Insiders and outsiders in corporate governance

Abstract

A common feature of large-public firms in the United States is that the owners of the firm typically do not manage the firm''s assets. Instead, professional managers are hired to operate the firm, creating the potential for moral hazard problems between shareholders and their agents. One mechanism that outside shareholders use to mitigate conflicts of interest with managers is a board of directors. This dissertation focuses on how the financial concerns of outside directors on the board enhance its effectiveness and how the fiduciary responsibility of top executives on the board of directors induces independency in decision making. This study comprises two essays. The first essay entitled "Corporate Insiders" studies board independency and the role of executives on the board of directors. Specifically, it expands the definition of board independency to suggest that directors are independent not only if they have no personal or direct business relation with the management team but also if they depend less on the CEO for information. The paper suggests a role for inside directors in providing the board with information that helps in decision making; it identifies situations where insiders facilitate information flow to outside directors and discusses how this information helps reduce CEO influence on the board and improves the board''s control over the CEO. The second essay entitled "Director Compensation and Board Effectiveness" explores the relation between stock option compensation to outside directors and the decision-making process on the board. In particular, the essay examines the effect of compensation structure of outside directors on the reliability of financial information; managers'' overinvestment and entrenchment behavior; CEO influence on the board and the riskiness of the investment strategy. It suggests that director stock options not only align the interests of directors and shareholders that may result in improving the reliability of financial information and monitoring of management but also align their risk preferences that may result in adopting riskier investment strategies. Overall, this dissertation advocates reexamination of the role of the board of directors. It suggests two directions for future research: the financial incentives for outside directors and the fiduciary responsibilities of inside directors.