How do directors add value to corporations, and what are their incentives? They add value through monitoring and advising management – although monitoring seems to have taken precedence in the wake of high-profile financial scandals. As for directors’ incentives, the answer is less straightforward. While director compensation has increased in recent years, non-pecuniary incentives remain important. The typical concern is one of board capture, i.e., directors siding uncritically with management. Yet, there is anecdotal evidence that some CEOs view their boards as overly aggressive and mainly interested in protecting their reputational capital. An extreme example of an antagonistic relationship is the recent (though quickly reversed) removal of the CEO of OpenAI by the company’s board.

We develop a model in which shareholders appoint the board of directors and design the directors’ compensation contract. Board composition determines whether the board is friendly or aggressive. For instance, a board that is dominated by debtholders or by former regulators or academics, who may be concerned mostly with their reputational capital, tends to be aggressive; a board dominated by directors with close social ties to the CEO tends to be friendly. The board can learn about the environment in two ways: by gathering information (e.g., combing through binders containing detailed business unit data ahead of a board meeting) and by direct communication with the CEO.

When nominating the board, the shareholders face a trade-off. On one hand, holding constant the board’s information, shareholders would best be served by an unbiased board. On the other hand, a biased board may yield informational benefits: an aggressive board has strong incentives to acquire information, whereas a friendly board communicate more effectively with the CEO. We study how shareholders should optimally navigate this tradeoff, depending on the specifics of the setting.

We show that whether the board should be biased – and if so, in what direction – ultimately depends on how well informed the CEO is. If the CEO is well informed, then the optimal board bias is weakly friendly, which allows the board to emphasize communication with such a CEO. By contrast, if the CEO is less well informed, then the optimal board bias is weakly antagonistic, which encourages the board to obtain information.

The tradeoff guiding the optimal equity stake for the board is between strengthening directors’ information gathering incentives and shareholder equity dilution. In general, our model predicts a positive relation between the severity of agency problems (empire building) on the part of management and the board’s equity stake.

Aside from assembling a friendly board, another way for shareholders to foster communication between the CEO and the board is by granting the CEO more equity, which mitigates the CEO’s empire building tendency. We show that these two options are often used in tandem: When shareholders want to foster communication between a board and a CEO, they typically choose a friendly board and grant the CEO a generous equity package. Prior literature has often viewed the positive association between board friendliness and CEO pay packages as a symptom of rent extraction by management. In contrast, our results provide an optimal contracting rationale for this situation.

Our model generates a number of predictions. First, we predict (weakly) friendly boards to be associated with CEOs who have a significant information advantage at the outset. Conversely, for CEOs with a limited information advantage, we predict (weakly) antagonistic boards. Interpreting the quality of the CEO’s information as a facet of CEO quality, this prediction is broadly in line with the empirical studies that have shown friendly boards to be associated with successful CEOs. Another way to interpret our result is by using CEO tenure as a proxy for informational advantage. The prediction of a positive relation between CEO tenure and board friendliness aligns well with empirical evidence. Second, our model predicts that the lower their cost of acquiring information, the less friendly boards will be.

A broader lesson from our paper is that interpreting a pay package as either optimal or excessive cannot be separated from the underlying incentive problem. Incentive pay not only encourages productive actions but also affects the incentives for managers and directors to share information. While higher CEO pay offered by friendly boards is commonly interpreted as a symptom of managerial rent extraction, our model provides an optimal contracting rationale.  Our results highlight the importance of considering contracting frictions beyond hidden effort, especially when fostering communication among key decision-makers within the organization is crucial.

This post comes to us from professors Tim Baldenius at Columbia Business School, Xiaojing Meng at New York University, and Lin Qiu at Purdue University. It is based on their recent article, “Biased Boards,” available here.