Corporate Governance and the role of Board of Directors

Introduction to Corporate Governance

Corporate Governance and Board of Directors.

Two concepts that we often hear without obviously knowing all the nuances and differences between the two. You will find below more information about the role of the board of directors in the operation of corporate governance but also the mechanism behind the concept of corporate governance.

The Board of directors

Board of directors is an intermediary between the firm’s shareholders and its top management team. The final arbiter of the major decision made by a firm is the Board. It has decision-making rights over firm’s assets. These decisions can be: decide the firm’s strategy, evaluate company performance, hiring and firing the company CEO and top managers, ensure an ideal business strategy, take action on issues for which top managers have a special interest such as auditing, compensation or nomination of new board members.

The board of directors is a group of individuals with limited size (2) . Ten members is usually the size of a board of directors for a medium to large company.

We can distinguish 2 types of directors: Inside (or executive) and Outside (or non-executive) directors. Most of outside board members are now part-time in the organization and show up for special occasions like board meetings and annual shareholder meeting.

One question that often comes back is the CEO position, to know if whether he/she is also the chairman of the board.

CEO Duality

When it happens it’s called ‘CEO duality’. This case is partly driven by the culture and by other institution of the country where the headquarters of the company are situated. It happens a lot in the US and in France but it is unusual in UK where the governance code emphasizes on separating the roles of CEO and chairman of the board to ensure the separation of powers.

Then comes the question of the outside directors’ independence. If the outsiders are not independent, it would  blunt their effectiveness. Board members are said to be independent if they have no ties to the firm and no special interests apart from their responsibility as board members. On the contrary, they are dependent if they have economics ties to the company or its manager.

By definition, executive directors are dependent on the company they are working for.

Outside the US, they pay a fixed fee to most outside directors . The UK governance code and other codes advise against stock options for their remuneration.

From an agency theory perspective, group work like this could create free-rider problems since individual directors can free ride on the activities of others. This is why it is important to understand the nuances of small group decision making in order to understand the overall effectiveness of the board of directors.

Most listed firms have committees for auditing, compensation and corporate governance. Companies form these committees consisting of subgroup of three or more board members. Key committees are composed mostly or exclusively of independent non-executive to avoid interference with interests of executive directors. For example, it seems obvious that the remuneration committee is exclusively composed of non-exclusive directors to avoid executives to serve their own interests.

The Theory of boards

Economic theories of the board often refer to the principal-agent theory as well as incomplete contracting. According to agency theory, whenever there is a separation of ownership and control, the board will serve as a control mechanism. This situation creates lots of asymmetries of information and most of the time the shareholders delegate the role of running the company to a CEO and top management team. This asymmetry can appear because the shareholders are not sure whether the CEO is acting for their best interests or if he is behaving opportunistically for his own interests. In the language of agency theory, they do not fully reveal effort of the CEO. It proved to be a moral hazard problem . One of the solutions to this problem is to create performance-driven contracts.

Agency theory shows that it’s more efficient for a company to be monitored by a group rather than a single individual, this is quite obvious when you want to avoid this board to serve its own interests.

Information asymmetries and collective decision imply high transaction costs for direct shareholder democracy. That’s why you have to keep in mind, it’s usually not easy to gather all boards member at the same time very often and compared to shareholders, the board of directors can give more continuous and flexible feedback to the management.

Independence of the Board

Another responsibility of the board is to ratify (or reject) the proposals made by the management (new strategies, M&A …). One a decision is taken; the management has to implement this solution which will be monitored by the board afterward. The CEO and managers are responsible for the initiation and implementation of core strategies decided by the board.

The board of directors has a formal authority to overrule executives, non-executive directors don’t have enough information to decide whether this is the right thing to do.

A dual board system also exists (in Germany for example). In this case, the supervisory board deals with the ratification/monitoring role and the management board with the initiation/implementation of the decision.

Other roles in a board of directors

Industry always expects other services apart from the main control role .

Consulting role:

Give some inputs to the strategy. E.g. If a board member is a lawyer, he/she may advise the board on any legal issue regarding its actions.

Contact role:

Networking function. This networking is all about establishing and maintaining contacts to important constituencies like investors, banks, customers …

Empirical evidence

The board structure has a big impact on the organization performance. It also affects stock market or operational measures as stock returns or return on assets. This structure is neither fixed nor is exogenous. Firm’s operating environment is influenced by a host of other factors . Better performance is a direct function of independent board of directors.

Board structure and company performance

Another proven fact is that smaller boards are more effective than larger board because they don’t suffer from free-rider problems. Even after multiple researches, nobody has proven the correlation between company performance and Independence of the Board.

Most of the time, the board structure and behavior will be determined by other corporate governance mechanisms. It may be combination with other firm’s variables.

Board Independence

Agent cannot monitor themselves. Also, industry cannot expect a good job out of other agents having vested interest. A solution to this is to increase the number of non-executive directors. Even with this kind of precautions, non-executive board members might have ties with the management. This prevent them from acting independently.

Short tenure directors are usually more efficient on a board as they are independent. Long tenure directors may have socialized with the management which can lead to a non-efficient decision taken.

Board diversity

The diversity of a board is something important, it gives to the board a wider range of knowledge and skills. This diversity can also avoid board members to gather in ‘groupthink’. In another part, too much diversity can lower the level of cohesiveness and teamwork.

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