Board games: how CEOs adapt to increases in structural board independence from management

Administrative Science Quarterly,  Sept, 1998  by James D. Westphal

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Over the past decade, institutional investors and other stakeholders have strongly criticized corporate boards of directors for failing to meet their perceived legal responsibility to monitor and control management decision making on behalf of shareholders (Wall Street Journal, 1995a, 1995b, 1996). Longstanding calls for board reform have emphasized specific changes in board structure thought to increase the board's ability to exercise control. Such changes include increasing the presence of outside or non-employee directors on the board, allocating board leadership to someone other than the chief executive officer (CEO), increasing demographic diversity on the board, and selecting directors who lack social or other ties to the CEO (Council of Institutional Investors, 1989; Economist, 1994). Several of these changes, including increases in the number of outsiders and changes in board leadership structure, appear to have spread somewhat among large companies in recent years (Kesner and Johnson, 1990; Heidrick & Struggles, 1995; Korn/Ferry, 1995). Moreover, descriptive surveys suggest that more companies are considering changes in board structure that are assumed to increase the board's power to protect shareholder interests (Korn/Ferry, 1995).

Academic research on boards has also focused largely on issues of board structure and control over management behavior and strategic decision making. Empirical studies in a number of disciplines, including strategic management, financial economics, and organization theory, have examined whether specific changes in board structure can influence specific outcomes, such as CEO compensation or corporate diversification, that have implications for shareholders' interests (e.g., Kesner, Victor, and Lamont, 1986; Hermalin and Weisbach, 1991; Westphal and Zajac, 1994). The theoretical basis for this research lies primarily in agency theory and secondarily in a structuralist view of power and control. According to this perspective, boards that are structurally more independent from management are better able to control management decision making on behalf of shareholders (Fama and Jensen, 1983). For instance, boards composed largely of inside directors are considered less likely than those with many outside directors to override management decisions that threaten shareholders' interests because such directors are subordinate to and therefore dependent on the CEO.

This dominant perspective on CEO-board relationships essentially suggests that structural board independence increases the board's overall power in its relationship with the CEO. Many studies have simply equated structural independence with board power (e.g., Zahra and Pearce, 1989), while others have discussed how CEOs exploit structural bases of power to maintain ultimate control over the board. For instance, several authors have suggested that CEOs may use their leadership position on the board to dictate the agenda of board meetings and otherwise minimize dissent (Lorsch and MacIver, 1989). Walsh and Seward (1990) discussed various mechanisms by which CEOs might exploit their structural position to avoid or bias board monitoring, including concealing negative information from the board, symbolically conforming to institutionally correct procedures, and mandating passivity among directors by "advising" them that challenges to managerial preferences are inappropriate (Mace, 1971:80). Conversely, recent empirical research has explored how structurally independent boards might limit top managers' ability to rely on such practices to maintain control. Abrahamson and Park (1994) provided some evidence that structurally independent boards limit the concealment of negative outcomes in letters to shareholders, and Westphal and Zajac (1994) found that structural board independence reduced the adoption of "symbolic" incentive plans that appeared to align management's and shareholders' interests without actually putting CEO pay more at risk. Board independence is also thought to limit the CEO's ability to mandate passivity among directors and force renegade directors to resign (Lorsch and MacIver, 1989).

While some research suggests that structural board independence may reduce the viability of concealment or overt forms of CEO influence, research investigating the relationship between board structure and the board's overall power to protect shareholders' interests has reported weak or negative relationships with such outcomes as firm performance (e.g., Hermalin and Weisbach, 1991; Baliga, Moyer, and Rao, 1996), the adoption of takeover defenses (Davis, 1991; Buchholtz and Ribbens, 1994), the commission of illegal acts (Kesner, Victor, and Lamont, 1986), the use of long-term incentive plans (Westphal and Zajac, 1994), and corporate diversification (Hill and Snell, 1988; Baysinger and Hoskisson, 1990). There seems to be little consensus that increased board independence necessarily improves corporate performance (Walsh and Seward, 1990: 433).