(2003), Audra L. Boone et al. (2007), andHarley E. Ryan and Roy A. Wiggins (2004)each fnd evidence consistent with the ideathat successul CEOs are able to bargain orless independent boards. Boone et al. fndthat variables that are reasonably associated

with bargaining power either or the board

or the CEO are signifcant and have theright sign. In particular, measures o CEObargaining power, tenure, and the CEOsshareholdings, are negatively correlated withboard independence. The tenure fndings, inparticular, are precisely what the Hermalinand Weisbach model predicts. Measuresthat indicate that the CEO has relatively lessbargaining power, including outside directorownership and the reputation o the frmsinvestment banker at the time o its IPO, areall positively correlated with board indepen-dence. Similarly, Baker and Gompers fndthat measures that reect the CEOs bar-gaining power, including an estimate o theCEOs Shapley value and the reputation o thefrms venture capitalists, have the predictedsigns (negative or the ormer and positive orthe latter) with respect to the percentage o

17 For instance, i the boards actions are deter-mined by a median-voter model, then the incum-bent median director (voter) knows that moni-toring will be optimal rom her perspective ithere is no change in board composition. I, how-ever, composition changes so that she is no longer themedian director, then the level o monitoring will nolonger be optimal rom her perspective. Provided,though, that the tastes o the new median directorrange on a continuum rom the incumbent mediandirectors, then having a new median director withonly slightly dierent tastes than the incumbentrepresents a second-order loss or the incumbent.


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non-inside directors on the board. At oddswith the Hermalin and Weisbach model andunlike Boone et al., Baker and Gompers fndapositivealbeit statistically insignifcantrelationship between CEO tenure and per-centage o non-inside directors. Finally, Ryanand Wiggins fnd that a CEOs pay becomesless linked to equity perormance as his con-trol over the board increases (proxied by histenure and the proportion o insiders). Theseauthors interpret these fndings as consistent

with the Hermalin and Weisbach bargainingramework, because it suggests that as CEOsbecome more powerul, they use this powerto improve their well-being (e.g., as here,

where this power allows them to reduce thevolatility o their compensation).

Baker and Gompers, Boone et al., andRyan and Wiggins are all sensitive to the issuethat governance structures are endogenous.Baker and Gompers, in particular, provide aconvincing solution to the problem by iden-tiying plausible instruments or the endoge-neous variable in their specifcation, venturecapital fnancing, these instruments beingthe state o operation and a time dummy thatcaptures exogenous capital inows to ven-ture capital unds. Yet none o these paperssheds light on whether successul CEOs areable to bargain or a less independent board

within the same frm, because they all relyon analyses o repeated cross-sections odata rather than panel data with frm fxed-eects. Shedding more direct empirical lighton the dynamic nature o the CEO-boardrelationship within frms remains an inter-

esting topic or uture research.2.2.2 Assessment and Project Selection

Dominguez-Martinez, Swank, and Visser(2008) is a model similar to Hermalin and

Weisbach (1998). A key dierence betweenthe two is that, in Dominguez-Martinez,Swank, and Visser, it is the CEO who deter-mines what inormation the board learns.An interpretation o Dominguez-Martinez,

Swank, and Vissers model is that there aretwo possible types o CEO, good and bad.In each o two productive periods, a CEOdraws a proect at random rom a distribu-tion o dierent proects (conditional onCEO ability, each periods draw is an inde-pendent event). Think o each proect beingsummarized by its net present value (NPV).The dierence between the two types oCEOs is that the distribution o proects(distribution o NPVs to be precise) is betteror the good type than the bad type (e.g.,the good types distribution dominates thebad types in the sense o frst-order stochas-tic dominance).

The CEO sees the stamped NPV on theproect he draws, whereas the board doesnot. In the second (fnal) period, the CEOsincentives are such that he implements theproect he draws i and only i it has a positiveNPV. In the frst period, however, the CEOsincentives are possibly misaligned with thato the shareholders: the CEO values keepinghis ob. I his frst-period actions or peror-mance lead the directors to iner he is thebad type and the board is not committed toretain him, then he will be dismissed as it isbetter to draw again rom the pool o CEOsthan to continue to the second period witha CEO who is known to be bad. The CEOsconcern about retaining his ob makes ittempting, thereore, or him to avoid risk tohis reputation by not pursuing even positiveNPV proects in the frst period.

One potential solution would be or theboard to commit to retain the frst-period

CEO or the second period. With that com-mitment, CEOs would choose only positiveNPV proects in the frst period. This, how-ever, is not necessarily optimal because thedirectors are throwing away the option toreplace the CEO i they iner he is likely tobe bad. That is, as is also noted in Hermalinand Weisbach, the ability to replace a CEOa board iners is probably bad creates a valu-able real option or the frm.


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Given that good-type CEOs are morelikely to have positive NPV proects than badtypes, an alternative strategy or the board

would be to commit to dismiss the CEOonly i he doesnt undertake a proect. This,however, is not without cost because now aCEO could be willing to undertake a nega-tive NPV proect i it is not so bad that thedisutility resulting rom pursuing the proectoutweighs his utility rom retaining his ob.18

Under this governance rule, some number onegative NPV proects will be pursued.

A third strategy might be or the boardto commit to keep the CEO only i he

18 Dominguez-Martinez, Swank, and Visser assume aCEOs frst-period utility unction is + , where isthe returns rom the frst-period proect, > 0 is his ben-eft o keeping his ob, and {0, 1} indicates whether heloses or keeps his ob, respectively.

undertakes a positive NPV proect. Thismight seem optimal, insoar as it avoids neg-ative NPV proects and allows some learn-ing, but could nevertheless be suboptimal:how much is learned about the CEOs abil-ity depends on the relative likelihood o thetwo types having proects with a particularNPV. It is possible, thereore, that i a givenNPV is more likely rom a good type thana bad type, then it could be worth having

that proect undertaken even i the NPV isnegative because seeing the proect provides

valuable inormation about the CEOs abil-ity. Conversely, i a given NPV is more likelyrom a bad type than a good type, then itcould be worthwhile dismissing the CEOollowing the realization o the proect eveni its NPV is positive. Figure 3 illustrates.Purely rom the perspective o optimal iner-ence, the board should retain a CEO i he

Figure 3. Illustration o the Dominguez-Martinez, Swank, and Visser (2008) Model

Notes: The probability density unctions over NPV are shown or the two types. From an inormational per-spective, the CEO should be retained i and only i the realized value o a proect is abovevi. I, however,v0denotes the proect with an NPV= 0, then the board, to limit frst-period losses, may wish to commit to retainthe CEO i and only i the realized value is above some cuto strictly betweenvi andv0.

vi

v0

NPV

Bad type density Good type density


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has a proect with an NPV abovevi and dis-miss him otherwise. I, howevervi< 0 =v0,then this cuto implies frst-period costs.Trading o these frst-period costs againstthe value o inormation, the board may

wish to set a cuto, vc, between vi and v0;that is, a CEO keeps his ob i and only i heundertakes a proect and that proect payso at leastvc.

Dominguez-Martinez, Swank, and Visserobserve that their model oers a possibleexplanation or why evidence o poor deci-sion making does not always lead to CEOdismissal. Sometimes it is optimal to let aCEO pursue a bad strategy rather than

stick to the status quo (i.e., better to pur-sue a negative NPV proect rather than donothing) because the inormation revealedrom that course o action allows the boardto update positively about the CEOs ability.Admittedly, as ormulated here, the samemodel would also explain the dismissal oa CEO ater moderate success i moderatesuccess is more associated with low abilitythan high ability.19 Dominguez-Martinez,Swank, and Vissers model also suggests anexplanation or why new CEOs rarely seemto be riding with training wheels whenit comes to managing their companies.Limiting a CEOs range o action, while per-haps a way to avoid risky mistakes, also lim-its how much the board can learn about hisability. Especially early in his career, whenrelatively little is known, the expected valueo inormation can outweigh the expectedcost o mistakes.

2.2.3 Assessment and CEO Selection

Hermalin (2005) is concerned with theact that inormation is more valuable whena board is seeking to iner the ability o a

19 Dominguez-Martinez, Swank, and Visser do notmake this point. This is one o the ways our interpretationo their model could be said to dier rom their actualmodel.

relatively unknown CEO than that o amore established veteran. The reason is thatthe option to dismiss a poorly perormingCEO and hire a new one is like an exchangeoption. Consequently, its value is greater,ceteris paribus, the greater is the amounto uncertainty. Hermalin builds on thisinsight to examine the relationship betweena boards structure and its propensity to hirea new CEO rom the outside (an externalhire) versus rom the inside (an internalhire). Presumably an internal hire is a bet-ter-known commodity than an external hire,meaning that an external hire oers greateruncertainty and, thus, a greater option

value. An external hire is, thereore, morevaluable ceteris paribus. How much morevaluable, however, depends on the degree towhich the board will monitor the CEO (itsdegree o diligence). Like the Hermalin and

Weisbach (1998) model, the board makes adecision as to how intensively it will monitorthe CEO, which is reected in the probabil-ity it will get an additional signal correlatedwith his ability.20 Without the signal, there isno option value. Consequently, the value ouncertainty about a new CEO is greater themore diligent the board (i.e., the more likelyit is to acquire the signal) and, thereore, amore diligent board is more willing to tradeo other attributes or greater uncertaintythan is a less diligent board. Hermalinargues that this insight oers an explana-tion or why there has been a growing trendtoward both more external hires and shorterCEO tenures: Due to increased pressure

rom institutional shareholders, more gov-ernment regulations, greater threats olitigation, and new exchange requirements,boards have become more independent and

20 Alternatively, and essentially equivalently, the signalis always observed, but its precision is an increasing unc-tion o the boards eorts at monitoring. See section 6 oHermalin.


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diligent.21 Hence, boards are more willingto monitor, which raises the likelihood theyhire externally or the CEO position.22 Moremonitoring directly raises the likelihood oCEO dismissal and indirectly raises it i itleads frms to hire CEOs about whom less isknown.

One response o CEOs to this greater mon-itoring pressure is or them to work harder(which could be interpreted as taking lessperquisites). Both because they are led to

work harder and their obs are less secure,

21 See Huson, Parrino and Starks (2001) and Stuart L.Gillan and Starks (2000) or evidence on trends towardgreater board independence (technically, boards with agreater proportion o outside directors) and the rise oinstitutional investors.

22 See Kenneth A. Borokhovich, Parrino, and TeresaTrapani (1996), Huson, Parrino, and Starks (2001), andJay Dahya, John J. McConnell, and Nickolaos G. Travlos(2002) or evidence that the proportion o new CEO hiresthat are external has been increasing; the last providesevidence or this trend outside the United States.

CEOs will demand greater pay in compen-sation. Hence, a consequence o more inde-pendent boards over time could be upwardpressure on CEO compensation.23 Figure 4summarizes Hermalins model.24

23 As Hermalin notes, the positive correlation betweenboard independence and CEO pay in time series neednot imply a positive correlation in the cross section at anypoint in time. Hermalin sketches an extension o his modelthat would predict anegative correlation in cross section,despite a positive correlation over time. See his section 5.

24 It is worth noting that Hermalin is not the only theo-

retical explanation or the trend toward more externalhires and greater CEO compensation. Kevin J. Murphyand Jn Zbonk (2006); Murphy and Zbonk (2004)oer a non-boards-based model that takes as its mainpremise that there has been a decline in the value omanagers frm-specifc knowledge relative to the value otheir general knowledge. As they show, this will increasethe willingness o frms to hire CEOs externally. GivenMurphy and Zbonks modeling o the CEO labor mar-ket, this greater willingness to go outside translates into arise in CEO compensation. Hermalin discusses how hismodel can be extended to incorporate the Murphy andZbonk model, see his section 6.

Greaterpropensityto monitor

Greatervalue ofoption More

externalhires

Moreeffort

Greatercompensation

Shorteraveragetenures

More risk more

incentive

More uncertainty morelikely redmore

likely to bediscovered lowability

Compensationrequired for

greater effort

Compensationrequired forless job

security

Moreindependentboards

More risk more

incentive

Figure 4. A Graphical Summary o the Hermalin (2005) Model


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2.2.4 Other Assessment Models

A number o other papers examine themechanisms associated with the boardsassessment o the CEO. Clara Grazianoand Annalisa Luporini (2005) also has aboard that seeks to determine CEO ability.Critical to their analysis is the presence o alarge shareholder on the board, one who is

willing to bear the cost o monitoring, butwho also gains private benefts i the com-pany pursues certain strategies (proects).Because only the large shareholder willmonitor, they fnd there can be advantagesto a dual-board system (e.g., as in much o

continental Europe) because it may beadvantageous to divorce the monitoring rolerom the power to have a say over the com-panys strategy. David Hirshleier and Anan

V. Thakor (1994) assume that boards alwaysreceive signals useul to assessing the CEOsability, but boards dier insoar as some arelax and some are vigilant. Vigilant boardsmay choose to fre the CEO on the basis oa bad signal. The situation in Hirshleier andThakor is complicated by the possibility o atakeover bid by an outside party with inde-pendent inormation about the frm; con-sequently, it may behoove a vigilant boardnot to act on its own inormation, but waitto see what inormation can be learned bythe presence (or not) o a takeover bid andthe price bid. This article also exemplifes theact that board governance is only one sourceo managerial discipline and, more specif-cally, it captures the notion that internal and

external monitoring can serve as substitutesor complements. Vincent A. Warther (1998)presents another model in which the boardacquires inormation about managerial abil-ity. Here, unlike the other models weve dis-cussed, each director gets a private signaland aggregation o inormation is costly inso-ar as a director who indicates he received anegative signal is at risk o losing his boardseat i he proves to be in the minority.

A recent strand o the literature hasrecognized that the boards monitoring othe CEO can create, in eect, a dangero opportunism or holdup by the board.25The ability to dismiss the CEO ater he hasmade frm-specifc investments means theboard can appropriate some o the CEOsreturns, thereby diminishing his originalinvestment incentives. Two papers in thisstrand are Andres Almazan and JavierSuarez (2003) and Volker Laux (2008). Inboth, two critical assumptions are (i) initialcontracts between board and CEO can berenegotiated and (ii) at least some kindso boards (strong in Almazan and Suarez,

independent in Laux) cannot commit to notbehaving opportunistically or aggressivelyin renegotiation.

In Almazan and Suarez, ater being hired,a CEO can, at personal cost, take a discreteaction that raises, by a discrete amount, theprobability that a given strategy or proect

will succeed. This action is observable by theboard, but not verifable, which creates anopportunity or later holdup. Ater the CEOtakes (sinks) his action, a proftable oppor-tunity or the frm may arise that requires anew CEO to exploit. I the board is strongenough to fre the incumbent CEO in avoro a new CEO, then the board can use thatpossibility to obtain salary concessions romthe incumbent because losing his ob meanshe loses a private beneft. The threat o beingorced to make such concessions can under-mine the CEOs initial incentive to take thecostly action.

To be more concrete, consider a variationon Almazan and Suarezs idea:26 Supposethat the new opportunity has the same

25 Opportunism and holdup problems have beenstudied in a large number o areas o economics sinceWilliamson (1975, 1976).

26 The actual Almazan and Suarez (2003) model ismore complex than what we present here. While thosecomplications lead to a richer and more nuanced analysis,they are not necessary to get the basic idea across.


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expected payo as keeping the incumbentCEO i he took the action and, thus, ahigher expected payo than keeping him ihe didnt take the action. Suppose a weakboard will never fre the CEO when theexpected value o keeping him equals thato the new opportunity, but can fre him

when the latter is greater. A strong board isalways capable o fring the CEO. Assumeit is possible, when the threat to dismiss theCEO is credible, or the board to capture,in renegotiation, the CEOs private benefto control and push the CEO to some reser-

vation utility (call it 0). Hence, a CEO witha strong board has no incentive to take the

action: I the new opportunity doesnt arise,he retains his ob no matter what he did,there is no renegotiation o his compensa-tion, and he enoys the control beneft. Buti the new opportunity does arise he gets 0regardless o his action; either he is fred,thus denied both pay and private beneft,or through renegotiation is orced down toa 0 reservation utility (payo). Because hisultimate payo is independent o his action,he has no incentive to incur the cost o tak-ing it. The story is, however, dierent or aCEO who aces a weak board. Now, he isstrictly better o i he has taken the actionand the new opportunity arises: the boardcannot threaten to fre him, so he contin-ues to capture rents (wage plus private ben-eft). I he didnt take the action and thenew opportunity arose, then he would loseboth wage and private beneft. I the newopportunity arises with low requency, so it

is efcient or the incumbent CEO to takethe action, then having a weak board will bebetter than having a strong board.

In Almazan and Suarez, the distinctionbetween strong and weak boards is a dis-tinction about their bargaining power. InLaux (2008), the board always has all thebargaining power at the renegotiation stage(can make a take-it-or-leave-it oer to theCEO), but boards dier in their degree o

independence. This variation in degree oindependence acts, however, like a shitin bargaining power. Consequently, orreasons similar to those in Almazan andSuarez, a frm can be better o with a lessindependent board than a more indepen-dent board.

2.2.5 Additional Empirical Analyses ofAssessment

There is both anecdotal and statisticalevidence that boards dismiss poorly per-orming CEOs. Based on interviews, Mace(1971) and Vancil (1987) conclude that

boards fre, albeit oten reluctantly, poorlyperorming CEOs. There are numerousstatistical analyses that show poor peror-mance, measured either as stock returnsor accounting profts, positively predicts achange in the CEO.27 Simply documenting arelationship between poor perormance andan increased probability o a CEO turnover,although suggestive o board monitoring, isnonetheless ar rom conclusive. Ater all, asense o ailure or pressure rom sharehold-ers could explain this relationship. To bet-ter identiy the role played by the board,

Weisbach (1988) interacts board composi-tion and frm perormance in a CEO turn-over equation. His results indicate thatwhen boards are dominated by outsidedirectors, CEO turnover is more sensitiveto frm perormance than it is in frms with

27A problem acing empirical work is that frms otenoer a ace-saving rationale or a change in CEO (e.g., hewishes to spend more time with his amily) rather thanadmit the CEO was orced out or doing a bad ob. SeeJerold B. Warner, Ross L. Watts, and Karen H. Wruck(1988), Weisbach (1988), Parrino (1997), and Dirk Jenterand Fadi Kanaan (2008) or urther discussions o thisissue and strategies or dealing with it. To the extentnon-perormance-based CEO turnover is random, itsimply adds noise to turnover regressions, thus reducingthe power o such tests, but leaves them unbiased andconsistent.


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insider-dominated boards.28 This result isconsistent with the predictions o Hermalinand Weisbach (1998) and Laux (2008) underthe presumption that outsider domination isa good proxy or board independence.

Yermack (1996) also seeks to relate boardstructure to CEO turnover. Instead o aninteraction between board composition andperormance, Yermack interacts the log oboard size with fnancial perormance andfnds a positive and signifcant coefcient onthis interaction term.29 That the coefcientis positive indicates that frms with smallerboards have a stronger relationship betweenpoor perormance and CEO turnover than do

frms with larger boards. This fnding is con-sistent with the oten-heard view that smallerboards are more vigilant overseers o the CEOthan larger boards. In particular, in responseto poor perormance, they may not be para-lyzed by ree-riding or otherwise plagued

with inertia in the way that larger boards are.Another o Yermacks fndings (supported

by later work by Theodore Eisenberg, SteanSundgren, and Martin T. Wells 1998) isthat board size and frm perormance, thelatter measured by average Tobins Q, are

negatively correlated.30 It is not obvious

28 Dahya, McConnell, and Travlos (2002); Dahya andMcConnell (2007) fnd a similar result in the UnitedKingdom: frms that adopted the recommendations othe Cadbury Commission show a greater sensitivity oCEO turnover to perormance than nonadopting frms.Related, Vidhan K. Goyal and Chul W. Park (2002) fndthat the sensitivity o CEO turnover to perormance isless when the CEO also serves as board chair. Adams

and Ferreira (2009) fnd that the proportion o women onboards increases the CEO perormance-turnover sensi-tivity even ater controlling or the proportion o outsidedirectors, which suggests that the proportion o emaleoutside directorsdirectors outside o the old-boy net-workis proxy ing or board independence.

29 See Olubunmi Faleye (2003) or a similar study.30 Average Tobins Q is the ratio o the market value o

assets to their book value. A presumption in the literatureis that Q > 1 is partially a reection o the good ob man-agement is doing. As long as one controls or book value oassets, Tobins Q regressions are similar to market-valueregressions.

how to reconcile Yermacks results with therenegotiation-based models discussed previ-ously: These models suggest that too vigilant(here, small) a board is detrimental to a frminsoar as it discourages the CEO rom tak-ing valuable actions or it means such actionscan be implemented only at greater cost.Yermacks fndings could also be at odds withHermalin and Weisbachs (1998) bargaining-based model: I larger boards are less vigi-lanteectively less independentthen thelogic o the Hermalin and Weisbach modelsuggests a successul CEO will bargain toincrease the size o his board. This would

yield a prediction consistent with Yermacks

interaction eect: larger boards will be lessresponsive to a signal o poor perormancethan smaller boards. However, because itis the more successul CEOs who have thelarger boards, the Hermalin and Weisbachmodel would seem to predict that frms

with larger boards would outperorm thosewith smaller boards, which is contrary toYermacks fndings.

It may be possible to reconcile Yermacksfnding with the Hermalin and Weisbachmodel i (i) a successul CEO is a CEO thattook successul advantage o valuable growthopportunities his frm had; and (ii) the timeit takes to recognize the CEO was success-ul is sufciently long that his frm would bemature at the time it is recognized, leadingto a lower Q.31

Such issues led Coles, Naveen D. Daniel,and Naveen (2008) to reestimate Yermack,but with greater attention to heterogeneity

issues. Consistent with the spirit o fgure 2and the conceptual ramework set orththere, Coles, Daniel, and Naveen seek tocontrol or the possibility that boards havedierent sizes because frms ace dierentproblems. In contrast to Yermacks fndings,Coles, Daniel, and Naveen fnd that frm

31 The authors thank Ren Stulz or this insight.


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perormance (average Tobins Q) is increas-ing in board size or certain types o frms,namely those that are highly diversifed orthat are high-debt frms.

Perry (1999) breaks down the cross-sec-tional relationship between CEO turnoverand frm perormance by whether the out-side directors are paid using incentives. Hefnds that the relationship between CEOturnover and frm perormance is stronger

when boards have incentives. This fndingsuggests that providing explicit incentivesto directors leads them to be more vigilant(act more independently). Beyond incentivereasons, another potential explanation is the

ollowing: in frms that make use o incen-tive pay or directors, the directors have aproessional rather than a personal relation-ship with the CEO and, thus, are relativelyindependent o him.

To conclude this section, it is worth not-ing that ew analyses o CEO turnover con-trol or frm-specifc heterogeneity usingfrm eects. As increasingly long panel-datasets become available, uture research willbe able to shed more light on within-frmchanges in CEO turnover.

2.3 Setting of Strategy

In addition to making decisions concern-ing the hiring and fring o CEOs, boardsmay also be involved in the setting o strat-egy or, somewhat equivalently, the selectiono proects. Certainly surveys o directorssee the discussion o Demb and Neubauer(1992) aboveindicate that directors believe

themselves to be involved in setting strategy.2.3.1 Theory

To an extent, many o the models discussedabove could be modifed to make themabout boards oversight o strategy. Insteado replacing the CEO, the board compelshim to change strategy. In an adaptation oAlmazan and Suarez (2003) or Hermalinand Weisbach (1998), the CEO could be

assumed to have an intrinsic preerence orthe incumbent strategy versus a replacement(the incumbent strategy provides, e.g., moreopportunity to consume perquisites). In anadaptation o Laux (2008), similar results

would ollow i one assumed the fnancialreturns to the replacement strategy are inde-pendent o the CEOs initial actions.

An alternative modeling approach is toinvestigate the choice o strategy as a gameo inormation transmission: the CEO (ormanagement more generally) has dierentpreerences than the board concerning pro-ects (strategies). A number o observers arecoming to the view that inormation trans-

mission between the board and the CEOis important or good governance (see, e.g.,Holmstrom 2005). This is particularly true

when the CEO has payo-relevant privateinormation, insoar as an agency problemarises because the CEO can inuence theboards decision through the strategic releaseo inormation.

Adams and Ferreira (2007) build amodel based on our broad assumptions:(i) the CEO dislikes limits on his actions(loss o control); (ii) advice rom the boardraises frm value without limiting a CEOsactions; (iii) the eectiveness o the boardscontrol and the value o its advice are bet-ter the more inormed the board is; and (iv)the board depends crucially on the CEOor frm-specifc inormation. In the Adamsand Ferreira model, the board can learn theamount, a [0, 1], by which a proect shouldbe optimally adusted (e.g., what the appro-

priate level o investment in it should be).The board can do this, however, only i theCEO has inormed them about the proect. Itis assumed the CEO can withhold that inor-mation, but i he chooses to share it, thenhe must do so honestly (i.e., using the stan-dard terminology o the contracts literature,the inormation is hard). The CEO has abias, b > 0, such that he likes to increasethe size o proects (e.g., invest more than is


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appropriate).32 Ignoring fxed terms and addi-tively separable aspects o their respectiveutilities, the utility o the board and CEO asa unction o the size o the proect,s, and thetrue a are quadratic losses,

UB= (sa)2 and UC= (sab)

2,

respectively. The boards knowledge o a isits private inormation. The board can, how-ever, send a messagem [0, 1] as to what its

value is. Unlike the CEOs inormation, theboards inormation is sot, in that a alsemessage (m a) can be sent. Provided theCEO has the power to choose s and the

board has learned a, the message-transmis-sion subgame is a cheap-talk game (VincentP. Craword and Joel Sobel 1982). This sub-game has multiple equilibria, but one is max-imallyalthough not ullyrevealing o theboards inormation.

Observe thats a (at least almost surely)because o the CEOs bias and the imperec-tion o inormation transmission in equilib-rium. This provides the board with a motiveto assert control; that is, take the choice osout o the CEOs hands. Suppose the boardcould always take control. Observe it would,then, be in the CEOs interest to have alwaysinormed it about the proect. Absent thatinormation, the board would sets = a,

where a= {a}. The CEOs payo wouldbe a concave unction o the random vari-able aab, which has an expected

value ob. With the CEOs inormation,the board would set s = a. The CEOs pay-

o would be a concave unction o the con-stant, b. Since the ormer scenario is amean-preserving spread o the second, itollows that the CEO will preer the second;that is, revealing his inormation.

32 Alternatively, one could assume he likes to econo-mize on eort, so preers smaller proects; in this case,b < 0. The critical assumption is thatb 0.

To generate urther tension between theboard and the CEO, Adams and Ferreiraassume the CEO suers a personal loss,> 0, i control is taken rom him. Further,they assume the board is not necessarilyassured o being able to seize control. Rather,the board chooses the probability, , that it

will seize control. The board incurs a cost thatis increasing in . The marginal cost o is,however, alling in the boards level o inde-pendence. The rationale or this last assump-tion is that more independent boards fnd iteasier to conront the CEO than less inde-pendent boards. Under Adams and Ferreirasmaintained assumptions, it is never optimal

or the board to choose = 1. Critically, theboard chooses afterthe CEO has or has notrevealed his inormation. Moreover, becausethe value o seizing control is greater whenthe board can sets = a rather than ust = a,the board will choose a greater value o

when it has been inormed by the CEO thanwhen it hasnt. Consequently, the CEO nowhas incentive to withhold his inormation: by

withholding it, he raises the probability heretains control (avoids losing ).

I the board is sufciently lacking in inde-pendence, then the probability o its seizingcontrol, even i the CEO reveals his inor-mation, is low. In act, it can be so low thatthe CEO is willing to run the increased risko losing control that ollows his revealinghis inormation in order to gain the boardsadvice (i.e., the inormative message m),because the advice will help him reduce hisexpected quadratic loss. Adams and Ferreira

show that there can exist an interior equilib-rium in which, provided the boards inde-pendence is below a cuto, the CEO indeedreveals his inormation. Conditional on theboards independence being at or below thecuto, the frms expected profts are great-est i the boards independence equals thecuto. At this level o independence, theexpected gain rom being able to utilize theboards inormation outweighs the expected


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loss rom the size o the proect sometimesbeing distorted (i.e., in those states whenthe CEO retains control). The Adams andFerreira model also implies that it may beoptimal to separate the advisory and moni-toring roles o the board; that is, to have adual board system as in many countries inEurope.

Milton Harris and Artur Raviv (2008)is similar in spirit to Adams and Ferreira.Harris and Raviv assume that the CEO andthe insider directors, like the outside direc-tors in Adams and Ferreira, have inormationrelevant to the quadratic loss. The payos,net o fxed terms and additively separable

aspects o their respective utilities, are

UO = (saOaI)2 and

UI = (saOaIb)2,

where the subscripts O and I denote outsid-ers and insiders, respectively, and at is theinormation that the t group o directorshave about the optimal size o the proect.Observe, now, that the optimal size rom theshareholders perspective iss = aO+ aI. The

value o at is the private inormation o thet group o directors. Unlike in Adams andFerreira, now it could be suboptimal, romthe shareholders perspective, to give controlovers to the outsiders: although the insiders

will almost surely not choose the optimal sgiven control, they might get closer i theirinormation is particularly valuable (i.e., the

variance o aI is relatively big). Harris and

Raviv consider two board structures: outsidercontrol and insider control. When group thas control, it has the choice o choosing sor delegating the choice to the other group.

When group t makes the choice it receivesa message rom the other group about thatother groups inormation. As in Adams andFerreira, the equilibria o these cheap-talkgames do not permit ull inormation rev-elation. When the insiders inormation is

sufciently valuable relative to the outsid-ers (i.e., Var(aI)/ Var(aO) > 1, a con-stant that depends on parameter values) andinormation is valuable relative to the agencyproblem (specifcally, Var(a

I

)/b2 > 1, a constant that depends on parameter val-ues), then insider control is superior to out-sider control. I those conditions arent met,then outsider control is superior.

Like Adams and Ferreira and Harris andRaviv, Charu G. Rahea (2005) wishes tounderstand board structure in the light o theboards need to obtain inormation about thefrms proects or strategies. Unlike Adamsand Ferreira, where all board members are

equally ignorant, or Harris and Raviv, whereboth inside and outside directors respectivelyhave private inormation, Rahea assumesthat only the inside directors possess privateinormation. In contrast to most o the litera-ture, Rahea departs rom the idea that thenon-CEO inside directors and the CEO havecoincident incentives. Insiders control theCEO through the threat o ratting him outto the outsiders, who will then oin with theinsiders in fring the CEO, should the CEOmisbehave.

Although a clever model, it is difcultto reconcile Raheas model with the evi-dence in Mace (1971) or Vancil (1987).Insubordination by a CEOs managementteam seems exceedingly rare. Moreover,

what evidence there is about whistle-blow-ers (rats) is hardly encouraging or Raheasmodel. Anecdotal evidence, at least, suggeststhat whistle-blowers tend to suer, more

than be rewarded, or their actions (see, e.g.,Joann S. Lublin, 2002). Evidence o whistle-blowers going to outside directors is rarethe most prominent recent whistle-blower,Enrons Sherron Watkins, or instance wentto the CEO (Ken Lay) with her concerns.

Fenghua Song and Thakor (2006) alsoconsider inormation transmission relevantto proect selection. Like some other work inthis area, they build on the career-concerns


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notions o Holmstrom (1999). Unlike previ-ous work, they assume that both the boardand the CEO have career concerns. UnlikeHolmstrom, who assumes all actors areequally ignorant about theirs and othersabilities, Song and Thakor assume that boththe CEO and board each know their ownabilities. In the Song and Thakor model,CEO ability means how likely the CEO isto identiy a proect to undertake; whereasboard ability means how accurate the boardis at assessing the value o any proect putorth by the CEO. Independent o his ability,the CEO also obtains a signal o a proectsquality, which he can pass along truthully

or not to the board. Song and Thakor showthat when the probability o good proectsis low, then the board will be biased towardunderinvestment. I the probability o goodproects is high, however, then the board willbe biased toward overinvesting. Song andThakor suggest that the probability o goodproects will be low during economic down-turns and high during economic booms,

which means their model oers an explana-tion o changes in governance over the busi-ness cycle: during downturns, the board willbe tougher and, during upturns, the board

will be more lenient.The Song and Thakor model is rather com-

plex, with many moving parts. To providesome intuition or its results, consider anadaptation o Hermalin and Weisbach (2009)motivated by Song and Thakor. Assumea risk-averse CEO with career concerns la Holmstrom (1999). Assume his abil-

ity, unknown ex ante to all, is N(0, 1/),where N(, 2) denotes a normal distribu-tion with mean and variance 2.33 A pro-ect arises that will payo r+ + , wherer is a known constant reecting the currenteconomic environment and N(0, 2). Apublic signal, s, about the CEOs ability is

33While the realization o is unknown by anyone, alldistributions are common knowledge.

realized ater the proect arises, but beorethe board must commit to the proect.AssumesN(, 1/q), where q is a measureo the boards quality. Note the uncondi-

tional distribution os is N(0, 1/H), where1/H = 1/ + 1/q. Normalize the frms rev-enues i the board decidesnot to pursue theproect to be 0. Using the standard ormulaor orming posteriors rom normal distri-butions (see, e.g., Morris H. DeGroot 1970,p. 167), the expected value o the proectconditional on the signal is

r +qs_____

q + .

The board proceeds with the proect i that ispositive; that is, i

s (q + )r_______q S .

Given the option o blocking a negative NPVproect, the frms expected valuepriorto thereception o the signal is

(1) V =

maxe

0, r+qs____

q+

f

___H___2

exp a H__2

s2bds w

=__H

____ (S__H)+ (1 (S

__H))rw ,where w is the CEOs compensation, () isthe density unction o a standard normalrandom variable (i.e., with mean zero and

variance one), and () is the correspondingdistribution unction.

Dierentiating V with respect to q, it isreadily shown that the frms expected value,V, is increasing in the quality o the board,q, all else held equal. Intuitively, the abilityto block a bad proect creates an option. An


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option that is never exercised is worthless;hence, i the signal were complete noise, as

would be the case i board had zero qual-ity (recall the signals variance is 1/q), there

would be eectively no option. As the qualityo the board and, thus, inormation improves,the more valuable this option becomesand, thereore, the more valuable the frmbecomes.

It is not, however, costless to increaseboard quality without bound. First, it seemsreasonable that higher quality directors com-mand a premium or that providing a board

with sufcient incentives to do a high-qualityob is expensive. So the cost o board qual-

ity is increasing in quality. Under suitableassumptions about this cost unction (e.g.,that marginal cost be rising in q), there willbe an optimal fnite value or q. In addition,i the CEO labor market reacts to the signalso that the CEOs uture salary is an increas-ing unction o the signal, then the CEO isexposed to more uture salary risk the moreinormative the signal is (i.e., the greateris q). Intuitively, the posterior estimate o theCEOs ability is a weighted average o theprior, which is fxed, and the signal, whichis noisy. The more inormative the signal isknown to be, the more weight is assigned thesignal. This increases the CEOs risk morethan the lower variance o the signal itselreduces it (see Hermalin and Weisbach 2009or details). A CEO will require compensa-tion or this greater risk, so his initial salary(w in expression (1)) will have to be greater.In light o this cost, under suitable condi-

tions, it will again be the case that a fnite qis optimal.

From expression (1), the marginal netreturn to q is

1____2q2

ar______H bH3/2 w___q

(note S__H = r/__H). The change in the

marginal net return to q with respect to r,

the measure o the current economic envi-ronment, has the same sign as

d___dr

ar____

__

H b< 0 ,

where the inequality ollows because anincrease in r is a move urther into the lettail o the density. Thereore, the marginalnet return to q is alling in r, which meansthat the optimal quality o the board is lower

when economic conditions are good (i.e., rishigh) than when they are bad (i.e., ris low).Intuitively, when times are good, the board

will wish to let mediocre CEOs go aheadwith proects, but they wont when times arebad. Consequently, the value o improvingthe monitoring o proects is greater whentimes are bad than when they are good.

Nina Baranchuk and Philip H. Dybvig(2009) is an interesting article in this areabecause it is not worried about inormationtransmission between CEO and board, butamong the various board members them-selves (which, in practice, include the CEO).Each director i has a belie, ai n, as to

what the frm should do. Similar to Adamsand Ferreira (2007) and Harris and Raviv(2008), a director expects to suer a qua-dratic loss in the distance between his beliesas to what the frm should do and what thefrms actual course o action, a, is; that is, adirectors utility is

ai a .

The directors arrive at a according to a solu-tion concept that the authors call consensus.This solution concept has many desirableproperties, including existence or all suchgames. A weakness o the concept, however, isthat there is no explicit extensive-orm gameto which it is a solution (consensus is a coop-erative game-theoretic concept). Anotherissue is there is no scope or directors to


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update their belies based on what they learno others belies. Absent biases on the part othe directors, it is not clear why the directors

would not reely share their inormation andarrive at a consensus belief, which in turn

would lead to a unanimous choice as to whatthe frm should do.

By the revelation principle, the inorma-tion-transmission models discussed herecould all be solved by a direct-revelationmechanism i complete contracting werepossible.34 That is, i the parties could ullycommit and monetary transers o any levelamong them were easible, then the partiescould achieve an inormationally constrained

optimum via contracting. There would,thereore, be no need to worry about boardcomposition or control. Hence, as is com-mon o many models seeking to explain theinstitutions we observe, there is a reliance, atsome level, on the assumption that contract-ing is necessarily incomplete. In particu-lar, either boards cannot commit ully as tohow they will use the inormation revealedto them or it is ineasible contractually orthem to pay the CEO (or others) in a man-ner sufcient to induce efcient revelation.For instance, in Harris and Raviv (2008), adirect-revelation mechanism would do bet-ter than the equilibrium outcomes consid-ered provided that the parties could contractdirectly on the size o the proect as a unc-tion o their announcements and they couldmake transers. Although this literaturetends not to explore ully why contracts areincomplete, casual empiricism would sug-

gest that there are, indeed, limits to bothcommitments and transers. So, realistically,organizations are necessarily in a second-or third-best situation. Consequently, thelaw o the second best oten appliestoremedy, in part, the second- or third-bestproblem, the parties can gain by introducing

34 Note Song and Thakor is not an inormation-transmission model.

another, partially osetting problem.35 In theliterature on boards, the osetting problemis having a less diligent/less controlling/lessindependent board. Having a lax board is a

way o partially committing to how inorma-tion will be used, thereby mimicking, in part,the commitment that a contractual solution,

were one easible, would provide.

2.3.2 Empirical and ExperimentalEvidence

Ann B. Gillette, Thomas H. Noe, andMichael J. Rebello (2003); Gillette, Noe andRebello (2008) perorm a series o interest-ing experiments designed to get at the issue

o inormation transmission within the board-room. In Gillette, Noe, and Rebello (2003),they consider a laboratory setting in whichinormed insiders are grouped with unin-ormed outsiders in a simulated boardroomsetting. They fnd that the inclusion o outsid-ers improves welare by making undesirableequilibria less likely. Gillette, Noe, and Rebello(2008) compare, again in a laboratory set-ting, single-tiered boards, two-tiered boards,insider-controlled boards, and outsider-controlled boards. They fnd that two-tieredboards tend to be overly conservative in theirchoices and that outsider-controlled boardstend to lead to the most efcient payos.

The class o models based on strategicinormation transer implicitly relies onthe assumption that outsider directors areless well inormed than are inside direc-tors. Enrichetta Ravina and Paola Sapienza(orthcoming) adopt a clever approach to

testing this assumption. These authorsexamine the relative proftability o tradesin their companies stocks made by outsiders

35 An example o the law o the second best is, orinstance, encouraging some degree o cartelization o apolluting industry: by reducing competition, price willbe driven above private marginal cost; hence, societymay hope to get price closer to social marginal cost (i.e.,cost inclusive o the negative externality caused by thepollution).


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and insiders and fnd that both types odirectors earn abnormal profts, but thatinsiders earn better returns than do outsid-ers. These results suggest that both types odirectors have access to inside inormationbut that outsiders inormation is strictlyworse than insiders. Thus the fnding sup-ports the underlying assumption o theinormation-based models o boards.

Breno Schmidt (2008) considers a situ-ation in which advice could be particu-larly valuable, namely during mergers andacquisitions. On the basis o the social tiesbetween the CEO and other directors, heclassifes boards as riendly (ties exist) and

unriendly (a continuous measure is alsoemployed). When it is likely that directorspossess valuable inormation about an acqui-sition (an index measure), the returns o theacquirer are higher on announcement o theacquisition or bidders with more riendlyboards. Conversely, when the need to disci-pline the manager is a greater concern, socialties prove to be a negative.

Although there is a growing empirical lit-erature seeking to estimate the role o direc-tors in strategy setting, it is sae to say thatthis is an area in which much work remainsto be done.

3. How are Boards of DirectorsStructured?

We have discussed some explanations orwhy there are boards, and why one mightexpect endogenously-chosen boards to pro-

vide monitoring o management, despite theact that management typically has somesay over the boards composition. But thetheories simply provide a stylized descrip-tion o the underlying tensions in the role othe board in corporate governance. Actualgovernance is much richer than these bare-bones characterizations.

There are a number o questions thatcan only be answered by looking at data

on real-world boards o directors. How areboards structured in practice? Does thisstructure coincide with the earlier-discussedtheories? How has it changed over time, bothin response to changes in the economy andregulatory environments?

3.1 Some Facts

Observers typically divide directors intotwo groups: inside directors and outsidedirectors. Generally, a director who is aull-time employee o the frm in questionis deemed to be an inside director, while adirector whose primary employment is not

with the frm is deemed to be an outside

director. Outside directors are oten taken tobe independent directors, yet the indepen-dence o some directors who meet the defni-tion o an outsider is questionable. Exampleso such directors are lawyers or bankers whodo business with the company. Outsiders odubious independence are sometimes put ina third category in empirical work (see, e.g.,Hermalin and Weisbach 1988): afliated orgray directors. In recent years, public pres-sure and regulatory requirements have ledfrms to have maority-outsider boards.

The characteristics o boards o large U.S.corporations have been described in a numbero studies. For example, Fich and Shivdasani(2006) consider a sample o 508 o the largestU.S. corporations between 1989 and 1995.They fnd that, on average, outsiders make up55 percent o directors, insiders 30 percent,and afliated directors the remaining 15percent. The average board contains twelve

directors, each receiving approximately$36,000 in ees (plus stock options), and has7.5 meetings a year. A number o the directorsserved on multiple boards; the outside direc-tors in these frms averaged over three direc-torships. While these data are or large publicfrms, James S. Linck, Jery M. Netter, andTina Yang (2008) consider a larger sample o8,000 (necessarily) smaller frms, with similarpatterns in the data.


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While the existence and basic structureo boards have remained relatively constantover time, the way in which they are com-posed has changed. Lehn, Sukesh Patro, andMengxin Zhao (2009) consider a sample o 81frms that have survived as public companiesrom 1935 until 2000. Survivorship bias com-plicates the interpretation o their fndings,nevertheless they reect some basic trendsthat have aected boards. First, board sizeappears to have a hump pattern over time; itaverages 11 in 1935, peaks at 15 in 1960, anddeclines to 11 in 2000. However, board sizehas become more uniorm over time as thestandard deviation o board size drops rom

5.5 in 1935 to 2.7 in 2000. These companiesboards have become more outsider-domi-nated as well; insider representation dropsrom 43 percent in 1935 to ust 13 percentin 2000. Part o this drop can be explainedby the typical lie cycle o frms. As ound-ing amilies exit and frms become moreproessionally managed, agency problemscan become worse as those in control are nolonger signifcant owners. In response, frms

will wish to add outside directors to counter-act the increased agency problems.

Since 2000, there have been signifcantchanges. SarbanesOxley contained a num-ber o requirements that increased the work-load o and the demand or outside directors(see Linck, Netter, and Yang 2009 or adescription o these requirements). In addi-tion, the scandals at Enron and Worldcomhave led to substantially increased public scru-tiny o corporate governance. Consequently,

boards have become larger, more indepen-dent, have more committees, meet moreoten, and generally have more responsibil-ity and risk (again see Linck, Netter, andYang 2009). These changes both increasedthe demand or directors and decreased the

willingness o directors to serve or a givenprice. It is not surprising, thereore, thatdirector pay and liability insurance premi-ums have increased substantially. From the

shareholders perspective, the net eect othis regulation is not clear; uture research

will need to address the extent to which theadditional monitoring osets the incremen-tal costs imposed by SarbanesOxley.

3.2 Factors in Board Composition thatPotentially Affect a Boards Actions

We have already discussed much o theliterature relating board composition (interms o the insider-to-outsider ratio) andboard size to board actions regarding over-sight o the CEO, as well as to overall frmperormance (see section 2.2). Yet beyondthe insider-to-outsider ratio and board size,

other board attributes no doubt play a role.Each board o directors is likely to have itsown dynamics, a unction o many actorsincluding the personalities and relationshipsamong the directors, their backgrounds andskills, and their incentives and connections.Some o these actors are readily measured

while others are not. There has been con-siderable research that seeks to estimate theimpact o various board characteristics onboard conduct and frm perormance.

3.2.1 CEOChairman Duality

Many CEOs also hold the title o Chairmano the Board; this duality holds in almost80 percent o large U.S. frms (see PaulaL. Rechner and Dan R. Dalton 1991). Thisstructure is viewed by many as giving CEOsgreater control at the expense o other par-ties, including outside directors. To mitigatethe consequent problems, many observers o

corporate governance have called or a prohi-bition on the CEO serving as chairman (see,e.g., Michael C. Jensen 1993).

A number o recent papers have examinedthe use o dual titles in corporate governanceempirically. James A. Brickley, Coles,and Gregg A. Jarrell (1997) estimates theperormance eects o combined titles. Theseauthors fnd little evidence that combiningor separating titles aects corporate


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perormance. They conclude that the sepa-ration and combination o titles is part othe natural succession process described by

Vancil (1987). In contrast, Goyal and Park(2002) fnd that the sensitivity o CEO turn-over to perormance is lower when titles arecombined, consistent with the notion thatthe combination o titles is associated withincreased power over the board. Similarly,Adams, Heitor Almeida, and Ferreira (2005)fnd evidence consistent with the view thatCEOs also holding the chairman title appearto hold greater inuence over corporate deci-sion making.

Overall, these studies are consistent with

the view that combined titles are associatedwith CEOs having more inuence in thefrm. However, this relation is not neces-sarily causal. Inuence inside an organiza-tion arises endogenously, and with inuencegenerally come ancier titles. The Goyal andPark and Adams, Almeida, and Ferreirafndings potentially reect CEO power thatcame about endogenously through a mannersimilar to that described in the Hermalin and

Weisbach (1998) model. In other words, aCEO who perorms well would be rewardedby his being given the chairman title as well.Such a process, especially i the increase inpower arises because o a demonstrated highability, would not necessarily imply peror-mance changes ollowing shits in titles, con-sistent with the Brickley, Coles, and Jarrellfndings.

Even i it is true that combining the titles oCEO and chairman means that an individual

has, on average more inuence over his frm,it does not ollow that mandating separatetitles would improve corporate perormance.In act, Adams, Almeida, and Ferreirasimilar to Brickley, Coles, and Jarrellfndthat measures o CEO power arenot system-atically related to frm perormance. This isconsistent with our overarching argumentthat actual corporate-governance practiceneeds to be seen as part o the solution to

the constrained optimization program that iscorporate-governance design. Hence,impos-

ing separate titles would either yield a lessoptimal solution or lead to a, possibly inef-cient, work-around that maintained the opti-mal amount o CEO power.36 Moreover, asnoted earlier, making the CEOs ob worselikely means an osetting increase in pay ascompensation. Consequently, as with mostpolicy prescriptions in the area o gover-nance, policy makers should be wary o callsor prohibiting the CEO serving as chairman.

3.2.2 Staggered Boards

A common, yet controversial, governance

arrangement is known as staggered boards.When a frm has a staggered board, insteado holding annual elections or each direc-tor, directors are elected or multiple yearsat a time (usually three), and only a raction(usually a third) o the directors are electedin a given year. This practice is typicallyadopted as a way o shielding a frm romtakeover because a potential acquirer can-not quickly take control o the frms boardeven it controls 100 percent o the votes.This arrangement is more common than onemight imaginein the Faleye (2007) sam-ple, roughly hal o the frms have classifed(staggered) boards.

While the consequence o the separa-tion o the CEO and chairman positionson frm perormance is ambiguous, lessambiguity exists with respect to staggeredboards; the empirical evidence indicatesthis arrangement is not in the sharehold-

ers interests (although, as with much o theempirical work, caution is warranted dueto oint-endogeneity issues). Both Jarrelland Annette B. Poulsen (1987) and JamesM. Mahoney and Joseph T. Mahoney (1993)

36 Recall that, in a number o models o boards, cedingsome control to management is optimal (see e.g., Almazanand Suarez 2003; Laux 2008; Adams and Ferreira 2007;and Harris and Raviv 2008).


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fnd negative returns when frms announcethey are classiying their boards (althoughJarrell and Poulsens fnding is not statisti-cally signifcant). Bebchuk, John C. Coates,and Guhan Subramanian (2002) fnd thata classifed board almost doubles the oddsthat a frm remains independent when aced

with a hostile takeover. Because some would-be acquirers are no doubt scared o by thestaggered board, the Bebchuk, Coates, andSubramanian fndings likelyunderestimatethe ability o a classifed board to resist take-overs. Bebchuk and Alma Cohen (2005) fndthat frms with staggered boards have lower

value than other frms, using Tobins Q as a

measure o value. Finally, Faleye (2007) fndsthat a staggered board lowers the sensitivityo CEO turnover to frm perormance.

An implication o the view that staggeredboards entrench managers and decrease

value is that when frms destagger, returnto annual elections or all directors, valueshould increase. Re-Jin Guo, Timothy A.Kruse, and Tom Nohel (2008) consider asample o frms that destagger and fnd thatthe value o these frms does, in act, increase.They also fnd that destaggering is not typi-cally initiated by managers, but by activistshareholders. Subsequent to the destagger-ing, investor reaction indicates that thesefrms are more likely to be takeover targets.All o these fndings reinorce the view thatstaggering boards is a mechanism that servesto protect management by making takeoversdifcult.

All in all, it appears that frms with stag-

gered boards do worse than frms withannual board elections. O course, someo this eect could be due to endogeneity;frms with already entrenched managers aremore likely to be able to convince sharehold-ers to adopt staggered boards. Or, to take aless sinister view, those managers who provethemselves are in a position to bargain orgreater ob security as part o an optimal(second-best) bargain or their continued

service (and those who ail to prove them-selves become vulnerable to destaggeringand takeover). In this light, stock-marketreaction to announcements about whetherthe board will be staggered or not could bedue to the news such announcements convey

vis--vis the bargaining toughness and inde-pendence o the board rat

adams hermalin and weisbach (2010) jel

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