Board Structures: Board Size

The most evident board characteristic is its size. From the governance literature in the pre- SOX era, research found two opposing relationships between board size and firm performance. The first school of thought supported increasing board size as the size and complexity of the organization was increased. For example, as a result of choices in firm strategy, large organizations are frequently more sophisticated in their operation. It has been proposed that they require greater board attention and a more diverse board skill set to monitor firm behaviour (Goodstein, Gautam, & Boeker, 1994; Mintzberg, 1983; Ocasio, 1994; Pfeffer, 1972; Pfeffer & Salancik, 1978; Provan, 1980). Thus, governance researchers have argued and empirically demonstrated that boards of larger organizations need to be larger to manage the increased set of responsibilities (Lehn, Patro, & Zhao, 2009) or higher levels of diversification (Yermack, 1996).

However, there are scholars who propose that smaller boards are actually more effective than large ones in their ability to make strategic decisions (Goodstein et al., 1994), avoid confrontation (Lipton & Lorsch, 1992) and work hard as part of a group (Kidwell & Bennett, 1993). This school of thought suggests that on larger boards, members become more isolated from each other, interacting less often thereby enabling the firm’s management to more easily manipulate board decision making. In addition, boards that are large and diverse may have higher levels of conflict and fragmentation (Goodstein et al., 1994) and may have higher costs to monitor (Boone, Field, Karpoff, & Raheja, 2007).

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Thus, the board size-firm performance relationship during the pre-SOX era is unresolved, with research suggesting there are linkages to stronger monitoring and performance with both large boards (Goodstein et al., 1994; Lehn et al., 2009; Mintzberg, 1983; Ocasio, 1994; Pfeffer, 1972; Pfeffer & Salancik, 1978; Provan, 1980) and small boards (Goodstein et al., 1994; Kidwell & Bennett, 1993). These research streams have mainly considered board size at the level of the full board without examining how their subordinate structures may impact information flows, relationship building and power dynamics. Given the focus on board size during the pre-SOX timeframe, it is important to provide details of its prominence in the literature; however, with the volume of research completed to date on board size in the pre- SOX timeframe and the focus of SOX on independence rather than size, I do not present hypotheses on board size as they would only be a replication of what has been extensively considered in the literature to date. Board size is proposed as an element of board independence power and discussed in more detail in Chapter 4.

The other key structural board variable in corporate governance research in the pre-SOX timeframe was the concept of board independence, although at that time there were no legal requirements for specific levels of board independence (NYSE, 2013). As noted by Dalton and Dalton (2011: 406): “it has been repeatedly argued that a board’s willingness and ability to responsibly monitor the enterprise is related to board members’ independence”. The analysis related to board independence from the pre-SOX era was predominately considered at the board level and the measurement of this construct did not use a uniform consideration of ‘outside director’. In its broadest consideration, an outside director is any board member who is not also an officer of the company, thus all non-management members of the board (Johnson et al., 1996). It is clear that the adoption of this classification of outside director could allow for large gaps in the monitoring role of the board if family members, former employees, individuals with contractual relationships with the firm (such as legal or financial services, suppliers or customers), or individuals over whom management holds sway are considered outside directors. Baysinger and Butler (1985: 110) suggest that those categories of outside directors are “assumed to be incapable of making or acting on a critical appraisal of management”. As a result, corporate governance literature has separated outside directors into two categories: affiliated directors who are not officers but are associated with management through significant business transactions ($60,000 per year or

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more) with the home firm (Finkelstein et al., 2009); and, independent directors who have no financial, family or psychological ties to the management of the company. As noted by Gordon (2007: 1477), “[the term] "independent director" entered the corporate governance lexicon only in the 1970s as the kind of director capable of fulfilling the monitoring role. Until then, the board was divided into "inside" and "outside" directors””. This segmentation is supported by regulatory requirements from the SEC for companies to publicly report on the different categories of outside director in their proxy statements (Braiotta, 2004; Daily & Dalton, 1994).

As outlined by Westphal and Zajac (1997), independent directors can be rendered ineffective monitors in one of two ways: the independent directors can either not have enough information to effectively monitor and evaluate the actions of the CEO and senior officers, or, they can be peer CEOs themselves (CEO-directors) and be sympathetic to the home firm CEO in a way that blunts their willingness to be dispassionate and unprejudiced in their assessment. The latter condition is exacerbated if there are further board interlocks between the CEO of the home firm and the independent board member of the home firm. Similarly, Useem (1984) thought that the interaction between CEOs and peers on the board of their firm would lead to the creation of an inner circle of elites that would support each other over the best interest of shareholders. This loyalty to the inner circle would effectively negate the monitoring effectiveness of the independent director while maintaining the perception that there were independent directors on the board (Gordon, 2007). However, research of large U.S. corporations by Westphal and Zajac (1997) discovered behaviour of increasing independence by CEO-directors from the CEO of the home firm between 1982 and 1992 suggesting, during that timeframe at least, independent directors on boards were attempting to self-correct for biases related to social exchange with the home firm CEO. The SOX-related structural changes outlined later on detail further steps taken to attempt to legally mitigate this interdependence.

Pre-SOX research into board independence explored the differentiation between types of directors (Hermalin & Weisbach, 1998; Weisbach, 1988) as well as the director independence-firm performance link (Baysinger & Butler, 1985; Bhagat & Black, 2002; Peng, 2004), the latter again presenting somewhat ambiguous results. In 1972, Pfeffer noted

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that only one published work to date (Vance, 1964) had attempted to use board composition (including board independence) as an independent variable and link it to the firm’s financial performance through quantitative means. Vance’s study of 103 large companies found that firms that had boards that were predominately insiders performed better on average than those firms who had outsider-led boards. He further discovered no shift in the percentage of insiders/outsiders over time. Baysinger and Butler (1985) categorized directors into three groups which roughly translated into inside directors (executive component), affiliated directors (instrumental component), and independent directors (monitoring component) and found no relationship between the percentage of independent directors and financial performance. Their research demonstrated that organizations with boards comprised of a mix of the three categories were more likely to survive and prosper. Lipton and Lorsch (1992) suggested that boards with a majority of independent directors would be better in monitoring management than boards with higher levels of inside directors. Finally, there was a robust stream of research put forward by Dalton, Daily, Ellstrand, and Johnson that provided both original empirical work and meta-analyses of corporate governance research into the role of board independence in the timeframe leading up to SOX (Daily & Dalton, 1993; Daily & Dalton, 1994; Daily et al., 2003; Dalton et al., 1999; Dalton et al., 1998; Johnson et al., 1996). The meta-analyses (Daily et al., 2003; Dalton et al., 1998) found no relationship between the percentage of outside directors and firm performance as captured through both accounting and market-based measures. I use the term outside deliberately as due to the heterogeneity in the measurement of director independence in the corporate governance studies, it cannot be stated with certainty that the measurement of independent directors did not combine affiliated directors with independent directors.

The categorization of director independence in the post-SOX era and the relationship between board independence and firm performance remains blurred and challenging to compare across studies. The shifting results could be due to changes in firm behaviour over the timeframes captured in the studies. However, the ambiguity could also be due to the difference in measurement of director independence with some research bifurcating directors between management and non-management without the empirical separation of affiliated directors. Regardless of the reason, the SOX changes mandating overall board

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independence clearly equated independent, non-affiliated directors with stronger monitoring and thus better corporate governance practices by the board.