Home > Corporate Governance Theory > Why do boards exist? The board as a team and its superiority.

Why do boards exist? The board as a team and its superiority.

The post follows an article by Stephen Bainbridge, William D. Warren Distinguished Professor of Law at the UCLA School of Law in Los Angeles, (1).

A) The board statutory role.

Boards are given by Corporate Law the power to manage companies, while shareholders are only entitled to vote a few things and react in a limited number of situations. Decisions at the board (or any other group) should be done through “consensus”, efficient when members of an organization have very similar information and interests, or “authority”, efficient when this is not the case and somebody gathers information and adopts the correct decisions, (see (2)).

Boards nevertheless are not there to manage day-to-day operations as Corporate Law grants the role of those under whose authority companies are run (by managers nominated by boards), in a waterfall of authority and power delegation. Companies have nevertheless become more a hierarchy of teams than of individuals.

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Although hierarchies are accepted as more efficient in complex organizations, both New Institutional Economics (3) and Behavioral Economics (4) accept their members to be only rationally bounded individuals. Branching hierarchies (waterfall of small groups) are an efficient solution to this reality, (both in production and transfer of information and in limiting agency costs –though with the problems of incomplete contracts, collective action problems, etc-). Contracting is an efficient ex-ante mechanism and governance an ex-post one, leading to reduce shirking and punish it, (see for example the M-form corporation).

At the top though there is a team, the board, not an individual. As there are problems arising for that, (individual input measurement, task often being even non separable, the creation of intra-team specific human capital, social loafing due to coordination, motivation difficulties, etc), the questions arises as to why a collective body at the top has been chosen.

B) Individuals versus teams. Why are groups better.

Empirical Evidence.

Some studies (5) verify (even accepting the limits to laboratory experiments) that groups decide better without additional decision delays). But if that is the case, what are the reasons? Let´s analyze the theoretical base for that.

The rationale for groups´ superiority.

a) Bounded rationality.

Decision-making requires gathering, storing, manipulating and communicating information. While gathering and communication within groups may offset their advantages, storing or memory in a group might be better, (level of knowledge but also who knows what…). As for manipulation, when bounded rationality is brought forward (unlike in Neoclassical economics) by Behavioral and New Institutional Economics, complex and uncertain decisions lead decision-makers both to act to limit eventual mistakes and to reduce the costs of decisions. As for the latter, the options are: (i) introducing heuristic or not-so-rigorous methods, or (ii) introducing governance mechanisms. This is the approach by Bainbridge, who will lead us to see team-boards as an adaptation to bounded rationality, bringing together different expertise, knowledge, interests, etc. There are several interpretations. First, it can be said that groups compensate mistakes and right guesses made by individuals, so that they average results; second, the better results may be due to the selection of the best member decision in every case, that is, groups are able to self evaluate.

b) Individual and group biases.

We can accept or not the hypothesis that cognitive biases compensate each other in average, so that the rational behavior holds, or not, (as behavioral and New Institutional Economics state). It seems that the group interaction helps counter the biases and stemming irrational behavior.

This is the case of herding, (when decision-makers imitate others against their own information and judgement). This may be a reputation risk-limiting decision for the manager, or a reaction to complexity and uncertainty, (following others supposedly better informed). If groups are an adaptation to bounded rationality, they may reduce herding. This may also be the case of overconfidence. Although individuals are more creative than groups they nevertheless keep to their plans not being able to see their (eventual) flaws. Groups are generally better at evaluation tasks, (consistent with the slate of functions assigned, -monitoring, service and resource gathering-). What about group biases? Although groups may be more risk-lovers that generally risk-averse individuals, the more relevant group bias is “groupthinking”, a response to the stress generated by challenges to group coordination rules and solidarity. Even if sometimes helpful, quality of decisions results affected as critical judgement is abandoned.

c) Agency costs.

The question here refers to whether group monitoring helps reduce shirking in vertical and horizontal dimensions. (i) Vertical monitoring. Individuals (the one at the top can´t be given the role of residual claimant proposed by Alchian and Demsetz (6)) are not good at avoiding their own shirking incentive. A group as the board is more efficient than an endless chain of individual monitors. Fama`s solution linked to the control by lower-rank employees fails because of specialization, and because of the usual respectful behavior towards superiors. Boards are groups of equals, which also solves this…with the help of independent directors. (ii) Horizontal monitoring. In a small group, where relationships are based on trust and social norms, directors need their actions to be perceived as having the right motivations; first, due to the threat of expulsion; second, due to eventual reputational damages; and third, due to reduced transaction costs within the group. (iii) Caveats: boards have nevertheless several limits to their capacity to monitor its own members and subordinates: first, the capacity is reduced with the size of the group as the cohesion among members declines; second, eventually free riding and social loafing are a problem.

C) Regulatory implications.

  1. Statutory Formalities
    1. Size of the board. Although it seems allowing unique-member boards is a good advise, multi-member ones are the norm. Size provides resource-gathering capacities; it also provides the necessary diverse expertise and skills; but since a certain size advantages don`t accumulate as social loafing, conflicts, fragmentation and partial capture by managers do.
    2. Meeting Procedures. Only decisions taken after a meeting with a certain quorum, or by phone if all members can hear all others are valid. Communications are formal, and meetings need to be called with enough time for members to get the necessary information. Cumulative voting provides diversity as desired.
  2. Director Liability. Looking at the board as a production team helps understand the Business Judgement rule; evaluating the decisions made by a group could be an impossible task for judges; what is more, external review could damage the strengths of the internal team structure as we have analyzed it, (for instance its group sanctions list and the incentives generated by it).

 

(1) Bainbridge, Stephen M., Why a Board? Group Decisionmaking in Corporate Governance. Vanderbilt Law Review, Vol. 55, pp. 1-55, 2002. Available at SSRN: https://ssrn.com/abstract=266683 or http://dx.doi.org/10.2139/ssrn.266683

(2) The Limits of the Organization, by Kenneth Arrow, at https://ia801605.us.archive.org/4/items/TheLimitsOfOrganization/The%20Limits%20of%20Organization.pdf

(3) O.E. Williamson, “The Economic Institutions of Capitalism”, at http://www.haas.berkeley.edu/groups/pubs/books/williamson/economic_institutions.html.

(4) Korobkin, Russell B. and Ulen, Thomas S., Law and Behavioral Science: Removing the Rationality Assumption from Law and Economics. California Law Review, Vol. 88, 2000; U Illinois Law & Economics Research Paper No. 00-01. Available at SSRN: https://ssrn.com/abstract=229937 or http://dx.doi.org/10.2139/ssrn.229937

(5) Blinder and Morgan at http://citeseerx.ist.psu.edu/viewdoc/download?doi=10.1.1.451.6825&rep=rep1&type=pdf , Shaw at https://www.jstor.org/stable/1415351?seq=1#page_scan_tab_contents , Miner at http://www.sciencedirect.com/science/article/pii/003050738490014X , etc.

(6) “Production, Information costs and economic organization”, at https://business.illinois.edu/josephm/BA549_Fall%202010/Session%205/Alchian_Demsetz%20%281972%29.pdf

(7) Agency Problems and the Theory of the firm, at https://business.illinois.edu/josephm/BA549_Fall%202010/Session%205/Fama%20(1980).pdf

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