Endogenously Informed Boards and the Optimality of Board Power

Abstract

This paper develops a theory of board power when the board of directors collects private information about the CEOs ability to make value-increasing investments. When CEO ability is unknown ex-ante, we show that board power can be helpful in inducing information production by the board and in eliminating over-investment by managers with low ability. However, we find that board power also comes at a cost of rejecting good investments by highly talented managers when the board is uninformed and hence has to rely on noisy public information. The paper thus highlights the importance of the interaction between board power and the public and private information environment faced by the board. Modeling explicitly the power of the board to reject major investment decisions we derive several novel implications on how board power impact managerial turnover, managerial investment, and overall firm value. For example, we find conditions under which more powerful boards will be associated with a lower sensitivity of managerial turnover to negative market signals as well as in boards that discourage efficient investments. The paper thus highlights some of the costs associated with awarding the board of directors with too much power and hence identifies the conditions under which increases in board power enhance shareholder value.

Keywords: board, information, power