Differentiating Control, Monitoring and Oversight: Influence of Power Relations on Boards of Directors - Insights from Investment Fund Boards

Importance and Key Contribution: Most traditional corporate governance research is based on corporate boards of publicly listed companies which are assumed to have full power to exercise three key accountability roles –... [ view full abstract ]

Importance and Key Contribution: Most traditional corporate governance research is based on corporate boards of publicly listed companies which are assumed to have full power to exercise three key accountability roles – control, monitoring and oversight roles. Such theoretical assumptions may not be applicable to the boards of other types of entity. Yet these taken-for-granted assumptions are often extended to other board types. Acknowledging this, scholars have repeatedly called for research on boards of directors beyond listed company boards (Daily et al., 2002; Dalton et al., 2007). By researching one extreme board type – investment fund boards – and the power relations around those boards – we show that not all boards are capable of operating the three key roles assumed of them. We differentiate control, monitoring and oversight roles, terms which are often used interchangeably in prior research. We distinguish between the three terms on the basis of the level of influence implied by each. Our findings and insights are generalisable to many other board types and situations. This study makes three contributions: (1) We examine the role of investment fund boards customised to context. By linking the unique characteristics of investment funds to investment fund board roles, we enhance theoretical understandings beyond prior research. (2) Based on interviews with investment fund directors, we add novel and unexpected insights on investment fund (and other) board roles not factored into prior empirical research; specifically that investment fund boards can only exercise oversight roles and are not able to control or monitoring. (3) The terms “control”, monitoring” and “oversight” are differentiated and separately defined. The distinction is important as we find that investment fund boards can only exercise oversight functions, which finding is likely to apply to other types of entity.

Theoretical Base: In addition to theorising on “open” corporations, Fama and Jensen’s (1983a) seminal text theorises the separation of ownership and control at the level of financial mutuals, including investment funds. Fama and Jensen (1983a) differentiate the decision management roles of management, the decision control roles of boards of directors and the residual risk-bearing claimant roles of shareholders. Unlike open corporations, shareholders in investment funds can redeem their claims at any time and as such are deemed to have a control role. Fama and Jensen (1983a) acknowledge this when they state that because of the strong decision control inherent in the redeemable residual claims of mutual fund shareholders, their boards are less important in the control process. This is where we pick up the story. While investment fund boards have been subject to empirical research, surprisingly, Fama and Jensen’s (1983a) theorising on financial mutuals has not been developed, possibly because of taken-for-granted assumptions on the part of researchers who do not adequately differentiate between open corporations and financial mutuals.

Fama and Jensen (1983b, p. 337) comment “…mutuals exist side by side with open corporations”. Thus, a fund promoter organisation will have its own “open corporation” board and also tens if not hundreds of investment fund boards operating alongside the fund promoter organisation’s own board. This has implications for how investment fund boards operate. We question whether the assumption that investment fund boards have a control role is appropriate. Rather than focusing solely on measurable variables, an understanding of the roles adopted by boards of directors in practice (Nicholson and Kiel, 2004) and the conditions under which they can execute these roles in practice (Roberts et al., 2005) is critical to evaluating investment fund (and other) board roles.

Research questions and methodology: The research addresses two questions: (i) Given their unique characteristics, is the assumption of prior research that investment fund boards have a control role appropriate? (ii) What roles do investment fund boards exercise in practice? Given the lack of understanding of how investment fund boards operate reflected in the prior literature, we develop theory of the role of investment fund boards from the ground up using the voices of fund directors. Grounded theory methodology, the most widely used qualitative approach in the social sciences (Denzin and Lincoln, 1994), was chosen to extend prior theory. We conducted 25 in-depth interviews and a focus group session with investment fund directors applying a grounded theory methodology.

Findings: The most significant finding of our research in terms of Fama and Jensen’s (1983a) seminal paper is the position of power enjoyed by fund promoter organisations. A discussion of fund promoters’ control and monitoring role is absent from Fama and Jensen’s (1983a) conceptualisations on the decision control framework of mutual funds. By excluding fund promoters’ control and monitoring role from their theorising on mutual funds, they ignore the practical realities of how funds operate as identified through our research. Critically, our research has found that many of Fama and Jensen’s (1983a) observations and assumptions on decision management versus decision control support fund promoters’ control and monitoring role. We argue that fund promoters should be identified as decision controllers in the context of the separation of decision management and control that characterises the agency problem in investment funds. Capturing this within a theoretical framework is an important step towards developing a more solid investment fund governance framework. Because of their unique position of power, we find that fund promoter organisations (that establish and attract investors to the funds) exercise control and monitoring roles. As a result, contrary to prior assumptions, oversight is the primary role of investment fund boards, rather than the control role or monitoring role associated with corporate boards. Our findings can be extended to other board-of-director contexts in which boards (e.g., subsidiary boards, boards of state-owned entities) have legal responsibility but limited power because of power exercised by other parties such as large shareholders.

Implications: The unexpected findings of our research challenges the control-role assumptions of prior empirical research on investment fund (and other) boards of directors. Shareholders and regulators generally assume boards exercise control and monitoring roles. This can lead to an expectations gap on the part of shareholders and regulators who may not consider the practical realities in which boards operate. This expectations gap compromises the very objective of governance – investor protection.

References

Daily, C.M., McDougall, P.P., Covin, J.G. and Dalton. D.R. (2002), “Governance and strategic leadership in entrepreneurial firms”, Journal of Management, Vol. 28 No. 3, pp. 387-412.

Dalton, D.R., Hitt, M.A., Certo, S.T. and Dalton, C.M. (2007), “The fundamental agency problem and its mitigation: Independence, equity, and the market for corporate control”, The Academy of Management Annals, Vol. 1 No. 1, pp. 1-64.

Denzin, N. and Lincoln, Y. (1994), Handbook of Qualitative Research, Sage, Thousand Oaks, CA.

Fama, E.F. and Jensen, M.C. (1983a), “Separation of ownership and control”, Journal of Law and Economics, Vol. 26 No. 2, pp. 301-325.

Fama, E.F. and Jensen, M.C. (1983b), “Agency problems and residual claims”, Journal of Law and Economics, Vol. 26 No. 2, pp. 327-349.

Nicholson, G.J. and Kiel, G.C. (2004), “A framework for diagnosing board effectiveness”, Corporate Governance: An International Review, Vol. 12 No. 4, pp. 442-460.

Roberts, J., McNulty, T. and Stiles, P. (2005), “Beyond agency conceptions of the work of the non-executive director: creating accountability in the boardroom”, British Journal of Management, Vol. 16 No. Supplement, pp. S5-S26.

Board of directors, Accountability, Control, Monitoring, Oversight, Power [ view full abstract ]

Board of directors, Accountability, Control, Monitoring, Oversight, Power