7.3 Functions of boards of directors

Private-sector boards of directors are the representatives of the shareholders who are the residual claimants in the activity of the organisation, and public-sector entities are similar, if it is considered that ministers are representatives of the public who are the residual claimants in that sense. The overarching function of a board is in acting for shareholders in respect of most decisions, excepting that of ownership itself. Adams, Hermalin and Weisbach (2010) list board functions as including:

• CEO selection, monitoring, evaluation and compensation
• setting firm strategy, and
• providing critical resources to the firm, such as external networks and perspectives that may not be present in the management team.

These roles require that the board has access to significant information that is not provided or generated by the firm.

A focus on the role of the board in monitoring the actions of management implicitly assumes that all decisions are delegated to management, and that in the extreme the primary power of the board comes from its appointment and evaluation of the chief executive. In practice, however, such complete delegation is rare. Most CEOs work under constraints that some decisions require the approval of the board of directors.[33] The role of the board in key decisions goes directly to the heart of the incomplete contracts perspective on governance: boards of directors exist not just to guard against opportunism in respect of the existing incentive contracts, but to provide for completeness in those areas where it is impossible for the owners to give the management appropriate direction (via their incentive contract) ex ante. It follows that board functions necessarily involve influencing (being responsible for) strategy as well as management monitoring and key final decisions.

In the private sector, goods and services are provided by for-profit and not-for-profit entities that are governed by boards. Not-for-profit entities are further divisible into owned firms (eg, as observed in the health sector) and non-owned firms (eg, universities). Hansmann (1996) contends that the ownership and control of firms will evolve to the entity being owned by the group of stakeholders whose ownership results in the least combined costs of ownership and contracting. In this, Hansmann has a broad definition of stakeholders that includes suppliers to the firm (including suppliers of raw materials, labour and finance—equity (shareholders) —and its customers. The costs of “ownership” include the costs of co-ordinating (eg, with relevant stakeholders in for-profit firms: shareholders) contracting, decision-making and motivation (ie, inducing management to run the firm efficiently). These contracting costs include transaction costs, costs of market power imbalances, and contractual hold-up costs. According to this theory, the board of directors oversees the operation of the organisation in the context of the functions that the organisation assumes. The board will be engaged in determining strategy, monitoring and completing incomplete contracts among its stakeholders.

The board is a team (Bolton and Dewatripont, 2005) and the agency factors associated with teams are relevant to the performance of boards of directors.[34] The performance of teams is affected by their size (Jensen, 1993) and, while all studies do not reach the same conclusion, many indicate that smaller boards of directors are associated with superior firm performance (Hermalin and Weisbach, 2003). The advantages of small boards include clearer accountability for the decisions taken by the board. Small boards also imply a commitment to focus board appointments on monitoring and decision-making capability, since smallness rules out allocating a seat on the board to all stakeholders. Small boards also have the advantage of facilitating higher payments to the individual members of the board, and this in turn is likely to attract individuals with higher opportunity cost of time and larger reputational capital at risk in the operation of the board—both factors that are likely to be positively correlated with good governance (Adams, Hermalin and Weisbach, 2010:91 – 96).

The boards of directors of not-for-profit firms differ from the foregoing, because these entities cannot summarise the outcome of their endeavour in a single dimension (profit or financial value added). Without a unifying aggregator (profit), these organisations have multiple activities that the board must reconcile in strategy and monitoring. Also, not-for-profit status alters the form of agency issues, because it rules out opportunistic behaviour with respect to the ex post allocation of rents between owners and managers (Glaeser and Shleifer, 2001) although quasi-rents may still be appropriated by management through perquisites. Not-for-profit organisations include consumer cooperatives[35] and firms that provide educational, health and social services based upon fee, donation and grant-funding. The multiple dimensions and service orientation of these activities require frequent monitoring[36] and service-specific knowledge by the board and CEO; which suggests larger boards and the inclusion of stakeholder directors. The not-for-profit status admits funding (donations) that would not be present, were the organisation for profit, and this too is often reflected in board expertise. These general differences from for-profit boards are confirmed in O'Regan and Oster (2005), which reports a survey illustrating that non-profit boards include donors, suppliers and recipients of the entity's services.

Boards of directors then may be considered a team of information providers, and decision-makers, among whom there are different interests, and incentives for participation and decisions. These differences can be expected to be at least as wide, where the board consists of non-equity stakeholders as is commonly the case in not-for-profit organisations. While it might be considered that the incentives for board opportunistic behaviour are strongest in for-profit firms, incentives for this behaviour in not-for profits may also be very substantial among stakeholder directors. In both sets of organisations, key agency issues concern interaction among the board and the CEO.

The position of CEOs relative to boards of directors and the proportions of independent directors[37] vary widely across countries (Tirole, 2006:30-31). We confine attention to boards of (largely) independent directors and non-director CEOs, but this changes the nature, rather than the quantum, of agency issues that arise. The limited theoretical literature tends to analyse each agency issue separately and the vast empirical literature is plagued with difficulty in controlling for factors so that the empirical import of a subset of these factors is hard to distinguish (Adams, Hermalin and Weisbach, 2010). Sources of conflict—and synergies that may be at the expense of shareholders—among inside/outside and independent directors in for-profit firms are discussed in Milgrom and Roberts (1992:Ch.15). Sources of opportunism include the managers having more information and control of an entity's resources, different incentives and appetite for risk, where they have weak interests as residual claimants. Even in for-profit entities, the board and management have mixes of conflict and coordination that significantly affect the performance of the entity. In not-for-profit organisations, the CEO agency issues remain, but differ by the implications of the different objective function and concomitant board composition. For example, the absence of a residual claimant in not-for-profits removes the separation of ownership and control and the concomitant opportunity for risk and management to be assigned to different parties (Fama and Jensen, 1983).