Regulated change effects on boards of directors: a look at agency theory and resource dependency theory.

Author:Bryant, Phil
Position:Report
 
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INTRODUCTION

Organizational theorists have examined the role of corporate boards of directors (BODs) from many different perspectives. Two major theoretical perspectives that provide insight into the role and structure of BODs are agency theory and resource dependency theory (Hillman, Cannella and Paetzold, 2000). In addition to academic attention, BODs have received much attention from the popular press as well. The most recent proliferation of attention paid to BODs is largely due to the Sarbanes-Oxley Act and the instigating events that led to its passage in 2002. The Sarbanes-Oxley Act of 2002, among other requirements, mandates strict controls by and of corporate boards of directors. Sarbanes-Oxley was passed in reaction to a series of corporate scandals of the late 1990s and early 2000s including at Enron, Tyco International, and WorldCom. Because of the impact of the Sarbanes-Oxley Act of 2002 on BODs, many questions have arisen in regards to the roles, responsibilities, accountabilities, and structures of BODs. Is the role of the BOD primarily administrative oversight and control, or is it primarily boundary spanning and environment linking? How can the BOD best be held accountable for the actions of the corporation? Are there corporate stakeholders outside of the shareholders to whom the BOD is also to be held accountable? What proportion of the BOD should be comprised of insiders and what proportion should be outsiders? Is the insider / outsider taxonomy the best way to categorize board members?

Although one of the most recent and salient, the Sarbanes-Oxley Act of 2002 is not the first government mandated regulation that requires major changes to be made by BODs. The 1978 deregulation of the United States Airline Industry and the 1980 deregulation of Savings and Loans associations followed by the subsequent Financial Institutions Reform, Recovery & Enforcement Act of 1989 are two additional examples of times that regulatory actions by the United States government caused major changes to be made by BODs. A third example of governmental actions requiring changes to be made by BODs is the Canadian government's 1983 amateur sports "Best Ever" program. It required radical changes of the volunteer BODs of Canada's National Sport Organizations (NSOs) (Amis, Slack, and Hinings, 2004a).

The intent of this paper is to consider the tenets of agency theory and resource dependency theory as they relate to the responses made by BODs in the face of major government regulated changes. In the remainder of this paper, we will first highlight the generally accepted major roles and responsibilities of BODs. This will provide a solid framework from which to examine the theoretical perspectives of agency and resource dependency regarding BODs. After highlighting the roles and responsibilities of BODs, we will then examine agency theory and resource dependency and their relation to BODs. Next, we consider four historical examples--the Sarbanes-Oxley Act of 2002, the 1978 deregulation of the United States airlines industry, the changes in Savings and Loans regulations of the 1980s, and Canada's Best Ever amateur sports initiative of 1983--as the contexts in which we will examine some historical responses of BODs to these government regulated changes. We conclude the paper with recommendations for the direction of further study.

ROLES, RESPONSIBILITIES & STRUCTURE OF CORPORATE BOARDS OF DIRECTORS

Pfeffer and Salancik (1978) divided the role of BODs into administrative and environmental linking responsibilities. Pfeffer and Salancik identified two areas of administrative duties: providing expert advice and counsel to the firm's management, and exercising monitoring responsibilities such as oversight and control over the firm's executive management team. The environmental linking responsibilities include providing access to information and other resources (Pfeffer & Salancik, 1978) and enhancing perceived legitimacy (Meyer & Rowan, 1977) of the organization. Inside board members, those who are currently, or were previously, employed by the organization (Pfeffer, 1972), generally serve the advice and counsel function while the oversight and control functions are generally served by outside board members (Baysinger & Butler, 1985). However, Daily and Dalton (1994) have shown that outside directors can also provide expert advice and counsel, especially in regards to boundary spanning and environmental linking issues such as the regulatory or competitive environment. Westphal (1999) has shown that both inside and outside directors can play several roles simultaneously and there are advantages to having a board structure with a mix of both insiders and outsiders. This insider / outsider taxonomy of BODs is the most widely used both in and out of academia and is influenced heavily by the agency theory perspective (Hillman, Cannella and Paetzold, 2000). A different taxonomy that disaggregates the outside director category (Hillman, Cannella and Paetzold, 2000) will also be considered.

THEORETICAL PERSPECTIVE--AGENCY THEORY

As previously indicated, agency theory has played a major part in studies of BODs (Hillman, Cannella and Paetzold, 2000). The agency theory approach looks at intraorganizational processes from an economic perspective. The genesis of agency theory is often attributed to Jensen and Meckling's 1976, "Theory of the firm." Agency theory generally refers to the various ways that agents of a firm can influence the economic outcomes and "behaviors" of the firm (Fama & Jensen, 1983).

Agency theory broadly states, given that agents of an organization are responsible for conducting business in the interest of the organization, and given that an agent's own self interests will never align completely with the interests of the organization, agents of an organization will sometimes experience conflicts of interest when conducting business on behalf of the organization. Given also that people can be expected to act on behalf of their own self-interests when those interests conflict with that of another entity, and given that agents will sometimes experience conflicts of interests while conducting business on behalf of the organization, agents are more likely to act in the interests of the organization when their own interests are aligned with those of the organization or when their behavior is monitored or controlled against self-interested behavior. Thus, according to normative agency theory, corporations should either increase incentive structures that align the interests of owners and managers (Fama & Jensen, 1983) or increase monitoring, control and oversight of managers by owner principal delegates (e.g. BODs). In fact, Westphal (1999) found that "management incentives decrease the need for board monitoring as a control mechanism." In this respect, agency theory views the administrative function of monitoring and controlling top executive decisions and actions as the primary function of the BOD.

Agency theory is a powerful tool in understanding and prescribing the compensation structures of top executives and the structures and actions of BODs. Additionally, agency theory has proven to be a popular theoretical framework from which to investigate the role of BODs. Agency theory holds implicit several assumptions about human motivation and the goals of corporate ownership which deserve a closer look: 1) wealth maximization is the top priority for corporate owners; 2) the BOD is an appropriate owner principle delegate; 3) management and board actions and interactions are primarily outcomes of economic forces; and 4) the BOD acts as a single unitary actor (Zajac & Westphal, 2002). Of course there are other assumptions of agency theory, for example, that management interests will conflict with owners' interests. The ones assumptions listed above and discussed below, however, are important to examine to highlight the fact that, although agency theory is an important and useful theory, there are other organizational theories (such as resource dependency theory) that are just as important and useful in understanding the roles and responsibilities of BODs.

The first assumption of agency theory listed above, that wealth maximization is the primary goal of corporate owners, can be seen in the normative agency theoretical framework that often prescribes long-term, financial-outcome based incentives such as stock ownership, performance based stock options, or stock appreciation rights for senior executives. The logic behind these prescriptions is to ensure that management's self interests will be aligned with the principal owners' interests. This is expected to be the case if they share the same financial goals and incentives. Fiss and Zajac (2004), however, found that infusing shareholder wealth maximization goals into firms in Germany led to short-term acceptance of the wealth maximization goals and then subsequent adoption of additional, non-wealth maximization-related goals. A generalization of this phenomenon might lead agency theorists to consider interest alignment mechanisms beyond the traditional wealth maximization mechanisms primarily prescribed by normative agency theory.

The agency theory assumption that the BOD is the most appropriate owner principal delegate is interesting to consider...

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