A Conceptual Framework and Survey

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American Economic Association

The Role of Boards of Directors in Corporate Governance: A Conceptual Framework andSurveyAuthor(s): Renée B. Adams, Benjamin E. Hermalin and Michael S. WeisbachSource: Journal of Economic Literature, Vol. 48, No. 1 (MARCH 2010), pp. 58-107Published by: American Economic Association

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Journal fEconomicLiterature010,48:1,58-107

http:www.aeaweb.org/articles.php?doi=10.1257/jel.48.1.58

TheRoleofBoardsofDirectorsnCorporate overnance: Conceptual

FrameworkndSurveyRenée Β.Adams, enjamin . Hermalin, nd Michael S.Weisbach*

Thispaper s a surveyf he iteraturen boards fdirectors, ith n emphasisn

research onesubsequento theBenjamin . Hermalin nd MichaelS. Weisbach(2003)survey. he twoquestionsmost sked about boards re whatdeterminestheirmakeupndwhat eterminesheir ctions? hese uestionsre undamentallyintertwined,hich omplicateshe tudy fboards ecausemakeupnd actions rejointly ndogenous.focus f his urveys how he iterature,heoreticals well sempirical,eals or on occasionsails o deal with his omplication. e uggestthatmanytudiesfboards an best e nterpreteds oint tatementsbout oth hedirector-electionrocessnd the ffectfboard ompositionn board ctions ndfirm erformance.JELG34,L25)

1. Introduction

Peopleoften uestionwhetherorporate

boardsmatter ecause their ay-to-dayimpacts difficultoobserve. utwhenhingsgowrong,heyanbecome he enterf tten-tion.Certainlyhiswas trueof theEnron,Worldcom,ndParmalatcandals. hedirec-tors fEnron ndWorldcom,nparticular,wereheld iablefor hefraud hat ccurred:Enrondirectors ad topay$168milliono

*Adams: University f Queensland and ECGI.Hermalin:UniversityfCalifornia, erkeley.Weisbach:Ohio StateUniversity.he authors ish o thank i-WoongChung,Rüdiger ahlenbach, liezerFich,JohnMcCon-nell,Léa Stern,René Stulz,and Shan Zhao forhelpfulcomments n earlierdrafts. he authors re especiallyappreciativefthecomments eceived rom hree nony-mousrefereesnd theeditor, ogerGordon.

investorlaintiffs,fwhich 13million asout fpocketnot overedy nsurance);ndWorldcomirectors ad topay$36million,ofwhich 18million as outofpocket.1 sa consequencef hese candals ndongoingconcernsbout orporateovernance,oardshavebeen at thecenter fthepolicy ebateconcerningovernanceeformndthefocusof considerablecademic esearch. ecauseof thisrenewednterestnboards, reviewofwhatwe have nd havenot earned rom

researchncorporateoards stimely.Much of the research n boards ulti-matelyouches n thequestionwhat s therole ofthe board?"Possible nswers angefrom oards'being implyegalnecessities,

1MichaelKlausner,Bernard S. Black,and Brian R.Cheffins2005).

58

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Adams,Hermalin,ndWeisbach: heRoleofBoards fDirectors 59

somethingkinto thewearing fwigs nEnglish ourts, o theirplayingn active

partntheoverall

managementnd control

of thecorporation.o doubt he truthiessomewhereetween hese xtremes;ndeed,therereprobably ultipleruths hen hisquestions asked fdifferentirms,ndiffer-ent ountries,r ndifferenteriods.

Given hat ll corporationsaveboards,thequestion f whether oardsplay rolecannot e answeredconometricallys thereis no variationn theexplanatoryariable.Instead, tudies ook at differencescrossboardsand ask whether hesedifferencesexplain ifferencesn thewayfirms unc-tion nd howthey erform.he boarddif-ferenceshat newouldmost ike ocaptureare differencesn behavior. nfortunately,outsidefdetailed ieldwork,t sdifficultoobserve ifferencesnbehavior nd harderstill oquantifyhemna way seful or ta-tisticaltudy. onsequently,mpirical orkin thisarea has focused n structuralif-ferencescross oards hat represumedocorrelate ithdifferencesn behavior. or

instance,commonresumptions that ut-side nonmanagement)irectors illbehavedifferentlyhan nsidemanagement)irec-tors.One can then ook at theconduct fboards e.g.,decision o dismiss heCEOwhenfinancial erformances poor)withdifferentatios f outside o insidedirec-tors o see whetheronduct ariesn a sta-tisticallyignificantannercross ifferentratios.When onducts notdirectlybserv-able e.g., dvice o theCEO about trategy),one an ook ta firm'sinancialerformanceto see whetheroard tructure atterse.g.,theway ccountingrofitsary ith heratioof utsideo nside irectors).

Oneproblemonfrontinguch nempiri-cal approachs that here s no reason osuppose board structure s exogenous;indeed,herereboth heoreticalrgumentsand empirical videnceto suggest oardstructuresendogenoussee,e.g.,Hermalin

and Weisbach 988,1998,and2003).Thisendogeneityreates stimationroblemsf

governancehoices remadeon thebasisof

unobservablesorrelatedith he rror ermintheregressionquations eing stimated.Infact,neof urmain ointsn his urveysthe mportancefendogeneity.overnancestructuresriseendogenouslyecause eco-nomic ctors hoose hemnresponseo thegovernancessues hey ace.2

Beyondhe mplicationsndogeneityoldsfor conometricnalysis,t also has mplica-tions or ow oview ctual overnancerac-tice. n

particular,henwe observewhat

appears o be a poorgovernancetructure,weneed o skwhyhat tructureas hosen.Althought s possible hat hegovernancestructure as chosen ymistake,ne needstogive t east omeweighto thepossibilitythattrepresentsheright,lbeit oor, olu-tion othe onstrainedptimizationroblemtheorganizationaces.Afterll,competitioninfactor,apital,ndproductmarketshouldlead, n Darwinian ashion,o thesurvivalof hefittest. hile dmittedlyfittest"oes

notmean optimal,"nythinghatwas sub-optimal orknown easonswouldbe unfitinsofarstherewould epressureo addressthese reasonsforsuboptimality.n otherwords, xistinguboptimalitys unlikelyolend tselfoquick robvious ixes.

This nsightbout ndogeneitys,however,easyto forgetn the face of data.Figureshows plotof two data points.3 n the

2Harold Demsetz and Kenneth Lehn (1985) were

among he firsto make hegeneral oint hat overnancestructures re endogenous.Otherswho have raised itincludeCharles P. Himmelberg, . GlennHubbard, ndDarius Palia (1999), Palia (2001), and Jeffrey. Coles,MichaelL. Lemmon, ndJ.FelixMeschke 2007). Thepointhas also been discussed n various urveys f theliterature; onsider, .g., Sanjai Bhagatand Richard H.Jefferis2002) and MarcoBecht, atrick olton,nd AilsaRöell 2003),among thers.

3Figure 1 is presented or llustrativeurposesandshouldnot be read as a critique fanyexisting esearch.In particular, oneofthestudiesdiscussedbelow are asnaive s figure .







60 JournalfEconomic iterature,ol.XLVIII March 010)

Financialperformance

' ''Firm 1

''

''

''

''

''

^ Firm 2'

'

Governanceattribute

Figure .Relation etween Specific irmAttributendFirmFinancialPerformance

horizontalxis s an attributefgovernance(e.g.,boardsize).On the vertical xis s ameasure ffinancialerformance.nefirmhas more f he ttributeutweaker erfor-mance,while he other irm as less of theattributeutbetter erformance.regres-sion ine hroughhepoints nderscoresheapparent egativeelation etween ttributeandperformance.ithout urthernalysis,onemightetemptedoconclude hat firmwoulddo betterf t shrank hesize of tsboard.Theproblem ith uch conclusion

isthat t fails oconsider hy largeboardmightavebeenchosennthefirstlace.Figure2 replicates igure , but it also

shows heoptimizationroblems acedbythe wo irmsnquestion. bservehat,/orgiven irm,here s a nonmonotonicelationbetween heattributendfinancialerfor-mance.nparticular,herelations concaveand admits ninterior aximum. oreover,each of the twofirmss at its maximum.

Consequently,hereas irm wouldpreferceterisaribusobe onFirm 'scurve,t sn'tand, hus,woulddo worse han t sdoingfitwereto shrinkts board n line with henaive onclusion rawn rom heregressioninfigure.

Figures1 and 2 illustratenotherssueconfrontinghe tudyfgovernance,amelyheterogeneityn he olutionsirmshoose ortheirgovernanceroblems.4s illustrated,

4To be sure,a real empirical tudywould attempt,in part,to control or uchheterogeneityy puttingnother ontrols,ncluding,f he datapermitted,irm ixedeffects.t should e noted,however,hat i) there an stillbe a problemwith hespecificationf he attributentersinto hespecificationnly inearlyas opposedto nonlin-early s suggested ytheparabolas n figure ); and (ii)ifdifferentirms acedifferentlyhapedtrade-offse.g.,iftheparabolas ren't he sameshapefor ll firms),henthe coefficientsn theattribute,ts quare, tc.,willvaryacrossfirms,uggestingrandom-coefficientspproachswarranted. ee Hermalin nd NancyE. Wallace (2001)andBhagat ndJefferis2002) for discussion f ome ofthesemethodologicalssues.







Adams,Hermalin,nd Weisbach: heRoleofBoards fDirectors 61

Figure . The Real DecisionsFacedby he Firms

Firms1 and 2 facedifferentovernanceproblemsnd,notsurprisingly,re drivento differentolutions.lmostverymodel fgovernancehows hat heequilibriumut-come s sensitiveo ts xogenousarameters;consequently,eterogeneityn those aram-eterswill ead toheterogeneitynsolutions.Moreover,nce onetakes nto ccount ari-ous sources fnonconvexity,uch as thosearisingn optimal ncentivechemes, nemayfind hat trategiconsiderationsead

otherwisedentical irms o adoptdifferentgovernanceolutionssee, e.g., Hermalin1994).

Somehelpwiththeheterogeneityssuecouldbe forthcomingrommore heoreti-cal analyses. lthough common and notnecessarilynaccurateperception f theliteraturencorporateovernance,articu-larly elatedo boards fdirectors,s that tis largelympirical,uch viewoverlooks

largebodyofgeneral heoryhat s readilyapplied o thespecific opic f boards.Forinstance,monitoringy the board wouldseem to fit ntothe general iteraturenhierarchiesnd supervisione.g.,OliverE.Williamson975;Guillermo . Calvo andStanislawWellisz1979;Fred Kofman ndJacquesLawarrée1993,JeanTirole1986;Tirole1992).As a second xample,ssues fboard collaboration ouldseem to fit ntothegeneraliteraturenfree-ridingnd the

teamsproblemsee,e.g.,BengtHolmstrom1982).The teams-problemxampleserves to

illustrateproblemhat an arise napply-ing off-the-shelf"heoryoboards.t s wellknownhat, s a member'share f team'soutputalls, e or he uppliesess ffort.orboards, owever,hequestions not singledirector'sffort,ut whathappens o totalefforte.g.,are larger oards ess capable








monitors ecause of the teamsproblem)?Yet,here, heoryannot rovide definitiveanswer whether otal

equilibriumffort

increases r not withboard size dependscriticallyn assumptionsbout functionalforms.5 hile"anythingoes"conclusionscan be acceptablenan abstractheoreticalmodel,heyreofteness han atisfactorynappliedmodeling.he ack f lear efinitivepredictionsn much f the related eneraltheorys,therefore,hindrance o model-inggovernancessues.Conversely,fa spe-cificmodel makesa definitiverediction,then necan often e leftwonderingf t s

an artifactfparticularssumptionsatherthan reflectionf robust conomicruth.

A second, elated oint s that,n a sim-ple, ndthus ractable, odel,heoryan betoostrong;hat s,by applicationfsophis-ticated ontracts r mechanisms,hepar-ties e.g., irectorsndCEO) canachievemore ptimalutcomehan ealityndicatesispossible. oanextent,hat roblemanbefinessed;ornstance,fonerestrictstten-tion o incompleteontracts. ut as others

havenoted, he assumptionf incompletecontracts an fail to be robust o minorperturbationsf the informationtructure(Hermalinnd Michael . Katz1991) rtheintroductionf a broader lass of mecha-nismsEricMaskin ndTirole 999).

A furtherssue s thatcorporationsrecomplex, et, o haveany raction,modelmust bstractwayfrommany eaturesfreal-lifeorporations.hismakes t difficulttounderstandhe omplexnd multifaceted

solutionsirms se to solve heir overnanceproblems. or instance, he optimalgov-ernance tructuremightnvolve certain

5For instance, f a team's total benefit s Σ^=1 en,whereen is the effort f agentn, each agent gets 1/Nof thebenefit,nd eachagentn'sutilitys (Σ^=1 em)/N(e,T+I)/(7 1), then totalequilibrium fforts N{l/N)l/'which s increasingn Ν if 7 > 1, decreasing n Ν if7 € (0, 1),and constantf7 = 1.

type fboard, peratingna certain ashion,having mplemented particularncentive

package,nd

respondingncertain

wayso

feedback romherelevantroductnd api-tal markets.o include ll thosefeaturesna model s infeasible,ut an weexpect heassumptionf eteris aribus ith espectothenonmodeledspects f he ituationobereasonable? heconstrainednswer rrivedatbyholdingll elseconstant eed notrep-resent heunconstrainednswerccurately.

Yet another oint,relatedbothto thepreviouspoint and to our emphasisonissuesofendogeneity,s that,motivatedyboth desire osimplifynd to conformoinstitutionaletails, he modeler s oftentemptedotakecertain spects f thegov-ernance tructure s given.The problemwith his s thatthegovernancetructureis largelyndogenous;t is, in itsentirety,thesolution eached yeconomic ctors otheir overnance roblems. fcourse, er-tainfeatures,uch s thenecessityfhavinga boardofdirectors,an largelye seen asexogenous althought shouldbe remem-

bered hat he decisiono make companya corporationatherhan, ay, partnershipis itselfndogenous).urthermore,hetim-ingofevents, articularlynthe short un,can make treasonableo treat ome spectsof hegovernancetructuresexogenousorthepurposes f nvestigatingertain ues-tions heoretically.

Inthis urvey,e focus rimarilyn workthat llustrateshe sorts fchallenges is-cussedabove,papersthathelp clarifyhe

nature fboardbehavior,r thatuse novelapproaches. e alsoattemptoput heworkunder the same conceptualmicroscope,namelyow houldheresults e interpretedin light fgovernancetructureseing hesecond-bestolutionothegovernancerob-lemsfaced y hefirm. ur focus s also onmore ecent apers, ven f hey re notyetpublished, ecauseprior urveys y KoseJohn nd Lemma W. Senbet 1998) and








Hermalin nd Weisbach2003)covermanyestablishedapersnthis ield. lthougheaim obe

comprehensive,twould e

impos-sibleto discuss very aper n light f therecentxplosionnthe iteraturenboards.6Of necessity, e omitmany nterestingpapersnthis rea andweapologize o theirauthorsn advance. For a more detaileddiscussion f theevent-studyvidence ur-roundingoard ppointments,e refer hereader o DavidYermack2006).M.AndrewFields ndPhyllis .Keys 2003)review hemonitoringoleoftheboard, s well s theemergingiteraturen boarddiversityseealso David A. Carter, etty .Simkins,ndW.Gary impson003;Kathleen . FarrellandPhilipL. Hersch 005; and RenéeB.Adams nd Daniel Ferreira 009 on boarddiversity).e do notdirectlyiscuss irec-tor urnover;ermalinndWeisbach2003)review ome of the relevantiteraturenthis opic.7or he ake fbrevity,e do notdiscuss he iteraturen boards f financialinstitutions.ecausethis s a surveyfcor-porateboards,we also do not discuss he

literaturenboards forganizationsuch snonprofitandcentral anks. artlyecauseofthedifficultyn obtainingata,this it-eratures lessdevelopedhan he iteratureon corporate oards WilliamG. Bowen1994 discusses omeof thesimilaritiesnddifferencesetweencorporate nd non-corporateoards).8imilar ata limitationsrestricts to a discussionfboards fpub-licly raded orporations.inally, e do not

6Afterearchinghe iterature,e estimate hatmorethan 200 working aperson boards were writtenn thefirstive ears ince Hermalin nd Weisbach2003) pub-lished heir oard urveynocausal ink s mplied).

7See also Eliezer M. Fich and Anil Shivdasani2007),TodPerrynd Shivdasani2005),and Yermack2004),forsomerecentworknthis rea.

8Also see Hermalin 2004) for discussion f howresearch n corporate oardsmay nform he study funiversityndcollegeboards.James . Freedman 2004)discusses he relation etweenuniversitiesnd colleges'boards nd their residents.

consider tudies hatcomparegovernanceinternationally.

Althoughhis

survey rimarilyonsid-

ers the economics nd financeiteratures,boards are a subjectof interestn manyother isciplines,ncludingccounting,aw,management, sychology,nd sociology.9While heres anoverlapntheseiteratures,there re alsodifferences.or nstance,heeconomics nd financeiterature'socus astraditionallyeen on theagency roblemsboards olve r,nsomenstances,reate.ncontrast,hesociologicalnd managementliteratureslso emphasize hatboardscan(i)play role nstrategyettingnd ii)pro-vide critical esourceso thefirm,uch asbuildingetworksndconnectionssee, .g.,Sydney inkelstein, ambrick,nd AlbertA.Cannella 009).Someof he opics revi-ouslynthedomain fother isciplinesrebeginningo be of nterestnthe econom-ics and financeiterature.orexample,hisliteratureasbegun o ncorporatessues fexpertise,rust, iversity,ower, nd net-worksnto heirnalyses.10

The next ection onsiders hequestionofwhatdirectors o. The section ollowing,section , considersssuesrelated o boardstructure.ection4 discusseshow boardsfulfill heirroles. Section5 examines he

9Some examplesof this broader iterature ncludeLucian A. Bebchuk ndJesseM. Fried 2004),Ada Demband F. FriedrichNeubauer 1992),AnnaGrandori2004),Donald C. Hambrick, heresa Seung Cho, and Ming-JerChen (1996),JayW. Lorsch 1989),MylesL. Mace

(1971),Jeffreyfeffer1972),MarkJ.Roe (1994),JamesD. Westphal ndEdwardJ. ajac (1995),Westphal1999),andZajac andWestphal1996).

10 orresearch rom n economic erspectiven direc-tordiversity,ee Carter,Simkins, nd Simpson 2003),Farrell and Hersch (2005), and Adams and Ferreira(2009).Director xpertises discussednfransection .3.Someaspectsofpowerrelated o boards are capturednHermalin nd Weisbach 1998); see RaghuramG. Rajanand Luigi Zingales 1998) for moregeneral conomicanalysis fpower norganizations.ee Asim jaz Khwaja,AtifMian and AbidQamar 2008) forwork n thevalue oa firm reated y tsdirectors' ocial networks.







64 JournalfEconomie iterature,ol.XLVIII March 010)

literaturen whatmotivates irectors.Weendwith ome oncludingemarks.

2. WhatDo Directors o?

To understand orporateboards, oneshould eginwith hequestion fwhatdodirectorso?11

2.1 Descriptivetudies

Oneway o determine hatdirectors oisto observe irectors;hats,do field ork.There s a large

descriptiveiterature n

boardse.g.,Mace1971;Thomas . Whisler1984; Lorsch1989; Demb and Neubauer1992, ndBowen 994).

The principalonclusionsfMace werethat directorserve s a sourceofadviceandcounsel,erve s some ort fdiscipline,and act in crisis ituations"fa change nCEO becomes ecessaryp.178). henatureof their adviceand counsel" s unclear.Mace suggestshat board serves argelyas a soundingoard for he CEO andtopmanagement,ccasionallyrovidingxper-tisewhen firmaces n issue boutwhichone ormore oardmembersreexpert. etDemb and Neubauers urvey esults indthatapproximatelywo-thirdsf directorsagreed hat settinghe trategicirectionfthecompany" asone of the obsthey id(p. 43, emphasis dded).12 ighty ercentofthedirectorslso agreed hat heywere

11 his question s distinct rom hequestion fwhatshoulddirectors o? This secondquestion s answered,inpart, ythe egalobligationsmposedbycorporateaw(both tatute ndprecedent), aving o do withfiduciaryobligationssee, e.g.,Robert C. Clark 1986, especiallychapters and4).

12 t s mportanto note hat heDemb andNeubauersurveys nd questionnairesampleveryfewAmericandirectors4.2percent). hetopfour ationalitiesurveyedby hem reBritish29.6percent), erman11.3percent),French11.3percent),ndCanadian 9.9percent). verall43.7percent f heir espondentsome fromommon-lawcountries.

"involvedn setting trategyor he com-pany" p.43).Seventy-fiveercentfrespon-dents o another fDemb and Neubauersquestionnaireseporthat heyset trategy,corporateolicies,verall irection, ission,vision"p.44). Indeedfarmore espondentsagreedwith hat escriptionf heirobthanagreedwiththe statementshattheirobentailedoversee[ing],onitor[ing]opman-agement, EO" (45 percent); succession,hiring/firingEO and top management"(26percent);r servings a "watchdogorshareholders,ividends"23percent).

Thedisciplinary

ole of boards s alsounclearfromdescriptivetudies.Perhapsreflectingheperiodhe studied,Mace sug-gests hatdisciplinetemsargelyromheCEO and other op managementnowing"that eriodicallyheymustppear eforeboardmade p argelyf heir eers"p.180).Lorsch akes n evendimmeriew,uggest-ing hat oards re sopassive hat hey fferlittle yway fdisciplinesee,especially,.96). Demb and Neubauers tatisticseembroadlyonsistentith his iew,s ess han

half of theirrespondentsgreethattheirjob is to"oversee,monitoropmanagement,CEO" and less than a quarter greethattheirob s toserve s a "watchdogor hare-holders,ividends"p.44).

On theother and,thas beensuggestedthat he boardpassivityescribed yMaceand Lorsch s a phenomenonfthepast.For nstance, aul W. MacAvoyndIra M.Millstein1999) suggest hat boardshaverecentlyecome esspassive; hat s, theyhave volvedromeingmanagerialubber-stampso active nd ndependent onitors."MacAvoynd Millstein rovide tatisticalevidence nsupportf hat onclusion,ind-ing hatCalPERS' gradingf firm'soardprocedures s positivelyorrelatedwithaccounting-basedeasures fperformance.Another iece ofevidence onsistent iththeviewthatboardshavebecome ougheris thatCEO dismissal robabilitiesave








beentrendingpwardseeMarkR. Huson,Robert arrino,ndLauraT.Starks001forevidence ver he

period1971to 1994 and

see StevenN. Kaplanand Bernadette .Minton006 formore ecentvidence).2.2 TheHiring, iring,nd Assessmentf

ManagementOne role that is typicallyscribed to

directors s control of the process bywhich opexecutivesre hired, romoted,assessed, nd, fnecessary,ismissedsee,e.g.,Richard . Vancil 987for descriptiveanalysisnd LalithaNaveen 006 for tatis-tical vidence).

Assessmentan be seen as having wocomponents,neismonitoringfwhat opmanagementoes nd he thers determin-ing he ntrinsicbility f opmanagement.Themonitoringfmanagerialctions an,inpart, e seen as part f board's bliga-tion o be vigilantgainstmanagerialmal-feasance. et,beingrealistic,t is difficultto see a boardactually eing n a positionto detectmanagerialmalfeasance irectly;atbest, boardwould eemdependentnthe actions f outside uditors,egulators,and, in some instances,he news media.Indirectly, board mightguard againstmanagerialmalfeasancehroughts choiceof auditor, ts oversight ver reportingrequirements,nd tscontrolver ccount-ingpractices.

The principal ocusof the literaturenassessment,t east t a theoreticalevel, asbeenon the uestionfhow heboard eter-

minesmanagerialbilityndwhat tdoeswiththatnformation.13ne strategyor tudyingthequestion fabilityssessment as beenthe daptationfHolmstrom's1999)model,whichnalyzes gencyndmonitoringhen

13Typically,he CEO is a member f the board. Instatinghe CEO is atodds with theboard,"we are, ikethe iterature,sing heboard as shorthand or he boardminus heCEO.

agentsave areeroncerns,oboards.Withinthat pproach,uthors avefocusedn howthe ssessmentf

bilityelates o the

poweroftheCEO (e.g.,Hermalin ndWeisbach1998); othe electionfprojectsnd trategy(e.g.,SilviaDominguez-Martinez,tto H.Swank,ndBaukeVisser008); o he rocessofselectinghe CEO (e.g.,Hermalin005);amongtherssues.

2.2.1Assessment,argainingower,ndCEO Control

The first rticleto applyHolmstrom'sframeworko boardswas Hermalin nd

Weisbach1998). In theirmodel, here san initial eriod ffirmerformancenderan incumbent EO. Based on thisperfor-mance, he boardupdates tsbeliefs boutthe CEO's ability.n light ftheseupdatedbeliefs,heboardmay hoose o dismissheCEO and hire replacementrom hepoolofreplacementEOs or tmay argain iththe ncumbentEO with egardochangesinboardcompositionnd his futurealary.Theboard, hen, hooseswhethero obtain

an additional,ostly ignal boutCEO abil-ity eitherhat f theoriginalncumbentfretainedr hereplacementfhired).14asedon this ignal,fobtained,he board gainmakes decisionboutkeepingrreplacingthe CEO. If replaced, (another) EO isdrawn rom hepoolofreplacementEOs.Finally,econd-andfinal-)eriod rofitsrerealized, ith he xpectedalue f heprof-itsbeing positive unctionf the then-in-charge EO's ability.

The board's nclinationo obtain n addi-tional ignals a functionf ts ndependence

14An alternative, ut essentially quivalent,model-ing strategyor his tagewouldbe to assume the boardalwaysreceives he additional ignal,but the board hasdiscretion ver the informativenessf the signal,withmore nformativeignalsbeing ostlier o theboard thanless informativeignals.See the discussionn Hermalin(2005) on thismatter.








fromheCEO.15 heboard'sndependencetthat tagewilldepend n theoutcomef he

bargainingamebetween heboard ndthe

incumbentEO ifhe isretained.16ecausetheacquisitionf the additionalignal anonlyncrease herisk fbeing ismissedndthe CEO enjoys noncontractibleontrolbenefit,heCEO prefersless ndependentboard; hat s,a board ess ikelyoacquirethis dditionalignal. he board,however,preferso maintaints ndependence. henthe CEO has bargaining ower specifi-callywhenhe has demonstratedhathe's a"rare ommodity"y performingell theboards independenceeclines. ntuitively,a CEO whohas shown imselfo be aboveaveragebargains n two dimensions: ecan bargainfor morecompensationnd,because he preferso remainCEO ratherthan efired,hedegree f heboard inde-pendence. tanymomentntime, iventsmarginalateof substitutionetween irmperformancenddisutilityfmonitoring,boardviews tself s optimallyndependent(i.e., he directorsiew ny hangentheir

compositionhatmayeadtomore r essdil-igencenmonitoringsmovingt way romthe ncumbent oard'soptimum).17ence,a local change n independence epresentsa second-ordeross for he board thetopofthehill s essentiallylat), hereas s anincreasenthe CEO's salarys a first-orderloss themarginalostof a dollar s alwaysa dollar). heboard, herefore,s morewill-

15Independences a complexoncept.With especttomonitoringheCEO,one magineshat irectorshohave lose ies o theCEO (e.g., rofessionally,ocially,or because heCEO haspower ver hem)would indmonitoringimmoreostlyhan irectorsith eweries(althougheeWestphal999for nopposingiew).Wediscussndependencet engthnfra.16HermalinndWeisbachssume here s sufficientcompetitionmongpotential eplacementEOs forthepositionhat replacementEO hasnobargainingpower. heirmodelwould e robustogiving replace-ment EO some argainingowers long s itwas essthan hatnjoyedy n ncumbentEO who s retained.

ingtobudgeon the ssue of ndependence(willingnessomonitor)han alary,t least

initially;ence, here s movementninde-

pendence.o a CEO who erformsell ndsup facing less ndependentoard.Theflipside s that CEO whoperformsoorlysvulnerableoreplacement.

MalcolmBaker and Paul A. Gompers(2003),AudraL. Boone et al. (2007),andHarley . Ryan ndRoyA.Wiggins2004)each find vidence onsistent ith he deathat uccessful EOs are able tobargain orless independentoards.Boone et al. findthat ariables hat rereasonablyssociatedwithbargainingower ither or he boardor the CEO are significantnd have theright ign. n particular, easures f CEObargaining ower, enure, nd the CEO'sshareholdings,renegativelyorrelated ithboardndependence.he tenure indings,nparticular,reprecisely hat he Hermalinand Weisbach model predicts.Measuresthat ndicate hat heCEO hasrelativelyessbargainingower,ncludingutside irectorownershipnd thereputationfthe firm's

investmentanker tthe ime f ts PO, areallpositivelyorrelated ith oard ndepen-dence.Similarly,aker nd Gompers indthatmeasures hatreflect he CEO's bar-gaining ower,ncludingn estimatef theCEO'sShapleyalue nd he eputationf hefirm'sentureapitalists,ave hepredictedsigns negativeor heformerndpositiveorthe atter) ith especto thepercentagef

17 or instance,f the board's ctions re deter-minedby a median-voter odel, hen the incum-bent median director voter)knows that moni-toringwill be optimalfrom her perspectivefthere s no change n boardcomposition.f, how-ever, ompositionhangeso that he s no ongerhemedian irector,hen he evelofmonitoringill nolongerbe optimalfromher perspective.rovided,though,hat he tastes f the new mediandirectorrangeon a continuumrom he incumbent ediandirector's,henhaving new mediandirector ithonly slightly ifferentastes than the incumbentrepresents second-ordeross for the incumbent.








non-insideirectorsn theboard.At oddswith heHermalin ndWeisbachmodel ndunlike oone tal.,Baker nd

Gompersind

apositive albeit tatisticallynsignificantrelationshipetween EO tenure ndper-centagefnon-insideirectors.inally, yanandWigginsind hat CEO's paybecomesless inked oequity erformanceshis on-trol ver heboard ncreasesproxied yhistenurendtheproportionf nsiders).heseauthorsnterprethese indingss consistentwith heHermalinndWeisbachargainingframework,ecause t uggestshat s CEOsbecomemore

owerful,heyse this

owerto improveheirwell-beinge.g., s here,where his ower llows hem o reduce hevolatilityf heirompensation).

Baker and Gompers, oone et al., andRyanndWigginsre ll ensitiveo he ssuethat overnancetructuresreendogenous.Baker ndGompers,nparticular,rovideconvincingolutiono theproblem y den-tifyinglausiblenstrumentsor he ndoge-neous ariablentheirpecification,enturecapitalfinancing,hese nstrumentseingthe tate f perationnd time ummyhatcaptures xogenous apital nflows o ven-ture apital unds. etnoneofthesepaperssheds ightn whetheruccessful EOs areable tobargain or less ndependentoardwithin hesamefirm,ecausethey ll relyon analyses f repeated ross-sectionsfdata rather hanpaneldatawith irmixed-effects.heddingmore irectmpiricalighton thedynamic ature f theCEO -boardrelationshipithin irms emains n inter-

esting opic or uture esearch.2.2.2 AssessmentndProjectelection

Dominguez-Martinez,wank, nd Visser(2008) is a model imilar o Hermalin ndWeisbach1998).A keydifferenceetweenthe two is that, n Dominguez-Martinez,Swank,ndVisser,t s theCEO whodeter-mineswhat nformationhe board earns.An interpretationfDominguez-Martinez,

Swank, nd Visser'smodel s that here retwopossible ypes fCEO, goodand bad.In each of two

productiveeriods,CEO

draws project trandom rom distribu-tion of differentrojects conditionalnCEO ability,achperiod's raw s an inde-pendentvent). hink f achproject eingsummarizedy tsnetpresentalue NPV).The differenceetween he twotypesofCEOs is that the distributionfprojects(distributionfNPVs o beprecise)sbetterfor hegood type han the bad type e.g.,thegood type's istributionominateshebad

type'snthe ense ffirst-ordertochas-

ticdominance).The CEO sees the stamped" PV on the

project e draws,whereas he board doesnot. n the econd final) eriod, heCEO'sincentivesre suchthathe implementsheproject e drawsf ndonlyf thas positiveNPV. n thefirsteriod, owever,heCEO'sincentivesrepossiblymisaligned ith hatof he hareholders:heCEO valueskeepinghis ob. If hisfirst-periodctions rperfor-mance ead thedirectorso infer e is the

badtype nd theboard s not ommittedoretain im, henhe willbe dismisseds it sbetter o draw gainfrom hepoolofCEOsthan o continue o the secondperiodwitha CEO who s known o be bad.TheCEO'sconcern boutretaining is job makes ttempting,herefore,or im o avoid isk ohisreputationynotpursuingvenpositiveNPVprojectsnthefirsteriod.

One potentialolution ouldbe for heboard to commit o retain hefirst-periodCEO for he econd eriod.With hat om-mitment,EOs would hooseonly ositiveNPVprojectsnthefirsteriod. his,how-ever,s notnecessarilyptimal ecausethedirectorsre throwingway heoption oreplace heCEO if heynfer e islikelyobe bad. That s, s is also notednHermalinandWeisbach,heabilityoreplace CEOa board nferssprobablyadcreates valu-able realoption or hefirm.








Figure . IllustrationftheDominguez-Martinez,wank, ndVisser2008) Model

Notes:TheprobabilityensityunctionsverNPV are shown or he two ypes. rom n informationaler-spective,heCEO should e retainedf ndonlyf he realizedvalue of projects aboveυ1. f,however,°denotes heprojectwith nNPV= 0,then heboard, o imit irst-periodosses,maywish o commit oretaintheCEO if ndonlyf he realizedvalue s above somecutofftrictlyetween l and u°.

Given thatgood-type EOs are morelikelyohave ositive PVprojectshan adtypes,n alternativetrategyor he boardwould be to commit o dismiss he CEOonlyfhedoesn't ndertakeproject. his,however,s notwithoutostbecause nowCEO couldbewillingoundertakenega-tiveNPVprojectf t snot o bad that hedisutilityesultingromursuingheprojectoutweighsisutilityrometainingis ob.18

Underhis overnanceule, omenumber fnegative PVprojects illbepursued.A third trategy ight e for he board

to commit o keep the CEO only f he

18Dominguez-Martinez,wank, nd Visser ssume aCEO's first-periodtilityunctions π + λχ,whereπ isthe returnsrom hefirst-periodroject, > 0 is his ben-efit fkeeping is ob,andχ € {0,1) ndicateswhether eloses orkeepshis ob, respectively.

undertakes positiveNPV project.Thismighteemoptimal,nsofars it voids eg-ativeNPVprojectsnd allows ome earn-ing,but couldneverthelesse suboptimal:howmuch s learned bout he CEO's abil-ity epends ntherelativeikelihoodfthetwotypeshaving rojects ith particularNPV. t s possible,herefore,hatf givenNPV is more ikely rom good type hana bad type, hen tcould be worth aving

thatproject ndertakenven ftheNPVisnegativeecause eeing heproject rovidesvaluable nformationbout heCEO's abil-ity. onversely,f givenNPV s moreikelyfrom bad type han goodtype, hen tcould be worthwhileismissinghe CEOfollowingherealizationftheprojectvenif ts NPV is positive. igure3 illustrates.Purelyromheperspectivef ptimalnfer-ence,the board hould etain CEO ifhe








hasa projectwith nNPVabovevl and dis-miss im therwise.f,however 1 0 = υ°,thenthis cutoff

mplies irst-periodosts.

Trading ff hesefirst-periodostsagainstthe value of information,he boardmaywish o set a cutoff,c,between 1 nd ν ;thats, CEO keepshis obif ndonlyfheundertakes project nd thatproject aysofft eastvc.

Dominguez-Martinez,wank,nd Visserobserve hat heirmodeloffers possibleexplanationorwhy vidence f poordeci-sionmaking" oes not lwaysead toCEOdismissal. ometimest is optimal o let aCEO pursuea bad strategyather hanstick o the status uo (i.e.,better opur-sue a negative PVproject atherhandonothing) ecause the nformationevealedfrom hat ourse f ction llows heboardtoupdate ositivelybout heCEO's ability.Admittedly,s formulatedere, he samemodelwouldalso explain he dismissal fa CEO aftermoderateuccess fmoderatesuccess s more ssociatedwith owabilitythanhighability.19ominguez-Martinez,Swank,nd Visser'smodel lso suggestsnexplanationorwhy ewCEOs rarelyeemto be ridingwithtrainingwheels whenit comes to managing heircompanies.LimitingCEO's range f ction, hile er-haps way o avoid iskymistakes,lso im-itshowmuch heboard an earn bouthisability. specially arlyn hiscareer,whenrelativelyittle sknown,he xpected alueof nformationan outweighheexpectedcostofmistakes.

2.2.3 Assessmentnd CEO SelectionHermalin2005) is concernedwith he

fact hatnformations more aluablewhena board s seeking o infer heability f a

19Dominguez-Martinez,wank,and Visser do notmake hispoint. his s one of heways ur nterpretationof theirmodel could be said to differ rom heir ctualmodel.

relativelynknownCEO than that of amore stablished eteran.he reasonsthatthe

optiono dismiss

poorly erformingCEO andhire newone s ike nexchangeoption.Consequently,ts value is greater,ceteris aribus, hegreaters the amountof uncertainty.ermalinbuilds on thisinsightoexamine herelationshipetweena board's tructurend tspropensityohirea new CEO from he outside an externalhire)versusfrom he inside an internalhire).Presumablyn internal ire s a bet-ter-knownommodityhan nexternalire,meaninghat n external ire ffersreateruncertaintynd, thus, a greateroptionvalue.An external ire s,therefore, orevaluable eteris aribus.How muchmorevaluable, owever,epends n thedegree owhich he boardwill monitorhe CEO (itsdegree fdiligence).iketheHermalin ndWeisbach1998)model, he boardmakesdecision s tohow ntensivelytwillmonitortheCEO, which s reflectedntheprobabil-itytwillget nadditionalignal orrelatedwith is bility.20ithouthe ignal,heres

nooption alue.Consequently,hevalueofuncertaintybout newCEO isgreaterhemore iligentheboard i.e., hemoreikelyit s toacquire hesignal) nd,therefore,more iligentoard smorewillingo tradeoff ther ttributesorgreater ncertaintythan is a less diligentboard. Hermalinargues hat his nsightffers n explana-tion orwhyhere as been a growingrendtoward othmore xternal ires nd horterCEO tenures:Due to increasedpressure

from nstitutionalhareholders, oregov-ernmentregulations, reaterthreatsoflitigation,nd newexchange equirements,boardshavebecomemorendependentnd

20Alternatively,ndessentially quivalently,hesignalis always bserved, ut tsprecisions an increasingunc-tionof the board'seffortstmonitoring.ee section ofHermalin.








MoreCEO

CompensationMore ceo nsk ^r I 1^S^ required or=> moreCEO >^ À Moré? sk ^^ greater ffortincentive S^ ^ more ^N*.

ySGreater '

incentive ^V^^ value f ι 1 ^^

More I I Greater I °Ption externalM°K

, I Greater. . ^ externalindependent -^* propensity > ceoboards to monitor ^ compensation

^^^ I Moreuncertainty ^^^^^. I =>.more

^^^ceo more ^^^ Τ likelyired ^^^likely o be ^^^ ▼

^^^ Compensationdiscovered low

^^^ Shorter J^^ requiredforability avemge fesjofe

ceo securitytenures

Figure . AGraphical ummaryf he Hermalin2005) Model

diligent.21ence,boards re morewillingto monitor,hich aises he ikelihoodheyhire xternallyor heCEO position.22oremonitoringirectlyaises helikelihood fCEO dismissalnd indirectlyaises t if tleadsfirmso hireCEOs aboutwhom ess sknown.

OneresponsefCEOs to his reater on-itoringressures for hem oworkharder"(which ouldbe interpreteds takingessperquisites).othbecausethey re led towork arder nd theirobs are lesssecure,

21See Huson,Parrino nd Starks2001) and Stuart .Gillanand Starks 2000) for vidence on trends owardgreater oard independencetechnically,oards with agreater roportionfoutsidedirectors)nd the rise ofinstitutionalnvestors.

22See KennethA. Borokhovich, arrino, nd TeresaTrapani 1996), Huson,Parrino, nd Starks 2001), andJayDahya,JohnJ.McConnell, ndNickolaosG. Travlos(2002) for vidence hat heproportionfnewCEO hiresthatare externalhas been increasing;he lastprovidesevidencefor his rend utside heUnited tates.

CEOs willdemand reater ay ncompen-sation.Hence, consequencefmore nde-pendent oards ver ime ouldbe upwardpressurenCEO compensation.23iguresummarizesermalin's odel.24

23AsHermalinnotes, hepositive orrelationetweenboard independence nd CEO pay in time series neednot mply positive orrelationn thecross ection tanypointntime.Hermalin ketches nextension fhismodelthatwouldpredict negative orrelationncross ection,despite positive orrelationver ime. ee his section .

24 t s worth otinghatHermalin s not heonly heo-

reticalexplanation orthe trendtowardmore externalhires and greater EO compensation. evinJ.Murphyand JánZábojník 2006); Murphy nd Zábojník 2004)offer non-boards-basedmodel that takes as its mainpremisethat there has been a declinein the value ofmanagers' irm-specificnowledge elative o thevalue oftheir eneralknowledge. s they how, hiswill ncreasethewillingness ffirms o hireCEOs externally. ivenMurphyndZábojníksmodeling f theCEO labor mar-ket, hisgreaterwillingnessogooutside ranslatesntorise n CEO compensation. ermalindiscusseshow hismodelcan be extended o incorporateheMurphy ndZábojníkmodel, ee hissection .








2.2.4 OtherAssessmentodels

A number f otherpapers

examine hemechanismsssociatedwith the board'sassessment f the CEO. Clara Grazianoand AnnalisaLuporini 2005) also has aboard hat eeks o determineEO ability.Criticalo theirnalysiss thepresence flarge hareholdern theboard, newho swilling obear thecost ofmonitoring,utwho alsogainsprivate enefitsfthecom-panypursues ertain trategiesprojects).Because onlythe large shareholder illmonitor,

heyind here an be advantages

to a dual-boardysteme.g., s inmuch fcontinental urope) because it may beadvantageousodivorcehemonitoringolefromhepower ohave sayover hecom-pany'strategy.avidHirshleiferndAnjanV.Thakor1994) ssume hat oards lwaysreceiveignals seful oassessingheCEO'sability,utboards iffernsofars some relax and someare vigilant. igilant oardsmay hoose ofire he CEO on thebasisofa badsignal. he situationn Hirshleifernd

Thakorscomplicatedy hepossibilityftakeoveridbyan outside artywith nde-pendentnformationboutthe firm; on-sequently,tmaybehoove vigilant oardnotto acton its own nformation,utwaitto see what nformationanbe learned ythepresenceornot)of a takeoverid andtheprice id.This rticlelsoexemplifieshefacthat oard overnancesonly ne ourceofmanagerialisciplinend,more pecifi-cally,tcaptureshenotionhat nternalnd

externalmonitoringan serve s substitutesorcomplements.incent . Warther1998)presentsnothermodel nwhich he boardacquiresnformationboutmanagerialbil-ity. ere,unlike heothermodelswe'vedis-cussed, ach director etsa private ignaland ggregationf nformationscostlynso-far s a director ho ndicates e receivednegativeignal s at risk f osing is boardseat fheprovesobe in theminority.

A recentstrandof the literature asrecognized hat he board'smonitoringfthe CEO can create, n effect,

dangerofopportunismrholdupbytheboard.25Theabilityodismiss heCEO after e hasmadefirm-specificnvestments eanstheboardcan appropriateomeofthe CEO'sreturns,hereby iminishingis originalinvestmentncentives.wopapers n thisstrandare AndresAlmazan and JavierSuarez 2003) andVolker aux (2008). Inboth, wo riticalssumptionsre i) initialcontractsetween oardand CEO canberenegotiatednd (ii) at least somekinds

of boards strongnAlmazan nd Suarez,independentnLaux)cannot ommito notbehaving pportunisticallyr aggressivelyinrenegotiation.

In AlmazanndSuarez, fter eing ired,a CEO can, tpersonalost, ake discreteaction hat aises, ya discretemount,heprobabilityhat given trategyrprojectwill ucceed. his ctions observabley heboard,butnotverifiable,hich reates nopportunityor ater oldup. fterheCEO

takes sinks) is action, profitableppor-tunityor hefirmmay rise hat equiresnew CEO toexploit.f the board s strongenough o fire he ncumbentEO infavorof newCEO, then heboard an usethatpossibilityoobtain alary oncessionsromthe ncumbentecause osing is obmeanshe oses privateenefit.he threat fbeingforced omake uch oncessionsan under-mine heCEO's initialncentiveo take hecostlyction.

To be more oncrete,onsider variationon Almazan and Suarez's dea:26 upposethat the new opportunityas the same

25Opportunismand holdup problemshave beenstudied n a largenumber f areas of economics inceWilliamson1975,1976).

26The actual Almazan and Suarez (2003) model ismorecomplex han what we presenthere. While thosecomplicationseadto a richernd morenuanced nalysis,they re notnecessaryoget he basic dea across.







72 Journal fEconomicLiterature, ol. XLVIII (March 2010)

expectedpayoff s keepingthe incumbentCEO if he took the action and, thus, a

higher xpected payoffhan

keepinghim if

he didn't take the action. Suppose a weakboard will never fire the CEO when theexpectedvalue ofkeepinghimequals thatof the new opportunity,ut can fire himwhen the latter s greater.A strong oard isalways capable offiring he CEO. Assumeit s possible,whenthe threat odismiss heCEO is credible,for he board to capture,in renegotiation,he CEO's privatebenefitof control ndpushtheCEO to some reser-vationutilitycall it0). Hence, a CEO with

a strong oardhas no incentive o take theaction: f the newopportunityoesn'tarise,he retainshis job no matterwhat he did,there s no renegotiation f his compensa-tion, nd he enjoysthe controlbenefit.Butifthe newopportunityoes arise he gets0regardlessof his action; either he is fired,thus denied both pay and privatebenefit,or through enegotiations forceddown toa 0 reservation tilitypayoff). ecause hisultimate ayoffs independent fhis action,

he has no incentive o incur the cost oftak-ingit. The storys,however, ifferentorCEO who faces a weak board. Now, he isstrictlyetteroff fhe has taken the actionand the new opportunityrises: the boardcannotthreaten o firehim,so he contin-ues tocapturerentswage plus privateben-efit). f he didn't take the action and thenew opportunityrose,then he would losebothwage and privatebenefit. f the newopportunityriseswith owfrequency,o it

is efficient or he incumbentCEO to taketheaction, henhaving weak boardwillbebetter hanhaving strong oard.

In Almazan and Suarez, the distinctionbetween strong nd weak boards is a dis-tinctionabout theirbargaining power. InLaux (2008), the board alwayshas all thebargaining owerat therenegotiationtage(can make a take-it-or-leave-itffer o theCEO), but boards differ n theirdegree of

independence.This variation n degree ofindependence acts, however,like a shiftin

bargaining power. Consequently,for

reasons similar to those in Almazan andSuarez, a firm an be betteroffwith a lessindependentboard than a more indepen-dent board.

2.2.5 AdditionalEmpiricalAnalyses fAssessment

There is both anecdotal and statisticalevidence that boards dismiss poorly per-forming EOs. Based on interviews,Mace

(1971) and Vancil (1987) conclude thatboards fire, lbeit oftenreluctantly, oorlyperformingCEOs. There are numerousstatistical nalyses that show poor perfor-mance, measured either as stock returnsor accounting profits, ositively redictsachange nthe CEO.27 Simply ocumentingrelationship etweenpoor performancendan increasedprobabilityf a CEO turnover,although uggestive f board monitoring,snonetheless arfrom onclusive.After ll, a

sense offailure rpressurefrom harehold-ers could explainthisrelationship. o bet-ter identify he role played by the board,Weisbach (1988) interactsboard composi-tionand firm erformancen a CEO turn-over equation. His results indicate thatwhen boards are dominated by outsidedirectors,CEO turnover s more sensitiveto firm erformancehan t s in firmswith

27A problem acing mpiricalwork s thatfirms ftenoffer face-savingationale or change n CEO (e.g.,hewishes to spendmoretime withhis family) ather hanadmit he CEO was forced utfordoinga bad job. SeeJeroldB. Warner,Ross L. Watts, nd Karen H. Wruck(1988),Weisbach 1988),Parrino1997),and DirkJenterand Fadi Kanaan (2008) forfurther iscussions f thisissue and strategies ordealingwith it. To the extentnon-performance-basedEO turnover s random, tsimplydds noiseto turnover egressions,husreducingthe powerof suchtests,but leaves them unbiased andconsistent.







74 Journal fEconomicLiterature,Vol. XLVIII (March 2010)

performanceaverageTobin'sQ) is increas-ing in board size for ertaintypesoffirms,

namelythose thatare

highlydiversified r

that rehigh-debt irms.Perry 1999) breaks down the cross-sec-

tional relationship etween CEO turnoverand firm erformance ywhether he out-side directors re paid using ncentives.Hefindsthat the relationship etween CEOturnover nd firmperformances strongerwhen boards have incentives.This findingsuggeststhat providing explicit ncentivesto directors eads them to be morevigilant(actmore ndependently). eyond ncentive

reasons, nother otential xplanations thefollowing:n firms hat make use of incen-tivepay fordirectors, he directorshave aprofessionalather han a personalrelation-shipwith the CEO and, thus, re relativelyindependentf him.

To conclude thissection, t is worthnot-ingthat fewanalysesofCEO turnover on-trol for firm-specific eterogeneity singfirm ffects. s increasinglyongpanel-datasets become available,futureresearchwill

be able to shed more lighton within-firmchanges nCEO turnover.

2.3 Setting fStrategyIn addition o makingdecisions concern-

ing the hiring nd firing f CEOs, boardsmayalso be involved n the setting f strat-egyor,somewhat quivalently,he selectionofprojects.Certainly urveys f directorssee the discussionof Demb and Neubauer(1992)above indicate hatdirectors elieve

themselves o be involvednsettingtrategy.2.3.1 Theory

To anextent,many f hemodelsdiscussedabove could be modified to make themaboutboards' oversightf strategy.nsteadof replacingthe CEO, the board compelshimto changestrategy.n an adaptationofAlmazan and Suarez (2003) or Hermalinand Weisbach (1998), the CEO could be

assumedto have an intrinsic reference orthe ncumbenttrategyersus replacement(the ncumbent

trategyrovides, .g.,more

opportunityo consumeperquisites). n anadaptationof Laux (2008), similar resultswould follow f one assumed the financialreturns o thereplacement trategyre inde-pendent f the CEO's initial ctions.

An alternativemodeling approach is toinvestigatehe choice of strategys a gameof informationransmission: he CEO (ormanagementmore generally)has differentpreferenceshanthe boardconcerning roj-ects (strategies). numberofobservers re

comingto the view that nformationrans-mission between the board and the CEOis important orgood governance see, e.g.,Holmstrom 005). This is particularlyruewhen the CEO has payoff-relevantrivateinformation,nsofar s an agency problemarises because the CEO can influence heboard'sdecision hroughhestrategiceleaseof nformation.

Adams and Ferreira (2007) build amodel based on four broad assumptions:(i) the CEO dislikes limits on his actions(loss of control); ii) advice from he boardraises firmvalue without imiting CEO'sactions; iii) the effectivenessf the board'scontrol nd the value of its advice are bet-ter the more nformed heboardis; and (iv)the board depends cruciallyon the CEOforfirm-specificnformation.n the Adamsand Ferreiramodel,the board can learn theamount, G [0,1],bywhich project houldbe optimally djusted e.g.,what the appro-

priate level of investment n it should be).The board can do this,however, nly ftheCEO has informed hem bouttheproject. tis assumed the CEO canwithhold hat nfor-mation,but if he chooses to share it,thenhe mustdo so honestlyi.e.,usingthe stan-dardterminologyfthe contractsiterature,the informations "hard").The CEO has abias, b > 0, such that he likes to increasethe size ofprojects e.g., nvestmore than s








lossfrom he size of theprojectometimesbeingdistortedi.e., n those stateswhenthe CEO retains ontrol).he Adams ndFerreiramodel lso implies hat tmaybeoptimal oseparate headvisoryndmoni-toringoles f theboard; hat s,to have adual board ystems inmany ountriesnEurope.

Milton Harris and ArturRaviv 2008)is similarn spirit o Adams nd Ferreira.Harris nd Raviv ssume hat heCEO andthe nsider irectors,ike he outside irec-torsnAdams ndFerreira,ave nformationrelevanto thequadraticoss. The payoffs,net offixed erms ndadditivelyeparableaspects f heir espectivetilities,re

Uo - -(s - ao - ö7)2 and

Ui = -(s - ao- aI- b)2,

where he ubscripts and denote utsid-ers and insiders,espectively,ndat is theinformationhatthe t groupof directorshave about heoptimal ize oftheproject.Observe, ow,hat he ptimalizefromheshareholders'erspectives = ao + a7.Thevalueof tis theprivatenformationf thet group f directors. nlike nAdams ndFerreira,ow t could be suboptimal,romthe hareholders'erspective,ogive ontrolover to theoutsiders:lthoughhe nsiderswillalmost urely otchoose heoptimalgiven ontrol,heymight etcloserftheirinformationsparticularlyaluablei.e., hevariance fal is relativelyig).Harris nd

Raviv onsiderwo oard tructures:utsidercontrol nd insider ontrol.Whengrouphas control,t has the choiceofchoosingordelegatinghechoice o theother roup.Whengroup makes he choice t receivesa message romhe other roup bout hatother roup information.sinAdams ndFerreira,heequilibria f thesecheap-talkgamesdo notpermit ull nformationev-elation.Whenthe insiders' nformations

sufficientlyaluablerelativeo the outsid-ers' i.e.,Var(ö7)/Var(öo)κ > 1,κ a con-stant hat

ependsnparameter

alues) ndinformations valuable elativeothe gencyproblemspecifically,ar(#7)/fo2ω > 1,ωa constant hatdepends n parameteral-ues), hen nsider ontrols superioro out-sider ontrol.fthose onditionsren'tmet,then utsiderontrolssuperior.

Like Adams nd FerreirandHarris ndRaviv,Charu G. Raheja (2005) wishes ounderstandoard tructuren he ightf heboard's eed oobtainnformationbout hefirm'srojects r strategies.nlikeAdams

andFerreira, here ll boardmembersreequally gnorant,r Harris ndRaviv, hereboth nside ndoutside irectorsespectivelyhaveprivatenformation,aheja assumesthat nly he nside irectorsossess rivateinformation.ncontrasto most f he itera-ture,Rahejadeparts rom he dea that henon-CEOnside irectorsnd heCEO havecoincidentncentives.nsiders ontrol heCEO throughhe hreatf ratting"im utto theoutsiders,howill henoinwith he

insidersnfiringheCEO, should heCEOmisbehave.Although clevermodel, t is difficult

to reconcileRaheja'smodelwiththe evi-dence in Mace (1971) or Vancil (1987).Insubordinationy a CEO's managementteam seems exceedinglyare. Moreover,what vidence here s aboutwhistle-blow-ers rats)s hardly ncouragingorRaheja'smodel.Anecdotalvidence,t east, uggeststhat whistle-blowersend to suffer,more

than e rewarded,or heirctionssee, .g.,Joann . Lublin, 002).Evidence fwhistle-blowers oing o outside irectorss rarethe mostprominentecentwhistle-blower,Enron's herronWatkins,ornstance entto theCEO (KenLay)with er oncerns.

FenghuaSong and Thakor 2006) alsoconsidernformationransmissionelevanttoprojectelection. ike ome therworknthis rea, hey uild n thecareer-concerns








option hat s never xerciseds worthless;hence,fthesignalwere omplete oise, swouldbe the case ifboardhad zero

qual-ityrecall hesignal's ariance s 1/q),herewould eeffectivelyooption. s the ualityof heboard nd, hus,nformationmproves,the more valuable this optionbecomesand,therefore,he morevaluable hefirmbecomes.

It is not, however,ostless o increaseboard uality ithout ound. irst,t seemsreasonablehat igher uality irectorsom-mand premiumr that rovidingboardwith ufficientncentivesodo a high-qualityjob is expensive.o thecostofboardqual-ity s increasingn quality.Under uitableassumptionsbout this costfunctione.g.,thatmarginalostbe risingnq),therewillbe anoptimal inite aluefor . In addition,if heCEO labormarketeacts o the ignalso that heCEO's futurealarys an ncreas-ingfunctionfthesignal, hen he CEO isexposed o more uturealary isk hemoreinformativehe signal s (i.e.,the greaterisq). Intuitively,heposteriorstimate f he

CEO's abilitys a weighted verage f theprior, hichs fixed,nd thesignal,whichis noisy. hemore nformativehesignal sknown obe,themoreweightsassignedhesignal. his ncreaseshe CEO's riskmorethan he ower ariance f thesignal tselfreduces t seeHermalinndWeisbach 009for etails).A CEO willrequire ompensa-tion or hisgreaterisk,o his nitial alary(winexpression1))willhave o be greater.In light fthiscost,under uitable ondi-

tions,twill gainbe thecase that finiteisoptimal.Fromexpression1), the marginalnet

returnoq is

1 λ ( -rr' TT3/2 dw

2rq20'^Jλ _

~dq

(note '/H = -rr/y/H). hechangenthemarginal et return oq with espect or,

the measure f thecurrentconomic nvi-ronment,as the ame ign s

άφί=μ' < 0drY'y/Hj

where the inequality ollows ecause anincreasen r is a movefurthernto he efttail of thedensity.herefore,hemarginalnetreturn oq is fallingnr,whichmeansthat heoptimal ualityf heboard s owerwhen conomic onditionsregood i.e., shigh) hanwhen hey re bad (i.e., is low).Intuitively,hen imes regood, he boardwillwish to let mediocre EOs go aheadwith rojects,ut heywon'twhen imes rebad. Consequently,he value of mprovingthemonitoringfprojectss greater hentimes rebad thanwhen heyregood.

Nina Baranchuknd PhilipH. Dybvig(2009) is an interestingrticlen this reabecause t s notworriedbout nformationtransmissionetween EO andboard,butamong hevariousboard membershem-

selveswhich,npractice,ncludeheCEO).Each director has a belief,tGW1, s towhat he firmhould o. Similar oAdamsand Ferreira2007) and Harris nd Raviv(2008),a directorxpects o suffer qua-draticoss nthedistance etween isbeliefsas to what hefirmhould o and what hefirm'sctual ourse f ction, , is;thats,adirector'stilitys

- || a, - â ||

The directorsrrive t â accordingo a solu-tion oncepthat he uthorsall consensus.This solution oncepthas manydesirableproperties,ncludingxistence or ll suchgames. weaknessf he oncept,owever,sthat heres noexplicitxtensive-formametowhich t s a solutionconsensuss a coop-erativegame-theoreticoncept).Anotherissue s there s no scope fordirectors o








update heir eliefs asedonwhat heyearnof thers' eliefs. bsentiases n thepart fthedirectors,t s not lear

whyhedirectors

wouldnotfreelyhare heirnformationndarrive t a consensus eliefwhich n turnwould eadto a unanimoushoice s towhatthefirmhould o.

Bythe revelationrinciple,he nforma-tion-transmissionodels discussed herecould all be solvedby a direct-revelationmechanismf complete ontracting erepossible.34hat s, f theparties ouldfullycommitndmonetaryransfersfany evelamong hemwerefeasible,hen hepartiescould chieve n nformationallyonstrainedoptimumvia contracting.here would,therefore,e noneed toworryboutboardcompositionr control. ence,as is com-mon fmanymodels eekingoexplain heinstitutionseobserve,here s a reliance,tsome evel, nthe ssumptionhat ontract-ing is necessarilyncomplete.n particu-lar, ither oards annot ommitullys tohowtheywilluse the nformationevealedto them r it is infeasibleontractuallyor

them opaythe CEO (orothers)na man-ner sufficiento induce fficientevelation.For nstance,nHarris ndRaviv 2008),direct-revelationechanism oulddo bet-terthantheequilibriumutcomes onsid-eredprovidedhat hepartiesould ontractdirectlyn the izeof heprojects a func-tion ftheir nnouncementsndthey ouldmake transfers. lthough his literaturetendsnot oexplore ully hy ontractsreincomplete,asual empiricism ouldsug-

gestthat here re, ndeed, imits o bothcommitmentsnd transfers.o,realistically,organizationsre necessarilyn a second-or third-bestituation. onsequently,he"law ofthe secondbest" often pplies toremedy,n part, hesecond- r third-bestproblem,hepartiesangainby ntroducing

34Note Song and Thakor is not an information-transmission odel.

another,artiallyffsettingroblem.35ntheliteraturenboards,he ffsettingproblem"is

havingless

diligent/lessontrolling/lessindependentoard.Having "lax" oard s away fpartiallyommittingo how nforma-tionwillbeused, hereby imicking,npart,thecommitmenthat contractualolution,were nefeasible, ould rovide.2.3.2 EmpiricalndExperimental

Evidence

Ann B. Gillette, homas H. Noe, andMichaelJ.Rebello2003);Gillette, oe andRebello 2008)perform series f nterest-

ingexperimentsesignedoget t the ssueof nformationransmissionithinheboard-room.n Gillette, oe,and Rebello 2003),they onsider laboratoryettingnwhichinformednsiders re groupedwith unin-formed utsidersn a simulated oardroomsetting.hey ind hat he nclusionf utsid-ers mproves elfarey makingndesirableequilibriaess ikely.illette, oe, ndRebello(2008) compare, gain n a laboratoryet-ting, ingle-tieredoards,wo-tieredoards,

insider-controlledoards, and outsider-controlledoards. heyfind hat wo-tieredboards end o be overlyonservativentheirchoices nd thatoutsider-controlledoardstend o ead othemost fficientayoffs.

The class of modelsbased on strategicinformationransfermplicitlyelies ontheassumptionhatoutsider irectorsreless well informedhan are inside direc-tors. nrichetta avina nd PaolaSapienza(forthcoming)dopta clever pproach o

testingthis assumption.These authorsexamine he relative rofitabilityf tradesintheirompanies'tocksmadeby utsiders

35An exampleof the law of the second best is, forinstance, ncouragingomedegreeof cartelization f apolluting ndustry: y reducing ompetition, ricewillbe driven above privatemarginal ost; hence, societymayhopetoget pricecloser o socialmarginal ost i.e.,cost inclusive f the negative xternalityaused bythepollution).








and insiders nd find hat bothtypesofdirectors arn abnormal rofits,ut thatinsiders arnbetter eturnshando outsid-ers.These resultsuggesthat oth ypes fdirectors ave access to inside nformationbut that outsiders' nformations strictlyworse han nsiders'. hus thefindingup-portsthe underlyingssumption f theinformation-basedodels fboards.

Breno Schmidt2008) considers situ-ation n which advice could be particu-larly aluable, amely uringmergersndacquisitions.n the basis of the social tiesbetween he CEO and otherdirectors,e

classifiesoards s "friendly"ties xist) nd"unfriendly"a continuousmeasure s alsoemployed).When t is likelyhatdirectorspossess aluable nformationbout nacqui-sitionan ndexmeasure),hereturnsftheacquirerrehighern announcementf heacquisitionorbidderswithmorefriendlyboards.Conversely,hen he need to disci-pline hemanagers a greateroncern,ocialtiesprove o be a negative.

Althoughheres a growingmpiricalit-

eratureeekingo estimateherole fdirec-torsnstrategyetting,t s safe osay hatthis s an area nwhichmuchwork emainsto be done.

3. How are Boards fDirectorsStructured?

We havediscussedomeexplanationsorwhy here re boards, ndwhy ne mightexpect ndogenously-chosenoards opro-

videmonitoringfmanagement,espitehefact thatmanagementypically as somesayover the board's omposition.ut thetheories imply rovide stylized escrip-tion f heunderlyingensionsntherole fthe board n corporate overnance. ctualgovernances much icher han hesebare-bones haracterizations.

There are a number f questions hatcan onlybe answered y looking t data

on real-worldoards fdirectors. ow areboards structuredn practice?Does thisstructureoincide ith he arlier-discussedtheories? owhas t hangedver ime, othinresponseochangesntheeconomyndregulatorynvironments?

3.1 SomeFacts

Observersypicallyividedirectorsntotwo groups: nside directors nd outsidedirectors.Generally, directorwho is afull-timemployeef thefirmn questionis deemed o be an insidedirector,hiledirector hoseprimarymployments not

with hefirms deemed to be an outsidedirector. utside irectorsre often aken obe independentirectors,et he ndepen-dence f ome irectors homeet hedefini-tion f noutsidersquestionable.xamplesof uchdirectorsre awyersrbankers hodo businesswith hecompany.utsidersfdubiousndependenceresometimesut na third ategorynempirical orksee,e.g.,HermalinndWeisbach988): affiliated"r"gray"irectors.nrecent ears, ublic res-sure and regulatoryequirementsave edfirmso havemajority-outsideroards.

The characteristicsfboards f argeU.S.corporationsave eendescribedn numberof tudies. or xample,ich nd Shivdasani(2006)considersample f 08of he argestU.S. corporationsetween 989 and 1995.They indhat,naverage,utsiders ake p55 percentfdirectors,nsiders0 percent,and affiliated irectors he remaining5percent. he average oard ontains welve

directors, ach receiving approximately$36,000 nfees plus tock ptions),nd has7.5meetingsyear. numberf hedirectorsserved nmultipleoards; heoutside irec-torsnthese irmsveragedver hree irec-torships. hile hese ata reforarge ublicfirms,ames . Linck, effry. Netter,ndTinaYang2008)consider larger ample f8,000 necessarily)mallerirms,ith imilarpatternsnthedata.








While the existence nd basic structureofboardshaveremainedelativelyonstantover ime, he

waynwhich

heyre com-

posedhaschanged. ehn, ukesh atro,ndMengxinhao 2009)considersample f 1firmshat ave urvivedspublic ompaniesfrom935until 000.Survivorshipias om-plicates he nterpretationf their indings,neverthelesshey eflectomebasic trendsthathaveaffected oards.First, oard izeappears o have hump atternver ime;taverages1 n1935, eaks t 15 n1960, nddeclines o11 n2000.However,oard izehas becomemore niformver ime s thestandard eviation fboard izedrops rom5.5 n 1935 o 2.7 n2000. These ompanies'boardshave become more outsider-domi-nated s well; nsider epresentationropsfrom 3 percentn 1935 to ust13percentin2000. Part fthisdrop an be explainedbythetypicalife ycle f firms. s found-ingfamilies xit and firms ecome moreprofessionallyanaged, gency problemscan becomeworse s thosencontrolre nolonger ignificantwners.n response,irms

willwish oadd outside irectorso counter-act he ncreasedgency roblems.Since2000, therehave been significant

changes. arbanes-Oxleyontained num-berofrequirementshat ncreased hework-loadof ndthedemand or utside irectors(see Linck,Netter,nd Yang2009 foradescriptionf theserequirements).n addi-tion, he scandals t Enron nd Worldcomhave ed o ubstantiallyncreasedubliccru-tinyfcorporate overnance.onsequently,

boardshave become arger,more ndepen-dent,have morecommittees, eet moreoften,ndgenerallyave more esponsibil-ity nd risk againsee Linck,Netter,ndYang2009).Thesechanges oth ncreasedthedemand or irectorsnd decreased hewillingnessf directorso serve or givenprice. t is not surprising,herefore,hatdirectorayand liabilitynsurance remi-umshave ncreasedubstantially.rom he

shareholders'erspective,heneteffect fthisregulations notclear;future esearchwillneed to address heextent o which headditionalmonitoringffsetshe ncremen-talcostsmposed ySarbanes-Oxley.3.2 FactorsnBoardCompositionhat

PotentiallyffectBoard'sActions

We havealready iscussedmuchoftheliterature elating oard compositioninterms f the insider-to-outsideratio) ndboard ize to board ctions egardingver-sight ftheCEO, as well as to overall irmperformancesee section .2). Yetbeyondthe nsider-to-outsideratio nd board ize,other oard ttributeso doubt lay role.Each boardof directorss likelyo have tsowndynamics, function fmany actorsincludinghepersonalitiesndrelationshipsamong hedirectors,heir ackgroundsndskills,nd their ncentivesnd connections.Some ofthesefactorsrereadilymeasuredwhileothers re not.Therehas been con-siderable esearch hat eeks o estimateheimpact f various oard characteristicsn

board onduct ndfirmerformance.3.2.1 CEO-ChairmanDuality

Many EOs alsohold he itle fChairmanof theBoard;thisduality olds n almost80 percent f largeU.S. firmssee PaulaL. RechnerndDan R. Dalton1991).Thisstructures viewed ymanysgiving EOsgreaterontrol t theexpense f other ar-ties,ncludingutside irectors.omitigatethe onsequent roblems, anybserversf

corporateovernanceave alled or prohi-bition n theCEO servings chairmansee,e.g.,Michael . Jensen993).

Anumberfrecent apers ave xaminedtheuse ofdual itlesncorporateovernanceempirically. ames A. Brickley,Coles,and GreggA. Jarrell1997) estimates heperformanceffectsf ombineditles. heseauthors ind ittle vidence hat ombiningor separatingtitles affects corporate








performance.hey onclude hat hesepa-ration nd combinationf titles s partofthe natural uccession

rocessescribed

yVancil 1987). n contrast, oyaland Park(2002)findhat he ensitivityfCEO turn-over operformances lowerwhen itles recombined,onsistent iththe notion hatthe combinationf titles s associatedwithincreased ower verthe board.Similarly,Adams, eitor lmeida,nd Ferreira2005)find vidence onsistentith he viewthatCEOs alsoholdinghe hairmanitleppeartohold reaternfluencever orporateeci-sionmaking.

Overall,hese tudies re consistentiththeview hat ombineditles reassociatedwithCEOs havingmore nfluencen thefirm.However,his relation s not neces-sarily ausal. nfluencenside n organiza-tion rises ndogenously,nd with nfluencegenerallyomefancieritles. heGoyal ndPark and Adams, Almeida, nd Ferreirafindingsotentiallyeflect EO power hatcame bout ndogenouslyhroughmannersimilaro hat escribedntheHermalinnd

Weisbach1998)model. n otherwords,CEO whoperformsellwould e rewardedbyhisbeing ivenhe hairmanitle s well.Sucha process, speciallyfthe ncreasenpower rises ecause f demonstratedighability, ouldnotnecessarilymply erfor-mance hanges ollowinghiftsntitles,on-sistent ith heBrickley,oles,andJarrellfindings.

Even f t strue hat ombininghe itles fCEO andchairman eans hat n ndividual

has, naveragemore nfluencever isfirm,it does not follow hatmandatingeparatetitles ouldmproveorporateerformance.In fact,Adams,Almeida, nd FerreirasimilaroBrickley,oles, ndJarrellfindthatmeasures fCEO powerrenot ystem-aticallyelated ofirmerformance.his sconsistent ithour overarchingrgumentthatactual corporate-governanceracticeneeds to be seen as partof the solution o

the onstrainedptimizationrogramhat scorporategovernanceesign. ence,mpos-

ing separateitleswould ither

ieldless

optimalolution r ead toa,possiblyneffi-cient, ork-aroundhatmaintainedheopti-mal amount f CEO power.36 oreover,snoted arlier,makinghe CEO's job worselikelymeans noffsettingncreasenpay scompensation.onsequently,s withmostpolicyprescriptionsn the area of gover-nance, olicymakershould ewary f allsfor rohibitingheCEO servings chairman.

3.2.2 Staggeredoards

A common, et ontroversial,overnancearrangements known s "staggeredoards."When firm as a staggeredoard,nsteadofholdingnnual lections or ach direc-tor, irectorsre electedformultiple earsat a timeusuallyhree),ndonly fraction(usually third) fthedirectorsre electedin a givenyear.This practice s typicallyadopted s a wayofshielding firm romtakeover ecause a potential cquirer an-notquicklyakecontrol f the firm's oard

even it controls 00 percent f the votes.This rrangements more ommon han nemightmagine in theFaleye 2007) sam-ple,roughlyalf fthefirms ave lassified(staggered)oards.

While the consequence f the separa-tionof the CEO and chairman ositionson firmperformances ambiguous,essambiguityxistswithrespect o staggeredboards; the empirical vidence ndicatesthisarrangements not n the sharehold-

ers' nterestsalthough,s withmuch ftheempiricalwork, aution s warranted ueto joint-endogeneityssues). Both Jarrelland Annette . Poulsen 1987) andJamesM.MahoneyndJoseph .Mahoney1993)

36Recallthat,n a number fmodels fboards, edingsome ontrol omanagementsoptimalseee.g.,Almazanand Suarez2003; Laux 2008; Adams nd Ferreira 007;and Harris nd Raviv 008).








find egativeeturns henfirms nnouncethey re classifyingheir oards although

Jarrellnd Poulsen's

indings notstatisti-

cally ignificant).ebchuk, ohn . Coates,and Guhan Subramanian2002) find hata classified oardalmost oubles heoddsthat firm emainsndependenthen acedwith hostileakeover.ecause omewould-be acquirersreno doubt cared ff ythestaggeredoard, heBebchuk, oates, ndSubramanianindingsikely nderestimatethe bilityf classifiedoard o resist ake-overs. ebchukndAlmaCohen 2005)findthat irms ith taggeredoardshave owervalue han ther irms,sing obin's as ameasure f alue. inally,aleye2007)findsthat staggeredoard owershe ensitivityofCEO turnoverofirmerformance.

An mplicationftheview hat taggeredboards entrenchmanagers nd decreasevalue s thatwhen irmsdestagger,"eturnto annualelections or ll directors,alueshould ncrease.Re-JinGuo, Timothy .Kruse, nd TomNohel 2008) considersample ffirmshat estaggernd find hat

the alue f hese irmsoes,nfact,ncrease.They lsofind hat estaggerings not ypi-cally nitiatedy managers,utbyactivistshareholders.ubsequento thedestagger-ing, nvestoreactionndicates hat thesefirmsre more ikelyo be takeoverargets.All ofthesefindingseinforceheview hatstaggeringoardss a mechanismhat ervestoprotectmanagementymakingakeoversdifficult.

All nall, tappears hat irms ith tag-geredboards do worse than firmswithannual board elections.Of course,someof this ffectould be due to endogeneity;firms ith lreadyntrenched anagersremoreikelyobe ableto convinceharehold-erstoadopt taggeredoards.Or,to takeless inisteriew,hosemanagers hoprovethemselvesre in a positionobargain orgreaterob securitys partof an optimal(second-best)argainfortheir continued

serviceandthosewho fail oprove hem-selves become vulnerable o destaggeringand takeover).n this

light,tock-market

reaction o announcementsbout whethertheboardwillbe staggeredr not ouldbedue tothenews uch nnouncementsonveyvis-à-vishebargainingoughnessnd nde-pendence f heboard atherhan osimplywhetherheboard s or sn't taggered.3.3 TheRoleofParticularypes fOutside

Directors

To be consideredn outsider,directorprimarymployment ustbe with a dif-ferentrganizationhan hefirmn whoseboardhe serves. utside irectorsypicallyhavebackgroundshatwill enablethem obe valuable o a board,or to representnimportantonstituency. small iteratureconsiders articular ypes fdirectorsndtheirpecificolesncorporateovernance.3.3.1 Bankers

Many irms avebankersn their oards.Bankersmaybe added to boards both

becausethey an monitorhefirm or helenderforwhomtheywork nd becausethey an provide inancialxpertise. othJamesR. Booth nd DanielN. Deli (1996)andDaniel T. Byrd ndMarkS. Mizruchi(2005)consider he xtento which ankersplay monitoringole.These authors indthat, hen directorsaffiliatedith banklendingo thefirm,he firm'sverall ebtratio s ower. hisfindings consistent itha view that uch an affiliatedirector an

protecthe bank's nteresty discouragingthefirm rom aking ut oans from therbanks that could increase he risk o thedirector's ank.Whilemonitoringhroughdirectorshipsay enefitbank,Randall .KrosznerndPhilip . Strahan2001) rguethat uchmonitoringlso involves osts. nparticular,ankers anbe held egallyiableif hey re on theboards ffirmshat nterfinancial istress. onsistent ith he dea








thatmonitoringhrough irectorshipsscostly,hey ind hat ankers re moreikelyto be on the boardsof

arge,tablefirms.

They lso arguethat iabilityxplainswhyfewer ankers re on boards fnonfinancialU.S. firms han nother ountries,uchasGermanyndJapan. .BurakGüner, lrikeMalmendier,ndGeoffreyäte 2008)findevidenceuggestinghat dding ommercialbankersoboards ncreases firm'sbilityto access debtmarkets,ut that he firmsthatutilize his ncreased inanciallexibil-ity hemost re those irms ith ood reditbutpoor nvestmentpportunities.üner,M lmendier,nd Täte arguethathavingbankers n boardscan be a double-edgedsword,n thatthe bankers an improvefirm'sccess to capitalmarkets,ut some-times thisimprovedccess works o thebenefit f the bank rather han the firmdoingthe borrowing. ecause theyhavepaneldata, Güner,Malmendier,nd Täteare bletoaddress,ntwoways,heproblemthat inancingeedsmay rive heappoint-ment fbankdirectorsnstead fviceversa.

First, hey se firm ixedffectso controlfor eterogeneitymong irms.econd, heyarguethatbankers ssociatedwithfailingbanks re less attractives directors. husan nstrumentorhenumber f ommercialbankers n theboard s thenumber fdirec-tors ired uring inancialrises.

3.3.2 Ventureapitalists

Manyfirms re foundedwithfundingfrom entureapitalists. s a condition f

receiving unding, ew enterprisesmustyield omedegree fcontrol o theventurecapitalists. entureapitalists ave a fidu-ciary esponsibilityo their wn nvestorsoexit hese nterpriseselativelyuickly,ndgenerallyeave these enterprises' oardswhentheysell theirownershiptakeinthem. espite he hortnessfventureapi-talists enures sdirectors,study yBakerand Gompers 2003) suggests hat their

presence an affect irmsongafter heyhave leftthe board. Baker and Gompersfind hat he initial

resencef a venture

capitalnvestor,speciallyne with strongreputation,s likelyo decrease he CEO'sbargaining owerrelative o the board.Empirically,high-reputationentureapi-talist eads to a more owerfuloard, venafter he ventureapitalistxitshis nvest-ment.The interpretationf thisresult sthat uch ventureapitalist egotiatesub-stantially ore ontrolightshan stypicalfor utside nvestorsnother rivate irms.When these firms o public, his balance

ofpower wayfrommanagementends opersist,eadingCEOs in venture-capital-ist-backed irmso have less control vertheirboardsthan CEOs in non-venture-capitalist-backedirms.

3.3.3 Politicallyonnected irectors

Firms that deal regularly ithgovern-ment,uch sregulatedtilities,roneswithsignificantovernmentontracts, lace ahigh alue nbeing bleto nfluenceovern-mental ecisions. onsequently,hesefirmsshouldhave a demandfordirectors ithpoliticalconnections. nup Agrawal ndCharlesR. Knoeber2001)test hishypoth-esis nd,not urprisingly,ind hat irmshatare more eliant ngovernmentalecisionsare more ikely o appointdirectors ithbackgroundsn law andpolitics. xtendingthis dea,EitanGoldman, örg ocholl,ndJongilo (2009)considerhenature f heseconnectionsngreateretail. hese authors

classifyirectorsythepartyo which heybelong.Around he timeof the 2000 elec-tion,whichwas a very losewinforGeorgeW.Bush nd heRepublicanarty,irms ithRepublican-connectedoards ncreasednvalue while Democratic-connectedirmsdecreasednvalue.Thisfindingmphasizesthevaluepoliticallyonnected irectorsanprovide nd,consequently,he mportanceof hese onnectionso firms.








3.3.4 CEOs as Directors

Sometimes n outsidedirector f onefirms the CEO ofanother. EOs ofotherfirmslearly avemanagementkills nd anunderstandingfthe ssues acing opman-agement. üdiger ahlenbrach,ngieLow,andRenéM. Stulz 2008)considerhe ffectofhaving EO directorsn boards.Theseauthorsfind no evidence,however,hatCEOs onboards ddvalue, t leastrelativeto other utside irectors.hisconclusionssomewhattoddswith ich 2005), iscussedindetailater, hich indshe nnouncementthatCEOs ofwell-performingirms illbeadded o theboardgeneratesositivebnor-malreturns.

Fellow CEOs on the boardmay,how-ever, educefirm alue n at least one cir-cumstance,amelywhen CEO is addedtoa board s a part f an interlock;hat s,when he CEO ofone firms addedto theboardofa secondwhile he second CEOsimultaneouslyerves n theboard of thefirst.When directors re added as inter-

locks, ahlenbrach,ow, nd Stulz ind hatfirm erformanceeclines. his decline sattributedo mutual back-scratching":heimplicithreat fwhat hefirst EO can dofor ragainsthe econdnthefirst'sole sdirectorauses he econd o actmore avor-ably oward hefirstnthe second role sdirector.onsistent ith his dea,KevinF.Hallock 1997)finds hat nterlockedirec-tors receive bnormally igh pay.Similarresults re foundn FrancisKramarz nd

DavidThesmar2006)and DavidF.Larckeret al. (2005),who use moresophisticatedmeasuresof connections etween CEOsandboards,ndfindvidence fworse irmperformancendhigherEO pay t firmsnwhich heCEO has onnectionso he oard.Fich ndLawrence .White2005)explore,moregenerally,hereasonswhyCEOs siton each others oards. heyfind hatmea-sures of CEO bargaining ower tenure,

evidence fabilityTobin'sQ), and sittingon the nominatingommittee are posi-

tivelyorrelated ith

nterlocks,hileCEO

ownerships negativelyorrelated. hesefindingsre consistent ith viewof nter-locks s a means fprovidinghe CEO jobsecurity.inally, ohn izjak, emmon,ndRyanWhitbyforthcoming)ind hatboardinterlocksncrease he ikelihoodf"optionbackdating," controversialractice hatserves o ncrease op management'saybyexpost djustinghe date on which ptionsare dated.This findingupportsheviewthatboards

playrole n

setting orporatepolicies ndprovides urthervidence hatinterlockedoards enefit anagement,os-siblyt the xpense f hareholders.

Overall, here ppearsto be substantialevidence hat nterlocksnd other utsidepersonal elationshipsetweenheCEO andhisdirectorsanbe associated ith oor er-formance. s before, owever,nterpretingtheseresultss trickyue to theunderlyingendogeneityroblem.t is difficulto knowiftheboard tructureetermineshe firm's

performancer heboard tructuresmerelya manifestationf hepower CEO hasoverhisfirmnd theproblemshat temfromthat. n addition, EOs maybe invitedojointheboards ffirmshat reperformingpoorly.hese distinctionsrenotmerelyfacademicnterest;olicies oregulate oardcompositionre often roposed nd some-times nacted.The extent o which hesepolicies re likely o be effectiveependscruciallyn the extent owhich heboard

structureausally hanges irmerformanceand s notmerely symptomfunderlyingissuesnside hefirm.

AnotherssuewithCEOs as directorsswhyhould hefirmheCEO manages er-mithimto devote ime nd efforto otherfirms?MartinJ. Conyonand Laura E.Read (2006)offer theoreticalxplanation.Servingn the boardsof other irms elpstobuild heCEO's humanapital.Moreover,







86 JournalfEconomic iterature,ol XLVIII March 010)

thefirman subtractheopportunityost fhistime nd effortway rom hefirm romthe

ompensationtpays

im. he nterestftheCEO andhisfirm'swnersrenot, ow-ever, erfectlyligned n thismatternso-far s theCEO alsogains personal enefitfrom ervice n theboards fother ompa-nies (e.g., dditionalncome nd prestige).Hence, firmhat id not imit henumberofdirectorshipstsCEO could cceptwouldfind hat he CEO acceptsmoredirector-ships hanwould e optimal rom he hare-holders' erspective. erry nd Urs Peyer(2005) provide ome evidence consistentwith his rgument. heyfind hat ccept-ing additionaldirectorshipsenefits he"sending irm"rimarilyhen hesendingfirmppears o bewell-governed.utwhenthesending irmxhibits otential gencyproblems,dditional irectorshipsppearvalue-decreasing.3.3.5 Stakeholderepresentativesn

Boards

Often,especiallyoutside the United

States, varietyf onstituenciesstakehold-ers)with n nterestna firmrerepresentedon thefirm'soard.Aparticularlymportantsetof uch takeholderss abor. resumablythe reasonwhy abor s eager o gainsuchrepresentations to influencemanagementto take ctions avorableo workers.aleye,VikasMehrotra,ndRandallMorck2006)findevidence that supports his notion:labor-controlledubliclyradedfirms endto nvestess n ong-termssets, akefewer

risks,ndexhibitower abor nd totalfac-tor roductivity.imilarly,aryGorton ndFrankA. Schmid2004)considermployeerepresentationn supervisoryoards inGermany.hese uthorsind hatwhen aborhasequal representation,irmsrade t a 31percent iscountofirms ith /3 mployeerepresentation,nd have higherpayrolls.BoththeFaleye,Mehrotra,nd Morck ndGorton nd Schmid rticles uggest hat,

when aborcan affect irm olicies, itherthroughoard epresentationrequitywn-

ership,t s able to nfluenceirm

olicieso

benefit orkerst the xpense f harehold-ers.However,arry auver ndMichael .Fuerst2006)find hat aborrepresentationon the boardsof Germanfirmss associ-ated withbetter erformance,articularlyinfirms hich ave greater eed for oor-dination. hissuggestshat abor anbringvaluable irst-handnowledgeotheboard.

4. HowDoes theBoardWork?

The discussion fboards o farhas lefttheworkingfthe board as a black box.Whatthey o hasbeendiscussed, ut nothowtheydo it.How do boardsfunction?What re themechanics ywhich hey otheirobs?These arequestionsowhichwenow urn.

An obvious roblemn addressinghesequestions s thatwhathappens nside aboardroomsnecessarilyrivate. hile omeacademic esearch astried ouncoverhese

workingsf the boardthroughnterviewsandcasestudiesseesection .1supra),mostresearch as reliedon publiclybservabledata that rguablyhed ight n the nnerworkingsf heboard.

4.1 TheWorkingfTeams

A board ofdirectorss a team.There sa lengthyheoreticaliteraturen econom-ics on theworkingsf teams see BoltonandMathias ewatripont,005,§8.1for n

introduction).s,however,asnoted arlier,applicationf his heoryo boards oes notalwayseadtoclear redictions.or nstance,totalboardeffortan increase rdecreasewith he ize of heboard.

One might opeto resolve uch mbigu-ous theoretical redictions y turningothedata. f,for xample,otalboardeffortis positively orrelatedwith outcomes,then potentialestof size on total ffort







88 Journal fEconomicLiterature,Vol. XLVIII (March 2010)

anyone board. The alternativergumentsthat he directorswho are considered busy"are in factchosen to be on so

manyboards

precisely ecause of theirhigh bility, hichserves to offset he effect f their ack oftime. Not surprisingly,herefore,he effec-tiveness f uch"busy"directors as becomean active rea of nterest.

4.2.1 TheoryThe simpletheory ehind theproblemof

busydirectors s that,the busier a directoris, the less effort e or she devotes to eachofhis or herduties.This idea is readilymod-

eled: Suppose,for implicity,hat he benefita director erivesfrom ffortxpendituresthe same for all her activities.Hence, hertotalbenefit sΣ™=ι b(am),where m s effortexpendedon the rath ctivity, :M+- » R+ isthe common benefit unction,nd M is thetotalnumber f activities. ritically,ssumespendingmoreeffort n activitya ncreaseshermarginalcost of effort n activity foranypairof activities aandj. Thiswould,forinstance,be trueifher cost ofeffort unc-

tion werec(^m=' flm)>herec(·) is increas-ing and convex i.e., her utility or eisureexhibits iminishingmarginalutility).f&(·)is concave,then the director ptimally llo-cates her efforts qually across her activi-ties;specifically,ffort nactivityasatisfiesthefirst-orderondition

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

We can rewrite4) as

(5) b'(a*(M))-c'(Ma'(M)) = 0,

where *(M) is theoptimal mountof effortshe expendson anyone activity iventhatshe is undertakingM activities.Using (5),it follows hata*(M+ 1) < fl*(M; that s, if

assignedone moreactivityboard seat),hereffortn anygiven ctivityalls.39

Aproblem

with thissimple

model is thatthe number f boardseatsheldbya directoris not nexogenous ariable i.e.,our directoris notcompelled oacceptM seats).Ratherdirector as choices.This makesM anendog-enousvariable,mplyinghatwe need to askwhy ome directors hooseto be busier hanothers. his, nturn, an alter ur conclusionthatbusierdirectors evote ess effort n agivenboard than their ess-busy olleagues.To see this, ssume there re typesof direc-tors,wherea director ftypeθ derivesben-

efit b(am) rom ffortxpendedon her rathactivity. type-0director's tility,s a func-tionofM, is

(6) ΜθΗα*(Μ)) - c(Ma*(M))

Utilizingthe envelope theorem, he cross-partialderivative f (6) withrespectto Mand θ is readily hown to be b(a*(M)) > 0;that s,higher-typeirectors njoy greatermarginalbenefit fromadding an activitythan do lower-type irectors. onsequently,higher-typeirectorswill optimally hooseto do moreactivities han ower-type irec-tors.Moreover, ecause a higher-ypedirec-torenjoys highermarginal eturn o effortthan does a lower-type irector, higher-type directorexpends more effort han alower-typedirectorholding constant thenumberof activities.n otherwords,busierdirectors re higher ypeswhowould, thus,expend more effort er activitywere they

39 roof:Suppose not; that is, suppose ö*(M+ 1) >fl*(M). ecause hermarginalosts rerisingntotal ffort,it follows hat

c'(Ma*(M))< c'((M + l)a*(M + 1))

Expression5) then ntails

b'(a*(M))< b'(a*(M+ 1))

but, because she has diminishing marginal ben-efits,this last expression mplies the contradictiona*(M) > a*(M+ 1).








table lUtility for Different Director Types According to

Number of Directorships Taken

Utility or ype

Directorships (9= 9 (9-15

3 13.33 33.71

4 13.47 37.78

5 12.33 39.70

6 10.20 39.98

7 7.27 38.94

Note: Numbers re calculatedaccording o theexampleconnected toexpression7) inthe text.

restrictedo the same numberof activitiesas less-busy lower-type) irectors. his is acountervailingffect is-à-vis he ess-effort-the-more-activitiesffect dentifiedn the

previous aragraph.Whichofthe two effectsdominatess,a priori,ndeterminate.heory,therefore,oes not offer definitiveredic-tionabout the effortfbusydirectors nceone recognizesthat the number of boardseats held s endogenous.

To illustratewhy this is an importantfact o recognize, upposethatb(a) = log(a)and c(x)= x2/2. Straightforward alcu-lations reveal that a*- νθ/Μ Expression(6) is readily hown oequal

(7)^log(^)-^,

which s a globally oncave functionf M foranyΘ.Supposethere re usttwotypes, and15. Table 1 demonstrateshat the optimalnumberof activities directorships)s 4 forthe 9-typeand 6 for the 15 typedirector.

Because ^15/6 > λ/9/4,t follows hat thedirectorswho are busier n equilibriumthe15-type) xpendmoreeffortn each of theirdirectorshipshan do the ess-busy irectors

(the9-type) n each of heirs.n otherwords,busier does notequate to less effortn thisexample.4.2.2 EmpiricalWork n BusyDirectors

Given thattheorys ambiguous n itspre-diction f the overall ffect fbusydirectorson firms, eople have attempted o discernempiricallywhichof the two effects omi-nates. In otherwords, s the fact thatbusydirectors are likelyto be relativelyhigh

qualitydirectorsmore important han theimpact ftheir otentialack oftimeon theireffectiveness?Consistent with the qual-ity arguments,Kaplan and David Reishus(1990), Booth and Deli (1996), and StephenP. Ferris,MuraliJagannathan,ndAdam C.Pritchard2003) find hatthere s a positiverelationship etween a firmsperformanceand the additional directorships cquiredby its board members:when the firm uts








itsdividend,ts directorsosedirectorships(Kaplan ndReishus); hen firmerformswell, ts directors re more

ikelyo land

seatson other oards Ferris, agannathan,and Pritchard). erris,Jagannathan,ndPritchard lso findthat"busy"directorsare equally ikely o serveon committeesas other irectorsnd are nomore ikelyobe sued than other irectors, hich heseauthorsnterprets supportinghe viewthatbusydirectors o not shirk n theirresponsibilities.

However,not being sued and agree-ingto serve n committeeseem ike rela-

tivelyndirect estsof thehypothesishatbeingbusyhurtsperformance.ich andShivdasani2006)providemore irect estsofthishypothesis.ich and Shivdasani indthatfirms ith majorityf directors hoserveon three r moreboardshave owermarket-to-bookatios han otherfirms.naddition, EO turnovers less sensitiveoperformancensuchfirmsomparedo oth-ers. Stock ricesncreasewhenbusydirec-torsdepart board.Conversely,he stock

priceof the firms n whose boardstheyalready it declineswhenbusydirectorsadd an additionaloard eat.Overall,hesefindingsuggest aving usydirectorsn aboard an fail obe inthefirmsnterests.40

The above contributionsotwithstand-ing,more esearchs stillnecessaryofullyunderstand he impactof busydirectors.Most mpirical ork elatesbusy" irectorstoaggregateirmutcomes.While t spos-sible hat everal dditionalirectorshipsf

directorsanhurt irmerformance,toftenseemsimplausiblehat"busyness"houldhave an economicallymeaningfulffect.Instead, usynessmay implye a proxyor

40Although, rawing romKhwaja,Mian,andQamar(2008),having directorwhositson many therboardscan improve firm's etworknd, hence, dd value. t ispossible hat he mportancef this ffects greatern adeveloping ountrysuchas the one studiedby Khwaja,Mian, ndQamar)than na developed ountry.

someunderlyingovernanceroblem. orexample, hivdasani nd Yermack1999)documenthat

usyirectorsremore

ikelyto be appointedo theboardwhen heCEOhas more nfluencever he director-nomi-nating rocess. hus, hepresence fmanybusydirectorsould ndicate situationnwhich heCEO has too much ower.n thiscase,thefindinghatbusydirectorsffectperformanceeed notsay anythingbouttheefforthat usy irectorsxert. erhapsthedevelopmentf more irect ffort ea-sures an aid in theunderstandingfbusydirectors. dams nd Ferreira2008) show

thatdirectors ithmoredirectorshipsremore ikelyo have attendanceroblemstboardmeetings, hich uggestshatbusydirectorspend esstime t eachfirm. usydirectorsould, hough,tillbe ofa highertype, s wedescribebove, hus otal ffortexertedybusy irectorsouldbe similar othat xertedy essbusy irectors.

4.3 BoardCommittees

Boardsusuallydo most of theirwork

in committees,nd data on the commit-tee structures generallyubliclyvailable.Someauthors aveused thesedatatostudythefunctioningf heboard.

Shivdasanind Yermack1999)use infor-mationbout henominatingommitteeodraw nferencesver heCEO's influencentheboard. hese uthors indhat, hen heCEO serves n thenominatingommitteeorwhen here s no suchcommittee,ewerindependentirectorsreappointedndthe

stock ricereactiono ndependentirectorappointmentss lower hanwhen here s anominatingommitteehat oes not ncludethe CEO. This effect ould be causal, nthatbeingon the nominatingommitteecould allowCEOs to exercise ontrol verboardselection,r it could simply eflectthatmore owerfulEOs are both bletoget ppointedonominatingommitteesndalso to nfluenceirectorelection.n either








case,the Shivdasani ndYermack indingsare consistent ith heviewthatpowerfulCEOs are able to nfluencehe structureftheir oard.

AprilKlein 1998)considers herelationbetween irmerformancend board om-mittee tructures.he finds hat, lthoughthere s no relation etween verall oardcompositionnd firmperformance,henumberf nsidersn thefinancend nvest-mentcommitteess positivelyssociatedwith etter erformance.he same causal-ityquestion s discussed bove s relevantfor

nterpretinger

findings:o insiders

on the finance nd investmentommitteescausegood performancer s this ommit-tee tructureomehowconsequencefbet-terperformance?n particular,ffirmsanimproveerformanceubstantiallyimplyyrearrangingheir ommitteetructure,hyhaven'tllfirmsoptimally"earrangedheircommittees?n the otherhand, t is pos-sible hat irmsace xternalressureo taffcommitteesith utsiders,hicheads hemtosuboptimizeyhavingoofew nsidersn

key ommittees.Morerecently,dams 2003)and RachelM. Hayes, Hamid Mehran,and ScottSchaefer2004)have onsideredoard om-mitteetructurenmore etail.Adams sesthecommitteetructurefboards s a wayto infer henature f the tasks o whichboardsspendtheir time. She finds hatboards fdiversifiedirms evotemore imetomonitoringhile oards fgrowingirmsdevotemore ime ostrategicssues.Hayes,Mehran, nd Schaefer ind number fresults, ost fwhich eflecthenumber fcommitteesnd their asks. he committeesof arger irmsnd ones thatpaydividendstend o have more asks ssigned o them,while hosenfirms ith igherEO owner-shiphavefewerasks. hesefindingsuggestthat heboard spart f heprofessionaliza-tion f hefirm. s thefirmecomesarger,moremature,nd transitionsrom ounder

managementowardprofessional anage-ment,heboardplays largerole ncorpo-rate

overnance.Finally, number f papershave useddata on audit committeemembershipodraw nferencesbouttheaccounting ro-cess nside ffirms.41his iteratureooks tthequality faccounting,uch as whetherfirmsmanipulatearningshroughccrualsandwhether firm'sarnings esponseoef-ficient eans hat arningsre informativeabout value. n general, hesepapersfindthat hemakeup f theaudit ommitteescorrelated ith hese ariables f

ccountingquality.nceagain,t s difficulto nferau-salityrom hese tudies.While t spossiblethat udit ommitteeslay role n mprov-ing ccountingractice,t s alsopossiblehatfirmseterminedoimproveheir ccount-ingchangeboththeir ccounting racticesandtheir udit ommittee embership.

Committeesredefinitelyn area wheremorework an be done.We still ack goodunderstandingf the causes of variationncommitteetructure;ordo we understand

therelationetween ommitteesnd hefullboard.One reason or lackofprogressnunderstandingommitteess that heres, syet,noreadilyvailable"canned") ata setcontainingll committees.

5. WhatMotivates irectors?

Directors ave fiduciaryuty oprotectshareholders'nterests.et,their nterestsareunlikelyo be perfectlylignedwith he

shareholders'.heir incentives,herefore,havebeena naturalopic or esearch,hichwesurveyere.Given hat heprecedingis-cussion ouchesnthese ssues ere nd here

41A partial ist of this iteraturencludesKirstenL.Anderson, eli, and Gillan 2003),Ronald C. Anderson,SattarA. Mansi,and David M. Reeb (2004), Deli andGillan (2000), Klein (2002), and Biao Xie,Wallace N.Davidson, nd PeterJ.DaDalt (2003).








andwe seek o avoid nnecessaryepetition,this ection illproveoberelativelyhort.

5.1 DirectCompensationLike all economic ctors, irectorsmay

bepresumedopreferreater ealth o esswealth; ence, hey hould e responsiveofinancialncentives.ndeed,firmsoutinelyuse a varietyf such ncentivesncludingadditional ees or ttending eetings,tockandoption rants,ndperformanceonuses.For sample f1,198 irmsn2002,StephenH. Bryan nd Klein 2004) reporthat heaverage irector eceived 102,976n total

annual ompensation;fthis, 71,839wasincentive ay and $31,137was cash. Thelatter igurelso contains n incentiveom-ponentnsofar s approximately8,129 reattendancecontingentees. Roughly73percentf firmsn thesamplemadeoptiongrantsnd37percenttock rants.42ermack(2004) finds vidence hatwhen ll incen-tives re accounted or including eepingcurrent oard eats ndgaining ewones),the verageutside irectorf Fortune 00

firmains 1cents or ach$1,000ncreasein firmalue.He findshat one standarddeviationhange n the marketapitaliza-tion f hemedianample irma$2.6billionchange) esultsn a $285,000 hangen anoutside irector's ealth.

5.1.1 TheoryFrom theoreticalerspective,he basic

ideas of ncentiveayare wellknown ndhave been analyzedat depth (see, e.g.,

Holmstrom979,Steven havell 979, ndSanford.GrossmanndOliver . Hart 983;Bolton ndDewatripont005 offers text-book reatment).hethree-levelierarchyfshareholders-directors-managementener-ates ome dditionalssues, uch s possible

42See KatherineM. Brown 2007) for a survey fsome of the, argely egal, ssues connected o directorcompensation.

collusion etweendirectors nd manage-ment, utmanyof these have also beenaddressednthebroaderiteraturesee,

.g.,Tirole 986, 992).An interestingboard-specific heo-

retical nalysiss PraveenKumar nd K.Sivaramakrishnan2008). First, unlikealmost all the theoretical iterature nboards, umarndSivaramakrishnanxam-ine herole f heboardnsettingheCEO'sincentiveompensation.econd, he uthorsexplicitlytudyheroleof ncentiveayfordirectors ith especto theperformanceftheir uties.Among heir indingsre thatboard independencend board incentivepay ouldbesubstitutes;ndependentoardscould be less diligentmonitorshan ess-independentoards; nd, s a consequence,having maximallyndependentoardneednotbe bestfor he hareholderseteris ari-bus.The basic ntuitions as follows. less-independentoard, nowingtwillnot e asstrong negotiatorgainst he CEO whenit comes ime osethiscompensation,as astrongerncentivehan oes more-indepen-dent oard o earn ayoff-relevantnforma-tionprior o thosenegotiations.he reasonbeing hat uch nformationelps o offsettheir eaker argainingosition.nessence,a less-independentoard s playing "lashitself o themast" trategyecause tknowsitwon't e able toresistheCEO's demandsaswell s itwould therwiseike.Becauseless-independentoardhas a strongerncen-tiveto gathernformation,hestrengthfthe compensationncentivest requires s

less hanwould e required y more nde-pendent oard.Hence, t s cheaper or heshareholderso employ less dependentboardnterms f nducingheboard o earnpayoff-relevantnformation.f course, hefact hat t sa more ependentoardmeansthe shareholdersear other osts;but asKumar ndSivaramakrishnanhow,t spos-sible orheformerffectobegreat noughtooutweighhese therosts.








5.1.2 EmpiricalWork

Therehas been someempirical

ork nthe determinantsf directorompensation.NikosVafeas 1999) conducts matched-sample nalysis ith sample f 122 firmsthatdopted directorompensationcheme(a plan providingor hegrant fstock roptions)etween989 nd1995 nd122thatdidnot andhadnot).He findshat stronglysignificantredictorf doptions the ropor-tion foutside irectors,hich s positivelyrelatedoadoption. omparingdoptersndtheirmatched

onadoptershree

earsfter

plan doption,afeas indsdoptersontinueto have higher roportionfoutside irec-tors.A comparisonf differencesetweenadoptersnd nonadopters,longwith ug-gestive,utnot lways tatisticallyignificant,regressionoefficients,ndicatehat irmshatadopt end obelargerasmeasuredy ales),are less ikelyohave n unaffiliatedlock-holder,ndhavebusier irectors.afeas utsforth he nterpretationhat dopting irmsaremore eliantn theboard s a monitoringdevice nd, hus, ontingentompensationspart f his overnancetrategy.

ConsistentithVafeas1999),BryanndKlein 2004) find vidence hatfirms ithgreatergency roblems ake reaterse ofoption ompensationor utside irectors.43In contrastoVafeas,hey ind o evidencethat hepercentagefoutside irectorss a

43The authors se measures f nvestmentpportuni-ties eitherR&D expenses r market-to-bookatio) s an

agency ariable; he dea beingthathavingmorepoten-tially quanderable nvestmentpportunitiesmeans theagency roblemsworse.Other gency ariables re ever-ageandbeing egulated;hediscipliningature fdebtoroutside egulationeduces gency roblems.More ontro-versial s a measure fcloseness o financial istress; heauthors rguethatdistress eads togreater reditoron-trol,which educes he gency roblem. lternatively,hehigherikelihood hat he stockwillbe worthless educesthe value of stock ptions,making hem less-powerfulincentive or directors.Or, as another lternative,hecreditors, orried boutthe asset-substitutionroblem,want o avoidgiving irectorsncentivesogamble.

significantredictorf ptionompensation.Inrelatingoardndependenceo the truc-ture fdirector

ompensation,t s

mportanttokeep nmind hat nside irectorsrenotpaidfor heir oard ervice.Hence, tmaysimply e too costly o introduceophisti-cated compensationontracts hen thereare few utside irectors. s the numberfoutsidersrow,tmay e more easonableoask shareholderso approve irector tockoptionnd hare lans.

LikeBryanndKlein, ich ndShivdasani(2005) find hat irms ithhighmarket-to-bookratios re more

ikelyo utilize

ptioncompensationor heir irectorshanfirmswith owmarket-o book atios. hey urtherfind hat, onsistent ith an attenuation-of-agency-problemstory,hestockmarketreacts avorablyothe doptionf directorstock-optionlan.Adoptioned tosignificantcumulativebnormal eturns0.31percentfor lladopters,.18percentor subsampleof "uncontaminated"vents). doptionlsoled to an improvementntheearnings-per-share orecast.

On the otherhand, t is possible hat,insteadof beinga solution o an agencyproblem, irector ompensationlans areevidence of an unresolvedgencyprob-lem. van E. Brick, dedPalmon,ndJohnK.Wald 2006)find strongositiveorrela-tion etween xcess EO compensationndexcessdirectorompensation,here xcesscompensations defined s the residualfrom pay-for-performanceegression.ftheregressionesidualsweretruly andom

errors,henthey houldbe uncorrelated.Correlation ndicates systematic actorswithin achfirm. rick, almon nd Waldsuggesthat ne such ystematicactorouldbe "cronyism"etweenhedirectorsndtheCEO; thats, hedirectorsndCEO colludetogethergainsthe hareholderso mprop-erlyncrease heirompensation.

Other authorsPerry1999 and AdamsandFerreira008)have oughto determine








whetherncentiveayfordirectors as aneffect n their ctions. dams nd Ferreira(2008)estimate heeffectf

meeting-atten-dance feeson directors'ecisions o attendboardmeetings.hese authors ind,ome-what urprisinglyivenhehigh pportunitycost of mostdirectors'ime, hatreceivingas little s $1,000per meetingignificantlyincreases ttendance. onsistent ith theview that ncentive ay improves erfor-mance, erryinds hat ncentiveaymakesoutsider-dominatedoards even morelikelyo dismissheCEO for oorfinancialperformance.

An importantonsiderationhen evalu-atingstudiesof director ompensationsthat othdirectors'ompensationnd theiractions ould be a functionf some thirdfactor. or example, ne possiblesourceof variationngovernances between ro-fessionally anaged ndfamilyirms.t islikelyhat rofessionallyanaged irmsremoreikelyohire ompensationonsultantswhendesigningirectorompensationys-tems, nd consequentlyre more ikely o

include ncentive-basedlans, nd are alsolikelyo havehigherevels fcompensation(givendirectorsmustbe hired via arms-lengthransactions).uch an explanationsoften ifficulto ruleout although damsand Ferreira2008) are largelyble to doso byusing othdirector ixed ffectsnddirectorshipffectswhich ontrol or am-ily ersus on-familyirms)nd nstrumentalvariables o address ndogeneityroblems.It is also likely hattheseprofessionally

managed irms avehighermarket-to-bookratios, igherttendancet boardmeetings,andmoreperformance-basedvaluation ftheCEO. Theprofessionalismf the man-agementeam s only ne ofmany ossibleomitted ariables. n theother and, hereis no"smokingun" o indicate hat ne ormore mitted actorsre the xplanationorthe results f these tudiesand, s noted,Adams nd Ferreira 008 is very areful).

Nevertheless,swe have mphasized,mit-ted variables re always worrisomeos-

sibilityhen

nterpretinghese and other)

findings.5.2 Reputationaloncerns

What othermotivations,esides directcompensation,ouldaffect irectorehav-ior?A possiblemotivehathas been heav-ily nvestigateds theconcern hat irectorshavefor eing een as able business eople.Anidea,dating ack at leastto EugeneF.Fama (1980), s that oncern orhisrepu-tationwill cause an agent o act more nhis principal's nterests han standardapproachesoagencymightuggest. n theother and, s Holmstrom1999) observes,reputationaloncerns re not sufficientoeliminategency roblemsndthey an, nfact,reate dditionalnes.With espectothe latter, eputationaloncerns an gen-erate gency roblems ithrespect o theagent'shoice frisky rojects.44

Directors' eputationsre likely o beimportantn the market ordirectorships.A strong eputationresumablyids nget-tingmore oard eatsorretaininghe onesalready eld, weakreputationheoppo-site. StuartC. Gilson 1990) and KaplanandReishus1990)examine hispossibilityempirically.45hese articles ind hat oorlyperformingEOs are ess ikelyogain oardseats n otherompanieshanwell-perform-ing CEOs (withpoor performanceeing

44 n Holmstrom1999),reputationaloncerns ause

the agentto shy wayfrom isky rojects.As, however,othershavenoted, hat conclusion ependson whetheroutsideobservers nowthe riskof theproject aken. fthey o,then n agent ouldrationallye overly isk ov-ingwhenchoosing rojects. he reason s that bserverswill notupdate theirbeliefs bout the agent's bilitiesmuch n response o a risky roject's utcome, ecauseit is a noisy ignal; consequently,he risk o theagent'sreputations lower han fhe undertook lessriskynd,hence,more nformativeroject. ee, e.g.,Hermalin ndWeisbach 2009) for morecompletediscussion f thisissue na governanceontext.

45Another rticlenthis rea s Yermack2004).








indicatedyfinancialistressr a reductionin dividends,espectively,n the two stud-ies).Fich 2005)studieshe

tock-priceeac-

tion o dding irectorsfdifferentualities.Mostnoticeably,efinds hat he umulativeabnormaleturnnresponseo the dditionof director ho sCEO of notherirmssignificantlyreaterhehigherhe ndustry-adjusted OA ofhisfirms. Thenewdirec-tor'sholding n MBA also has a positiveimpact n the cumulativebnormaleturn,albeit t a marginalevelofsignificance.soberingindingbout ur ownreputationsis that

ddingcademicso a board s asso-

ciatedwith negativeeturn,lthoughheeffects not tatisticallyignificant.

Fichand Shivdasani2007) examine heeffect n directors'eputationsf they iton theboards ffirms hat rethesubjectofshareholderlass-actionawsuitsllegingfinancialraud. hey ind hat utside irec-tors reno more ikelyo eave heboard fthe uedfirmhan heywould e otherwise.Thesedirectorso,however,ee a significantdrop nother oard eatsheld.The size of

this ropsgreaterhemoreevere hefraudallegationsthere s an associatedformalaction ytheSEC) and when hey rguablybear greater esponsibilityormonitoringfraudthey erveon theaudit ommittee).Finally,hese"tainted" irectorsre morelikelyo osedirectorshipstfirms ithrgu-ably trongerorporateovernanceasmea-sured y heGompers,oyshii, ndAndrewMetrick003 index) nd their eparturesassociatedwithpositive umulativebnor-

malreturnsor hese irms.Althoughuch studiesare valuable, t

is worth bservinghat hey ouch nly nmeasuresfreputationisible otheecono-metrician;hey on'tnecessarilyickupon"soft" imensionsfreputation.n particu-lar,a director ho wishes o maintain robtain oard eats ould, t least ntheory,face reputationalrade-off.s the studiesabove ndicate, director hodevelops

publicreputations a poormonitors hurtwith espectothenumber fboard eatsheor sheholds.At the sametime,however,directorhodevelops private eputationsa poormonitor thats, s someone nlikelyto rock heboat mighte favoredyCEOswho are looking o acquirepowerat theexpense f heboard.Certainly,number fthe models iscussedn section .2 rely nthere eing bservableto heCEO at east)differencescrossdirectorsnthe ntensitywithwhich hey arry ut theirmonitoringroles.

Amodel hat artiallyets tthis ual en-

sion s Warther1998). n hismodel, hereis a three-personoardconsistingf twooutside irectorsndtheCEO. The outsidedirectorsare about heir ublic eputation,so wish oremove poorlyerformingEO.TheCEO, of ourse, ever otes or isownremoval,o any emovalequires nanimitybetweenheoutside irectors. problemnachievingnanimitys that hetwooutsidedirectorseceive rivateignalsf heCEO'sability hat are, conditional n his abil-

ity,ndependentlyistributed.he outsidedirectorsansharenformation,ut nlynacostlymanner:n outside irector ho ndi-cates he has a negativeignal f heCEO'sability illbe punished or erdisloyaltyotheCEO by osing erboard eat f hefailsto oust him.Consequently,othdirectorscanreceivemoderatelyadsignalsbout heCEO, such hat twouldbe optimalo ousthim, utneitherpeaksupfor ear f osingher eat. f,however,director'signals bad

enough,hen i) herconcern orherpublicreputationill be more evere nd (ii) themore ikelyt s thather o-outsideirectorhas also received badsignal; ence,nthiscase,shespeaksoutagainst heCEO. Theoverall esult s that nly rulywful EOsgetfired, ith oohigh proportionfweakCEOs' gettingokeep heirobs.

As formulated,here re twopoints fconcern ith heWarther odel. irst, hy








has the CEO been granted hepowertodetermine horemainsn theboard?ftheCEO can'tretaliate

gainstboat-rocker,

theproblem isappears. econd,why on'ttheoutsidedirectors haretheir videnceprivatelyrom he CEO and coordinatetheir ubsequentctions?n the Warthermodel, hedirectors,aving hared nfor-mation,will agree as to the CEO's abil-ity ndwill, hus, greeaboutwhether eshould o orstay; ence, he CEO's powerto ridhimselff a trouble-makingirectoris no longer elevant. s notedpreviously,grantingheCEO an ability o influence

boardmemberships consistent ithfieldstudies e.g.,Mace 1971),but thisdoesn'texplainwhyhe has thatpower. t is pos-siblethat ntegratingarther's odel ntoa bargaining-typeodel fboarddetermi-natione.g.,Hermalin nd Weisbach 998)couldrationalizeheCEO's abilityo retali-ateagainst issentingirectors.he secondissuemight lso be finessed ya suitablechange n the model.Supposethe direc-tors, or omereason, o not greewhat he

standardor ismissal hould e. The morehard-nosed irector ould be reluctantoapproachhe more enient irectoror ear(i) theywould reach differentonclusionsand ii)the more enient irectormightatheroutto theCEO (perhapsocurry avorwith the CEO, to avoid future roblemswith dissident irector,r to promoteprivate eputationmongCEOs as a direc-torwhodoesn't ock heboat).

6. Conclusions

Corporategovernance,nd in particu-lar the roleofboards fdirectors,as beenthetopic f much ttentionately. lthoughthis ttentions particularlyopicaldue towell-publicized overnancefailures andsubsequent egulatoryhanges, orporategovernances an area of ongstandingnter-est in economicsdating ack to at least

Adam Smith1776).46 ecause of corpora-tions' enormous hareof economic ctiv-

itynmodern conomies,he costof their

agencyproblemss extremelymportant.Consequently,orporategovernance ndthe role of boards of directors re issuesof fundamentalmportancen economics.Understandinghe ole fboards svital othfor urunderstandingfcorporateehaviorandwith espectosetting olicyoregulatecorporatectivities.

Given hefundamentalmportancef heissue and itsprominentlacein thepubliceye, t s not urprisinghat here as been

a surge f research n boardsofdirectors;indeed, erhapshe urprisingact s thatthas taken olong or oards o become uchanactiveopic f esearch. esurveyhis it-erature ere, aying pecial ttentiono thatdonebythe economics nd finance rofes-sions, nd also to that esearch one subse-quent o theHermalin ndWeisbach2003)survey. navoidablyhere s muchworkwehaveneglected;ne of the difficultspectsofwritinghis urveys that here re new

papers ppearing early very ay, utstrip-ping ur apacityowrite bout hem 47

Boards of directors re difficultnstitu-tions ostudy.he two uestionsmost skedabout oards oncern hat eterminesheir

46Withrespect odirectors,mithwrote The direc-torsof such companies,however, eing the managersratherfother eople'smoneyhan f heir wn, t annotwell be expected hat hey houldwatchover t with . .anxious igilance . . Negligencendprofusion,herefore,must lwaysprevail,moreor less, n themanagementf

the affairs f uchcompanies]" BookV,Part II, ArticleI, "OfthePublickWorks nd Institutions hich re nec-essary or acilitatingarticular ranches fCommerce,"paragraph 8).

47A possiblereason for he growthn the literatureis betterdata availability. number f new databaseson boards have become available nd have been used ina number f studies.A database providedbyCompactDisclosurehas a longtime eries,running rom 988 tothe present,while an alternative atabaseprovidedbyIRRC has detailed nformationn committee tructureand theprofessional ackgroundf directors. oth data-bases are used and described nFahlenbrach2009).








makeup,nd what eterminesheir ctions.These questions re, however,undamen-

tallyntertwinedthe

makeupf boards s

interestingecause t ffects hat heboarddoes; and, consequently,heirmakeup sinfluencedy desire o affect hat hey o.Thisproblemf oint ndogeneitys vexingfor oth heoreticalndempiricalesearchonboards; esearchhat ocuses n one sideof theequationwhile gnoringhe other snecessarilyncompletend the resultsmis-leading.Nevertheless,rogress as beenmade,much f t nthe astfive r ixyears.

Empiricaltudyfboardssdifficultor

numberfreasons. irst,ne must ealwithbroaderhandeal lassificationsfdirectors.Anoutside irector,ornstance,ets odedas suchwhetherhe strulyndependentrshe's heCEO's oldest riend.48econd, earlyall variables f interestre, as discussed,jointlyndogenous. nlike he situationnsome ther reasof conomics,here re nocure-allnstrumentshat necan use to dealwith hisendogeneity.ltimately,uch fwhat ne earns bout oards s about qui-librium ssociations.ausality,nthe usualsense, s oftenmpossibleo determine.orexample,onsiderWeisbach(1988)findingsthat utside irectorsppearmorerespon-sive to performancen the CEO reten-tiondecisionhan nside irectors.ecausethe directorsn questionwere determinedthroughomeequilibriumalbeit, ossibly,second-best)electionrocess,ne does nothave classic xperimentnwhich ifferentdirectorypes rerandomlyssignedo con-

trol ndtreatmentools.Whether andomallocations fdirectors ouldyield imilarfindingss unknowablend, hus,necannotbe sure hat hefindings,lthoughoth en-sible ndsuggestive,re notdriveny ome

48Byoung-Hyoun wangand SeoyoungKim (2009)and Lauren Cohen,AndreaFrazzini,and ChristopherMalloy 2008) are two recent ttemptso estimatewhichoutside irectors retrulyndependent.

unseen hird orce hat etermineshepro-portionf outsiders n theboard, heper-formancef heCEO, and

proclivitiesf he

formerofirehe atter.Ultimately,any f thestrongestmpiri-

calregularitieshat ave eenfound anbestbe interpreteds statementsbout oth hedirector-selectionrocess nd theirdirecteffectn board actions. orexample, tag-geredboards tend to base CEO -retentiondecisionsesson theirCEO's performancethan do non-staggered oards. Why?Perhapsbecause, as the consequenceof

past good performance,he CEO

gainsbargainingower,which e uses toprotecthimself.hus,fornstance, e arranges orhisboard o become taggered;ut ncreas-inghispowernthisway omes t the costof a reducedability o discipline im inthe future houldcircumstances arrant.Hence, n the onger un,firms ith tag-geredboards will have lower valuationsthandofirms ithnon-staggeredoards.Asimilartoryan be told or nydecreasenboardpower,uchas the creationf nter-

locked oards.Other mpiricalesultsan be interpretedsensibly y consideringoththe selectionand ctionsfboards. or xample,here rea numberf tudies hatook tthe ctions foutside irectorshat end ofind hat oardsdominated y outsiders endto be moreshareholder-friendlyhanboards ominatedby nsiders.49et, tudies hat ave xaminedtheoverall erformanceffirms ith iffer-entkinds fboards ave ll foundittle rno

differencen overall erformance.50heseostensibly onflictingesultsmake sensewhenboth the selection nd action ssuesare considered. utside irectorsreprob-ablybetter rom shareholdererspective,

49See, for example,Weisbach (1988), Shivdasani(1993), ndBrickley,oles,andRory . Terry1994).

50See, for xample,MacAvoy t al. (1983),Hermalinand Weisbach 1991), rBhagat nd Black 1999).








but becausethey end o be added follow-ing poorperformancesee, e.g.,Hermalinand Weisbach 988) or mostdemonstratetheir alue n crisis ituations,he relationbetween utsider irectorsndfirmalue sobscured.

Theory,oo,faces tshurdles. oards reonly art f he orporate overnancequa-tion, ut n all-inclusive odel s mpracticalgiven hecomplexitiesfgovernance.venlimitingttentiono boards, t is hard todecidewhich nstitutionshould e treatedas exogenous nd which as endogenous.Letting oo muchbe endogenousnd the

models ecomeunwieldynd often ailtoyield efinitiveesults.reatingoo much sexogenousnd riticalointsfoint ndoge-neity etoverlooked,enderingonclusionsthat resuspect.

Despite these issues,valuable insightshave been gleaned. Models linking hedeterminantsf the board and its moni-toringfunctionhave proved reasonablyrobust nd broadly onsistent ith ubse-quentempirical nalyses.There has also

beenprogressn models hat xamine heboard'srole in setting trategy,lthoughtheir onclusionsredifficulto test mpiri-callyand thesemodels have not alwaysbeen as sensitiveo oint-endogeneityssuesas would e ideal.

Wheredo we see research n boardsheaded?The open questionsremany ndoftenfundamental.or instance, re thevariousmeans ofgoverning corporationcomplementsr ubstitutes?hat s,do firms

tend to be strong-governanceirms crossallthevarious imensionsf ncentiveom-pensation,pennessotakeovers,nd boardindependence?51r does strengthn oneareacorrespondo weaknessnanother? ta theoreticalevel, hisquestions almostsurelympossibleo answer, ut one can

51Hirshleifer nd Thakor 1994) can be seen as anearly ontributionothis uestion.

hopeto see progressn theempiricalide.Even understandinghethergovernancemechanismsre

complementsr ubstitutes,

one s eft oponderhe ources fheteroge-neityngovernancehatweobserve; ow ssuchheterogeneityest xplained? lthoughtherehas been some work n this area(consider,.g.,Hermalin 994 as an earlyattempt),here re stillmany pen ques-tions.Other romisingreas for heoryrehow heboardfitsnto heCEO successionprocess;herole f he omplexityf firm'soperationsndenvironmentn the hoice fdirectorsndtheirctionswe ketchedos-siblepaths oexplorebove);more ynamicmodels fboard volutionnd the ong-termpath fgovernance; odelingoard nterac-tionsWarther998representingne ineofapproach);ndwhat enefit,ther han ro-tectingheCEO, insiders n a boardmightplay.

Empiricalworkwillneed to continue odeviseways fdealingwith heoint-endoge-neityssue.Apossibletrategynthis egardis to ookfor naturalxperiments."ne set

of suchexperimentsrechangesn regula-tion.nparticular,f newregulationsputin place, t is possible hat ome firms realreadyncompliance ith t,whileothersare not. fbargaining odels fgovernance(e.g.,Hermalin ndWeisbach 998) re cor-rect,henwe should ee ittle onochangenCEO compensationor hose irmshatwerealready n compliance,while CEO com-pensationhould,nthe ong erm, iseforthose irmshatmust ome nto ompliance.

Iffirmset their overnancetructurepti-mally iven heir onstraints,hen he ong-runperformancefthosefirms orwhichthe newregulationsind shouldbe worsethan hat f hose lreadyncompliance.nthe hort un,however,heresults ouldbemore onfused,othe xtenthat heregula-tionholds ptheCEO for he hareholders'benefit;hat s,totheextent hat he CEObargainedor omethinghat enefittedim








at shareholderxpense,uthadthat argainsubsequentlyndone y heregulation,herewould e short-term

ain yhareholdersthis

iswhytmaybe more elevanto considerCEO compensationhanfirm alue).VidhiChhaochhariandYaniv rinstein2009)fol-low his pproach ith espectochangesnthe NYSE andNasdaqboardrequirementsmaden hewake f heEnron ndWorldcomscandals. hey ind vidence onsistentiththe redictionsor he hort-runffects:hosefirmshatwereout ofcompliance ith heregulationst the ime f heregulationsawa fall n CEO

compensation.here s also

some, lbeitweak, videncen favor f thelong-termiew hatbindingonstraintsanpush pCEO compensation:fterhe mme-diate hock,EO compensationegan oriseover imeChhaochhariandGrinstein,ableI, PanelC). It would e interestingoknowwhether,hen longeranel sexamined,fthose irmshatwere ut f ompliancetthetimehe egulationsere utnplacehad hefasterrowthnCEO compensationfter heimmediatehock han hose hat adbeen n

compliance.Additionalopics hat trike s as profit-able reas ffutureesearchre:

1. How are potential utside directorsidentified?52hat s the roleof searchfirmsn thisprocess?What s the roleof social networksn thisprocess?53Moreover,s notedabove,there aredifferentindsof outsidedirectorsbusiness eople, ormeroliticians,ca-

demics, nd otherprominent eople.Do firmsnsearch fnewdirectorsirstidentifyhe kindthey eek,then the

52Thisquestionhas received ttention utside f eco-nomics; ee,e.g.,Westphal ndZajac (1995).The relationbetween he dentificationfdirectors nd theirperfor-mance or how the mechanics f directordentificationaffect ur models of board behaviorhave, however, otreceived ttentionothebestofourknowledge.

53Westphal ndZajac (1995)provide partial nswer.

individual r do they ompare rangeof differentinds f ndividualsimul-

taneously?o shareholdersxercise

nycontrolf heprocess?54A related uestions how are inside

directorshosen. re hey,s sometimesclaimedsee, .g.,Vancil 987), electedbecause they re potential uccessorsto thecurrent EO and service n theboard allows the outsidedirectors oassess their bilities?55n alternative,but notmutuallyxclusive,ypothesisis that avingmoremanagementn theboard acilitatesetternformationlow,either o theCEO or frommanagementto therest f heboard.

2. As thepreviousopic lludes nd as hasbeen mentionedere and there revi-ously, ow do socialnetworksmongdirectorsitnto he quation?f corpo-ration dds a director ho its nmanyboards, oes it benefit rom he addi-tional onnectionshisbrings?o whatextent ould such a benefit utweighthe costofhaving busy irector? resuch ocialnetworkseneficialn someeconomiese.g.,developingconomies,societies hat tress ersonal ies, tc.)and essbeneficialnothers?conomistshavebegunto paymoreattentionosocialnetworkssee, .g., anjeevGoyal2007 andMatthew .Jackson008) ndthe pplicationf his nalysiso boardsseems logicalxtension.56

54JieCai,Jacqueline . Garner,ndRalphA.Walkling(forthcoming)xamine heresponsivenessf hareholdersto director erformancehen tcomes o their eelection.Theyfind hat hareholdersre responsiveo some mea-sures fperformance.

55Statisticalfindings n Hermalin and Weisbach(1988) are consistent ith hisview,but cannotbe seenas definitive.

56As discussed supra, Khwaja, Mian, and Qamar(2008) is one suchexploration. singPakistani ata,theyfind vidence that the social networkmongdirectorsbenefitshe firms n which hey it.








3. If,as some evidencereviewed bovesuggests,directors re a source of

expertise,henhow nd

whyoes this

expertisematter?57fterll,firms anand do hiremanagementonsultants.Such consultants resumably evotemore ours o hefirmhan oes n out-side directorndthey avean impres-sive amount f experience, esearch,andanalytic apabilities ponwhich odraw. s the benefit f directorxper-tiseperhaps,hen, hat he CEO can-not ignore hem,unlike consultants?(Of course, necouldhavetheconsul-tants eporto theboard,makinghemharderto ignore.)Alternatively,er-haps he xpertise e areconsideringstheexpertiseobe effective onitors;thats, he bilityo detect hewarningsigns hat he CEO and othermanag-ers re notupto snuffrthat hey avenot houghthrough proposed ourseof actionwith ufficientiligence. eta furtherlternatives that he CEOis especially arefulwhen t comes to

those dimensions n which a direc-tor's xpertiseouldcauseher o blockwhat the CEO wishesto do. In thiscase,expertise nly omes nto lay ffthe equilibrium ath; n equilibrium,the CEO never triggers" director'sexpertise.

4. There has been some workon thedynamicswithin boards. Typically,the board s modeled s a single eci-

sionmaker. lthoughuch n approachcould e ustifiedy ppeal o median-votermodel r ertain ther reference-aggregation ethods,tstill eaves heactualworkingsf theboard a black

57There are, in fact, number f issuesconcerninginformationlow naddition oexpertise;here s therisk,fornstance, fherdingr nformationalascades.See,forinstance, teveL. Slezak and NaveenKhanna 2000).

box.Given urveyvidenceDembandNeubauer 992,p. 142)thatAmericanboards can be characterized s star("hub-and-spoke") ocial networks,with he CEO at thehub, t is a non-trivial uestion o understand owthedirectorsoordinateo, orxample,is-miss heCEO.58Lorsch1989)providesevidence hat t s "taboo" or irectorstoconsult ach other ehind heCEO'sback p.93);yet, t the ame ime, heyreport urvey esults hat ndicate na crisis he average core on a three-

pointcale 1=

always,

= sometimes,3 = never) or he uestionf ontactingother irectorsrivatelybout inancialperformanceata is 1.6 (p. 100),sug-gestinghistaboo can be broken. nthe ther and, n the ame hree-pointscale,themean scoreon "confrontingCEO atboardmeetingbout epressedmarket alue ofshares" s 1.98 and onprivately ontacting ther directorsabout he amematterhemean s 2.21.The 1.98 measure s also consistent

with urveyvidence hat 1percentfdirectors eel nhibitedbout peakingout nboardmeetingsp.83).A robustunderstandingf theroleofdirectorsrequires better nderstandingf ustwhat oeson ntheboardroom.

58Westphal 1999) considers ome issues related tothishub-and-spokeystem.n particular,e studieshowboard-CEO interactionsffect irm erformance,indingthatfirmshat core better n measures f "adviceandcounselinteractions"nd "board monitoring"ave sta-tistically ignificantreater eturn n equity hanthosefirms hat coreworse.Westphal rgues hathisfindingssuggesthat trongerocial ties ntheCEO-director rela-tionshipnhances oard nvolvement,o thebenefit f hefirm. chmidt2008) provides urthervidence; n inter-pretationf his analysis s that ocial ties are beneficialwhenmonitorings less mportantnd detrimental henmonitorings important. dams nd Ferreira2009) canbe seenas furthervidence hat ooser ocial ties reben-eficialwhenmonitorings mportante.g.,when decisionmust e made toretain r fire heCEO).








5. Althoughhere as been a growingit-eratureookingtthe ole fboard om-mitteessee discussion

upra),he role

ofcommitteesenerallynd their ela-tion o theoverall oard pecificallyrenotfullynderstood.he samedynam-icsquestionssked bout he board sa wholeapply qually o committees.Furthermore,ow do the committeesrelateto overallboard behavior. orinstance,ecent eforms ave dictatedthat irmsave ome ommitteesaudit,compensation)omprised ntirely foutside irectors.oes

providingome

outside irectorsnopportunityotalkoutside fmanagementhearingffectthe overallboard's behaviorwhenitcomes o ssues uch s approvingargecapital rojectsrdecidingwhetherodismissheCEO? Do these ommitteeschangetheboard from einga hub-and-spokeocial networko beinganinterlinked-starocial network? oesservingn committeesncrease utsidedirectors'nderstandingndknowledgeofthefirm,makinghem ettermoni-tors r imply oremeddlesome?heremayalso be opportunitiesor ntel-lectualarbitrage ere, s the relationbetweenegislativeommitteesndtheoverall egislatures an issue thathasbeen tudiednpoliticalcience.59

6. Thevastmajorityf he iteratureocuseson Anglo-Americanirms. tudiesofboardsnnon-Anglo-Americanirmsnd

comparisonsfboards cross ountriesis, ncontrast,n understudiedrea. tisnot, obesure, nemptyrea spaceconsiderationsed us not osurveyhisarea but s,arguably,nder xplored.

59Examples of this literaturenclude Kenneth A.Shepsle1979) ndThomasW.Gilligannd KeithKrehbiel(1989); Gilligan nd Krehbiel 1990).The authors hankErnestoDal Bo for uidance n this iterature.

Numerous uestions xist:does, forinstance, oard independencemattermorein countrieswith weak share-holder rotectionhanncountries ithstronghareholderrotection?ow dodifferentoard rrangementse.g., ualboards s inmuch fEuropeversus heunitaryoards f heUnited tates)or-relatewith ther spects fgovernance(e.g., ompensation,xecutiveurnover,takeovers,tc.)or withfirm ehavior(profitability,erger ctivity,elationswith uppliers,tc.)? n particular,necoulduse differencesn the aws

gov-erning oards s "naturalxperiments"to help test varioushypotheses. orinstance,f heoryndicatesmore ffac-tor should ead to more fy,do we seefirmsn nations hatrequire reaterhavingmore ornot?

A related ssue,which lso harkensback to how are directorshosen, swhetherirms enefit rom aving or-eign directors n theirboards,par-ticularlynsituationsn which hey re

consideringcquisitionf foreignirm,seekingoexpandnforeign arkets,rhavemportantuppliersverseas.

7. There are undoubtedlyinksbetweenboards nd thegrowingield f behav-ioral corporate finance (see, e.g.,Malmendiernd Täte2005). Directorscould, for nstance, uffer he well-knowncognitive ias of putting oomuchweightntheir nitialmpressionof the CEO and notupdatinguicklyenoughn thebasis fnew nformation.Conversely,hey ouldbe subjecto thefundamentalttributionias and, forexample,ssign oo much esponsibilityfor utcomeso heCEO andnot noughonthe ircumstanceshat ffectedheseoutcomes.ndeed, fthey refavorablydisposed o theCEO, researchuggeststhat irectorsould hen ttributeood







102 JournalfEconomic iterature,ol XLVIII March 010)

outcomesotheCEO andbad outcomesto circumstancessee,e.g., ScottPious1993,

specially hapter6); funfavor-

ably disposed, hen the opposite iaswould xist.nthisight,t s nterestingto speculate bout he extent o whichthe cult f heCEO" that asemergedinthe ast wentyears elps xplainherise nCEO turnoversHuson, arrino,andStarks 001 ndKaplan nd Minton2006): As people become morecon-vinced bout hecentralityftheCEOto firm'success rfailure,o directorscome o over ttributead outcomeso

the CEO and under ttributehem ocircumstances?

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A Conceptual Framework and Survey

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