Academic journal article Journal of Managerial Issues

Lone-Insider Boards: Improved Monitoring or a Recipe for Disaster?

Academic journal article Journal of Managerial Issues

Lone-Insider Boards: Improved Monitoring or a Recipe for Disaster?

Article excerpt

Corporate governance research attempts to explain how firms' owners oversee the activities of managers and how owners' oversight impacts firm strategy and performance (Neeley and Boyd, 2010; Owusu-Ansah and Ganguli, 2010; Pugliese et al., 2009; Rhoades et al., 2000; Silva and Tosi, 2004). One way that owners oversee managers in large, publically-held corporations is by electing a board of directors to represent their interests in hiring, compensating, and monitoring top managers (Johnson et al., 1996). Fama describes boards as "... the ultimate internal monitor ... whose most important role is to scrutinize the highest decision-makers within the firm" (1980: 294). Boards are required by law for publicly-held firms and are composed of a mixture of individuals from three groups: insiders (firm employees), affiliated outsiders (e.g., suppliers), and unaffiliated outsiders (e.g., other firm CEOs). As the proportion of unaffiliated outsiders grows, boards are considered more independent (Johnson et al., 1996).

Perhaps because of agency-based theory predictions that independent boards are more effective (Fama and Jensen, 1983), and because of public outcry after a spate of high profile scandals, the last two decades have been characterized by increased pressure on firms to adopt more independent boards. In the 1990s, for example, the United Kingdom's Greenbury Committee suggested that remuneration committees should be composed exclusively of outside directors (Conyon and Peck, 1998), and The Business Roundtable, a group of prominent U.S. CEOs, urged boards to shift to a majority of independent directors (The Business Roundtable, 1997). Further, the Sarbanes-Oxley Act of 2002 (SOX) in the U.S. requires boards to have a majority of independent directors. All of these efforts have their foundation in agency theory's prediction that independent boards more vigilantly monitor top managers and provide a better check against self-interested managerial behaviors (Fama and Jensen, 1983).

As boards have moved towards more independent structures, however, an increasing number of firms removed all insiders from the board except for the CEO. The authors call this phenomenon a "lone-insider board." From 1996 through 2002, when SOX was introduced, the number of lone-insider boards among S&P 1500 firms increased from 117 to 289 (Risk Metrics, 2010). By 2010, the number of lone-insider boards listed among S&P 1500 firms reached 608 (Risk Metrics, 2010). Thus, there has been an over 100 percent increase in the number of lone-insider boards since the passage of SOX. Lone-insider boards now comprise over 40 percent of all S&P 1500 boards.

The authors submit that lone-insider boards constitute a fundamentally distinct governance arrangement worthy of inquiry. Although agency theory might suggest that the trend toward lone-insider boards is positive because it increases board independence, there is both theory and empirical evidence to suggest that inside directors (other than the CEO) have important roles on effective boards (e.g., Baysinger and Hoskisson, 1990; Ocasio, 1994). Given the lack of inside directors to perform these important roles, the effectiveness of lone-insider boards is questionable - despite their having the highest possible percentage of outside directors. In short, whereas existing theory and trends emphasize the positive benefits of board independence, too much independence in the form of lone-insider boards might actually harm shareholders. Indeed, prior governance research has not found strong or consistent evidence regarding the effects of board independence (Dalton et al., 2008). A possible explanation is that positive effects of independence turn negative in lone-insider structures. Thus, the purpose of this study is to develop a theoretical framework to help explain how the shift toward lone-insider boards might negatively impact board effectiveness and, more generally, offer a starting point for future inquiry into the efficacy of lone-insider boards. …

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