How do firms choose an optimum board structure? Numerous scandals and corporate failures at the turn of 21st century resulted in regulatory authorities in many countries prescribing a set of governance practices with an emphasis on the monitoring role of the board. Prominent amongst these were the 1992 Cadbury Committee Report in UK and the 2002 Sarbanes-Oxley Act in the US. A key aspect of these and several other reform codes was their emphasis on the presence of independent directors on the boards.
Conventional wisdom on board structure, based primarily on agency theory, suggests that an independent board, compared to a board comprising insiders, is able to monitor a firm more effectively, and consequently enhances firm performance (Coles et al., 2008). This is reflected in the governance codes in several countries (Otten, 2007) as well as in the beliefs held by various institutions. For example, both New York Stock Exchange and Nasdaq require listed firms to have a majority of independent directors.
TIAA-CREF and CALPERS, two large US based pension funds, have a stated preference to invest in firms that have a majority of outsiders on their boards. There is, however, no consensus about the superiority of an independent board with respect to firm performance (Dalton & Dalton, 2011), or even about the primary function of the board in a firm (Brennan, 2006).
In view of the conflicting findings with respect to board independence – firm performance relationship, scholars have cautioned against pressuring firms to conform to a single model of board composition (Bhagat & Black, 2001; Hermalin & Weisbach,
50 2003; McConnell, 2002). An independent board is expected to minimize the traditional agency conflict between the owner and managers. However, the principal-agent conflict becomes subordinate to principal-principal conflict in many situations where majority owners also work as managers and misappropriate the firm value at the expense of minority owners (Dharwadkar, et al., 2000). Under such situations, the importance of independent directors diminishes as the monitoring role becomes less important. At the same time, boards are expected to perform several other roles such as strategy and service, which take precedence over the monitoring role under certain conditions. Depending on the relative importance of different roles, firms are expected to structure their board that would maximize the effectiveness of the board in fulfilling those roles. Recognizing the multiple roles that board members perform, Anderson and Reeb (2003) suggest that board composition depends on which theoretical standpoint a scholar assumes.
Scholars in recent years have proposed that optimal board structure can be decided by taking a holistic view on different roles of directors. For example, Raheja (2005) proposed that board composition should depend on firm and director characteristics, and there are cross sectional variations depending on firm characteristics.
He concluded that in some cases, presence of insiders may be important for the monitoring role as they are better informed about the quality of projects being proposed by the CEO. Adams and Ferreira (2007) extended Raheja‘s work to argue that management friendly board may be optimal as CEOs may be reluctant to reveal insider information to independent members who are a tougher monitor. In both these theoretical models, the emphasis is on increasing the effectiveness of the board in its monitoring role. I extend this line of inquiry in two ways. First, I argue that relative
51 importance of monitoring and advising/resource dependence roles vary depending on the context. Second, I argue that optimal board structure is dependent not only on firm characteristics, as is suggested by the extant literature, but also on the governance context which determines the relative importance of monitoring and advising/resource dependence roles.
Consequently, I consider two sets of factors that determine the relative importance of various board functions, and consequently the board structure. First, I propose that the ownership structure of a firm determines its internal governance context (Anderson &
Reeb, 2003). Ownership structure affects the nature and type of agency problems a firms faces, and consequently has an effect on board structure. Second, in several emerging economies, some firms arrange themselves in the form of a business group.
Group affiliation is a consequence of institutional (Khanna & Palepu, 2000a; Leff, 1978), socio-cultural (Encarnation, 1989; Guillen, 2000), as well as political conditions in a country (Evans, 1979; Ghemawat & Khanna, 1998). In the case of emerging economies, group affiliation works as a quasi-governance mechanism (Kedia et al., 2006; Khanna &
Palepu, 2000b), which has a consequence for the board structure that firms assume.
Further, ownership structure, which represents the internal governance context, and business group affiliation, which represents the external governance context interact with each other in affecting the board composition.
I use an integration of agency theory and resource dependence view with institutional perspective to predict board structure based on internal and external factors.
Agency theory and resource dependence are two dominant theoretical perspectives that extant literature has used to analyze board functions (Hillman & Dalziel, 2003).
52 Agency theory and resource dependence view are two somewhat contrasting views on different roles that a board assumes. I argue that using an institutional theory, we can decipher the relative importance of these roles in a given context. In the following section, I elaborate on this to develop specific hypotheses about antecedents of board structure.
THEORY AND HYPOTHESES