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The Monitoring and Advisory Functions of Corporate Boards: Theory and Evidence

57 Pages Posted: 14 Jan 2009 Last revised: 5 Sep 2010

Dong Chen

University of Baltimore

Date Written: August 1, 2008

Abstract

I develop and test a model of the two primary functions of the board of directors of a public corporation: monitoring and advising management. The model shows that there is tradeoff between these two functions: advising management leads to lower monitoring quality and higher agency costs. It is therefore not optimal for the board to advise unless its ability to do so is sufficiently high to overcome these costs. To test the model, I use the number of independent directors who are at the same time executive board members of other corporations as an empirical proxy for the board's ability to advise. Consistent with the predictions of the model, I find that independent executives (IEs) are associated with lower monitoring quality and higher agency costs. I provide the first direct and comprehensive evidence for the advisory function of the board, by contrasting the corporate policies that executives choose for their own firms with those they advocate as IEs. I find that IEs are positively, significantly, and causally associated with firm performance. These results suggest that boards act optimally in balancing their monitoring and advisory functions, as predicted by the model. Finally, I argue that the significant relation between IEs and firm performance is due to the scarcity of IEs, and use the passage of Sarbanes-Oxley Act as a natural experiment to demonstrate the validity of this argument.

Keywords: Corporate Governance, Board of Directors, Monitoring, Advisory, Agency Cost

JEL Classification: G30

Suggested Citation

Chen, Dong, The Monitoring and Advisory Functions of Corporate Boards: Theory and Evidence (August 1, 2008). Available at SSRN: https://ssrn.com/abstract=1327066 or http://dx.doi.org/10.2139/ssrn.1327066

Dong Chen (Contact Author)

University of Baltimore ( email )

1420 N. Charles Street
Baltimore, MD 21201
United States

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