Can the Board of Directors Save Corporate America? Paradoxically, the Answer Appears to be No!

Abstract

We model a board as a team of insiders and outsiders and ask whether it can perform the monitoring function necessary to maximize shareholder wealth. Faced with a collective decision, each board member can expend costly effort to collect information and then cast a vote in favor or against the decision. We show that even with optimal incentive contracts, boards will make inferior decisions relative to CEOs because of free riding on fellow directors' effort, information and votes. Such free-riding occurs whether the firm's corporate governance mandates that board decisions be made through majority or unanimity rules and balloting is open or secret. While active board monitoring does reduce executive compensation, shareholders are on net better off under an optimally compensated CEO with a rubber stamping board. Paradoxically, our theory suggests that reforms aiming to make boards more independent and more accountable are likely to reduce shareholder wealth.