The board of directors is comprised of a group of individuals who are elected to represent stockholders to monitor a firm’s management (Weisbach, 1988). A large body of prior studies has focused on the board of directors as an important factor in internal CG mechanisms, and shows that management characteristics have a significant impact on the engagement of EM (e.g., Du, Lai, & Pei, 2016; Qi, Lin, Tian, & Lewis, 2017).
The primary roles of the board of directors are to make decisions on behalf of their shareholders and to fairly represent the interests of shareholders. Board directors are divided into two categories: inside directors who are also the managers of the company, and outside directors who are independent employees of the company. The board characteristics present great potential for agency conflict. The prior research presents evidence that a high proportion of inside directors motivates the board to make decisions more beneficial to the managers (Reddy, Locke, & Scrimgeour, 2010). In China, Chen et al. (2006) find that an increase in the proportion of outside directors on the board contributes to the reduction of fraud committed by companies.
Other board characteristics include board size, board diligence, and board expertise. Board size is an important element in the internal CG mechanism and closely relates to agency problems. There are pros and cons for both small and large board sizes. Small boards are easier to manage and tend to be more effective. However, large boards tend to have expanded resources since more board members have external sources of information (Eisenberg et al., 1998).
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A large body of prior literature has established that board diligence and board expertise are essential board characteristics. For instance, researchers have found that more diligent boards lead to more effective management (Conger, Finegold, & Lawler, 1998; Vafeas, 1999). The diligence of the board can be observed in terms of the number of board meetings, the level of preparation for meetings, attention in meetings, and action after meetings. (Carcello, Hermanson, Neal, & Riley, 2002). A more diligent board is expected to be more efficient, caters for shareholders’ demands better, and aligns manager’s incentives with shareholders better. Therefore board diligence is considered an important indicator of agency conflicts. The monitoring role of board directors is important in improving CG quality (Lipton & Lorsch, 1992). There are several factors that limit boards’ effectiveness in carrying out their monitoring functions. The first factor that hinders board effectiveness relates to the limited time spent by the directors on each meeting or on the business of the board. Outside directors may take a role in many boardrooms, and typically, when they finally sit in a boardroom, most of the time they will be occupied by formalities like management reports, which leave no time for directors to exchange meaningful ideas. Particularly with large boards, there is often insufficient time for all the members to express their ideas.
Secondly, the complexity of information makes it difficult for board directors to carry out their duties. Lipton and Lorsch (1992) emphasize that managers and directors are supposed to devote themselves to organizing and conceptualizing the provided data, instead of drowning in the complexity of the data they receive. Even with well-organized data, outside directors may still find it difficult to make a decision based on the existing information, considering that outside/independent directors may lack sufficient experience and knowledge in the particular industry or company affairs. This phenomenon has led to the proposition that the more time
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directors spend on company affairs, the more diligent they are, and the more open exchange of ideas they have, the better they can manage and monitor the company. Other factors that limit board effectiveness include lack of cohesiveness, overpowered CEOs/top management, and confused accountability (Lipton & Lorsch, 1992, p. 23). To help board directors monitor a company’s performance more efficiently, Lipton and Lorsch (1992) propose measures such as reducing the board size moderately, maintaining at least a 2% ratio of independent directors to other directors, and increasing board meeting frequency and board meeting duration. Board directors are expected to be diligent enough to spend at least 100 hours annually on each board to prepare for regular meetings, reviewing reports in advance. Notably, board diligence has an important impact on how effectively boards carry out their monitoring functions, and is thus an important indicator of the company’s CG.
The importance of board diligence is supported by empirical studies. For example, in Malaysia, Foo and Zain (2010) tested the relationship between board diligence and the firm’s liquidity, and suggest that board diligence indicates active monitoring of the firm’s management and more alignment between managers’ incentives and shareholders. Thus board diligence is expected to mitigate agency conflicts as well as information asymmetry and to positively associate with liquidity. Their empirical results support the hypotheses. However, there are also opposing arguments in the literature. For instance, Vafeas (1999) examines whether the frequency of board meeting addresses CG problems, and finds a negative association between the frequency of board meetings and firm performance, which indicates that board meetings with regard to CG serve as a reactive approach instead of a proactive one. The increased number of board meetings, in this case, led to weaker CG or firm performance.
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Board independence is another important factor in CG (Rosenstein & Wyatt, 1990). An independent board is considered a necessity for good corporate governance. Outside or independent directors with multiple directorships have a strong incentive to contribute to the decision-making process in order to build their reputations as experts (Fama, 1980; Fama & Jensen, 1983). However, the effectiveness of independent board members can be compromised in a number of ways. One example relates to the expertise of outside directors. Lacking sufficient background may limit outside directors’ insight into a particular business, and consequently, affect the firm’s development in the long run. The ‘busyness’ of board directors is also associated with CG quality. Prior research indicates that directors with multiple directorships tend to be more at risk of opportunistic behaviour (Gilson, 1990). To prevent directors with multiple directorships engaging in EM, the quality of audit service must increase with the number of directors with multiple directorships (Carcello et al. 2002). Also, when a director is sitting on a large number of boards, due to the level of distraction, the director may not be able to provide thoughtful and quality oversight of the firm’s executives. To measure the degree of board independence, the percentage of inside directors on the board is often used (Ahmed & Duellman, 2007).