A Theory of Board Control and Size

Abstract

We extend the traditional view of corporate boards as monitors to include a role for outside board members as suppliers of expertise or information. Indeed, both outsiders and insiders may have private information relevant to the decision. Because of the agency problem between managers and owners (who are assumed to be represented by the outside directors), neither party will communicate his or her information fully to the other. Outsiders in our model control agency problems by making some decisions themselves. When they do, the refusal of insiders to communicate their information fully becomes costly. Therefore, shareholders can sometimes be better off by having boards controlled by insiders. We characterize whether the board is optimally controlled by insiders or outsiders, the optimal number of outsiders, and resulting profits as functions of the importance of insiders’ and outsiders’ information, the extent of agency problems, and some other factors. This leads to an endogenous relationship between profits and the number of outside directors that furthers our understanding of some documented empirical regularities.