Boards of directors: A review and research agenda

Journal of Management 1996, Vol. 22, No. 3.409-438

Boards of Directors: A Review and Research Agenda Jonathan L. Johnson University of Arkansas

Catherine M. Daily Purdue University

Alan E. Ellstrand California State University at Lang Beach Boards of directors have been the subject of extensive conceptualization and empirical research. We review literature addressing boards of directors from the perspective of the control, service, and resource dependence roles that directors are hypothesized to fulftll, with particular focus on that research reported after the Zahra and Pearce (1989) compendium. We also discuss a number of methodological and conceptual elements which complicate the aggregation of research in this area of inquiry.

Boards of directors have generated considerable attention in recent years, as evidenced by their consistent coverage in both the business and academic press. The prevalence of boards of directors research, however, has not yet resulted in convergence around a specified role set for directors (e.g., Lipton & Lorsch, 1992; Vance, 1983). Current disagreement regarding directors’ roles may, in part, be a function of a continuing controversy regarding the extent to which corporate management dominates the board of directors, a perspective which is the mainstay of managerialism (Berle & Means, 1932). This issue has taken on added salience in recent years with the rising influence of institutional investors. In the past fifteen years, institutional investors have come to control greater than 50 percent of the stock in large publicly-held corporations (Useem, 1993). Increasingly, selected institutions-typically public pension funds-are utilizing the power inherent in concentrated stock ownership as a mechanism for pressuring firms toward suggested board reforms. One of the more notable of institutions’ initiatives is the reconstitution of the board with directors who operate independently of the CEO, both economically and socially. Of late, institutions’ reform efforts, while often expensive and highly contentious, are meeting with some success (e.g., Davis & Thompson, 1994; Useem, 1993). Direct all correspondence Fayetteville, AR 7270 1.

to: Jonathan L. Johnson, University

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The academic community, too, often favors board reforms. Notably, this discussion has a rich history which predates efforts by institutional investors and other shareholder activist groups (e.g., Berle & Means, 1932; Mizruchi, 1983). Several theoretical approaches address aspects of the nature and functioning of the board and therefore may assist both academics and practitioners in their reform efforts. Agency theory (Fama & Jensen, 1983), for example, addresses the need for the board as a monitoring mechanism, as well as the potential contributions of inside directors. Resource dependence theorists provide some focus on the appointment of representatives of interdependent organizations as a means for gaining access to resources critical to firm success (Pfeffer & Salancik, 1978). According to these theories, successful efforts by board reformers to reconstitute boards with entirely independent directors may diminish corporate performance. In the following sections, we review the literature on boards of directors, focusing largely on research conducted since Zahra and Pearce’s (1989) review. As will be evident in subsequent sections, the literature provides little consensus as to the specific configuration of an effective corporate board. The lack of consensus may result from the multiple roles fulfilled by directors. Clearly, the proposition of multiple, and in some cases contradictory, roles for the board of directors is differentially supported as a function of the chosen theoretical perspective. We should note that this review focuses specifically on the inter-relationships between the board, firm management, and stockholders of contemporary publicly-held corporations. We recognize that boards of directors have additional roles in the service of other constituencies, including local and national elites (e.g., Palmer, Friedland & Singh, 1986; Useem, 1984), corporate and financial sectors (Mintz & Schwartz, 1985), as well as other corporate stakeholders (e.g., Freeman & Evan, 1990). We have elected, however, to focus specifically on the organizational stakeholders that have received the most attention in the corporate governance literature. In the relatively short time since Zahra and Pearce’s (1989) review, there have been numerous scholarly articles published which address the boards of directors. Beyond that, there have been any number of empirical efforts which, while not directly focused on the board of directors, have relied on elements of the board for control variables (e.g., Buchholtz & Ribbens, 1994; Mizruchi & Stearns, 1994; Ocasio, 1994; Zajac & Westphal, 1995). We focus here primarily on that work which relies on board composition. We include theories and research from the legal, management, financial and sociological literatures pertaining to the board, specifically director independence. Our objective is to provide the reader with an overview of the basic issues surrounding directors’ roles and independence. This review is structured around a set of three roles largely consistent with the views of the board proposed by Pfeffer and Salancik (1978), and more recently the functions of the board described by Daily and Dalton (1993), Kesner and Johnson (1990), and Goodstein, Gautam and Boeker (1994). The role typology identified here, while not perfectly isomorphic with other proposed role sets (e.g., Alexander, Fennel & Halpern, 1993; Lorsch & MacIver, 1989; Mace, 1971; JOURNAL

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Minzberg, 1983; Zahra & Pearce, 1989), captures directors’ most significant duties and functions. We have classified directors’ responsibilities into three broadly defined roles, which we have labeled control, service, and resource dependence. The control role entails directors monitoring managers as fiduciaries of stockholders. In this role, directors’ responsibilities include hiring and firing the CEO and other top managers, determining executive pay, and otherwise monitoring managers to ensure that they do not expropriate stockholder interests (e.g., Monks & Minow, 1995). The service role involves directors advising the CEO and top managers on administrative and other managerial issues, as well as more actively initiating and formulating strategy. The resource dependence role is in keeping with Pfeffer’s (1972, 1973) and Pfeffer and Salancik’s (1978) view of the board as a means for facilitating the acquisition of resources critical to the firm’s success. Directors fulfilling this role are often representatives of specific institutions, but may also serve a legitimizing function (Selznick, 1949). Directors’ Control Role Most theories of corporate governance identify the board of director’s control role as conceptually and normatively important (Bainbridge, 1993; Fama, 1980; Mizruchi, 1983; Zahra & Pearce, 1989). The relative volume of research devoted to the different board roles reflects the predominance of the control role. Moreover, the academic perspectives relevant to control are particularly wideranging, including those of the legal, management, and finance literatures. Several themes relevant to directors’ control role can be identified from these bodies of literature, including control of the proxy mechanism, directors’ fiduciary duty, implications from the increase in institutional stockholdings, and director dependence on the CEO. The Proxy Machinery

Both managerialism and agency theory provide a foundation for the discussion of the control of firm proxies. The proxy is of central importance in the corporate form of organization because major firm decisions, such as the election of directors, are decided by shareholder vote. Typically, however, firm shareholders do not attend annual meetings to vote on such decisions; rather, they routinely sign a proxy card granting management the power to cast their vote. Consequently, firm managers have been able to gain control of the proxy mechanism largely as a result of the separation of ownership and control in the modem corporation (Berle & Means, 1932; Dent, 1989; Eisenberg, 1969; Mace, 1979; Ruder, 1983). While shareholders are technically-even legally-responsible for electing directors, management clearly has the potential to dominate such decisions. Management control of director elections is further ensured by state laws which enable shareholders to elect, but not nominate, directors (Brudney, 1985; Goforth, 1994). Even if shareholders were to refuse to assign their proxies to management, they would retain only a passive vote given their inability to nominate director JOURNAL

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candidates. This situation led one observer to comment that corporate elections are “procedurally much more akin to the elections held by the Communist party of North Korea” than the intended democratic process because “they normally provide only one slate of candidates” (Lipton, 1987, p. 67). At issue here is the extent to which directors are able to effectively fulfill the control role. Arguably those directors who may feel beholden to management for their positions on the board potentially face some difficulty in evaluating this same management (Gilson & Kraakman, 1991), especially when management performance is substandard. In fact, director candidates are often selected on the basis of their willingness to support management decisions (Goforth, 1994). Directors’ Fiduciary Duty Directors’ fiduciary duty has been the subject of the most substantial scrutiny in the legal literature. Much of this attention derives from state law which requires corporations to establish a board of directors (Bainbridge, 1993; Cieri, Sullivan & Lennox, 1994; Loewenstein, 1994). According to legal theory, the primary purpose of the board is as a fiduciary charged with monitoring management for the benefit of the corporation (e.g., Bainbridge, 1993; Bud&z, 1990; Cieri et al., 1994; Miller, 1993). The courts evaluate directors’ fiduciary responsibility on the basis of the business judgment rule. The business judgment rule presumes that directors make decisions on an informed basis, in good faith, with the best interests of the corporation in mind, and, importantly, that directors be disinterested and independent (e.g., Block, Barton & Radin, 1989; Cieri et al., 1994; Manning, 1984; Miller, 1993). The business judgment rule recognizes directors’ obligations to the corporation, but also protects directors individually from liability when they have operated under good faith, even when such decisions prove detrimental to the corporation (Cieri et al., 1994; Manning, 1984). Two specific elements used in applying the business judgment rule are the duties of care and loyalty (Budnitz, 1990; Cieri et al., 1994; Miller, 1993). It is only when a director violates one of these duties that the burden shifts from shareholders to directors in proving that board decisions benefited the corporation (Cieri et al., 1994). The duty of care, as specified in the business judgment rule, “requires directors to exercise that degree of care that an ordinarily prudent person would exercise under the same or similar circumstances” (Miller, 1993, p. 1467; see also, Bogart, 1994; Budnitz, 1990; Cieri et al., 1994; Manning, 1984). Early applications of the duty of care excused directors from liability for “ordinary” mistakes, as compared to the more stringent legal standard of utmost care (Goforth, 1994, p. 392). While considerable controversy surrounds this aspect of the business judgment rule (Manning, 1984) Block et al. (1989) have noted that the courts have applied this method of evaluation for better than 150 years. Manning (1984, pp. 620-621) may have best summarized current understanding of the duty of care: “We do not know what the directors are supposed to do; we know only that they are supposed to do it ‘with care.’ ” The second standard applied in the business judgment rule is the duty of loyalty. This duty “prohibits self-dealing and the usurpation of corporate opportuJOURNAL

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nities” (Miller, 1993, p. 1467; see also, Bogart, 1994; Manning, 1984). The crux of this issue is the extent to which directors are subject to conflicts of interest. Critics suggest, however, that in conflict of interest situations, directors should no longer be protected by the business judgment rule. A commonly noted conflict of interest is a takeover situation (Goforth, 1994; Manning, 1984). Directors of target firms, for example, may reject a takeover bid which is beneficial to shareholders for fear of losing their positions with the firm (Manning, 1984). Alternatively, directors may consummate deals not directly benefiting sh~eholders for the purpose of providing executives with increased compensation and related perquisites as a function of the increased size of the firm (Goforth, 1994). One commentator has rather harshly noted that hostile takeovers have less to do with enhancing shareholder value than with self-interest on the part of directors initiating the takeover (Bebchuk, 1982). Another conflict of interest circums~nce may result from directors identifying more strongly with their peer executives at the firm they serve, as compared to shareholders (e.g., Manning, 1984). This situation is likely given the high percentage of outside directors that are themselves CEOs (Lorsch & MacIver, 1989). Moreover, directors seldom have contact with shareholders, but are in regular contact with firm m~agement as a function of their board service. In support of this position, Bainbridge (1993) has noted that directors who are also executives themselves may sympathize with target firm management’s job security fears in a takeover situation, perhaps fearing that one day their own job security might also be threatened. The business judgment rule has received intense scrutiny because it so effectively protects directors from the consequences of bad decisions (Mining, 1984). The takeover context aptly illustrates some of the discomfort with the business judgment rule. Goforth (1994), in particular, has criticized it as offering an unjustified level of protection to directors given the lack of evidence for enhanced shareholder value following a takeover (see pp. 419-420). Notably, takeover defense mechanisms which have received considerable scrutiny (e.g., poison pills, golden p~achutes~ are also protected by the business judgment rule, typically on the basis that they protect shareholders from inappropriate tender offers (Goforth, 1994). In response to the noted problems with the business judgment rule as a mechanism for evaluating directors’ fulfillment of their fiduciary duty, Bogart (1994) has recommended the application of a new duty-the duty of independence (see also, Bainbridge, 1993; Cieri et al., 1994; Loewenstein, 1994 for related discussion). The Delaware courts have adopted a modified business judgment rule which parallels the concepts in the duty of independence (Cieri et al., 1994). The modified business judgment rule is applied specifically to takeovers and shifts the burden to directors to demonstrate a threshold of reasonableness before being protected by the business judgment rule (Cieri et al., 1994). Application of the duty of independence involves dete~ination of whether directors would have reached the same decision if they were free from management influence. One means for assessing directors’ independence is through board composition (this issue is developed in a subsequent section). As noted by BainJOURNAL OF ~~A~EM~NT,

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bridge (1993), however, neither the specific roles of directors nor the composition of the board has been specified in corporate law. Cary (1974, p. 663) referred to this lack of specificity on these dimensions as a “race to the bottom,” in which shareholder interests are sacrificed for the purpose of making corporate directors’ and managers’ lives more comfortable (see also, Hazen, 1987). The financial literature has also addressed directors’ control role. Financial treatment of the board of directors is predominately grounded in agency theory (see, for example, Jensen & Meckling, 1976, and Eisenhardt, 1989, for an overview of agency theory). Agency theory is based on the potential for managerial selfinterest when ownership and control of the firm are disparate. Applied to corporate governance, then, this perspective would suggest that directors may face conflicts between their legal duty to effectively monitor firm management and their professional and personal associations with management (e.g., Baysinger & Hoskisson, 1990; Eisenhardt, 1989; Lorsch & MacIver, 1989; Zahra & Pearce, 1989). This is clearly related to Bogart’s (1994) conception of the duty of independence. The agency perspective differs slightly from the legal perspective. Eisenberg (1969) advocated an extreme view which suggests that agency theory is inappropriate for addressing directors’ legal obligations. In practice, most courts have rejected the agency perspective (Budnitz, 1990). The primary difference between these two perspectives is in the source of directors’ power. Legal theory views directors’ powers as emanating from state law (see Budnitz, 1990, p. 1220), whereas agency theory would suggest directors’ power is derived from shareholders. As will be demonstrated, however, there are more similarities than differences in applying these two perspectives to directors’ control role. Simply stated, legal theory is less specific in identifying directors’ duty to shareholders than is agency theory (Budnitz, 1990). Bankruptcy provides a salient illustration of the intersection of legal theory and financial (agency) theory. Once a firm had been determined to be insolvent, directors’ duties shift from protecting shareholder interests to protecting the interests of the firm’s creditors (Chou, 1991; Cieri et al., 1994; Markell, 1991; Miller, 1993; Waldera & Sullivan, 1993). With limited exceptions, directors in the solvent firm owe no responsibility to creditors (Cieri et al., 1994). While shareholders in the bankrupt firm constitute a class of creditors, their claims are typically subordinated to virtually all other classes of creditors (see, for example, Brudney, 1983; Cieri et al., 1994; LoPucki & Whitford, 1990). Shareholders generally constitute a separate class of creditors (Franks & Torous, 1989). Notably, the courts have determined that this shift in focus may occur prior to formal action (e.g., filing a bankruptcy petition) which clearly identifies the firm as insolvent (Miller, 1993). Simply stated, “creditors’ rights take priority over equity interest” (Markell, 1991, p. 70). The Influence of Institutional Investors An influential monitoring body has asserted itself in recent years-institutional investors. Some observers have commented that the increase in institutional ownership in major corporations has the promise to end the problems inherent in the separation of ownership and control (e.g., Davis & Thompson, 1994; Coffee, JOURNAL

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1994). Useem (1993) has adopted an even more aggressive stance, proposing that institutional investors are the first force significant enough to reverse the managerialist revolution described by Berle and Means (1932). In support of his arguments, Useem has documented in detail several instances where institutional investors have been able to directly impose dramatic changes in a firm’s management. Furthermore, he provides evidence that institutions’ impact is widespread. In many respects, institutional investors have become the monitors of firms’ appointed monitors-the board of directors. In fact, Black (1992) has noted that the primary value of institutional investor monitoring is in improving corporate boards, “many of which could surely stand improvement” (p. 839). Activism aimed at the board typically focuses on board composition, with the intent of improving director quality, independence and accountability (Gordon, 1994). Institutional investors have also exhibited a propensity to bypass the board and effectively negotiate directly with management (Useem, 1993). From a legal perspective, institutional voice is possible largely as a result of the Securities and Exchange Commission Act, Section 14a-8 (Barnard, 1991; Sommer, 1990). This rule requires management to include shareholder-initiated proposals in the proxy materials whenever management seeks shareholder voting proxies (Ryan, 1988). While this rule has been in place since 1934 (see Goforth, 1994), institutional investors have not utilized this tool until recently. The Securities and Exchange Commission has also aided institutional activism with the 1992 adoption of amendments to federal proxy rules which remove unnecessary impediments to shareholder exercise of voting rights and inter-shareholder communication (Davis & Thompson, 1994; Goforth, 1994). It is notable that simply the threat of a shareholder proposal has often been sufficient to get management to respond to shareholder (institutional investor) concerns. Not all observers are satisfied with Rule 14a-8. One criticism of the rule is that it has become a means for a politicized minority of shareholders to force their agenda on management (Coffee, 1994; Dent, 1985). It is the case that very few institutional investors choose to become activist (Useem, Bowman, Myatt & Irvine, 1993). What is not as clear, however, is the extent to which this level of activism is a reflection of a “politicized minority” or the costs of activism. Many institutional investors lack the resources more than they lack the incentive to be activists (Goforth, 1994). One group of institutional investors has emerged as the clear leader of corporate governance activism-public pension funds. While many groups of private institutional investors are subject to potential conflicts of interest in becoming activists, public pension funds are virtually free of such conflicts, leading some observers to label them “pressure resistant” (Coffee, 1994). Pressure sensitive institutional investors, such as banks and insurance companies, risk the potential loss of current and future business should they gain a reputation for confronting corporate leaders (e.g., Black, 1992; Coffee, 1994). Public pension funds are not subject to these same pressures. Some of pressure-sensitive institutional investors’ reticence to actively oppose firm leaders may be overcome when a number of institutions act in concert (Davis & Thompson, 1994). Black (1992) has noted that collective action may JOURNAL OF MANAGEMENT,

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diminish the risk of losing corporate business. When only a few institutions confront firm leaders, however, the risk of relation is significantly enhanced (Black, 1992). Recently, institutional investors have increasingly engaged in collective action (Barnard, 1991). Collaborative efforts are typically focused on unacceptable managerial behavior such as golden parachutes, greenmail, and confidential voting (Barnard, 1991; Coffee, 1994). Another common approach to activism involves private pension funds-generally quite hesitant to engage in activism (Useem et al., 1993)-approaching public funds with a request that they lead an activist effort (Coffee, 1994). This can be a symbiotic relationship; private funds accomplish their governance reform goals and public funds enhance their reputations as activists (Coffee, 1994). As previously noted, a considerable amount of institutional investor activism is directed at reforming corporate boards. Reapportionment of the board toward a majority of independent directors has been a particular focus (Schellhardt, 199 1). According to the Investor Responsibility Research Center (IRRC), the New York City Teachers and New York City Employee retirement funds, two influential public pension funds, have been the most frequent sponsors of recent shareholder proposals calling for a majority of independent directors on the board, nominating committee, and/or compensation committee of targeted firms (IRRC, 1994). Moreover, in the 1993 survey of institutional investors conducted by the IRRC, a substantial majority of pension fund managers indicated that they would support shareholder proposals requiring a majority of independent directors (IRRC, 1994). While practitioner and academic attention to institutional investor activism has increased conco~t~tly with the actual activity, we still know relatively little about the role of institutional investors in the modem corporation (Matheson & Olson, 1992). What is clear, however, is that institutional investors are no longer willing to be passive participants in the governance process (Barnard, 1991). Nonetheless, we caution against an over-reliance on institutions as monitors of firm m~agement. As noted by Barnard (1991, p. 1168), “[alfter all, it is the board, not the shareholders, that is charged with making the corporation perform.” Concerns regarding the board’s ability to fulfill the control role have typically focused on individual directors’ independence of the CEO. This is most often manifest in a search for indicators of relationships between the CEO and directors that may affect directors’ ability or willingness to responsibly meet their fiduciary responsibilities (e.g., Fizel & Louie, 1990; Pearce & Zahra, 1992). Directors who are potentially influenced by the CEO vis-a-vis personal, professional, and/or economic relationships may be less effective monitors of firm management (Bainbridge, 1993; Baysinger & Butler, 1985; Daily & Dalton, 1994a, 1994c). Because board decisions are typically decided by majority rule, boards comprised predominately-or in the extreme exclusively (Lipton & Lorsch, 1992)-of inde~ndent directors are expected to more effectively monitor management self-interest than are boards with higher proportions of dependent directors. JOURNAL

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Many activist groups (including a coalition of influential institutional investors, the Council of Institutional Investors), large stock exchanges, and the Securities Exchange Commission have adopted operational definitions of dependent directors, typically focusing on those directors with relationships to the firm or its management which may complicate their ability to be fully objective in monitoring firm management. Board reform activists, in particular, rely on these operational definitions in developing prescriptions for board reform. In the following sections, we review the various measures of board composition most often found in academic research and the relative degrees of independence associated with each category. Inside Directors. The earliest research on board composition focused primarily on the distinction between inside and outside directors, an operationalization that is still widely used. While the measurement of this category of board composition has certainly not been uniform (Daily, Johnson & Dalton, 1995) inside directors have generally been defined as those directors also serving as firm officers (Byrd & Hickman, 1992; Cochran, Wood & Jones, 1985; Gilson, 1990; Goodstein & Boeker, 1991; Hermalin & Weisbach, 1988), with outside directors being classified as all non-management members of the board (Daily & Dalton, 1992, 1993; Dalton & Kesner, 1987; Goodstein et al., 1994; Molz, 1988; Rosenstein, Bruno, Bygrave & Taylor, 1993; Schellenger, Wood & Tashakori, 1989). The appropriateness of having inside directors serve on the board has been questioned for a variety of reasons, most of which relate to the potential for ineffective monitoring. One of the primary tasks of the board is the periodic evaluation of upper management’s performance, especially that of the CEO. In this role, inside directors may find themselves in an uncomfortable position (Fleischer, Hazard & Klipper, 1988; Patton & Baker, 1987; Weisbach, 1988). Inside directors’ loyalty to the CEO, in addition to their fear of retaliation from treating the CEO harshly, may diminish their ability to provide objective and fair evaluation (see e.g., Baysinger & Hoskisson, 1990; Kesner & Dalton, 1986). Moreover, the board is charged with managing several important issues that may present inside directors with a direct conflict of interest-e.g., executive-level compensation, the adoption of anti-takeover provisions, and executive succession. It may be umeasonable to expect inside directors to fully separate their personal interests on such issues from those of shareholders. Consequently, boards composed of a majority of outside directors are regarded by many to be crucial for the control role. There are, however, a few important qualifications to this view. Agency theorists advocate including at least a few inside directors, in addition to the CEO, on the board (e.g., Fama & Jensen, 1983; Baysinger & Hoskisson, 1990). According to this view, inside directors provide an important internal monitoring function. Absent the presence of inside directors, the CEO may enjoy a considerable advantage as a result of information asymmetry. Inside directors, however, are able to provide valuable input to board deliberations regarding the CEO’s activities and overall performance. It is noteworthy that agency theorists insist that inside directors be protected from sanctions by the CEO, specifically by empowering only the board to have the authority to fire top managers who serve as JOURNAL

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inside directors. This may be an unduly simplistic expectation, however, given the political realities of modern corporate life (Pfeffer, 1981). The proportion of inside directors may also affect the strategic direction of the firm. Baysinger and Hoskisson (1990), for example, have argued that without information from inside directors, outside directors may be forced to rely exclusively on financially-based indicators of CEO success (essentially equivalent to outcome based performance measures; see Eisenhardt, 1989) in determining CEOs’ compensation. This focus may lead CEOs to favor low risk diversification strategies. Inside directors, as a function of their day-to-day exposure to the CEO, may be in a better position to evaluate the quality of the CEO’s strategic decision making (equivalent to behavior-based controls), and recommend appropriate awards for risky, but justifiable, strategic decisions. While inside directors are arguably not independent of the CEO or the firm, there clearly exists some sentiment that a balance of outside and inside directors may be the most appropriate board configuration (Baysinger & Butler, 1985; Byrd & Hickman, 1992). Outside Directors. Outside (non-management) directors are believed to be more effective monitors of firm management than are insiders. Outsiders’ effectiveness derives from their independence of the CEO and the firm as a function of their employment status. A considerable amount of research has relied on the proportion of outside directors as an indicator of board independence. Increasingly, however, researchers question the ability of the traditional inside/outside director distinction to appropriately capture the independence of the outside director (e.g., Daily & Dalton, 1994a). At issue is the extent to which an outside director is truly independent of the firm and its management (Bainbridge, 1993; Baysinger & Butler, 1985; Daily & Dalton, 1994a; Karmel, 1984). Researchers and board reform activists have proposed a variety of factors which may diminish an outside director’s ability to effectively oversee management (e.g., Baysinger & Butler, 1985; Buchholtz & Ribbens, 1994; Byrd & Hickman, 1992; Daily & Dalton, 1994a; Johnson, Hoskisson & Hitt, 1993; Weisbach, 1988). Outside directors with personal or professional relationships with the firm or its management may be less effective than outside directors absent such relationships in fulfilling the control role. The Securities and Exchange Commission (SEC) has provided specific guidance for determining director independence. The SEC Regulation 14A, Item 6(b) requires that publicly-traded corporations report in their proxy materials information regarding non-management directors’ personal and/or professional relationships with the firm or firm management (Daily & Dalton, 1994a). Directors meeting any of the following criteria are referred to as affiliated directors and are considered to be characterized by a lack of independence: l

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Affiliation with the firm as an investment banker within the past two years or within the upcoming year Association with a law firm engaged by the corporation, and Stock ownership resulting in the SEC designation of control person.

Most empirical research on affiliated directors focuses on economic and social relationships that span a variety of levels. Many researchers rely on the existence of formal professional or economic relationships as indicators of director dependence (e.g., Baysinger & Butler, 1985; Co&ran et al., 1985; Daily & Dalton, 1994a; Johnson et al., 1993; Pearce & Zahra, 1991). Directors engaged in personal services contracts with the focal firm, as in the case of consultants or lawyers, may feel a sense of obligation to the CEO, who almost certainly was instrumental in the establishment of such a relationship. In such instances, the director’s livelihood is at least partially dependent on the maintenance of a contract over which the CEO may have considerable influence. Similar arguments apply to affiliated directors who represent organizations involved in substantive relationships with the focal organization (e.g., suppliers, customers, or creditors). These directors may be hesitant to challenge a CEO who has the discretion to sever an important economic relationship. As noted in the SEC classification guidelines, affiliated directors may also be characterized by interpersonal relationships with the CEO or other managers. Familial relationships between a director and a top manager, for example, would indicate a lack of independence. Other more subtle indicators of interpersonal ties have also been used in empirical research. Relying on a social psychological framework, Wade, O’Reilly and Chandratat (1990) suggested that directors who are elected to the board during a CEO’s tenure may feel a personal sense of obligation, or loyalty, to that CEO. Additionally, other researchers have relied on organizational demographics in hypothesizing interpersonal relationships between the CEO and directors (e.g., Kosnik, 1990; Westphal & Zajac, 1995). Researchers have met with some success in relying on measures which distinguish dependent and independent outside directors (e.g., Byrd & Hickman, 1992). We would note, however, that the extant empirical research would indicate little consistency in operationalizing either outside or affiliated directors (Daily et al., 1995). As previously indicated, many shareholder activist groups have adopted their own operational definitions of outside directors designed to capture their relative independence (see, for example, IRRC, 1994). Virtually all director classification schemes, whether emanating from the academic or practitioner community, regard inside directors and directors who are related to firm managers as dependent, with some classifications including provision for directors engaged in reciprocal interlocks with other corporations. The numerous operational differences, however, almost certainly affect the comparability of board composition studies. Increasing the specificity of the definition of affiliated directors has the potential to provide several benefits for future research, and we advocate the SEC’s guidelines as a point of departure. Firstly, as previously noted, these categories clearly identify those directors whom important monitoring bodies believe JOURNAL

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may experience some difficulty in effectively discharging their oversight role. Also, many important individuals and groups in the investment community base many of their recommendations or demands regarding reapportionment of the board on these criteria. Some consistency in the focus of these demands is needed. The Securities and Exchange Commission’s uniform reporting requirements may provide the academic and investment communities a point of convergence for these efforts. Lastly, the adoption of standardized operationalizations of director independence (board composition) would greatly facilitate the comparison and compilation of governance studies.

Empirical Investigations of Director Independence These issues of director independence have generated an impressive series of empirical research. Much of this research has examined hypothesized linkages among the various operationalizations of board composition and firm financial performance. Other assessments have focused on alternative outcome variables including executive turnover, CEO compensation, and anti-takeover defenses. The following section provides a review of the relevant literature investigating the relationship between board independence and firm financial performance, as well as alternative outcome measures. Director Independence and Firm Financial Performance. Findings regarding the performance implications of board independence do not uniformly support the dominance of the independence/dependence perspectives. Vance (1964), Co&ran et al. (1985), and Kesner (1987), for example, report a positive relationship between the proportion of inside directors and several indicators of firm financial performance. Other research, however, has reported no significant relationship between inside director proportion and firm financial performance (e.g., Molz, 1988; Mallette & Fowler, 1992; Daily & Johnson, in press). Another stream of research demonstrates a positive relationship between the proportion of outside directors and firm financial performance (e.g., Hill & Snell, 1988; Schellenger et al., 1989; Pearce & Zahra, 1992). A series of work relying largely on financial theory has examined the relationship between board composition and stockholder wealth. This stream of research has demonstrated that stockholders may interpret independent boards as a signal that the firm is being managed in their interest. Rosenstein and Wyatt (1990), for example, found that the appointment of outside directors was positively associated with firms’ stock price. In a study of the effect of a takeover bid announcement on the stock price of the bidding firms, Byrd and Hickman (1992) found that firms with high proportions of unaffiliated outside directors realized higher abnormal returns following the announcement of the tender offers than did firms with fewer independent directors. Finally, Brickley, Coles and Terry (1994) reported that the stock price of firms with predominately unaffiliated outside directors rose after the announcement of the adoption of a poison pill anti-takeover provision, in contrast to firms with majority inside and affiliated boards. Brickley et al’s (1994) findings may indicate that the market treats the presence of an independent board as a signal that poison pills will be used in stockholders’ interest. JOURNAL

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The vast majority of research investigating the relationship between board independence and firm financial performance has suggested that certain board configurations (i.e., independent boards) will lead to higher firm performance. Recently, researchers have begun investigating the potential for a reverse causal relationship (e.g., Daily & Johnson, in press; Hermalin & Weisbach, 1988; Pearce & Zahra, 1992). Hermalin and Weisbach (1988) and Pearce and Zahra (1992), for example, found that following periods of poor performance, firms tended to add outside directors to the board. Moreover, Hermalin and Weisbach reported that inside directors were more likely than outside directors to leave the firm following poor firm performance. Daily and Johnson (in press) found that prior firm success was associated with future dependent boards. These findings of a reversed causal relationship-changes in performance lead to changes in board composition-may provide some evidence that poor ,performance signals a need for more vigilant monitoring of firm management (Hermalin & Weisbach, 1988). These findings may also represent the board’s realization of a need to realign the firm with its external environment (Pearce & Zahra, 1992). Alternatively, these findings may indicate that CEOs of successful firms enjoy enhanced power and prestige which enables them to construct dependent boards (Daily & Johnson, in press; see also Ocasio, 1994). As demonstrated by the research reviewed here, there is little consistency in findings regarding the relationship between board composition and financial performance. These inconsistencies have led a number of researchers to re-examine the process by which boards may affect corporate performance. Some researchers, for example, have suggested that under normal circumstances the board may not be an important direct determinant of firm performance (Kesner & Johnson, 1990). The board of directors is generally far removed from the nexus of daily decision making in the firm, and even the most activist boards are largely relegated to oversight of the most important strategic decisions that may have an immediate or short-term impact on firm performance (Mace, 1971). Boards are, however, charged with specific duties that over the long-run may impact stockholder wealth. As a means for accessing those firm decisions/outcomes which the board might directly impact, researchers have devoted an increasing amount of attention to the relationship between board independence and internal governance issues, including the compensation and replacement of top management, shareholder lawsuits, anti-takeover provisions, and the oversight of financially distressed and bankrupt firms (Goodstein et al., 1994). This research may be especially informative, as it examines situations where the board directly intervenes in the affairs of the corporation (Kosnik, 1987). Director Independence and Executive Turnover. One of the board’s primary responsibilities is CEO selection and replacement (e.g., Lorsch & MacIver, 1989). There is some evidence that differentially configured boards are more likely to replace a CEO. Boeker (1992) for example, reported an interaction between the proportion of outside directors and poor performance in increasing the chance of CEO dismissal. Weisbach (1988) found that boards dominated by JOURNAL

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independent outside directors relied more heavily on performance indicators in terminating a CEO than did inside boards. Boeker and Goodstein (1993) investigated the extent to which board composition impacts CEO successor origin. They found that firms with more inside directors were less likely to select outside CEO replacements. Moreover, they found that poor performance and insider board domination interacted to reduce the probability of outside chief executive officer replacements. Their finding may support the belief that insiders tend to resist organizational change (Pfeffer, 1981). Director Independence and Distressed/Bankrupt Firms. Recent research has investigated the relationship between board composition and financial distress/bankruptcy (Daily, in press; Daily & Dalton, 1994a, 1994b, 1995; Lorsch & MacIver, 1989). Directors may be especially critical to a firm in crisis. Certain board configurations, for example, may be more effective in preventing a crisis or in initiating a successful turnaround. Outside director control may be especially important for fnms attempting to avoid a bankruptcy filing (Daily & Dalton, 1994a). As evidence, Daily and Dalton (1994b) found that firms characterized by lower proportions of independent directors and the dual board leadership structure (CEO and chairperson positions held by the same individual) were positively associated with bankruptcy in the five year period prior to filing. Similarly, Daily (1995) found the proportion of outside directors to be positively associated with the successful reorganization of a Chapter 11 bankruptcy filing and negatively associated with a liquidation outcome from a Chapter 11 bankruptcy filing. Interestingly, she also found that independent directors (outsiders not appointed by the current CEO) were negatively associated with successful reorganization and positively associated with liquidation. Director Independence and CEO Compensation. Determining executive-level compensation is another critical function of the board which may present certain categories of directors with a conflict of interest. We might expect independent outside directors to most effectively determine appropriate compensation levels. As previously noted, however, there are potential downsides to excluding inside directors from the decision process (e.g., Baysinger & Hoskisson, 1990). Also, even independent outside directors who themselves are CEOs may experience some conflict in determining a peer CEO’s compensation knowing that a similar process will be applied to them as well (O’Reilly, Main & Crystal, 1988). Empirical results have not uniformly supported the outside director’s effectiveness at determining executive-level compensation. Mange1 and Singh (1993), for example, found no relationship between the proportion of outside (nonmanagement) directors and CEO compensation (see also Kerr & Kren, 1992). Boyd (1994) investigated the impact of inside directors on the compensation decision and found a negative relationship between board control and CEO compensation. Board control was operationalized as a unidimensional latent variable which included the proportion of inside directors, CEO duality, director stock ownership, and institutional owner representation on the board. Inside director proportion was not significantly related to CEO compensation. Westphal and Zajac (1995) employed measures of demographic similarity between the CEO and members of the board in an examination of CEO compensaJOURNAL

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tion. They found that powerful CEOs appointed demographically similar directors who were likely to be sympathetic to CEOs’ interests. These boards, in turn, were associated with higher levels of CEO compensation. Zajac and Westphal (1995) in a related examination, found that the proportion of outside directors appointed during the current CEO’s tenure (loyal directors) was positively associated with human resource, as compared to agency theory, explanations for long-term incentive plans granted to CEOs. Human resource explanations may be more indicative of a positive view of the CEO as a “valuable human resource to be rewarded and retained” (Zajac & Westphal, 1995, p. 301), in contrast to agency problems to be managed. Related research examining the adoption of golden parachute contracts has been the subject of investigation as well. Contrary to expectations, Co&ran et al. (1985) and Singh and Harianto (1989a, 1989b) found that boards with greater proportions of outside directors were more likely to grant golden parachutes. Conversely, Wade et al. (1990) found a positive association between the proportion of loyal directors and the provision of a golden parachute contract in managerialist corporations (i.e., firms with no dominant stockholders). Director Independence and the Takeover Context. Another corporate decision that may present directors with a conflict of interest is the adoption of anti-takeover provisions. Some might argue that these provisions are a source of job security for top managers and do not effectively serve shareholder interests (e.g., Fama & Jensen, 1983). Several researchers have investigated the relationship between board composition and the adoption of these provisions. Davis (199 l), for example, found no support for a relationship between the proportion of inside directors and the adoption of poison pills. Similarly, Mallette and Fowler (1992) found no relationship between affiliated directors and the adoption of poison pills. Kosnik (1987) found that boards with a greater concentration of outside directors, outside directors with executive experience, and outside directors with contractual relations with the company were more likely to resist managerial attempts to pay greenmail. Conversely, she also found that high proportions of outside directors with familial relations and interlocked directors were less likely to resist greenmail payments. Additionally, in a later study grounded in organizational demographics, Kosnik (1990) found that firms whose directors had relatively long average tenure and shared similar principal occupations were less likely to pay greenmail. Director Independence and Shareholder Lawsuits. Kesner and Johnson (1990) analyzed the relationship between board composition and shareholder lawsuits. They found a positive relationship between inside director proportion and the likelihood of a firm being subject to a shareholder lawsuit. Interestingly, they found no relationship between board composition and the outcome of a shareholder lawsuit. These findings may suggest that boards comprised of higher proportions of inside directors are perceived by shareholders as less effective in the control role; however, the courts are apparently not in agreement based on the outcomes of these suits. JOURNAL OF MANAGEMENT,

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Director Independence and Strategic Orientation. Board composition may also affect firms’ general strategic orientation. Baysinger and Ho&&son (1990) suggested that boards composed only of outside directors may depend exclusively on financial (outcome-based) controls in evaluating CEOs. As previously noted, this may increase the likelihood that CEOs pursue diversification strategies which are not isomorphic with shareholders’ interests. Recent research, for example, has found that outsider dominated boards are more likely to adopt diversification strategies (Baysinger, Kosnik & Turk, 1991; Hill & Snell, 1988, 1989). In contrast, Hoskisson, Johnson and Moesel (1994) found no relationship between board composition and corporate restructuring. While we are persuaded that board composition is related to directors’ monitoring function, we find the following caveat by Barnard to be noteworthy for its recognition of the complexity of this relationship: Changing board composition to decrease the percentage of corporate CEOs, or to include directors whose nomination originated outside of the executive suite, is not enough, although it is a necessary precondition effective governance reform (1991, p. 1169).

to

Some of the cautions which accompany even independent outside directors result from the multiple demands upon their time. As previously noted, often these directors are themselves CEOs (Lorsch & MacIver, 1989). The challenges of managing their own firms may leave these directors with little time to fully appreciate the operational intricacies of those firms for which they serve as directors (Bainbridge, 1993). Gilson and Kraakman (1991) have also noted that independent directors wishing to maintain their board positions are often not independent of management given management’s strong role in the director nomination process (e.g., Wade et al., 1990). Finally, Coffee has observed that “there is no assurance that an independent director would be an effective director” (199 1, p. 1360).

Service Role The service role addresses directors’ provision of advice and counsel to the CEO (Lorsch & MacIver, 1989). Support for the service role is primarily a function of accounts from directors and managers that one of the more prevalent functions of directors is to advise and support the CEO (e.g., Lorsch & MacIver, 1989; Mace, 1971; Mintzberg, 1983). Lorsch and MacIver (1989), for example, have noted that a considerable amount of directors’ time is spent “advising the CEO, a task that, while not as dramatic as replacing him, enables them to play what many consider to be their key normal duty” (1989, p. 64; see also Useem, 1993). Moreover, they noted that it is directors’ value as expert advisors which accounts for the prevalence of so many active and retired CEOs on corporate boards. Recently, researchers have begun incorporating directors’ service roles into governance theories. Agency theory provides an interesting perspective on this role. Expert directors may facilitate effective evaluation of management proposals, in part, by providing valuable advice as strategies are formulated (e.g., Fama & Jensen, 1983). The service role may be most visible in organizations which JOURNAL

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experience less need for active board monitoring as a result of strong alternative monitoring forces such as product and managerial labor markets (e.g., Byrd & Hickman, 1992; Fama & Jensen, 1983). As previously noted, another important external force is that of dominant shareholder groups such as institutional investors (Useem, 1993). In the extreme, some authors have argued that these outside forces may completely replace the board’s control function (Demsetz, 1983; Hart, 1983; see also Rosenstein & Wyatt, 1990). Organizations characterized by strong external monitoring may elect to utilize the other potentials of the board, including tapping into the breadth of knowledge that outside board members provide to complement the depth of organization-specific knowledge of inside directors (Kesner & Johnson, 1990). In the sections that follow, we discuss the degree to which directors are actually engaged in the decision making process beyond their normal fiduciary responsibilities. We then review findings from representative studies that have examined the service role. Board Involvement

in Decision Management

Several survey and interview-based studies support the service role, as captured by the initiation and development of strategy. These studies commonly rely on Mace’s (1971) examination of boards of directors as a baseline for directors’ involvement in service-related activities. Based on a survey of CEOs, Tashakori and Boulton (1983), for example, found that board involvement has increased significantly in all phases of the strategic planning process. They reported, however, that most directors did not directly engage in strategy formulation. Henke (1986) found that directors primarily influence strategy development by way of committee (see also Harrison, 1987). Lorsch and MacIver’s (1989) extensive interview-based study also found that directors’ advisory roles predominated. They concluded that a small, but growing, number of boards were explicitly becoming more active in strategy formulation both as the board-at-large and through the committee structure. Additional evidence of the board’s role in the determination of corporate strategy may be found in research investigating the diffusion of innovations throughout interlocking directorates. Davis (1991), for example, found that poison pill anti-takeover provisions diffused through the interlocking directorate. Mizruchi (1989) demonstrated that proximity in the interlocking directorate accounted for similarities in political contributions by major corporations to political action committees. The diffusion of more fundamental managerial innovations and norms, such as adoption of multidivisional corporate structures (Palmer, Jennings & Zhou, 1993) or general acquisition strategies (Haunschild, 1993), also provides evidence that directors not only advise, but may also initiate important strategic changes in corporate strategy. Judge and Zeithaml(1992) provide additional support for directors’ involvement in strategy formulation. Relying on institutionalist and strategic choice theories, they examined the antecedents and consequences of board involvement in strategy formulation. Based on 114 interviews with CEOs and directors, they found that insider representation, in addition to board size, firm diversification, JOURNAL

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and organizational age, were related to board involvement in strategy formulation. Importantly, Judge and Zeithaml reported that board involvement in the strategic decision process was positively related to financial performance. Hermalin and Weisbach (1988) found that CEOs utilize directors as sources of information in the formulation of strategy. They hypothesized that newly appointed CEOs would appoint outside directors to the board in search of expert advice and counsel as they began their new jobs. Consistent with this argument, they found that after the appointment of a new CEO, insiders on the board tended to resign from the organization, and were typically replaced by outsiders. Hill and Snell (1988) also found a relationship between board composition and firm strategy. They found that outsider representation on the board was negatively related to the adoption of innovation strategies. They suggested that this finding represented the need for a high degree of intra-firm integration when following an innovation strategy. Their findings may suggest that governance processes indirectly affect firm performance through strategic choice. Johnson et al. (1993) examined the board’s involvement in corporate restructuring. They hypothesized that boards of directors would become involved in restructuring only if prior management strategies proved inadequate. They found that monitoring, an emphasis on strategic controls, and top management team tenure resulted in less board involvement in restructuring. Ultimately, however, outsider dominated boards will initiate restructuring in the event that other governance mechanisms fail. Alexander et al. (1993) argued that only certain kinds of boards will be actively involved in the strategy formulation process. They found that CEOs in organizations with large boards tended to use their power to entrench themselves, which led to a generally stable strategic orientation. Smaller, administratively focused boards, however, maintained their power by frequently replacing the CEO. This led to more variance in the number of strategies their sample hospitals exhibited over time. Consistent with these findings, Goodstein et al. (1994) found that more diverse and larger boards were less successful at initiating strategic change in turbulent environments than more homogeneous, smaller boards. Two recent studies assessed boardroom decision-making processes. Judge and Dobbins (1995) reasoned that directors who were more aware of the CEO’s decision making style would be more knowledgeable of the important strategic issues facing the firm as compared to directors with little or no appreciation of the CEO’s decision making style, and that this knowledge would positively impact firm performance. Based on interviews with CEOs and outside directors, they found that director awareness was positively related to firm performance and negatively related to financial risk. Pearce and Zahra (1991) proposed a typology of boards based on the underlying dimensions of CEO power and board power. Based on survey data, they found that organizations with powerful boards, especially participative boards which are characterized by high board power and high CEO power, outperformed firms with weaker boards. Interestingly, however, they found no differences in outsider board composition between the four board typologies. JOURNAL

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Several authors have also examined the role of contextual factors (e.g., firm size, ownership structure) which may impact the relationship between the service role and firm performance (e.g., Daily & Dalton, 1992, 1993; Rosenstein et al., 1993). Daily and Dalton (1992, 1993) suggested that the service role may be especially important in smaller and entrepreneurial firms. Specifically, they suggested that firms’ managers may benefit from the breadth of knowledge that outside directors provide. Consistent with their expectations, they found that the proportion of outsiders was positively associated with performance in smaller (Daily & Dalton, 1993) and entrepreneurial (Daily & Dalton, 1992) corporations., Rosenstein et al. (1993) also supported directors’ service role. In an examination of high technology firms receiving venture capital backing, they found that CEOs valued outside board members, particularly during the early developmental stages of their firms. These CEOs especially appreciated the outside directors’ information and expertise. Interestingly, CEOs reported that they tended to value outside directors less over time. Perhaps the greatest support for the service role lies in directors’ self-reports that they devote a considerable proportion of their board-related time and effort to contributing to corporate decision making. These perceptions are empirically supported by research which has found that boards impact the strategic management process through their review of strategic initiatives, and in some cases their involvement in strategy formulation. The predominance of this role in corporate boardrooms should motivate further development of theories and empirical tests of the service role.

Resource Dependence Role The resource dependence perspective views the board as one of a number of instruments that management may use to facilitate access to resources critical to the firm’s success. Resource dependence is grounded in Selznick’s (1949) study of the TVA. Research by Zald (1969), Pfeffer (1972, 1973), and Pfeffer and Salancik (1978) provided much of the framework for investigations into the use of boards as a mechanism for managing resource dependencies. Several aspects of boards characterize work addressing the resource role. Included among these are board size, the proportion of outside directors, patterns of interlocks between firms representing different economic sectors (Burt, 1980), and the repair of accidentally “broken” director interlocks (Omstein, 1984; Palmer, 1983; Richardson, 1987). In addition to this empirical work, several authors have reviewed directors’ resource role (e.g., Galaskiewicz, 1985; Mizruchi & Galaskiewicz, 1993; Penning, 1980; Scott, 1991; Zahra & Pearce, 1989). Board Interlocks and Access to Capital Board interlocks provide an example of direct application of resource dependence to the board of directors. Capital is a highly generalized resource (Burt, 1983) and as a result, a considerable amount of attention has been focused on board interlocks with financial institutions on the theory that such linkages will facilitate firms’ access to cash. A long stream of research has generally supported JOURNAL OF MANAGEMENT,

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the hypothesis that board membership may be used as a tool to facilitate access to capital. Two studies provide recent evidence of directors’ effectiveness in this role. In a study that spanned 27 years, Mizruchi and Steams (1988) found that the appoin~ent of represen~tives of tinancial institutions depended on both organizational performance (declining profits and solvency) and general economic conditions (e.g., the contraction of the business cycle). In a subsequent piece (Stearns & Mizruchi, 1993), these authors found that the types of financial institutions represented on a firm’s board influenced the types and amounts of financing obtained by the firm. In an international ex~nation, Kaplan and Minton (1994) found that poor stock performance was an important determinant of the appointment of corporate and financial directors to the board of large Japanese corporations. They also found that poor earnings predicted the ap~intment of financial directors to the board. Similar but weaker patterns were found in U.S. firms. Kaplan and Minton’s (1994) study differed from that of Steams and ~i~chi (1993) in an important way. They concluded that directors were the initiators in the interlocks and sought out seats in order to impose some control over the organization, i.e., “banks and corporate shareholders play an important monitoring and disciplinary role in Japan” (p, 225). Competitors are vitally important external actors. From the point of view of the sto~~olders and m~agement, it would benefit the firm to closely monitor their primary rivals. While law specifically prohibits direct interlocks between competitors (Clayton Act of 1912), several researchers have claimed that these laws are routinely ignored and often not enforced (see Penning, 1980). Zajac (1988), however, countered claims of direct interlocks, suggesting that this research may have misclassified firms based on overly broad industry classifications. Analyses based on more specific industry definitions demons~at~ that the degree of competitor interlocking was much less pervasive than had previously been thought. In contrast to previous research, Zajac concluded that firms do not use interlocks as a means to coopt their competitors. Lang and Lockhart (1990) also investigated the relationship between a focal firm’s board and its competitors relying on the resource dependence perspective. Current law does not preclude representatives of each competitor from sitting on the board of a third firm, creating an indirect interlock (Burt, 1983). In a longitudinal study of interlocking among eight airline firms that were direct competitors, Lang and Lockhart argued that deregulation in that indust~ “removed a mechanism of coordination and increased uncertainty” (p. 115), and thus created pressures for competitors to establish indirect interlocks. Lang and Lockhart (1990) found evidence of direct interlocks between competitors, particularly after deregulation. They also found that firm interlocking with financial institutions was positively associated with financial dependence. Relying largely on the resource dependence framework, Pearce and Zahra (1992) proposed several determinants of board composition (proportion of affiliated and un~~liated outsiders) and board size. Specifically, they argued that features of the environment, strategy, and past financial performance would partially determine board characteristics, which in turn would impact future finanJOURNAL OF MANAGEMENT,

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cial performance. They found that several factors influenced board composition and size, including environmental uncertainty, firm strategy, and financial performance. Moreover, they found that board composition and size were positively associated with future performance. Boyd (1990) and Boeker and Goodstein (1991) have also supported the efficacy of board interlocks. A variety of contextual variables may moderate the importance of the resource dependence function of the board. Small and newly established firms in which access to critical resources may be especially problematic tend to have fewer options for managing their organizational dependencies than their large firm counterparts (Pfeffer & Salancik, 1978). Moreover, small or entrepreneurial firms-which are more likely to lack “a sense of historical legitimacy” (Selznick, 1949, p. 259)-may benefit from the appointment of a prestigious director to their board. In addition to finding support for the service role, Daily and Dalton’s (1992, 1993) research on small and entrepreneurial firms suggests that the resource dependence role may be important for success in small and entrepreneurial firms. They found that board composition and size, often used as proxies for the resource dependence as well as service roles, were significantly related with accounting and market-based performance measures for the organizations in their sample. The resource dependence role may also be important for firms facing or trying to emerge from bankruptcy. Sutton and Callahan (1987) note that an important issue in organizational crises is the maintenance of exchange relationships with important constituencies. Gales and Kesner (1994) found that bankrupt firms had smaller boards than survivor firms before and after bankruptcy, and that bankrupt firms experienced a decline in board size during the two years prior to bankruptcy. Similarly, Daily (in press) found that board size declined in the five years preceding a prepackaged bankruptcy tiling. Gales and Kesner also documented a loss of outside directors in bankrupt firms. Moreover, Daily (1995) found that the proportion of outside directors was positively associated with successful Chapter 11 bankruptcy reorganization, and negatively associated with liquidation.

Suggestions for Future Research In general, this review does not provide a vehicle for sustaining strong consensus across the subsets of empirical research. More commonly, findings are inconsistent and where there may be consistency, associations are modest. The sections that follow suggest some methodological and conceptual factors which may, in part, account for some of the difficulty in aggregating this literature. Board Composition Measures

As previously noted, it is apparent that no consensus has yet been reached on the appropriate measurement of director dependence, and derivatively, board dependence. Daily et al. (1995) identified over twenty-five separate operationalizations of director dependence on the CEO in the governance literature. More importantly, using the various operationalizations, they could not find support for a single construct that was indicative of director dependence on the CEO. In other JOURNAL

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words, no group of indicators shared sufficient variance to be considered a single dimension. While they were able to identify three constructs (inside director proportion; outside director proportion; affiliated director proportion) with acceptable psychometric properties, many of the specific operationalizations relied on in the literature failed to load on any construct. Among the potential implications from having such a broad range of divergent indicators of director dependence is the frustration inherent in comparing and synthesizing existing studies. There is another potential issue which may cloud the interpretation of board composition data. The calculation of board composition almost invariably is based on a ratio with board size as the denominator. This ratio is essentially an interaction term, and variance in either the numerator or denominator can contribute to variance explained in the dependent variable of interest. Given that board size itself may be relevant to numerous relationships in corporate governance research (e.g., Alexander et al., 1993; Ocasio, 1994), caution may be well advised when interpreting relationships involving composition variables, perhaps by using board size as a control in multivariate models. Pelformance

Measurement

A review of the corporate governance research, like other foci of strategic studies (see especially work related to executive compensation, e.g., Kerr & Kren, 1992) illustrates that there is no consensus on what constitute appropriate measures ,of corporate financial performance. A list of the dependent variables included in studies reviewed here includes return on assets, return on equity, return on investment, Jensen’s alpha, profit margin, Treynor’s measure, and price/ earnings ratio. Indicators of firm profitability such as return on assets (ROA), return on equity (ROE) or return on investment (ROI) have been reported for a single year, multiple lagged (2,3,4) years, or an average of some period (2,3,4,5 years). In other cases, these measures have been adjusted for industry effectsusually defined by reference to two, three, or four digit SIC codes-either by subtracting or dividing by the average of returns for firms within an industry, or by subtracting the industry average from the focal firm’s returns, and then dividing by the standard deviation of the industry returns. Other studies have made further adjustments to return measures to account for risk, most commonly by dividing the return by the firm’s beta. The lack of consensus on choice and operationalization of dependent variables severely limits the generalizability of governance research findings. Board Composition and Director Roles As we noted earlier in this review, governance researchers and shareholder activists often use the term “board composition” to refer to a board-level attribute of dependence on the CEO, which has implications for directors’ control role. That this same “board composition” concept may be a factor in the execution of other board roles may lead to some confusion. Mintzberg (1983), for example, noted that the multiple roles that directors are hypothesized to fulfill may lead to confounded explanations from empirical findings. The proportion of outside directors may provide an example. Daily and JOURNAL OF MANAGEMENT,

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Dalton (1993) noted that outside directors are likely to be relevant to all three board roles. Outsiders are hypothesized to monitor managerial opportunism, while at the same time bringing to the board a diversity of perspectives and expertise that management can draw upon in formulating and implementing strategy. Moreover, directors serving resource dependence roles will normally be outsiders, and the proportion of outside directors is sometimes used as an indicator of the board’s resource dependence role. Also, it seems that an affiliated director, argued by some to be dependent on the CEO, could have access to resources critical to the firm. Indeed, it may be that such access was the reason the director was recruited from the onset. Board size is another issue for which there is no apparent consensus. Board size is a widely used measure of the resource dependence role, and is also frequently mentioned as an indicator of board control over the CEO (e.g., Ocasio, 1994; Pearce & Zahra, 1992; Zahra & Pearce, 1989). With respect to the control role, Zahra and Pearce (1989) are unequivocal: [Llarger boards are not as susceptible to managerial domination as their smaller counterpart. . . [Tlhese boards will be more actively involved in monitoring and evaluating CEO and company performance, normally through specialized committees (p. 309). This view is supported by findings reported by Pearce and Zahra (1992) and Ocasio

(1994). Conversely,

Alexander et al. concluded from their 1993 study that:

Our results confirm expectations that larger, more heterogeneous boards are associated with top-management stability, perhaps because such boards are actually less likely to become involved in decisions conceming the succession of CEOs and are more likely to be controlled by the CEO (p. 93).

These results provide some support for Lipton and Lorsch (1992) who proposed that in order for the board to best carry out the control function, it should be composed of a small number of directors, ideally eight, with a maximum of ten (see also, Chaganti, Mahajan & Sharma, 1985). Beyond Counting: Alternatives

to Composition Ratios

This article has largely focused on board composition measures primarily because they represent the bulk of the empirical studies that have been conducted in the area of corporate governance. There are, however, alternative measures and methods which have potential for furthering our understanding of board-management relations. Concepts and methodologies from organizational demographics, for example, have recently been successfully applied to the study of boards (Kosnik, 1990; Westphal & Zajac, 1995). Another alternative to composition measures may be found in social network methods. Social network techniques have long been used in research on the interlocking directorate, where the firm is the unit of analysis, but this technique may also be fruitfully applied to the study of relationships between individual directors JOURNAL

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within boards (see Palmer, 1988, for a discussion of the “dual nature” of corporate interlocks). Most board composition measures represent inferences of relationships that exist between directors and the CEO. Social network analysis provides a means for researchers to model power and dependence relationships even more directly than demographic methods. Many social network algorithms may be used to model specific, individual relationships between not only the CEO and outside directors, but also between the directors themselves. From these models, coalitions and structurally defined roles may be identified, and individual measures of power, as well as network measures relevant to the board as a whole, may be calculated. The challenge in using this methodology is in identifying valid indicators of the different relationships of interest, especially when relying on archival records. Researchers might begin by using traditional dependence variables, as well as data used in demographic studies based on homophily or cohort effects to construct networks. Finkelstein (1992) has identified several indicators of relative power in top management teams that may also be used to construct relationships for use in network analyses. Aside from creating networks from archival records, social network techniques are quite amenable to the study of small populations, making them especially relevant to the direct studies of boards, especially when used in combination with qualitative methods. Reintroducing

the Inside Director

In retrospect, the title of this review, or at least that part alluding to “boards of directors,” may have been misspecified. Much of the empirical work and the conceptualization informing it does not actually address boards of directors. Rather, the clear focus is on “outside directors,” more specifically non-management directors. With few exceptions (e. g., Baysinger & Hoskisson, 1990; Fama & Jensen, 1983), the role of the inside director has received little attention, although agency theorists’ advocacy of inside directors as monitors of the CEO has received preliminary, but indirect, support (e.g., Byrd & Hickman, 1992). Other aspects of the inside director’s role remain largely unaddressed. Do inside directors with particular functional specialties perform better as directors? Are those inside directors with particular profiles more likely to become CEOs in their own or other firms? The literature is largely moot with regard to these officers, three or four of whom will typically serve on the board of large corporations. Board Roles as Social Constructions A perspective on board roles decidedly different from the research tradition examined in this paper would examine the determinants and consequences of directors’ own perceptions of their role(s). Socioeconomists regard economic institutions and their components, including boards, to be social constructions (Fligstein & Freeland, 1995). Given the ongoing uncertainty among directors themselves of what their roles are and who their constituencies are (e.g., Lorsch & MacIver, 1989; Mace, 1971; Boulton, 1978; Andrews, 1980), it would be interesting to explain variations in directors’ conceptions of their roles. Rather than searching for “objective” characteristics of efficient and effective boards-many JOURNAL

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studies have used interviews and surveys to identify such attributes, including the two best known works by Mace (1971) and Lorsch and MacIver (1989)-studying the conceptions themselves and their variations across geographic regions, industries, interlock clusters, and time periods would add insights into the study of boards. Given the likelihood that interlocking directorates are conduits for the spread of norms and managerial innovations (e.g., Davis, 1991; Fligstein, 1985; Mizruchi, 1989), it may be that the implicit and explicit role definitions are likewise diffused. In a related vein, Lorsch & MacIver (1989), Alderfer (1986), and others have expressed particular concern about norms in boardrooms that appear to dampen director action, especially with respect to their control role. Given the powerful influence these norms-many of which appear to be “global”+xert on directors, their identification and the study of how they emerged, have been reinforced, or have been defeated, would also be useful. Conclusion To our knowledge, there has been no documented evidence of the existence of a unicorn. With tongue slightly in cheek, there can be two general rationales for our failure to “discover” this legendary species. First, this animal simply does not exist. Second, we have not searched in the right place, at the right time, with the right equipment. In many ways an aggregation and summary of the boards of directors/financial performance/other outcomes literature has this same character. Maybe such relationships simply do not exist in nature. Or, if they do exist, their magnitude is such that they are not of practical importance. Alternatively, given the heterogeneity of typical independent variables (e.g., the multiple operationalizations of board composition) and the dependent variables (any number of operationalizations of financial performance), it may be unrealistic to reasonably compare and summarize this body of work. For us, it is entirely too early to cancel the next series of expeditions for a search of the “boards of director” phenomena. Pressing the metaphor, however, it may not be too early to standardize at least some of our equipment. References Alderfer, C.P. (1986). The invisible director on corporate boards. Harvard Business Review, (November): 38-5 1, Alexander, J.A., Fennel, M.L. & Halpem, M.T. (1993). Leadership instability in hospitals: The influence ofboardCEO relations and organizational growth and decline. Administrufive Science Quarterly, 38: 74-99. Andrew, K.R. (1980). Directors’ responsibility for corporate strategy. Harvard Business Review, (November): 30. Bainbridge, SM. (1993). Independent directors and the ALI corporate governance project. George Washington Law Review, 6/: 1034-1083. Barnard, J.W. (1991). Institutional investors and the new corporate governance. North Carolina Law Review, 69: 1135-l 187. Baysinger, B.D. & Butler, H. (1985). Corporate governance and the board of directors: Performance effects of changes in board composition. Journal ofhw, Economics and Organization, I: 101-134. Baysinger, B.D. & Hoskisson, R.E. (1990). The composition of boards of directors and strategic control. Academy of Management Review, IS: 72-87. JOURNAL

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