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The Interaction of Insiders and Outsiders in Monitoring: A Theory of Corporate Boards

I explicitly model the interaction of inside and outside corporate board members in a firm where the board is responsible for monitoring projects and making CEO succession decisions. Inside directors are better informed regarding the quality of firm investment projects proposed by the CEO. Outsiders can use CEO succession to motivate insiders to reveal their superior information. Board structure affects the flow of information and the effectiveness of the corporate board in replacing inferior projects with superior ones. I endogenously derive the optimal board size and composition by maximizing the board effectiveness in monitoring. I also develop testable implications for the cross-sectional differences in the optimal board structure across firms.