Influence costs and the scope of board authority.

• Author: Badawi, Adam B.

ABSTRACT I. INTRODUCTION II. INFLUENCE COSTS IN THE FIRM III. INFLUENCE COSTS AND THE SCOPE OF BOARD AUTHORITY A. The Board, Management, and Lobbying Within the Firm B. The Board's Place in Corporate Law IV. INFLUENCE COSTS APPLIED A. Independence and Influence Costs B. Intrafirm Lobbying and the Regulation of Agency Costs V. CONCLUSION I. INTRODUCTION

The theory of the firm has long lauded hierarchy and authority as the institutional attributes that justify the existence of firms. The exercise of hierarchical authority allows firms to avoid the indeterminacy, risk, and expense associated with governing transactions solely through contracts. A firm can end an internal dispute through fiat and, in so doing, avoid the expense associated with haggling and use of the court system. Oliver Williamson's synthesis of this problem explains that, because firms rarely use courts to resolve intrafirm matters, "the parties must resolve their differences internally. Accordingly, hierarchy is its own ultimate court of appeal." (1)

Given this celebration of authority and hierarchy, the group at the top of most firms-the board of directors--looks like a curious institution. These groups have the legal authority to manage "the business and affairs" of what are often multi-billion dollar enterprises. (2) As the ultimate source of authority within the firm, one might expect boards to exercise that authority in an extensive way. But this is not how the boards of most public companies behave. Many directors have a full-time job doing something else, they meet infrequently as a board, and they limit the scope of their authority to a relatively small number of decisions. (3) If authority is the central reason for the existence of firms and boards are vested with ultimate authority, why do they exercise so little of it?

This Article seeks to answer this question by drawing on recent work in the theory of the firm. This developing literature examines how lobbying and squabbling within hierarchies can affect the allocation of authority in the firm. (4) This work's key insight identifies a dynamic that helps to explain how lobbying can affect decision-making structures within an organization. (5) If a firm has a variety of constituencies that care about decisions, those who do not have authority may spend their time trying to influence those who do. The ideal allocation of authority should account for this likely lobbying.

This sort of firm politicking should be familiar to anyone who has spent time in a large organization. Subordinates will sometimes try to cajole and persuade their superiors into making decisions that benefit those subordinates. Similarly, if employees have some control over the information that their bosses receive, they may spend time shading that information as a way to influence superiors. (6) People presumably engage in this sort of lobbying because it works, at least with respect to furthering the interests of those who can influence effectively. (7)

The literature on influence costs explores the potential downsides of this sort of behavior. When employees lobby within the firm, it can take away from time that they could devote to more productive activity. (8) Theorists argue that firms may set up a decision-making structure with an eye towards minimizing the costs of these influence activities. One way to do this is to vest authority in parties that have intense preferences over a given set of decisions. If those parties get to make the decisions, they do not need to lobby anyone. Likewise, companies may institute policies like lockstep promotion and closed-door meetings that can sharply reduce the incentive to lobby. This sort of minimization of influence activities can decrease the drag that politicking has on firm performance. (9)

Delegating authority to management can help to minimize the amount of effort management puts into lobbying. This effect of delegation may be one reason the board exercises a limited amount of its plenary authority over the firm. This desire to limit lobbying may provide some counterweight to the central role of the board, which, in the modern understanding of the role of directors, is to help limit the agency costs that arise as a natural consequence of the separation between ownership and control. (10) Concentrating authority in a small board helps to avoid the free riding and conflict that would come with having a large and diffuse group of shareholders control the corporation. (11) But boards must deal with managers who have most of their human capital bound up with the firm. (12) These circumstances mean that managers are likely to have intense preferences over firm decisions. If managers do not have authority over a choice that will affect their well-being, they are likely to lobby those that do have authority. Excessive amounts of this sort of lobbying could have a detrimental effect on firm performance.

By exercising control over a small number of decisions, a board can limit the amount of lobbying by management to influence those decisions. (13) Limiting this lobbying may benefit the firm by freeing management to devote more time to improving firm performance. But limiting the scope of board authority may have adverse consequences on agency costs. A board that works on a part-time basis presumably cannot monitor as closely as a full-time board.

This Article argues that understanding influence costs helps to explain why boards take measures to insulate themselves from the firms they oversee. (14) If boards were to expand the scope of the authority they exercise, management might have more opportunities to lobby. (15) Management lobbying could adversely affect firm performance. But if boards do too little, managers might be able to exploit the agency costs that directors are supposed to minimize. As this account suggests, incorporating influence costs into the board's role poses a tradeoff between those influence costs and minimizing agency costs.

This theory of board authority helps to answer some questions left open by existing accounts of the board's place in the firm. Theories that argue for director or shareholder primacy have been influential because they provide compelling reasons for the long-term success of the corporate form. (16) But neither of these approaches offers a prediction for how a board will settle on the scope of its authority. This Article argues that thinking about how influence costs affect that scope of authority can provide new insight into problems that corporate law has yet to explain completely.

One puzzle that influence costs help to understand is the muted success of the move toward more independent boards. (17) These shifts, some compelled by regulation, have led public company boards to fill their ranks with directors who do not have financial or familial links to the firm. (18) This shift may have an effect on the lobbying dynamics in the boardroom. As the number of independent directors on a board increases, the number of insider directors is likely to decrease. These insiders, who have little incentive to lobby when they serve as directors, now have an incentive to lobby the board. The resulting increase in lobbying may offset the gains that come from better monitoring of agency costs. The combination of these effects may provide little net benefit, which account for the ambiguous evidence about the impact of the increase in director independence.

This theory of board authority also provides a different perspective on the law that governs director behavior. The history of corporate law is one, by and large, of hesitation to impose liability on directors for the board's decisions. (19) The business judgment rule is the doctrinal embodiment of this concept. One might understand the extreme deference that the business judgment rule--and the statutory exculpation clauses that have followed court attempts to impose stronger fiduciary duties on directors--as a concession to influence costs. (20) Imposing liability on directors will almost always involve rules that require stronger oversight. To avoid this liability, directors will have to increase the scope of their authority. This change may work to the firm's detriment if doing so increases the amount of influence costs that the firm must collectively tolerate. The business judgment rule can be viewed as recognition that boards are in the best position to determine the ideal scope of their authority.

The remainder of this Article develops a theory of how influence costs may contribute to the role the board plays. It then places that theory within the context of ongoing debates in corporate law. Part II is a literature review that briefly explains how scholars of the firm have used influence costs to describe how firms conduct their affairs. The analysis in this work, developed by Robert Gibbons and Michael Powell, asks how to divide decision rights optimally when lobbying is possible. (21) They articulate the likely costs and benefits that come with different allocations of those rights. They explain some firm practices, such as lockstep promotion and closed-door policies, as ways that firms might minimize lobbying when the cost of this activity is likely to be high.

Part III applies the theory of decision rights and influence costs to the board's role. This discussion identifies the tradeoff that the corporation faces in allocating power between management and the directors. Exercising a decision right provides the straightforward benefit of ensuring that the decision will be made in a way that interests the board (or whomever the board represents). But as the board expands the number of decision rights it exercises, management is likely to subject the board to increased lobbying. In addition to taking away from management's efforts elsewhere, these lobbying costs affect the quality of information that the board receives and thus, degrade the quality of the decisions...