Too much emphasis on monitoring tends to create a rift between non-executive and executive directors, whereas the more traditional job of forming strategy requires close collaboration. In both activities, though, independent directors face the same problem: they depend largely on the chief executive and the company's management for information. (The Economist[February 10, 2001, p. 68], describing a survey by PriceWaterhouseCoopers of British boards.)
Both the Business Roundtable and the American Law Institute list the provision of advice to management among the top five functions of boards of directors in the United States (Monks and Minnow (1996)). The advisory role of boards is important not only in the sole board system in the United States, but also in the dual board system in, for example, several European countries, in which boards are formally separated into a management board and a supervisory board. While there is a large literature that studies the monitoring role of boards, the advisory role has received little attention.1 This paper examines the implications of combining the board's two roles in the sole board system, and then turns to a discussion of the dual board system.
The board is the ultimate legal authority with respect to decision making in the firm. According to the American Bar Association's Committee on Corporate Laws (1994), this means, among other things, that the board must review and approve fundamental operating and financial decisions, and other corporate plans and strategies. Because managers' preferred projects are not always those that maximize shareholder value, directors must be willing to withhold approval and insist on change. This active participation in the firm's decision making characterizes the monitoring role of the board.
In its advisory role, the board takes a more hands-off approach. The board draws upon the expertise of its members to counsel management on the firm's strategic direction. As one director puts it, “Directors are sounding boards for management. They contribute their opinions as to general policy, and their judgement whenever a problem comes up” (Lorsch and MacIver (1989), p. 64). However, since many board members have full-time jobs in other corporations, they rely on the CEO to provide them with relevant firm-specific information. The better the information the CEO provides, the better is the board's advice.
To analyze the implications of combining the board's two roles, we first present a model of the interaction between a sole board and a CEO. In this model, moral hazard problems arise because the CEO's preferred projects differ from those of the shareholders. When monitoring by the board is successful, the board effectively controls project selection, and the CEO, unable to implement his preferred projects, loses valuable control benefits. When the board does not control project selection, the board advises the CEO. The crucial assumption is that the quality of the board's advice improves as the CEO provides it with better information about the firm's investment opportunities.
In our model, independent boards monitor management more intensively. Thus, the CEO faces a trade-off in sharing information. On the one hand, the board will give better advice if the CEO shares his information. On the other hand, information revealed by the CEO helps the board determine the range of options available to the firm. The more precise the board's information about these options, the greater the risk to the CEO that the board will interfere in decision making. As a result, we show that the CEO will not communicate firm-specific information to a board that is too independent.
At first glance, the advisory and monitoring roles of a sole board complement each other, because the board uses any information the CEO provides both to make better recommendations and to implement better decisions. However, consistent with the quote above, the two roles of the board may also conflict. We show that in selecting their boards, shareholders may choose to play off one role against the other. Specifically, to encourage the CEO to share information, shareholders may optimally elect a less independent or friendlier board that does not monitor the CEO too intensively.
Several theoretical papers in the finance literature examine why boards may not monitor too intensively. Warther (1998) shows how the management's power to eject board members may result in a passive board. Similarly, Hermalin and Weisbach (1998) use a manager's power over the board selection process to show how board composition is a function of the board's monitoring intensity. These authors also describe how a passive board may arise. Almazan and Suarez (2003) argue that passive (or weak) boards may be optimal because, in their framework, severance pay and weak boards are substitutes for costly incentive compensation. Our paper is similar to Almazan and Suarez (2003) in that we also show that it might be optimal to have a passive (or, in our terminology, management-friendly) board. However, in our paper the driving forces behind this result are the potential conflicts between the different roles of the board.
After analyzing the sole board system, we reinterpret our model to discuss the separation of the board's advisory and monitoring functions in a dual board system. When the two roles are separated, the CEO does not face a trade-off in providing information. The model therefore shows that under certain conditions, shareholders prefer a dual board system to a sole board system. Thus, the model has implications for cross-country variation in governance systems. While the dual board structure allows for the cleanest separation of the board's two roles, it is possible to replicate this structure by separating the roles through the use of board committees. For example, one can view the audit committee in the sole board systems of the United States and the United Kingdom as fulfilling some of the functions of a supervisory board. Under this interpretation, our model may also shed some light on the policy debate concerning audit committees.
In the final part of the paper, we relax the assumption that the board's preferences are aligned with those of the shareholders. In the United States, boards' preferences may diverge from those of shareholders because nonshareholder constituency statutes allow directors to consider the effects of their decisions on nonshareholder stakeholders. Similarly, the preferences of management and supervisory boards may differ from each other in a dual board system because, in some countries, such as Germany, workers are given explicit representation on the supervisory board. We show that when the board's preferences are more closely aligned with those of the CEO, the quality of the advice that the board provides is higher. This is an additional reason why shareholders may benefit from a CEO-friendly board in the sole board system. In the dual board system, shareholders prefer boards whose preferences are adapted to their role.
Our analysis has several policy implications that are particularly relevant given the emphasis on governance reform in both the United States and Europe in the wake of recent corporate scandals. Because boards have been criticized for being too friendly to managers (e.g., U.S. House (2002)), Congress (through the Sarbanes-Oxley Act of 2002), the NYSE, and NASDAQ now require that independent directors play a more important role in firm governance. Others have asked whether a two-tier board structure might enhance board oversight in countries, such as Britain, that currently have a sole board structure (see the discussion by O'Hare (2003) in The Financial Times).
In the context of our model, we find first that policies that enhance board independence may be detrimental for shareholders in a sole board system, but not for shareholders in a dual board system. Second, while the sole board structure can achieve the first–best outcome for shareholders more often than the dual board structure can, the latter is sometimes the second–best option for shareholders. Thus, where possible, shareholders should be allowed to choose between board structures. Finally, our model illustrates that shareholders are always at least weakly better off if the board has an advisory role.
This paper is structured as follows. Section I presents the model of the CEO's trade-off in consulting a sole board in an advisory capacity and discusses its empirical implications. Section II discusses the model's extension to the dual board system and to boards whose preferences may not be aligned with those of the shareholders. In Section III, we highlight the policy implications of our analysis and conclude. We present proofs in the Appendix.