A Theory of Board Control and Size

This paper presents a model of optimal control of corporate boards of directors. In particular, we determine when one would expect inside directors or outside directors to control the board, when the controlling party will delegate decision-making to the other party, the extent of communication with the deciding party, and the number of outside directors. Our model incorporates the traditional view of corporate boards as monitors along with a role for board members as suppliers of expertise or information. Because of the agency problem between corporate insiders 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, contrary to conventional wisdom. We characterize optimal board control and delegation decisions, 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 calls into question the usual interpretation of some documented empirical regularities. 1 Harris is the Chicago Board of Trade Professor of Finance and Economics, Graduate School of Business, University of Chicago. Raviv is the Alan E. Peterson Distinguished Professor of Finance, Kellogg School of Management, Northwestern University. We are grateful for comments from Patrick Bolton, Doug Diamond, Steve Kaplan, Anil Kashyap, Chester Spatt, Lars Stole, and especially Wouter Dessein as well as participants in the Workshop on the Theory of Organizations at the University of Chicago, the Smith Breeden Seminar at Duke/UNC, the 2005 Utah Winter Finance Conference, the Harvard-MIT Organizational Economics Seminar, and the 2005 NBER Corporate Governance Workshop. Financial support from the Center for Research in Security Prices at the University of Chicago Graduate School of Business is gratefully acknowledged. Address correspondence to Professor Milton Harris, Graduate School of Business, 5807 S. Woodlawn Avenue, Chicago, IL 60637; (773) 7022549; [email protected]; http://gsbwww.uchicago.edu/fac/milton.harris/more. A Theory of Board Control and Size