Home -> Law Blog Directory -> Corporate Governance Blogs -> The Harvard Law School Corporate Governance Blog

Corporate Governance

: The Harvard Law School Corporate Governance Blog

Who Monitors the Monitor?

By Harvard Law School Program on Corporate Governance

(Editor?s note: This post by Praveen Kumar and K. Sivaramakrishnan at the University of Houston is part of the series of posts on corporate governance articles accepted for publication in prominent Finance Journals)

Our forthcoming article in the Review of Financial Studies entitled “Who Monitors the Monitor? The Effect of Board Independence on Executive Compensation and Firm Value” evaluates the efficacy of recent corporate governance reforms that focus on board independence and encourage equity ownership by directors. For instance, both the NYSE and the NASDAQ now require that a majority of directors on corporate boards should be independent, and that the audit and compensation sub-committees should be made up entirely of independent directors. These reforms appear to reflect a widely held belief among regulatory bodies and the corporate world that board independence and equity-based director incentives unambiguously improve board performance and, therefore, enhance shareholder value.

In this paper, however, we show that this belief may sometimes be misplaced. We analyze the efficacy of such reforms in a model where both adverse selection and moral hazard are present at the level of the firm’s management. Delegating governance to the board improves monitoring but creates another agency problem because directors themselves avoid effort and are dependent on the CEO.

We show that as the board’s dependence on the CEO increases, its monitoring efficiency may increase even as incentive efficiency deteriorates with respect to compensation contracts awarded to the managers. The reason is that a more dependent director benefits less from superior information about the firm?s economic prospects generated by monitoring. This endogenous tension implies - contrary to the assumptions underlying recent reforms - that outside shareholders’ value can indeed decrease as board independence increases. Moreover, and again contrary to the general presumption in the literature, higher equity incentives for the board sometimes may increase (equity-based) compensation awards to management.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on May 20, 2008 (boomark / email).