Why Do Boards Exist? Governance Design in the Absence of Corporate Law

Mike Burkart is Professor of Finance at the London School of Economics; Salvatore Miglietta is Associate Professor of Finance at BI Norwegian Business School. This post is based on a recent paper authored by Mr. Burkart, Mr. Miglietta, and Ms. Charlotte Ostergaard, Professor of Finance at BI Norwegian Business School.

The board is commonly described as a monitor of management on behalf of dispersed shareholders, but fundamental aspects of exactly how and when it adds value, are still open questions (Adams, Hermalin and Weisbach (2010)). While boards help to solve managerial agency problems, they also entail costs by introducing an additional agency layer to the organizational structure. The trade-offs between costs and benefits are, however, obscured because the statutory law, in any jurisdiction, does not only mandate the board but also prescribes its powers and duties.

We study 85 Norwegian publicly traded industrial firms at the turn of the 20th century when Norway had no statutory corporate law but limited liability firms had legal personhood, individuals could freely found a corporation and decide whether to install a board. Furthermore, owners had the contractual freedom to allocate authority over major corporate decisions (e.g., the firm’s dividend policy) to the board (if instituted), to management or to the general shareholders’ meeting. This is in sharp contrast to modern legal regimes that mandate the allocation of control powers over some major corporate decisions to specific bodies. For example in the US dividend policy is controlled by the board of directors, whereas French, German, and British laws mandate shareholders’ approval of dividends.

The unique features of our setting allow us to draw inferences about boards as optimal governance choices. Consider, for instance, a firm which sets up a board and assigns authority to it. The additional agency costs of having a board must be smaller than the its benefits. Thus, by observing under what circumstances boards arise and which control powers they are given, we can infer when boards add value and what function(s) they serve. Together with the institution of a board, the allocation of control powers is a key aspect of governance

design. When a corporate body controls a decision, it holds formal authority over it, including the right to ratify it. For example, when a decision must be ratified in a general meeting, shareholders can prevent management from pursuing initiatives that are against their interests. Yet, information asymmetries or collective action problems can prevent shareholders from meaningfully evaluating decisions pertaining to particular aspects of the business. In this case, the shareholders may prefer to establish an informed board and give it the formal authority over certain decisions.

The above considerations suggest several testable predictions: First, we expect share-holders to retain authority over a larger number of strategic corporate decisions when their informational disadvantage relative to management is small. That is, the general meeting should hold more decision power in firms with large, active owners, who have an incentive to keep themselves informed about the firm’s business. Conversely, when owners are small and collective action problems exist, the cost of retaining control with the general meeting is high. In such firms, shareholders are more likely to delegate some important decisions to either a board or to management. Second, firms plagued by collective action problems should be more likely to establish boards, as, by virtue of being a smaller body than the general meeting, decision-making by boards is less costly. Third, we expect that more authority should be transferred to the board, rather than management, in firms where managerial agency costs are high, reflecting that the cost of managerial discretion exceeds the costs of having a board. Alternatively, if boards are set up for other reasons than to monitor management, they should not be given authority in order to incentivize communication with better-informed managers (Adams and Ferreira (2007)). Finally, delegation of authority to management should be more prevalent when collective action problems exist and the managers’ informational advantage is large. Such situations may occur when, e.g., the nature of the production technology renders the benefit of managerial expertise especially valuable.

In our empirical analysis, we consider the authority allocation of five major corporate decisions of strategic nature: the purchase/sale of company assets, secured borrowing, equity issuance, liquidation, and dividend payments. Because our data contains only sporadic share-holder lists, ownership structures are not directly observable. We argue that small(er) owners are more likely to be found in firms that issue shares of small nominal value, so-called small-denomination firms, and conversely that large informed (“active”) owners are more likely to be found in large-denomination firms. The results suggest that collective action problems among owners are a first-order determinant of shareholders’ decision to delegate authority. Small-denomination firms are more likely to delegate some authority compared to other firms, whereas large-denomination firms are less likely to do so. We therefore observe more delegation in firms where the cost of retaining authority with the GM is relatively high.

We then investigate the role of boards. On average, firms with boards are larger in size and have a larger number of shares outstanding. Thus, boards seem to arise when the shareholder population is large and more likely to include small investors, that is, when the potential for collective action problems is large. Large denomination firms virtually never set up a board, suggesting that boards and active owners are substitutes.

Board existence affects the balance of power in the corporation. Firms with a board give management and the GM significantly less authority compared to firms without a board. The decision most frequently controlled by the board is the dividend decision. Half of the firms with a board also give it authority over one or more of the four other strategic decisions and explicitly require the board to collect information through inspections. This suggest that boards are given authority to monitor management and asked to be informed to be able to act and decide independently. Moreover, we show that boards perform other roles beside monitoring management, and that different roles are associated with different powers. Boards that hold authority over dividends only, are not required to collect information. We conjecture that the main role of boards in these cases is to mediate between shareholders (with diverging preferences over dividends). Also, we find that in firms where managers have authority, board duties are more related to advice. Thus, we uncover three roles of boards: monitoring, advising, and mediating among shareholders.

We also observe that boards complement voting caps intended to curtail the influence of large shareholders. While such restrictions protect minority shareholders, they also reduce incentives for blockholders to emerge, and detrimentally enlarges the scope of managerial discretion. Firms that strongly cap votes more likely to set up a board. Finally, we find that firms where the founder is involved, are more likely to give management discretion over one or more decisions, and less likely to set up a board. We also find that when managers’ and owners’ preferences are aligned, costly contracting is sometimes avoided by leaving authority over decisions unassigned.

The full paper is available for download here.


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