3.3.2 Board composition according to the agency theory

Agency theorists prescribe independent boards to monitor management and to avoid the fact that managers pursue their self-interest at the expense of profit maximisation. The independence of boards can be accomplished by appointing a large proportion of independent directors and by the separation of the CEO and chairman positions. Both measures dilute the power of CEO and management – represented by executive directors on the board – in the decision-making process of the board and enable the entire board to pass judgement independently on management’s decisions, acquisitions and strategy (Muth and Donaldson 1998: 7).

There are other factors that might affect board independence as well. Besides the separation of the CEO and chairman positions and the proportion of independent directors, Muth and Donaldson suggest that board size, age of directors and tenure of directors have implications for the independence of the board (1998: 7-9). Smaller groups of directors offer opportunities for management and the CEO to dominate the board easily. On the contrary, large boards require much effort and time for the CEO and management to influence their members. According to proponents of the agency theory, increasing board size leads to more independence of the board from management and consequently to fewer opportunities for agents to maximise self-interest at the expense of shareholder wealth. The same applies to higher average age and lower average tenure of board members.

Psychological research has proved that managers of lower age are more likely to take risks and change strategy, while older directors are more conservative. ‘It may be in part that older decision makers exhibit better moral judgement because they (a) tend to take longer to reach decisions and to seek greater amounts of information, (b) are able to diagnose the value of information more accurately, and (c) are less confident of their decisions and more willing to reconsider them’ (Daboub et al. (1995: 152) cited in Muth and Donaldson (1998: 8)). A long tenure with the company is a characteristic that might imply less independence from management, because ‘tenure tends to foster cohorts within an organisation’ (Muth and Donaldson 1998: 8). Directors with a long term together in office are likely to think alike, reach consensus early due to their shared experience and will probably become committed to management. Fresh directors with a background from a different organisation are not familiar with the current situation in the company and will reduce social cohesion and will create a more heterogeneous group of directors. The level of innovative-ness is expected to be lower when the average tenure is higher, because a long average tenure leads to insulation and a narrowing of vision (Bantel and Jackson 1989: 110). Higher average age and lower average tenure of the board will lead to a better ability of directors to judge independently on corporate decision-making.

Boards that are independent of management, which can be realised by the above-mentioned mechanisms, are associated with high levels of monitoring that deter agents from taking actions and making decisions driven by self-interest. Due to intense monitoring, agents are less likely solely to pursue utility maximisation at the expense of principals. Consequently residual losses and agency costs will drop and this therefore culminates in high corporate performance (Muth and Donaldson 1998: 5, 9; Nicholson and Kiel 2007: 587-588). Nicholson and Kiel conjecture the truth of the reverse of this statement: a small proportion of independent directors leads to low levels of monitoring, which culminates in low agency costs and consequently in low corporate performance.

The implementation of agency theory mechanisms in a company does not automatically lead to managers who increase shareholders’ wealth, but to managers who strive to increase shareholder wealth. Shareholders’ wealth maximisation is not only frustrated by poor motivation and inadequate alignment of principal/agent interests, but also by low ability, lack of knowledge and poor information (Davis et al. 1997: 23-24). The underlying model of man of the agency theory is subject to discussion as well. The next section describes the transaction costs economics theory, which is based on the same model of man. An alternative view on the behaviour of managers is provided by the stewardship theory, which is discussed in section 3.5.