Board Fiduciary Duty, Communication, and Compensation

This paper examines the consequences of tightening board fiduciary duty rules in a setting that combines agency frictions and strategic communication. A firm needs to tailor an investment decision (e.g., mergers and acquisitions) to the state of the world. The CEO is privately informed about the state but is an empire builder. The board can learn about the firm’s state through exerting a costly information gathering effort or through communication. In equilibrium, the board values communication more than the shareholders do. By granting the CEO a larger equity stake, the board fosters communication, and this reduces its need for costly information acquisition. Anticipating this, rational shareholders can adjust the board’s equity stake to boost its effort incentive. Surprisingly, the benefit to shareholders from stricter fiduciary duty rules is nonmonotonic in CEO agency conflicts and can diminish as the severity of agency conflict increases. Moreover, welfare analysis shows that strengthening fiduciary duty rules can weaken board effort incentives and reduce total equity value and overall welfare. Paradoxically, these efficiency losses occur when CEO agency conflicts are severe—the very situations in which stringent fiduciary duty rules are typically introduced to address such concerns. These findings suggest unintended consequences of strengthening board fiduciary duty rules and highlight the importance of taking boards as strategic, self-interested entities. This paper was accepted by Prof. Ranjani Krishnan, accounting.