Outside Directors and Managerial Monitoring

Article excerpt

Outside Directors and Managerial Monitoring*

In recent years, the role of the board of directors of a corporation has received considerable attention in both the popular press [2] and academic journals [5,6]. The board is seen in an agency theoretic framework as a mechanism for reducing the contracting problems arising from the separation of ownership (risk-bearing) and control (management) in the modern corporation. More specifically, most medium to large size corporations in the U.S. are run by a management team that owns only a small fraction of the firm's common stock. As a result, management does not fully bear the costs of any non-value-maximizing behavior in which it engages. This provides an incentive for management to act in ways benefiting itself personally but causing the value of the firm's stock to decline. Examples of this type of behavior include shirking, excess perk consumption, and the funding of suboptimal investments. Since share ownership by management is limited, management will bear only a small portion of the cost of its misbehavior (through the decline in the value of the common equity of the firm). * I wish to thank Dan McCarty, Bill McDaniel and Geraldo Vasconcellos for their useful comments or an earlier vision of this paper.

Several devices have been suggested as a means of controlling the non-value-maximizing behavior of management; one of these is the board of directors of the firm (see Fama [5] for a discussion of others). As the highest level of authority in the firm, the board has the responsibility of monitoring the entire operation of the firm including the performance of its management. The board members, as the elected representatives of the common shareholders, are charged with seeing that the firm is operated in accordance with the shareholders' wishes. Boards usually consist of members who fall into two categories: inside or management directors are members of the firm's management who also sit on the board, while outside directors are individuals on the board who are not managers of the firm. Clearly, the self-monitoring incentives of management directors are limited since they benefit from some of the activities they were placed on the board to stop. Outside directors are not generally subject to this conflict of interest and are therefore more likely to engage in the managerial monitoring desired by shareholders.

Other means of limiting the agency problems associated with the separation of ownership and control include managerial wage and benefit contracts that motivate managers to perform as shareholders desire, the market for corporate control, and the managerial labor market. The more effectively these mechanisms function, the smaller the benefits of outside director monitoring of management.

Even though agency theory asserts that outside directors have a role in monitoring management, other authors have questioned their usefulness in this regard. Flanagan [7] points out that CEOs play a major role in determining who is nominated for board positions. This might allow the CEO to nominate candidates for board positions who are either unwilling (personal friends) or unable to properly supervise management. Evidence in support of the former possibility is also provided by Flanagan, who notes that nearly 80 percent of outside director candidates are known by the CEO or other board members. Vance [10] also believes many outside directors may not be competent to perform their assigned tasks and observes that there are no established standards for directorial qualifications or performance evaluation.

Several authors have attempted to ascertain the effectiveness of outside directors in monitoring the firm's management. Baysinger and Butler [1] performed an analysis in which they classified outside directors as either instrumental directors (specific knowledge providers) or monitoring directors. They found that there was no relationship between the percentage of monitoring directors on the board in 1970 and the relative profitability of the firm in the same year. …