Understanding why firms exist has long been a preoccupation of economists. The leading answers—the ones that have won people Nobel prizes or put them on the short list[1]—focus on the ability of firms to get things done by asserting authority rather than relying on contracts or formal dispute resolution. To put it simply, if the boss tells you to stay late to finish a project, you don’t start a lawsuit, you just do it.

In the modern corporation, the board of directors is the ultimate source of this authority.[2] That authority gives the board the power to control the business and the affairs of the corporation. But directors who are not insiders almost always exercise this power in a part-time way. These directors meet infrequently, they have relatively little interaction with senior management beyond the CEO, and they typically have extremely demanding jobs running other companies. This approach by the board poses a puzzle: if authority is the reason that justifies the existence of firms why does the ultimate source of authority exercise so little of it?

In a recently published article, I develop a theory to help explain the hands-off approach that many boards take. This theory focuses on what scholars call “influence costs,” but what others might simply call office politicking.[3] These sorts of politics are well known to anyone who has spent time in just about any organization. Subordinates cajole, badger, and otherwise schmooze their bosses with the aim to get those bosses to make decisions that the subordinates favor. Perhaps the most powerful tool for this type of persuasion is the control that subordinates have over the information that superiors receive. Massaging and otherwise tweaking this information can lead managers to make decisions that subordinates like.

While this politicking may benefit those who engage in it, this sort of activity has an organizational cost. All that time spent kissing up to the boss is time that is not spent doing the work of the firm. Academics who think about influence costs have suggested that policies like lockstep promotion and closed-door meetings may be motivated by the desire to minimize the costs associated with this internal lobbying.[4]

In the context of the board, the danger posed by management lobbying is a serious one. Relative to independent directors, managers have a tremendous amount of their human capital invested in the firm.[5] A decision that is not all that consequential to the firm as a whole—say whether to continue a marginally profitable product line—may have a substantial impact on individual executives. Those managers can be expected to try to influence directors either through direct arm-twisting or by skewing information about the decision. These activities take time and effort, which could be directed at more productive activities.

The prospect of this lobbying suggests a tradeoff for boards. As they expand the scope of the authority they exercise they presumably aid the corporation by minimizing agency costs and increasing the benefits from strategic oversight. But as the board makes more decisions, the potential for lobbying by executives increases as well. This lobbying can exert drag on firm performance, and this cost undermines the benefits associated with expanded authority.

Incorporating influence costs into thinking about the board has consequences for the drive to increase the use of independent directors. The typical tradeoff that scholars identify when contrasting independent and non-independent directors have is one between financial interest and agency costs.[6] Independent directors may be better able to reign in insider excesses, but their lack of financial interest in the firm may diminish effort. This is, of course, an issue. But the use of independent directors also exacerbates lobbying concerns.

When boards are made up of insiders, those insiders have no superiors to lobby. A shift in board composition to include more independent directors, however, will presumably push insiders off boards. Those insiders now have superiors, and given the importance those decisions have over the lives of those insiders, they can be expected to lobby these superiors with fervor. These influence activities by top-level managers—who would have no reason to lobby if they were on the board—can distract from the work of the firm. Directors that want the firm to succeed may worry that excessive amounts of this lobbying will hurt firm performance. Put another way, the increasing use of independent directors may introduce the lobbying tradeoff where it did not exist before. Directors may respond by cutting back on the scope of authority they exercise because, as they exert more of it, lobbying concerns increase.

This unrecognized effect of independence may help to understand why the push to make boards more independent has not been a clear success.[7] An increase in independence should help improve oversight because independent directors are likely to be better stewards of firm resources. But increasing independence also increases the incentive to lobby. As independent directors do more to police agency costs, managers can be expected to spend more time lobbying them. This behavior can hurt firm performance. The upshot is that the decrease in agency costs that come with independence may be largely cancelled out by the lobbying costs that come with that independence.

The potential lobbying should also give courts and policymakers some pause about requiring directors to do more. As legal or regulatory mandates impose additional burdens on directors, those directors will necessarily have to expand their authority and oversight. Doing so, however, can increase the amount of lobbying that executives do. The benefits of oversight may or may not outweigh the additional influence costs that they entail. But failing to take into account the increased lobbying costs that come with additional oversight requirements make it less likely that this sort of regulation will benefit shareholders.

ENDNOTES

[1] See Ronald H. Coase, The Nature of the Firm, 4 Economica 386, 388 (1937); Oliver E. Williamson, Markets and Hierarchies: Some Elementary Considerations, 63 Am. Econ. Rev. 316, 316 (1973); Sanford J. Grossman & Oliver D. Hart, The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration, 94 J. Pol. Econ. 691 (1986).

[2] See, e.g., 56 Del. Code Ann. tit. 8, § 141(a).

[3] See Robert Gibbons, Four Formal(izable) Theories of the Firm?, 58 J. Econ. Behav. & Org. 200 (2005).

[4] Michael Powell, An Influence-Cost Model of Organizational Practices and Firm Boundaries, J. L., Econ. & Org. (forthcoming).

[5] Sanjai Bhagat & Bernard Black, The Non-Correlation Between Board Independence and Long-Term Firm Performance, 27 J. Corp. L. 231, 264 (2002) (“Inside directors lack independence, but have their human capital, and often most of their financial capital, committed to their company.”)

[6] Id. (“There is . . . a trade-off between independence and incentives. Many independent directors own small amounts of their company’s shares, and hence have limited incentives to monitor carefully.”)

[7] See Sanjai Bhagat & Bernard Black, The Non-Correlation Between Board Independence and Long-Term Firm Performance, 27 J. Corp. L. 231, 263 (2002) (“We find a reasonably strong inverse correlation between firm performance in the recent past and board independence. However, there is no evidence that greater board independence leads to improved firm performance. If anything, there are hints that greater board independence may impair firm performance.”); Jeffrey N. Gordon, The Rise of Independent Directors in the United States, 1950–2005: Of Shareholder Value and Stock Market Prices, 59 Stan. L. Rev. 1465, 1500 (2007) (“Evidence that connects the increased presence of independent directors to shareholder benefit is weak at best.”).

The preceding post comes to us from Adam B. Badawi, Associate Professor of Law at Washington University Law.  The post is based on his recent article entitled “Influence Costs and the Scope of Board Authority”, which is available here.