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March 15, 2021 11:11 AM

Board Monitoring and Advising in Dynamic Agency

Posted by ARC Team

In a recent study, forthcoming in the European Accounting Review (EAR), Svetlana Katolnik, Sandra Kronenberger and Jens Robert Schöndube present a model to show that if managerial contract renegotiation is possible, then an active board of directors might not always be desirable from the shareholders’ perspective.

 

The shareholders delegate the roles of monitoring, advising, and incentivizing the manager to the board of directors (Larcker and Tayan, 2016). Monitoring is considered valuable because it is employed to ensure that executives do not pursue their myopic interests but manage the company in the best interest of the shareholders. Similarly, advising management on the firm's strategy is regarded as beneficial because the board's expertise is used to add value to the firm (Baldenius et al., 2019).

When incentivizing the manager by choosing the optimal compensation contract, the board needs to take into account how its monitoring and advising will influence the managerial behavior. We investigate this question from a dynamic perspective and analyze how the implementation of the desired (unobservable) board activity depends on the interrelationship between the board's advising and monitoring role and the board's composition. We consider the board's monitoring and advising roles as being inseparable and simultaneous. For example, Adams and Ferreira (2007) emphasize that efficient advising will only be possible if the board monitors and through monitoring gathers better information. In our model the board's roles are intertwined and they simultaneously increase the output and the manager's performance measures via advising and decrease the noise in the performance measures via monitoring.

We find that if the manager's contract is not subject to renegotiation, then high board activity is always desirable ex ante because it directly increases the output and directly decreases the manager's risk premium. However, with an independent board, this high board activity cannot necessarily be implemented after the manager has accepted the contract because the advising effect raises the manager's performance-based compensation. Thus, if the performance effect of advising is stronger than its output effect, a certain fraction of insiders is needed to implement high board activity (similar results as in Drymiotes, 2007).

On the other hand, if the manager's initial contract can be renegotiated after the first period, then high board activity is not always desirable. The reason for this is that the board's activity not only directly raises output and directly reduces the manager's risk premium but also increases the sequentially optimal second-period incentive rate. If the renegotiation option increases the manager's incentives in the second period, high board activity may reinforce this incentive distortion to such an extent that the desirable direct board activity effects are overcompensated by the undesirable indirect effects. Here, the shareholders' surplus is maximized with a low board activity. Our study shows that even though shareholders could induce high board activity by appointing a sufficient number of insiders, in some cases, it is not optimal to do so, and a fully independent, and thus inactive, board is efficient. To induce an inactive board via the board structure, the performance effect of advising must be stronger than its output effect.

Discover more about our study at: https://www.tandfonline.com/doi/pdf/10.1080/09638180.2021.1890630

 

References:

Adams, R. B. and D. Ferreira (2007). A theory of friendly boards. Journal of Finance 62(1), 217-250.

Baldenius T., X. Meng and L. Qiu (2019). Biased boards. The Accounting Review 94(2), 1-27.

Drymiotes, G. (2007). The monitoring role of insiders. Journal of Accounting and Economics 44(3), 359-377.

Larcker, D. and B. Tayan (2016). Corporate governance matters: A closer look at organizational choices and their consequences (2nd ed.). Pearson Education.

 

 

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