The members of the board of directors are elected agents of the shareholders entrusted with the responsibility of monitoring and rewarding management appropriately. The board will typically consist of inside directors, who are current or former employees of the firm, and outside directors. There exists a large variation in the size and composition of corporate boards.
The board oversight is the most important internal control mechanism to safeguard the interests of shareholders since outsiders will find it prohibitively costly to actively monitor management individually. Short o perfect ex-post settling up, managers have the incentive to engage in personally fulfilling but shareholders wealth-reducing activities.
The inherent competition between firms forces the evolution of efficient methods to evaluate and discipline all levels of management. This discipline takes the form of both internal and external control mechanisms. Internally, managers monitor other managers both above and below them. Lower-level managers would like to step over higher ranking but less productive managers. Similarly, higher-level managers must stay ahead of their rivals below. Additionally, all managers realize that to some extent their abilities will be judged on the overall performance of the firm by the external markets and seek credible ways to signal their abilities to the managerial labor market. Outsides directors are viewed as professional referees and a natural response to this need.
The composition of the board of directors has become increasingly important in the corporate governance literature. The distinction between inside, outside, and grey directors are critical in evaluating the monitoring function of the board and safeguarding the interest of shareholders. The directors that were current or former employees can rationally be expected to vote with current management and are classified as the Executive Component (inside directors).
The Monitoring Component (outside directors) of the board is composed of unaffiliated members such as academics, decision-makers from other firms, professional directors, etc. who are more likely to render an independent judgment of incumbent management. The Instrumental Component (grey directors) represent directors who were not employees of the firm but had ties to the firm such as financiers, consultants, and legal counsel. The Instrumental Component has the potential to increase the efficiency of organizational decision-making through vertical integration and improved information transfer. However, it is not obvious ex-ante if such directors will align themselves with management or render independent judgment.
Role of the Outside Directors
The board of directors can reduce the level of managerial perquisite consumption and more generally agency cost. The outside directors may serve as decision experts, instead of monitors, to explain the larger representation in acquisition states. The outside directors are more likely to join the board after a poor corporate performance or exit from an industry. Similarly, inside directors are appointed to the board as the CEO approaches retirement age. This appointment may serve to groom the next CEO or evaluate potential successors.
The most important role of the board is to oversee the direction of the firm and, when necessary, to remove inefficient management. A well-functioning board would force out a CEO following poor performance after adjusting for systematic factors such as poor industry prospects. The premise is that if outside directors actively monitor management then boards with higher percentages of outside directors should increase the likelihood of CEO turnover following the unsatisfactory performance.