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What do boards need to do to effectively monitor managers?

Nicola F. Sharpe recently published an article (1) in which he leads readers towards a more behavioral approach to the boards`decision-making processes and their monitoring activities.

According to him, law gives boards the power to manage the corporation, they then delegate the vast majority of functions to managers, and legislation reinforces from time to time the board`s control function. Nevertheless, the number of once solid firms filing for bankruptcy as a result of managers-only decisions is still large. But there is a widespread theoretical and legislative model where boards command the corporation, as previously said.

Both shareholder and board-centric theories advocate for authority being allocated to the Board, so that it performs a monitoring function. Still, managers control decision-making processes and relevant information. A reason may lie in the fact that authority has been granted in the form of board structure rules, not in the form of effective control of those processes.

 

 The author argues:

 

–         The managerial theory is a realistic description, and the dominance of independent directors leads boards to a much less effective monitoring function.

–         The access to information is the main channel boards may use to exercise their control function.

–         Without an effective decision-making process, (from now on D-M P) and an adequate organizational structure, boards lack the authority for the control and oversight function they are legally granted.

 

Let`s see how they base their arguments!

 

  1. How is Authority distributed according to the main theories and law.

 

    1. The board`s control function. Monitoring constitutes the main role of a board in most legal literature, due to the dominance of the Agency Theory. In that role, boards oversee and ratify the managers`s decisions, with the help of a handset of tools, (approving financial statements, M&A transactions, selecting a Ceo, taking care of self-interested transactions, etc).
    2. Authority is held by a group over the decisions of a second group when it has a superior position in a hierarchy, only if it also controls the D-M P`s.
    3. Theories allocate Authority to managers, (Managerial theories), shareholders, (prescriptive shareholder-centric theories) or boards, (director-centric or team production theories).
    4. Authority and Law: the last reforms try to reinforce the board`s authority over managers, and also its accountability, through diverse measures: independents as better monitors than executive directors; shareholders` access to the proxy ballot, (owners of a 3% for three years can propose their candidate for election as a director after Dodd-Frank); the business judgement rule as another pivotal element of the board`s authority: it presumes directors act in good faith, with due care, and pursuing acceptable business purposes. Unless it is demonstrated that they didn`t act diligently to gather “all material information reasonably available to them”, they will be supposed to have discharged their duties.
    5. Structural obstacles to Authority: the increase of formalization of the last decades has made it more difficult for boards to be proactive (boards are more reactive) in their value generation and loss avoiding tasks. This formalization goes against effective monitoring decisions when these decisions are unique and not standard ones, and a board must also be well equipped for these ones. Formalization is also more adequate for an unrealistic world where a board possess something similar to perfect information, and is able to clearly identify challenges and problems.

 

  1. The gap between theories, law, …., and practice.

The fact is the board cannot really have effective authority over the managers so as to execute its monitoring function, if it does not have information gathering tools; let`s go through the different steps in the decision-making process and see why:

 

                                                               i.      Identification of information about problems and opportunities; this step acts as a gatekeeper, as only those informations identified will be dealt with and eventually base a decision. The bias, (expertise, goals, self-interest, and statu quo perspective) of those searching for information is essential in the result. All these biases limit the agenda, and managers are the ones to do the research. Boards don`t have the information gathering assignment, so managers really have the power to control the agenda.

                                                             ii.      Analysis: determining what information is considered, estimating values, …., is also a task managers do, and they control the resources for that. Guiding this part of the process towards their selective choices is their prerogative.

                                                            iii.      Choice of response: choosing the first course of action, rather than the best is human. So doing, managers avoid to provide all information to the board, but they push for those pieces best recommending the chosen path.

                                                           iv.      Approval: boards do participate in this phase, but with information, analyses and alternative choices that have been mediatized by managers.

                                                             v.      Implementation: managers have enormous discretion in this part.

 

  1. How to fill the Gap: organizational features for effective decision-making processes. Effectiveness of a board greatly depends on both exogenous and endogenous factors; among the latter the authors deal with the board`s authority: information and its impact on the decision-making process are its main key drivers.
    1. How to add value through the decision-making process, that is, how to recover authority for the board:

 

i.      Types of D-M P. The classical approach assumes perfect information and prescribes how information should be made to obtain optimal results. The behavioral approach assumes bounded rationality, in an uncertain world with imperfect information about means and ends. In this last approach D-M P can be consensus or authority-based, and it is widely accepted boards act in this latter manner. It`s a better approach in the presence of different interests and information asymmetries among potential decision makers, exactly the case of board and managers. But within boards there is no hierarchy nor authority, but consensus is more generally accepted to govern. In fact, in many cases, the Ceo, with its control of information, holds the authority and leads the board`s D-M P, so that the board does not really take the firm to shareholder value maximization.

 

ii.      Types of decisions. Programmed decisions allow boards to adopt standardized answers. But the most important decisions are nonprogrammed ones. These need creativity, and directors face big uncertainty about cause-effect relationships between action and result. The author argues independent directors are badly equipped for these decisions not knowing the market; consequently the board may become a complacent one and may allow Ceo and managers to exercise authority.

 

 

    1. Organizational behavioral D-M framework. The authors argue that the recent structural and composition reforms (and particularly independence), does not enhance the board`s performance. So, they propose a process-oriented framework based on organizational behavioral theory. They focus on what makes individuals decide well, analyzing the attributes of an effective D-M P.

 

    1. Attributes of a D-M P. The main elements of an effective D-M P are:

 

i.      Forward looking approach to information and data. In nonprogrammed decisions, finding alternatives depends on information, the usual memory of past decisions is not useful, and it can even be damaging.

ii.      Independent gathering information mechanism. The channels through which the board has access to information determine the alternatives it considers when analyzing a situation. Ceos often share  biased information because of their personal interests, their stickiness to current strategies, etc. The board needs independent information sources, with access to the company resources and staff, but without undermining the Ceo`s authority.

iii.      Proactive role in goal setting. Goal setting determines the opportunities and problems the firm will consider and face, and if managers decide on the goals, they will surely refrain from questioning the current strategy, and provide information for that purpose. Boards should be involved in strategy formation, not just in its supervision. This also helps boards when adopting nonprogrammed decisions.

iv.      A system to solve conflicts. Having such a system, (Devil`s advocate or other) helps having a constructive debate in the boardroom. Lack of information, lack of ideas from directors, directors`s capture, group thinking, … all of them prevent boards from debating and questioning path dependent decisions; directors need to be involved and act differently. These enhanced processes empower outside directors and increase the board`s authority.

v.      Implications for policy and board`s processes. Independence and compliance-led reforms may have led to increased asymmetries between boards and managers, thus to the loss of the board`s authority.  But the above cited mechanisms will help boards avoid the regulatory effects and enhance its performance through a more informed and higher quality D-M P.

 

(1)   Nicola F. Sharpe, Associate Professor, Richard W. and Marie L. Corman Scholar, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2003010

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