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«Three essays on corporate boards R. Øystein Strøm A dissertation submitted to BI Norwegian School of Management for the degree of Dr.Oecon SERIES ...»

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Aligned, informed, and decisive Øyvind Bøhren and R. Øystein Strøm1 Abstract This paper explores how board composition influences the conflict of interest between principals and agents, the production of information for monitoring and advice, and the board’s effectiveness as a decision-maker.

Paying particular attention to the board’s independence, information production, and diversity, we exploit unusually rich data from an unexplored institutional environment to estimate models that control for endogeneity.

We find that the firm’s performance is higher when its directors own equity in the firm, have wide information networks to other firms, and when the board has low gender diversity, no employee directors, and small size.

No association is found between performance and independence. Board mechanisms are often endogenously determined, both by each other and by the firm’s performance. These characteristics of value-creating boards are consistent with theoretical predictions and the limited evidence from other institutional regimes, but lend no support to popular opinion and the current politics of corporate governance.

Keywords: Corporate governance, Board composition, Regulation, Endogeneity JEL classification codes: G34, G38 1 This paper has benefited from comments by Paul Guest, Bang Nguyen-Dang, Øyvind Norli, Trond Randøy, David C. Smith, participants in the 6th European Workshop on Corporate Governance and Investment (Universitat de les Illes Balears), the Workshop on the Politics of Corporate Governance (Copenhagen Business School), the European Finance Association meeting 2007 in Ljubljana, and particularly from Richard Priestley. We gratefully acknowledge financial support from the Research Council of Norway (grant no.


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2.1 Introduction The corporate governance literature argues that the fundamental concerns in board design are to align the interests of principals and agents, to provide information for monitoring and advice, and to foster decision-making effectiveness (Becht et al., 2003 and Hermalin and Weisbach, 2003). However, constructing aligned, informed, and decisive boards involves a number of difficulties. In particular, the task involves a wide set of board mechanisms, but we lack both theory and evidence of how these mechanisms relate to each other and to economic performance (Becht et al., 2003)2. This also means that when regulators currently restrict the admissible range of board mechanisms like independence and diversity, they do so without knowing the impact of their actions neither on other board mechanisms nor on the firm’s performance. If anything, the limited empirical research mostly questions the validity of the current regulatory practice or has nothing to say about it.

Our paper addresses the board design problem empirically by analyzing an unusually rich set of board mechanisms in an unexplored regulatory regime, using a methodological approach that controls for endogeneity. Because the directors’ independence, network, and diversity are often debated in the public, we pay particular attention to these mechanisms, constructing new empirical proxies for independence and network that are more consistent with the existing theory. The regulatory environment of our sample firms allows us to study the economics of compulsory law in place (such as mandatory employee directors), of recent complyor-explain regulation (such as the OECD codes and national codes for director independence), and the economic rationale for introducing new mandatory rules in the future (such as a minimum fraction of board seats per gender).

The economics of the boardroom involves a wide range of mechanisms, their potential endogeneity is difficult to handle both theoretically and empirically (such as feedback from performance to alignment or from alignment to decisiveness), some of the mechanisms are hard to operationalize (such as independence and network), and the access to highquality data is limited (such as directors’ equity holdings, tenure, and netBecht et al. (2003) argue that “... formal analysis of the role of boards of directors and how they should be regulated is almost non-existent.... In sum, the formal literature on boards is surprisingly thin given the importance of the board of directors in policy debates.

This literature mainly highlights the complexity of the issues. There is also surprisingly little common ground between the models.”


work). This environment has produced empirical research which often relates corporate performance to a narrow subset of board mechanisms, assumes board mechanisms are exogenous or that endogeneity is limited, and uses empirical proxies with low validity and reliability.

The current politics of board design is driven by governance scandals in a few firms, such as Ahold, Enron, Parmelat, and Skandia. This has produced a series of regulatory restrictions on owners’ control rights in the board room, such as the Sarbanes-Oxley act in the US and corporate governance codes in more than 50 countries worldwide. The problem is that these attempts at avoiding what politicians consider the worst outcome (i.

e., governance scandals) in a few firms may prevent owners from attaining their best outcome (maximum firm value) in the typical firm, where governance breakdown is an improbable event. First, Hermalin and Weisbach (2006) show theoretically that board regulation can only improve welfare if there is either information asymmetry at the contracting stage, externalities to non-contracting parties, or if regulators have remedies that contracting parties do not have. It is not obvious whether any of these conditions are met in practice. Second, the research literature lends little support to enrouraging more board independence. In fact, Adams and Ferreira (2007) show theoretically that more independence reduces information production, hurts the board’s advice function, and may also reduce the value of monitoring. Also, Bhagat and Black (1999) conclude that the US evidence finds no clear link between independence and performance. If anything, the relationship is negative. Third, research on the relationship between performance and board diversity is very sparse and mostly inconclusive.

Overall, the limited existing research provides no convincing support for neither current nor planned board regulation.

We try to improve on this situation in four ways. The first contribution is based on the fact that our data set includes an unusually wide set of governance mechanisms. We analyze three alignment mechanisms (inside ownership concentration, outside ownership concentration, and director independence), four information mechanisms (director network, having the firm’s CEO on the firms’s board, having the firm’s CEO on other firms’ boards, and having other firms’ CEO on the firm’s board), and four decisiveness mechanisms (board size, gender mix, age dispersion, and employee directors). The sample covers all non-financial firms listed on the Oslo Stock Exchange from 1989 to 2002, which is a long time series of board data by international standards. This panel of up to fourteen observations per firm allows us to study board dynamics over extenCHAPTER 2. ALIGNED, INFORMED, AND DECISIVE sive periods, and to control for unobserved determinants by fixed effects estimation, which is uncommon in the literature. Our ownership structure data are unusually detailed, accounting for every equity holding by every owner in every firm at every year-end.

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